1. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Growth, Business Cycles, Unemployment, and Inflation Chapter 22

2. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve An Indian-born economist once explained his personal theory of reincarnation to his graduate economics class.

3. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve “If you are a good economist, a virtuous economist,” he said, “you are reborn as a physicist.” “But if you are an evil, wicked economist, you are reborn as a sociologist.”

4. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n Macroeconomics is the study of the aggregate moods of the economy. n The four central problems are growth, business cycles, unemployment, and inflation.

5. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Two Frameworks: The Long Run and the Short Run n Issues of growth are considered in a long- run framework. n Business cycles are generally considered in a short-run framework. n Inflation and unemployment fall within both frameworks.

6. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Growth n The primary measurement of growth is changes in real gross domestic product. n Real gross domestic product (real GDP) – the market value of goods and services stated in the prices of a given year.

7. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Growth n The U.S. secular growth rate is between 2.5 to 3.5 percent per year.

8. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Growth n Per capita real output growth has been 2.5 to 3.5 percent per year. n Per capita real output is real GDP divided by the total population.

9. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Global Experience with Growth n Today's growth rates are high by historical standards. n The range of growth rates among nations is wide. n African countries have consistently grown below the world average.

10. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Global Experience with Growth n The growth trend we now take for granted started at the end of the of the18th century. n At about the same time, markets and democracies became the primary organizing structures of society.

11. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Benefits and Costs of Growth n Per capita economic growth allows everyone in society, on average to have more. n Growth, or predictions of growth, allows governments to avoid hard questions.

12. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Benefits and Costs of Growth n The costs of growth include pollution, resource exhaustion, and destruction of natural habitat.

13. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Business Cycles n The business cycle is the upward and downward movement of economic activity that occurs around the growth trend.

14. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Business Cycles n There are a number of policies regarding business cycles. n Classical economists generally favor laissez-faire or noninterventionist policies. n Keynesians generally favor activist policies.

15. U. S. Business Cycles McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Civil War Recovery of 1895 World War I Panic of 1893 Panic of 1907 Great Depression Korean War Vietnam War World War II

16. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Phases of the Business Cycle n The peak is the top of the business cycle. n A boom is a very high peak, representing a big jump in output. n The downturn is the phenomenon of economic activity starting to fall from a peak.

17. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Phases of the Business Cycle n A recession is a decline in output that persists for more than two consecutive quarters in a year. n A depression is a large recession. n A trough is the bottom of the recession or depression.

18. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Phases of the Business Cycle n An expansion is an upturn that lasts at least two consecutive quarters of a year.

19. Expansion Recession The Phases of the Business Cycle Boom Secular growth trend Downturn Upturn Trough Peak 0 Jan.- Mar Total Output Apr.- June July- Sept. Oct.- Dec. Jan.- Mar Apr.- June July- Sept. Oct.- Dec. Jan.- Mar Apr.- June McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

20. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Do Business Cycles Occur n Recessions and expansions are caused primarily by demand-side of the economy. n A debate exists about whether these fluctuations can and should be reduced.

21. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Do Business Cycles Occur n Most economists believe that potential depressions should be offset by economic policy.

22. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Do Business Cycles Occur n Since the late 1940s, compared to prior years: l Downturns and panics have generally been less severe. l The duration of business cycles has increased. l The average length of expansions has increased while the average length of contractions has decreased.

23. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Do Business Cycles Occur n Most economists believe that business fluctuations have become less severe because of the stronger role of government in the economy.

24. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Leading Indicators n Leading indicators tell us what's likely to happen in the economy 12 to 15 months from now.

25. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Leading Indicators n Leading indicators include the following: l Average workweek for production workers in manufacturing. l Unemployment claims. l New orders for consumer goods and materials.

26. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Leading Indicators n Leading indicators include the following: l Vendor performance, measured as a percentage of companies reporting slower deliveries from suppliers. l Index of consumer expectations. l New orders for plant and equipment.

27. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Leading Indicators n Leading indicators include the following: l Number of new building permits issued for private housing units. l Change in stock prices. l Interest rate spread. l Changes in the money supply.

28. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment n The unemployment rate is the number of people who are willing and able to work but are not working.

29. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment n Cyclical unemployment is that which results from fluctuations in economic activity. n Structural unemployment is that caused by economic restructuring making some skills obsolete.

30. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment as a Social Problem n The Industrial Revolution created the possibility of cyclical unemployment. n It brought a change in how families dealt with unemployment. n What had previously been a family problem, became a social problem.

31. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment as Government’s Problem n As capitalism evolved, capitalist societies no longer saw the fear of hunger as an acceptable answer to unemployment.

32. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment as Government’s Problem n Full employment – an economic climate in which just about everyone who wants a job can have one.

33. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment as Government’s Problem n Frictional unemployment is the unemployment caused by: l New entrants into the job market, and l People quitting a job just long enough to look for and find another one.

34. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment as Government’s Problem n The target rate of unemployment is the lowest sustainable rate of unemployment that policymakers believe is achievable under existing conditions. n It is sometimes called the natural rate of unemployment.

35. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment as Government’s Problem n In the 1980s and 1990s, the target rate of unemployment was been between 5 and 7 percent. n Today, the target rate of unemployment is about 5 percent.

36. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why the Target Rate of Unemployment Changed n In the 1970s and early 1980s, a low inflation rate seemed to be incompatible with a low unemployment rate. n Demographics have changed – different age groups have different rates of unemployment.

37. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why the Target Rate of Unemployment Changed n Social and institutional structures have changed. n Governmental institutions also changed.

38. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Whose Responsibility Is Unemployment? n Classical economists believe that individuals are responsible for their own jobs. n Keynesian economists tend to say that society owes people jobs commensurate with their training or past job experience.

39. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. How Is Unemployment Measured? n The unemployment rate is published by the U.S. Department of Labor's Bureau of labor Statistics.

40. Unemployment Rate Since 1900 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 30 20 10 0 19101920 1940 19501960198019902000201019701930 Target rate

41. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating the Unemployment Rate n The unemployment rate – the number of unemployed individuals divided by the number of people in the civilian labor force then multiplied by 100.

42. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating the Unemployment Rate n The labor force – those people in an economy who are willing and able to work. n The labor force excludes those incapable of working and those not looking for work.

43. Unemployment/Employment Figures (in millions) Total civilian population (288.4 million) Noninstitutional population (214.0 million)Labor force (142.5 million) Employed (134.3 million) Not in labor force (71.4 million) Unemployed (8.3 million) Incapable of working (74.4 million) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

44. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. How Accurate Is the Official Unemployment Rate? n The unemployment rate does not include discouraged workers. n Discouraged workers – people who do not look for a job because they feel they do not have a chance of getting one.

45. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. How Accurate Is the Official Unemployment Rate? n The unemployment rate counts as employed those who are underemployed. n Underemployed – part-time workers who would prefer full-time work.

46. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. How Accurate Is the Official Unemployment Rate? n The unemployment rate includes as unemployed, people who say they are looking for a job who are really not. n Many are “working off the books, others are vacationing.

47. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. How Accurate Is the Official Unemployment Rate? n The Bureau of Labor Statistics uses the labor force participation rate and the employment rate to gauge the state of the labor market.

48. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. How Accurate Is the Official Unemployment Rate? n The labor force participation rate measures the labor force as a percentage of the total population at least 16 years old. n The employment rate measures the number of people who are working as a percentage of the labor force.

49. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment and Potential Output n The capacity utilization rate indicates how much capital is available for economic growth. l Capacity utilization rate – the rate at which factories and machines are operating compared to the maximum sustainable rate at which they could be used.

50. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment and Potential Output n Potential output – output that would be achieved at the target rates of unemployment and of capacity utilization.

51. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Unemployment and Potential Output n Okum's rule of thumb is used to determine the effect changes in the unemployment rate will have on income. l A one percent change in unemployment will cause output to change in the opposite direction by two percent.

52. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Microeconomic Categories of Unemployment n Microeconomic policies are sometimes used to supplement macroeconomic policies for dealing with unemployment.

53. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Microeconomic Categories of Unemployment n The following categories of unemployment are analyzed by economists: l How people become unemployed. l Demographic unemployment. l Duration of unemployment. l Unemployment by industry.

