Study Sheet for Exam 2. Chapter 4

Study Sheet for Exam 2 Chapter 4 I. Introduction A. The market can determine WHAT goods to produce, HOW, and for WHOM. B. Some questions we might ask are: 1. Are the market outcomes necessarily most desirable? 2. Is the mix best? 3. Is the balance between production and environment satisfied? 4. Is income distribution fair? C. Government intervention may be needed to ensure better answers. D. The key questions addressed by this chapter are: 1. Under what circumstances do markets fail? 2. How can government intervention help? 3. How much government intervention is desirable? II. Market Failure (Figure 4.1) A. Our goal is to produce the optimal mix of output. 1. Definition: Optimal Mix of Output - The most desirable combination of output attainable with existing resources, technology, and social values. B. The market mechanism moves resources from one industry to another in response to consumer demands. 1. Definition: Market Mechanism The use of market prices and sales to signal desired outputs (or resource allocations). 2. Changes in market prices direct resources from one industry to another, moving us along the perimeter of the production-possibilities curve. 3. The market mechanism may produce a mix of output that is different from the one society desires. This is called market failure. 4. Definition: Market Failure An imperfection in the market mechanism that prevents optimal outcomes. 5. Market failure implies that the forces of supply and demand have not led us to the best point on the production-possibilities curve. 6. Market failure establishes a basis for government intervention. C. Sources of Market Failure 1. Public goods. 2. Externalities. 3. Market power. 4. Equity. D. Public Goods 1. Definition: Private Good - A good or service whose consumption by one person excludes consumption by others. An example of a private good is a donut. When one person consumes the donut, the process of consumption excludes others from consuming that same donut. 1

2. No Exclusion Definition: Public Good is a good or service whose consumption by one person does not exclude consumption by others. An example of a public good is national defense. One person s consumption of national defense does not preclude others from consuming the same amount of national defense. In the News: Israel s Iron Dome Frustrates Hamas An air defense system is a public good, as consumption of its services by one individual does not preclude consumption by others. Nonpayers cannot be excluded. 3. The Free-Rider Dilemma. (Figure 4.2) The communal nature of public goods may cause consumers to try for a free ride. Definition: Free Rider An individual who reaps direct benefits from someone else s purchase (consumption) of a public good. The consumers will not demand the product hoping that someone else will purchase it thus providing them with the benefit(s) of the good or service without any cost to them. An example of the free rider problem is flood protection. If your neighbor provides flood protection for her home and that also protects your home, then you will not provide your own flood protection. 4. Underproduction of Public Goods If public goods were marketed like private goods, everyone would wait for someone else to pay. The result might be a total lack of public services. Either the government or the private sector can produce public and private goods. Because of the inability of the market mechanism to get us to the optimal mix of output (public goods), we need a nonmarket force (government intervention) to get there. 5. In the News: Firefighters Watch as Home Burns to the Ground Firefighters in Tennessee proved that fire protection is not inherently a public good: they let the nonpaying homeowner s house burn down. E. Externalities (Figure 4.3) 1. Definition: Externalities - Costs (or benefits) of a market activity borne by a third party; the difference between the social and private costs (benefits) of a market activity. 2. Whenever externalities are present, the preferences expressed in the marketplace will not be a complete measure of a good s value to society. 3. The market responds to consumer demand, not externalities. 4. External cost behavior has a negative impact on the third party. 2

5. The social demand is the market demand minus the external cost (or plus the external benefit). 6. The optimal production mix is where the social demand curve intersects the market supply curve. 7. World View: Secondhand Smoke Kills 600,000 People a Year Secondhand smoke is associated with a list of serious diseases. 8. External Benefits Externalities can also be beneficial. An example is the students education. Not only does it benefit the student and the school, but it also benefits society through research or having better informed citizens. If a product yields external benefits, the social demand is greater than the market demand. 9. The market will under-produce goods that yield external benefits and overproduce those that generate external costs. 10. When externalities are present, the market mechanism will not get us the optimal mix of output; we may need government intervention. F. Market Power 1. With public goods and externalities, the market fails to achieve the optimal mix of output because the price signal is flawed. The market may also fail when the response to price signals is flawed, rather than the signals themselves. 2. Definition: Market power - The ability to alter the market price of a good or service. 3. Restricted Supply: Market power gives a producer the ability to maximize profits rather than produce the optimal mix of output. 4. A natural monopoly is the classic example. 5. Definition: Natural Monopoly An industry in which one firm can achieve economies of scale over the entire range of market supply. 6. Government intervention is necessary to prevent or dismantle concentrations of market power. This is the essential purpose of antitrust policy. Definition: Antitrust Government intervention to alter market structure or prevent abuse of market power. G. Inequity 1. The distribution of goods and services generated by the marketplace is not necessarily fair. 2. Taxes and Transfer Payments These are the principal tools for transferring money from those who have too much to those who have too little. Definition: Transfer Payments - Payment to individuals for which no current goods or services are exchanged, like Social Security, welfare, and unemployment benefits. 3. Definition: Merit Good: A good or service society deems everyone is entitled to some minimal quantity of. 3

