Economics 1021 - Lecture Notes - Professor FazzariTopic II: Macroeconomic Data

(Update January 29, 2013 )

**Important Note** The material covered in this section of the notes on the measurement of inflation and unemployment will not be discussed in class, but you need to learn about these things for the homework and the first exam. The lecture notes for topics B. and C. in this file below provide the material that you need for these topics. Please study these notes carefully on your own.

A. Measuring Aggregate Output

1. Why Measure Output?

To test various theories about the economy, we need measures of total production. For example, we need good measures to determine what happens to the economy when interest rates fall. We also might want to compare economic performance across countries. For these "positive" reasons we need good measures of overall economic performance.

Good data are also essential as a guide to policy. For the Fed, the Congress, and the President to know what kinds of policies to pursue, they need good information about the state of the economy. Thus, there are "normative" reasons for measuring output.

Macroeconomic measures also have important political ramifications. Most voters may know little about GDP, but news of its weak or strong growth will matter for the outcome of national elections. Example: George H.W. ("Daddy") Bush lost the election of 1992 to Bill Clinton. There were undoubtedly many reasons for this outcome, but perhaps none was more significant than the weak news about the economy during 1992, particularly slow GDP growth. The economic figures also played a large role in the presidential election of 2012. The main theme of the Romney campaign to defeat Obama was that economic performance had been weak during Obama’s first term. These numbers matter!

While these points are made specifically about GDP, they also apply to measures of inflation and unemployment discussed in the lecture notes below. Indeed, in recent years, unemployment may be more important for political purposes than GDP because it is more tangible to the average voter.

2. Adding Up Diverse Products

If the economy produced just one kind of physical good (corn, for example), it would be easy to measure total output.

But it is difficult to calculate GDP because you have to find a way to measure and compare thousands (millions?) of very diverse products. It’s hard enough to

compared physical goods (How many boxes of corn flakes equals one car?). But a large majority of what a mature economy like the U.S. produces is not even physical "goods" that can be counted. Instead a lot of production comes from the “service sector” that employs vastly more people than the goods-producing “manufacturing” sector. In 2009 services accounted for about 75% of the production of developed economies. (See the International Monetary Fund statistics listed by Wikipedia at http://en.wikipedia.org/wiki/List_of_countries_by_GDP_sector_composition ). Examples of services include education, visits to the doctor, much of health care, etc.

Somehow, all the diverse goods and services produced must be aggregated to come up with a measure of total national output.

3. GDP Definition

Gross Domestic Product (GDP): the money value of all final goods and services produced in an economy over a given time period.

GDP is typically measured over a period of a quarter or a year. GDP always is associated with a time period. It only makes sense to measure output over a period of time, not at a single point in time.

The definition of “an economy” is usually a country, but it could be a state or smaller unit. (There are statistics available called “gross state product.”)

a) Logic of Using Money Values as Weights for Aggregation

To meet the challenge of the vast diversity of products, economists use the money value of goods and services to determine their individual values. The money values are then added up to get a measure of aggregate output.

Relative money values reflect the different values people put on different goods. The reason a car represents more production to society than a box of corn flakes is that people value a car more highly. This point is reflected in the relative money values of cars and corn flakes, and all other goods produced in a market society.

You may be asking yourself, "well, duh, what else could economists possibly use?" An answer to your question is that we could measure GDP based on how many hours were worked to produce the goods and services. However, money values give a better estimate of the relative value society places on different goods and services (as opposed to the effort that goes into producing different things).

The computation of GDP is a very complicated statistical process. The Bureau of Economic Analysis in the Department of Commerce conducts surveys and employs tax data to arrive at an estimate of GDP in each quarter. Estimates first appear one month after the end of the quarter but they are subsequently revised. Sometimes substantial revisions occur even after a couple of years.

b) Final vs. Intermediate Goods and Services

A final good is one that is ultimately used by the consumer

An intermediate good (or service) is one that is purchased to be used in the production of another good (or service)

Only final goods are included in the GDP totals. Intermediate goods are not counted in GDP because we would be double-counting the amount of output that is actually produced.

Example: Consider a car that costs $30,000 from the dealer: Let's say the dealer bought the car from the producer for $25,000, and the producer spent $15,000 on parts and materials to make the car. The total value of the transactions involved in producing the car is the sum of $30,000 (the retail cost of the car), $25,000 (the wholesale price the dealer paid to the car manufacturer), and $15,000 (the value of inputs purchased by the manufacturer.) But it should be clear that this approach would greatly overstate the value of goods represented by the car, which is just $30,000. We exclude the purchases of items prior to the sale of a final good to the ultimate consumer as intermediate goods.

Another example: the value of electricity used in a home counts towards GDP because the person in the home is the final consumer. Electricity used in a place of business is considered an intermediate good, as that electricity is just an intermediate good that is used to produce another good/service.

c) GDP Sales and Inventories

GDP measures production, NOT sales. However, we do measure GDP in money values, so sales are involved in the calculation of GDP.

Goods that are produced during the year but not sold are added to inventories. These goods still count towards GDP at the time they were produced, even though they are not sold.

The relationship between GDP and sales is given by the following equation:

GDP = Final Sales + Change in Inventories

So, a $1,000 refrigerator produced in the year 2010 but not sold until 2011 will count towards GDP in the year 2000 as a positive change in inventory. When the refrigerator is sold in 2001, final sales will increase and there will be a negative change in inventories, so the net change in GDP for 2001 is zero. In table form:

GDP Final Sales Change in Inventories

2010 +$1,000 -0- +$1,000

2011 -0- +$1,000 -$1,000

d) Investment: Intermediate or Final Good?

(1) Definition of investment

Investment consists of these three components:

o Structures, equipment, and software purchases by firms. Basically durable goods that firms use to carry out their business. This category is called “nonresidential fixed investment” in the government statistics. Software was added to this component a number of years ago.

o Residential Construction: value of new housing built in the GDP time period (not the value of existing houses). Home improvement, like a room addition or substantial remodeling, also adds to this component.

o Change in Inventories

Note that "investment" for purposes of this course refers to these components, not the purchase of stocks, bonds, or other financial assets. Thus, the term “investment,” as typically used in macroeconomics, usually means something different from its common usage.

(2) Should investment goods be counted as final output?

It may seem like these investment goods purchased by a business should be intermediate goods because they are used to produce other goods and services. However, economists include them in GDP because they are durable. Durable goods are defined as goods that last for at least 3 years. A durable good will still be used for many years after they are produced. An economy that produces a lot of investment goods in a year that are available for future use is more productive than an economy with little investment. Thus, it makes sense to include investment goods in GDP.

Software did not used to be counted as investment, it used to be considered a simple intermediate good when purchased by firms (like raw materials or electricity). However, software is “durable” and has recently been included in the investment category. This change of definition would raise GDP, even with no change in the production of anything. (Do you understand the previous sentence fully? If so, you have a pretty good idea of what we have covered so far.)

(3) Gross vs. Net Domestic Product (NDP)

One might argue that something should be subtracted from GDP to account for productive goods that are used up during the year.

Definition of Depreciation: the value of that portion of the nation’s capital equipment that is used up within the year

Net Domestic Product = GDP – Depreciation

GDP measures final output and does not take into account the capital used up in the process (which must eventually be replaced). NDP deducts the depreciation to arrive at a net measure of production.

NDP is conceptually better than GDP. NDP allows for the fact that investment goods produced this year may not be fully used up this year. But the NDP measure also account for the fact that some investment goods wear out every year.

Nevertheless, GDP is the primary measure used by economists and policy makers because depreciation is very difficult to measure accurately. Therefore, NDP is considered a less reliable measure of output than GDP.

e) Pre-Existing Assets Goods or services sold in a year that were produced in a prior year do not count

toward GDP.

Example: A 1995 car resold in 2000 does not count towards GDP in the year 2000. Remember that GDP measures production, not sales, and the car was already counted when it was produced in 1995.

Other examples include sales of homes built in previous years and sales of artwork produced before the year of interest.

The buying and selling of existing businesses would also fall into this category. If one company purchases another one, there is no effect on GDP.

Because shares of stock represent ownership of an existing business, exchange of shares of stock does not raise GDP. Note, however, that the value of brokerage services paid by individual investors are counted as the production of a final service and therefore add to GDP. The same principles apply to banking, insurance, real estate, etc. The value of assets bought and sold does not add to GDP, but the amount paid to financial service companies does represent production.

f) Market versus Non-market Exchange

GDP does not measure any transaction that does not go through markets (Examples: work that you do in your own home, illegal activities).

This means that hiring a person to mow your lawn for you counts towards GDP, whereas mowing your own lawn does not count towards GDP

This is a shortcoming of GDP. In principle, work you do for yourself or other activities that do not go through markets represent production and one could argue that it should be counted in GDP. However, it would be nearly impossible to account for all the non-market transactions that take place.

One application of this idea is to analyze the impact of GDP of greater labor force participation of women in recent decades. Their production for the market is now added to GDP, but the work they no longer do in the home (outside of the market) is not subtracted from GDP. Thus, one might argue that the growth rate of measured GDP during the past 40 years is somewhat higher than it should be.

If we look at the GDP figures of less developed countries, we will see that the per capita GDP is only a few hundred dollars. These countries are very poor. But their low GDP numbers probably exaggerate the extent of their poverty compared with developed countries. Most likely, a much greater proportion of their production does not go through a market, so it is not counted in GDP. The same problem arises for countries in which the underground economy is large. There exists a downward bias in their GDP because illegal transactions are unreported and uncounted.

g) The Components of GDP

(1) The GDP equation: GDP = C + I + G + Ex – Im

C = Consumption: everything consumers buy except housing. Consumption includes all durable assets (aside from residential housing), like cars and appliances.

I = Investment: the three components discussed above

G = Government Spending on goods and services

Ex = exports (goods produced in the U.S. and sold abroad)

Im = imports (goods produced outside the U.S. and sold here)

(2) Government spending on goods and services as one use for output

Government spending on goods and services (the “G” in the GDP equation) includes money spent on building roads, public education, local police and fire departments, and the military, and many other things. Goods and services bought by the government are considered, by definition, final goods and services, even though they may be considered intermediate when consumed by the private sector.

(3) Valuation of Government Services at Cost

Because there is no “market price” for these goods and services we use the cost to the government of providing this output as the contribution to GDP. For example, the contribution of soldiers to GDP is measured by what they are paid.

The relevant distinction between private production and government production is that no one makes a decision to buy government goods and services at a market price (most of the time). Perhaps government services are worth more or less to society than they actually cost. If this is the case, the actual measure of this component of GDP could be a distorted measure of the true “money value” of government goods and services.

o Useless things produced by the government would be counted in GDP even though they are not worth anything to people in the society.

o The government might provide extremely valuable goods or services, but at a cost much lower than the value people put on them. In this case, the measure of GDP would understate true money value of government.

