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Economics 1021 - Lecture Notes - Professor Fazzari
Topic II: Macroeconomic Data
(Update January 29, 2013 )
**Important Note** The material covered in this section of the notes on the
measurement of inflation and unemployment will not be discussed in class, but you need
to learn about these things for the homework and the first exam. The lecture notes for
topics B. and C. in this file below provide the material that you need for these topics.
Please study these notes carefully on your own.
A. Measuring Aggregate Output
1. Why Measure Output?

To test various theories about the economy, we need measures of total production.
For example, we need good measures to determine what happens to the economy
when interest rates fall. We also might want to compare economic performance
across countries. For these "positive" reasons we need good measures of overall
economic performance.

Good data are also essential as a guide to policy. For the Fed, the Congress, and the
President to know what kinds of policies to pursue, they need good information about
the state of the economy. Thus, there are "normative" reasons for measuring output.

Macroeconomic measures also have important political ramifications. Most voters
may know little about GDP, but news of its weak or strong growth will matter for the
outcome of national elections. Example: George H.W. ("Daddy") Bush lost the
election of 1992 to Bill Clinton. There were undoubtedly many reasons for this
outcome, but perhaps none was more significant than the weak news about the
economy during 1992, particularly slow GDP growth. The economic figures also
played a large role in the presidential election of 2012. The main theme of the
Romney campaign to defeat Obama was that economic performance had been weak
during Obama’s first term. These numbers matter!

While these points are made specifically about GDP, they also apply to measures of
inflation and unemployment discussed in the lecture notes below. Indeed, in recent
years, unemployment may be more important for political purposes than GDP
because it is more tangible to the average voter.
2. Adding Up Diverse Products

If the economy produced just one kind of physical good (corn, for example), it would
be easy to measure total output.

But it is difficult to calculate GDP because you have to find a way to measure and
compare thousands (millions?) of very diverse products. It’s hard enough to
compared physical goods (How many boxes of corn flakes equals one car?). But a
large majority of what a mature economy like the U.S. produces is not even physical
"goods" that can be counted. Instead a lot of production comes from the “service
sector” that employs vastly more people than the goods-producing “manufacturing”
sector. In 2009 services accounted for about 75% of the production of developed
economies. (See the International Monetary Fund statistics listed by Wikipedia at
http://en.wikipedia.org/wiki/List_of_countries_by_GDP_sector_composition ).
Examples of services include education, visits to the doctor, much of health care, etc.

Somehow, all the diverse goods and services produced must be aggregated to come
up with a measure of total national output.
3. GDP Definition

Gross Domestic Product (GDP): the money value of all final goods and services
produced in an economy over a given time period.

GDP is typically measured over a period of a quarter or a year. GDP always is
associated with a time period. It only makes sense to measure output over a
period of time, not at a single point in time.

The definition of “an economy” is usually a country, but it could be a state or
smaller unit. (There are statistics available called “gross state product.”)
a) Logic of Using Money Values as Weights for Aggregation

To meet the challenge of the vast diversity of products, economists use the money
value of goods and services to determine their individual values. The money
values are then added up to get a measure of aggregate output.

Relative money values reflect the different values people put on different goods.
The reason a car represents more production to society than a box of corn flakes is
that people value a car more highly. This point is reflected in the relative money
values of cars and corn flakes, and all other goods produced in a market society.

You may be asking yourself, "well, duh, what else could economists possibly
use?" An answer to your question is that we could measure GDP based on how
many hours were worked to produce the goods and services. However, money
values give a better estimate of the relative value society places on different goods
and services (as opposed to the effort that goes into producing different things).

The computation of GDP is a very complicated statistical process. The Bureau of
Economic Analysis in the Department of Commerce conducts surveys and
employs tax data to arrive at an estimate of GDP in each quarter. Estimates first
appear one month after the end of the quarter but they are subsequently revised.
Sometimes substantial revisions occur even after a couple of years.
b) Final vs. Intermediate Goods and Services

A final good is one that is ultimately used by the consumer

An intermediate good (or service) is one that is purchased to be used in the
production of another good (or service)

Only final goods are included in the GDP totals. Intermediate goods are not
counted in GDP because we would be double-counting the amount of output that
is actually produced.

Example: Consider a car that costs $30,000 from the dealer: Let's say the dealer
bought the car from the producer for $25,000, and the producer spent $15,000 on
parts and materials to make the car. The total value of the transactions involved
in producing the car is the sum of $30,000 (the retail cost of the car), $25,000 (the
wholesale price the dealer paid to the car manufacturer), and $15,000 (the value
of inputs purchased by the manufacturer.) But it should be clear that this
approach would greatly overstate the value of goods represented by the car, which
is just $30,000. We exclude the purchases of items prior to the sale of a final
good to the ultimate consumer as intermediate goods.

Another example: the value of electricity used in a home counts towards GDP
because the person in the home is the final consumer. Electricity used in a place
of business is considered an intermediate good, as that electricity is just an
intermediate good that is used to produce another good/service.
c) GDP Sales and Inventories

GDP measures production, NOT sales. However, we do measure GDP in money
values, so sales are involved in the calculation of GDP.

Goods that are produced during the year but not sold are added to inventories.
These goods still count towards GDP at the time they were produced, even though
they are not sold.

The relationship between GDP and sales is given by the following equation:
GDP = Final Sales + Change in Inventories

So, a $1,000 refrigerator produced in the year 2010 but not sold until 2011 will
count towards GDP in the year 2000 as a positive change in inventory. When the
refrigerator is sold in 2001, final sales will increase and there will be a negative
change in inventories, so the net change in GDP for 2001 is zero. In table form:
GDP
Final Sales
Change in Inventories
2010
+$1,000
-0-
+$1,000
2011
-0-
+$1,000
-$1,000
d) Investment: Intermediate or Final Good?
(1) Definition of investment

Investment consists of these three components:
o Structures, equipment, and software purchases by firms. Basically durable
goods that firms use to carry out their business. This category is called
“nonresidential fixed investment” in the government statistics. Software
was added to this component a number of years ago.
o Residential Construction: value of new housing built in the GDP time
period (not the value of existing houses). Home improvement, like a room
addition or substantial remodeling, also adds to this component.
o Change in Inventories

Note that "investment" for purposes of this course refers to these components, not
the purchase of stocks, bonds, or other financial assets. Thus, the term
“investment,” as typically used in macroeconomics, usually means something
different from its common usage.
(2) Should investment goods be counted as final output?

It may seem like these investment goods purchased by a business should be
intermediate goods because they are used to produce other goods and services.
However, economists include them in GDP because they are durable. Durable
goods are defined as goods that last for at least 3 years. A durable good will still
be used for many years after they are produced. An economy that produces a lot
of investment goods in a year that are available for future use is more productive
than an economy with little investment. Thus, it makes sense to include
investment goods in GDP.

Software did not used to be counted as investment, it used to be considered a
simple intermediate good when purchased by firms (like raw materials or
electricity). However, software is “durable” and has recently been included in the
investment category. This change of definition would raise GDP, even with no
change in the production of anything. (Do you understand the previous sentence
fully? If so, you have a pretty good idea of what we have covered so far.)
(3) Gross vs. Net Domestic Product (NDP)

One might argue that something should be subtracted from GDP to account for
productive goods that are used up during the year.

Definition of Depreciation: the value of that portion of the nation’s capital
equipment that is used up within the year

Net Domestic Product = GDP – Depreciation

GDP measures final output and does not take into account the capital used up in
the process (which must eventually be replaced). NDP deducts the depreciation
to arrive at a net measure of production.

NDP is conceptually better than GDP. NDP allows for the fact that investment
goods produced this year may not be fully used up this year. But the NDP
measure also account for the fact that some investment goods wear out every year.

Nevertheless, GDP is the primary measure used by economists and policy makers
because depreciation is very difficult to measure accurately. Therefore, NDP is
considered a less reliable measure of output than GDP.
e) Pre-Existing Assets
 Goods or services sold in a year that were produced in a prior year do not count
toward GDP.

Example: A 1995 car resold in 2000 does not count towards GDP in the year
2000. Remember that GDP measures production, not sales, and the car was
already counted when it was produced in 1995.

Other examples include sales of homes built in previous years and sales of
artwork produced before the year of interest.

The buying and selling of existing businesses would also fall into this category. If
one company purchases another one, there is no effect on GDP.

Because shares of stock represent ownership of an existing business, exchange of
shares of stock does not raise GDP. Note, however, that the value of brokerage
services paid by individual investors are counted as the production of a final
service and therefore add to GDP. The same principles apply to banking,
insurance, real estate, etc. The value of assets bought and sold does not add to
GDP, but the amount paid to financial service companies does represent
production.
f) Market versus Non-market Exchange

GDP does not measure any transaction that does not go through markets
(Examples: work that you do in your own home, illegal activities).

This means that hiring a person to mow your lawn for you counts towards GDP,
whereas mowing your own lawn does not count towards GDP

This is a shortcoming of GDP. In principle, work you do for yourself or other
activities that do not go through markets represent production and one could argue
that it should be counted in GDP. However, it would be nearly impossible to
account for all the non-market transactions that take place.

One application of this idea is to analyze the impact of GDP of greater labor force
participation of women in recent decades. Their production for the market is now
added to GDP, but the work they no longer do in the home (outside of the market)
is not subtracted from GDP. Thus, one might argue that the growth rate of
measured GDP during the past 40 years is somewhat higher than it should be.

If we look at the GDP figures of less developed countries, we will see that the per
capita GDP is only a few hundred dollars. These countries are very poor. But
their low GDP numbers probably exaggerate the extent of their poverty compared
with developed countries. Most likely, a much greater proportion of their
production does not go through a market, so it is not counted in GDP. The same
problem arises for countries in which the underground economy is large. There
exists a downward bias in their GDP because illegal transactions are unreported
and uncounted.
g) The Components of GDP
(1) The GDP equation: GDP = C + I + G + Ex – Im

C = Consumption: everything consumers buy except housing. Consumption
includes all durable assets (aside from residential housing), like cars and
appliances.

