copyright 2008 the mcgraw-hill companies 7-1 7 introduction to economic growth and instability

Copyright 2008 The McGraw-Hill Companies7-1

7Introduction to

Economic Growth and Instability


Learning objectives

• In this chapter students will learn: In this chapter students will learn:

1.1. How economic growth is measured and why it is How economic growth is measured and why it is important.important.

2.2. About the business cycle and its primary phases.About the business cycle and its primary phases.

3.3. How unemployment and inflation are measured.How unemployment and inflation are measured.

4.4. About the types of unemployment and inflation and About the types of unemployment and inflation and their various impacts.their various impacts.


Economic Growth-how to increase the economy’s productive capacity over time.

Two definitions of economics growth are given.Two definitions of economics growth are given.1.1. The increase inThe increase in real GDP real GDP, which occurs over a period of time., which occurs over a period of time.2.2. The increase in The increase in real GDP per capitareal GDP per capita, which occurs over time. , which occurs over time.

This definition is superior if comparison of living standards is This definition is superior if comparison of living standards is desired. For example, China’s 2003 GDP was $1410 billion desired. For example, China’s 2003 GDP was $1410 billion compared to Denmark’s $212 billion, but per capita GDP’s compared to Denmark’s $212 billion, but per capita GDP’s were $1110 and $33,750 respectively.were $1110 and $33,750 respectively.

3.3. Growth in real GDP does not guarantee growth in Growth in real GDP does not guarantee growth in real GDP real GDP per capitaper capita. If the growth in population exceeds the growth in . If the growth in population exceeds the growth in real GDP, real GDP per capita will real GDP, real GDP per capita will fallfall..

Growth is an important economic goal because it means more Growth is an important economic goal because it means more material abundancematerial abundance and ability to meet the and ability to meet the economizing economizing problemproblem. Growth lessens the . Growth lessens the burdenburden of scarcity. of scarcity.


WEF, GCR: 2009/2010


The “rule of 70”The “rule of 70”

• The arithmetic of growth is impressive. Using the “rule of The arithmetic of growth is impressive. Using the “rule of 70,” a growth rate of 2 percent annually would take 35 70,” a growth rate of 2 percent annually would take 35 years for GDP to double, but a growth rate of 4 percent years for GDP to double, but a growth rate of 4 percent annually would only take about 18 years for GDP to annually would only take about 18 years for GDP to double. (The “rule of 70” uses the absolute value of a rate double. (The “rule of 70” uses the absolute value of a rate of change, divides it into 70, and the result is the of change, divides it into 70, and the result is the number of number of years it takes the underlying quantity to doubleyears it takes the underlying quantity to double.).)

Main sources of growth are: Main sources of growth are:

1.1. increasing inputs or increasing inputs or

2.2. increasing productivity of existing inputs.increasing productivity of existing inputs.

• About one-third of U.S. growth comes from more inputs.About one-third of U.S. growth comes from more inputs.

• About two-thirds comes from increased productivity.About two-thirds comes from increased productivity.


• The arithmetic of growth needs to be qualified.The arithmetic of growth needs to be qualified.

a.a. Growth doesn’t measure quality improvements.Growth doesn’t measure quality improvements.

b.b. Growth doesn’t measure increased leisure time.Growth doesn’t measure increased leisure time.

c.c. Growth doesn’t take into account adverse effects on Growth doesn’t take into account adverse effects on environment or human security.environment or human security.

d.d. International comparisons are useful in evaluating the International comparisons are useful in evaluating the country’s performance. For example, Japan grew more than country’s performance. For example, Japan grew more than twice as fast as U.S. until the 1990s when the U.S. far twice as fast as U.S. until the 1990s when the U.S. far surpassed Japan. (see Global Perspective 7.1). There is also surpassed Japan. (see Global Perspective 7.1). There is also some tendency for growth rates to move together, reflecting some tendency for growth rates to move together, reflecting the interdependence of the global economy.the interdependence of the global economy.


Selected Growth Rates

Source: Economic Report of the President, 2006

-4

-2

0

2

4

6

U.S.

Germany

France

Japan

U.K.

Italy

1997 1999 2001 2003 2005

Per

cen

tag

e C

han

ge

(an

nu

al r

ate)

GLOBAL PERSPECTIVE


Overview of the Business Cycle

Four phases of the business cycle are identified over a Four phases of the business cycle are identified over a several‑year period. (See Figure 7.1)several‑year period. (See Figure 7.1)

1.1. A A peakpeak is when business activity reaches a temporary is when business activity reaches a temporary maximummaximum with full employment and near-capacity output. with full employment and near-capacity output.

