8 - 1 Introduction to Economic Growth and Instability 8 C H A P T E R

8 - 2 INSTRUCTIONAL OBJECTIVES Define two measures of economic growth and explain why growth is a desirable goal. Identify two main sources of growth and explain the “rule of 70.” Explain what is meant by a business cycle and describe its four phases. Describe how innovation and/or random events might cause business cycles. Explain why business cycles affect capital and consumer durable goods industries more than non-durable goods and service industries. Describe how to measure unemployment.

8 - 3 State the causes of frictional, cyclical, and structural unemployment. Identify full employment or the natural rate of unemployment. Identify the economic costs of unemployment and the groups that bear unusually heavy unemployment burdens. Define inflation and list two types of inflation. List three groups who are hurt and two groups who may benefit from unanticipated inflation. Present three possible effects of inflation on output and employment.

8 - 4 How to increase the economy’s productive capacity over time. Two definitions of economic growth: 1.The increase in real GDP, which occurs over a period of time. 2.The increase in real GDP per capita, which occurs over time. ECONOMIC GROWTH

8 - 5 Per-capita GDP = GDP/population (the share of each inhabitant of the GDP on average) This definition is superior if comparison of living standards is desired. e.g., China’s 2001 GDP was $1131 billion compared to Kuwait’s $36 billion, But per capita GDP’s were $890 and $18000 respectively.

8 - 6 Growth in real GDP does not guarantee growth in real GDP per capita. If the growth in population exceeds the growth in real GDP, real GDP per capita will fall (lower standards of living). Expansion of total output relative to population results in: –Rising real wages and income –Higher standards of living

8 - 7 Growth as a Goal Growth is an important economic goal because it means more material abundance and ability to meet the economizing problem. Growth lessens the burden of scarcity. Arithmetic of Growth: Rule of 70 The “rule of 70” uses the absolute value of a rate of change, divides it into 70, to tell us about the number of years it will take for some measure to double (in compound rates).

8 - 8 e.g., If growth rate = 3%. It will take 23 years to double GDP Small changes in the rate of growth are important. If the rate of growth increased to 4%. It will take about 18 years only to double GDP. In USA with a $10 trillion GDP, the difference between the rate of 3% and 4% equals 100 billion (almost 3 times the GDP of Kuwait).

8 - 9 Main sources of growth Sources: Increasing inputs of resources Increasing productivity of resources productivity = real output per unit of input e.g., productivity of labor productivity of labor = real output / No. labor units How can we improve productivity of labor?? Two thirds of growth in USA result from improved productivity. Only one-third of U.S. growth comes from more inputs

The rate of growth of real GDP in Kuwait War and liberation effect

But note that the arithmetic needs to be qualified: a.Growth doesn’t measure quality improvements. b.Growth doesn’t measure increased leisure time. c.Growth doesn’t take into account adverse effects on environment or human security.

International comparisons are useful in evaluating performance. For example, Japan grew more than twice as fast as U.S. until the 1990s when the U.S. far surpassed Japan. There is also some tendency for growth rates to move together, reflecting the interdependence of the global economy.

Overview of the Business Cycle Fluctuations in economic activity Individual cycles vary substantially in duration and intensity: - short cycle - medium cycle - long term cycle

THE BUSINESS CYCLE Phases of the Business Cycle PEAK Level of business activity Time RECESSION TROUGH RECOVERY GROWTH TREND

Four phases of the business cycle are identified over a several ‑ year period. 1.A peak is when business activity reaches a temporary maximum with full employment and near-capacity output. At peak: -Full employment -Real output is close to capacity -Prices increase

A recession is a decline in total output, income, employment, and trade lasting six months or more. It is marked by a widespread concentration of business activity in many sectors of the economy Prices fall only if a depression occurs (many prices are sticky)

A trough (recession or depression) is the bottom of the recession period. Output and employment bottom out at their lowest levels 4.A recovery is when output and employment are expanding toward the full ‑ employment level. Price level may increase before full employment.

There are several theories about causation 1.Momentous innovations: Major innovations may trigger new investment and/or consumption spending. e.g., railroads, automobiles, synthetic fibers and micro- ships, have great impact on investment spending and thus on output, employment and prices. Contribute to variability of economic activity

Changes in productivity may be a related cause: When productivity expands, the economy booms When productivity fall the economy recedes 3.Monetary causes: -Too much money leads to inflationary boom -Too little money triggers recession

Changes in total spending: Most agree that the level of aggregate spending is important, especially changes on capital goods and consumer durables. When total spending sinks, output, income and employment fall. When total spending rises, output, income and employment rise.