I = Investment: the three components discussed above

G = Government Spending on goods and services

Ex = exports (goods produced in the U.S. and sold abroad)

Im = imports (goods produced outside the U.S. and sold here)
(2) Government spending on goods and services as one use for output

Government spending on goods and services (the “G” in the GDP equation)
includes money spent on building roads, public education, local police and fire
departments, and the military, and many other things. Goods and services bought
by the government are considered, by definition, final goods and services, even
though they may be considered intermediate when consumed by the private
sector.
(3) Valuation of Government Services at Cost

Because there is no “market price” for these goods and services we use the cost to
the government of providing this output as the contribution to GDP. For example,
the contribution of soldiers to GDP is measured by what they are paid.

The relevant distinction between private production and government production is
that no one makes a decision to buy government goods and services at a market
price (most of the time). Perhaps government services are worth more or less to
society than they actually cost. If this is the case, the actual measure of this
component of GDP could be a distorted measure of the true “money value” of
government goods and services.
o Useless things produced by the government would be counted in GDP
even though they are not worth anything to people in the society.
o The government might provide extremely valuable goods or services, but
at a cost much lower than the value people put on them. In this case, the
measure of GDP would understate true money value of government.
(4) Role of Transfer Payments

Government spending DOES NOT include transfer payments, which is money
given to individuals as grants from the government rather than as a payment in
exchange for services. Examples include social security and unemployment
benefits. These grants likely do help the recipients buy consumption. But it is the
consumption of final goods and services that is counted in GDP, not the value of
transfer payments.
o Interest payments on the government debt are also a form of transfer
payments.
o Government payments for medical care fall in a particularly tricky
category. As an insurance payment, government payments through
Medicare and other programs are treated as transfer payments. The logic
is that the recipient purchases the medical care (and it’s therefore counted
as consumption in the GDP equation) and the government makes an
insurance payment which counts as a transfer and does not appear directly
in GDP. The spending on medical care paid for by government insurance
programs is part of personal consumption.

For this reason, the G component of GDP is typically much smaller than the
standard measure of government spending. When we talk about total federal
government spending, for example, we usually include transfer payments.
o Total government expenditure (2012:Q3): $5.7 trillion
o Government spending on goods and services (2012:Q3): $3.3 trillion

Transfer payments also take place among private individuals; consider gifts,
grants, prizes, etc. These payments do not represent production and they
therefore are not counted as GDP.
(5) Correcting components for imports to arrive at domestic production

While exports and imports can be in the form of consumption goods, investment
goods, or government spending, we lump them all together in the export and
import categories.

Exports are counted in GDP because the goods are still produced in the U.S., even
if they are consumed outside the U.S. Even intermediate goods exported from the
U.S. count in GDP because they were produced in this country and will not be
counted in any other U.S. final output.

Imports do not contribute to GDP because they are produced elsewhere.
However, imports are included in the other components of GDP, so we must
subtract imports to get a measure of production in the domestic economy. For
example, if the U.S. imports a television and sells it, the money spent on that
television is included in consumption. However, the TV was not produced in the
U.S., so we subtract the amount the importer paid for the TV from GDP. (Note,
however, that the profit made by the company that imported and sold the TV
importer would count in GDP.)

Another example: Toyota assembles a $30,000 car in the U.S. However, the car
contains $10,000 worth of imported parts. The car will add $30,000 to
consumption (if it is bought by a household) or investment (if it is bought by a
business), but the $10,000 of imported parts will be subtracted from GDP. So the
contribution of this car to GDP is $30,000 - $10,000 = $20,000.
4. GDP and Income
a) Why GDP must equal income

At the aggregate level, income and production are conceptually the same thing.
When goods are produced, they are eventually sold, and they generate revenue
that goes into national income.

Example: think about a car that is produced and sold for $30,000. This revenue
generates various income flows, such as wages, profits, interest, and rent. Some
of the revenue goes to buy intermediate goods. But payments for intermediate
goods generate revenues for the firms that produce them and these revenues are
also transformed into incomes. If you continue to trace the intermediate goods
through the various stages of production, you will see that at each stage a greater
and greater share of the $30,000 in initial revenue is transformed into some kind
of income. In the limit, all of the $30,000 generated by the production of the car
will be transformed into some kind of income.

The main point is that every dollar of final output will be transformed into some
kind of income. Production of output is the source of income. Thus, we can use a
production concept, such as GDP, to also represent income, and therefore living
standards.

It is also useful to recognize that production (and subsequent sale of what is
produced) is ultimately the source of income. Income doesn’t come from the
printing of money or any other financial process. We think of income in terms of
money because we value production by its money value. But to get income,
something must be produced.
b) Technical issues: depreciation, indirect business tax, and international
income flows

While conceptually, income and GDP are the same thing, the actual statistics
differ for the following reasons.

Depreciation is subtracted from national income.

Due to indirect business taxes (mostly sales taxes), we pay more than businesses
actually receive as revenue when we buy a good or service.

Also, Americans earn income abroad that counts toward U.S. national income and
foreign citizens earn income from U.S. production that is subtracted from national
income.

The following equations account for these technical issues to reach the statistical
definition of national income:
GNP = Gross National Product
GNP = GDP + Income earned by U.S. citizens abroad
– Income earned by foreign citizens in the U.S.
National Income = GNP – Depreciation – Indirect Bus. Taxes

But these technicalities do not change the main point: production is the source of
all income and the two concepts are often used interchangeably.
5. GDP as a Measure of Social Welfare
a) Desire to measure whether an economy is better off

GDP is useful for the purpose of comparing how a country is doing over time,
whether the economy improves following certain policies etc. There is normative
value embedded into the concept.

If GDP is higher so it income. When we think of economic well-being, we
usually relate it to income. Consider the debates about the “top 1%.” This is
usually defined in terms of income. Remember the conceptual equivalence
between GDP and income. So, if you accept that income is a measure of
economic welfare, this is almost the same thing as using GDP as a measure of
welfare.

We typically would want to scale GDP (or national income) by some measure of
population to measure material standards of living. (Example: China has a higher
overall GDP than Switzerland, but the average Chinese citizen does not have a
higher standard of living than the average Swiss citizen.) GDP divided by
population is called per capita GDP.
b) More is Better?

In this class (and most other economics classes), we usually assume that “more is
better,” meaning that people are better off when they have more goods and
services.
o Note that if we take into account unfavorable aspects of production, such
as pollution, this assumption may not necessarily be true. There are
clearly other aspects of human satisfaction beyond material goods and
services.
(1) Critique: Possibility of misleading assumptions about what brings human
happiness

The “more is better” assumption certainly may not apply across individuals. We
can all think of examples of wealthy people who are very unhappy and people of
modest means who seem quite happy.
(2) Examples: The 1960s is sometimes considered a macroeconomic “Golden Age.”

GDP growth was very high and unemployment was low. Yet, there was
substantial social unrest. Clearly there was more to measuring the well-being of
U.S. citizens than just GDP.

More recently, psychologists and economists have looked at how various survey
measures of happiness and life satisfaction change with income. The results are
mixed.
o A recent prominent study found that higher income made Americans happier
up to about $75,000 in family income (measured in 2008 and 2009). After
that, higher income seemed to have little effect on survey responses that
indicated happiness.
o This finding is consistent with a view that once basic needs are met (where
what is “basic” may well be determined by typical social conditions in a
country) more income does not add much to satisfaction.
o If this is the case, one might question the typical “more is better” assumption
that underlies much of macro analysis.

However, it seems that most people are indeed happy, other things equal, when
they can consume more goods and services from one year to the next, that is,
people seem to appreciate more material output over time. This point helps to
justify the “more is better” assumption.
o Research also shows that people are quite unhappy if their incomes fall. This
finding justifies the objective of much of macroeconomics to understand, and
ultimately to address, problems of recession and unemployment.
6. Limitations of GDP as a Social Welfare Measure

We will assume that higher levels of GDP and faster growth are better. However,
even if you accept that “more is better,” there are limitations to the concept of
GDP.
a) GDP and Income Distribution

Macroeconomics usually focuses on aggregate production and consumption and
therefore suppresses any discussion of how the consumption of goods and
services is distributed across individuals or groups within the society.
(1) Does money value reflect true social value when distribution is unequal?

An increase in GDP represents rising material living standards for the society as a
whole, but this increase may not be equally distributed across all members of the
society. The most significant concern is usually that relatively wealthy people get
a greater share of rising GDP.

Example: In the U.S., since roughly the late 1970s, income distribution has
become less equal. There was substantial GDP growth (and therefore income
growth) in the aggregate from the early 1980s until the onset of the Great
Recession in late 2007. But middle- and lower- income people have enjoyed less
benefit from this growth than high-income people. This fact has contributed to
the sense that the middle class standards of living has stagnated.
o The chart below shows the rising share of (pre-tax) income in the U.S. earned
by the top 5% of the income distribution. The increase since the early 1980s
is quite pronounced.

Other examples of this problem occur in less developed countries. In Latin
America, in particular, the distribution of income is very unequal, with a few very
rich people and a majority of the population living in poverty.

To the extent that income distribution is important, the GDP measure is a limited
indicator of the overall material welfare of a society.
o For example, one might argue that the growth in U.S. GDP in recent decades
overstates the rise in the country’s standard of living because so much of the
growth has gone to the top of the income distribution (who may not benefit
from it all that much if the happiness research mentioned earlier is correct!)

However, when the economy is booming, most people are doing better than they
were. When the economy is in a recession, most people are worse off. Even if
one doesn’t lose one’s job in a recession, wages and salaries usually grow more
slowly (or even contract). And even the greater threat of losing one’s job can
create stress and reduce well being. Income distribution may change to some
extent during business cycles, but, once again there is likely to be positive
correlation across individuals in their economic well-being during cycles.
(2) Importance of values to evaluate economic changes.

To make comparisons across people with different levels of income or wealth,
one needs to make value judgments. The judgment that society would be better
off by allocating additional production to the less fortunate than to the wealthy is
a value judgment.

Economists are sometimes reluctant to make value judgments, but such judgments
are inevitable in assessing many social policies.