(4) Role of Transfer Payments

Government spending DOES NOT include transfer payments, which is money given to individuals as grants from the government rather than as a payment in exchange for services. Examples include social security and unemployment benefits. These grants likely do help the recipients buy consumption. But it is the

consumption of final goods and services that is counted in GDP, not the value of transfer payments.

o Interest payments on the government debt are also a form of transfer payments.

o Government payments for medical care fall in a particularly tricky category. As an insurance payment, government payments through Medicare and other programs are treated as transfer payments. The logic is that the recipient purchases the medical care (and it’s therefore counted as consumption in the GDP equation) and the government makes an insurance payment which counts as a transfer and does not appear directly in GDP. The spending on medical care paid for by government insurance programs is part of personal consumption.

For this reason, the G component of GDP is typically much smaller than the standard measure of government spending. When we talk about total federal government spending, for example, we usually include transfer payments.

o Total government expenditure (2012:Q3): $5.7 trillion

o Government spending on goods and services (2012:Q3): $3.3 trillion

Transfer payments also take place among private individuals; consider gifts, grants, prizes, etc. These payments do not represent production and they therefore are not counted as GDP.

(5) Correcting components for imports to arrive at domestic production

While exports and imports can be in the form of consumption goods, investment goods, or government spending, we lump them all together in the export and import categories.

Exports are counted in GDP because the goods are still produced in the U.S., even if they are consumed outside the U.S. Even intermediate goods exported from the U.S. count in GDP because they were produced in this country and will not be counted in any other U.S. final output.

Imports do not contribute to GDP because they are produced elsewhere. However, imports are included in the other components of GDP, so we must subtract imports to get a measure of production in the domestic economy. For example, if the U.S. imports a television and sells it, the money spent on that television is included in consumption. However, the TV was not produced in the U.S., so we subtract the amount the importer paid for the TV from GDP. (Note, however, that the profit made by the company that imported and sold the TV importer would count in GDP.)

Another example: Toyota assembles a $30,000 car in the U.S. However, the car contains $10,000 worth of imported parts. The car will add $30,000 to consumption (if it is bought by a household) or investment (if it is bought by a business), but the $10,000 of imported parts will be subtracted from GDP. So the contribution of this car to GDP is $30,000 - $10,000 = $20,000.

4. GDP and Income

a) Why GDP must equal income

At the aggregate level, income and production are conceptually the same thing. When goods are produced, they are eventually sold, and they generate revenue that goes into national income.

Example: think about a car that is produced and sold for $30,000. This revenue generates various income flows, such as wages, profits, interest, and rent. Some of the revenue goes to buy intermediate goods. But payments for intermediate goods generate revenues for the firms that produce them and these revenues are also transformed into incomes. If you continue to trace the intermediate goods through the various stages of production, you will see that at each stage a greater and greater share of the $30,000 in initial revenue is transformed into some kind of income. In the limit, all of the $30,000 generated by the production of the car will be transformed into some kind of income.

The main point is that every dollar of final output will be transformed into some kind of income. Production of output is the source of income. Thus, we can use a production concept, such as GDP, to also represent income, and therefore living standards.

It is also useful to recognize that production (and subsequent sale of what is produced) is ultimately the source of income. Income doesn’t come from the printing of money or any other financial process. We think of income in terms of money because we value production by its money value. But to get income, something must be produced.

b) Technical issues: depreciation, indirect business tax, and international income flows

While conceptually, income and GDP are the same thing, the actual statistics differ for the following reasons.

Depreciation is subtracted from national income.

Due to indirect business taxes (mostly sales taxes), we pay more than businesses actually receive as revenue when we buy a good or service.

Also, Americans earn income abroad that counts toward U.S. national income and foreign citizens earn income from U.S. production that is subtracted from national income.

The following equations account for these technical issues to reach the statistical definition of national income:

GNP = Gross National Product

GNP = GDP + Income earned by U.S. citizens abroad – Income earned by foreign citizens in the U.S.

National Income = GNP – Depreciation – Indirect Bus. Taxes

But these technicalities do not change the main point: production is the source of all income and the two concepts are often used interchangeably.

5. GDP as a Measure of Social Welfare

a) Desire to measure whether an economy is better off

GDP is useful for the purpose of comparing how a country is doing over time, whether the economy improves following certain policies etc. There is normative value embedded into the concept.

If GDP is higher so it income. When we think of economic well-being, we usually relate it to income. Consider the debates about the “top 1%.” This is usually defined in terms of income. Remember the conceptual equivalence between GDP and income. So, if you accept that income is a measure of economic welfare, this is almost the same thing as using GDP as a measure of welfare.

We typically would want to scale GDP (or national income) by some measure of population to measure material standards of living. (Example: China has a higher overall GDP than Switzerland, but the average Chinese citizen does not have a higher standard of living than the average Swiss citizen.) GDP divided by population is called per capita GDP.

b) More is Better?

In this class (and most other economics classes), we usually assume that “more is better,” meaning that people are better off when they have more goods and services.

o Note that if we take into account unfavorable aspects of production, such as pollution, this assumption may not necessarily be true. There are clearly other aspects of human satisfaction beyond material goods and services.

(1) Critique: Possibility of misleading assumptions about what brings human happiness

The “more is better” assumption certainly may not apply across individuals. We can all think of examples of wealthy people who are very unhappy and people of modest means who seem quite happy.

(2) Examples: The 1960s is sometimes considered a macroeconomic “Golden Age.”

GDP growth was very high and unemployment was low. Yet, there was substantial social unrest. Clearly there was more to measuring the well-being of U.S. citizens than just GDP.

More recently, psychologists and economists have looked at how various survey measures of happiness and life satisfaction change with income. The results are mixed.

o A recent prominent study found that higher income made Americans happier up to about $75,000 in family income (measured in 2008 and 2009). After that, higher income seemed to have little effect on survey responses that indicated happiness.

o This finding is consistent with a view that once basic needs are met (where what is “basic” may well be determined by typical social conditions in a country) more income does not add much to satisfaction.

o If this is the case, one might question the typical “more is better” assumption that underlies much of macro analysis.

However, it seems that most people are indeed happy, other things equal, when they can consume more goods and services from one year to the next, that is, people seem to appreciate more material output over time. This point helps to justify the “more is better” assumption.

o Research also shows that people are quite unhappy if their incomes fall. This finding justifies the objective of much of macroeconomics to understand, and ultimately to address, problems of recession and unemployment.

6. Limitations of GDP as a Social Welfare Measure

We will assume that higher levels of GDP and faster growth are better. However, even if you accept that “more is better,” there are limitations to the concept of GDP.

a) GDP and Income Distribution

Macroeconomics usually focuses on aggregate production and consumption and therefore suppresses any discussion of how the consumption of goods and services is distributed across individuals or groups within the society.

(1) Does money value reflect true social value when distribution is unequal?

An increase in GDP represents rising material living standards for the society as a whole, but this increase may not be equally distributed across all members of the society. The most significant concern is usually that relatively wealthy people get a greater share of rising GDP.

Example: In the U.S., since roughly the late 1970s, income distribution has become less equal. There was substantial GDP growth (and therefore income growth) in the aggregate from the early 1980s until the onset of the Great Recession in late 2007. But middle- and lower- income people have enjoyed less benefit from this growth than high-income people. This fact has contributed to the sense that the middle class standards of living has stagnated.

o The chart below shows the rising share of (pre-tax) income in the U.S. earned by the top 5% of the income distribution. The increase since the early 1980s is quite pronounced.

Other examples of this problem occur in less developed countries. In Latin America, in particular, the distribution of income is very unequal, with a few very rich people and a majority of the population living in poverty.

To the extent that income distribution is important, the GDP measure is a limited indicator of the overall material welfare of a society.

o For example, one might argue that the growth in U.S. GDP in recent decades overstates the rise in the country’s standard of living because so much of the growth has gone to the top of the income distribution (who may not benefit from it all that much if the happiness research mentioned earlier is correct!)

However, when the economy is booming, most people are doing better than they were. When the economy is in a recession, most people are worse off. Even if one doesn’t lose one’s job in a recession, wages and salaries usually grow more slowly (or even contract). And even the greater threat of losing one’s job can create stress and reduce well being. Income distribution may change to some extent during business cycles, but, once again there is likely to be positive correlation across individuals in their economic well-being during cycles.

(2) Importance of values to evaluate economic changes.

To make comparisons across people with different levels of income or wealth, one needs to make value judgments. The judgment that society would be better off by allocating additional production to the less fortunate than to the wealthy is a value judgment.

Economists are sometimes reluctant to make value judgments, but such judgments are inevitable in assessing many social policies.

The concept of GDP itself implicitly reflects a value judgment if we use it as an index of social welfare. The use of money values to determine the relative “weights” of different kinds of output reflect not just the value people put on different kinds of production but also the ability of different people to pay for goods. The poor have little influence in the markets that determine prices because they cannot pay as much for goods and services as the middle class, or certainly the rich.

b) Value of Leisure

GDP measures what is produced in the market if people work more, they produce more, so GDP goes up. GDP does not reflect, however, what people give up when they work. In particular, people may sacrifice leisure when they work to produce for the market. In this sense again, GDP is a limited indicator of social welfare because it does not account for the sacrifice of leisure people make when they work.

Example: In World War II, many people, especially women, entered the labor force and took war production jobs that they never would have taken in peace time. GDP rose dramatically due to production for the war. However, there was no deduction for the cost the extra workers incurred by sacrificing their leisure. More broadly, these workers gave up other things besides simply "leisure." They likely reduced their household, non-market production and other activities that they preferred to factory work.

Another example: In Europe, most people take much longer vacations than in the U.S. More vacation time implies less market work, and less GDP. But Europeans might well have greater welfare nonetheless.

c) Environmental Degradation

In recent years, most people have recognized the damage to the environment caused by standard production activities. Production causes air and water pollution, destruction of natural habitats for wildlife, urban sprawl, global warming, etc.

This damage is bad for society, but no subtraction is made from GDP to account for environmental degradation.

Some people have tried to estimate what has been called "Green GDP," a measure of GDP that makes subtractions for environmental damage resulting from production. In principle, this can be done by measuring environmental damage, putting prices on the damage, and subtracting the resulting costs from the market

value of final goods and services. In practice, however, it is difficult to measure the environmental effects of production, and perhaps it is even more difficult to determine the appropriate prices to value environmental damage. How do you put a "price" on global warming, for example?

Again, the inability of the standard GDP measure to account for environmental problems makes GDP a limited measure of social welfare.

d) Bads versus goods

Sometimes good economic performance stems from an event or situation that is bad for society

(1) Examples:

World War II caused GDP to rise dramatically, but no one would argue that the war was a good thing.

Earthquakes in California caused production to rise because a lot of construction and replacement of goods occurred. The effect of natural disasters, such as hurricanes, are so strong that they can be observed in the aggregate data.

A flu epidemic that raises medical production, also raises GDP. Yet, illness is not a desirable outcome for society.

When a society has a high crime rate, more prisons are built and more prison guards are hired. This will raise GDP, but a high crime rate certainly isn’t desirable

Summary: We have seen that there are many reasons why we cannot measure social welfare based purely on economic performance. For example, people’s happiness can result from much more than just material goods, leisure may be undervalued in measuring GDP, and often natural disasters or wars can actually lead to improved economic performance. However, from an economic perspective, we will continue to assume that high GDP growth is desirable and good for a society. In most cases, this is a reasonable assumption, but you should recognize that there are some limitations to it.