54. Unemployment by Microeconomic Subcategories, 2002 16-19 1.2 million (15.4%) 20-24 1.0 million (9.2%) Male – 4.5 million (6.0%) Unemployment rate by age 25-54 – 4.8 million (4.7%) 55 and over 0.8 million (3.8%) Female – 3.7 million (5.6%) Unemployment rate by sex Total unemployment – 8.3 million (5.8%) Total unemployment rate McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

55. Unemployment by Microeconomic Subcategories, 2002 Job losers – 4.5 million Less than 5 weeks – 2.8 million White – 6.1 million (5.1%) Duration of unemployment Unemployment rate by race* Black – 2.2 million (9.1%) 5-14 weeks – 2.5 million Reason for unemployment Job leavers 0.9 million Re-entrants – 2.4 million More than 15 weeks 2.9 million New entrants 0.5 million McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

56. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Inflation n Inflation is a continual rise in the price level. l From 1800 until World War II, the U.S. inflation rate and price level fluctuated. l Since World War II, the rate fluctuated, but the movement of the price level has been consistently upward.

57. Inflation Since 1900 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 30201019004050607080902000 –10 –5 0 5 10 15 20 25

58. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Measurement of Inflation n Inflation is measured with changes in price indexes. n Price index – a number that summarizes what happens to a weighted composite of prices of a selection of goods over time.

59. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Creating a Price Index n A price index is calculated by dividing the current price of a basket of goods by the price of the basket in a base year then multiplying by 100.

60. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Simple Year-to-Year Market Basket Comparison

61. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real-World Price Indexes n Real-world price indexes include the PPI, the CPI, and the GDP deflator.

62. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The GDP Deflator n The GDP deflator (gross domestic product deflator) is an index of the price level of aggregate output or the average price of the components in GDP relative to a base year.

63. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The GDP Deflator n Another price index is the chain-type price index for GDP which uses a GDP deflator with a constantly moving base year.

64. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The GDP Deflator n The GDP deflator is the measure of inflation most economists favor since it includes the widest number of goods.

65. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Consumer Price Index (CPI) n The consumer price index (CPI) measures the prices of a fixed "basket" of consumer goods. n It is weighed according to each component's share of an average consumer's expenditures.

66. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Consumer Price Index (CPI) n Many economists believe that the CPI as currently constituted, overstates inflation by one percentage point. n To avoid some of the problems of the CPI, some policymakers have been focusing on the personal consumption expenditure (PCE) deflator.

67. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Consumer Price Index (CPI) n Personal consumption expenditure (PCE) deflator – a measure of prices of goods that consumers buy that allows yearly changes in the basket of goods that reflect actual consumer purchasing habits.

68. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Composition of CPI Recreation (5.9%) Food and beverage (16.4%) Apparel (4.2%) Transportation (16.6%) Medical care (6.0%) Housing (40.5%) Other (5.0%) Education and Communication (5.4%)

69. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Producer Price Index (PPI) n The producer price index (PPI) is an index of prices that measures average change in selling prices received by domestic producers of goods and services over time. n It gives an early indication as to where inflation is headed.

70. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real and Nominal Concepts n Nominal output is the total amount of goods and services measured at current prices. n Real output is the total amount of goods and services produced, adjusted for price level changes.

71. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real and Nominal Concepts n The “real” amount is the nominal amount divided by the price index. n It is the nominal amount adjusted for inflation.

72. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Expected and Unexpected Inflation n Expected and unexpected inflation affects behavior differently. n Expected inflation is inflation people expect to occur. n Unexpected inflation is inflation that surprises people.

73. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Expected and Unexpected Inflation n Expectations of inflation play an important role in the inflation process. n Inflationary expectations can accelerate large inflation.

74. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Costs of Inflation n Inflation may not make a nation poorer. n It can redistribute income from those who do not raise their prices to those who do. n It can reduce the amount of information that prices are supposed to convey.

75. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Costs of Inflation n Inflation is usually accepted by governments as long as it stays at a low level. n What worries policymakers is hyperinflation.

76. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Costs of Inflation n Hyperinflation – exceptionally high levels of inflation of, say, 100 percent or more a year. n The U.S. has not experienced hyperinflation since the Civil War (1861-65).

77. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Growth, Business Cycles, Unemployment, and Inflation End of Chapter 22