When market mechanisms do not provide adequate merit goods, government steps in to fill the gaps. H. Macro Instability 1. The micro failures of the marketplace imply that we are at the wrong point on the production-possibilities curve or inequitably distributing the output produced. 2. The goal of macro intervention is to foster economic growth - to get us on the production-possibilities curve (full employment), to avoid inflation (price stability), and increase our capacity to produce (growth). 3. Definition: Unemployment The inability of labor-force participants to find jobs. 4. Definition: Inflation An increase in the average level of prices of goods and services. III. Growth of Government A. The potential micro and macro failures of the marketplace provide specific justifications for government intervention. B. Federal Growth (Figures 4.4 and 4.5) 1. The increasing responsibilities of the federal government have greatly increased its size. Employed 350,000 people and spent only $650 million in 1902. Today, the federal government employs nearly 4,000,000 and spends $4 trillion a year. 2. Direct Expenditures: The absolute size of the government has increased but its relative size (as a percentage of national output) has actually declined. 3. Virtually all of the recent growth in federal expenditure has come from increased income transfers, not purchases of goods and services. C. State and Local Growth (Figure 4.4) 1. Initially, state and local spending on goods and services dominated public-sector spending. 2. During World War II the share of total output going to state and local governments shrink dramatically. 3. Since then, the state and local governments have increased their share until today when they buy much more output than the federal government and employ three times as many people. IV. Taxation A. The opportunity costs of public spending are not always apparent. B. Definition: Opportunity Costs The most desired goods or services that are forgone in order to obtain something else. C. We don t directly hand over factors of production to the government. The primary function of taxes is to transfer command over resources (purchasing power) from the private sector to the public sector. 4

D. Federal Taxes 1. Income Taxes The Sixteenth Amendment to the U.S. Constitution (1915) granted the federal government authority to collect income taxes. It is now the largest single source of government revenue. See Figure 4.5. The government now collects over $1 trillion in income taxes. The federal income tax is designed to be progressive. Definition: Progressive Tax A tax system in which tax rates rise as incomes rise. In 2014, a single person with less than $9,000 taxable income was taxed at 10%. A person with $37,000 $89,000 taxable income paid a 25 percent marginal tax rate. The marginal tax rate is as high as 39.6 percent for people with over $407,000 of income. 2. Social Security Taxes The social security tax is the second major source of federal revenue. Workers transfer part of their earnings to retired workers by making contributions to Social Security. Nearly $1 trillion was collected in 2014 in that manner. Definition: Proportional Tax: A tax that levies the same rate on every dollar of income. Definition: Regressive Tax: A tax system in which tax rates fall as incomes rise. This tax is regressive due to the ceiling placed on the maximum income subject to the tax. 3. Corporate Taxes The federal government taxes the profits of corporations as well as consumer incomes. Despite the imposed tax rate of up to 35 percent, this tax only netted the federal government $350 billion. This tax, like the personal income tax, is progressive. 4. Excise Taxes Excise taxes are taxes imposed on certain goods and services; for example: liquor, gasoline, cigarettes, and telephone service. By increasing the price, this tax discourages consumption and production of these goods. E. State and Local Revenues 1. Taxes Cities depend heavily on property taxes while states rely heavily on sales taxes. State and local taxes tend to be regressive. 5

Definition: Regressive Tax A tax system in which tax rates fall as incomes rise. A regressive tax takes a larger share of income from the poor than from the rich. This is due to poorer consumers spending most, if not all, of their income on taxed goods and services. F. In the News: Perpetuating Poverty: Lotteries Prey on the Poor The poor spend more dollars on lottery tickets than those who are better off, so they spend a much larger share of their income. This makes lotteries a regressive source of revenue for governments. V. Government Failure A. Some government intervention in the marketplace is clearly desirable, as when the market mechanism will not get us to our economic goals. However, governments, like markets, can fail. B. Definition: Government Failure Government intervention that fails to improve economic outcomes. C. Perceptions of Government Failure 1. The average taxpayer believes that state governments waste 42 cents out of each dollar, while federal government wastes 53 cents out of each tax dollar. 2. With such inefficiency, we are producing inside our productionpossibilities curve. 3. In The News: Little Confidence in Government About 70 percent of the population is not confident in the ability of the federal government to make progress on the important problems and issues facing the country. In other words, they expect government failure. D. Opportunity Cost 1. The issue of government waste encompasses two distinct questions: Efficiency: Are we getting as much service as we could from the resources we allocate to the government? Opportunity Cost: Are we giving up too many private-sector goods in order to get those services? 2. Everything the government does entails an opportunity cost. 3. We must consider not only what governments do, but also what we give up to allow them to do it. E. Valuation Problems. 1. Additional public-sector activity is desirable only if the benefits from that activity exceed its opportunity costs. 2. It is sometimes very difficult to put a monetary value on these benefits. F. Ballot-box Economics 1. Voting mechanisms substitute for the market mechanism in allocating resources to the public sector and deciding how to use them. 2. Bond referendums, although important, account for less than 1 percent of state and local expenditures. 6