2.2. A A recessionrecession is a is a declinedecline in total output, income, employment, in total output, income, employment, and trade lasting six months or more.and trade lasting six months or more.

3.3. The The troughtrough is the is the bottombottom of the recession period. of the recession period.

4.4. The The expansionexpansion is when output and employment are expanding is when output and employment are expanding toward full‑employment level.toward full‑employment level.


The Business Cycle

Lev

el o

f R

eal O

utp

ut

Time

Peak

Peak

Peak

Recession

Recession

Expa

nsio

n Exp

ansi

on

Trough

Trough

Growth

Trend

O 7.1Phases of the Business Cycle

Cyclical Impact:Durables and Nondurables


What causes the business cycleWhat causes the business cycle• There are several theories about causation.There are several theories about causation.1.1. Major innovationsMajor innovations may trigger new investment and/or may trigger new investment and/or

consumption spending.consumption spending.2.2. Changes in productivityChanges in productivity may be a related cause of the may be a related cause of the

business cycle.business cycle.3.3. The The level of aggregate spendinglevel of aggregate spending is important, especially is important, especially

changes on capital goods and consumer durables.changes on capital goods and consumer durables.

Cyclical fluctuations: Cyclical fluctuations: DurableDurable goods output is more goods output is more volatilevolatile than than non-durablesnon-durables and services because spending on latter and services because spending on latter usually can not be postponed.usually can not be postponed.


Unemployment (One Result of Economic Downturns)

Measuring unemployment (see Figure 7.2 for 2005):Measuring unemployment (see Figure 7.2 for 2005):• The population is divided into three groups: The population is divided into three groups:

1.1. those under age 16 or institutionalizedthose under age 16 or institutionalized2.2. those who are “not in labor force,” (e.g., housewives) andthose who are “not in labor force,” (e.g., housewives) and3.3. the labor force that includes those age 16 and over who are the labor force that includes those age 16 and over who are willing willing

and ableand able to work, and actively to work, and actively seeking workseeking work (demonstrated job (demonstrated job search activity within the last four weeks).search activity within the last four weeks).

• The The unemployment rateunemployment rate is defined as the percentage of the is defined as the percentage of the labor forcelabor force that is not employed. (Note: Emphasize that is not employed. (Note: Emphasize notnot the the percentage of the percentage of the populationpopulation.).)

• The unemployment rate is calculated by The unemployment rate is calculated by random surveyrandom survey of of 60,000 households nationwide. (Note: Households are in 60,000 households nationwide. (Note: Households are in survey for four months, out for eight, back in for four, and survey for four months, out for eight, back in for four, and then out for good; interviewers use the phone or home visits then out for good; interviewers use the phone or home visits using laptops.)using laptops.)


• The unemployment rate is defined as the percentage of the labor force (not of population) that is not employed.

Unemploymentrate

unemployed

labor forcex100=


Unemployment

Under 16And/or

Institutionalized(70.5 Million)

Labor Force, Employment, and Unemployment, 2005

TotalPopulation

(296.6 Million)

Not inLabor Force(76.8 Million)

Employed(141.7 Million)

LaborForce(149.3 Million)

Unemployed(7.6 Million)


Two factors cause the official unemployment rate to understate Two factors cause the official unemployment rate to understate actual unemployment.actual unemployment.

a.a. Part‑time workersPart‑time workers are counted as “employed.” are counted as “employed.”b.b. ““Discouraged workersDiscouraged workers” who want a job, but are not ” who want a job, but are not

actively seeking one, are not counted as being in the labor actively seeking one, are not counted as being in the labor force, so they are not part of unemployment statistic.force, so they are not part of unemployment statistic.

Types of unemployment:Types of unemployment:1.1. Frictional unemployment:Frictional unemployment: consists of those searching for consists of those searching for

jobs or waiting to take jobs soon; it is regarded as jobs or waiting to take jobs soon; it is regarded as somewhat desirable, because it indicates that there is somewhat desirable, because it indicates that there is mobility as people change or seek jobs.mobility as people change or seek jobs.