B. Employment and Unemployment1. The large human cost of unemployment

The material economic losses due to unemployment are fairly obvious. People want to work more to consume more goods and services. If they are unemployed they will miss out on these material opportunities.

o Maintaining life styles during spells of unemployment is difficult if not impossible. The savings of the unemployed are often depleted, lowering their sense of economic security.

o Unemployed people usually lose their fringe benefits, particularly their employer-paid health insurance.

o These costs are offset to an extent by unemployment insurance. But this insurance replaces only a part of lost wage, insurance benefits can be collected for only a limited period (often just six months), and some workers are not a not covered by such insurance.

Even to the extent that the material losses are offset by unemployment insurance there are still significant social and psychological costs of unemployment.

o Our society places much emphasis on material success and career status. Individuals' self esteem is often closely bound up with their job situations.

o The work place is an important social environment for many people. It provides friendship and support. People are cut off from these links when they are out of work.

o Studies have shown that unemployment increases the chances of family breakup. It probably also contributes to child and spouse abuse.

Being unemployed hurts an individual's work record, making it more difficult for him or her to find another job.

2. Unemployment as a waste of resources

The labor that people are willing to offer but are unable to expend is not "saved" to be used at some other time. The material goods that unemployed workers might have created are lost to society. It's just as if these goods and services had been thrown away.

o It has been occasionally argued by some economists that unemployed people are "resting," at least to some extent. Then, because of their time off, they may be more willing to work later in life. If this were true, the material goods lost to unemployment might not be a total waste.

o But given the human costs mentioned above, it is hard to believe that the leisure of unemployed workers is much of a benefit. It is even less credible to assume that the labor wasted due to unemployment will be recaptured in the future when these "well rested" workers manage to find jobs.

A macro textbook claimed some time ago that a conservative estimate of the wasted resources due to unemployment from 1974 to 1993 amounts to $1.6 trillion. This is a big number. The economy performed well between 1993 and 2000, with little additional loss due to unemployment. But from 2001 through (at least 2003), more resources were wasted due to unemployment.

o Unemployment in the “Great Recession” that began in late 2007, and its aftermath has been devastating by historical standards. One could make the

case that the economy has lost value of between $1 trillion and $2 trillion every year since 2009. This estimate is controversial, but if it is correct it is a huge waste of resources.

People want to work and they want to consume more; they don't ask for something for nothing. The inability of the economic system to coordinate the willingness to work with the ability to work and earn the means to purchase more goods and services is a fundamental failure of modern economic systems. It is an important problem that we should care deeply about.

3) The unemployment rate

a) Survey method of measurement for official statistics

A person is not counted as unemployed simply because he or she is not working for pay. (Most of the students at Wash. U. are not working for pay, but they would not be counted as unemployed.) To be counted as unemployed, an individual must be actively seeking a job (or laid off and expecting to return to work).

Respondents to the survey can be classified in three different ways. 1) If an individual is working he or she is counted as employed and part of the labor force (call the number of people in this category "W"). 2) If a person is not working but has actively looked for work in the previous four weeks, or if the person is laid off from a job but expects to be recalled, he or she is classified as part of the labor force, but unemployed (call the number of people in this category "U"). 3) If a person is not working and has not actively sought work recently, he or she is classified as out of the labor force.

The unemployment rate is the number of unemployed people as a percentage of the labor force. In terms of the definitions above:

Unemployment Rate = 100 x [ U / (W + U) ].

Recent data: the official unemployment rate was 7.8 percent of the labor force (December, 2012). The rate has trended downward from its worst point of the Great Recession, now measured at 10.0 percent in October of 2010. But unemployment remains very high in early 2013 by historical standards.

o Unemployment was in the middle 4 percent range before is started rising in late 2007. Most economists considered the economy to be close to full employment at that time.

b) Changes in the unemployment rate due to changes in unemployment versus changes in the labor force

While a declining unemployment rate is usually viewed as a good thing, it is important to recognize the source of the decline. The rate can decline because unemployed people find jobs (good) or because people get discouraged from

looking for jobs and are therefore no longer counted as part of the labor force (bad).

There is some evidence that some of the improvement in the unemployment rate since 2010 is the result of “discouraged” workers dropping out of the labor force. The chart below shows the “Labor Force Participation Rate” for more than 60 years. This is the share of the population working or looking for work

o The dominant feature of this chart is the massive rise in participation from the mid 1960s through about 2000. The biggest factor that explains this rise is the increasing number of women in the market labor force. (Remember the discussion of market versus non-market activity in the discussion of the GDP concept.)

o Since 2000, the participation rate has dropped quite significantly. Some of this drop is likely due to the aging of the baby-boom generation born in the 20 years after World War 2.

o But much of this drop is also likely due to weak economic conditions, starting with the recession of 2001 and then greatly magnified by the Great Recession. Note that the participation rate was head upward modestly right before the Great Recession. Much, perhaps most, of the drop in labor force participation is likely due to a weak economy, not demographics.

c) Under-employed and discouraged workers: under-estimates of unemployment

The unemployment survey does not capture "under-employed" workers. These are individuals who would like to work more hours, but cannot. Some

might argue that people who cannot find jobs commensurate with their skills should be counted as under-employed, even though they have some kind of job.

This phenomenon could be important. In November of 1989, a survey claimed that 5 percent of the labor force consisted of part-time workers that wanted to be working full time. For comparison, the official unemployment rate at this time was 5.4 percent so nearly as many workers seemed to be affected by "underemployment" as those that were officially classified as unemployed.

Similarly, the unemployment rate does not count "discouraged workers." Suppose someone lost his job and looked for new work for a while, but gave up because he was unsuccessful in finding a job. Four weeks after he stopped actively looking for work, this person would be counted as out of the labor force, non unemployed. Again, this phenomenon could cause the official unemployment rate to understate the true magnitude of the unemployment problem. Indeed, there are months during periods of poor economic performance when the unemployment rate actually drops because discouraged workers stop looking for new jobs. (See the example of 1992 discussed above.)

d) Incidence of unemployment over a year versus measured rate at a point in time

The official survey may understate the incidence of unemployment because it is measures only those workers unemployed at a single point in time. For example, in 1986 the average unemployment rate was 6.2 percent. However, other research shows that 14.3 percent of the labor force experienced unemployment at some time during 1986. Thus, the phenomenon of unemployment may be more widespread than the official statistics suggest. Of course, this problem is likely to be especially severe during recessions. In bad economic times most U.S. families are either affected by unemployment themselves or are close to someone who is affected. This fact makes the economics of unemployment a very personal issue, and it raises the political stakes surrounding unemployment.

4. Cyclical, structural, and frictional unemployment

Frictional unemployment due to job turnover. We would not expect frictional unemployment to ever be zero. We probably would not want frictional unemployment to be zero. Job switches allow people to seek more productive and satisfying work, improving personal as well as social welfare.

Structural Unemployment due to a fundamental change in the job market that destroys the jobs people had. For example, automation of an assembly line with robots might permanently eliminate some assembly line workers’ jobs. We would hope that structurally unemployed people would eventually find new jobs. But one might expect these new jobs to pay substantially less since any job-specific or firm-specific skills the structurally unemployed had in their old occupations would be lost.

o One way of characterizing the difference between frictional and structural unemployment is that one would expect frictionally unemployed workers to return to the same or similar jobs eventually. Structurally unemployed workers usually must either leave the labor force or change careers.

o It is a paradox that technological change that generates economic growth over the long run may also create negative effects through structural unemployment.

o An important difference between frictional and structural unemployment is that the former may often be voluntary. People may quit their current jobs to look for something better. It is hard to imagine a situation in which structural unemployment would be voluntary.

Cyclical unemployment due to reduced production. This category is the main focus of macroeconomic analysis. It arises when firms are not selling enough output to keep all their employees working.

5) Unemployment rate as a “lagging indicator” of the business cycle

Note that cyclical unemployment (and the overall unemployment rate) is a "lagging indicator" of the business cycle. That is, cyclical unemployment begins to rise after production begins to fall in a recession. This happens because firms may not immediately lay off workers when their sales decline. They often wait to cut employment until a recession becomes more serious. Similarly, firms will not immediately re-hire workers when the economy begins to recover. They may wait until they are confident that economic conditions will improve for a sustained period.

This phenomenon can be explained, at least in part, by substantial hiring and training costs of workers. Firms are reluctant to lay off workers that they may need in the near future. But firms are also cautious about hiring and training new workers in the early stages of a recovery when they are not sure that the new employees will really be needed.

The reluctance of firms to hire new workers, even as the economy recovers from a recession, was blamed for unusually low employment growth after the recession that officially ended in the middle of 1991. The unemployment rate continued to rise after the recession was officially over, and, even though statistics show that the economy was growing through 1992, the general perception at the time was one of poor economic performance. Thus, even though the recession was officially over more than a year before the 1992 presidential election. high unemployment, slow job growth, and negative perceptions of the economy greatly hurt George Bush and paved the way for Bill Clinton's November, 1992 victory.

6) Recent statistics on the unemployment rate

Data from the early 1990s recession: When the recession officially began in June of 1990 the unemployment rate was 5.1 percent. By the official end of the recession in May of 1991, it had risen substantially to 6.7 percent. But, as mentioned above, unemployment continued to rise even though production (GDP)

was recovering slowly in the second half of 1991 and early 1992. (Remember, unemployment is a "lagging indicator" of the business cycle.) The unemployment rate peaked at 7.8 percent in June of 1992, and it had declined only to 7.4 percent by the election in November, 1992.

Similarly, as mentioned above, in the recession and weak growth period of 2001 to 2003, unemployment rose from a low point of 3.8 percent in April of 2000 (the lowest since the 1960s) to a high point of 6.3 percent in June of 2003.

While the early 1990-91 and 2001 recession were serious, cyclical unemployment has been much worse in earlier downturns. In the deep recession of the early 1980s the unemployment rate hit 10.7 percent in one month, and it averaged 9.7 percent for all of 1982. The 1975 average of 8.5 percent was also high in a severe recession year. But these episodes pale in the face of the Great Depression. The average unemployment rate for 1933 was 24.9 percent, and unemployment remained excessive throughout the 1930s. (It still averaged 17.2 percent in 1939.) World War II took care of unemployment, however. It was only 1.9 percent in 1945.

Economists are now looking carefully at the unemployment rate in the Great Recession. We will discuss this dramatic event in some detail in class. Although the rate never hit the 10.7 peak from 1982, the rise from below 5% in 2007 to 10% in 2010 was larger than the rise in the deep early 1980s recession. And the recovery appears to be slower. Almost all economists agree that the Great Recession and the slow recovery that followed it has been the worst economic crisis since the Great Depression of the 1930s.

7) Definition of full employment

The easiest definition of full employment is a situation in which cyclical unemployment is zero. Because of frictional and structural unemployment, however, we would not expect the official measured unemployment rate to be zero even when economists would claim the economy is at full employment.