3. We do not know what the real demand for public goods is, and votes alone do not reflect the intensity of individual demands. G. Public Choice Theory 1. Government officials may pursue their own agendas over public interest. 2. The theory of public choice emphasizes the role of self-interest in public policy. 3. Definition: Public Choice Theory of public-sector behavior emphasizing rational self-interest of decision-makers and voters. 4. A central tenet of public-choice theory is that bureaucrats are just as selfish (utility maximizing) as everyone else. VI. The Economy Tomorrow: Right Sizing Government? A. Right size will depend less on self interest and more on trust in markets to generate optimal outcomes or trust government intervention to improve on market failures. Chapter 5 V. I. Introduction A. Government only wants to tackle problems that it can measure. B. The Great Depression resulted in a commitment to national income accounting. 1. Definition: National-Income Accounting The measurement of aggregate economic activity, particularly national income and its components. 2. Developed by Simon Kuznets and the U.S. Department of Commerce, it answers questions such as: How much output is being produced? What is it being used for? How much income is being generated in the marketplace? What s happening to prices and wages? W. II. Measures of Output A. Gross Domestic Product (GDP) (Table 5.1) 1. Definition: Gross Domestic Product (GDP) The total market value of final output produced within a nation s borders in a given time period. 2. The use of prices to value market output allows us to summarize output activity and compare outputs of one period with that of another. 3. GDP vs. GNP GNP refers to output produced by American-owned factors regardless of location. GDP refers to output produced within America s borders. 7

GDP is geographically focused, including all output produced within a nation s borders regardless of whose factors of production are used to produce it. For example, Apple s output in Singapore ends up in Singapore s GDP; the cars produced at Honda s Ohio plant are counted in U.S. GDP. 4. International Comparisons The geographic focus of GDP facilitates international comparisons of economic activity. The World View in chapter 2 illustrates a comparison of GDP values. 5. GDP per Capita Definition: GDP per Capita - Total GDP divided by total population: average GDP. GDP per capita is commonly used as a measure of a country s standard of living. Disparities in per capita GDP mean that people in low-income countries have little access to telephones, televisions, paved roads, schools, and healthcare. World View: Global Inequalities 900 million people live in nations the World Bank calls lowincome. The average income in low-income nations is only $1,800. Behind statistical comparisons of GDP per capita lie very tangible differences in the way people live. Low GDP per capita implies a lot of deprivation. Measures of per capita GDP tell us nothing about the way GDP is actually distributed or used; they are only a statistical average. B. Measurement Problems 1. Non-market activities GDP measures exclude most goods and services produced that are not sold in the market. For example, the homemaker who cleans, washes, gardens, shops and cooks produces goods of value, but they are not exchanged in the market and are thus not included in GDP. Exclusion of non-market activities causes problems when comparing living standards. As homemakers enter the workforce and pay for housekeeping services, current GDP figures might exaggerate increases in GDP because services are now provided through the market and are included in GDP. 2. Unreported income The GDP statistics also fail to capture market activities that are not reported to tax or census authorities. The underground economy is motivated by tax avoidance or the desire to conceal illegal activities. 8

IRS estimates that two-thirds of the underground income comes from legitimate services. In The News: A Lot Going On Under the Table GDP statistics include only the value of reported market transactions. Several statistics that estimate the size of the underground economy are listed. Since many transactions are not included in the official GDP, it likely is significantly understated. C. Value Added (Table 5.2) 1. Not all reported market transactions get included at full value in GDP statistics. If it did, the same output would be counted repeatedly. 2. The production of most goods and services involves a series of stages. 3. To accurately measure GDP we must distinguish intermediate goods from final goods. 4. Definition: Intermediate Goods Good or services purchased for use as input in the production of final goods or in services. 5. Two ways to calculate GDP. Compute the value of the final output. Count only the value added at each stage of production. Definition: Value Added The increase in the market value of a product that takes place at each stage of the production process. Real vs. Nominal GDP (Tables 5.3, 5.4 and Figure 5.1) 1. Changes in GDP brought about by changes in the price level can give a distorted view of economic activity. 2. Distinguishing increases in quantity from increases in prices is done by distinguishing between real GDP and nominal GDP. Definition: Nominal GDP The value of final output produced in a given period, measured in the prices of that period (current prices). Definition: Real GDP The value of final output produced in a given period, adjusted for changing prices. The distinction between nominal and real GDP is important whenever the price level changes. Definition: Base Period The time period used for comparative analysis; the basis for indexing price changes. Formula 9

