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In chapter 2 beginning on page 45, the textbook will tell you about the 3 key economic indicators: Gross Domestic Product, the Unemployment Rate, and the Price Indexes, which tell you what the rate of inflation is. The first of the 3 key economic indicators is Gross Domestic Product.
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Here is your text’s definition of Gross Domestic Product from page 45. (Read definition.) I have underlined two parts of this definition. I have underlined “final” because Gross Domestic product excludes so‐called intermediate goods. I have underlined “in a country” because the determinant of which country’s GDP the production of a given good or service goes in is WHERE WAS THE GOOD OR SERVICE MADE? The nationality of the company that owns that factory is irrelevant. All that matters is “in which country is that factory located?”
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This image came from a 2014 WSJ article in which Honda announced it will build a new plant in Greensburg, Indiana. To know whose GNP this will be included in, you need to know who owns it. This Honda plant will be 100% owned by Honda Motor Company, a Japanese company; therefore the output of this plant will be included in Japan’s GNP. However, because the plant is located in the United States, its output will be included in U.S. GDP.
Maquiladoras constituted 54% of the US‐Mexico trade in 2004; and by 2005, the maquiladora exports accounted for half of Mexico's exports. Maquiladoras are owned by a
variety of corporations most of whom are headquartered in the U.S., Japan, or one of the
European countries. Whose GNP the output of these plants will be reported in depends on the nationality of the company that owns them. But we don’t need to know who owns them to know which country’s GDP the output of these maquiladoras will be reported in. Because they are located in Mexico, their output will be included in Mexico’s GDP, regardless of who owns them.
Break: Small group assignment 2‐1.
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GDP is the result of one year’s collaboration between business owners, workers, and landowners. The businesses say to the landowners (enter) “I’ll pay you some rent” and the landowners say “you can use my land this year.” The businesses say to the workers (enter) “I’ll pay you some wages” and the workers say “I’ll work for you this year. I’ll do whatever you tell me to do – within reason.” The businesses carefully analyze consumer tastes and preferences. They study the best and most efficient ways to manufacture things. Then they (enter) make the set of goods and services they think will be most highly valued by consumers, and they make it as efficiently as they can. And they say to the workers and landowners – who are also the consumers by the way – here’s what I made: I made some (enter) cars and some (enter) food and some (enter) clothing and some (enter) new houses and some (enter) new buildings and some (enter) medical services and some (enter) other stuff. What do you think? And the landowners and workers say “Wow! You made a lot of stuff! And it was just the stuff we wanted! Thanks!”
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Per capita GDP is The country’s GDP in a given year divided by its population in that same year. By the way, This is the most popular way to measure a country’s standard of living.
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So per capita GDP measures how much goods and services each person in a country would get IF we passed out all those new goods and services equally to everyone. Notice that we are focusing not on the WAGES workers earn due to the existence of business – we’re focusing on the goods and services made by business. Businesses don’t want these goods and services. They want to sell them to consumers. They want the revenue. If the businesses in a given country make a lot of goods and services per person, then the people in that country will be materially better off. They will be more comfortable. They will have more and better stuff to use and consume. That’s why per capita GDP is the most popular measure of the standard of living in a country.
Break: Small Group Exercise 2‐2
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GDP = C + I + G + NX. C is consumption. I is investment. That means new physical capital. We learned what that was in chapter 1: it’s machines, tools, and buildings that make workers more productive. G is government spending. NX is “Net exports,” which equals exports minus imports. We’ll learn more about that in chapter 3. If we remove the net exports from the $500 billion, we’re left with $422 billion dollars’‐worth of goods and services produced in Norway in 2014 that remained in Norway in 2014. This was split between per year they actually consume (or if capital goods, place into operation). That’s $84,400 per living, breathing person in the country (not per worker.) They spend that on housing, healthcare, education, entertainment, food, etc. Actually they spend some of it on new equipment for their factories, fishermen, and oil fields. But if those are smart purchases, that’s going to increase their GDP next year, so in the end that will produce an increase in consumption also.)