How high is the measured unemployment rate when the economy is at full employment? It is difficult to answer this question, since we have no unambiguous way of classifying unemployed people into the frictional, structural, and cyclical categories. The lowest estimates I have seen are around 3 percent. For many years, most economists believed, however, that the economy is at full employment when the measured unemployment rate is 5 to 6 percent. These views were challenged by the experience of the late 1990s. The unemployment rate was below 6 percent from 1994 through early 2003 and below 5 percent from 1997 until late 2001, and from mid 2005 until 2008. This evidence supports the views of those who believe that the U.S. economy can operate effectively for sustained periods with low unemployment rates.

a) Possible inflation problems if the unemployment rate falls below the full employment level

This debate over full employment and how far the economy is from that desirable state is central to macroeconomics and policy decisions. There is wide agreement among economists that if the government tries to stimulate the economy when it is already at full employment, wages will start to rise faster (as firms have to compete harder to hire workers) and inflation will accelerate.

In 1994, the Federal Reserve chairman, Alan Greenspan, took actions to reduce stimulus to the economy because of fears about inflation; these actions were strengthened in August, 1994. These moves were controversial and led to much criticism of Greenspan and the Fed from people who believe that unemployment should still fall more.

o The critics of the Fed have some support from economic statistics. Wage data show that in spite of the fall in the unemployment rate from 1993 through 1998 and the steady low unemployment rate through 2000, wage inflation did not accelerate. This experience caused many economists to re-evaluate their views about how low the unemployment rate can get without triggering higher inflation. Now, most economists probably believe that unemployment can be sustained below 5 percent during periods of good economic performance.

Again in 1999 the Fed raised interest rates out of the concern that an "overheated" economy with too much growth and too low unemployment would cause inflation. These actions, however, have been called a "pre-emptive strike" because there really was no significant evidence of higher inflation during this period. Indeed, the recession and slow growth period of late 2000 through mid 2003 may have been due, in part, to the attempt of the Fed to preemptively slow down the economy. In retrospect, the actions of the Fed in 1999 look like a mistake.

C. Measuring Prices and Inflation

1. Defining inflation and its costs

a) Movements in all prices versus movements in relative prices: macro vs. micro perspective

Prices change all the time, but not all price changes are inflation. Inflation occurs when most prices in the economy tend to rise together. It is this kind of phenomenon that suggests the need for macroeconomic theories, because there appears to be something going on that cuts across lots of different microeconomic markets.

In the U.S. economy in recent years, prices have risen moderately, most of the time. But inflation isn't inevitable. Sometimes economies experience deflation,

that is, the systematic decline of most prices. The last sustained deflation in the U.S. occurred during the Great Depression in the 1930s.

o In Japan there have been periods of falling prices since 1990 as the result of persistent economic weakness.

o In the U.S., there was a short period of deflation in the worst part of the Great Recession, but this probably had to do more with fluctuations of energy prices than anything else. That said, the Great Recession was serious enough that policy makers worried about the possibility of sustained deflation.

o Deflation is widely viewed as very unfavorable, a situation that economic policy tries hard to avoid.

b) Misconceptions about the costs of inflation: a “neutral” inflation

People typically believe that inflation, and the price increases it entails are bad for them. Of course, they would rather pay lower prices for the goods and services they buy, other things equal. But other things are not likely to be equal in an inflationary environment.

Consider the example of what economists might call a "neutral" inflation. This is a situation in which all prices are rising at exactly the same rate. These prices include, importantly, individuals' wages and salaries. They would also include other income categories like profits and rents. In a neutral inflation, any quantity measured in dollars would rise in money value (or what economists would call "nominal" value) at exactly the same rate.

(1) Real versus nominal quantities

Therefore, even though prices are higher, people could buy the same amount of goods and services because their incomes would have risen by the same amount. Economists would say that even though prices were higher, “real” wages and salaries remained the same because nominal wages and salaries kept up with prices. The purchasing power of wages does not change in a neutral inflation.

Economists usually assume that people care about these real quantities (purchasing power), not nominal quantities. That is, people don't care whether they are in an economy with wages of $10 per hour and prices of $1 per unit of output compared with an economy with wages of $20 per hour and prices of $2 per unit of output. Therefore, it is not obvious why anybody should care about neutral inflation.

(2) Psychological impact of inflation

One reason that people might dislike inflation is more psychological than economic. They might view the increase in their wages as something they earned and anticipate that they should get more purchasing power for. When prices go up, their purchasing power is eroded and they get mad. But if wages and prices

rise at the same rate, the real economic situation is not really any different from a world with zero inflation. To understand citizens’ concerns about inflation, therefore, economists have looked more deeply to identify costs of inflation.

c) Economic costs of inflation: why do we care?

Economic costs from inflation usually arise when inflation is not neutral. That is, when all quantities measured in money terms (prices, wages, the value of financial contracts, etc.) do not rise in money value at the same rate.

(1) Effects on individuals with fixed nominal incomes

For some people their income or wage may be fixed in dollar terms, no matter what prices are, at least for some period of time.

This situation used to be true for recipients of Social Security benefits. Their checks remained the same regardless of the rate of inflation. As prices rose, the purchasing power (or "real value") of Social Security benefits declined. Therefore, many analysts identified a large burden of inflation on the economic welfare of the elderly. In the 1970s, the Social Security laws were changed to automatically increase benefit payments when prices rose. (This is called the indexation of benefits.) Now, Social Security checks rise every year whenever the consumer price index goes up from one year to the next. Some private pensions, however, are still fixed in nominal terms. Individual with this kind of pension suffer from inflation.

Similar problems arise when workers are locked into long-term wage contracts. The real wages earned by these workers falls the higher the inflation rate. This phenomenon led to an indexation of wage contracts, especially in the late 1970s and early 1980s when inflation in the U.S. was relatively high by historical standards. These indexation clauses in wage contracts are often called COLAs, for "cost of living adjustment."

(2) Impact on wealth of borrowers and lenders

(a) Gains and losses on financial contracts

People who have lent money will lose purchasing power from inflation. The more prices rise during the term of the loan, the lower the purchasing power of the money lenders receive as repayment for loans.

Conversely, borrowers benefit from inflation since it reduces the real value of the money they must repay.

(b) Inflation expectations and interest rates

For these reasons, inflation expectations are a key determinant of the interest rates lenders require on loan contracts. If a lender expects inflation to be high over the course of the loan, he or she is likely to demand a high interest rate to compensate for the loss of purchasing power.

You can observe this phenomenon in real-world financial markets by noting that when good news comes out about inflation statistics, interest rates usually fall (bond prices rise) and vice-versa.

(c) Real versus nominal interest rates

Let's look in more detail at how interest rates and inflation interact. Suppose you lend a friend $1,000 for a year and you expect inflation to be 5 percent. If you charge your friend 5 percent interest, you will get back $1,050 at the end of the year. This is more money than you lent, but it does not represent an increase in purchasing power. Since inflation was 5 percent, the extra 50 bucks you received was just enough to offset the effect of increased prices. The "real" value of your money has stayed the same.

In this example the "nominal" interest rate was 5 percent. This is the interest rate actually quoted in financial contracts. But economists would say that the "real" interest rate was zero, because the purchasing power of the money did not change due to inflation.

If you had charged a nominal interest rate of 9 percent, earning $90 of interest, you would have enough to compensate for inflation ($50) plus some "real" return ($40). Your purchasing power would have increased by approximately 4 percent. The real interest rate was 4 percent.

Conversely, if you had charged no interest at all the purchasing power of your money would have declined by about 5 percent when the loan was repaid. In this case, while the nominal interest was zero, the real interest rate was negative 5 percent.

The general result is that the real interest rate is the nominal rate minus the inflation rate.

(3) Examples

(a) Home mortgages in the 1970s

Inflation had a big effect on those who had long-term home mortgages taken out in the 1960s and early 1970s before inflation increased in the mid and late 1970s. Lenders did not expect much inflation, and they were willing to lend long-term money for houses at interest rates of 5 to 7 percent. When inflation accelerated to 7 to 10 percent, mortgage lenders lost wealth while the borrowers gained. (The effective real interest rate on these loans was negative.) Many borrowers paid off their mortgages as slowly as possible because they could earn

more interest on savings deposits than they were paying on their mortgages. Ironically, while my mother complained about the rise in the price of hamburger in the 1970s, she was benefiting from inflation as the real value of her mortgage declined! These events also contributed to the financial problems of savings and loans that made lots of home mortgage loans.

(b) Inflation and government debt

The government is the biggest debtor in the U.S. Therefore, the real value of government debt is eroded by inflation. The numbers involved are huge. In 2012, for example, government debt held by private investors totaled about $11.3 trillion. Even at a modest inflation rate of 2.0 percent, about $220 billion of the purchasing power of this debt will be eroded over a year.

(c) Were interest rates higher under Carter and Reagan?

A brief history: Nominal interest rates were very high in the U.S., relative to historical standards during Jimmy Carter's presidency in the late 1970s. Given the analysis above, this fact should not be too surprising, since this was also a period of high inflation. Ronald Reagan was very critical of Carter's economic policy during the campaign leading up to the 1980 election. Among other things, his criticism focused on high interest rates. Of course, Reagan won the 1980 election and he pursued some new economic policies. Nominal interest rates did fall substantially in the early 1980s. In the 1984 campaign, Reagan claimed credit for this decline and warned that if his challenger, Walter Mondale (Carter's vice president), was elected, the country would return to an economic policy that produced the high interest rates during the Carter years. Mondale countered that while nominal interest rates had fallen, real rates had actually risen under Reagan.

The table below shows the nominal interest rate (measured as the yield on U.S. government Treasury Bills that mature in three months), the inflation rate, and the resulting real interest rate:

Nominal RealInterest Inflation Interest

Year Rate Rate Rate

1977 5.3 6.7 -1.41978 7.2 7.3 -0.11979 10.0 8.9 1.11980 11.5 9.0 2.51981 14.0 9.7 4.31982 10.7 6.4 4.31983 8.6 3.8 5.51984 9.6 4.1 5.51985 7.5 3.3 4.2

The table shows that Mondale had a point! Let's assume that economic conditions during the first year of a president's term are the result of his predecessor's policies. Then, averaging the four years Carter was responsible for (1978-1981) gives a nominal interest rate of 10.7 percent, an inflation rate of 8.7 percent, and a real interest rate of 2.0 percent. The same calculations for Reagan's first term (1982-85) give a nominal rate of 9.1 percent, inflation of 4.4 percent, and a real interest rate of 4.7 percent.

If, as most economists would argue, it is the real interest rate that really matters for the economy, Reagan (an economics major as an undergraduate!) should have had some tough explaining to do in the 1984 campaign. This example shows why it's important to understand some basic economics when evaluating modern political discourse.

(4) Inflation and the tax system

The U.S. income tax system is called "progressive," meaning that the tax rate on an additional dollar of income earned (the "marginal" tax rate) rises as income goes up. This phenomenon is what people mean when they talk about moving into a higher "tax bracket."