Nominal GDP in year t Real GDP in year t = Price index 3. Inflation tends to obscure actual declines in real output. 4. Definition: Inflation An increase in the average level of prices of goods and services. 5. Chain-Weighted Price Adjustments Chain-weighted indexes use a moving average of price levels in consecutive years as an inflation adjustment. E. Net Domestic Product 1. Changes in real GDP tell us how much the economy s output is growing. 2. Growth at the expense of future output occurs unless factors of production are replaced. 3. Next year, we won t be able to produce as much output unless we replace the capital we use this year. 4. Definition: Production Possibilities The alternative combinations of final goods and services that could be produced in a given time period with all available resources and technology. 5. Value of capital used up in producing goods and services is called depreciation and is estimated by U.S. Department of Commerce. 6. Definition: Depreciation The consumption of capital in the production process; the wearing out of plant and equipment. 7. Definition: Net domestic product (NDP) = GDP- depreciation. 8. Some of each year s output will consist of newly produced plant and equipment or investment goods. 9. Definition: Investment Expenditures on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories. 10. Distinction between GDP and NDP is mirrored in the difference between gross investment and net investment. Definition: Gross Investment - Total investment expenditure in a given time period. Definition: Net Investment - Gross investment less depreciation. 11. The stock of capital the total collection of plant and equipment will not grow unless gross investment exceeds depreciation. X. III. The Uses of Output A. The GDP accounts also tell us what mix of output has been selected, that is, society s answer to the question of WHAT to produce. B. Consumption 1. The major uses of total output conform to the four sets of market participants. 2. Goods and services used by households are called consumption goods. 10

3. Consumer spending claims over two-thirds of our annual output. C. Investment 1. Investment goods are the plant, machinery, and equipment that we produce. 2. Investment spending claims approximately one-sixth of total output. D. Government Spending 1. Third major user of GDP is the public sector. 2. Resources purchased by the government sector are unavailable for consumption or investment purposes. 3. Claims approximately one-fifth of total output. E. Net Exports 1. Definition: Exports Goods and services sold to international buyers. 2. Definition: Imports Goods and services purchased from international sources. 3. We export some goods; thus, GDP will be larger than the sum of our own consumption, investment, and government purchases. 4. We import some goods and services which are not calculated as part of America s GDP since they were not produced within our borders. 5. Exports are added to GDP and imports are subtracted. 6. Definition: Net Exports The value of exports minus the value of imports. 7. The value of GDP can be computed by adding up expenditures of market participants. 8. Formula Where GDP = C + I + G + (X - M) C = consumption expenditure I = investment expenditure G = government expenditure X = exports M = imports Y. IV. Measures of Income (Table 5.5 and Figure 5.2) A. GDP accounts have two sides: one is expenditure (demand), the other is income (supply). B. The total value of market incomes must equal the total value of final output, or GDP. C. National Income 1. By charting the flow of income through the economy, we see FOR WHOM the output is produced. 2. Depreciation Depreciation charges reduce GDP to the level of NDP (Net Domestic Product) before any income is available to current factors of production. 11

Formula NDP = GDP - depreciation Once depreciation charges are subtracted from GDP, we are left with Net Domestic Product. To this we add net foreign factor income to calculate national income. Definition: National Income (NI) Total income earned by current factors of production: NDP plus net foreign factor income D. Personal Income (Table 5.6 and Figure 5.3) 1. Corporate taxes, indirect business taxes and retained earnings are subtracted from national income before determining consumer income. 2. Social security tax is then removed giving the personal income before the payment of personal taxes. Chapter 6 Z. I. Introduction A. This chapter focuses on the following questions. 1. When is a person unemployed? 2. What are the costs of unemployment? 3. What s an appropriate goal for full employment? AA. II. The Labor Force A. To assess dimensions of unemployment problems we must first decide who wants a job. B. Individuals who want a job and those who don t are divided into two groups, labor force participants and non-participants. C. Definition: Labor Force - All persons age 16 and over who are either working for pay or actively seeking paid employment. 1. People who are neither employed nor actively seeking work are not counted. 2. Only half of the U.S. population participates in the labor force. (Figure 6.1) 3. Since 1960 U.S. labor force has more than doubled. This growth has come from two distinct sources (Figure 6.2). Population growth. Rising labor force participation among women. 4. Definition: Labor-force Participation Rates The percentage of the population working or seeking employment. D. Labor Force Growth (Figure 6.3) 12

1. Definition: Production Possibilities The alternative combinations of final goods and services that could be produced in a given time period with all available resources and technology. 2. Continuing growth of the labor force increases both our capacity to produce goods and services and the need to keep creating jobs for people who want to work. 3. Production is limited by two factors. The availability of factors of production. Technological know-how. 4. Labor Force Growth (Figure 6.3) As the labor force grows, the production possibilities curve shifts outward. This outward shift illustrates the increased capacity to produce goods and services given available technology and institutional constraints. E. Unemployment 1. Definition: Unemployment The inability of labor-force participants to find jobs. 2. To reach a point on the production-possibilities curve, the labor force must be fully employed. 3. Okun s Law Arthur Okun quantified the relationship between the shortfall in real output and unemployment. Definition: Okun s Law 1 percent more unemployment results in 2 percent less output. 2 to 1 ratio puts a dollar value on the aggregate cost of unemployment. In 2010, high unemployment left us $1 trillion short of our production possibilities, implying a loss of $3000 of goods and services for every American. BB. III. Measuring Unemployment A. U.S. Census Bureau surveys about 60,000 households a month to determine how many people are actually unemployed. B. The Unemployment Rate (Figure 6.4 and Table 6.1) 1. Definition: Unemployment Rate The proportion of the labor force that is unemployed. 2. Formula: Number of Unemployed People Unemployme nt Rate = Labor Force 3. If a person is not employed and is actively seeking work they are counted as unemployed. 4. In 2013, an average of 11.5 million people were counted as unemployed, accounting for 7.4 percent of total labor force. 13

