Economic Growth and Instability

Economic Growth How to increase the economy’s productive capacity over time Two definitions of economic growth: Two definitions of economic growth: The increase in real GDP, which occurs over a period of time.The increase in real GDP, which occurs over a period of time. The increase in real GDP per capita, which occurs over timeThe increase in real GDP per capita, which occurs over time This is superior if comparison of living standards is desired This is superior if comparison of living standards is desired

Growth in real GDP does not guarantee growth in real GDP per capita Growth in real GDP does not guarantee growth in real GDP per capita If growth in population exceeds the growth in real GDP, real GDP per capita will fall.If growth in population exceeds the growth in real GDP, real GDP per capita will fall. Growth is an important economic goal because it means more material abundance and ability to meet the economizing problem 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.Growth lessens the burden of scarcity.

Using the “Rule of 70,” a growth rate of 2% annually would take 35 years for GDP to double, but a growth rate of 4% annually would only take about 18 years for GDP to double. Using the “Rule of 70,” a growth rate of 2% annually would take 35 years for GDP to double, but a growth rate of 4% annually would only take about 18 years for GDP to double. Rule of 70: Uses the absolute value of a rate change, divides it into 70, and the result is the number of years it takes the underlying quantity to double Rule of 70: Uses the absolute value of a rate change, divides it into 70, and the result is the number of years it takes the underlying quantity to double

Main sources of growth: Main sources of growth: Increasing inputsIncreasing inputsOR increasing productivity of existing inputsincreasing productivity of existing inputs About 1/3 of U.S. growth comes from more inputs About 1/3 of U.S. growth comes from more inputs About 2/3 comes from increased productivity. About 2/3 comes from increased productivity.

Growth doesn’t measure quality improvements Growth doesn’t measure quality improvements Growth doesn’t measure increased leisure time Growth doesn’t measure increased leisure time Growth doesn’t take into account adverse effects on environment or human security Growth doesn’t take into account adverse effects on environment or human security International comparisons are useful in evaluating U.S. performance International comparisons are useful in evaluating U.S. performance

Overview of the Business Cycle Historical Record Historical Record The U.S. impressive long-run economic growth has been interrupted by periods of instability.The U.S. impressive long-run economic growth has been interrupted by periods of instability. Uneven growth has been the pattern Uneven growth has been the pattern with inflation often accompanying rapid growthwith inflation often accompanying rapid growth and declines in employment and output during periods of recession and depressionand declines in employment and output during periods of recession and depression

Overview of Business Cycle Four phases of the business cycle are identified over a several-year period: Four phases of the business cycle are identified over a several-year period: Peak – When business activity reaches a temporary maximum with full employment and near-capacity output.Peak – When business activity reaches a temporary maximum with full employment and near-capacity output. Recession – A decline in total output, income, employment, and trade lasting six months or moreRecession – A decline in total output, income, employment, and trade lasting six months or more Trough – The bottom of the recession period.Trough – The bottom of the recession period. Recovery – When output and employment are expanding toward the full-employment levelRecovery – When output and employment are expanding toward the full-employment level

Several Theories About Causation Major innovations may trigger new investment and/or consumption spending Major innovations may trigger new investment and/or consumption spending Changes in productivity may be a related cause. Changes in productivity may be a related cause. Most agree that the level of aggregate spending is important, especially changes on capital goods and consumer durables. Most agree that the level of aggregate spending is important, especially changes on capital goods and consumer durables.

Cyclical Fluctuations: Durable goods output is more volatile than non-durables and services Durable goods output is more volatile than non-durables and services This is because spending on services usually cannot be postponed. This is because spending on services usually cannot be postponed.

Unemployment One Result of Economic Downturn Population is divided into three groups: Population is divided into three groups: Those under age 16 or institutionalizedThose under age 16 or institutionalized Those not in the workforce.Those not in the workforce. The labor force that includes those age 16 and over who are willing and able to work, and actively seeking work (demonstrated job search activity within the last four weeks)The labor force that includes those age 16 and over who are willing and able to work, and actively seeking work (demonstrated job search activity within the last four weeks)

Unemployment Rate Defined as the percentage of the labor force that is not employed Defined as the percentage of the labor force that is not employed Note: NOT the percentage of populationNote: NOT the percentage of population The unemployment rate is calculated by random survey of 60,000 households nationwide. The unemployment rate is calculated by random survey of 60,000 households nationwide. Households are in survey for four months, out for eight, back in for four, and then our for goodHouseholds are in survey for four months, out for eight, back in for four, and then our for good Interviewers use the phone or home visits using laptops.Interviewers use the phone or home visits using laptops.

