..

InflationInflation““Too much money”Too much money”

Real GDP

Real GDP Rea

l GD

P

Rea

l GD

P

UnemploymentUnemployment

BusinessBusinessCyclesCycles

Unemployment 1960-PresentUnemployment 1960-Present

InflationInflation

Economic GrowthEconomic Growth [Increase in RGDP] & [Increase in RGDP] & InstabilityInstability

PeakPeak

TroughTrough

One cycleOne cycle[average 5 yrs][average 5 yrs]

Rec

over

y

Rec

over

y

Real GDPper year

Peak:Peak: real GDP reaches its maximum.

Recession:Recession: real GDP declines 6 months.

Recovery:Recovery: an upturn - real GDP rises.Trough:Trough: real GDP reaches its minimum.

Recession

Recession

Time

PeakPeak

Four Phases of the Business CycleFour Phases of the Business CycleFour Phases of the Business CycleFour Phases of the Business Cycle

Characteristics of Characteristics of ExpansionsExpansions and and RecessionsRecessions ExpansionsExpansions 1. Less unemployment2. Increase in real GDP3. Rapid job growth4. Increasing interest rate5. Increasing prices6. Fewer social problems (alcoholism, domestic violence, divorce, and suicides)

Four Phases of Business CycleFour Phases of Business Cycle

RecessionsRecessions1. More unemployment2. Decrease in Real GDP3. Reduced job growth4. Lower interest rates5. Decreasing prices6. More social problems (alcoholism, domestic violence, divorce and suicide)

PostwarPostwar ExpansionsExpansions//RecessionsRecessions

Over 200 Years of Business CyclesOver 200 Years of Business Cycles

UnemploymentUnemployment,, InflationInflation,, & & Business CyclesBusiness Cycles

Inflation – “too many dollars chasing Inflation – “too many dollars chasing too few goods.”too few goods.”Deflation – “too few dollars chasing Deflation – “too few dollars chasing too many goods.”too many goods.”

..

Downturns in the Business CycleDownturns in the Business Cycle

RRecessionecession - - contraction for 2 quarterscontraction for 2 quarters

There have been 11 recessions11 recessions since World War II.They have ranged from 6 6 monthsmonths toto 16 16 monthsmonths, averaging10 months10 months. ExpansionsExpansions average average aboutabout 5 years5 years. RecessionsRecessions usually cost the layoff of 1 out 1 out of of every 20every 20 workers[1 out of every 4 or 5 familiesworkers[1 out of every 4 or 5 families]. The other 19 are better off19 are better off because interest rates go downinterest rates go down. There has been a recessionrecession every decade for over 200 years.

TroughTrough – pit of a recession – pit of a recession

The trough is ““bad newsbad news”” and “good“good news.”news.” It is the bottom of the “ “valley”valley” of the downturn and the foot of the “hill”“hill” of expansion.

TroughTrough (“basebase”) – demand, production and unemployment are at their lowest lowest pointpoint. Real GDP begins to increase again.A trough marks the “pit of a recession”“pit of a recession”, but – the start of an expansionary phasestart of an expansionary phaseof the business cycle. The Fedlowers interest rateslowers interest rates.

The The Great DepressionGreat Depression [How Bad?] [How Bad?]

100,000 businesses failed.

Stock values fell from $89 billion to $15 billion.From 381 to 41. $74 billion was lost.

25% unemployment rate [15 million](125 million

in the U.S.) [Unemployment was 3% in 1929.]

Unemployment stayed above 14.3% from 1931-1940. Average unemployment was 18%

10,797 banks failed out of over 25,000, taking the life savings of 9 million people.

Apple sellers could make $1.15 profit on 72 sold apples.

Many factory wages went from .55 an hour to .05 an hour.

Agriculture collapsed.

Prices and wages dropped around 25%.

Factory production dropped 50%.

Auto production fell from 4.5 million cars in 1929 to 1.1 million in 1933.

Those who checked into hotels were asked,“For sleeping or jumping”?