The concept of GDP itself implicitly reflects a value judgment if we use it as an
index of social welfare. The use of money values to determine the relative
“weights” of different kinds of output reflect not just the value people put on
different kinds of production but also the ability of different people to pay for
goods. The poor have little influence in the markets that determine prices because
they cannot pay as much for goods and services as the middle class, or certainly
the rich.
b) Value of Leisure

GDP measures what is produced in the market if people work more, they produce
more, so GDP goes up. GDP does not reflect, however, what people give up
when they work. In particular, people may sacrifice leisure when they work to
produce for the market. In this sense again, GDP is a limited indicator of social
welfare because it does not account for the sacrifice of leisure people make when
they work.

Example: In World War II, many people, especially women, entered the labor
force and took war production jobs that they never would have taken in peace
time. GDP rose dramatically due to production for the war. However, there was
no deduction for the cost the extra workers incurred by sacrificing their leisure.
More broadly, these workers gave up other things besides simply "leisure." They
likely reduced their household, non-market production and other activities that
they preferred to factory work.

Another example: In Europe, most people take much longer vacations than in the
U.S. More vacation time implies less market work, and less GDP. But Europeans
might well have greater welfare nonetheless.
c) Environmental Degradation

In recent years, most people have recognized the damage to the environment
caused by standard production activities. Production causes air and water
pollution, destruction of natural habitats for wildlife, urban sprawl, global
warming, etc.

This damage is bad for society, but no subtraction is made from GDP to account
for environmental degradation.

Some people have tried to estimate what has been called "Green GDP," a measure
of GDP that makes subtractions for environmental damage resulting from
production. In principle, this can be done by measuring environmental damage,
putting prices on the damage, and subtracting the resulting costs from the market
value of final goods and services. In practice, however, it is difficult to measure
the environmental effects of production, and perhaps it is even more difficult to
determine the appropriate prices to value environmental damage. How do you put
a "price" on global warming, for example?

Again, the inability of the standard GDP measure to account for environmental
problems makes GDP a limited measure of social welfare.
d) Bads versus goods

Sometimes good economic performance stems from an event or situation that is
bad for society
(1) Examples:

World War II caused GDP to rise dramatically, but no one would argue that the
war was a good thing.

Earthquakes in California caused production to rise because a lot of construction
and replacement of goods occurred. The effect of natural disasters, such as
hurricanes, are so strong that they can be observed in the aggregate data.

A flu epidemic that raises medical production, also raises GDP. Yet, illness is not
a desirable outcome for society.

When a society has a high crime rate, more prisons are built and more prison
guards are hired. This will raise GDP, but a high crime rate certainly isn’t
desirable

