© the mcgraw-hill companies, inc., 1998 irwin/mcgraw-hill economic growth, business cycles,...

© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill

Economic Growth, Economic Growth, Business Cycles, Business Cycles, Unemployment, Unemployment,

and Inflationand Inflation Chapter 7


Laugher CurveLaugher Curve

An Indian-born economist once explained his personal theory of reincarnation to his graduate economics class.



“If you are a good economist, a virtuous economist,” he said, “you are reborn as a physicist.”



“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.”


Chapter ObjectivesChapter Objectives

Summarize some relevant statistics about growth, business cycles, unemployment, and inflation.



Summarize some relevant statistics about growth, business cycles, unemployment, and inflation.

Name five sources of growth.



List four phases of the business cycle.



List four phases of the business cycle. Explain how unemployment is

measured and state some microeconomic categories of unemployment.



Relate the target rate of unemployment to potential income.



Relate the target rate of unemployment to potential income.

Define inflation and distinguish a real concept from a nominal concept.



Differentiate between cost-push and demand-pull inflation and expected and unexpected inflation.



Differentiate between cost-push and demand-pull inflation and expected and unexpected inflation.

State two important costs of inflation.


Central Problems of Central Problems of MacroeconomicsMacroeconomics Growth is one of the four central

problems of macroeconomics.


Central Problems of Central Problems of MacroeconomicsMacroeconomics Growth is one of the four central

problems of macroeconomics. The others are business cycles,

unemployment, and inflation.


GrowthGrowth

The Benefits and Costs of Growth


GrowthGrowth

The Benefits and Costs of Growth Generally the U.S. economy is

growing or expanding.


GrowthGrowth

The Benefits and Costs of Growth Real gross domestic product (GDP) is

the market value of goods and services stated in the prices of a given year.


GrowthGrowth

The Benefits and Costs of Growth Real gross domestic product (GDP) is

the market value of goods and services stated in the prices of a given year.

The primary measurement of growth is changes in real GDP.


GrowthGrowth

The Benefits and Costs of Growth Since 1890, the U.S. economic output

has grown at an annual rate of 2.5 to 3.5 per annum.


GrowthGrowth

The Benefits and Costs of Growth Since 1890, the U.S. economic output

has grown at an annual rate of 2.5 to 3.5 per annum.

This is called the secular growth trend.


GrowthGrowth

The Benefits and Costs of Growth Per capita economic growth allows

everyone in society, on average to have more.


GrowthGrowth

The Benefits and Costs of Growth Politically, growth, or predictions of

growth, allows governments to avoid hard questions.


GrowthGrowth

The Benefits and Costs of Growth Politically, growth, or predictions of

growth, allows governments to avoid hard questions.

A growing economy creates jobs, to the joy of politicians.


GrowthGrowth

The Benefits and Costs of Growth The costs to material growth include

pollution, resource exhaustion, and destruction to natural habitat.


GrowthGrowth

The Benefits and Costs of Growth Since many believe the

environmental costs of growth are important, the result is often an environmental-economic growth stalemate.


GrowthGrowth

The Sources of Growth


GrowthGrowth

The Sources of Growth Institutions with incentives

compatible with growth Technological development Available resources Investment and accumulated capital Entrepreneurship


GrowthGrowth

Institutions With Incentives Compatible With Growth


GrowthGrowth

Institutions With Incentives Compatible With Growth Growth-compatible institutions—those

that foster growth—must have incentives built into them that lead people to work hard and discourage people from activities that inhibit growth.


GrowthGrowth

Institutions With Incentives Compatible With Growth Private ownership of property plays

an important role in growth.


GrowthGrowth

Institutions With Incentives Compatible With Growth A corporation is another example of a

growth-promoting economic institution because of limited liability.


GrowthGrowth

Institutions With Incentives Compatible With Growth Many developing nations have

merchantist policies dictating governmental permission before economic activity can take place.


GrowthGrowth

Institutions With Incentives Compatible With Growth Many developing nations have

merchantist policies dictating governmental permission before economic activity can take place.

This does not foster growth.


GrowthGrowth

Technological Development


GrowthGrowth

Technological Development A much larger aspect of growth

involves changes in technology—changes in the goods we buy and changes in the way we make goods.