- Inflation pushes up nominal incomes, but not real incomes. So inflation would cause people to pay higher marginal tax rates if the tax system set rates based on nominal incomes. This phenomenon was called "bracket creep" in the 1970s.

- Since the Tax Reform Act of 1986 was passed, however, U.S. tax rates are "indexed" to inflation. This means that the income level at which higher marginal tax rates apply floats upward each year based on government statistics that measure inflation. This indexation has eliminated bracket creep.

A more subtle feature of the tax system does cause taxes to be higher in an inflationary environment: the fact that the government taxes nominal interest, not real interest.

- Suppose you have a $1000 savings account that pays 3% interest in an economy with no inflation. You will earn $30 of interest in a year. If your (marginal) tax rate is one third, you will pay $10 of this interest in taxes and have a real gain of $20.

- Now consider the same $1000 savings account in an economy with 6% inflation per year. Also assume that the nominal interest rate rises to keep the real interest rate at 3%. That is, the nominal interest rate in the inflationary economy is 9%. It might seem like the higher nominal interest rate is adequate to compensate you for the wealth you lose due to inflation, but look more closely at the tax consequences.

- You will earn $90 in nominal interest over the year. You need $60 to just compensate you for the reduced purchasing power of your savings account due to inflation. Moreover, you have to pay one third of your nominal interest earnings as taxes. This costs you another $30. Because of the tax system, you get no real benefit from the interest you earn, even though nominal interest rates are higher due to inflation.

The tax the government imposes on nominal interest creates another cost of inflation for savers. There has been some discussion about changing the tax system to index interest income for inflation, but this has not been done.

Similar problems apply to capital gains income (the money you make by buying assets, like shares of corporate stock, at low price and selling it at a high price). Again, there is some support for tax reform that would index capital gains income to inflation.

(5) Costs of uncertainty due to difficulty in contracting

Another widely emphasized cost of inflation is also linked to the fact that people make contracts in money terms that operate over time. When inflation is variable, it is hard to engage in such contracts.

For example, consider a lender who finances an automobile purchase over five years. How much interest should she charge? If she does not know what the inflation rate will be, it will be very difficult to know what kind of payments she should require.

When this kind of uncertainty rises, the amount of financial contracting in the economy is likely to decline. It then becomes more difficult for consumers to finance large purchases (like housing and cars). Perhaps more important, it becomes more difficult for firms to finance their acquisition of new productive assets. These changes weaken the economy.

(a) Extreme chaos of hyperinflation

In the U.S., these problems have not been negligible. Recent volatility of prices in the stock and bond markets have been undoubtedly affected by uncertainty about inflation. But the U.S. problems are tiny compared to those in countries that have undergone "hyperinflation."

Hyperinflation is a situation in which prices are rising by hundreds or even thousands of percent over short periods. The classic example is in Germany between the world wars. Currency became essentially worthless in this economy.

- Latin American and Eastern European economies have experienced hyperinflation in recent years.

With hyperinflation, almost all financial contracting breaks down. People cannot make long-term loans. Wages may change daily. It is impossible to post

accurate prices. People worry about whether they do their grocery shopping in the morning or evening, because prices can change a lot in between!

This situation is extremely chaotic, and economic welfare is greatly injured. In hyperinflationary economies, the costs of inflation are extreme.

2. Alternative Measures of Inflation

To measure inflation for the whole economy, we need a way of "aggregating" the many individual prices in the system. The basic idea is to come up with a statistic that is an appropriate weighted average of the individual prices in the economy. Then, inflation is measured as the percentage change in this statistic over time. The two statistics most commonly referred to are the Consumer Price Index and the GDP Deflator.

a) Price index: the change in the price of a fixed market basket of goods

A price index is cost of a fixed "market basket" of goods, often set to equal an arbitrary value of 100 in a "base year."

Let's consider a simple example. Suppose we create a price index for student weekends when the typical student buys one large pizza for $10 and three cokes for $1 each in 2009. The cost of the student weekend "market basket" is $13. We will choose 2009 as our base year.

- Now suppose that the price of the large pizza rises to $11 and the price of a coke rises to $1.25 in 2010. Then the student weekend market basket will cost $14.75. Also assume that the price of pizza in 2008 was $9.50, and the cost of a coke was $1, so the market basket cost $12.50 in 2008.

- The price index is defined as follows:

Index for Year t = 100 x (Cost of Basket in t) / (Cost of Basket in Base Year)

- For our example, then, the price index would be:

2008: 96.1 = 100 x ($12.50 / $13)2009: 100.0 = 100 x ($13 / $13)2010: 113.5 = 100 x ($14.75 / $13)

- The inflation rate for student weekends is measured as the percentage change in these figures:

2009 Inflation = 4.06% = 100 x [(100.0 – 96.1) / 96.1]2010 Inflation = 13.50% = 100 x [(113.5 – 100.0) /100.0]

The consumer price index (CPI) is computed in a similar way, but it includes a "market basket" of several hundred goods that U.S. consumers typically buy. The CPI for 2006 was 201.6 and it was 195.3 for 2005 (the base year is 1983). These figures tell you that consumer prices were 101.6 percent higher in 2006 than they were in 1983 and 95.3 percent higher in 2005 compared with the 1983 base (that’s approximately double). Consumer price inflation between 2005 and 2006 was:

3.23% = 100 x [(201.6 – 195.3) / 195.3].

This figure is low in comparison with the high inflation rates of the 1970s and early 1980s, but probably somewhat higher than most economists would consider desirable. (Many economists believe that an inflation target of 1% to 2% is best for the economy.)

(a) Components of the CPI

The government also reports price indexes for components of the CPI. You will often hear reports about food, energy, or health care prices. These are categories within the CPI. Because food and energy prices are quite volatile from month to month, inflation statistics are often reported for the CPI excluding food and energy. This statistic is sometimes called the “core” rate of inflation. The government is often more interested in core inflation because it is likely a better measure of the long-term price trends than the simple measure that includes volatile food and energy prices.

In 2005, simple CPI inflation was 3.38% and in 2006 it was 3.23%. The core rates of inflation for these two years were 2.17% and 2.51%, respectively. The big difference is likely due primarily to the high rates of increase for energy prices due to Hurricane Katrina and the war in Iraq. Notice that the core inflation rates are not much above the 2% target that many economists consider desirable for the U.S. economy.

With the severe economic weakness of the “Great Recession” period inflation fell even more. The core CPI in December, 2010 was 222.187. In December, 2009, the core CPI was 220.764. Therefore, inflation over this period was roughly just 0.6%. Most economists would blame the very weak labor market for such low inflation. When unemployment is high, wages rise very little, or even fall. So firms’ costs grow very slowly and they are not compelled to raise prices as quickly. Also, firms have difficulty selling their products in a weak economy, which further limits price increases.

(3) The producer price index (PPI)

(a) Leading indicator of consumer price inflation?

The producer price index (PPI) is also mentioned at times in the press. It is based on a market basket of commodities typically bought by firms. The PPI is often considered a "leading indicator" of consumer price inflation, that is, changes in the rate of increase of the PPI will likely be reflected a few months later in the CPI. This is because firms are likely to pass on changes in their input costs to the buyers of their final products.

(4) Criticisms of measuring inflation with price indexes

There are a number of criticisms of price indexes as measures of inflation for the macroeconomy.

The composition of goods in the market basket remains fixed for relatively long periods of time. The price index becomes less relevant over time as people change the composition of the goods they purchase.

To consider an extreme example, inflation would be badly mismeasured today if we used the market basket of goods people consumed at the beginning of the century as the basis for the CPI. The influence of the price of horseshoes would be vastly overstated, and how would the price of home computers affect inflation measures?

In addition, price indexes only cover a portion of the economy. We would like to have a broader measure.

b) The GDP price index: broader coverage

The GDP Price Index addresses some criticisms of the CPI. (This statistic is also called the GDP Chain-Type Price Index or the Chain Weighted GDP Deflator.) It takes account of all goods produced in the economy, and the importance of the price of any single good changes as the share of aggregate expenditure on that good changes. (So, for example, computers have played a more significant role in the GDP Price Index in recent years.)

For these reasons, when we correct total output in the economy for inflation, we usually use the GDP Price Index.

Regardless of the specific inflation measure you use, U.S. inflation has bee remarkably low in recent years, mostly 2% or lower (especially if one adjusts for volatile energy costs).

D. Historical Fluctuations of Output, Employment, and Inflation1. GDP Statistics

a) Magnitude of GDP

U.S. GDP in 2012 is likely to be approximately $15.7 trillion, that is, $15.7 x 1012. (We don’t yet have GDP data for the fourth quarter of 2012 and there will still be some revisions to earlier quarters.)

This is a really big number. If one were to lay $100 bills end-to-end ($200 per foot), the stream of bills would have to go about 595 times around the world to equal this amount of money!

It is important to keep in mind the enormous size of U.S. GDP to have the right perspective on macroeconomic issues. A million dollars sounds like a lot of money, but it's only a tiny fraction of GDP. Even a billion dollars is less than just one hundredth of one percent of GDP.

b) Annual and quarterly figures

U.S. GDP statistics are compiled by the federal government’s Bureau of Economic Analysis (BEA) in the National Income and Product Accounts (NIPA). The data from these accounts are released every calendar quarter.

To make sure that all NIPA data are comparable, quarterly figures are "annualized," that is, they are expressed as if the economic activity that actually occurred during a quarter had continued for a full year.

Example: The reported GDP for the third quarter of 2012 (current estimate) was $15.8 trillion. Of course it's not possible that the economy produced $15.8 trillion of goods and services in just a single quarter of GDP when it produced $15.7 during the entire year of 2012. Indeed, the quarterly figure is annualized by multiplying by four. The U.S. GDP in the second quarter of 2012 was actually $15.8 trillion / 4 = $3.9 trillion. Only the annualized figure is reported, however.

c) Annualized Growth Rates

The level of GDP is computed by the government and reported in the financial press (such as the Wall Street Journal). But these figures are found, if at all, buried deep in news stories. Much more attention is paid to the growth rate of GDP. There are probably two reasons for the focus on growth rates.

- Growth rates are easier to understand than the huge magnitude of the level of GDP

- People are more concerned about the change of GDP than the level. Is GDP rising or falling? How fast?

Just like the levels of GDP, reported growth rates are annualized. The reason for this, again, is so that all figures are comparable. The annualized growth rate is the rate the economy would grow over a full year if it expanded for the whole

year at the same rate at which it expanded during the quarter. Consider a little bit of algebra to define the annualized growth rate:

Let "g" denote the actual quarterly growth rate of the economy between quarter 1 and quarter 2.

- The definition of a growth rate means that:

- GDP2 = (1 + g) GDP1

where GDP2 is the level of GDP in the second quarter and GDP1 is the level of GDP in the first quarter.

Suppose the economy grows for a full year (four quarters) at rate g. It would then reach a level of output we will call GDPA. That is, we define GDPA as:

GDPA = GDP1 (1+g) (1+g) (1+g) (1+g) = GDP1 (1+g)4

The annualized growth rate (defined as gA) is the rate of growth that takes output from GDP1 to GDPA in one step:

GDPA = GDP1 (1+gA).

