What is Macroeconomics?Macroeconomics is the study of the structure and performance of national economies and of the policies that governments use to try to affect economic performance

1.What determines a nation’s long run economic growth?2.What causes a nation's economic activity to fluctuate?3.What causes unemployment?4.What causes prices to rise?5.Can government policies be used to improve a nation’s economic performance?

7Introduction to Economic Growth and Instability

Chapter Objectives• The Business Cycle and its Primary Phases• How Economic Growth is Measured and

Why is it Important• How Unemployment and Inflation are

Measured• The Types of Unemployment and Inflation

and their Various Economic Impacts

Economic Growth• Economic growth is calculated as a

percentage rate of growth per time period

1. Increase in Real GDPExample: Real GDP in the US was $10,755.7 billion in 2004 and $11,134.8 billion in 2005. Rate of economic growth in US for 2005 was?[(11,134.8- 10,755.7 )/ 10,755.7 ] = 3.5%

Economic Growth2. Increase in Real GDP Per Capita• Takes into consideration the size of the population. • Found by dividing real GDP by the size of the populationExample: • Real GDP in the US was $10,755.7 billion in 2004 and population was 293.9 million• GDP per capita = $36,596• In 2005 GDP per capita rose to $37,536. Rate of growth of GDP per capita?• 2.6%

Economic Growth• Growth as a Goal

• Arithmetic of Growth– Rule of 70

Approximate number of years required to doublereal GDP =

70

annual percentage rateof growth

Main Sources of Growth1. Increases in Inputs

2. Increases in Resource Productivity

• Productivity: measured as real output per unit of input

• Productivity in the United States– Improved Products and Services

– Understating the actual growth of economic well being– Added Leisure

– Increases achieved despite increases in leisure– Other Impacts

– Environment and quality of life

The Business Cycle• Business cycles are alternating rises and

declines in the level of economic activity• Phases:

– Peak: business activity reaches a temporary maximum

– Recession: period of decline in total output, income and employment

– Trough: output and employment at the lowest levels

The Business Cycle

Lev

el o

f R

eal O

utp

ut

Time

Peak

Peak

Peak

Recession

Recession

Expa

nsio

n Exp

ansi

on

Trough

Trough

Growth

Trend

Phases of the Business Cycle

Cyclical Impact• The business cycle is felt everywhere but affects differs across sectors of the economy:

1.Durables:

•Industries producing capital goods (eg. Heavy equipment etc) and consumer durables (eg. Household electronics)

1.Nondurables: •Service industries such as medical and legal services and nondurable consumer goods such as bread, milk etc

•Relatively insulated from the most severe effects of recession

• Twin Problems of the Business Cycle

– Unemployment

– Inflation

Unemployment• Measurement of Unemployment

1. People under 16 years of age and people who are institutionalized2. Not in Labour Force3. Labour Force

• Unemployment Rate

Unemployment RateUnemployed

Labor Force= x 100

Unemployment Rate

Criticisms:

– Part-Time Employment• Want to work full time or are working fewer hours than they

want

– Discouraged Workers• After unsuccessfully seeking employment for a time, become

discouraged and drop out of the labour force

UnemploymentUnder 16And/or

Institutionalized(70.5 Million)

Labor Force, Employment, and Unemployment, 2005

TotalPopulation

(296.6 Million)

Not inLabor Force(76.8 Million)

Employed(141.7 Million)

LaborForce(149.3 Million)

Unemployed(7.6 Million)

Types of Unemployment1. Frictional Unemployment

– ‘Frictional’ implies that the labour market does not operate perfectly and instantaneously in matching workers and jobs

1. Search unemployment

2. Wait unemployment

Types of Unemployment2. Structural Unemployment

- Changes over time in consumer demand and in technology alter the ‘structure’ of the total demand

- Composition of the labour force does not respond immediately or complete to the new structure of ob opportunities

- Geographically

Types of Unemployment• Distinction between frictional and

structural is hazy- Frictional is short term because the unemployed have salable skills

- Structural is longer term and unemployed workers find it hard to obtain new jobs without retraining, gaining additional education or relocating

Types of Unemployment

3. Cyclical Unemployment

• Caused by decline in total spending

• Typically in the recession phase

• Insufficient demand for goods and services

Full Employment• Because frictional and structural unemployment is

largely unavoidable, ‘full employment’ is something less than 100% employment of labour force