GrowthGrowth

Technological Development Society gets people to work on these

new developments by doing the following:


GrowthGrowth

Technological Development Society gets people to work on these

new developments by doing the following:

Providing incentives. Working with institutions that foster

creativity and bold thinking. Working through institutions that foster

hard work.


GrowthGrowth

Technological Development U.S. educational institutions do a

good job of fostering creativity but a poor job of fostering hard work.


GrowthGrowth

Available Resources


GrowthGrowth

Available Resources What is a resource depends on the

technology used.


GrowthGrowth

Available Resources What is a resource depends on the

technology used. A resource in one time period may

not be a resource in another.


GrowthGrowth

Investment and Accumulated Capital


GrowthGrowth

Investment and Accumulated Capital Capital accumulation and investment

were once seen as the key elements to growth.


GrowthGrowth

Investment and Accumulated Capital This is not longer thought to be true

because:


GrowthGrowth


because: The empirical evidence does not support

it. Products and processes change. Capital is far more than machines.


GrowthGrowth


because: Capital also includes human capital—

peoples' knowledge and social capital—the habitual way of doing things that guides people in how they approach production.


GrowthGrowth

Entrepreneurship


GrowthGrowth

Entrepreneurship Entrepreneurship involves creativity,

vision, and the ability to translate that vision into reality.


GrowthGrowth

Turning the Sources of Growth Into Growth


GrowthGrowth

Turning the Sources of Growth Into Growth Even if the five ingredients to growth

exist, they may not exist in the right proportion.


GrowthGrowth

Turning the Sources of Growth Into Growth Even if the five ingredients to growth

exist, they may not exist in the right proportion.

It is the combination of investing in machines and technological change that plays a central role in the growth of any economy.


Business CyclesBusiness Cycles

The business cycle is the upward and downward movement of economic activity that occurs around the growth trend.



The business cycle is the upward and downward movement of economic activity that occurs around the growth trend. The secular growth trend is an

average 2.5 to 3.5 percent increase in GDP.


Business CyclesBusiness CyclesP

erc

en

tag

e F

luc

tua

tio

ns

in

Re

al

GD

P

Civil War

Recovery of 1895

World War I

Panic of 1893 Panic

of 1907Great

Depression

20

10

0

–10

–20

Years

World War II

Korean WarVietnam War

1860 65 70 75 80 85 90 95 1900 05 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 2000



There are a number of theories regarding business cycles.



There are a number of theories regarding business cycles. The Classicals generally favor laissez-

faire or noninterventionist policies.



There are a number of theories regarding business cycles. The Keynesians generally favor

activist policies.



There are a number of theories regarding business cycles. The rational expectationists argue

that expectations about the future based on the best current information is often undermined by the public who anticipate government's actions and do the opposite of what is expected of them.



Each business cycle is different.



Each business cycle is different. After World War II, however, down

turns have been less severe.



Each business cycle is different. If prolonged contractions are a type of

cold the economy catches, the Great Depression of the 1930s was double pneumonia.



Each business cycle is different. If the severity of business fluctuations

has been reduced, one reason is that changes in institutional structure were made as a result of the Great Depression.



Each business cycle is different. Since 1945, the average expansion

has lasted about 51 months.


The Phases of the The Phases of the Business CycleBusiness Cycle The peak is the top of the business

cycle.


The Phases of the The Phases of the Business CycleBusiness Cycle The peak is the top of the business

cycle. A boom is a very high peak,

representing a big jump in output.


The Phases of the The Phases of the Business CycleBusiness Cycle The downturn -- the phenomenon of

economic activity starting to fall from a peak.


The Phases of the The Phases of the Business CycleBusiness Cycle The downturn -- the phenomenon of

economic activity starting to fall from a peak.

A recession is a decline in output that persists for more than two consecutive quarters in a year.


The Phases of the The Phases of the Business CycleBusiness Cycle A depression is a large recession.


The Phases of the The Phases of the Business CycleBusiness Cycle A depression is a large recession. The bottom of the recession or

depression is called the trough.


The Phases of the The Phases of the Business CycleBusiness Cycle As total output starts to expand, the

economy comes out of the trough into an upturn, which may turn into an expansion—an upturn that lasts at least two consecutive quarters of a year.