Unemployment Rate Two factors cause the official unemployment rate to understate actual unemployment Two factors cause the official unemployment rate to understate actual unemployment Part-time workers are counted as “employed”Part-time workers are counted as “employed” “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.“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 Frictional Frictional Structural Structural Cyclical Cyclical

Full Employment Full employment does not mean zero unemployment Full employment does not mean zero unemployment The full-employment unemployment rate is equal to the total of frictional and structural unemployment The full-employment unemployment rate is equal to the total of frictional and structural unemployment The full-employment rate of unemployment is also referred to as the “natural” rate of unemployment The full-employment rate of unemployment is also referred to as the “natural” rate of unemployment

Natural Rate of Unemployment Achieved when labor markets are in balance; The number of job seekers equals the number of job vacancies Achieved when labor markets are in balance; The number of job seekers equals the number of job vacancies At the end of the last century the economy’s potential output was being achieved. At the end of the last century the economy’s potential output was being achieved.

Natural Rate of Unemployment The recent drop in the natural rate from 6% to 4 or 5% has occurred mainly because The recent drop in the natural rate from 6% to 4 or 5% has occurred mainly because the aging of the work forcethe aging of the work force Improved information flows in job marketsImproved information flows in job markets Work requirements enacted with welfare reformWork requirements enacted with welfare reform Doubling of the U.S. prison population since 1985.Doubling of the U.S. prison population since 1985.

Natural rate of unemployment not fixed but depends on the demographic makeup of the labor force and the laws and customs of the nations. Natural rate of unemployment not fixed but depends on the demographic makeup of the labor force and the laws and customs of the nations.

Economic Cost of Unemployment GDP gap and Okun’s Law: GDP gap and Okun’s Law: The GDP gap is the difference between potential and actual GDP. The GDP gap is the difference between potential and actual GDP. Economist Arthur Okun quantified the relationship between unemployment and GDP as follows: Economist Arthur Okun quantified the relationship between unemployment and GDP as follows: For every 1% of unemployment above the natural rate, a negative GDP gap of 2% occurs.For every 1% of unemployment above the natural rate, a negative GDP gap of 2% occurs. This is known as “Okun’s Law.”This is known as “Okun’s Law.”

Unequal Burdens of Unemployment Rates are lower for white-collar workers Rates are lower for white-collar workers Teenagers have the highest rates Teenagers have the highest rates Blacks have higher rates than whites Blacks have higher rates than whites Rates for males and females are comparable, though females had a lower rate in 2002 Rates for males and females are comparable, though females had a lower rate in 2002 Less-educated workers, on average, have higher unemployment rates than workers with more education. Less-educated workers, on average, have higher unemployment rates than workers with more education.

Non-Economic Costs Loss of self-respect and social political unrest Loss of self-respect and social political unrest International comparisons International comparisons

Inflation – Defined and Measured Inflation – a rising general level of prices (not all prices rise at the same rate, and some may fall). Inflation – a rising general level of prices (not all prices rise at the same rate, and some may fall). Main Index used to measure inflation: Consumer Price Index (CPI). Main Index used to measure inflation: Consumer Price Index (CPI). The “Rule of 70” permits quick calculation of the time it takes the price level to double The “Rule of 70” permits quick calculation of the time it takes the price level to double

Facts of Inflation In the past, deflation has been as much a problem as inflation. In the past, deflation has been as much a problem as inflation. 1930s, the depression was a period of declining prices and wages 1930s, the depression was a period of declining prices and wages Prospect of deflation is a recent concern of economic policymakers Prospect of deflation is a recent concern of economic policymakers All industrial nations have experienced the problem All industrial nations have experienced the problem Some nations experience astronomical rates of inflation (Angola’s was 4,145% in 1996) Some nations experience astronomical rates of inflation (Angola’s was 4,145% in 1996)