If we equate the two expressions for GDPA above we can solve for gA in terms of the actual quarterly growth rate g:

GDP1 (1+gA) = GDP1 (1+g)4 => gA = (1+g)4 - 1

Example (with more precise statistics): GDP in the second quarter of 2012 was $15.586 trillion, in the third quarter of 2012 it was $14.811 trillion. Therefore, the actual growth rate between the second and first quarters (g) was:

g = ($15.811 trillion - $15.586 trillion) / ($15.586 trillion)

= 0.0144 or 1.144 percent

Using the formula above, we can annualize this growth rate as follows:

gA = (1.0144)4 – 1 = 0.0591 or 5.91 percent

Note that the annualized growth rate is approximately four times the quarterly growth rate, but the relation is not exact. In fact, the annualized growth rate is slightly more than four times the quarterly growth rate (you get 5.78% if you just multiply 1.44% by 4). This outcome is due to "compounding." The growth in the second quarter "compounds" with the growth in the first quarter, similarly for the third and fourth quarters. The result is that the annualized growth rate is somewhat larger than just four times the quarterly rate. This effect is small for low growth rates over short periods of time, but it becomes much more significant over many quarters with higher growth rates.

2. Corrections for inflation

a) Reason to adjust for inflation

GDP is measured in terms of money values. This means it is a nominal variable. We use money values because it makes the aggregation of different types of goods and services possible. However, using nominal GDP presents a problem when we want to compare GDP figures during two different years (as we would want to do to calculate GDP growth). If nominal GDP changes over time, you cannot tell whether this change is caused by

- a change in the quantity of goods and services produced (economic expansion or contraction) or

- a change in the prices of goods and services (inflation or deflation).

To solve this problem, economists have developed methods to remove the effect of inflation from GDP measures and, in particular, GDP growth rates.

b) Real GDP

To correct GDP for inflation, economists use a "price index." This index is based on the prices of all goods and services produced in the economy.

In constructing the GDP price index (also called the “implicit price deflator”), economists arbitrarily choose a year to be the base year, and the index for that year is by definition set to 100. Recent statistics use 2005 as the base year. A GDP price index of 115.035 for the second quarter of 2012 means that prices of goods and services produced throughout the economy were about 15 percent higher in April through June of 2012 than they were in 2005.

Real GDP is a measure of production, with the effect of higher prices taken out. We get real GDP by dividing the nominal GDP figure by the price index.

Consider the following example, using actual data:

Year GDP Price Index Nominal GDP

2012:2 115.035 $15.586 x 1012

2012:3 115.810 $15.811 x 1012

The basic formula for real GDP is

Real GDP Year t = Nominal GDP Year t(GDP Price Index Year t / 100)

The price index is divided by 100 to make real and nominal GDP equal in the base year. (It would be easier to work with these numbers if the government set the price index to 1 in the base year rather than 100!)

Real GDP in the first two quarters of 2012 was:

2010:2 Real GDP = $15.586 x 10 12 = $13.549 x 1012

(115.035 / 100)

2010:3 Real GDP = $15.811 x 10 12 = $13.653 x 1012

(115.810 / 100)

A bit on terminology: In the above examples, we would say that “The real GDP in the second quarter of 2012 is $13.549 x 1012 in 2005 prices” or “-- in 2005 dollars.”

The Consumer Price Index (CPI) is sometimes used instead of the GDP price index to adjust for inflation. The CPI reflects the average household purchase, whereas the GDP Deflator takes into account purchases of all final goods and services, including government purchases, and firms' purchases of investment goods. The two indices both measure the rise in the price level, and they do tend to rise and fall together, but they are not identical.

Now, we will compute the growth rate of real GDP between the second and third quarter of 2012, annualized as described above. By convention, this is called the annualized growth rate of real GDP in the third quarter.

The quarterly growth rate of real GDP is:

[($13.652 x 1012 – $13.549 x 1012) / $13.194 x 1012] = 0.00767 or 0.77%

Annualize this growth rate:

(1 + 0.00767)4 – 1 = 0.0310 or 3.10%

This is the figure reported in the press as the growth of the economy in the third quarter of 2012. (More accurately, it would be called the growth rate of real GDP between the second and third quarter of 2012.) Note that this reported figure is both "real" and "annualized." It is likely that many news stories about this figure will not explicitly recognize that these adjustments have been made.

You can use the same method to compute the annualized inflation rate in the third quarter of 2012 using the GDP price index data:

Actual: [(115.810 – 115.035) / 110.488] = 0.00674 or 0.674 percent

Annualized: (1.00674)4 – 1 = 0.0272 or 2.72 percent

3. Long-term inflation and real growth rates

We will now discuss how to compare growth rates of output over longer periods of time. Here are a few figures for annual real GDP:

Year Real GDP (Billions of 2005 $)

1995 9,093.71999 10,779.82002 11,553.0

(Note that most downloaded data give GDP and related figures in billions, not trillions of dollars. A trillion is 1,000 billions.)

The growth rate from 1995 to 1999 was 18.54% and the growth rate from 1999 to 2002 was 7.17%. Clearly, the economy grew more in the earlier period, but the earlier period was four years rather than three. We need a method to make growth over these periods more comparable.

Again, we will "annualize" the growth rates. We want to find that rate of growth (call it gA) such that if the economy had expanded at this steady rate every year from 1995 to 1999, real GDP would have grown from $9,093.7 billion to $10,779.8 billion.

If GDP grew at a steady rate gA for four years from 1995 to 1999, gA would satisfy the following equation:

Real GDP1999 = Real GDP1995 (1 + gA)4

Because we are given the real GDP values, we can solve this equation for gA:

(Real GDP1999 / Real GDP1995) = (1 + gA)4

(Real GDP1999 / Real GDP1995)1/4 = 1 + gA

gA = (Real GDP1999 / Real GDP1995)1/4 – 1

Using the numbers given above:

gA = ($10,779.8 billion / $9,093.7 billion)1/4 – 1

= (1.1854)1/4 – 1 = 0.0434 or 4.34%

This is the annualized rate of real growth of the economy from 1995 to 1999. Note that it is somewhat less than a quarter of the total growth over the same four years (that is, 4 x 4.34 < 18.54). This happens because the annual growth "compounds" from one year to the next. Just dividing 18.54 by four will not give the annualized growth rate.

The calculation for the annualized growth rate from 1999 to 2002 is given by:

gA = ($11,553.0 / $10,779.8 billion)1/3 – 1

= (1.0717)1/3 – 1 = 0.0233 or 2.33%

Note that the exponent in the equations above is 3 because there are 3 years from 1999 to 2002. (Compare with the 4 in the calculation for 1995 to 1999.)

The annualized growth rates are directly comparable. The comparison shows that the economy did indeed grow faster in the late 1990s than it did during the first few years of this century. This outcome is not surprising. The late 1990s was a boom period, and there was a recession in 2001.

Example: Let us compare GDP growth rates of the Bill Clinton and George W. Bush presidencies. You may find GDP data at http://research.stlouisfed.org. (Note that GDP data are revised periodically, so current figures may differ somewhat from the figures presented below.)

Year Real GDP (Billions of 2005 $)

1992 8,287.12000 11,226.02008 13,228.8

The growth rate from 1992 to 2000 was 35.46% and the growth rate from 2000 to 2008 was 17.84%. Clearly, the economy grew more in the Clinton years. But it is somewhat difficult to put these figures into perspective. For example, how do these records compare to typical annual real growth rates that in normal times range between 2.5 and 3.5 percent per year. Again we need to “annualize” the growth rates to make growth over these periods comparable.

Clinton gA = ($11,226.0 / $8,287.1 billion)1/8 – 1

= (1.3546)1/8 – 1 = 0.0387 or 3.87%

Bush gA = ($13,228.8 / $11,226.0 billion)1/8 – 1

= (1.1784)1/8 – 1 = 0.0207 or 2.07%

The annualized growth rates of 3.87% and 2.07% are directly comparable. The comparison shows that the economy did indeed grow faster during the Clinton years than it did during Bush’s term. The difference is significant. Growth in the Clinton years was above almost all estimates of long-term normal growth. Growth in the Bush years was below almost all estimates of long-term growth.

Note, however, that this example does not address directly the success or failures of each administration’s economic policies because it does not take into account policy lags and a multitude of other factors (some of which will be covered later in this class).

The same approach can be used to measure annualized inflation rates. Inflation is the growth in the GDP price index.

Example: The 1970s are often considered a period of high inflation in the U.S. The GDP price index in 1970 was 29.3 and it was 57.4 in 1980 (both using a 2005 base). What was the annualized inflation rate over this ten-year period?

Calculation:

Ann. Inflation Rate = (57.4 / 29.3)1/10 – 1

= (1.9590)1/10 – 1 = 0.070 or 7.00%

This is a high number, confirming the impression of the 1970s as a high-inflation period.

For comparison, the GDP price index in 2000 was 88.64. It grew to 110.65 in 2010. Confirm for yourself that the annualized inflation rate was only 2.2 percent over these years, a big drop from the 1970s.

4. Definition of peaks, troughs, recessions, and growth recessions

Real GDP

Time

The business cycle is defined in terms of the movements of real GDP.

A "peak" of a business cycle is defined as the highest level of real GDP before a recession.

A "trough" is defined as the lowest level of real GDP before it begins to grow again.

A "recession" is a period of negative real GDP growth. How long must GDP decline before it is officially a recession? There is no definite rule, although it’s common to roughly define two consecutive quarters of negative GDP growth as recession. (One quarter of negative growth is not usually considered a recession.)

- The actual beginning and end of a recession are defined by a group of economists on the National Bureau of Economic Research’s business cycle dating committee. The committee takes a variety of factors into account in making their determination of when the peak and trough occurs. Real GDP is the main indicator, but the committee also looks at other data such as employment. The committee dated the peak before the Great Recession as December, 2007 and the trough as June, 2009.

- The period of the recession is defined from the peak to the trough.

PEAK

TROUGH

RECESSION

RECOVERY

The recovery period begins when GDP growth is positive once again. However, there is no exact time when we say that the recovery ends. One way to think about the recovery is the period over which it takes GDP to regain it's previous long-term trend. After the recession that began in late 2007, this point happened in the fourth quarter of 2010, following the summer 2009 trough.

A period of positive growth is called an expansion. If an expansion has a particularly high growth rate, we call it an “economic boom.”

a) Appropriate benchmark: zero growth or long-term trend growth

A recession is defined with a benchmark of zero GDP growth. Thus, any positive growth is not considered a recession, even though low positive GDP growth rates still indicate poor economic performance.

Periods of sustained growth rates below typical levels are called often "growth recessions."

A growth recession looks like this:

RealGDP

Time

Even though a growth recession still has positive growth, it is still cause for concern as unemployment may rise and the economy is not producing as many goods and services as it could by fully utilizing its resources.

b) Stagnant and “jobless” recoveries

Prior to the 1990s there was a sense that once the economic trough occurred, recovery would be reasonably fast. Output and employment would grow much faster than the long-term average to rather quickly make up the lost ground during the recession.