Types:Types:• Voluntarily moving from one job to anotherVoluntarily moving from one job to another• Fired and seeking another jobFired and seeking another job• Housewives who decided to workHousewives who decided to work• New graduates looking for jobs for the first timeNew graduates looking for jobs for the first timeNote: this type of unemployment is inevitableNote: this type of unemployment is inevitable


2. Structural unemployment: due to changes in the structure of demand for labor; e.g., when certain skills become obsolete or geographic distribution of jobs changes. Examples of structural unemployment:

a. Glass blowers were replaced by bottle-making machines.b. Oil-field workers were displaced when oil demand fell in

1980s.c. Airline mergers displaced many airline workers in

1980s.d. Foreign competition has led to downsizing in U.S.

industry and loss of jobs.e. Military cutbacks have led to displacement of workers in

military-related industries.

• Difference between frictional and structural unemployment is that frictional unemployed have salable skills, but structurally unemployed will find it difficult to find a job


3.3. Cyclical unemploymentCyclical unemployment is caused by the recession phase of is caused by the recession phase of the business cycle. the business cycle.

a.a. As firms respond to insufficient demand for their As firms respond to insufficient demand for their goods and services, output and employment are reduced.goods and services, output and employment are reduced.

b.b. Extreme unemployment during the Great Depression Extreme unemployment during the Great Depression (25 percent in 1933) was cyclical unemployment.(25 percent in 1933) was cyclical unemployment.

• It is sometimes not clear which type describes a person’s It is sometimes not clear which type describes a person’s unemployment circumstances.unemployment circumstances.


Definition of “Full Employment”Definition of “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 The full‑employment unemployment rate is equal to the total

frictional and structural unemployment. The frictional and structural unemployment. The full‑employment rate of unemployment is also referred to as full‑employment rate of unemployment is also referred to as the natural rate of unemployment NRU.the natural rate of unemployment NRU.

• The natural rate is achieved when labor markets are in The natural rate is achieved when labor markets are in balance; the number of job seekers equals the number of job balance; the number of job seekers equals the number of job vacancies. The natural rate of unemployment is not fixed but vacancies. The natural rate of unemployment is not fixed but depends on the demographic makeup of the labor force and depends on the demographic makeup of the labor force and the laws and customs of the nations.the laws and customs of the nations.

• Recently the natural rate has dropped from 6% to 4 to 5%. Recently the natural rate has dropped from 6% to 4 to 5%. This is attributed to:This is attributed to:a.a. The aging of the work force as the baby boomers approach The aging of the work force as the baby boomers approach retirement.retirement.b.b. Improved job information through the internet and temporary-Improved job information through the internet and temporary-help agencies.help agencies.c.c. New work requirements passed with the most recent welfare New work requirements passed with the most recent welfare reform.reform.d.d. The doubling of the U.S. prison population since 1985.The doubling of the U.S. prison population since 1985.


Economic cost of unemployment:Economic cost of unemployment:• GDP gap and Okun’s Law: GDP gap is the difference GDP gap and Okun’s Law: GDP gap is the difference

between between potential and actual GDPpotential and actual GDP. (See Figure 7.3) . (See Figure 7.3) Economist Arthur Okun quantified the relationship Economist Arthur Okun quantified the relationship between unemployment and GDP as follows: For every 1 between unemployment and GDP as follows: For every 1 percent of unemployment percent of unemployment above the natural rateabove the natural rate, a , a negative negative GDP gap of about 2 percentGDP gap of about 2 percent occurs. This is known as occurs. This is known as “Okun’s law”“Okun’s law”

• Unequal burdens of unemployment exist. (See Table 7.3)Unequal burdens of unemployment exist. (See Table 7.3)1.1. Rates are lower for white‑collar workers.Rates are lower for white‑collar workers.2.2. Teenagers have the highest rates.Teenagers have the highest rates.3.3. African-Americans have higher rates than whites.African-Americans have higher rates than whites.4.4. Rates for males and females are comparable, though females had a Rates for males and females are comparable, though females had a

lower rate in 2002.lower rate in 2002.5.5. Less educated workers, on average, have higher unemployment Less educated workers, on average, have higher unemployment

rates than workers with more education.rates than workers with more education.


UnemploymentActual and Potential GDP and the Unemployment Rate

5,000

6,000

7,000

8,000

9,000

10,000

11,000

12,000

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

The GDP Gap12,000

11,000

10,000

9,000

8,000

7,000

6,000

5,000GD

P (

bil

lio

ns

of

1996

do

lla

rs)

0

2

4

6

8

10

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

The Unemployment Rate10

8

6

4

2

0

Un

emp

loy

men

t(p

erce

nt

of

civi

lian

Lab

or

forc

e)

Source: Congressional Budget Office & Bureau of Economic Analysis

GDP gap(positive)

GDP gap(negative)

Potential GDP

Actual GDP


• Noneconomic costs include loss of self‑respect and social and Noneconomic costs include loss of self‑respect and social and political unrest.political unrest.