YearYear UUnemplnempl Real GDPReal GDP “C”“C” “Ig”“Ig” “G”“G” In.In. RRateate InflationInflation19291929 3.23.2 203.6203.6 139.6 40.4 139.6 40.4 22.022.0 5.95.9 ___ ___19301930 8.98.9 183.5183.5 130.4 27.4 130.4 27.4 24.324.3 3.63.6 -2.6-2.619311931 16.316.3 169.5169.5 126.1 16.8 126.1 16.8 25.425.4 2.62.6 -10.1-10.119321932 24.124.1 144.2144.2 114.8 114.8 4.74.7 24.224.2 2.72.7 -9.3-9.31933 25.21933 25.2 141.5141.5 112.8 112.8 5.35.3 23.323.3 1.71.7 - 2.2- 2.219341934 22.022.0 154.3154.3 118.1 118.1 9.49.4 26.626.6 1.01.0 7.47.419351935 20.320.3 169.5169.5 125.5 18.0 125.5 18.0 27.027.0 0.80.8 0.90.919361936 17.0 17.0 193.2193.2 138.4 24.0 138.4 24.0 31.831.8 0.80.8 0.20.219371937 14.314.3 203.2203.2 143.1 29.9 143.1 29.9 30.830.8 0.9 4.20.9 4.219381938 19.1 19.1 192.9192.9 140.2 17.0 140.2 17.0 33.933.9 0.80.8 -1.3-1.319391939 17.217.2 209.4209.4 148.2 24.7 148.2 24.7 35.235.2 0.60.6 -1.6-1.61940 14.61940 14.6 227.2227.2 155.7 33.0 155.7 33.0 36.436.4 0.60.6 1.61.6

Great Depression StatsGreat Depression Stats [In 1958 dollars] [In 1958 dollars]

-30-30%% -20-20%% -87-87%% -23-23%%

Global Depression, 1929-1932Global Depression, 1929-1932

FORMULASFORMULAS

$6,737$6,737[199[1994]/4]/126.1126.1[1987([1987($4,540$4,540)]x100 =)]x100 = $5,343$5,343 [[+$803.+$803.]]““RealReal GDP GDP deflatesdeflates nominal GDPnominal GDP to actual valueto actual value”[”[takes thetakes the airair out out of theof the nominal balloonnominal balloon]]

Base year[$50/$50=1x100= 0]Base year[$50/$50=1x100= 0] $46/$50x100=92[deflation of 8%]$46/$50x100=92[deflation of 8%]

Price of Market Basket(2001Price of Market Basket(2001) [nominal GDP][nominal GDP] $64$64GDP Price IndexGDP Price Index = = Price of samePrice of same Market Basket(1998)x100Market Basket(1998)x100;; [R[Real eal GDP] $50x100=128GDP] $50x100=128[GDP Deflator][GDP Deflator] in the base year (1998) in the base year (1998) [$64/128 x 100 = $50][$64/128 x 100 = $50]

UnemploymentUnemployment 5,655,0005,655,000Labor ForceLabor Force x 100 = x 100 = unemployment rate;unemployment rate; 140,863,000140,863,000 x 100 = 4% x 100 = 4%[Employed + unemployed[Employed + unemployed]] [[135,208,000+5,655,000] [2000]135,208,000+5,655,000] [2000]

Okun’sOkun’s LawLaw or or GDP gap GDP gap)=Unemployment Rate over 6% x 2%; 7.5%, so 1.5x2% = 33%%. Or, $3 billion GDP Gap[$100 billion nominal GDP x .03% = $3 billion].

(2000-later year) (1999-earlier year)(2000-later year) (1999-earlier year) [[**Change/original x 100]Change/original x 100] Current year’s index – last year’s indexCurrent year’s index – last year’s index 172.2-166.6(5.6)172.2-166.6(5.6)C.P.I.C.P.I. = Last year’s index(1999-earlier year) x 100; 166.6 x100 = 3.4%= Last year’s index(1999-earlier year) x 100; 166.6 x100 = 3.4%

_________________________ “ “Rule of 72”Rule of 72” = % annual rate of increase (3%) = 24 years

““Real Income”Real Income” measures the amount of goods/services nominal income will buy.[%% change in real incomechange in real income = % change in nominal income% change in nominal income - % change in PL% change in PL.] 5%5% 10%10% 5%5%