(Write GDP = C + I + G + NX on the board. Explain each letter. Show that Norway’s split is 41, 21, 26, 12 and the U.S.’s is 69, 18, 16, and ‐3. Sum up by saying GDP per capita shows how much COULD have been spent on consumption per living, breathing person, but in reality it gets spent on a mix of C, I, and G. But the G produces parks and fire protection and education, which contributes to our quality of life, and the I contributes to our FUTURE standard of living and quality of life, so in the end it still is strongly positively correlated with the welfare of the citizens in that country.)
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Well it’s not everybody, but it’s 7‐26% of the population, depending on which province you’re talking about.
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This is the capital city of Bali Province.
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This is the island of Nias, west of northern Sumatra. 15
And these people are looking for food in a heap of trash.
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China was both politically and economically communist from about 1927 until 1978; but while it has remained politically communist, it has converted its economy to a form of economic socialism. China began to allow private business ownership in 1978. They started by privatising agricultural production. Ten years later, they began to privatize their industrial and service sectors. Finally, ten years after that, they began to privatize their banking sector. Since beginning to allow private business ownership in 1978, China’s standard of living has improved very rapidly.
Here is one look at the rapid improvement in Chinese standard of living which took place beginning in about 1978. Each phase of privatization produced additional increases in standard of living. This chart shows that China’s improvement in its standard of living since 1978 has been much better than India’s. India has had a socialist economy throughout this period, but India’s government meddles with the operation of their economy at a micro‐
level. Their parliament moves to block each major multinational corporation that wants to do business in India, or at least has in the past. It took almost a year for Coca‐Cola to win approval to sell its products in India. It took KFC almost a year as well. Bureaucratic government offices require extensive paperwork from businesses for anything: if you want to get electricity for your factory, you need a permit. If you want to hook up the sewer system, you need a permit. And that’s OK, but the government offices take YEARS to approve each permit. They’re super inefficient. I’m not sure why. China intervenes in the operation of its economy more at the macro level. They offer support for new businesses in strategically important technological areas like solar power, nanotechnology, and 3D printing. They streamline the approval process for putting up new buildings. And this 17
makes a huge difference regarding how quickly private businesses can grow and get things done.
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Some people say that North and South Korea’s fortunes since the 38th parallel was drawn in 1945 are like a controlled laboratory experiment being conducted in the real world on the effectiveness of two forms of economic organization: communism and capitalism. They argue that the culture, geography, work ethic, and initial economic starting points of North and South Korea were virtually identical in 1945, so the relative success of these two countries should tell us whether capitalism – which was adopted in South Korea in 1945 –
or communism – which was practiced in North Korea – is better for its people. The answer seems pretty clear. The standard of living in South Korea is 25 times as high as the standard of living in North Korea. That means the average South Korean citizen gets to consume 25 times as much goods and services each year as the average North Korean citizen.
On page 41, your book defines Communism as an economic and political system in which the government makes almost all economic decisions and owns almost all of the major factors of production. The government of North Korea is the best example of an economically communist nation today. It is also a command economy.
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On page 42, your book defines Command Economies as Economic systems in which the government largely decides what goods and services will be produced, who will get them, and how the economy will grow. North Korea is a command economy. A command economy is a 100% planned economy. In a planned economy, the government owns 100% of the means of production, and has a central national planning committee which decides how much of each major category of goods and services the nation should manufacture next year. So for example they might decide that they want 10% of their output to be for health services, 10% to be for new housing stock, 20% to be for food, 5% each to be for the military and new furniture, and so on. This national planning committee will decide which regions should specialize in the production of food, automobiles, et cetera. They develop regional quotas and they allocate them to these regions. Then each region has a planning committee that decides which cities shall make which goods, what exact goods they shall make, and so on. All economic output is planned and overseen by government committees and agencies.
China, Vietnam and the Soviet Union used to be command economies but aren’t any longer. The only remaining command economy in the world is, I believe, North Korea.