- For example in the two years after the deep recession of 1974/75 employment grew at a 2.2% annualized rate. Not spectacular, but probably fast enough to make up for some lost ground.

GROWTH RECESSION

- In the two years after the 1982 recession, employment grew at an annualized rate of 4.1%, which generated quick recovery in the labor market.

- But the annualized employment growth rate in the two years after the recession in 1990-91 was just 1.0%. After the 2001 recession was over in terms of GDP employment continued to fall. The recession was over by late fall of 2001 but employment continued to fall until August of 2003. In the next two years, the annualized growth of employment was just 1.7%.

- The Great Recession ended in the summer of 2009, but employment continued to fall until February of 2010. The drop in jobs during the Great Recession was (by far) the worst in percentage terms that the U.S. experience since the Great Depression. Employment dropped by 6.4% from its peak in January of 2008 to February of 2010 (that’s an annualized rate of decline of -3.1%). Some economists were hoping that after such a sharp drop, we could expect a quick rebound, perhaps something like the brisk growth in employment that occurred after the deep recession that ended in 1982. But it hasn’t happened. Job growth since the trough of employment through December of 2012 has been at an annualized rate of just 1.3%, only slightly higher than necessary to absorb the new entrants to the labor force from growth in the working-age population. This growth rate is not nearly high enough to move the economy quickly toward full employment. We haven’t gotten two years beyond the trough of the “Great Recession” in 2009, but in the 14 months of data we have so far the employment growth rate has also been very low: 0.7% (again, annualized

These observations imply that even though GDP may be growing, and therefore the recession is over according to a narrow technical definition, the sense of economic stagnation and below normal performance does not necessarily end with the official “trough” of the recession. The perception of citizens and journalists may well be that the bad times associated with the concept of “recession” continue.

5. Fluctuations in GDP, inflation, and unemployment: A brief look at the history of the business cycle

a) 19th and Early 20th Centuries: Volatility

During this period, GDP growth tended to bounce around a lot

The "Panic" of 1893 began with railroad bankruptcies and spread to bank failures. The economy declined significantly and experienced a long four-year recession. This was the deepest recession to that date, and may be the second

deepest of U.S. economic history (after the Great Depression). The data we have for this period are much rougher than for post World War 2 history, but estimates suggest that an equivalent measure to today’s unemployment rate hit at least 12%, perhaps as high as 17%.

The Panic of 1907 was marked by significant financial instability. A number of large New York banks were close to insolvent. The financier J.P. Morgan coordinated a private bank bailout widely regarded as critical to restoring financial order. But the financial system experienced high levels of stress and there was concern that private institutions would not be able to repeat Morgan’s success in future periods of instability. The direct result of this event was the creation of the Federal Reserve Bank in 1913.

World War I led to an economic boom, as wars usually do because of increased production to meet military needs. But the immediate post-WWI period was a period of recession (also typical of post-war periods)

In the 1920s, the economy was strong and stock prices soared: the "roaring 20s"

Some people have compared the economy of the late 1990s, and especially the dramatic, speculative housing boom of the middle 2000s as similar to the economy in the 1920s. This parallel creates concern, because the Depression that followed was historic.

b) The economic catastrophe of the Great Depression: 1929 – 1939 This is the BY FAR the worst period of economic history for the U.S.

The depression began in October of 1929 after a huge crash in the stock market prices. At the bottom of the Depression, the Dow Jones Industrial Average fell to 15% of its peak pre-Depression era value.

Unemployment: rose to 25%; a level that we have not even come close to since.

GDP: declined sharply in the early 1930s. The cumulative decline in GDP from 1929 to 1933 was 26.7 percent. The annualized decline over this four-year period was about 7.5 percent. No post-World-War-2 recession was nearly this severe. (See the statistics posted on the “lecture graphics” page of the course web site. Make sure you know how to compute the annualized growth rate!)

By 1933, the economy was producing more than a third less than an estimate of its long-term trend, an enormous "GDP gap." (The “gap” is an estimate of the difference between what the economy actually produces and what it is capable of producing.)

There was some fast growth in the middle part of the 1930s, but the GDP gap remained large. The economy again contracted significantly in 1938.

Inflation: Prices fell (deflation) in the early 1930s. The annualized rate of deflation was about 7.0 percent between 1929 and 1933. This experience shows

that prices can indeed decline, even though recently inflation is the more typical situation.

Falling prices caused considerable trouble in the financial system. All prices declined include money wages and salaries (the price of labor). But people owed money and the size of their loans did not decline. Therefore, people had less money income to pay their money debts. When people could not pay back their loans, banks failed in large numbers.

This experience also is an example, albeit an extreme one, of the normal relationship between inflation, GDP growth and unemployment. When the economy is weak, GDP growth is low, even negative, unemployment rises, and inflation tends to fall. In this case inflation actually became negative.

The severe economic troubles of the Depression led to a set of policies designed to help the economy, usually called the "New Deal." These policies were instituted early in the first Roosevelt administration in 1933. They include public spending policies to help stimulate the economy as well as the birth of our current Social Security system.

- The Roosevelt administration imposed some tax increases to try to close the federal budget deficit in 1937. The economy turned downward again in 1938, with real GDP falling by 3.4%.

- This event is discussed today as a possible example of the difficulty created when “fiscal austerity” is imposed too soon during an economic recovery, slowing the recovery or even creating a “double dip” in the economy.

The financial panics of the Depression led to more extensive regulation of the financial system by the federal government. Most of the Depression-era financial regulations were repealed by the late 1990s. Some analysts argue that this financial deregulation helped set the stage for the financial instability that hit the U.S. and world economies in 2008.

Explaining the economic disaster of the Great Depression gave birth to the study of macroeconomics as separate from microeconomics. Obviously, there was a massive correlation across markets in what happened that could not be explained by looking at individual markets alone.

c) World War II

According to many economists, it took WWII to finally get the U.S. out of the Great Depression. By 1939 the U.S. was already raising military production in preparation for war and sending supplies overseas, so the War positively affected the economy even before the U.S. officially entered it in December, 1941 after the attack on Pearl Harbor.

Real GDP: extremely high growth during the early 1940’s (16-18% in the middle of the war), followed by post-war negative GDP growth. This period of negative growth might be called a recession, but it was caused more by coming down off the dramatic mobilization of the WWII period rather than business cycle fluctuations.

Unemployment: extremely low during the war. People were working more than they would have ever considered in normal times. The economy was producing at a level well above its long-run trend.

Note that the economy was producing above Prof. Fazzari’s estimate of potential or full employment output. The idea of potential output is not truly the maximum the economy can produce, but rather the amount of output consistent with normal economic choices over a long time horizon. American citizens were not making “normal” choices during World War 2. Many people worked in the market labor force who usually would not work outside of the home. (Prof. Fazzari’s grandmother worked in an aircraft factory.) Over time was almost certainly much higher than people would have chosen under normal circumstances.

Inflation: the strong economy did appear to cause inflation to accelerate, although there were price controls in place on some commodities that suppressed inflation until the end of the war.

Many contemporary analysts of the economy feared that the U.S. would return to the awful economic circumstances of the Depression after the military stimulus to the economy ended in 1945.

The economy did slow down, but this was probably desirable because economic activity had been so incredibly intense. The economy did not return to anything like the problems of the Depression

d) Impressive performance of the 1950s and 1960s: a benchmark for output, unemployment, and inflation

The economy had mixed results in the 1950s. GDP grew quickly at beginning of decade because of the Korean War, followed by a brief post-war recession, then a strong recovery in 1955. GDP grew rather slowly in 1956 and 1957 and a recession occurred in 1958. Overall, inflation was low. Compared with the volatile decades of the first half of the 20th century, things looked reasonably good in the 1950s.

The 1960s Boom: The 1960s look even better from a purely macroeconomic perspective. At least until the middle 1990s, this period was considered a benchmark for good economic performance. Growth was moderate in 1960 and 1961. But real growth then took off and remained above 3 percent for the rest of the decade. Using older data with a different price index base, the annualized real growth rate of GDP from 1959 to 1969 was

(4269.9 / 2762.5)1/10 – 1 = 0.044 or 4.4%

(Data in 2005 dollars). An annualized rate of growth of 4.4% for a full decade is an excellent record by any measure.

Inflation was low for first half of decade. However, with the strong growth and falling unemployment, inflation accelerated to over 5% by 1969. Again, the usual pattern prevailed, inflation rose when the economy was strong. But it took several years of very fast growth before there was much effect on inflation.

Some people argue that the outstanding GDP growth during the 1960s was due to an increase in the population (i.e.: the presence of the Baby Boomers). While there certainly was an increase in the population, the Baby Boomers were not old enough to be part of the labor force yet. Therefore, they would not have affected GDP growth rates significantly.

Because of the excellent macroeconomic performance in the 1960s, some economists have label it the "Golden Age." There is some justification for this characterization based on macroeconomic statistics alone. However, a former student noted that there was much upheaval and unrest in U.S. society during the 1960s (the war in Vietnam, assassinations, urban riots, emergence of strong cultural divides over race and gender, etc.) From this broader perspective, one can certainly criticize the "Golden Age" label for the society as a whole. This point is another example that looking solely at macroeconomic performance provides a limited perspective on society.

e) Disappointments of the 1970s

The term “stagflation” was born during the mid 1970s. Informally, this is a period of low GDP growth, high unemployment, and high inflation (as the word literally means stagnation and inflation. Clever, isn’t it?) This recession was, by far, the most significant downturn in the U.S. economy since the Great Depression

Remember that inflation usually slows down during a recession and accelerates during periods of high growth. Therefore, stagflation is an unusual situation because inflation increases during a recession. The cause of the stagflation was the 1973 energy crisis initiated by an embargo that the Organization of Petroleum Exporting Countries (OPEC) imposed on the United States. This event arose from political conflicts in the middle east. Oil prices increased dramatically. Inflation exceeded 9% in 1975 and remained high into the early 1980s.

Unemployment reached over 8% and remained high for several years

Effect on perception of U.S. dominance: Coming out of WW2, and certainly throughout the 1960s, the United States was perceived as the politically and economically dominant country in the world. The poor economic performance of the middle 1970s was unexpected, and it shook confidence in the U.S. that the OPEC embargo could have such a disastrous effect on the economy. Policymakers and political leaders became focused, probably for the first time, on

the sensitivity of the U.S. economy to the volatile politics of the middle east. No doubt this experience explains part of continued U.S. involvement in this oil-rich region.

Although the economy recovered with reasonably high real GDP growth in the late 1970s, inflation remained high. Indeed, in 1978 the revolution that overthrew the Shah of Iran (who was backed by the U.S.) causes another rapid rise in oil prices that likely contributed to the acceleration of inflation in 1978 and 1979.

f) Recession and growth in the 1980s

In 1980 there were 2 quarters of negative growth, then 1982 GDP growth in 1982 was nearly -2%, the worst full year since the Great Depression. No recession in the past quarter century was worse. Unemployment peaked at 10.8% in late 1982, also the highest level reached in the U.S. since the Great Depression of the 1930s.