• International comparisons. (See Global Perspective 7.2)International comparisons. (See Global Perspective 7.2)


Unemployment

Source: Bureau of Labor Statistics

0

5

10

15

U.S.Germany

Italy

Japan

France

1995 2000 2005

Un

emp

loym

ent

Rat

e (p

erce

nt)

Unemployment Rates in Five Industrial Nations,1995-2005

GLOBAL PERSPECTIVE


Task 2: UNEMPLOYMENT IN KUWAITTask 2: UNEMPLOYMENT IN KUWAIT

1.1. Collect data about unemployment in KuwaitCollect data about unemployment in Kuwait

2.2. What are the main trends of unemploymentWhat are the main trends of unemployment

3.3. Why do we have such a problem Why do we have such a problem

4.4. What can we do to moderate unemploymentWhat can we do to moderate unemployment


Inflation: Defined and Measured• Definition: Inflation is a rising general level of prices (not all prices rise at Definition: Inflation is a rising general level of prices (not all prices rise at

the same rate, and some may fall). The main index used to measure inflation the same rate, and some may fall). The main index used to measure inflation is the is the Consumer Price Index (CPI).Consumer Price Index (CPI).

• To measure inflation, subtract last year’s price index from this year’s price To measure inflation, subtract last year’s price index from this year’s price index and divide by last year’s index; then multiply by 100 to express as a index and divide by last year’s index; then multiply by 100 to express as a percentage.percentage.

• 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 = ((127-123)/123)% = 3.25%

• ““Rule of 70”Rule of 70” permits quick calculation of the time it takes the price level to 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 double: Divide 70 by the percentage rate of inflation and the result is the approximate number of years for the price level to double. 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 If the inflation rate is 7 percent, then it will take about ten years for prices to double. (Note: You can also use this rule to calculate how long it takes double. (Note: You can also use this rule to calculate how long it takes savings to double at a given compounded interest rate).savings to double at a given compounded interest rate).


• Facts of inflation:Facts of inflation:1.1. In the past, deflation In the past, deflation has been as much a problemhas been as much a problem as as

inflation. For example, the 1930s depression was a period of inflation. For example, the 1930s depression was a period of declining prices and wages. The prospect of deflation was a declining prices and wages. The prospect of deflation was a concern of economic policymakers earlier this decade.concern of economic policymakers earlier this decade.

2.2. All industrial nations have experienced the problem (see All industrial nations have experienced the problem (see Global Perspective 7.3).Global Perspective 7.3).

3.3. Some nations experience astronomical rates of inflation Some nations experience astronomical rates of inflation (Zimbabwe is a recent case). For more details Visit my blog: (Zimbabwe is a recent case). For more details Visit my blog: Economic Notes: Economic Notes: http://economicnotes.maktoobblog.com/http://economicnotes.maktoobblog.com/

4.4. The inside covers of the text contain historical rates for the The inside covers of the text contain historical rates for the U.S.U.S.


• Causes and theories of inflation:Causes and theories of inflation:1.1. Demand‑pull inflation: Spending increases faster than Demand‑pull inflation: Spending increases faster than

production. It is often described as “too much spending production. It is often described as “too much spending chasing too few goods.”chasing too few goods.”

2.2. Cost‑push or supply‑side inflation: Prices rise because of rise Cost‑push or supply‑side inflation: Prices rise because of rise in per-unit production costs (Unit cost = total input cost/units in per-unit production costs (Unit cost = total input cost/units of output). of output). a.a. Output and employment Output and employment declinedecline while the price level is while the price level is

rising.rising.b.b. Supply shocks have been the major source of cost-push Supply shocks have been the major source of cost-push

inflation. These typically occur with dramatic increases in inflation. These typically occur with dramatic increases in the price of raw materials or energy.the price of raw materials or energy.

3.3. Complexities: It is difficult to distinguish between Complexities: It is difficult to distinguish between demand‑pull and cost‑push causes of inflation, although demand‑pull and cost‑push causes of inflation, although cost‑push will die out in a recession if spending does not also cost‑push will die out in a recession if spending does not also rise.rise.


InflationAnnual Inflation Rates in the United States,1960-2005

0

5

10

15

1960 1970 1980 1990 2000

Infla

tion

Rat

e (p

erce

nt)



Inflation


-1

0

1

2

3

4

5

6

U.S.