7272

Indicators of the Business CycleIndicators of the Business Cycle[“The leading indicators have predicted 11 of the last 15 recessions”]

Leading IndicatorsLeading IndicatorsAvg. work week Building permitsCredit Delivery timesNew orders InventoriesNew businesses Materials pricesStock prices Money supplyNew orders Unemployment claims

Had a recession in 2001Had a recession in 2001

““BarometerBarometerOf The Future”Of The Future”

[6-9 months[6-9 months]]

A A drop for drop for three straight three straight months usually indicatesmonths usually indicates a recession is coming.a recession is coming.

““Where we are heading”Where we are heading”

Indicators of the Indicators of the BusinessBusiness Cycle Cycle

Coincident IndicatorsCoincident Indicators1. Personal income minus transfer payments2. Nonagricultural payrolls3. Industrial production4. Manufacturing and trade sales

““Where we are now”Where we are now”

Indicators of the Business CycleIndicators of the Business Cycle

Lagging IndicatorsLagging IndicatorsLabor cost, unemployment rate & duration, prime rates, CPI for services, commercial loans

““Where we have been”Where we have been”

History of Inflation, 1860-2006History of Inflation, 1860-2006

2006

$1.50$1.50 $11$11

$7$21$21

Inflation Since 1954Inflation Since 1954

Inflation – overall increase in pricesInflation – overall increase in prices Deflation – decrease in prices (1954)Deflation – decrease in prices (1954)

Disinflation – decrease in inflation(1980-83)Disinflation – decrease in inflation(1980-83)

Up in 2004Up in 2004Tomatoes 50%Tomatoes 50%Fuel Oil 40%Fuel Oil 40%Butter 28%Butter 28%Gasoline 26%Gasoline 26%Home gas 16%Home gas 16%Chicken 8%Chicken 8%CCol.ol. Tuition 9% Tuition 9%Sausage 7%Sausage 7%SSportsports tickets tickets 7%7%

Down in 2004Down in 2004EggsEggs -20% -20%PCsPCs -14% -14%PhotosPhotos -14% -14%TVs -12%TVs -12%Lettuce -8%Lettuce -8%ToysToys -6% -6%Cars -4%Cars -4%Girls cloth -1%Girls cloth -1%

Above about 2.0% inflation isAbove about 2.0% inflation is considered too much. [4.1% in 2005]considered too much. [4.1% in 2005]

Take some money Take some money out of circulation out of circulation to make it more to make it more valuable. valuable.

Demand-Pull InflationDemand-Pull Inflation – increase in AD.[“Too many dollars chasing too few goods”][“Too many dollars chasing too few goods”] Originates from “buyers side of the market”“buyers side of the market”

Cost-Push InflationCost-Push Inflation – 3 things maycause “cost-push” inflation.1. Wage-pushWage-push – strong labor unions2. Profit-pushProfit-push – companies increase prices when their costs increase.3. Supply-sideSupply-side cost shocks cost shocks – unanticipated

increase in raw materials such as oil.

Demand-Pull & Cost-Push InflationDemand-Pull & Cost-Push InflationDD1 1 DD22

““Demand-pull”Demand-pull”

PP22

““Wage-price”Wage-price”SpiralSpiral

SS11SS22DD

PLPL22

PLPL11

““Cost-push”Cost-push”

SS

PP11

The debtor winsdebtor wins with 20%20% unanticipated inflationunanticipated inflation.(some examples)

1. In 1914, total German mortgage debt was $10 German mortgage debt was $10 billionbillion marks marks. In 1923, $10 $10 billionbillion marks marks was was worth 1 worth 1 centcent. All debt All debt was was wiped outwiped out.

2. Signed union contracts agreeing to 3% raises3% raises for next 3 years3 years. (A $30,000 salary$30,000 salary would increase to $32,782$32,782 but it would take $51,840$51,840 to buy what $30,000 would buy 3 years before)

3. Signed union contracts agreeing to COLAsCOLAs for next 3 years. (So a $30,000 salary$30,000 salary of 3 years ago would now pay $51,840$51,840 which would buy what $30,000 would buy 3 years ago.