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Labor productivity is another important economic indicator. It doesn’t make our list of the top three, but if we had room for one more, this would be it.
Remember standard of living? That’s GDP per living, breathing person in the economy.
Well, labor productivity is simply GDP per worker. It is Tightly coupled to standard of living through this formula: GDP per person equals gdp per worker times workers per person. GDP per person is of course standard of living. GDP per worker is labor productivity. Workers per person is called the employment to population ratio. If you want to increase standard of living, which is the number on the left, you have to increase one or both of the numbers on the right. There’s simply no other way to do it!
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Break: Small Group Exercise 2‐3
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Scylla and Charybdis were two mythical sea monsters who blocked Odysseus’s path home. Charybdis was a monster who made a whirlpool and tried to suck ships down into his mouth. Scylla was a six‐headed monster. Odysseus decided it was better to lose six men than his whole ship, so he kept his distance from Charybdis, which put his ship close to Scylla. Scylla snatched 6 of Odysseus’s men from his deck, but Scylla’s mouths were too busy chewing and swallowing to snatch any more. What economic policymakers try to do is use fiscal and monetary policy to steer a path right down the middle, trying to avoid being eaten either by the inflation monster or the unemployment monster.
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Another way of looking at it is to imagine that the economy is like a steam locomotive. To get it to do work, you have to increase the pressure level in the boiler. The higher the pressure level, the more horsepower you will get out of the engine. But if you heat up the boiler so much that its pressure is above the red warning line, it might explode! That will kill the engineer and cause the train to grind to a halt! You don’t want that. So you try to keep the pressure just below the red line at all times. When economic policymakers try to use fiscal and monetary policy to go above the red line, the economy doesn’t explode, but what happens is you get hyperinflation. I’ll come back to that 9 slides from now.
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This is an exaggerated picture of the tendency of free market economies to experience business cycles.
Periods of (use callout) RAPID GROWTH in the level of (use callout) real output or real GDP are called “ECONOMIC RECOVERIES.” But these periods tend to be interrupted at somewhat regular intervals with (use callout) periods of recession. The low point in this cycle is called the trough and the high point is called the peak.
Classical economists of the early 1900s couldn’t understand why recessions and troughs lasted so long. Their theories predicted that when there is excess unemployment, wages should adjust downward immediately and as much as necessary to cause the labor market to “clear;” that is, to cause the quantity of labor demanded to match the quantity of labor that people want to supply This process should take at most a few months, but recessions and troughs were lasting for six to nine years typically. They scratched their heads and said this is impossible. Yet it happened again and again. In the 1930’s, a young economist named John Maynard Keynes was shocked and saddened by the widespread suffering created by the great depression, which started in 1929 and continued through much of the 1930s. Official unemployment rates in the United States reach 25% during the Great Depression, but many people believe the real rate was much higher. Parents were separated from their children and never saw them again. People committed suicide, they were so ashamed that they could no longer provide for their families. A fist fight broke out in New York city between 50 men over the rights to the contents of one pail of garbage. This was levels of suffering that had not been seen before in the Twentieth century, and Mr. Keynes vowed to get to the bottom of it. He set out to invent a new theory of economics that could explain how this terrible tragedy could have occurred, and give economic policymakers a road map for making sure it never happened again. He invented macroeconomics as we know it.
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For the period (enter) 1954 – 2010, the average annual U.S. employment rate has only fallen below 4% four times: from 1966‐1969. Why has unemployment only rarely and briefly fallen below 4% in modern times? To understand the answer to this question, we need to understand the four components of unemployment.
These are listed in your book in a yellow inset panel on page 46.