The Phases of the The Phases of the Business CycleBusiness Cycle

Tot

al O

utpu

t

Peak

0Jan.– Mar.

Apr.– June

July– Sept.

Oct.– Dec.

Jan.– Mar.

Quarters

Apr.– June

Secular growth trend

July– Sept.

Oct.– Dec.

Jan.– Mar.

Apr.– June

Trough

Expansion ExpansionRecession


Leading IndicatorsLeading Indicators

Leading indicators are those that tell us what's likely to happen in the economy 12 to 15 months from now.



Leading indicators include the following:



Leading indicators include the following: Average workweek for production

workers in manufacturing Unemployment claims New orders for consumer goods and

materials



Leading indicators include the following: Vendor performance, measured as a

percentage of companies reporting slower deliveries from suppliers

Contracts and orders for plant and equipment



Leading indicators include the following: Number of new building permits

issued for private housing units Change in stock prices



Leading indicators include the following: Change in consumer expectations Changes in the money supply



The drudge work of sifting through statistical series is the backbone of business economists' work


UnemploymentUnemployment

Business cycles and growth are directly related to unemployment in the U.S. economy.



Unemployment occurs when people are looking for a job and cannot find one.



The unemployment rate is the number of people who cannot find a job as a percent of those people in the economy who are willing and able to work.


Types of Types of UnemploymentUnemployment Frictional unemployment is the

unemployment caused by new entrants into the job market and people quitting a job just long enough to look for and find another one.


Types of Types of UnemploymentUnemployment Structural unemployment is that caused

by economic restructuring making some skills obsolete.


Types of Types of UnemploymentUnemployment Structural unemployment is that caused

by economic restructuring making some skills obsolete. It existed in pre-industrial society.


Types of Types of UnemploymentUnemployment Cyclical unemployment is that which

results from fluctuations in economic activity.



results from fluctuations in economic activity. It did not exist in pre-industrial

society.



results from fluctuations in economic activity. The Industrial Revolution changed the

nature of work and introduced unemployment as a problem for society.



results from fluctuations in economic activity. The Industrial Revolution was

accompanied by a change in how families dealt with unemployment.



results from fluctuations in economic activity. What had previously been a family

problem, now became a social problem.



results from fluctuations in economic activity. Hunger was the early solution for

unemployment.



results from fluctuations in economic activity. Hunger was the early solution for

unemployment. It was not an effective answer to

unemployment.



results from fluctuations in economic activity. In the Employment Act of 1946,

government took responsibility for full employment—an economic climate in which just about everyone who wants a job can have one.


The Target Rate of The Target Rate of UnemploymentUnemployment The target rate of unemployment is the

lowest sustainable rate of unemployment that policymakers believe is achievable under existing conditions.


The Target Rate of The Target Rate of UnemploymentUnemployment Initially government regarded 2 percent

unemployment as a condition of full employment.


The Target Rate of The Target Rate of UnemploymentUnemployment Initially government regarded 2 percent

unemployment as a condition of full employment. The 2 percent was made up of

frictional unemployment.


The Target Rate of The Target Rate of UnemploymentUnemployment In the 1980s and 1990s, the target rate

of unemployment was been between 5 and 7 percent.


The Target Rate of The Target Rate of UnemploymentUnemployment The target rate of unemployment has

changed over time for the following reasons:



changed over time for the following reasons: In the 1970s and early 1980s, a low

inflation rate seemed to be incompatible with a low unemployment rate.



changed over time for the following reasons: Demographics have changed.



changed over time for the following reasons: Demographics have changed. Different age groups have different

rates of unemployment.



changed over time for the following reasons: Social and institutional structures

have changed.



changed over time for the following reasons: The economy has undergone major

structural readjustments -- modifications in the types of goods produced and the methods of production.



changed over time for the following reasons: Governmental institutions also

changed.


Whose responsibility is Whose responsibility is unemployment?unemployment? The Classicals believe that individuals

are responsible for their own employment.


Whose responsibility is Whose responsibility is unemployment?unemployment? Keynesian economists tend to say that

society owes a person a job commensurate with the individual's training or past job experience.