5. Figure 6.4 illustrates unemployment rates vary significantly by race, sex, age, and education. C. Duration of Unemployment (Table 6.1) 1. Most people who become unemployed don t stay jobless long. 2. Only one in three people were jobless six months or more in 2013. D. Reasons for Unemployment (Figure 6.5) 1. How long a person remains unemployed is also affected by the nature of the joblessness. 2. The reasons for unemployment include: Job leavers Job losers Reentrants New entrants E. Discouraged workers 1. Definition: Discouraged Worker An individual who is not actively seeking employment but would look for or accept a job if one were available. 2. When unemployment persists, job seekers become increasingly frustrated in their efforts to secure unemployment. 3. Discouraged workers are not counted as part of the unemployment problem after they give up looking for a job. They are no longer considered part of the labor force. F. Underemployment 1. Definition: Underemployment People seeking full-time paid employment who work only part time or are employed at jobs below their capability. 2. Some people are forced to take any job available. 3. These people are excluded from the count of unemployed, but not from the condition of underemployment. 4. Underemployed workers represent labor resources that are not being fully utilized. G. The Phantom Unemployed 1. Some of the people who are counted as unemployed probably should not be. 2. Many report that they are actively seeking work when their actual interest in finding employment is low. 3. To some extent, public policy encourages this behavior by requiring most welfare and unemployment benefit receivers to provide evidence that they are looking for work. 4. In The News: Unemployment Benefits Not for Everyone Not all people who are unemployed are eligible for benefits. Only those who worked a substantial length of time, earned a minimum 14

amount of wages, and lost their jobs for a valid reason are eligible. Even then, the duration of the benefits is likely limited. CC. IV. The Human Costs A. Although not perfect, measurements of unemployment are a reliable index to a serious macro problem. B. The immediate impact of unemployment on individuals is loss of income, which over a long period can spell financial disaster, depending on the reason for unemployment. C. Studies have shown that unemployment is associated with crime, health problems, divorce and other problems. D. German psychiatrists have also observed that the anxieties and other nervous disorders that accompany one year of unemployment can reduce life expectancy by as much as five years. E. In Japan, the suicide rate jumped by 50 percent when the economy plunged into recession. F. In The News: The Real Costs of Joblessness The cost of unemployment is not measured in lost wages alone. Several social statistics are provided which show the negative impact on families during economic downturns. H. Defining Full Employment A. Full employment is not the same as zero unemployment. B. Seasonal Unemployment 1. Definition: Seasonal Unemployment Unemployment due to seasonal changes in employment or labor supply. 2. At the end of each season, thousands of workers must go searching for new jobs, experiencing seasonal unemployment in the process. C. Frictional Unemployment 1. Definition: Frictional Unemployment Brief periods of unemployment experienced by people moving between jobs or into the labor market. 2. Frictional unemployment exists when there is adequate demand for labor individuals have adequate skills the period of job search is short 3. Most economists agree that frictional unemployment is responsible for an unemployment rate of 2 or 3 percent. D. Structural Unemployment 15

1. Definition: Structural Unemployment Unemployment caused by a mismatch between the skills (or location) of job seekers and the requirements (or location) of available jobs. 2. Periods between jobs may be lengthened due to lack of skills that employers require. 3. Structural unemployment violates the second condition for frictional unemployment, that the unemployed can perform the available jobs. E. Cyclical Unemployment (Figure 6.6) 1. Definition: Cyclical Unemployment Unemployment attributable to the lack of job vacancies, that is, to an inadequate level of aggregate demand. 2. This occurs when there are simply not enough jobs to go around. 3. The Great Depression is the most striking example of cyclical unemployment. F. The Full-Employment Goal 1. In the Employment Act of 1946, Congress committed the federal government to pursue a goal of maximum employment, but didn t specify what that rate was. 2. Presumably this means avoiding as much cyclical and structural unemployment as possible, while keeping frictional unemployment within reasonable bounds. 3. Inflationary Pressures The first attempt to define full employment more precisely was undertaken in the early 1960 s. The Council of Economic Advisers (created by the Employment Act of 1946) decided that proximity to full employment could be gauged by watching prices. Rising prices are signals that employment is nearing capacity. The Council placed full employment at 4% unemployment; below that, prices begin rising. This 4 percent unemployment was regarded as an acceptable compromise of employment and price goals. 4. Changes in Structural Unemployment During the 1970 s and early 1980 s this view of fullemployment potential was considered optimistic. Unemployment stayed far above 4% even when the economy expanded, and inflation began to rise at higher levels of unemployment. In view of these factors, the Council of Economic Advisers later raised the level of unemployment thought to be compatible with price stability. In 1983, the Reagan administration concluded that the inflation-threshold unemployment rate was between six and seven percent. The structural barriers that intensified inflationary pressures in the 1970s and early 1980s receded in the 1990s. 16