Summary: We have seen that there are many reasons why we cannot measure
social welfare based purely on economic performance. For example, people’s
happiness can result from much more than just material goods, leisure may be
undervalued in measuring GDP, and often natural disasters or wars can actually
lead to improved economic performance. However, from an economic
perspective, we will continue to assume that high GDP growth is desirable and
good for a society. In most cases, this is a reasonable assumption, but you should
recognize that there are some limitations to it.
B. Employment and Unemployment
1. The large human cost of unemployment
 The material economic losses due to unemployment are fairly obvious. People
want to work more to consume more goods and services. If they are unemployed
they will miss out on these material opportunities.
o Maintaining life styles during spells of unemployment is difficult if not
impossible. The savings of the unemployed are often depleted, lowering their
sense of economic security.
o Unemployed people usually lose their fringe benefits, particularly their
employer-paid health insurance.
o These costs are offset to an extent by unemployment insurance. But this
insurance replaces only a part of lost wage, insurance benefits can be collected
for only a limited period (often just six months), and some workers are not a
not covered by such insurance.
 Even to the extent that the material losses are offset by unemployment insurance
there are still significant social and psychological costs of unemployment.
o Our society places much emphasis on material success and career status.
Individuals' self esteem is often closely bound up with their job situations.
o The work place is an important social environment for many people. It
provides friendship and support. People are cut off from these links when
they are out of work.
o Studies have shown that unemployment increases the chances of family
breakup. It probably also contributes to child and spouse abuse.
 Being unemployed hurts an individual's work record, making it more difficult for
him or her to find another job.
2. Unemployment as a waste of resources
 The labor that people are willing to offer but are unable to expend is not "saved"
to be used at some other time. The material goods that unemployed workers
might have created are lost to society. It's just as if these goods and services had
been thrown away.
o It has been occasionally argued by some economists that unemployed people
are "resting," at least to some extent. Then, because of their time off, they
may be more willing to work later in life. If this were true, the material goods
lost to unemployment might not be a total waste.
o But given the human costs mentioned above, it is hard to believe that the
leisure of unemployed workers is much of a benefit. It is even less credible to
assume that the labor wasted due to unemployment will be recaptured in the
future when these "well rested" workers manage to find jobs.
 A macro textbook claimed some time ago that a conservative estimate of the
wasted resources due to unemployment from 1974 to 1993 amounts to $1.6
trillion. This is a big number. The economy performed well between 1993 and
2000, with little additional loss due to unemployment. But from 2001 through (at
least 2003), more resources were wasted due to unemployment.
o Unemployment in the “Great Recession” that began in late 2007, and its
aftermath has been devastating by historical standards. One could make the
case that the economy has lost value of between $1 trillion and $2 trillion
every year since 2009. This estimate is controversial, but if it is correct it is a
huge waste of resources.
 People want to work and they want to consume more; they don't ask for
something for nothing. The inability of the economic system to coordinate the
willingness to work with the ability to work and earn the means to purchase more
goods and services is a fundamental failure of modern economic systems. It is an
important problem that we should care deeply about.
3) The unemployment rate
a) Survey method of measurement for official statistics
 A person is not counted as unemployed simply because he or she is not working
for pay. (Most of the students at Wash. U. are not working for pay, but they
would not be counted as unemployed.) To be counted as unemployed, an
individual must be actively seeking a job (or laid off and expecting to return to
work).
 Respondents to the survey can be classified in three different ways. 1) If an
individual is working he or she is counted as employed and part of the labor force
(call the number of people in this category "W"). 2) If a person is not working
but has actively looked for work in the previous four weeks, or if the person is
laid off from a job but expects to be recalled, he or she is classified as part of the
labor force, but unemployed (call the number of people in this category "U"). 3)
If a person is not working and has not actively sought work recently, he or she is
classified as out of the labor force.
 The unemployment rate is the number of unemployed people as a percentage of
the labor force. In terms of the definitions above:
Unemployment Rate = 100 x [ U / (W + U) ].
 Recent data: the official unemployment rate was 7.8 percent of the labor force
(December, 2012). The rate has trended downward from its worst point of the
Great Recession, now measured at 10.0 percent in October of 2010. But
unemployment remains very high in early 2013 by historical standards.
o Unemployment was in the middle 4 percent range before is started rising in
late 2007. Most economists considered the economy to be close to full
employment at that time.
b) Changes in the unemployment rate due to changes in unemployment versus
changes in the labor force
 While a declining unemployment rate is usually viewed as a good thing, it is
important to recognize the source of the decline. The rate can decline because
unemployed people find jobs (good) or because people get discouraged from
looking for jobs and are therefore no longer counted as part of the labor force
(bad).
 There is some evidence that some of the improvement in the unemployment rate
since 2010 is the result of “discouraged” workers dropping out of the labor force.
The chart below shows the “Labor Force Participation Rate” for more than 60
years. This is the share of the population working or looking for work
o The dominant feature of this chart is the massive rise in participation from the
mid 1960s through about 2000. The biggest factor that explains this rise is the
increasing number of women in the market labor force. (Remember the
discussion of market versus non-market activity in the discussion of the GDP
concept.)
o Since 2000, the participation rate has dropped quite significantly. Some of
this drop is likely due to the aging of the baby-boom generation born in the 20
years after World War 2.
o But much of this drop is also likely due to weak economic conditions, starting
with the recession of 2001 and then greatly magnified by the Great Recession.
Note that the participation rate was head upward modestly right before the
Great Recession. Much, perhaps most, of the drop in labor force participation
is likely due to a weak economy, not demographics.
c) Under-employed and discouraged workers: under-estimates of unemployment
 The unemployment survey does not capture "under-employed" workers. These
are individuals who would like to work more hours, but cannot. Some might
argue that people who cannot find jobs commensurate with their skills should be
counted as under-employed, even though they have some kind of job.
 This phenomenon could be important. In November of 1989, a survey claimed
that 5 percent of the labor force consisted of part-time workers that wanted to be
working full time. For comparison, the official unemployment rate at this time
was 5.4 percent so nearly as many workers seemed to be affected by
"underemployment" as those that were officially classified as unemployed.
 Similarly, the unemployment rate does not count "discouraged workers."
Suppose someone lost his job and looked for new work for a while, but gave up
because he was unsuccessful in finding a job. Four weeks after he stopped
actively looking for work, this person would be counted as out of the labor force,
non unemployed. Again, this phenomenon could cause the official
unemployment rate to understate the true magnitude of the unemployment
problem. Indeed, there are months during periods of poor economic performance
when the unemployment rate actually drops because discouraged workers stop
looking for new jobs. (See the example of 1992 discussed above.)
d) Incidence of unemployment over a year versus measured rate at a point in time
 The official survey may understate the incidence of unemployment because it is
measures only those workers unemployed at a single point in time. For example,
in 1986 the average unemployment rate was 6.2 percent. However, other research
shows that 14.3 percent of the labor force experienced unemployment at some
time during 1986. Thus, the phenomenon of unemployment may be more
widespread than the official statistics suggest. Of course, this problem is likely to
be especially severe during recessions. In bad economic times most U.S. families
are either affected by unemployment themselves or are close to someone who is
affected. This fact makes the economics of unemployment a very personal issue,
and it raises the political stakes surrounding unemployment.
4. Cyclical, structural, and frictional unemployment
 Frictional unemployment due to job turnover. We would not expect frictional
unemployment to ever be zero. We probably would not want frictional
unemployment to be zero. Job switches allow people to seek more productive and
satisfying work, improving personal as well as social welfare.
 Structural Unemployment due to a fundamental change in the job market that
destroys the jobs people had. For example, automation of an assembly line with
robots might permanently eliminate some assembly line workers’ jobs. We would
hope that structurally unemployed people would eventually find new jobs. But
one might expect these new jobs to pay substantially less since any job-specific or
firm-specific skills the structurally unemployed had in their old occupations
would be lost.
o One way of characterizing the difference between frictional and structural
unemployment is that one would expect frictionally unemployed workers to
return to the same or similar jobs eventually. Structurally unemployed
workers usually must either leave the labor force or change careers.
o It is a paradox that technological change that generates economic growth over
the long run may also create negative effects through structural
unemployment.
o An important difference between frictional and structural unemployment is
that the former may often be voluntary. People may quit their current jobs to
look for something better. It is hard to imagine a situation in which structural
unemployment would be voluntary.
 Cyclical unemployment due to reduced production. This category is the main
focus of macroeconomic analysis. It arises when firms are not selling enough
output to keep all their employees working.
5) Unemployment rate as a “lagging indicator” of the business cycle
 Note that cyclical unemployment (and the overall unemployment rate) is a
"lagging indicator" of the business cycle. That is, cyclical unemployment begins
to rise after production begins to fall in a recession. This happens because firms
may not immediately lay off workers when their sales decline. They often wait to
cut employment until a recession becomes more serious. Similarly, firms will not
immediately re-hire workers when the economy begins to recover. They may
wait until they are confident that economic conditions will improve for a
sustained period.
 This phenomenon can be explained, at least in part, by substantial hiring and
training costs of workers. Firms are reluctant to lay off workers that they may
need in the near future. But firms are also cautious about hiring and training new
workers in the early stages of a recovery when they are not sure that the new
employees will really be needed.
 The reluctance of firms to hire new workers, even as the economy recovers from a
recession, was blamed for unusually low employment growth after the recession
that officially ended in the middle of 1991. The unemployment rate continued to
rise after the recession was officially over, and, even though statistics show that
the economy was growing through 1992, the general perception at the time was
one of poor economic performance. Thus, even though the recession was
officially over more than a year before the 1992 presidential election. high
unemployment, slow job growth, and negative perceptions of the economy greatly
hurt George Bush and paved the way for Bill Clinton's November, 1992 victory.
6) Recent statistics on the unemployment rate
 Data from the early 1990s recession: When the recession officially began in June
of 1990 the unemployment rate was 5.1 percent. By the official end of the
recession in May of 1991, it had risen substantially to 6.7 percent. But, as
mentioned above, unemployment continued to rise even though production (GDP)
was recovering slowly in the second half of 1991 and early 1992. (Remember,
unemployment is a "lagging indicator" of the business cycle.) The unemployment
rate peaked at 7.8 percent in June of 1992, and it had declined only to 7.4 percent
by the election in November, 1992.
 Similarly, as mentioned above, in the recession and weak growth period of 2001
to 2003, unemployment rose from a low point of 3.8 percent in April of 2000 (the
lowest since the 1960s) to a high point of 6.3 percent in June of 2003.
 While the early 1990-91 and 2001 recession were serious, cyclical unemployment
has been much worse in earlier downturns. In the deep recession of the early
