EconomicsCombined Version

Edwin G. DolanBest Value Textbooks

4th edition

Chapter 17In Search of

Prosperity and Stability

Economic Growth• The growth rate of real Gross

Domestic Product (GDP) per capita is the most common measurement of increasing prosperity– Nominal GDP is stated in terms

of prices at which goods are actually bought and sold

– Real GDP is adjusted to remove the effects of inflation

• US growth rate of real GDP is about average for the world– About 2-3% per year

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Real and Nominal GDP• The term "real" means adjusted for inflation. • Nominal GDP is a measure of national output

based on the current prices of goods and services. It is also called “money GDP”.

• Real GDP is a measure of the quantity of final goods and services produced, obtained by eliminating the influence of price changes from nominal GDP.

• Adjusting for Inflation requires a price index of some sort.

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Real Verses Nominal Growth:

What Increased?

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Calculating a Price Index:the old fashioned, simple way

• Select a basket of goods

• Price of that basket of goods in Y1 divided by the price of that same basket in Y2

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Calculating an Index

price index = current cost of basket base period cost of basket

Notes: • This formula yields a decimal. To translate it into the published form of

the index (like CPI) multiply it by 100 (as if you were turning it to a percentage).

• When using the index to calculate “real” values, use it in its decimal form

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Calculating “Real” ValuesReal GDP, Real Wage, Real Price, Real

Income, etc.

Real Value of Xt = Xt . Price index at time t

• Note: when using this formula, be sure you use the price index in it’s decimal form, not in its expanded percentage form.

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Three Key Price Indexes Consumer Price IndexConsumer Price Index (CPI)(CPI)

– measures the impact of price changes on the cost of the typical bundle of goods and services purchased by households.

Producer Price Index (PPI)Producer Price Index (PPI)– A measure of the average prices received by producers for raw

materials, intermediate, and final goods. The PPI used to be called the Wholesale Price Index (WPI).

GDP Deflator (GDP Price Index or GDPPI)GDP Deflator (GDP Price Index or GDPPI)– Is a broader price index than the CPI. It is designed to measure the

change in the average price of all the goods and services included in GDP.

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Price Indexes • The value of a price index in any particular year indicates how

prices have changed relative to a base year. (1982-84)• The base year is the year against which all other years are

compared.• The index is 100 the percent change in prices from the base

year.• This type of index suffers from substitution bias as some

buyers will change the mix of goods that they buy in response to price changes.

• Chain-type indexes of real GDP were created to correct for this bias. Such an index uses the mean of the growth rates using beginning and ending year prices.

Sources of Growth

• Growth of population and increased labor force participation

• Growth of productivity (output per worker)– Increase in capital per worker – Increase in total factor productivity

Productivity Growth in the United StatesProductivity growth varies from year to year. In the 1970s U.S. productivity growth slowed down. It revived again during the hi-tech boom of the 1990s, but has recently slowed again.

Growth and the environment:Trade-off?

• In early stages of economic development, increasing production of material goods often leads to reduced environmental quality (A to B)

• In later stages, properly managed growth can increase both production of material goods and environmental quality

Actual and Natural/Potential GDP GrowthBecause of increasing population and productivity, the nation’s natural or potential GDP increases steadily over time. As it does so, actual real output is sometimes above and sometimes below the natural level. The difference is called the output gap

Business Cycles• Business Cycle: the pattern of real GDP rising and

falling.

• Recession (Contraction): two or more successive quarters of falling real GDP.

• Depression: a severe, prolonged economic contraction. Usually involves unemployment rising to greater than 10% for years.

The Business Cycle

Economic Indicators• Leading Indicators

• Variables that fairly consistently changes before real GDP changes

• Coincident Indicators• Variables that fairly consistently changes at the same time