Cyclical fluctuations: Durable goods output is more volatile than non-durables and services because spending on latter usually cannot be postponed. Capital goods and consumer durables are affected most. In recession firms delay the purchase of new machines and equipments and consumers repair their old appliances. In booms firms replace their capital and consumers buy new appliances. Nondurable consumer goods are little affected by recessions. They will decline but not so much

Unemployment (One Result of Economic Downturns) The population is divided into three groups: those under age 16: “not potential members of the labor force” homemakers, full time students and retirees: not in labor force. labor force: includes those in age 16 and over who are willing and able to work, and actively seeking work.

The unemployment rate is defined as the percentage of the labor force (not of population) that is not employed. Unemployment rate unemployed labor force x 100 =

In USA the unemployment rate is calculated by random survey of 60,000 households nationwide. Two factors cause the official unemployment rate to understate actual unemployment: a.Part ‑ time workers are counted as “employed.” b.“Discouraged workers” who want a job, but are not actively seeking one, are not counted as being in the labor force, so they are not part of unemployment statistic.

Types of unemployment 1.Frictional unemployment: Workers between jobs. consists of those searching for jobs or waiting to take jobs soon; it is regarded as somewhat desirable, because it indicates that there is mobility as people change or seek jobs. Types: Voluntarily moving from one job to another Fired and seeking another job Housewives who decided to work New graduates looking for jobs for the first time Note: this type of unemployment is inevitable

Structural unemployment is due to changes in the structure of demand for labor; e.g., when certain skills become obsolete or geographic distribution of jobs changes. e.g. in USA, Glass blowers were replaced by bottle-making machines. Airline mergers displaced many airline workers in 1980s. Foreign competition has led to downsizing in U.S. industries and a loss of jobs. Military cutbacks have led to displacement of workers in military-related industries.

Difference between frictional and structural is that frictional unemployed have salable skills. Structurally unemployed will find it difficult to find a job

Cyclical unemployment is caused by the recession phase of the business cycle, which is sometimes called deficient demand unemployment. When demand for goods and services falls, employment falls and unemployment increases. It is sometimes not clear which type describes a person’s unemployment circumstances.

Definition of “Full Employment” 1.Frictional unemployment is unavoidable, hence, full employment is something less than 100%. Full employment does not mean zero unemployment. 2.The full ‑ employment unemployment rate is equal to the total of frictional and structural unemployment. 3.The full ‑ employment rate of unemployment is also referred to as the natural rate of unemployment NRU.

The natural rate is achieved when labor markets are in balance; the number of job seekers equals the number of job vacancies. Hence at NRU the economy is producing its potential output The number of job seekers equals the number of jobs offered Note: It is not necessary that the economy will work at NRU. At times of recession unemployment will be greater than NRU.

The natural rate of unemployment is not fixed, but depends on the demographic makeup of the labor force and the laws and customs of the nations. Recently in USA the natural rate has dropped from 6% to 4 or 5%. This is attributed to: a.The aging of the work force as the baby boomers approach retirement. b.Improved job information through the Internet and temporary-help agencies. c.The doubling of the U.S. prison population since 1985.

Economic cost of unemployment 1.Foregone output. Failure to create enough jobs leads to loss of potential output (NRU). This is measured by GDP gap. the GDP gap is the difference between potential and actual GDP. GDP gap = Actual GDP - Potential GDP GDP gap and Okun’s Law: Economist Arthur Okun quantified the relationship between unemployment and GDP as follows: For every 1 percent of unemployment above the natural rate, a negative GDP gap of 2 percent occurs. This is known as “Okun’s law.”

Unequal Burdens: Burden of unemployment is unequally distributed. Occupations: workers in lower skilled occupations have higher unemployment rates than higher skilled workers Age: Teenagers have much higher unemployment rates than adults (less skills and less experience). Race and ethnicity: rate is high among blacks, Hispanics and emigrants. Education: rate is higher among less educated.

Non-economic costs Loss of skills Loss of self respect Plummeting morals Family disintegration Societal unrest Racial and ethnic tensions Other diseases include suicide, homicide, fatal heart attacks and mental illness.