• Full-Employment Rate of Unemployment or the Natural Rate of Unemployment (NRU)

• At NRU, economy is producing its potential output

• The economy will not always operate at this rate – due to cyclical unemplpyment

Economic Cost of Unemployment• Basic cost is forgone output resulting in a GDP GAP GDP gap = Actual GDP – Potential GDP

• Okun’s Law - quantify the relationship between unemployment rate and the GDP gap

• For every 1 percentage point by which the actual unemployment rate exceeds the natural rate, a negative GDP gap of about 2 % occurs

• Eg: if unemployment rate was 7.4% and natural rate of unemployment 6%, what will be the GDP gap?

• 2.8% of potential GDP

UnemploymentActual and Potential GDP and the Unemployment Rate

5,000

6,000

7,000

8,000

9,000

10,000

11,000

12,000

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

The GDP Gap12,000

11,000

10,000

9,000

8,000

7,000

6,000

5,000GD

P (

bil

lio

ns

of

1996

do

lla

rs)

0

2

4

6

8

10

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

The Unemployment Rate10

8

6

4

2

0

Un

emp

loy

men

t(p

erce

nt

of

civi

lian

Lab

or

forc

e)

Source: Congressional Budget Office & Bureau of Economic Analysis

GDP gap(positive)

GDP gap(negative)

Potential GDP

Actual GDP

Economic Cost of Unemployment• Unequal Burdens

– Occupation– Age– Race and Ethnicity– Gender– Education– Duration

• Noneconomic Costs- Depression

Inflation

• Inflation is a rise in the general level of prices

• Reduces the purchasing power of money

Measurement of InflationConsumer Price Index:– CPI report the price of a ‘market basket’ that

are purchased by a typical urban consumer

– Set CPI equal to 100 for the base year

CPIPrice of the Most Recent Market

Basket in the Particular Year

Price of the Same MarketBasket in base year

= x 100

– Inflation is found for a year by comparing the year’s index with the index in previous year

– Example: CPI was 195.3 in 2007, up from 188.9 in 2006. So the rate of inflation for 2007 is:

Rate of inflation =

[( 195.3 – 188.9)/ 188.9 ]* 100 = 3.4%

– Can apply the rule of 70 to estimate how long will it take for the price level to double

Types of Inflation1. Demand Pull Inflation

- Changes in the prices level caused by an excess of total spending beyond the economy’s capacity to produce

- Excess demand pushes up the price of the limited output

- ‘too much spending chasing too few goods’

2. Cost-Push Inflation

- Inflation arising on the supply or cost side of the economy

- Rising prices explained by rises in per unit production costs: (total input cost/ unit of output)

- Caused by supply shocks such as abrupt increases in the cost of raw materials or energy inputs

Redistributive Effects of inflation–Nominal income

–Number of dollars received

–Real Income–Measure of the amount of goods and

services nominal income can buy

–Purchasing power of nominal incomeReal income = nominal income / price index

Redistributive Effects of inflation

– Percentage change in real income is approximately given by:

Percentage change in nominal income – percentage change in price level

- If nominal income and price level rises by same percentage points then real income remains unchanged

Who is Hurt by Inflation?

• Fixed-Income Receivers

• Savers - Real value of accumulated value decreases

• Creditors (lenders)

Who is unaffected or helped by Inflation?

– Flexible-Income Receivers• Indexed to the CPI• Cost-of-Living Adjustments• Businesses whose resource costs rise less than

rise in product price

– Debtors (borrowers)• When borrowed was worth more, will now return

the principal and interest with dollars whose purchasing power has decreased

Anticipated Inflation– Redistribution effects of inflation are less severe

or are eliminated altogether if people anticipate inflation–Nominal Interest Rate –Real Interest Rate– Inflation Premium

NominalInterest

Rate

RealInterest

Rate

InflationPremium

11%

5% 6%

=+

Does inflation affect output?

• Cost-Push Inflation and Real Output - As prices rise, the quantity of goods and services

demanded falls so firms respond by producing less

• Demand-Pull Inflation and Real Output- Even low levels of inflation diverts time and effort

towards activities such as cost of changing prices on shelves

Hyperinflation

• Extraordinarily rapid inflation

• As prices shoot up sharply and unevenly during hyperinflation, people begin to anticipate even more rapid inflation