1980s the unemployment rate hit 10.7 percent in one month, and it averaged 9.7
percent for all of 1982. The 1975 average of 8.5 percent was also high in a severe
recession year. But these episodes pale in the face of the Great Depression. The
average unemployment rate for 1933 was 24.9 percent, and unemployment
remained excessive throughout the 1930s. (It still averaged 17.2 percent in 1939.)
World War II took care of unemployment, however. It was only 1.9 percent in
1945.
 Economists are now looking carefully at the unemployment rate in the Great
Recession. We will discuss this dramatic event in some detail in class. Although
the rate never hit the 10.7 peak from 1982, the rise from below 5% in 2007 to
10% in 2010 was larger than the rise in the deep early 1980s recession. And the
recovery appears to be slower. Almost all economists agree that the Great
Recession and the slow recovery that followed it has been the worst economic
crisis since the Great Depression of the 1930s.
7) Definition of full employment
 The easiest definition of full employment is a situation in which cyclical
unemployment is zero. Because of frictional and structural unemployment,
however, we would not expect the official measured unemployment rate to be
zero even when economists would claim the economy is at full employment.
 How high is the measured unemployment rate when the economy is at full
employment? It is difficult to answer this question, since we have no
unambiguous way of classifying unemployed people into the frictional, structural,
and cyclical categories. The lowest estimates I have seen are around 3 percent.
For many years, most economists believed, however, that the economy is at full
employment when the measured unemployment rate is 5 to 6 percent. These
views were challenged by the experience of the late 1990s. The unemployment
rate was below 6 percent from 1994 through early 2003 and below 5 percent from
1997 until late 2001, and from mid 2005 until 2008. This evidence supports the
views of those who believe that the U.S. economy can operate effectively for
sustained periods with low unemployment rates.
a) Possible inflation problems if the unemployment rate falls below the full
employment level
 This debate over full employment and how far the economy is from that desirable
state is central to macroeconomics and policy decisions. There is wide agreement
among economists that if the government tries to stimulate the economy when it
is already at full employment, wages will start to rise faster (as firms have to
compete harder to hire workers) and inflation will accelerate.
 In 1994, the Federal Reserve chairman, Alan Greenspan, took actions to reduce
stimulus to the economy because of fears about inflation; these actions were
strengthened in August, 1994. These moves were controversial and led to much
criticism of Greenspan and the Fed from people who believe that unemployment
should still fall more.
o The critics of the Fed have some support from economic statistics. Wage data
show that in spite of the fall in the unemployment rate from 1993 through
1998 and the steady low unemployment rate through 2000, wage inflation did
not accelerate. This experience caused many economists to re-evaluate their
views about how low the unemployment rate can get without triggering higher
inflation. Now, most economists probably believe that unemployment can be
sustained below 5 percent during periods of good economic performance.
 Again in 1999 the Fed raised interest rates out of the concern that an "overheated"
economy with too much growth and too low unemployment would cause
inflation. These actions, however, have been called a "pre-emptive strike"
because there really was no significant evidence of higher inflation during this
period. Indeed, the recession and slow growth period of late 2000 through mid
2003 may have been due, in part, to the attempt of the Fed to preemptively slow
down the economy. In retrospect, the actions of the Fed in 1999 look like a
mistake.
C. Measuring Prices and Inflation
1. Defining inflation and its costs
a) Movements in all prices versus movements in relative prices: macro vs. micro
perspective
 Prices change all the time, but not all price changes are inflation. Inflation occurs
when most prices in the economy tend to rise together. It is this kind of
phenomenon that suggests the need for macroeconomic theories, because there
appears to be something going on that cuts across lots of different microeconomic
markets.
 In the U.S. economy in recent years, prices have risen moderately, most of the
time. But inflation isn't inevitable. Sometimes economies experience deflation,
that is, the systematic decline of most prices. The last sustained deflation in the
U.S. occurred during the Great Depression in the 1930s.
o In Japan there have been periods of falling prices since 1990 as the result of
persistent economic weakness.
o In the U.S., there was a short period of deflation in the worst part of the Great
Recession, but this probably had to do more with fluctuations of energy prices
than anything else. That said, the Great Recession was serious enough that
policy makers worried about the possibility of sustained deflation.
o Deflation is widely viewed as very unfavorable, a situation that economic
policy tries hard to avoid.
b) Misconceptions about the costs of inflation: a “neutral” inflation
 People typically believe that inflation, and the price increases it entails are bad
for them. Of course, they would rather pay lower prices for the goods and
services they buy, other things equal. But other things are not likely to be equal in
an inflationary environment.
 Consider the example of what economists might call a "neutral" inflation. This is
a situation in which all prices are rising at exactly the same rate. These prices
include, importantly, individuals' wages and salaries. They would also include
other income categories like profits and rents. In a neutral inflation, any quantity
measured in dollars would rise in money value (or what economists would call
"nominal" value) at exactly the same rate.
(1) Real versus nominal quantities
 Therefore, even though prices are higher, people could buy the same amount of
goods and services because their incomes would have risen by the same amount.
Economists would say that even though prices were higher, “real” wages and
salaries remained the same because nominal wages and salaries kept up with
prices. The purchasing power of wages does not change in a neutral inflation.
 Economists usually assume that people care about these real quantities
(purchasing power), not nominal quantities. That is, people don't care whether
they are in an economy with wages of $10 per hour and prices of $1 per unit of
output compared with an economy with wages of $20 per hour and prices of $2
per unit of output. Therefore, it is not obvious why anybody should care about
neutral inflation.
(2) Psychological impact of inflation
 One reason that people might dislike inflation is more psychological than
economic. They might view the increase in their wages as something they earned
and anticipate that they should get more purchasing power for. When prices go
up, their purchasing power is eroded and they get mad. But if wages and prices
rise at the same rate, the real economic situation is not really any different from a
world with zero inflation. To understand citizens’ concerns about inflation,
therefore, economists have looked more deeply to identify costs of inflation.
c) Economic costs of inflation: why do we care?
 Economic costs from inflation usually arise when inflation is not neutral. That is,
when all quantities measured in money terms (prices, wages, the value of
financial contracts, etc.) do not rise in money value at the same rate.
(1) Effects on individuals with fixed nominal incomes
 For some people their income or wage may be fixed in dollar terms, no matter
what prices are, at least for some period of time.
 This situation used to be true for recipients of Social Security benefits. Their
checks remained the same regardless of the rate of inflation. As prices rose, the
purchasing power (or "real value") of Social Security benefits declined.
Therefore, many analysts identified a large burden of inflation on the economic
welfare of the elderly. In the 1970s, the Social Security laws were changed to
automatically increase benefit payments when prices rose. (This is called the
indexation of benefits.) Now, Social Security checks rise every year whenever
the consumer price index goes up from one year to the next. Some private
pensions, however, are still fixed in nominal terms. Individual with this kind of
pension suffer from inflation.
 Similar problems arise when workers are locked into long-term wage contracts.
The real wages earned by these workers falls the higher the inflation rate. This
phenomenon led to an indexation of wage contracts, especially in the late 1970s
and early 1980s when inflation in the U.S. was relatively high by historical
standards. These indexation clauses in wage contracts are often called COLAs,
for "cost of living adjustment."
(2) Impact on wealth of borrowers and lenders
(a) Gains and losses on financial contracts
 People who have lent money will lose purchasing power from inflation. The
more prices rise during the term of the loan, the lower the purchasing power of the
money lenders receive as repayment for loans.
 Conversely, borrowers benefit from inflation since it reduces the real value of the
money they must repay.
(b) Inflation expectations and interest rates
 For these reasons, inflation expectations are a key determinant of the interest rates
lenders require on loan contracts. If a lender expects inflation to be high over the
course of the loan, he or she is likely to demand a high interest rate to compensate
for the loss of purchasing power.
 You can observe this phenomenon in real-world financial markets by noting that
when good news comes out about inflation statistics, interest rates usually fall
(bond prices rise) and vice-versa.
(c) Real versus nominal interest rates
 Let's look in more detail at how interest rates and inflation interact. Suppose you
lend a friend $1,000 for a year and you expect inflation to be 5 percent. If you
charge your friend 5 percent interest, you will get back $1,050 at the end of the
year. This is more money than you lent, but it does not represent an increase in
purchasing power. Since inflation was 5 percent, the extra 50 bucks you received
was just enough to offset the effect of increased prices. The "real" value of your
money has stayed the same.
 In this example the "nominal" interest rate was 5 percent. This is the interest rate
actually quoted in financial contracts. But economists would say that the "real"
interest rate was zero, because the purchasing power of the money did not change
due to inflation.
 If you had charged a nominal interest rate of 9 percent, earning $90 of interest,
you would have enough to compensate for inflation ($50) plus some "real" return
($40). Your purchasing power would have increased by approximately 4 percent.
The real interest rate was 4 percent.
 Conversely, if you had charged no interest at all the purchasing power of your
money would have declined by about 5 percent when the loan was repaid. In this
case, while the nominal interest was zero, the real interest rate was negative 5
percent.
 The general result is that the real interest rate is the nominal rate minus the
inflation rate.
(3) Examples
(a) Home mortgages in the 1970s
 Inflation had a big effect on those who had long-term home mortgages taken out
in the 1960s and early 1970s before inflation increased in the mid and late 1970s.
Lenders did not expect much inflation, and they were willing to lend long-term
money for houses at interest rates of 5 to 7 percent. When inflation accelerated to
7 to 10 percent, mortgage lenders lost wealth while the borrowers gained. (The
effective real interest rate on these loans was negative.) Many borrowers paid off
their mortgages as slowly as possible because they could earn more interest on
savings deposits than they were paying on their mortgages. Ironically, while my
mother complained about the rise in the price of hamburger in the 1970s, she was
benefiting from inflation as the real value of her mortgage declined! These events
also contributed to the financial problems of savings and loans that made lots of
home mortgage loans.
(b) Inflation and government debt
 The government is the biggest debtor in the U.S. Therefore, the real value of
government debt is eroded by inflation. The numbers involved are huge. In
2012, for example, government debt held by private investors totaled about $11.3
trillion. Even at a modest inflation rate of 2.0 percent, about $220 billion of the
purchasing power of this debt will be eroded over a year.
(c) Were interest rates higher under Carter and Reagan?
 A brief history: Nominal interest rates were very high in the U.S., relative to
historical standards during Jimmy Carter's presidency in the late 1970s. Given the
analysis above, this fact should not be too surprising, since this was also a period
of high inflation. Ronald Reagan was very critical of Carter's economic policy
during the campaign leading up to the 1980 election. Among other things, his
criticism focused on high interest rates. Of course, Reagan won the 1980 election
and he pursued some new economic policies. Nominal interest rates did fall
substantially in the early 1980s. In the 1984 campaign, Reagan claimed credit for
this decline and warned that if his challenger, Walter Mondale (Carter's vice
president), was elected, the country would return to an economic policy that
produced the high interest rates during the Carter years. Mondale countered that
while nominal interest rates had fallen, real rates had actually risen under Reagan.
 The table below shows the nominal interest rate (measured as the yield on U.S.