In the 1990 s these structural barriers receded, making it easier to lower unemployment rates without increasing inflation. In 1991 full employment was equivalent to 5.5 percent. Definition: Full-Employment The lowest rate of unemployment compatible with price stability; variously estimated at between 4 and 6 percent unemployment. The Clinton administration suggested the full employment threshold might have dropped to 5.3 percent. The Bush administration set it at 5.1% in 2004. The consensus was that full employment entails 4 to 6 percent unemployment. G. The Natural Rate of Unemployment 1. The ambiguity about what rate of unemployment triggers an upsurge in inflation has convinced some analysts to abandon the inflation-based concept of full employment. 2. Definition: Natural Rate of Unemployment Long-term rate of unemployment determined by structural forces in labor and product markets. 3. The natural rate of unemployment consists of frictional and structural components only. 4. If the structural determinants of unemployment change, presumably so does the level of natural unemployment. H. Congressional Targets 1. The Full Employment and Balanced Growth Act of 1978 (Humphrey- Hawkins Act) states our national goal is a 4% unemployment rate with a required goal of 3% inflation. 2. The escape clause is that in the event that both goals could not be met, the President could set higher provisional definitions of employment. 3. In the News: Unemployment Rate Hits a 26 Year High In October 2009, unemployment hit 10.2%, a rate not seen since 1983. DD. VI. The Historical Record A. Our greatest failure to achieve full employment occurred during the Great Depression, when as much as one-fourth of the labor force was unemployed. (Figure 6.6.) B. Unemployment rates fell dramatically during World War II; the civilian unemployment rate reached a rock bottom 1.2 percent. C. Since 1950, unemployment rate has fluctuated from a low of 2.8 percent during the Korean War (1953) to a high of 10.8 percent during the 1981-82 recession. D. From 1982 to 1989, unemployment fell, but shot up again in the 1990-91 recession. E. During the last half of the 1990s unemployment fell steadily, and then rose in late 2001. 17

F. Full employment was reached in 2006-2007, but was wiped out by the Great Recession. G. Return to full employment has been agonizing slow as the economy grew. VII. The Economy Tomorrow: Outsourcing Jobs A. To keep unemployment low, 2 million new jobs are required each year. Outsourcing potentially could offset new job creation. Definition: Outsourcing: The relocation of production to foreign countries. B. Cheap labor motivates outsourcing; cheap high speed telecommunication makes it possible. C. There is also insourcing of jobs when foreign firms build production facilities in the U.S. D. There also are potential cost savings of outsourced jobs that raise US productivity that may allow U.S. workers to focus on higher value tasks. 1. In the News: Outsourcing May Create U.S. Jobs Outsourcing increases U. S. productivity and profits while reducing U. S. production costs and prices. These outcomes may increase demand for U. S. jobs by more than immediate job loss. Chapter 7 I. Introduction A. High inflation as occurred in Germany in 1923 and later in Hungary, Russia, Japan, Argentina, Zaire, Yugoslavia, Zimbabwe, and other countries, can cause economic collapse. B. The U.S. has never experienced such a price frenzy. In 1971, the Nixon administration took drastic action to stop inflation; before Nixon took office prices were rising three percent per year. The federal government imposed price controls on American producers to keep prices from rising any faster and for ninety days all wages and prices were frozen by law. For three more years, wage and price increases were limited by legal rules. At the beginning of the 1990 s the inflation rate in the United States was about six percent. Alan Greenspan, chairman of the Federal Reserve, asserted that it was unacceptable and set a goal of zero percent. Pursuit of this goal might require us to forsake other macro goals. C. This chapter examines the basis for these policy concerns by posing the following questions: What kind of price increases are referred to as inflation? Who is hurt (or helped) by inflation? What is an appropriate goal for price stability? 18

II. What Is Inflation? A. Most people associate inflation with price increases of specific goods and services. 1. Definition: Inflation - An increase in the average level of prices of goods and services. 2. Inflation is an increase in the average level of prices, not a change in any specific price. B. The Average Price 1. The average price is determined by finding the average price of all output, then looking for changes. If the average price rises it is called inflation If it falls it is referred to as deflation. Definition: Deflation A decrease in the average level of prices of goods and services. C. Relative Prices vs. The Price Level (Table 7.1) 1. Because inflation and deflation are measured in terms of average price levels, it is possible for individual prices to rise or fall continuously without changing the average price level. 2. Definition: Relative Price The price of one good in comparison with the price of other goods. 3. Changes in relative prices may occur in a period of stable average price, or in periods of inflation or deflation. 4. Relative price changes are an essential ingredient of the market mechanism resulting in a reallocation of resources in the economy. III. Redistributive Effects of Inflation A. Although inflation makes some people worse off, it makes some people better off. B. Price Effects (Table 7.2) 1. Price changes are the most familiar effect of inflation. 2. The effect on economic welfare is shown in the difference between nominal and real income. Definition: Nominal Income The amount of money income received in a given time period, measured in current dollars. Definition: Real Income - Income in constant dollars; nominal income adjusted for inflation. 3. In The News: College Tuition Up Again Public and private college tuition and fees have risen 2.9% in the last year. Tuition increases reduce the real income of students. 4. Two basic lessons to be learned about inflation: Not all prices rise at the same rate during inflation. Not everyone suffers equally from inflation. C. Income Effects (Figure 7.1) 1. Even if all prices rose at the same rate, income would still be redistributed. 19

