Chapter Ten Economic Growth and Business Cycles

Copyright © Houghton Mifflin Company. All rights reserved.10 | 2 A long-run trend in real GDP growth is easily discernible, although erratic Trends in Economic Growth

Copyright © Houghton Mifflin Company. All rights reserved.10 | 3 Economic growth is important because it is the primary cause of increased living standards The trend in economic growth has differed across historical periods Measuring Economic Growth

Copyright © Houghton Mifflin Company. All rights reserved.10 | 4 If we can understand the variables that cause economic growth, we may be able to enact policies to encourage such Studying growth is easier said than done! The study is difficult for many reasons –Measurements are inaccurate –Depreciation is difficult to estimate precisely –Difficult to measure the quality of capital goods accurately Why Study Economic Growth?

Copyright © Houghton Mifflin Company. All rights reserved.10 | 5 Labor is measured both in terms of how many people work, and for how long Labor force = employed people + unemployed people The labor force is not the whole population, as only members of the working-age population who are actively seeking employment are counted Thus the labor-force participation rate is the most useful measure, as it tells is what percentage of the population is engaged in work Economic Growth & Labor

Copyright © Houghton Mifflin Company. All rights reserved.10 | 6 The labor-force participation rate has been fairly steady, except from the mid-1960s to the early 1990s Economic Growth & Labor (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.10 | 7 The working-age population is further divided into those in and out of the labor force. The labor force is then divided between the employed and unemployed Economic Growth & Labor (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.10 | 8 The unemployment rate is the number of unemployed workers as a fraction of the overall labor force The Unemployment Rate

Copyright © Houghton Mifflin Company. All rights reserved.10 | 9 The actual amount of work provided by employed workers depends not just on the number of workers, but also on the number of hours they work Hours Worked

Copyright © Houghton Mifflin Company. All rights reserved.10 | 10 Labor Productivity Labor productivity measures the average amount of output produced per worker Productivity gains enable to economy to enjoy more goods and services, even with fewer hours worked

Copyright © Houghton Mifflin Company. All rights reserved.10 | 11 The table suggests that changes in labor productivity growth are the driving force behind overall growth. It does not, however, tell us the reasons behind the productivity gains Labor Productivity (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.10 | 12 Again, an overall trend that is upward, yet slightly erratic, can be seen. Productivity gains result in higher standards of living for members of the economy Labor Productivity (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.10 | 13 Labor is not the only factor of production that can lead to productivity gains Capital (i.e., buildings, equipment, etc.) entrepreneurs, etc. can also contribute Unfortunately, capital is difficult to quantify Contributions of Labor AND Capital

Copyright © Houghton Mifflin Company. All rights reserved.10 | 14 Economists use total factor productivity (TFP) to measure contributions to productivity beyond only those of labor and capital. TFP estimates the contributions of the quantity of capital (K) and the quantity of labor (L) and solves for the remainder. Total Factor Productivity

Copyright © Houghton Mifflin Company. All rights reserved.10 | 15 TFP & Output Growth Increases in growth rates of just labor or just capital do not have the same effect on the overall growth rate TFP calculations account for not just hours worked, but also for the quality of those hours

Copyright © Houghton Mifflin Company. All rights reserved.10 | 16 Changes in TFP growth parallel those changes in labor productivity growth, suggesting the same factors are responsible for both measures TFP & Output Growth (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.10 | 17 Business cycles are short-term fluctuations in the economy based on the movement of key economic variables Business cycles are a repetition of four phases –Expansion: A period of rising income, output, and employment –Peak: The end of an expansionary period, when the above variables begin to decline –Recession: A period of declining income, output, and employment –Trough: The end of a recessionary period, when the above variable once again begin to increase Business Cycles

Copyright © Houghton Mifflin Company. All rights reserved.10 | 18 Over the course of the business cycle, economic growth (as measured by output) varies around its long-term trend Business Cycles (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.10 | 19 Actual data supports the business cycle. While all three periods experienced both expansions and recessions, the most (and longest) recessions occurred during the reorganization period Business Cycles (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.10 | 20 The National Bureau of Economic Research (NBER) announces business cycle phases after the fact. The NBER defines a recession as lasting more than one quarter Business Cycles (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.10 | 21 Many economic variables move together over the business cycle, such as output growth and unemployment Business Cycles (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.10 | 22 While not definitive, some of the causes of business cycles may be 1.Erratic growth of the nation’s money supply 2.Swings of optimism and pessimism that cause investment in capital goods to fluctuate 3.Sudden changes in productivity growth 4.Changes in the prices of key factors of production The Causes of Business Cycles

Copyright © Houghton Mifflin Company. All rights reserved.10 | 23 Led by Milton Friedman, the monetarists believe that the money supply should be directed to grow formulaically The most compelling argument for monetarism is the sharp decline in the money supply during the Depression Opponents argue that while money indeed affects prices and inflation, it is not so significant as to cause fluctuations in the business cycle The Monetarists

Copyright © Houghton Mifflin Company. All rights reserved.10 | 24 Based on the work of John Maynard Keynes, the Keynesians believe that changes in aggregate demand are the main cause of business cycles Because wages and prices are “sticky”, the economy is unable to return to macroeconomic equilibrium immediately Opponents argue that it is less costly to adjust wages or prices than to lay off workers, so wage and price stickiness could not influence the business cycle The Keynesians

Copyright © Houghton Mifflin Company. All rights reserved.10 | 25 Based on the work of Edward Prescott, RBC theory states that changes in the business cycle are brought about by productivity shocks Productivity is susceptible to many sudden changes, or shocks, which may explain up to 70% of business cycle fluctuations Opponents argue that what RBC theorists dub productivity shocks are not changes in productivity at all, but rather simple responses to changes in product demand The Real Business Cycle Theorists

Copyright © Houghton Mifflin Company. All rights reserved.10 | 26 Business cycles may be caused by abrupt changes in the price of productive resources, especially oil Economists are unsure whether the relationship between oil prices and business cycle phases is one of causation, or only correlation Changing Resource Prices

Copyright © Houghton Mifflin Company. All rights reserved.10 | 27 When the economy’s output is higher, someone must be earning more income…Why not you??? The table shows that workers’ compensation tends to grow alongside productivity gains Economic Growth & Income Potential