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

Causes and Theories of Inflation Cost-push Inflation (or supply-side inflation): Cost-push Inflation (or supply-side inflation): Prices rise because of a rise in per-unit production costs (Unit cost = total input cost/units of output).Prices rise because of a rise in per-unit production costs (Unit cost = total input cost/units of output). Output and employment decline while the price level is rising.Output and employment decline while the price level is rising. Supply shocks have been the major source of cost-push inflation.Supply shocks have been the major source of cost-push inflation. These typically occur with dramatic increases in the price of raw materials or energy.These typically occur with dramatic increases in the price of raw materials or energy.

Complexities Difficult to distinguish between demand-pull and cost-push causes of inflation Difficult to distinguish between demand-pull and cost-push causes of inflation although cost-push will die out in a recession if spending does not also rise.although cost-push will die out in a recession if spending does not also rise.

Redistribution Effects of Inflation Price index is used to deflate nominal income into real income Price index is used to deflate nominal income into real income 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). 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).

Redistribution Effects of 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. Unanticipated inflation has stronger impacts: those expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects.

Redistribution Effects of Inflation Fixed income groups will be hurt because their real income suffers. Their nominal income does not rise with prices. Fixed income groups will be hurt because their real income suffers. Their nominal income does not rise with prices. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Their savings will lost purchasing power.Their savings will lost purchasing power.

Redistribution Effects of Inflation Debtors (borrowers) can be helped and lenders can be hurt by unanticipated inflation. Debtors (borrowers) can be helped and lenders can be hurt by unanticipated inflation. Interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” dollars that have less purchasing power for the lender.Interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” dollars that have less purchasing power for the lender.

Redistribution Effects of Inflation 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. 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.

Redistribution Effects of Inflation Inflation Premium: The amount that the interest rate is raised to cover effects of anticipated inflation. Inflation Premium: The amount that the interest rate is raised to cover effects of anticipated inflation. Real interest rate – nominal rate minus inflation premium Real interest rate – nominal rate minus inflation premium

Final Points Unexpected deflation is a decline in price level and will have the opposite effect of unexpected inflation. Unexpected deflation is a decline in price level and will have the opposite effect of unexpected inflation. Many families are simultaneously helped and hurt by inflation because they are both borrowers and earners and savers. Many families are simultaneously helped and hurt by inflation because they are both borrowers and earners and savers. Effects of inflation are arbitrary, regardless of society’s goals. Effects of inflation are arbitrary, regardless of society’s goals.

Output Effects of Inflation Cost-push inflation, where resource prices rise unexpectedly, could cause both output and employment to decline. Real income falls. Cost-push inflation, where resource prices rise unexpectedly, could cause both output and employment to decline. Real income falls. Mild inflation (<3%) has uncertain effects. Mild inflation (<3%) has uncertain effects. It may be a health by-product of a prosperous economy, or it may have an undesirable impact on real income.It may be a health by-product of a prosperous economy, or it may have an undesirable impact on real income.

Output Effects of Inflation Danger of creeping inflation turning into hyperinflation can cause: Danger of creeping inflation turning into hyperinflation can cause: SpeculationSpeculation Reckless spendingReckless spending More inflationMore inflation

The Stock Market and the Economy Do changes in stock prices and stock market wealth cause instability? Do changes in stock prices and stock market wealth cause instability? Yes. But usually the effect is weak.Yes. But usually the effect is weak. There is the wealth effect: There is the wealth effect: Consumer spending rises as asset values rise and vice versa if stock prices decline substantially.Consumer spending rises as asset values rise and vice versa if stock prices decline substantially.

The Stock Market and The Economy Investment Effect Investment Effect Rising share prices lead to more capital goods investment and the reverse is true for falling share pricesRising share prices lead to more capital goods investment and the reverse is 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) 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)

The Stock Market and The Economy Stock price averages are included as a “Leading Indicator” used to forecast the future direction of the economy Stock price averages are included as a “Leading Indicator” used to forecast the future direction of the economy By themselves, stock values are not a reliable predictor of economic conditions. By themselves, stock values are not a reliable predictor of economic conditions.