4. Your Econ teacher buys a $300,000 CD$300,000 CD from the 1st Econ Bank which pays him 5% interest5% interest for the next 3 years. [SaverSaver] Mr. Econ would earn $47,288earn $47,288 in interest at 5%5%, however at 20%,20%, he could earn $218,400$218,400.] So the saver loses heresaver loses here.

Who wins/loses with 20Who wins/loses with 20% % Unanticipated InflationUnanticipated Inflation??

[[CreditorsCreditors, , DebtorsDebtors, , SaversSavers]]

(Measures of Inflation PPI)(Measures of Inflation PPI)

Prices at the wholesale or production level which are early indicators of inflation. The 2,800 items include prices for raw materials, intermediate goods, and finished goods. The PPI does not include services.

PPI was 5.4 in 2005, highest since1990. The “corecore PPI” [no volatile food and energy] was only 1.7%.

2003

Consumer Price Index (CPI)Consumer Price Index (CPI)

[CPI measures cost of living relative to a base year[100][CPI measures cost of living relative to a base year[100]

The CPI is a market basket of 364 items364 items at 21,00021,000establishmentsestablishments in 91 cities91 cities that the typical householder buys. It does not include exports because we do not buy exports but does include imports. About 55% of the CPI is services55% of the CPI is services.

The The ““Market Basket”Market Basket”

Household10.0%

Food18.0%

Alcohol4.5%

Recreation10.4%

Clothing6.6%

Health4.3%

Transportation18.3%

Shelter27.9%

What’s in the CPI’s Basket? The The “Market Basket”“Market Basket”

CPI ShortcomingsCPI Shortcomings1. Substitutes not counted2. Quality not considered (airbags)

3. No discount stores (“outlet bias”)4. New items not counted a. 1st VCR, the Phillips 1500, the world’s 1st VCR for home use sold for $1,295 but $50 today. They fell in price 70% before entering the CPI.

b. First solar powered calculators appeared in 1972 for $120 but didn’t make the CPI until 1978. c. In 2000, a 20-inch LCD TV cost $5,000, today $550. d. Cell phones[The “Brick”“Brick”]were introduced in 1984 at $3,995. e. The camcorder cost $1,500 in 1987, now under $400. f. HDTV cost $8,000 in 1998. g. 42 inch Plasma TV in 1999 cost $11,000, now $1,500$1,500.

1969 Sharp QT-8D Calculator for $475 [4 functions]1969 Sharp QT-8D Calculator for $475 [4 functions][First battery-powered electronic calculator][First battery-powered electronic calculator]

If orange goesIf orange goesfrom $1.00 tofrom $1.00 to

$2.00$2.00&&

Tomato juice Tomato juice goes from $1goes from $1

to .80 to .80 Plasma “42”Plasma “42”““$11,000”$11,000”

PPIPPI and and CPICPI in March 2005 in March 2005

GDP DeflatorGDP Deflator – more broad – more broad

GDP DeflatorGDP Deflator includes prices for all goods all goods thatthat we producewe produce:

1.What householdershouseholders are buying2.What businessesbusinesses are buying3.What the governmentgovernment is buying4.What foreignersforeigners are buying [does does not include importsnot include imports because we don’t produce imports]

PCE (Personal Consumption Expenditures) Price Index

This price index is the “personal consumption” component“personal consumption” component in the quarterly GDPreport. It includes purchases of durables, non-durables, and servicesdurables, non-durables, and services, including operating expenses of nonprofit institutions, and the values of food, clothing, fuel, housing, and financial services. Unlike the CPI [a “fixed basket”], it takes intoaccount changeschanges in in consumer spendingconsumer spending (substitutions for higher priced products).

The Fed has decided this is a better indicator of inflationbetter indicator of inflation than the CPI, PPI, oroverall GDP Deflator.

GDP Deflator Compared to the CPIGDP Deflator Compared to the CPI [CPI is normally higher.][CPI is normally higher.]