Frictional unemployment consists of those individuals who either quit their last job or who are entering the labor market for the first time. It does NOT include people who were FIRED or LAID OFF of their last job. Labor market friction is the lag or delay between the time a person with skills employers want STARTS LOOKING for a job and the time that person gets hired. In an ideal world, all markets would be frictionless – buyers and sellers would be able to find each other right away. But in the real world, markets have friction. It takes time for the employer and the employee to find each other. Electronic job boards like HotJobs.com and Monster.com probably are decreasing the amount of friction in the labor market, and that’s a good thing. The sooner these people find a job, the better. From the employee’s perspective, low friction is good because they’re ready to work right now. From society’s perspective, low friction is good because the sooner that person starts working, the more value or GDP we will be able to create this year.
Structural unemployment is that portion of unemployment that is caused by a mismatch between the skills that the unemployed people in a particular geographic area have, and the skills that employers in that geographic area are looking for.
For example, if there are 500 laid‐off aerospace engineers currently seeking employment in the South Bay Area, but there are only 100 job openings for aerospace engineers, then there are at least 400 people in the South Bay who are structurally unemployed. There may be hundreds of job openings for people with other skills, such as software engineers, but if those aerospace engineers don’t have the skills for those jobs, they are not going to get hired into them.
The main solution to structural unemployment is job retraining. As some industries grow and others decline, some individuals are going to have to go back to school and acquire new skills in order to become employed again.
Seasonal unemployment is that portion of unemployment that is caused by seasonal ups and downs in demand for workers which occur rhythmically each year in certain industries. For example, California farmers employ far more workers during the picking season than they do at any other time during the year. This annual spike in employment can cause a corresponding dip in employment for the remainder of the year for those individuals who have few or no other skills to offer to employers.
Finally, cyclical unemployment is caused the tendency of free‐market economies to grow their gross domestic product not at a steady rate, but in spurts of extra‐rapid growth, separated by periods of relatively poor growth, or even decline in GDP.
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Frictional unemployment consists of those individuals who either quit their last job or who are entering the labor market for the first time. It does NOT include people who were FIRED or LAID OFF of their last job. Labor market friction is the lag or delay between the time a person with skills employers want STARTS LOOKING for a job and the time that person gets hired. In an ideal world, all markets would be frictionless – buyers and sellers would be able to find each other right away. But in the real world, markets have friction. It takes time for the employer and the employee to find each other. 33
Electronic job boards like HotJobs.com and Monster.com have permanently decreased the amount of friction in the U.S. labor market. These tools enable qualified job candidates and companies with job openings to find each other faster.
The California Employment Development Department (EDD) operates a similar service called CalJOBS.
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Structural unemployment is that portion of unemployment that is caused by a mismatch between the skills that the unemployed people in a particular geographic area have, and the skills that employers in that geographic area are looking for.
For example, if there are 500 laid‐off aerospace engineers currently seeking employment in the South Bay Area, but there are only 100 job openings for aerospace engineers, then there are at least 400 people in the South Bay who are structurally unemployed. There may be hundreds of job openings for people with other skills, such as software engineers, but if those aerospace engineers don’t have the skills for those jobs, they are not going to get hired into them.
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Seasonal unemployment is that portion of unemployment that is caused by seasonal ups and downs in demand for workers which occur rhythmically each year in certain industries such as farming, fishing, and retail sales. For example, California farmers employ far more workers during approximately four brief picking seasons than they do at other times during the year. These periodic spikes in employment can cause a corresponding dip in employment for the other months of the year for those individuals who have few or no other skills to offer to employers. The Alaska fishing industry hires fishing guides, but only in the summer. Some retail companies, such as Macy’s, Target, and WalMart hire additional employees for the Christmas season. The seasonal component of unemployment affects monthly unemployment figures, but not annual ones. When you look at an annual average unemployment rate, the seasonal component is zero.
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Finally, cyclical unemployment is caused by the tendency of free‐market economies to grow their gross domestic product not at a steady rate, but in spurts of extra‐rapid growth separated by periods of relatively poor growth, or even decline, in GDP. It is the only component of unemployment that can be addressed, by which I mean kept to a minimum, by fiscal and monetary policy.