Inflation was stubbornly high from the early 1970s through the early 1980s. But the deep recession seemed to "break the back" of inflation, which slowed considerably in 1982 and 1983.

This experience is called disinflation. Inflation never turned negative (that would be deflation), but the positive inflation rate came down significantly. This experience is typical of recessions after World War 2 (except the one in 1974-75). Recessions have caused disinflation, but, so far, not sustained deflation. (Note: Japan suffered significant recessions and stagnant growth after 1990. Things got bad enough to create deflation, but nearly as bad as the Great Depression.)

A strong recovery began in 1983 and 1984. GDP growth was significantly higher than the rate most economists associate with the long-term trend (especially in 1984 with a growth rate above 7 percent). This fast growth allows the economy to "catch up" with the trend that it fell away from in the recession.

Inflation remained moderate in comparison with the 1970s, in the 2-4% range for the rest of the decade. Inflation rates actually fell much more quickly than economists had predicted. Unemployment, though declining, remained fairly high through the end of the 1980s. (It never fell below 5 percent, and was above 6 percent for most of the decade.)

g) The 1990 – 1991 recession

By 1989, the U.S. had entered a growth recession. Real GDP growth in the final three quarters of 1989 was between one and three percent, clearly below the long-term trend. The economy entered an official recession in the third quarter of 1990, with three consecutive quarters of very low or negative real GDP growth.

There was also disinflation during and after this recession.

Unemployment: reached nearly 7 percent during the recession, but continued to rise and remained high throughout 1993. This is a perfect example of unemployment being a lagging indicator, meaning that unemployment peaks after real GDP hits its trough.

After the 1990-1991 recession, the economy did not recover very quickly, which was a change in the pattern of business cycles from the deep recessions of 1974-75 and 1980-82. Although the recession had ended by the middle of 1991, real GDP growth was never really high until the fourth quarter of 1993.

The poor economic performance was an important issue in the 1992 Clinton / Bush election (that is, Bush “senior,” George H.W. Bush). Clinton chose to emphasize the poor economy during the election, blaming Bush’s policies. It is difficult to say whether one can blame Bush for the poor economy, as the slow economic growth started immediately after Bush took office. Bush hadn’t even implemented new policies at the time the economy started to look weak. Furthermore, we now know that the economic recovery started to pick up in 1992. But these data were too late to help Bush in the 1992 election. Also, the unemployment rate remained near its peak (7.6 percent) until the election.

The labor market weakness in the aftermath of the 1990-91 recession led it to be called “the jobless recovery.” Data charts discussed in class show how the jobs recovery stretched out longer after this recession than after the more severe downturns in 1974-75 and 1980-82. As it turns out, the jobless recovery problem became even more severe after the 2001 recession and it seems to be a major problem in the aftermath of the Great Recession, even into early 2011.

h) The 1990s boom: a “New Economy”

Unlike the first Bush, Clinton was a lucky guy (politically speaking of course). Just as poor economic performance began as soon as Bush took office, the economy started to look better as soon as Clinton took office (far too early for Clinton's policies to be responsible).

Unemployment began to fall in the summer before Clinton took office and continued to fall down to approximately 4 percent late in his presidency.

Inflation was very low: 1.5 – 2.5%

This period now ranks as the longest expansion in U.S. history. Real growth rates were quite high. Many economists believed the long-term trend growth rate of the economy was around 3 percent, but growth in the late 1990s was usually well above this level. (Annualized real GDP growth from 1995 to 2000 was about 4.3%.)

The high growth and low inflation make this period quite remarkable: it led to talk of a "new economy" which could grow faster with lower inflation and unemployment than most macroeconomists thought possible through the 1980s and early 1990s. (The term “New Economy” was most famously used in a speech by Alan Greenspan at this time.) Indeed, many economists encouraged the Fed to

raise interest rates because they believe inflation was about to break out due to such low unemployment.

- The term “New Economy” was most famously used in a speech by Alan Greenspan at this time. Greenspan resisted calls to raise interest rates until 2000.

- After the fact, it seemed that Greenspan was correct to keep interest rates low through the late 1990s boom. There was no significant rise of inflation. Indeed, not long after Greenspan ultimately did raise rates, the economy slowed into the 2001 recession. Again after the fact, it seems that even the interest rate increases in 2000 were not necessary.

i) Bursting “tech bubble” and the recession of 2001

End of the 1990s boomo The 1990s boom was truly remarkable, with high GDP growth, the lowest

unemployment since the 1960s, and very low inflation.

o During the late 1990s, there was a remarkable run up in stock prices, especially for high technology companies. The tech-heavy NASDAQ stock price index peaked in the spring of 2000 and then fell rapidly. Investment by high-technology industries decline rapidly and aggregate capital investment fell substantially.

After the fact, the remarkably high stock prices for technology companies in the late 1990s looks like a “bubble.” In a bubble, prices remain high because people expect them to rise (so they buy the asset) even though the “fundamental” earning power behind the asset may not justify such a high price.

It’s much easier to diagnose a bubble after the fact. While it is going on, there is often a story for why it should continue. In the late 1990s, this story was that technology was fueling a new economy with rapid growth as far as the eye could see that would drive higher profits, especially in tech industries.

o Growth began to slow, however, in late 2000. The most obvious reason was the decline in investment, led downward by tech industries.

o The slowing economy was not much of an issue in the 2000 campaign leading up to the presidential election because there was little evidence at that time of any trouble. But immediately after the election, the incoming Bush administration criticized economic weakness and changed the motivation of its tax cut proposals to emphasize simulating the weak economy.

o Real growth was negative or very low during 2001, and the National Bureau of Economic Research (NBER) declared a recession. Unemployment began to rise and inflation fell.

o The tax cuts proposed by the Bush administration and passed by the Congress in the spring of 2000 where remarkably timely. Usually, it takes longer for fiscal policy to respond to a recession. But the Bush administration already had a tax package on the table when Bush took office.

Role of September 11, 2001 terrorist attack

o Many commentators were concerned that the Sept. 11 attacks would greatly weaken the economy. It is clear, however, that the recession was well underway before the attacks.

o Somewhat ironically, the economy starts to recover in the fourth quarter of 2001, right after the attack. Consumers seemed to begin high spending remarkably quickly, with some help from incentives such as zero-percent financing on new cars.

o The attack obviously hurt some industries at the "micro level" (airlines and hotels, for example), but the overall macroeconomic statistics were actually stronger immediately after the attack than they were before the attack.

Another "jobless" recovery

o The economy resumed positive growth in the fourth quarter of 2001 and did not had a negative growth quarter in 2002 or 2003. Therefore, the recession, as it's usually defined relative to a "zero growth benchmark" has been over since late 2001.

o However, growth has been slow in many of the quarters since the end of 2001. The economy has not had a strong rebound that allows it to catch up with the previous trend.

o The most obvious manifestation of this fairly weak performance is that the unemployment rate continued to rise, or at least it did not fall much through 2003. Also, the number of people working has declined (job creation) in almost every month through 2002 and 2003, even though the economy was officially in a recovery stage.

o Just to keep up with growth in the labor market due to higher population, the economy needs to create about 125,000 to 150,000 jobs every month. The new job numbers were well below this figure for every quarter from the middle of 2000 through 2003. Most of these quarters had negative job growth. This stretch of poor job performance is unusually long, even

though the recession was relatively mild. The first part of the recovery after the 2001 recession was, once again, labeled "jobless."

Looking back on the period from the middle 1980s until the middle of the first decade of the 21st century, economists began to talk about something that has been called the “Great Moderation.” The volatility of the economy declined substantially. It seemed that recessions were more shallow, although recoveries tended to be slower.

o Some economists believed that better policy was responsible for a more stable, less volatile economy. Monetary policy, in particular, was given credit for working better.

o Other economists argued that we were just lucky, and the random disturbances (usually called “shocks”) that hit the economy just tended to be small in the Great Moderation period. (These points suggest a debate between a “good policy” explanation and a “good luck” explanation.)

o Regardless of the reason for the Great Moderation, it encouraged macroeconomists to believe that the U.S. economy had entered a new era of relative stability. This perspective spilled over to business, and especially financial markets. There seemed to be less concern about risk.

o This Great Moderation optimism would be severely challenged by financial instability and the very deep recession that began in December of 2007.

A closer look at the profile of the 2001 downturn and the slow recovery after it, especially in the labor market, also suggests a somewhat different interpretation than the general optimism of the Great Moderation discussion.

o It is true the drop in real GDP during the 2001 recession was quite “mild.” Look at the data on real GDP growth presented in class the negative numbers in 2001 are much tiny (in absolute value) compared to earlier recession (and what was to come in 2008 and 2000). So, if the only worry were true “recessions” with negative real GDP growth, this event would look minor, consistent with Great Moderation thinking.

o But also look at the job profile for 2001 to 2005 in the charts discussed in class. The job losses 25 to 30 months after the beginning of the downturn, well after the official recession with declining GDP was over, are almost as bad as what occurred at the worst part of the 1982 recession. (The latter was, at the time, widely regarded as the worst event since the Depression.)

o Furthermore, the recovery was very slow. Employment does not return to the level it had attained prior to the downturn until almost four years.

o The economy was less “volatile” in the early 2000s, than in the early 1980s. That’s the narrow meaning of the Great Moderation. But the job situation from 2001 through 2004 was pretty bad by historical standards.

Another factor to keep in mind about the early 2000s is that economic policy became very expansionary. Monetary policy lowered interest rates to historic levels. The combination of the Bush tax cuts, various government spending initiatives, and the drop in tax revenue due to the recession (when incomes fall, tax revenues go down automatically), led to a massive expansion of the government deficit. Despite all of this economic “stimulus,” the economy turned to recovery very slowly.

o The difficulty of turning things around, even with dramatic policy shifts, foreshadows the difficulty the economy is about to face in just a few years.

George W. Bush was up for re-election in 2004 (his Democratic opponent was John Kerry). The economy did seem to finally rebound rather strongly in the second half of 2003 and early 2004, in terms of GDP growth. Job creation was finally pretty good in the first half of 2004. But some slowing occurred over the summer of 2004.

A few economists began to talk about a big risk to economic growth from the dramatic rise in consumer debt. (Indeed, the 2007 version of Fazzari’s 1021 course notes mentioned this concern.) Consumption spending held up rather well in the 2001 recession and subsequent slow growth period. This fact kept economic performance from being even worse. But to keep consumption reasonably strong in a weak economy, households borrowed a lot. If they were forced to re-pay some of this debt quickly, or even just to stop borrowing as quickly, consumption spending will have to slow and the recovery will be threatened.

j) The “Great Recession” and financial crisis

Discussed in class

k) Perspectives on “Great Moderation” and future prospects

The Great Moderation is the reduced volatility of macro data following the early 1980s recession. Recessions were fairly shallow in 1990-91 and 2001. Inflation was on a downward trend and less variable. Unemployment also trended downward through the late 1990s.

Is this favorable period over with the Great Recession?

Further discussion in class