Misery IndexMisery IndexInflation Rate + Unemployment Rate = Misery IndexInflation Rate + Unemployment Rate = Misery Index

Arthur Okun developed the economic “discomfort“discomfort index” index” to summarize the “health of the economy.”“health of the economy.”

Jimmy Carter used it against Gerald Ford and won. Ronald Reagan used it against Carter(20%) and won.

ArthurArthurOkunOkun

Inflation RateInflation Rate

Unemployment RateUnemployment Rate

Misery IndexMisery Index

GDP

GDP can be measured either by total total spending on U.S. productionspending on U.S. production or by total total income received from that production.income received from that production.

Expenditure approachExpenditure approach [C+Ig+G+Xn] [C+Ig+G+Xn] Adds up the aggregate expenditure on all final

goods and services produced during that year

Income approachIncome approach Adds up the aggregate income earned during the

year by those who produce that output

GDP

Government Purchases ( G )Government Purchases ( G )Government Purchases ( G )Government Purchases ( G )

Net Exports( XNet Exports( Xnn)) Net Exports( XNet Exports( Xnn))

Personal Consumption Expenditure Personal Consumption Expenditure (C)(C)Personal Consumption Expenditure Personal Consumption Expenditure (C)(C)

Gross Private Domestic Gross Private Domestic Investment (IInvestment (Igg))Gross Private Domestic Gross Private Domestic Investment (IInvestment (Igg))

EXPENDITURES APPROACHEXPENDITURES APPROACH

Net Exports (Xn)=Exports (X)–Imports (M)

[M represents production outside a country]

Eight Things Not Counted in GDPEight Things Not Counted in GDP[no production][no production]

1. Second Hand Sales[no production]2. Public/Private Transfer Payments3. Purely Financial Transactions4. Intermediate Goods

5. U.S. Corporations producing overseas6. Non-market transactions [household or volunteer work]Underground EconomyUnderground Economy7. Illegal business activity8. Unreported legal business activity

Importance of Real GDP in Determining aImportance of Real GDP in Determining a RecessionRecession

Apple GDP ExampleApple GDP ExampleA country produces 10 apples x $1;A country produces 10 apples x $1; GDP = $10 [base year =100]GDP = $10 [base year =100]

A country produces 10 apples x $1.25;A country produces 10 apples x $1.25; GDP = $12.50 (no recession but worse off)GDP = $12.50 (no recession but worse off)

Or, a country produces 9 apples x $1.259 apples x $1.25; GDP=$GDP=$11.2511.25 (recessionrecession but nominal GDP is upnominal GDP is up)

Real GDP is Nominal GDP corrected for inflationReal GDP is Nominal GDP corrected for inflation..

NominalNominal [money][money] GDPGDP v. Real GDPv. Real GDPAn increase in pricesincrease in prices and/or outputoutput will increasenominal GDP.

Only an increase in output will increase real GDPincrease in output will increase real GDP.Nominal GDP could increase even if output falls.

Real GDP = Nominal Y/GDP deflator x 100

So, nominal GDP measures output & pricesnominal GDP measures output & prices.

Real measures only output [actual production]Real measures only output [actual production]

Constant (real) GDP Constant (real) GDP v. current (money) GDP current (money) GDP

NominalNominal GDP GDP v. v. RealReal GDP GDP

Nominal [Current) GDPNominal [Current) GDPvv..

Real (constant) GDPReal (constant) GDP

Price of Market Basket(2001Price of Market Basket(2001) [nominal GDP][nominal GDP] $64$64GDP Price IndexGDP Price Index = Price = Price of sameof same Market Basket(1998)x100; Market Basket(1998)x100; [Real GDP] $50x100=128[Real GDP] $50x100=128[GDP Deflator][GDP Deflator] in the base year (1998) in the base year (1998) [$64/128 x 100 = $50][$64/128 x 100 = $50]

BBase yearase year[$50/$50=1x100=100][$50/$50=1x100=100] $46/$50x100=92 $46/$50x100=92 [deflation of 8%][deflation of 8%]

The “GDP” BalloonThe “GDP” Balloon

takes Nominal – measured in terms of money.

