26 Introduction to Economic Growth and Instability

 The Business Cycle and its Primary Phases  How Economic Growth is Measured and Why is it Important  How Unemployment and Inflation are Measured  The Types of Unemployment and Inflation and their Various Economic Impacts

 Increase in Real GDP  Increase in Real GDP Per Capita  Growth as a Goal

 What is scarcity?  How can growth help overcome it ?  An economy experiencing economic growth is better able to meet people’s wants and resolve socioeconomic problems  A growing economic, unlike a static economy, can consume more today while increasing its capacity to produce more in the future!!!

 Mathematical approximation of the effect of growth  Approximate number of years required to double GDP = 70/ (annual percentage rate of growth)

1. Increasing its inputs of resources 2. Increasing productivity of inputs  Productivity (real output per unit of input) rises by increasing health, sanitation, training, education, motivation etc

 Does growth take place persistently?  Case of Pakistan: episodic growth between  Now?  Phases of economic growth/ activity are characterized as business cycles

 Business cycle is the alternate rise and decline in the level of economic activity, sometimes over several years

 Peak: temporary maximum in activity. Economy is near or at full employment, and the level of real output is at or very close to the economy’s capacity. Price level is likely to rise  Recession: a period of decline in total output, employment, trade, income.  Trough: bottom lowest in the temporary cycle  Recovery: rise in output and employment towards full employment. A recession is usually followed by a recovery and expansion

Level of Real Output Time Peak Recession Expansion Trough Growth Trend Phases of the Business Cycle Cyclical Impact: Durables and Nondurables

 Causes of business cycles  Shocks to the economy  Changes in productivity  changes in spending levels  Growth trend is the overall trend of the business cycles  Expansionary  Contractionary

 Who is affected the most through a cycle?  Capital goods/ consumer durables can be put off to a later date e.g. car industry in the US  Whereas,  Non-durable consumer goods (services) harder to remove oneself from e.g. medical, legal services  Twin Problems of the Business Cycle  Unemployment  Inflation

Under 16 And/or Institutionalized (70.5 Million) Labor Force, Employment, and Unemployment, 2005 Total Population (296.6 Million) Not in Labor Force (76.8 Million) Employed (141.7 Million) Labor Force (149.3 Million) Unemployed (7.6 Million)

 Measurement of Unemployment  Labor Force  Unemployment Rate  Part-Time Employment  Discouraged Workers Unemployment Rate Unemployed Labor Force = x 100

 Those part of the labor force which are not employed  must be actively seeking work to be considered unemployed  Unemployment rate = unemployed * 100 labor force

1. Frictional  In search of employment  In between jobs, fresh graduates 2. Structural  Changes in consumer preferences, consumer demand and in technology e.g hand made products  Structurally unemployed find hard to obtain new jobs without retraining, additional education or relocating 3. Cyclical  Caused by changes in spending, less demand and less income causes higher unemployment e.g. Credit Crunch Typically begins in the recession phase of the business cycle

 The maximum population that can be employed at a time (considering only structural and frictional unemployment)  Natural Rate of Unemployment (NRU)  unemployment rate at full employment level. When number of job seekers equal the number of job vacancies. This is always a positive percentage.

 Economic Cost of Unemployment  Potential Output  GDP Gap and Okun’s Law GDP Gap Actual GDPPotential GDP = -

 Large unemployment has costs  Causes a GDP gap The amount by which actual GDP falls short of potential GDP (at full employment levels) Okun’s law: for every 1percentage point unemployment rises above NRU  a GDP gap of 2 percent occurs  Cost of unemployment is unequally distributed  Different groups experience different unemployment rates

 Unemployment varies by  Occupation  Age  Race and ethnicity  Gender  Education  Duration  Non-economic costs:  depression, socio-political unrest, lowering morale, poverty, ethnic and racial tension

 Rise in the general level of prices  Each dollar buys fewer goods and services  Reduces the purchasing power of money

Price indices  Consumer price index Each month or each year Market basket of some 300 consumer goods and services CPI Price of the Most Recent Market Basket in the Particular Year Price of the Same Market Basket in = x 100

 Demand-pull  Excess of total spending beyond the economy’s capacity to produce  Excess demand for goods, can push up prices  “too much spending chasing too few goods”  Cost-push  Supply or cost side of economy  Rising per-unit production costs  Reduces profits and thus reduces output  Prices rise  Also known as supply shocks

 Inflation hurt some people, leaves others unaffected, and actually helps still others  Anticipations Anticipated Inflation, avoid or lesson effects of inflation Unanticipated Inflation( not expected)

 Nominal vs. Real income Nominal income is the number of dollars received as wages, rent, interest, profits  Real income = Nominal income / price index Real income is measures the amount of goods & services nominal income can buy. It is the purchasing power of nominal income % change in real income = % change in nominal income - % change in price level

 Who is Hurt by Inflation?  Fixed-Income Receivers  Savers  Creditors  Who is Unaffected or Hurt by Inflation?  Flexible-Income Receivers Cost-of-Living Adjustments (COLAs)  Business  Debtors

 Deflation: the effects of unanticipated declines in the price level. People with fixed nominal incomes will benefit. Creditors and Savers will benefit.  Hyperinflation is extraordinarily rapid inflation. Money loses its value and status as medium of exchange

 Anticipated Inflation  Nominal Interest Rate  Real Interest Rate  Inflation Premium Nominal Interest Rate Real Interest Rate Inflation Premium 11% 5% 6% =+

Basic Macroeconomic Relationships