Economic Growth, Business Cycles, Unemployment, and Inflation

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1 CHAPTER 24 Economic Growth, Business Cycles, Unemployment, and Inflation Remember that there is nothing stable in human affairs; therefore avoid undue elation in prosperity, or undue depression in adversity. Socrates McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2 Macroeconomics Macroeconomics is the study of the economy as a whole the big picture We look at the aggregate, or the whole economy McGraw-Hill/Irwin Colander, Economics 2

3 Two Frameworks: The Long Run and the Short Run To analyze macro issues, we look at two frameworks: the long run and the short run The long-run growth framework focuses on incentives for supply Sometimes called supply-side economics Issues of growth are considered in a long-run framework 24-3

4 The Short Run The short-run business cycle focuses on demand Sometimes called demand-side economics Business cycles are generally considered in a short-run framework Inflation and unemployment fall within both frameworks McGraw-Hill/Irwin Colander, Economics 4

5 Economic Growth Growth is measured by: An increase in real GDP over time An increase in real GDP per capita over time (usually used to determine standard of living; more on this in CH 25) McGraw-Hill/Irwin Colander, Economics 5

6 The Business Cycle McGraw-Hill/Irwin Colander, Economics 6

7 The Business Cycle The business cycle is the upward or downward movement of economic activity, or real GDP 24-7

8 The Business Cycle Economists debate the causes of business cycles Keynesians: generally favor activist government policy fluctuations should be controlled Classicals: generally favor laissez-faire policies fluctuations are expected McGraw-Hill/Irwin Colander, Economics 8

9 The Phases of the Business Cycle The four phases of the business cycle are: Expansion: where real GDP is growing Peak: the top of the business cycle (right before the downturn) 24-9

10 The Phases of the Business Cycle Contraction: period where real GDP is falling A recession is two consecutive quarters where real GDP has fallen A depression is a prolonged period of economic decline McGraw-Hill/Irwin Colander, Economics 10

11 The Phases of the Business Cycle Trough: the bottom of the business cycle where the contraction has ended and is about to make an upward turn McGraw-Hill/Irwin Colander, Economics 11

12 Total Output Draw the Business Cycle Peak Trough Expansion Recession Expansion Quarters 24-12

13 Leading Indicators Leading indicators are the signs that indicate when a recession is about to occur Average work week Unemployment claims New orders for consumer goods Vendor performance New orders for capital goods Building permits Stock prices Interest rate spread Index of consumer expectations Money supply, M 2 McGraw-Hill/Irwin Colander, Economics 13

14 Unemployment McGraw-Hill/Irwin Colander, Economics 14

15 Unemployment The unemployment rate is the percentage of people who are willing and able to work but who are not working 24-15

16 Types of Unemployment Frictional unemployment: unemployment caused by people entering the job market/people quitting a job just long enough to look for and find another job People between jobs that are temporarily unemployed Examples: a parent reentering the workforce or a college graduate looking for a job McGraw-Hill/Irwin Colander, Economics 16

17 Types of Unemployment Structural unemployment: unemployment caused by changes in the structure of the labor force make some skills obsolete Workers do not have transferable skills and these jobs will never come back Workers must learn new skills to get a job Also includes the outsourcing of jobs to other countries McGraw-Hill/Irwin Colander, Economics 17

18 Types of Unemployment Cyclical unemployment: unemployment due to economic downturns/the business cycle (think due to recession and/or times of lower output by businesses) McGraw-Hill/Irwin Colander, Economics 18

19 Types of Unemployment Seasonal unemployment: unemployment due to seasonal work McGraw-Hill/Irwin Colander, Economics 19

20 Full Employment Full employment: an economic climate where nearly everyone who wants a job has one (about 5% unemployment) McGraw-Hill/Irwin Colander, Economics 20

21 Target Rate/Natural Rate of Unemployment The target rate/natural rate of unemployment is the lowest rate of unemployment that policy makers believe is achievable under existing conditions Generally, this is around 5% This means full employment is about 95% 24-21

22 Whose Responsibility is Unemployment? Classical economists believe that individuals are responsible for their own jobs If people really want a job, they will find one 24-22

23 Whose Responsibility is Unemployment? Keynesian economists tend to say that society owes people jobs that fit with their training or past job experience Jobs should be close enough to home so that people don t have to move McGraw-Hill/Irwin Colander, Economics 23

24 Calculating the Unemployment Rate The labor force is made up of those at least 16 years of age who are willing and able to work The labor force excludes those incapable of working and those not looking for work McGraw-Hill/Irwin Colander, Economics 24