government Treasury Bills that mature in three months), the inflation rate, and the
resulting real interest rate:
Year
Nominal
Interest
Rate
Inflation
Rate
Real
Interest
Rate
1977
1978
1979
1980
1981
1982
1983
1984
1985
5.3
7.2
10.0
11.5
14.0
10.7
8.6
9.6
7.5
6.7
7.3
8.9
9.0
9.7
6.4
3.8
4.1
3.3
-1.4
-0.1
1.1
2.5
4.3
4.3
5.5
5.5
4.2
 The table shows that Mondale had a point! Let's assume that economic conditions
during the first year of a president's term are the result of his predecessor's
policies. Then, averaging the four years Carter was responsible for (1978-1981)
gives a nominal interest rate of 10.7 percent, an inflation rate of 8.7 percent, and a
real interest rate of 2.0 percent. The same calculations for Reagan's first term
(1982-85) give a nominal rate of 9.1 percent, inflation of 4.4 percent, and a real
interest rate of 4.7 percent.
 If, as most economists would argue, it is the real interest rate that really matters
for the economy, Reagan (an economics major as an undergraduate!) should have
had some tough explaining to do in the 1984 campaign. This example shows why
it's important to understand some basic economics when evaluating modern
political discourse.
(4) Inflation and the tax system
 The U.S. income tax system is called "progressive," meaning that the tax rate on
an additional dollar of income earned (the "marginal" tax rate) rises as income
goes up. This phenomenon is what people mean when they talk about moving
into a higher "tax bracket."
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Inflation pushes up nominal incomes, but not real incomes. So
inflation would cause people to pay higher marginal tax rates if the tax
system set rates based on nominal incomes. This phenomenon was
called "bracket creep" in the 1970s.
-
Since the Tax Reform Act of 1986 was passed, however, U.S. tax rates
are "indexed" to inflation. This means that the income level at which
higher marginal tax rates apply floats upward each year based on
government statistics that measure inflation. This indexation has
eliminated bracket creep.
 A more subtle feature of the tax system does cause taxes to be higher in an
inflationary environment: the fact that the government taxes nominal interest, not
real interest.
-
Suppose you have a $1000 savings account that pays 3% interest in an
economy with no inflation. You will earn $30 of interest in a year. If
your (marginal) tax rate is one third, you will pay $10 of this interest
in taxes and have a real gain of $20.
-
Now consider the same $1000 savings account in an economy with 6%
inflation per year. Also assume that the nominal interest rate rises to
keep the real interest rate at 3%. That is, the nominal interest rate in
the inflationary economy is 9%. It might seem like the higher nominal
interest rate is adequate to compensate you for the wealth you lose due
to inflation, but look more closely at the tax consequences.
-
You will earn $90 in nominal interest over the year. You need $60 to
just compensate you for the reduced purchasing power of your savings
account due to inflation. Moreover, you have to pay one third of your
nominal interest earnings as taxes. This costs you another $30.
Because of the tax system, you get no real benefit from the interest you
earn, even though nominal interest rates are higher due to inflation.
 The tax the government imposes on nominal interest creates another cost of
inflation for savers. There has been some discussion about changing the tax
system to index interest income for inflation, but this has not been done.
 Similar problems apply to capital gains income (the money you make by buying
assets, like shares of corporate stock, at low price and selling it at a high price).
Again, there is some support for tax reform that would index capital gains income
to inflation.
(5) Costs of uncertainty due to difficulty in contracting
 Another widely emphasized cost of inflation is also linked to the fact that people
make contracts in money terms that operate over time. When inflation is variable,
it is hard to engage in such contracts.
 For example, consider a lender who finances an automobile purchase over five
years. How much interest should she charge? If she does not know what the
inflation rate will be, it will be very difficult to know what kind of payments she
should require.
 When this kind of uncertainty rises, the amount of financial contracting in the
economy is likely to decline. It then becomes more difficult for consumers to
finance large purchases (like housing and cars). Perhaps more important, it
becomes more difficult for firms to finance their acquisition of new productive
assets. These changes weaken the economy.
(a) Extreme chaos of hyperinflation
 In the U.S., these problems have not been negligible. Recent volatility of prices
in the stock and bond markets have been undoubtedly affected by uncertainty
about inflation. But the U.S. problems are tiny compared to those in countries
that have undergone "hyperinflation."
 Hyperinflation is a situation in which prices are rising by hundreds or even
thousands of percent over short periods. The classic example is in Germany
between the world wars. Currency became essentially worthless in this economy.
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Latin American and Eastern European economies have experienced
hyperinflation in recent years.
 With hyperinflation, almost all financial contracting breaks down. People cannot
make long-term loans. Wages may change daily. It is impossible to post accurate
prices. People worry about whether they do their grocery shopping in the
morning or evening, because prices can change a lot in between!
 This situation is extremely chaotic, and economic welfare is greatly injured. In
hyperinflationary economies, the costs of inflation are extreme.
2. Alternative Measures of Inflation
 To measure inflation for the whole economy, we need a way of "aggregating" the
many individual prices in the system. The basic idea is to come up with a statistic
that is an appropriate weighted average of the individual prices in the economy.
Then, inflation is measured as the percentage change in this statistic over time.
The two statistics most commonly referred to are the Consumer Price Index and
the GDP Deflator.
a) Price index: the change in the price of a fixed market basket of goods
 A price index is cost of a fixed "market basket" of goods, often set to equal an
arbitrary value of 100 in a "base year."
 Let's consider a simple example. Suppose we create a price index for student
weekends when the typical student buys one large pizza for $10 and three cokes
for $1 each in 2009. The cost of the student weekend "market basket" is $13. We
will choose 2009 as our base year.
-
Now suppose that the price of the large pizza rises to $11 and the price
of a coke rises to $1.25 in 2010. Then the student weekend market
basket will cost $14.75. Also assume that the price of pizza in 2008
was $9.50, and the cost of a coke was $1, so the market basket cost
$12.50 in 2008.
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The price index is defined as follows:
Index for Year t =
100 x (Cost of Basket in t) / (Cost of Basket in Base Year)
-
For our example, then, the price index would be:
2008: 96.1 = 100 x ($12.50 / $13)
2009: 100.0 = 100 x ($13 / $13)
2010: 113.5 = 100 x ($14.75 / $13)
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The inflation rate for student weekends is measured as the percentage
change in these figures:
2009 Inflation = 4.06% = 100 x [(100.0 – 96.1) / 96.1]
2010 Inflation = 13.50% = 100 x [(113.5 – 100.0) /100.0]
 The consumer price index (CPI) is computed in a similar way, but it includes a
"market basket" of several hundred goods that U.S. consumers typically buy. The
CPI for 2006 was 201.6 and it was 195.3 for 2005 (the base year is 1983). These
figures tell you that consumer prices were 101.6 percent higher in 2006 than they
were in 1983 and 95.3 percent higher in 2005 compared with the 1983 base (that’s
approximately double). Consumer price inflation between 2005 and 2006 was:
3.23% = 100 x [(201.6 – 195.3) / 195.3].
This figure is low in comparison with the high inflation rates of the 1970s and
early 1980s, but probably somewhat higher than most economists would consider
desirable. (Many economists believe that an inflation target of 1% to 2% is best
for the economy.)
(a) Components of the CPI
 The government also reports price indexes for components of the CPI. You will
often hear reports about food, energy, or health care prices. These are categories
within the CPI. Because food and energy prices are quite volatile from month to
month, inflation statistics are often reported for the CPI excluding food and
energy. This statistic is sometimes called the “core” rate of inflation. The
government is often more interested in core inflation because it is likely a better
measure of the long-term price trends than the simple measure that includes
volatile food and energy prices.
 In 2005, simple CPI inflation was 3.38% and in 2006 it was 3.23%. The core
rates of inflation for these two years were 2.17% and 2.51%, respectively. The
big difference is likely due primarily to the high rates of increase for energy prices
due to Hurricane Katrina and the war in Iraq. Notice that the core inflation rates
are not much above the 2% target that many economists consider desirable for the
U.S. economy.
 With the severe economic weakness of the “Great Recession” period inflation fell
even more. The core CPI in December, 2010 was 222.187. In December, 2009,
the core CPI was 220.764. Therefore, inflation over this period was roughly just
0.6%. Most economists would blame the very weak labor market for such low
inflation. When unemployment is high, wages rise very little, or even fall. So
firms’ costs grow very slowly and they are not compelled to raise prices as
quickly. Also, firms have difficulty selling their products in a weak economy,
which further limits price increases.
(3) The producer price index (PPI)
(a) Leading indicator of consumer price inflation?
 The producer price index (PPI) is also mentioned at times in the press. It is based
on a market basket of commodities typically bought by firms. The PPI is often
considered a "leading indicator" of consumer price inflation, that is, changes in
the rate of increase of the PPI will likely be reflected a few months later in the
CPI. This is because firms are likely to pass on changes in their input costs to the
buyers of their final products.
(4) Criticisms of measuring inflation with price indexes
 There are a number of criticisms of price indexes as measures of inflation for the
macroeconomy.
 The composition of goods in the market basket remains fixed for relatively long
periods of time. The price index becomes less relevant over time as people
change the composition of the goods they purchase.
 To consider an extreme example, inflation would be badly mismeasured today if
we used the market basket of goods people consumed at the beginning of the
century as the basis for the CPI. The influence of the price of horseshoes would
be vastly overstated, and how would the price of home computers affect inflation
measures?
 In addition, price indexes only cover a portion of the economy. We would like to
have a broader measure.
b) The GDP price index: broader coverage
 The GDP Price Index addresses some criticisms of the CPI. (This statistic is also
called the GDP Chain-Type Price Index or the Chain Weighted GDP Deflator.) It
takes account of all goods produced in the economy, and the importance of the
price of any single good changes as the share of aggregate expenditure on that
good changes. (So, for example, computers have played a more significant role in
the GDP Price Index in recent years.)
 For these reasons, when we correct total output in the economy for inflation, we
usually use the GDP Price Index.
 Regardless of the specific inflation measure you use, U.S. inflation has bee
remarkably low in recent years, mostly 2% or lower (especially if one adjusts for
volatile energy costs).
D. Historical Fluctuations of Output, Employment, and
Inflation
1. GDP Statistics
a) Magnitude of GDP
 U.S. GDP in 2012 is likely to be approximately $15.7 trillion, that is, $15.7 x
1012. (We don’t yet have GDP data for the fourth quarter of 2012 and there will
still be some revisions to earlier quarters.)
 This is a really big number. If one were to lay $100 bills end-to-end ($200 per
foot), the stream of bills would have to go about 595 times around the world to
equal this amount of money!
 It is important to keep in mind the enormous size of U.S. GDP to have the right
perspective on macroeconomic issues. A million dollars sounds like a lot of
money, but it's only a tiny fraction of GDP. Even a billion dollars is less than just
one hundredth of one percent of GDP.
b) Annual and quarterly figures
 U.S. GDP statistics are compiled by the federal government’s Bureau of
Economic Analysis (BEA) in the National Income and Product Accounts (NIPA).
The data from these accounts are released every calendar quarter.
 To make sure that all NIPA data are comparable, quarterly figures are
"annualized," that is, they are expressed as if the economic activity that actually
occurred during a quarter had continued for a full year.
 Example: The reported GDP for the third quarter of 2012 (current estimate) was
$15.8 trillion. Of course it's not possible that the economy produced $15.8 trillion
of goods and services in just a single quarter of GDP when it produced $15.7
during the entire year of 2012. Indeed, the quarterly figure is annualized by
multiplying by four. The U.S. GDP in the second quarter of 2012 was actually
$15.8 trillion / 4 = $3.9 trillion. Only the annualized figure is reported, however.
c) Annualized Growth Rates
 The level of GDP is computed by the government and reported in the financial
press (such as the Wall Street Journal). But these figures are found, if at all,