How is unemployment How is unemployment measured?measured? The unemployment rate is published by

the U.S. Department of Labor's Bureau of labor Statistics.


How is unemployment How is unemployment measured?measured? The unemployment rate is published by

the U.S. Department of Labor's Bureau of labor Statistics. Visit the Bureau of Labor Statistics on

the Internet at : http://stats.Bls.Gov.


Unemployment Rate Since Unemployment Rate Since 19001900

Pe

rce

nta

ge

of

lab

or

forc

e u

ne

mp

loy

ed 30

20

10

0

Target rate

Years

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Average unemployment


Calculating the Calculating the Unemployment RateUnemployment Rate The unemployment rate is calculated by

dividing the number of unemployed individuals by the number of people in the civilian labor force and multiplying by 100.



dividing the number of unemployed individuals by the number of people in the civilian labor force and multiplying by 100.

unemployment rate=number unemployedlabor force

100



dividing the number of unemployed individuals by the number of people in the civilian labor force and multiplying by 100. The labor force is those people in an

economy who are willing and able to work.


How accurate is the How accurate is the official unemployment official unemployment rate?rate? The unemployment rate does not

include discouraged workers—people who do not look for a job because they feel they do not have a chance of getting one.


How accurate is the How accurate is the official unemployment official unemployment rate?rate? The unemployment rate counts as

employed those who are underemployed—part-time workers who would prefer full-time work.


How accurate is the How accurate is the official unemployment official unemployment rate?rate? Both the Classicals and the

Keynesians, for completely different reasons, agree that the unemployment figures are imperfect.


How accurate is the How accurate is the official unemployment official unemployment rate?rate?

Total civilian population (258 million)

Noninstitutional population (201 million)

Labor force (133.9 million)

Employed (126.7 million)

Not in labor force—(66.6 million)

Unemployed (7.2 million)

Incapable of working—(63 million)


Unemployment and Unemployment and Potential IncomePotential Income The capacity utilization rate is the rate

at which factories and machines are operating compared to the maximum sustainable rate at which they could be used.


Unemployment and Unemployment and Potential IncomePotential Income The capacity utilization rate indicates

how much capital is available for economic growth.


Unemployment and Unemployment and Potential IncomePotential Income Potential output is the output that would

materialize at the target rate of unemployment and the target rate of capacity utilization.


Unemployment and Unemployment and Potential IncomePotential Income Potential income is defined as the

output that will be achieved at the target rate of unemployment and at the target level of capacity utilization.


Unemployment and Unemployment and Potential IncomePotential Income There is debate about where the actual

level of potential income is.


Unemployment and Unemployment and Potential IncomePotential Income To determine the effect changes in the

unemployment rate will have on income, we use Okum's rule of thumb.


Unemployment and Unemployment and Potential IncomePotential Income To determine the effect changes in the

unemployment rate will have on income, we use Okum's rule of thumb. The rule states that a 1 percentage

point change in unemployment will cause income to change in the opposite direction by 2.5 percent.


Microeconomic Microeconomic Categories of Categories of UnemploymentUnemployment Macroeconomic measures of

unemployment may be too crude.


Microeconomic Microeconomic Categories of Categories of UnemploymentUnemployment Macroeconomic measures of

unemployment may be too crude. Different types of unemployment are

susceptible to different types of products.


Microeconomic Microeconomic Categories of Categories of UnemploymentUnemployment Some microeconomic categories of

unemployment are reason for how people become unemployed, demographic unemployment, duration of unemployment, and unemployment by industry.


InflationInflation

Inflation is a continual rise in the price level.


InflationInflation

Since World War II, the U.S. inflation rate has remained positive and relatively stable.


InflationInflationIn

flatio

n

25 20 15 10

5 0

–5 –10 –15

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000


Measurement of Measurement of InflationInflation In order to estimate inflation one must

first create a price index.


Measurement of Measurement of InflationInflation A price index is a composite of prices.


Measurement of Measurement of InflationInflation A price index is a composite of prices.

It is a series of numbers that summarizes what happens to prices of a selection of goods (often called a market basket of goods) over time.


Measurement of Measurement of InflationInflation The Producer Price Index (PPI)



An index or ratio of a composite of prices of a number of important raw materials, such as steel, relative to a composite of the prices of those raw materials in a base year.