25 Calculating the Unemployment Rate We start with the total civilian population and subtract those unavailable for work (those under age 16, in prison, or otherwise not available to work) Then, subtract those not in the labor force (homemakers, disabled, etc.) You are left with the potential workforce McGraw-Hill/Irwin Colander, Economics 25

26 Calculating the Unemployment Rate Unemployment Rate = Number Unemployed Labor Force x

27 Accuracy of the Unemployment Rate Does not include discouraged workers, people who do not look for a job because they feel they don t have a chance of finding one Therefore, the unemployment rate is understated 24-27

28 Accuracy of the Unemployment Rate Does not take into account the underemployed, which are part-time workers who would prefer full-time work Includes people who say they are unemployed, but voluntarily don t work McGraw-Hill/Irwin Colander, Economics 28

29 Other Ways to Measure Employment The labor force participation rate is also looked at: this measures the labor force as a percentage of the total population at least 16 years of age The employment-population ratio is the number of people who are working as a percentage of people available to work McGraw-Hill/Irwin Colander, Economics 29

30 Okun s Rule of Thumb States that a 1% change in the unemployment rate will be associated with a 2% change in output in the opposite direction + 1% Δ unemployment 2% Δ in output 24-30

31 Inflation/Deflation McGraw-Hill/Irwin Colander, Economics 31

32 Inflation/Deflation Inflation a rise in the price level that reduces the purchasing power of money Deflation is a continual fall in the price level Hyperinflation: when inflation hits triple digits 24-32

33 Who Is Helped/Hurt by Unanticipated Inflation Hurt by Inflation Lenders: People who lend money (at fixed interest rates) People with fixed incomes Savers Helped by Inflation People who borrow money A business where the price of the product increases faster than the price of resources McGraw-Hill/Irwin Colander, Economics 33

34 Measuring Inflation A price index: a number that summarizes what happens to a weighted composite of prices of a selection of goods over time The price index is always 100 in the base year unless otherwise stated The most commonly used measurement of inflation for consumers is the Consumer Price Index (CPI) McGraw-Hill/Irwin Colander, Economics 34

35 Price Indexes The CPI measures prices of only the goods and services bought by consumers Looks at a market basket of about 400 goods and services 24-35

36 Price Indexes If given the value of market baskets in two different years, you can calculate the price index CPI= Year 2 - Year 1 Year 1 or base year x 100 If you have the price indexes, you can calculate the change in inflation (price level) Year 2 Year 1 x 100 Year 1 or base year 24-36

37 Price Indexes Example: the market basket in 2014 was $540 and in 2015 it was $675. Calculate the price index. McGraw-Hill/Irwin Colander, Economics 37

38 Price Indexes Example: the market basket in 2014 was $540 and in 2015 it was $675. Calculate the price index /540 x 100= 125 (Prices were 25% higher in 2015 than in the base year) McGraw-Hill/Irwin Colander, Economics 38

39 Price Indexes Now, calculate the change in inflation between those two years. McGraw-Hill/Irwin Colander, Economics 39

40 Price Indexes Calculate the change in inflation between those two years X 100 = 25% McGraw-Hill/Irwin Colander, Economics 40

41 Real vs. Nominal Interest Rates Nominal interest rate: the rate you pay or receive Real interest rate: the nominal interest rate adjusted for inflation Real interest rate= Nominal interest rate inflation McGraw-Hill/Irwin Colander, Economics 41

42 Chapter Summary Economists use two frameworks to analyze macroeconomic problems: The long-run growth framework focuses on supply The short-run business cycle framework focuses on demand Growth is measured by the change in: Real gross domestic product (GDP) Per capita real GDP 24-42

43 Chapter Summary Phases of the business cycle are peak, downturn, trough, upturn Unemployment is calculated as the number of unemployed people divided by the labor force Unemployment rises during a recession and falls during an expansion 24-43

44 Chapter Summary The target rate of unemployment is the lowest sustainable rate of unemployment possible under existing institutions The lower the target rate of unemployment, the higher an economy s potential output A real concept is a nominal concept adjusted for inflation Real output equals nominal output divided by the price index Inflation is the continual rise in the price level 24-44

45 Chapter Summary The CPI, the PPI, and the GDP deflator are all price indexes used to measure inflation Expectations of inflation can provide pressure for inflation to continue even when other causes don t exist Inflation redistributes income from people who do not raise their prices to people who do raise their prices 24-45

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