buried deep in news stories. Much more attention is paid to the growth rate of
GDP. There are probably two reasons for the focus on growth rates.
-
Growth rates are easier to understand than the huge magnitude of the
level of GDP
-
People are more concerned about the change of GDP than the level. Is
GDP rising or falling? How fast?
 Just like the levels of GDP, reported growth rates are annualized. The reason for
this, again, is so that all figures are comparable. The annualized growth rate is the
rate the economy would grow over a full year if it expanded for the whole year at
the same rate at which it expanded during the quarter. Consider a little bit of
algebra to define the annualized growth rate:
 Let "g" denote the actual quarterly growth rate of the economy between quarter 1
and quarter 2.
-
The definition of a growth rate means that:
-
GDP2 = (1 + g) GDP1
where GDP2 is the level of GDP in the second quarter and GDP1 is
the level of GDP in the first quarter.
 Suppose the economy grows for a full year (four quarters) at rate g. It would then
reach a level of output we will call GDPA. That is, we define GDPA as:
GDPA = GDP1 (1+g) (1+g) (1+g) (1+g) = GDP1 (1+g)4
The annualized growth rate (defined as gA) is the rate of growth that takes
output from GDP1 to GDPA in one step:
GDPA = GDP1 (1+gA).
If we equate the two expressions for GDPA above we can solve for gA in
terms of the actual quarterly growth rate g:
GDP1 (1+gA) = GDP1 (1+g)4 => gA = (1+g)4 - 1
 Example (with more precise statistics): GDP in the second quarter of 2012 was
$15.586 trillion, in the third quarter of 2012 it was $14.811 trillion. Therefore,
the actual growth rate between the second and first quarters (g) was:
g = ($15.811 trillion - $15.586 trillion) / ($15.586 trillion)
= 0.0144 or 1.144 percent
Using the formula above, we can annualize this growth rate as follows:
gA = (1.0144)4 – 1 = 0.0591 or 5.91 percent
 Note that the annualized growth rate is approximately four times the quarterly
growth rate, but the relation is not exact. In fact, the annualized growth rate is
slightly more than four times the quarterly growth rate (you get 5.78% if you just
multiply 1.44% by 4). This outcome is due to "compounding." The growth in the
second quarter "compounds" with the growth in the first quarter, similarly for the
third and fourth quarters. The result is that the annualized growth rate is
somewhat larger than just four times the quarterly rate. This effect is small for
low growth rates over short periods of time, but it becomes much more significant
over many quarters with higher growth rates.
2. Corrections for inflation
a) Reason to adjust for inflation
 GDP is measured in terms of money values. This means it is a nominal variable.
We use money values because it makes the aggregation of different types of
goods and services possible. However, using nominal GDP presents a problem
when we want to compare GDP figures during two different years (as we would
want to do to calculate GDP growth). If nominal GDP changes over time, you
cannot tell whether this change is caused by
-
a change in the quantity of goods and services produced (economic
expansion or contraction) or
-
a change in the prices of goods and services (inflation or deflation).
 To solve this problem, economists have developed methods to remove the effect
of inflation from GDP measures and, in particular, GDP growth rates.
b) Real GDP
 To correct GDP for inflation, economists use a "price index." This index is based
on the prices of all goods and services produced in the economy.
 In constructing the GDP price index (also called the “implicit price deflator”),
economists arbitrarily choose a year to be the base year, and the index for that
year is by definition set to 100. Recent statistics use 2005 as the base year. A
GDP price index of 115.035 for the second quarter of 2012 means that prices of
goods and services produced throughout the economy were about 15 percent
higher in April through June of 2012 than they were in 2005.
 Real GDP is a measure of production, with the effect of higher prices taken out.
We get real GDP by dividing the nominal GDP figure by the price index.
 Consider the following example, using actual data:
Year
GDP Price Index
Nominal GDP
2012:2
115.035
$15.586 x 1012
2012:3
115.810
$15.811 x 1012
The basic formula for real GDP is
Real GDP Year t =
Nominal GDP Year t
(GDP Price Index Year t / 100)
 The price index is divided by 100 to make real and nominal GDP equal in the
base year. (It would be easier to work with these numbers if the government set
the price index to 1 in the base year rather than 100!)
Real GDP in the first two quarters of 2012 was:
2010:2 Real GDP =
$15.586 x 1012 = $13.549 x 1012
(115.035 / 100)
2010:3 Real GDP =
$15.811 x 1012 = $13.653 x 1012
(115.810 / 100)
 A bit on terminology: In the above examples, we would say that “The real GDP
in the second quarter of 2012 is $13.549 x 1012 in 2005 prices” or “-- in 2005
dollars.”
 The Consumer Price Index (CPI) is sometimes used instead of the GDP price
index to adjust for inflation. The CPI reflects the average household purchase,
whereas the GDP Deflator takes into account purchases of all final goods and
services, including government purchases, and firms' purchases of investment
goods. The two indices both measure the rise in the price level, and they do tend
to rise and fall together, but they are not identical.
 Now, we will compute the growth rate of real GDP between the second and third
quarter of 2012, annualized as described above. By convention, this is called the
annualized growth rate of real GDP in the third quarter.
The quarterly growth rate of real GDP is:
[($13.652 x 1012 – $13.549 x 1012) / $13.194 x 1012] = 0.00767 or 0.77%
Annualize this growth rate:
(1 + 0.00767)4 – 1 = 0.0310 or 3.10%
This is the figure reported in the press as the growth of the economy in the third
quarter of 2012. (More accurately, it would be called the growth rate of real GDP
between the second and third quarter of 2012.) Note that this reported figure is
both "real" and "annualized." It is likely that many news stories about this figure
will not explicitly recognize that these adjustments have been made.
 You can use the same method to compute the annualized inflation rate in the third
quarter of 2012 using the GDP price index data:
Actual: [(115.810 – 115.035) / 110.488] = 0.00674 or 0.674 percent
Annualized: (1.00674)4 – 1 = 0.0272 or 2.72 percent
3. Long-term inflation and real growth rates
 We will now discuss how to compare growth rates of output over longer periods
of time. Here are a few figures for annual real GDP:
Year
Real GDP (Billions of 2005 $)
1995
1999
2002
9,093.7
10,779.8
11,553.0
(Note that most downloaded data give GDP and related figures in billions, not
trillions of dollars. A trillion is 1,000 billions.)
The growth rate from 1995 to 1999 was 18.54% and the growth rate from 1999 to
2002 was 7.17%. Clearly, the economy grew more in the earlier period, but the
earlier period was four years rather than three. We need a method to make growth
over these periods more comparable.
 Again, we will "annualize" the growth rates. We want to find that rate of growth
(call it gA) such that if the economy had expanded at this steady rate every year
from 1995 to 1999, real GDP would have grown from $9,093.7 billion to
$10,779.8 billion.
 If GDP grew at a steady rate gA for four years from 1995 to 1999, gA would
satisfy the following equation:
Real GDP1999 = Real GDP1995 (1 + gA)4
Because we are given the real GDP values, we can solve this equation for gA:
(Real GDP1999 / Real GDP1995) = (1 + gA)4
(Real GDP1999 / Real GDP1995)1/4 = 1 + gA
gA = (Real GDP1999 / Real GDP1995)1/4 – 1
Using the numbers given above:
gA
= ($10,779.8 billion / $9,093.7 billion)1/4 – 1
= (1.1854)1/4 – 1 = 0.0434 or 4.34%
This is the annualized rate of real growth of the economy from 1995 to 1999.
Note that it is somewhat less than a quarter of the total growth over the same four
years (that is, 4 x 4.34 < 18.54). This happens because the annual growth
"compounds" from one year to the next. Just dividing 18.54 by four will not give
the annualized growth rate.
 The calculation for the annualized growth rate from 1999 to 2002 is given by:
gA
= ($11,553.0 / $10,779.8 billion)1/3 – 1
= (1.0717)1/3 – 1 = 0.0233 or 2.33%
Note that the exponent in the equations above is 3 because there are 3 years from
1999 to 2002. (Compare with the 4 in the calculation for 1995 to 1999.)
 The annualized growth rates are directly comparable. The comparison shows that
the economy did indeed grow faster in the late 1990s than it did during the first
few years of this century. This outcome is not surprising. The late 1990s was a
boom period, and there was a recession in 2001.
 Example: Let us compare GDP growth rates of the Bill Clinton and George W.
Bush presidencies. You may find GDP data at http://research.stlouisfed.org.
(Note that GDP data are revised periodically, so current figures may differ
somewhat from the figures presented below.)
Year
Real GDP (Billions of 2005 $)
1992
2000
2008
8,287.1
11,226.0
13,228.8
The growth rate from 1992 to 2000 was 35.46% and the growth rate from 2000 to
2008 was 17.84%. Clearly, the economy grew more in the Clinton years. But it is
somewhat difficult to put these figures into perspective. For example, how do
these records compare to typical annual real growth rates that in normal times
range between 2.5 and 3.5 percent per year. Again we need to “annualize” the
growth rates to make growth over these periods comparable.
Clinton gA = ($11,226.0 / $8,287.1 billion)1/8 – 1
= (1.3546)1/8 – 1 = 0.0387 or 3.87%
Bush gA
= ($13,228.8 / $11,226.0 billion)1/8 – 1
= (1.1784)1/8 – 1 = 0.0207 or 2.07%
 The annualized growth rates of 3.87% and 2.07% are directly comparable. The
comparison shows that the economy did indeed grow faster during the Clinton
years than it did during Bush’s term. The difference is significant. Growth in the
Clinton years was above almost all estimates of long-term normal growth.
Growth in the Bush years was below almost all estimates of long-term growth.
 Note, however, that this example does not address directly the success or failures
of each administration’s economic policies because it does not take into account
policy lags and a multitude of other factors (some of which will be covered later
in this class).
 The same approach can be used to measure annualized inflation rates. Inflation is
the growth in the GDP price index.
 Example: The 1970s are often considered a period of high inflation in the U.S.
The GDP price index in 1970 was 29.3 and it was 57.4 in 1980 (both using a 2005
base). What was the annualized inflation rate over this ten-year period?
 Calculation:
Ann. Inflation Rate
= (57.4 / 29.3)1/10 – 1
= (1.9590)1/10 – 1 = 0.070 or 7.00%
This is a high number, confirming the impression of the 1970s as a high-inflation
period.
 For comparison, the GDP price index in 2000 was 88.64. It grew to 110.65 in
2010. Confirm for yourself that the annualized inflation rate was only 2.2 percent
over these years, a big drop from the 1970s.
4. Definition of peaks, troughs, recessions, and growth recessions
Real GDP
PEAK
RECOVERY
TROUGH
RECESSION
Time
 The business cycle is defined in terms of the movements of real GDP.
 A "peak" of a business cycle is defined as the highest level of real GDP before a
recession.
 A "trough" is defined as the lowest level of real GDP before it begins to grow
again.
 A "recession" is a period of negative real GDP growth. How long must GDP
decline before it is officially a recession? There is no definite rule, although it’s
common to roughly define two consecutive quarters of negative GDP growth as
recession. (One quarter of negative growth is not usually considered a recession.)
-
The actual beginning and end of a recession are defined by a group of
economists on the National Bureau of Economic Research’s business
cycle dating committee. The committee takes a variety of factors into
account in making their determination of when the peak and trough
occurs. Real GDP is the main indicator, but the committee also looks
at other data such as employment. The committee dated the peak
before the Great Recession as December, 2007 and the trough as June,
2009.
-
The period of the recession is defined from the peak to the trough.
 The recovery period begins when GDP growth is positive once again. However,
there is no exact time when we say that the recovery ends. One way to think
about the recovery is the period over which it takes GDP to regain it's previous
long-term trend. After the recession that began in late 2007, this point happened
in the fourth quarter of 2010, following the summer 2009 trough.
 A period of positive growth is called an expansion. If an expansion has a
particularly high growth rate, we call it an “economic boom.”
a) Appropriate benchmark: zero growth or long-term trend growth
 A recession is defined with a benchmark of zero GDP growth. Thus, any positive
growth is not considered a recession, even though low positive GDP growth rates
still indicate poor economic performance.
 Periods of sustained growth rates below typical levels are called often "growth
recessions."
 A growth recession looks like this:
Real
GDP
GROWTH RECESSION
Time
 Even though a growth recession still has positive growth, it is still cause for
concern as unemployment may rise and the economy is not producing as many
goods and services as it could by fully utilizing its resources.
b) Stagnant and “jobless” recoveries
 Prior to the 1990s there was a sense that once the economic trough occurred,
recovery would be reasonably fast. Output and employment would grow much
faster than the long-term average to rather quickly make up the lost ground during
the recession.
-
For example in the two years after the deep recession of 1974/75
employment grew at a 2.2% annualized rate. Not spectacular, but
probably fast enough to make up for some lost ground.