Real – measured in terms of goods/services.

$6,736.9/126.1 x 100 = $5,342.5

RecessionRecession[RealReal, not nominalnominal GDP GDP has declined]

1990-911990-91

Real GDPReal GDP

InflationInflationcomponentcomponent

UNEMPLOYMENTUNEMPLOYMENT Measurement of Unemployment, 2008Measurement of Unemployment, 2008

Employed

Not in laborforce

Under 16 and/orinstitutionalized

TotalTotalPopulationPopulation

304,000,000304,000,000

LaborLaborforceforce

149,800,000149,800,000

84,200,000

76,000,000

Unemployed 10,200,000

139,600,000

Full Employment = 4-6% unemploymentFull Employment = 4-6% unemployment

Discouraged workersDiscouraged workers – those who have given up.Unemployed workersUnemployed workers - those who are actively looking.Part-time workersPart-time workers – half employed, half unemployed,but counted as fully employed.Employed workersEmployed workers – those who work for even one hourper week for wages or 15 hours a week if not getting paid.

We have full employmentfull employment when cyclical unemploymentcyclical unemployment is is ““00””.

Wish I had Wish I had not dropped not dropped out of H.S..out of H.S..

Will workWill workFor FoodFor Food

Survey on UnemploymentSurvey on Unemployment

BLS calls 60,000 households every month. BLS calls 60,000 households every month. They ask three questions: 1. Are you working?1. Are you working? If the answer is nono, 2. Did you work at all this month-even 1 day?Did you work at all this month-even 1 day? You are a member of the LF if “yes”“yes” on 1 or 2.

3. Did you look for work during the last month?Did you look for work during the last month? [agency, resume, interview] A “yes”“yes” counts you aspart of the LFLF. A “no”“no” means you are not countednot counted.You are a “discouraged worker.”“discouraged worker.” The labor force consists of the employedemployed and unemployedunemployed.

Three Types of UnemploymentThree Types of UnemploymentFrictionalFrictional – “temporary”, “transitional”, “short-term.”(“between jobs” or “search” unemployment)

Examples:1. People who get “fired”“fired” or “quit”“quit” to look for a better one.2. “Graduates”“Graduates” from high school or college who are looking for a job.3. “Seasonal”“Seasonal” or weather-dependent jobs such as ““agricultural”agricultural”, “construction”“construction”, “retail”“retail”, or “tourism”“tourism”. [lifeguards, resort workers, Santas, & migrant workers.]Frictional unemployment signals that “new jobs”“new jobs” are availableand reflects “freedom of choice”.“freedom of choice”.

These are qualified workers “transferable” skillsThese are qualified workers “transferable” skills..

2.2. Structural UnemploymentStructural Unemployment

StructuralStructural – “technological”“technological” or “long term”.“long term”. There are basic changes in the “structure”“structure” of the labor force which make certain “skills obsolete”.“skills obsolete”.

AutomationAutomation may result in job losses.Consumer tasteConsumer taste may make a good “obsolete”.The autoauto reduced the need for carriage makers.

Farm machineryFarm machinery reduced the need for farm laborers.““Creative destruction”Creative destruction” means as jobs are created, other jobs are lost. Jobs of the future destroy jobs oftoday. Frictional and Structural make up the “natural“naturalrate of unemployment”rate of unemployment”.

““These jobs do not come back.”These jobs do not come back.”““Non-transferable skills”Non-transferable skills” – choice is prolonged unemployment or retraining.

3. CCyclical yclical UUnemploymentnemployment

CyclicalCyclical – ““economiceconomic downturns” downturns” in the business cyclebusiness cycle.

““Cyclical fluctuations”Cyclical fluctuations” caused by “deficient AD”“deficient AD”““Durable goods jobs”Durable goods jobs” are impacted the most.These cancan be be postponedpostponed because they can be repairedcan be repaired.““Cyclical unemployment”Cyclical unemployment” is “real unemployment”.“real unemployment”.

““These jobs do come back.”These jobs do come back.”