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Now that we have looked at the four types of unemployment, we are prepared to understand why unemployment has (enter) rarely gone below 4 percent in modern times. Four percent (enter), which is sometimes called the “natural rate of unemployment,” is the sum of the frictional and structural components of unemployment. Any unemployment (enter) ABOVE 4% is called “excess unemployment.” It is the cyclical component of unemployment. 40
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A. ($21,883 /$21,667)‐1 = .01 = 1%
B. (215/100)‐1 = 1.15 = 115%
C. ($21,667 x 100)/100 = $21,667
D. ($21,883 x 100)/215 = $10,178
E. ($10,178/$21,667)‐1 = ‐0.53 = ‐53%
Break: Small Group Exercise 2‐4
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The purpose of modern macroeconomic policy is to dampen the amplitude of the business cycle. 46
The purpose of modern macroeconomic policy is to dampen the amplitude of the business cycle. To make the vertical distance from the peak to the trough smaller. This way, there will be less (use squiggle callout) excess unemployment during the troughs. Excess unemployment is a complete waste. When someone who wants to work is idle for a year, you can never get that time back. Economists call this kind of loss a “pure deadweight loss.” You see, when my neighbor is unemployed, it not only hurts him, it hurts me, too. Because if he had been working, he might have built a web page I could have used, or a car I wanted to buy, or cooked some restaurant meals I wanted to buy. When people are working, they create wealth and value out of thin air, using their hands and minds. When they are not working, no such value is created.
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The dampened business cycle will, under ideal conditions, look something like this. We have (enter enter enter, then use 3 crossout callouts) gotten rid of some of the excess unemployment.
Explain deadweight loss.
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Modern macroeconomic policy has two components: fiscal policy and monetary policy. Fiscal policy is control of government spending and taxes by the government. Monetary policy is control of interest rates and the money supply by the Federal Reserve Bank, which is technically a government agency, but it operates very independently from the other parts of the federal government. The goals of fiscal and monetary policy are the same: to dampen the fluctuations in the GDP growth rate to avoid some of the excess unemployment that we would otherwise haved experienced during the recessions and troughs. They know that can’t completely ELIMINATE the fluctuations, but they would like to dampen them as much as possible. This should produce a slightly more rapid rate of growth in standard of living and will CERTAINLY eliminate a substantial portion of the deadweight loss.
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The kind of economic policy that Mr. Keynes invented is called FISCAL POLICY. Fiscal policy has two tools: government spending and taxes.
Fiscal policy is an effort by the government to put their FOOT ON THE GAS when the economy is unnecessarily sluggish or slow or cold and to put their FOOT ON THE BRAKE PEDAL when the economy is growing at rate that is unsustainable and merely likely to create a bunch of inflation rather than improve real standard of living. In fiscal policy, the government can put its foot on the gas pedal either by increasing government spending or by decreasing taxes.
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In the middle column, the government is putting its foot on the gas pedal. It can do that either by INCREASING GOVERNMENT SPENDING or by DECREASING TAXES. If it does both of those, it’s like stomping on the gas pedal, but it will cause the national debt to increase, so doing that isn’t very popular. Increasing government spending puts people back to work by directly creating demand for more goods and services. Decreasing taxes puts people back to work by giving people more take‐home pay, which causes them to demand more goods and services, which causes the businesses they buy goods and services from to hire more people. The government call also put its foot on the brake pedal either by DECREASING government spending or INCREASING taxes. If it does both of those at the same time, it’s like STOMPING on the brake pedal.
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Generally speaking, macroeconomic policymakers don’t have to worry about inflation and unemployment at the same time. At the peak (enter), unemployment will be 4% ‐ or maybe even a little below. Inflation will be 4% or higher, and if you try to hold at that peak by stepping on the gas, inflation will begin to accelerate and will continue to accelerate indefinitely. There are countries that have experienced inflation rates as high as 1000% per year because their governments followed unwise economic policies. Your economy can only grow if you are educating your workforce, inventing new products and manufacturing methods, and buying better tools for your workers. But some countries couldn’t wait. They just stepped on the gas. Instead of getting real GDP to grow, they created an inflation monster, with runaway inflation that is very, very hard to fix once you unleash it.