2. Redistributive effects originate both in expenditure and income patterns. 3. What looks like a price to a buyer looks like an income to a seller. 4. If prices are rising, incomes must be rising. D. Wealth Effects (Table 7.3) 1. The same kind of redistribution occurs between those who hold some form of wealth and those who do not. 2. When the real value of some assets increase and the real value of other assets decrease, there is effectively a redistribution of wealth. E. Redistributions 1. The redistributive mechanics of inflation include: Price effects Income effects Wealth effects 2. Inflation acts like a tax, taking income or wealth from one group and giving it to another. F. Social Tensions 1. Because of the redistributive effects of inflation, social and economic tensions are increased. 2. Tensions between labor and management, between government and the people, and among consumers may overwhelm a society and its institutions. 3. World View: Zimbabwe s Trillion-Dollar Currency Hyperinflation causes consumers to struggle to keep up, and government has to issue larger and larger currency denominations to facilitate trades. 4. Psychotherapists report that inflation stress leads to more frequent marital spats, pessimism, diminished self-confidence, and even sexual insecurity. Some people turn to crime as a way of solving the problem. G. Money Illusion 1. Even people whose nominal incomes keep up with inflation often feel oppressed by rising prices. 2. They feel cheated when they discover that their higher (nominal) wages don t buy additional goods. 3. This is a phenomenon economist s call money illusion. 4. Definition: Money Illusion The use of nominal dollars rather than real dollars to gauge changes in one s income or wealth. IV. Macro Consequences A. Inflation has macroeconomic effects as well as the effects on income and wealth redistribution. Inflation can alter the rate and mixes of output by changing consumption, work, saving, investment, and trade behavior. B. Uncertainty 1. One of the most immediate consequences of inflation is uncertainty. 2. When the average price level is changing significantly in either direction, economic decisions become increasingly difficult. 20

3. Uncertainties created by changing price levels affect production decisions as well. C. Speculation 1. Inflation threatens not only to reduce economic activity but also to change its very nature. 2 If you expect prices to rise, it makes sense to buy goods and resources now for resale later. 3. If speculative profits become too easy, few people will engage in production. 4. People may also be encouraged to withhold resources from the production process, hoping to sell them later at higher prices. 5. Definition: Hyperinflation Inflation rate in excess of 200 percent, lasting at least one year. D. Bracket Creep 1. Another reason why savings, investment, and work effort decline when prices rise is that taxes go up as well. 2. Federal income tax rates are progressive, designed to redistribute income. 3. Inflation tends to increase everyone s income pushing them into a higher tax bracket. 4. Definition: Bracket Creep The movement of taxpayers into higher tax brackets (rates) as nominal incomes grow. 5. In recent years bracket creep has been limited by the inflation indexing of personal income tax rates and a reduction in the number of tax brackets. Social Security, payroll taxes and most state and local taxes are not indexed. E. Deflation Dangers 1. A falling price level a deflation might not make people happy either. When prices are falling, people on fixed incomes and long-term contracts gain more real income. Lenders win and creditors lose. 2. A deflation simply reverses the kinds of redistribution caused by inflation. 3. Falling price levels also has similar macro consequences. Time horizons get shorter. Businesses are more reluctant to borrow money or to invest. 4. People lose confidence in themselves and public institutions when declining price levels deflate their incomes and assets. Measuring Inflation A. Measurement of inflation serves two purposes: 1. To gauge the average rate of inflation. 2. To identify its principal victims. B. Consumer Price Index (CPI) (Figure 7.2 and Table 7.4) 1. The CPI is the most common measure of inflation. 21

Definition: Consumer Price Index (CPI) A measure (index) of changes in the average price of consumer goods and services. 2. By observing the extent of price increases, we can calculate the inflation rate. Definition: Inflation Rate The annual percentage rate of increase in the average price level. 3. We can see how inflation is measured by observing how the CPI is constructed: The process begins with identifying a market basket of goods and services that consumers usually buy through surveys done by the Bureau of Labor Statistics. Within the broad categories of expenditure, the Bureau of Labor Statistics then itemizes specific goods and services. As a result of these surveys, we can tell what s happening to the average prices consumers pay. 4. In practice, the CPI is usually expressed in terms of what the market basket costs in a specific base year. Definition: Base Year The time year used for comparative analysis: the basis for indexing (for example, of price changes). 5. The effect of a specific price change on the inflation rate depends on the product s relative importance in consumer budgets. The relative importance of a product is reflected in its item weight. Definition: Item Weight The percentage of total expenditure spent on a specific product; used to compute inflation indexes. 6. Core Rate: The Labor Department also reports the change in the core price level of consumer goods. This measurement excludes food and energy prices which can be very volatile. Definition: Core Inflation Rate- Changes in the CPI excluding food and energy prices. C. Producer Price Indexes 1. There are three producer price indexes (PPI) which keep track of average prices received by producers. One includes crude materials, another intermediate goods, and the last covers finished goods. The PPI indexes do not include all producer prices but primarily those in mining, manufacturing, and agriculture. 2. Over long periods, PPI s and CPI s generally reflect the same inflation rate, but in the short run, the PPI s usually increase first. 3. For this reason, PPI s are watched as a clue to potential changes in consumer prices. D. The GDP Deflator 22