Germany

Italy

Japan

France

1995 2000 2005

Infl

atio

n R

ate

(per

cen

t)

Inflation Rates in Five Industrial Nations,1995-2005

GLOBAL PERSPECTIVE


Redistributive effects of inflation:

• The price index is used to deflate nominal income into real The price index is used to deflate nominal income into real income. income.

• Inflation may reduce the real incomeInflation may reduce the real income of individuals in the of individuals in the economy, but won’t necessarily reduce real income for the economy, but won’t necessarily reduce real income for the economy as a whole (someone receives the higher prices economy as a whole (someone receives the higher prices that people are paying).that people are paying).

• Unanticipated inflationUnanticipated inflation has stronger impacts; those has stronger impacts; those expecting inflation may be able to adjust their work or expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects.spending activities to avoid or lessen the effects.

• Fixed‑income groupsFixed‑income groups will be hurt because their real income will be hurt because their real income suffers. Their nominal income does not rise with prices.suffers. Their nominal income does not rise with prices.

• SaversSavers will be hurt by unanticipated inflation, because will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power.Their savings will lose purchasing power.


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

• If inflation is anticipated, the effects of inflation may If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may be less severe, since wage and pension contracts may have inflation clauses built in, and interest rates will have inflation clauses built in, and interest rates will be high enough to cover the cost of inflation to savers be high enough to cover the cost of inflation to savers and lenders.and lenders.

• ““Inflation premiumInflation premium” is amount that interest rate is ” is amount that interest rate is raised to cover effects of anticipated inflation.raised to cover effects of anticipated inflation.

• ““Real interest rateReal interest rate” is defined as nominal rate minus ” is defined as nominal rate minus inflation premium. (See Figure 7.5)inflation premium. (See Figure 7.5)

Effects of inflation are arbitrary, regardless of society’s Effects of inflation are arbitrary, regardless of society’s goals.goals.


Inflation• Anticipated Inflation

–Nominal Interest Rate –Real Interest Rate–Inflation Premium

NominalInterest

Rate

RealInterest

Rate

InflationPremium

11%

5%

6%

= +

O 7.2


Output Effects of Inflation

• Cost‑push inflation, where resource prices rise unexpectedly, Cost‑push inflation, where resource prices rise unexpectedly, could cause both output and employment to decline. Real could cause both output and employment to decline. Real income falls.income falls.

• Mild inflation (<3%) has uncertain effects. It may be a Mild inflation (<3%) has uncertain effects. It may be a healthy by-product of a prosperous economy, or it may have healthy by-product of a prosperous economy, or it may have an undesirable impact on real income.an undesirable impact on real income.

• Danger of creeping inflation turning into hyperinflation, Danger of creeping inflation turning into hyperinflation, which can cause speculation, reckless spending, and more which can cause speculation, reckless spending, and more inflation (see examples in text of Japan following World War inflation (see examples in text of Japan following World War II, and Germany following World War I).II, and Germany following World War I).


The Stock Market and the Economy

• Supply and Demand in the Stock MarketSupply and Demand in the Stock Market• Collective Expectations of Future Profits and LossesCollective Expectations of Future Profits and Losses• Dow Jones Industrial Average (DJIA)Dow Jones Industrial Average (DJIA)• Volatility of the Stock MarketVolatility of the Stock Market• Wealth EffectWealth Effect• Investment EffectInvestment Effect• Studies Show Consumption and Investment UnaffectedStudies Show Consumption and Investment Unaffected• Little Impact on MacroeconomyLittle Impact on Macroeconomy• Stock Market Bubbles Do Have an ImpactStock Market Bubbles Do Have an Impact• Stock Price Cycle PredictionsStock Price Cycle Predictions• Index of Leading IndicatorsIndex of Leading Indicators• Stock Prices Not a Reliable Predictor AloneStock Prices Not a Reliable Predictor Alone

Last

WordDo Stock Prices Affect Macroeconomic Do Stock Prices Affect Macroeconomic Instability?Instability?


Key Terms• economic growth• real GDP per capita• rule of 70• productivity• business cycle• peak• recession• trough• expansion• labor force• unemployment rate• discouraged workers• frictional unemployment• structural unemployment• cyclical unemployment• full-employment rate of unemploy

ment• natural rate of unemployment (N

RU)

• potential output• GDP gap• Okun’s law• inflation• Consumer Price Index (CPI)• demand-pull inflation• cost-push inflation• per-unit production costs• nominal income• real income• anticipated inflation• unanticipated inflation• cost-of-living adjustments (COLAs)• real interest rate• nominal interest rate• deflation• hyperinflation


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