It does not accurately measure what most consumers are interested in—final goods.



It does not accurately measure what most consumers are interested in—final goods.

It gives an early indication as to where inflation is headed.


Measurement of Measurement of InflationInflation The GDP Deflator (Gross Domestic

Product Deflator)



Product Deflator) An index of the price level of

aggregate output or the average price of the components in GDP relative to a base year.



Product Deflator) This is the measure of inflation most

economists favor since it includes the widest number of goods.



Product Deflator) Since it is difficult to compute, it is

published only quarterly and with a fairly substantial lag.


Measurement of Measurement of InflationInflation The Consumer Price Index (CPI)



Measures the prices of a fixed "basket" of consumer goods, weighed according to each component's share of an average consumer's expenditures.



It is the measure of inflation most often presented in news broadcasts.



Many economists believe that the CPI as currently constituted, overstates inflation by one to two percentage points.


Composition of CPIComposition of CPI

Food and beverage (17.3%)

Housing (41.3%)

Other (7.1%) Entertainment (4.4%)

Medical care (7.4%)

Transportation (17%)

Clothing (5.5%)


Real and Nominal Real and Nominal ConceptsConcepts Nominal output is the total amount of

goods and services as measured by current prices.


Real and Nominal Real and Nominal ConceptsConcepts Real output is the total amount of goods

and services produced, adjusted for price level changes.


Real and Nominal Real and Nominal ConceptsConcepts Real output is the total amount of goods

and services produced, adjusted for price level changes.

100 X index price

output nominal =output real


Real and Nominal Real and Nominal ConceptsConcepts The “real” amount is the nominal

amount adjusted for inflation.


Why does inflation Why does inflation occur?occur? The economy has nominal wage- and

price-setting institutions in which people set their relative prices by setting a nominal price.


Why does inflation Why does inflation occur?occur? Demand-pull inflation is the inflation that

occurs when the economy is at or above full employment.


Why does inflation Why does inflation occur?occur? Demand-pull inflation is the inflation that

occurs when the economy is at or above full employment. When the majority of industries are

close to capacity and they experience increases in demand, we say there's demand-pull inflation.


Why does inflation Why does inflation occur?occur? Cost-push inflation involves a rise in the

price level resulting from restrictions on supply due to some sort of legal or social pressure.


Demand-Pull InflationDemand-Pull Inflation

Pri

ce

P1

P0

Q0 Q1

Quantity

D0

S0


Demand-Pull InflationDemand-Pull Inflation

Pri

ce

P1

P0

Q0 Q1

Quantity

D1

D0

S0


Cost-Push InflationCost-Push Inflation

Pri

ce

P1

P0

0(0-A)

Quantity

Qa(A-B)

D0

S0

A B


Cost-Push InflationCost-Push Inflation

Pri

ce

P1

P0

0(0-A)

Quantity

Qa(A-B)

D0

S0

S1

A B


Expected and Expected and Unexpected InflationUnexpected Inflation Expectations of inflation play an

important role in exacerbating inflation further.


Expected and Expected and Unexpected InflationUnexpected Inflation Expected inflation is that which people

anticipate.


Expected and Expected and Unexpected InflationUnexpected Inflation Expected inflation is that which people

anticipate. Unexpected inflation is that which

surprises people.


Costs of InflationCosts of Inflation

Inflation does not make a nation poorer.



Inflation causes income to be redistributed from those who do not raise their prices to those who do.



Inflation causes income to be redistributed from those who do not raise their prices to those who do. For example, from lenders to

borrowers.



Inflation can reduce the amount of information that prices are supposed to convey.



Despite redisributive costs and a blurring of price information, inflation is usually accepted by governments as long as it stays at a low level.



The danger is when inflation becomes hyperinflation—exceptionally high levels of inflation of, say, 100 percent or more a year.



The U.S. has never experienced a hyperinflation.


Economic Growth, Economic Growth, Business Cycles, Business Cycles, Unemployment, Unemployment,

and Inflationand Inflation

End of Chapter 7

© the mcgraw-hill companies, inc., 1998 irwin/mcgraw-hill economic growth, business cycles,...

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