1. The broadest price index is the GDP deflator that covers all output including consumer goods, investment goods, and government services. Definition: GDP Deflator A price index that refers to all goods and services included in GDP. Unlike the CPI and PPI, the GDP deflator is not limited to a fixed basket of goods and services. The GDP deflator is not a pure measure of price changes since its value reflects both price changes and market responses. Thus, it usually registers a lower inflation rate than the CPI. 2. Real vs. Nominal GDP GDP deflator is used to adjust nominal output values for changing price levels. Definition: Nominal GDP The value of final output produced in a given period, measured in the prices of that period (current prices). Definition: Real GDP - The value of final output produced in a given period, adjusted for changing prices. Formula Real GDP Nominal GDP X100 GDP Deflator Changes in real GDP are a good measure of how output and living standards are changing. Nominal GDP statistics, by contrast, mix up output and price changes. VI. The Goal: Price Stability A. An explicit numerical goal for price stability was established by the Full Employment and Balanced Growth Act of 1978. 1. Definition: Price Stability The absence of significant changes in the average price level; officially defined as a rate of inflation of less than 3 percent. B. Unemployment Concerns 1. Congress chose the 3 percent rate because of their concern about unemployment. 2. To keep prices from rising, the government might have to restrain spending in the economy that could lead to cutbacks in production and an increase in joblessness. 3. From this perspective, a little bit of inflation might be the price the economy has to pay to keep unemployment rates from rising. C. Quality Changes = 23

1. The CPI is not a perfect measure of inflation since it only monitors the price of specific goods over time, not any changes in the goods themselves. 2. Over time, the goods themselves change as a result of quality improvements. 3. The U.S. Bureau of Labor Statistics does adjust the CPI for quality changes. D. New Products 1. The exclusion of new products, whose prices may be declining result in the CPI overstating the level of inflation 2. In The News: Ignoring Cell Phones Biases CPI Upward This article illustrates the problem of omitting new items (cell phones) whose prices declined while traditional telecommunication services (which were included) rose. VII. The Historical Record (Table 7.5 and Figure 7.3) A. In the long view of history, the United States has done a good job in maintaining price stability. Upon closer inspection, however, our inflation performance is very uneven. B. See Table 7.5 and Figure 7.3 for a historical summary of the long view and more recent inflation experiences. VIII. Causes of Inflation A. Demand-Pull Inflation 1. Demand-pull inflation is excessive pressure on the demand side of the economy. 2. In the classic case of too much money chasing too few goods, producers begin raising prices. 3. The result would be a demand-driven rise in average prices, i.e., demand-pull inflation. B. Cost-Push Inflation 1. The pressure on price could also originate on the supply side. 2. Hurricanes Katrina and Rita destroyed oil production facilities causing oil prices to increase. This, in turn, raised transportation and production costs for other industries, which increased their prices. The same thing happened in Haiti after the earthquake in 2010. This illustrates cost-push inflation. IX. Protective Mechanisms (Table 7.6) A. Even at low rates of inflation, the real value of money declines over time. For example, if prices rise by an average of just 4 percent a year, the real value of $1,000 drops to $822 in five years and to only $676 in ten years. B. COLAs 1. Market participants can protect themselves by indexing their nominal incomes. 24

2. Whenever the inflation rate exceeds three percent, Social Security benefits automatically rise by the same percentage to ensure that nominal benefits keep pace with rising prices. 3. COLAs are commonly used by landlords as well as in labor agreements and government transfer programs. When used, a COLA protects real income from inflation. 4. Definition: Cost-Of-Living Adjustment (COLA) Automatic adjustments of nominal income to the rate of inflation. C. ARMs 1. Cost-of-living adjustments have also become more common in loan agreements. 2. If prices rise faster than interest accumulates, the real interest rate will be negative. 3. Definition: Real Interest Rate The nominal interest rate minus the anticipated inflation rate. 4. Formula Real Interest Rate = Nominal Interest Rate - Anticipated Rate of 5. ARMs were developed to protect lenders against losses during long term rises in inflation. 6. Definition: Adjustable-Rate Mortgage (ARM) A mortgage (home loan) that adjusts the nominal interest rate to changing rates of inflation. 7. The objective is to maintain a stable rate of real interest. Inflation X. The Economy Tomorrow: The Virtues of Inflation 1. Due to the money illusion many people would rather have low inflation and high unemployment. 2. This implies a policy bias towards low inflation even at the expense of high unemployment and low economic growth. 3. There are times a little inflation might be a good thing. During the Great Recession inflation was zero and interest rates were low but market participants were reluctant to borrow and spend and economic recovery was slow. 4. But if there was an expectation of prices rising buyers would be encouraged to spend. 5. The challenge of tomorrow s economy is to find the optimal rate of inflation one that will not raise the specter of the inflationary flashpoint. 6. Definition: Inflationary Flashpoint The rate of output at which inflationary pressures intensify; on the AS curve where the slope increases sharply. 25