At the trough (enter), unemployment tends to be around 10%, and inflation tends to be close to zero percent. It can even be negative. 52
Monetary policy is the other kind of macroeconomic policy besides fiscal policy.
Monetary policy is administered by a federal government agency called the Federal Reserve Bank. While technically a federal government agency, the Federal Reserve bank is highly independent from the other branches of the federal government. So, by “the Fed,” we don’t mean “the federal government,” we mean “the Federal Reserve Bank.”
Monetary policy adds one more tool to government’s toolkit for navigating a course between unwanted inflation and unnecessary unemployment. Both this slide and chapter two imply that monetary supply adds two tools: the money supply and interest rates; but in
reality, these are just two faces of the same tool. If the economy is overheated because it is nearing a peak, then there is a risk that unnecessary and undesirable levels of inflation will occur. By RAISING INTEREST RATES (or contracting the money supply, which will CAUSE interest rates to rise,) the Federal Reserve can COOL OFF THE ECONOMY. That is their BRAKE PEDAL. When the economy has cooled more than it needs to, which means that unemployment is higher than it needs to be, the Federal Reserve can LOWER INTEREST RATES. This will cause the economy to SPEED UP. Lower interest rates are the GAS PEDAL of monetary policy.
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When the economy is near a peak in the business cycle, the Fed will find that inflation is above 4%, real gdp per capita is growing at 2% or more per year, and unemployment is at or near 4%. Unemployment at or near 4% is good, and real gdp per capita growing at 2% or more per year is good, so the only problem here is that inflation is dangerously high. In this situation, inflation will be public enemy number one, and the Fed will raise interest rates to cool off the economy. When interest rates go up, two groups of people will spend less money: consumers who are thinking of buying something by taking out a loan will spend less money, and BUSINESSES who are thinking of EXPANDING their business by taking out a loan will also spend less money. So if a family is thinking of putting a second story on their home by taking out a mortgage loan, when they look at how high the interest rate on that loan will be, they say “You know what? Let’s wait ‘til next year to build that second story.” The same is true of businesses that are thinking of taking out a loan to expand their factory. At a high interest rate, when they run the numbers, they find “we can’t make a profit with an expanded factory if we have to pay such a high interest rate on the loan we will need to take out in order to BUILD the factory.” With these two groups REDUCING their spending and all other groups keeping their spending the same, the overall level of demand for goods and services will go down. Construction companies and factory equipment companies will find that there is less demand for their products. This takes away the excess demand pressure that causes inflation. It also lowers GDP a little bit. But lowering GDP is exactly what we want to do. GDP is too high. It’s at levels that are unsustainable. That’s an “overheated” economy.
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I said earlier that fiscal and monetary policymakers have the same goals. Now I am ready to tell you what those goals are, at least for the U.S. economy. Their goals are: 1. to keep inflation steady at between 1.5% and 2% per year. 2. to keep unemployment steady at between 4% and 4.5% per year, and 3. to keep real GDP per capita growing at 2% per year or higher.
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When the U.S. economy is in recession, or when the unemployment rate is substantially above 4%, both fiscal and monetary policy makers will want to step on the gas. Our economy’s monetary policymakers, who work at the Fed, will do this by lowering interest rate.
When interest rates go DOWN, two groups of people will spend MORE money: consumers who are thinking of buying something by taking out a LOAN, and businesses who are thinking of expanding their business, such as by building a new factory, by taking out a loan. When these two groups increase their spending and all other groups keep their spending the same, the overall level of demand for goods and services goes up. This causes more economic transactions to take place than would have taken place without the monetary stimulus. But more economic transactions is just another way of saying higher GDP. So GDP will go up and businesses will re‐hire all those unemployed workers and put them back to work.
Break: Small group exercise 2‐5
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