France U.K. Germany U.S. Japan GLOBAL PERSPECTIVE Unemployment Rates 5 Industrial Nations Source: Economic Report of the President, 2003

Task 2: UNEMPLOYMENT IN KUWAIT Visit:

Inflation: Defined and Measured Definition: Inflation is continuous rise in the general level of prices. - a continuous rise. A one shot rise in the price level is not inflation (price rise) - the general price level It is not necessary that all prices must increase at the same time. During inflation some prices can go down (e.g., computers)

The main index used to measure inflation is the Consumer Price Index (CPI). Measuring Inflation: the percentage change in CPI  2002 CPI = 123  2003 CPI – 127  Inflation = (( )/123)% = 3.25% The “rule of 70” permits quick calculation of the time it takes the price level to double: Divide 70 by the percentage rate of inflation and the result is the approximate number of years for the price level to double. If the inflation rate is 7 percent, then it will take about ten years for prices to double.

Inflation in Kuwait Average inflation in Kuwait = 1.5% Other Nations in 2002 –Romania – 23% –Belarus – 43% –Turkey – 45% –Myanmar – 57%

France Italy Germany U.S. Japan Source: Bureau of Labor Statistics GLOBAL PERSPECTIVE Inflation Rates in Five Industrial Nations

Causes and theories of inflation Demand ‑ pull inflation: Spending increases faster than production. It is often described as “too much spending chasing too few goods.”

Increases in Total Spending Price level Real domestic output & employment Q P Q f Range 1 Range 2 Range 3 Full- employment output DEMAND-PULL INFLATION

Range 1: output is low relative to potential output -Unemployment is high -significant output gap When total spending increases, real output will increase and unemployment falls. There will be little or no effect on the price level. Range 2: output continues to expand in response to further spending and reaches full employment. Price level increases even before full employment.

Labor costs go up as demand for labor increases -Other input costs go up as demand for them increases. -Industries reach their full capacity, full employment output (NRU). -With increasing demand for resources households may supply extra resources, e.g., teenagers labor. Unemployment rate will be less than NRU. -Actual GDP exceeds potential GDP.

Range 3: total spending increases and the economy cannot supply resources. -Real GDP reaches its maximum -Any increase in total spending will raise the price up. -No increases in output to absorb increased spending -Demand pull inflation

Cost ‑ push or supply ‑ side inflation: Prices rise because of a rise in per-unit production costs. Per unit cost = total input cost/units of output. Rising costs squeeze profits and reduce output firms are willing to produce at current prices. Supply of goods decreases and prices go up

Note a.Output and employment decline while the price level is rising. b.Supply shocks (due to higher cost of inputs) have been the major source of cost-push inflation. These typically occur with dramatic increases in the price of raw materials or energy.

Redistributive effects of inflation Nominal and real income Nominal income is the number of KDs received as wages, rent, interest and profits Real income is a measure of the amounts of goods and services income can buy. Therefore; Real income = nominal income / price level % change in real income = % change in nominal income – percentage change in price level

What if: Inflation is 6% and nominal income increased by 6%? Inflation is 6% and nominal income increased by 10%? Inflation may reduce the real income of individuals in the economy, but won’t necessarily reduce real income for the economy as a whole (someone receives the higher prices that people are paying).

Anticipated and unanticipated inflation. Unanticipated inflation has stronger impacts; those expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects. Who is hurt by inflation: 1- fixed income receivers like -Pensioners -Landlords

Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power. e.g., -A 1000 CD with a 6% interest and inflation 13%, after one year -Nominal value = Real value = (1060/1.13) = 938

Debtors (borrowers) can be helped and lenders are hurt by unanticipated inflation. Interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” money that have less purchasing power for the lender. If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders.

“Inflation premium” is amount that the interest rate is raised to cover effects of anticipated inflation. “Real interest rate” is defined as nominal rate minus inflation premium.

Nominal Interest Rate Real Interest Rate Inflation Premium = 11% 5% 6% + ANTICIPATED INFLATION

Output Effects of Inflation A. Cost ‑ push inflation, where resource prices rise unexpectedly, could cause both output and employment to decline. Real income falls. B. Mild inflation (<3%) has uncertain effects. It may be a healthy by-product of a prosperous economy, or it may have an undesirable impact on real income. C. Danger of creeping inflation turning into hyperinflation, which can cause speculation, reckless spending, and more inflation

LAST WORD: The Stock Market and The Economy: How, if at all, do changes in stock prices relate to macroeconomic stability? Do changes in stock prices and stock market wealth cause instability? The answer is yes, but usually the effect is weak. There is a wealth effect: Consumer spending rises as asset values rise and vice versa if stock prices decline substantially.

Also, there is an investment effect: Rising share prices lead to more capital goods investment and the reverse in true for falling share prices. Stock market “bubbles” can hurt the economy by encouraging reckless speculation with borrowed funds or savings needed for other purposes. A “crash” can cause unwarranted pessimism about the underlying economy.