Macroeconomic Instability: Unemployment and Inflation Chapter 8

Real GDP How do we compare GDP from one year to the next? Finding a way to make the dollar worth the same from year to year Create a price index

Price Index A measure of the price of a specified collection of goods and services, called a “market basket,” in a given year as compared to the price of an identical collection of goods and services in a reference year

Real GDP GDP Price index = Nominal GDP/Price index (decimal/hundredths form)

(Consumer) Price Index Price of Market Basket in Given Year X Price of Market Basket in Base Period 100

Economic Growth Approximate number of years required to double real GDP: = 70/annual % rate of growth 3%

Business Cycle Peak Recession Trough Recovery

Causes of the Business Cycle Major innovations (railroad, automobile, etc…) cause fluctuations Political events (e.g., war) Monetary: increases/decreases in money supply Psychology—optimism and pessimism Fiscal: changes in government spending and taxes

Noncyclical Fluctuations Changes in business activity not resulting from business cycle: –Pre-Christmas and Pre-Easter Secular Trend: expansion and contraction of business cycle over a long period of years.

Durables/Nondurables Nondurables are “insulated” from most severe effects of recession Durables (e.g., housing, commercial building, heavy capital goods, refrigerators, gas ranges, cars) are most affected due to: Postponability Monopoly power: reluctant to lower prices and set off price war Durables benefit most from expansion

Types of Unemployment

Frictional Unemployment Search unemployment Wait unemployment: temporarily laid off

Structural Unemployment Changes in consumer demand Mismatch between their skills and skills required Geographical mismatch between their location and location of job openings Discrimination

Seasonal Unemployment Jobless during seasons/times of the year

Cyclical Unemployment Caused by lower total spending

Full Employment Unemployment rate Natural rate of unemployment Cyclical unemployment = 0 4-6% Not automatic: It has declined because: Percentage can possibly change over time: 1960s—4%; 1980s—6% Number of younger workers has declined Temporary help agencies Welfare laws require people to work Prison population has increased removing the least employable people

Unemployment Rate (Unemployed/labor force) X 100 Does not measure properly : Underemployment:  Part-time employment  Over-qualified Discouraged Workers: the jobless who have stopped looking for work

Economic Cost of Unemployment

Okun’s Law For every 1 percentage point which the actual unemployment rate exceeds the natural rate, a GDP gap of about 2 percent occurs GDP Gap: amount by which actual GDP falls short of potential GDP

Unequal Burdens of Unemployment Occupation: white collar workers less affected than blue collar workers Age: teenagers more unemployed than adults Race: minorities more unemployed than whites Gender: very similar Education: less educated more unemployed Duration: long-period unemployment (at least 15 weeks) is less than overall unemployment rate, but it rises during recessions

Noneconomic Costs Psychological depression Family problems Sociopolitical unrest

INFLATION

Inflation A general rise in the price level

CPI Consumer Price Index Measures the value of the market basket of goods in a given year compared to its value in the base year ( ) 154 in 1992: prices are 54% higher in 1992 compared to the base year 40 in 1950: prices are 60% lower in 1950 compared to the base year.

Rate of Inflation CPI present – CPI past X 100 CPI past

Rule of 70 Number of years it takes for inflation to double the price level = 70/annual percentage rate of inflation

Causes of Inflation

Demand Pull Inflation Total spending is greater than economy’s capacity to produce Too much spending chasing too few goods

Demand Pull Inflation: Range 1 Output and total spending is relatively low Unemployment high As total spending increases, real domestic output will increase with no change in the price level  Unemployed workers do not ask for salary increases when called back to work

Demand Pull Inflation: Range 2 Prices will rise before full employment is reached since:  Some industries may reach full capacity before others As full employment is reached, firms may hire less qualified workers If unemployment falls below natural rate, inflation increases at a more rapid rate

Demand Pull Inflation: Range 3 firms respond to increases in demand by raising prices

Cost-Push (Supply-Side) Inflation Output and employment declining and prices increasing Per-unit costs increasing Caused by: OPEC  stagflation  Wage-price spiral Rising production costs Wage-push variant: unions set higher wages and set a standard for non-union workers in other firms

Redistribution Effects of Unanticipated Inflation Fixed incomers are hurt  Social Security is not fixed income due to COLAs Savers are hurt Creditors are hurt Debtors benefit because the money they pay back is worth less than the money they borrowed

Inflation Premium Increasing interest rate by the amount of the anticipated inflation Nominal interest rate = real interest rate + inflation premium

Hyperinflation Extremely rapid inflation 828 octillion pengos (1934) = 1 pengo pre-war in Hungary Prices rose 116 times in Japan from 1938 to 1948 Prices rose 1,300,000,000,000 time in Germany in 1923 (butter = 1.5 million marks, postage = 200,000 marks, bread = 200,000 marks, 1 egg = 600,000 marks

Redistribution Effects of Unanticipated Inflation Consumers: real income decreases Poor are more affected by inflation because they spend a greater percentage of their income than wealthier people (regressive)

Deflation A general decline in prices Deflationary expectations can set in: consumers will hold off on certain purchases (especially durables)—AD decreasing Firms will lower prices, which will reinforce deflationary expectations Result in a GDP declining and possibly a recession or even a depression

Problems Text (3, 5, 7, 10) – pg 151