as real GDP changes

• Lagging Indicators• Variables that fairly consistently changes after real GDP

changes

Indicators of Business CycleLeading Indicators

Average Work WeekAverage Work Week

New Building PermitsNew Building Permits

Unemployment ClaimsUnemployment Claims

Manufacturers’ New Orders

Manufacturers’ New Orders

Interest Rate SpreadInterest Rate Spread

Stock PricesStock Prices

New plant and equipment orders

New plant and equipment orders

Consumer ExpectationsConsumer Expectations

Money SupplyMoney Supply

Indicators of Business CycleCo-incident Indicators

Personal income Personal income

Manufacturing and trade sales Manufacturing and trade sales

Industrial production Industrial production

Payroll employment Payroll employment

Indicators of Business CycleLagging Indicators

Unemployment duration

Unemployment duration

Inventories to sales ratio

Inventories to sales ratio

Prime interest rate Prime interest rate

Labor cost per unit of output

Labor cost per unit of output

Great Depression

Year U.S. Unemployment Rate

1929 3.2%

1930 8.7%

1931 15.9%

1932 23.6%

1933 24.9%

1939 17.2%

UnemploymentThe unemployment rate is the percentage of the labor force that is not working.

The U.S. Labor Department defines the labor force as being equal to:

• All U.S. residents• Over the age of 16• Who are not institutionalized• Who are working or looking for work

Rate ofUnemploymen

t

number unemployednumber in the Labor Force=

Interpreting theUnemployment Rate

• Discouraged Workers are workers who have looked for work in the past year, but who have stopped looking because they believe no one will offer them a job.

• Underemployment is the employment of workers in jobs that do not utilize their productive skills.

Types of Unemployment

Seasonal Unemployment:

A product of regular, recurring changes in the hiring needs of certain industries on a monthly or seasonal basis.

For example, retail sales are higher during the holiday season therefore unemployment in this industry goes down during the months of November and December.

Types of Unemployment

Frictional Unemployment

Usually short term, occurs because workers and employers have to find one another.

Example: College graduates seeking employment are a good example of frictional unemployment.

Types of Unemployment

Structural Unemployment

Reflects an imperfect match-up of employee skills and the skill requirements of the available jobs or a permanent reduction in demand for an industry’s output.

Example: Advancements in technology have resulted in consistent declines in employment in the agriculture, forestry and fishing industries.

Cyclical Unemployment

A product of business cycle fluctuations.As a recession occurs, cyclical unemployment increases, and as growth occurs, cyclical unemployment decreases.

As the housing boom of the early 21st century slows, unemployment in related industries like builders and real estate agents increases.

Types of Unemployment

Unemployment and Its Costs• Natural Rate of Unemployment

The level of unemployment that results when the rate of unemployment is normal, considering both frictional and structural factors. Also called the NAIRU (Nonaccelerating Inflation Rate of Unemployment)

• Potential Real GDPThe level of output produced when nonlabor resources are fully utilized and unemployment is at its natural rate.

• GDP gap = potential real GDP – actual GDP

Unemployment in the United StatesThe unemployment rate rises during contractions and falls during expansions. Because some people are always entering the labor force or changing jobs, it never falls to zero.

Unemployment: US vs EuropeThe natural rate of unemployment varies from country to country, depending on cultural factors and labor laws. The natural rate has fallen over time in the United States while it has risen in Europe

Unemployment by duration

During a recession, more people are unemployed, and the average duration of unemployment also increases. Even during a recession, many of the unemployed are out of work for 14 weeks or less. Social costs of unemployment fall most heavily on the long-term unemployed, whose numbers increase greatly during a recession.

Inflation in the United States• Inflation means a sustained

rise in the price level• Deflation means a

sustained fall in the price level

• During 2009, the United States experienced several months of deflation, but prices began to rise again late in the year.

World inflation averages• Inflation was much

higher in the 1970s and 1980s than it is now

• During the 1990s, inflation fell, first in advanced countries and then in developing countries

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Calculating an Inflation Rate

Inflation or deflation = change in index X 100 initial value of the index

Notes: • Inflation is stated as a percentage, hence, the “X 100” which is just

shifting a decimal to a percentage.

• Price increases are referred to as Inflation, price decreases are Deflation

• Once you’ve calculated the total inflation, you can divide it by the number of years to get an annualized inflation Rate

Inflation and interest rates

• Inflation affects interest rates as well as prices

• The nominal rate of interest is expressed in the ordinary way, in current dollars

• The real rate of interest is the nominal rate adjusted by subtracting the rate of inflation

Let• R = nominal rate of interest• r = real rate of interest• π = rate of inflationThen

r = R - π

Inflation and GrowthInflation of more than a few percent per year tends to undermine economic growth. On average, countries with more than 100 percent annual inflation have negative economic growth.