-
In the two years after the 1982 recession, employment grew at an
annualized rate of 4.1%, which generated quick recovery in the labor
market.
-
But the annualized employment growth rate in the two years after the
recession in 1990-91 was just 1.0%. After the 2001 recession was
over in terms of GDP employment continued to fall. The recession
was over by late fall of 2001 but employment continued to fall until
August of 2003. In the next two years, the annualized growth of
employment was just 1.7%.
-
The Great Recession ended in the summer of 2009, but employment
continued to fall until February of 2010. The drop in jobs during the
Great Recession was (by far) the worst in percentage terms that the
U.S. experience since the Great Depression. Employment dropped by
6.4% from its peak in January of 2008 to February of 2010 (that’s an
annualized rate of decline of -3.1%). Some economists were hoping
that after such a sharp drop, we could expect a quick rebound, perhaps
something like the brisk growth in employment that occurred after the
deep recession that ended in 1982. But it hasn’t happened. Job
growth since the trough of employment through December of 2012 has
been at an annualized rate of just 1.3%, only slightly higher than
necessary to absorb the new entrants to the labor force from growth in
the working-age population. This growth rate is not nearly high
enough to move the economy quickly toward full employment. We
haven’t gotten two years beyond the trough of the “Great Recession”
in 2009, but in the 14 months of data we have so far the employment
growth rate has also been very low: 0.7% (again, annualized
These observations imply that even though GDP may be growing, and
therefore the recession is over according to a narrow technical definition, the
sense of economic stagnation and below normal performance does not
necessarily end with the official “trough” of the recession. The perception of
citizens and journalists may well be that the bad times associated with the
concept of “recession” continue.
5. Fluctuations in GDP, inflation, and unemployment: A brief look at the history of
the business cycle
a) 19th and Early 20th Centuries: Volatility
 During this period, GDP growth tended to bounce around a lot
 The "Panic" of 1893 began with railroad bankruptcies and spread to bank failures.
The economy declined significantly and experienced a long four-year recession.
This was the deepest recession to that date, and may be the second deepest of U.S.
economic history (after the Great Depression). The data we have for this period
are much rougher than for post World War 2 history, but estimates suggest that an
equivalent measure to today’s unemployment rate hit at least 12%, perhaps as
high as 17%.
 The Panic of 1907 was marked by significant financial instability. A number of
large New York banks were close to insolvent. The financier J.P. Morgan
coordinated a private bank bailout widely regarded as critical to restoring
financial order. But the financial system experienced high levels of stress and
there was concern that private institutions would not be able to repeat Morgan’s
success in future periods of instability. The direct result of this event was the
creation of the Federal Reserve Bank in 1913.
 World War I led to an economic boom, as wars usually do because of increased
production to meet military needs. But the immediate post-WWI period was a
period of recession (also typical of post-war periods)
 In the 1920s, the economy was strong and stock prices soared: the "roaring 20s"
 Some people have compared the economy of the late 1990s, and especially the
dramatic, speculative housing boom of the middle 2000s as similar to the
economy in the 1920s. This parallel creates concern, because the Depression that
followed was historic.
b) The economic catastrophe of the Great Depression: 1929 – 1939
 This is the BY FAR the worst period of economic history for the U.S.
 The depression began in October of 1929 after a huge crash in the stock market
prices. At the bottom of the Depression, the Dow Jones Industrial Average fell to
15% of its peak pre-Depression era value.
 Unemployment: rose to 25%; a level that we have not even come close to since.
 GDP: declined sharply in the early 1930s. The cumulative decline in GDP from
1929 to 1933 was 26.7 percent. The annualized decline over this four-year period
was about 7.5 percent. No post-World-War-2 recession was nearly this severe.
(See the statistics posted on the “lecture graphics” page of the course web site.
Make sure you know how to compute the annualized growth rate!)
 By 1933, the economy was producing more than a third less than an estimate of
its long-term trend, an enormous "GDP gap." (The “gap” is an estimate of the
difference between what the economy actually produces and what it is capable of
producing.)
 There was some fast growth in the middle part of the 1930s, but the GDP gap
remained large. The economy again contracted significantly in 1938.
 Inflation: Prices fell (deflation) in the early 1930s. The annualized rate of
deflation was about 7.0 percent between 1929 and 1933. This experience shows
that prices can indeed decline, even though recently inflation is the more typical
situation.
 Falling prices caused considerable trouble in the financial system. All prices
declined include money wages and salaries (the price of labor). But people owed
money and the size of their loans did not decline. Therefore, people had less
money income to pay their money debts. When people could not pay back their
loans, banks failed in large numbers.
 This experience also is an example, albeit an extreme one, of the normal
relationship between inflation, GDP growth and unemployment. When the
economy is weak, GDP growth is low, even negative, unemployment rises, and
inflation tends to fall. In this case inflation actually became negative.
 The severe economic troubles of the Depression led to a set of policies designed
to help the economy, usually called the "New Deal." These policies were
instituted early in the first Roosevelt administration in 1933. They include public
spending policies to help stimulate the economy as well as the birth of our current
Social Security system.
-
The Roosevelt administration imposed some tax increases to try to
close the federal budget deficit in 1937. The economy turned
downward again in 1938, with real GDP falling by 3.4%.
-
This event is discussed today as a possible example of the difficulty
created when “fiscal austerity” is imposed too soon during an
economic recovery, slowing the recovery or even creating a “double
dip” in the economy.
 The financial panics of the Depression led to more extensive regulation of the
financial system by the federal government. Most of the Depression-era financial
regulations were repealed by the late 1990s. Some analysts argue that this
financial deregulation helped set the stage for the financial instability that hit the
U.S. and world economies in 2008.
 Explaining the economic disaster of the Great Depression gave birth to the study
of macroeconomics as separate from microeconomics. Obviously, there was a
massive correlation across markets in what happened that could not be explained
by looking at individual markets alone.
c) World War II
 According to many economists, it took WWII to finally get the U.S. out of the
Great Depression. By 1939 the U.S. was already raising military production in
preparation for war and sending supplies overseas, so the War positively affected
the economy even before the U.S. officially entered it in December, 1941 after the
attack on Pearl Harbor.
 Real GDP: extremely high growth during the early 1940’s (16-18% in the middle
of the war), followed by post-war negative GDP growth. This period of negative
growth might be called a recession, but it was caused more by coming down off
the dramatic mobilization of the WWII period rather than business cycle
fluctuations.
 Unemployment: extremely low during the war. People were working more than
they would have ever considered in normal times. The economy was producing at
a level well above its long-run trend.
 Note that the economy was producing above Prof. Fazzari’s estimate of potential
or full employment output. The idea of potential output is not truly the maximum
the economy can produce, but rather the amount of output consistent with normal
economic choices over a long time horizon. American citizens were not making
“normal” choices during World War 2. Many people worked in the market labor
force who usually would not work outside of the home. (Prof. Fazzari’s
grandmother worked in an aircraft factory.) Over time was almost certainly much
higher than people would have chosen under normal circumstances.
 Inflation: the strong economy did appear to cause inflation to accelerate, although
there were price controls in place on some commodities that suppressed inflation
until the end of the war.
 Many contemporary analysts of the economy feared that the U.S. would return to
the awful economic circumstances of the Depression after the military stimulus to
the economy ended in 1945.
 The economy did slow down, but this was probably desirable because economic
activity had been so incredibly intense. The economy did not return to anything
like the problems of the Depression
d) Impressive performance of the 1950s and 1960s: a benchmark for output,
unemployment, and inflation
 The economy had mixed results in the 1950s. GDP grew quickly at beginning of
decade because of the Korean War, followed by a brief post-war recession, then a
strong recovery in 1955. GDP grew rather slowly in 1956 and 1957 and a
recession occurred in 1958. Overall, inflation was low. Compared with the
volatile decades of the first half of the 20th century, things looked reasonably
good in the 1950s.
 The 1960s Boom: The 1960s look even better from a purely macroeconomic
perspective. At least until the middle 1990s, this period was considered a
benchmark for good economic performance. Growth was moderate in 1960 and
1961. But real growth then took off and remained above 3 percent for the rest of
the decade. Using older data with a different price index base, the annualized real
growth rate of GDP from 1959 to 1969 was
(4269.9 / 2762.5)1/10 – 1 = 0.044 or 4.4%
(Data in 2005 dollars). An annualized rate of growth of 4.4% for a full decade is
an excellent record by any measure.
 Inflation was low for first half of decade. However, with the strong growth and
falling unemployment, inflation accelerated to over 5% by 1969. Again, the usual
pattern prevailed, inflation rose when the economy was strong. But it took
several years of very fast growth before there was much effect on inflation.
 Some people argue that the outstanding GDP growth during the 1960s was due to
an increase in the population (i.e.: the presence of the Baby Boomers). While
there certainly was an increase in the population, the Baby Boomers were not old
enough to be part of the labor force yet. Therefore, they would not have affected
GDP growth rates significantly.
 Because of the excellent macroeconomic performance in the 1960s, some
economists have label it the "Golden Age." There is some justification for this
characterization based on macroeconomic statistics alone. However, a former
student noted that there was much upheaval and unrest in U.S. society during the
1960s (the war in Vietnam, assassinations, urban riots, emergence of strong
cultural divides over race and gender, etc.) From this broader perspective, one
can certainly criticize the "Golden Age" label for the society as a whole. This
point is another example that looking solely at macroeconomic performance
provides a limited perspective on society.
e) Disappointments of the 1970s
 The term “stagflation” was born during the mid 1970s. Informally, this is a
period of low GDP growth, high unemployment, and high inflation (as the word
literally means stagnation and inflation. Clever, isn’t it?) This recession was, by
far, the most significant downturn in the U.S. economy since the Great
Depression
 Remember that inflation usually slows down during a recession and accelerates
during periods of high growth. Therefore, stagflation is an unusual situation
because inflation increases during a recession. The cause of the stagflation was
the 1973 energy crisis initiated by an embargo that the Organization of Petroleum
Exporting Countries (OPEC) imposed on the United States. This event arose
from political conflicts in the middle east. Oil prices increased dramatically.
Inflation exceeded 9% in 1975 and remained high into the early 1980s.
 Unemployment reached over 8% and remained high for several years
 Effect on perception of U.S. dominance: Coming out of WW2, and certainly
throughout the 1960s, the United States was perceived as the politically and
economically dominant country in the world. The poor economic performance of
the middle 1970s was unexpected, and it shook confidence in the U.S. that the
OPEC embargo could have such a disastrous effect on the economy.
Policymakers and political leaders became focused, probably for the first time, on
the sensitivity of the U.S. economy to the volatile politics of the middle east. No
doubt this experience explains part of continued U.S. involvement in this oil-rich
region.
 Although the economy recovered with reasonably high real GDP growth in the
late 1970s, inflation remained high. Indeed, in 1978 the revolution that overthrew
the Shah of Iran (who was backed by the U.S.) causes another rapid rise in oil
prices that likely contributed to the acceleration of inflation in 1978 and 1979.
f) Recession and growth in the 1980s
 In 1980 there were 2 quarters of negative growth, then 1982 GDP growth in 1982
was nearly -2%, the worst full year since the Great Depression. No recession in
the past quarter century was worse. Unemployment peaked at 10.8% in late 1982,
also the highest level reached in the U.S. since the Great Depression of the 1930s.
 Inflation was stubbornly high from the early 1970s through the early 1980s. But
the deep recession seemed to "break the back" of inflation, which slowed
considerably in 1982 and 1983.
 This experience is called disinflation. Inflation never turned negative (that would
be deflation), but the positive inflation rate came down significantly. This
experience is typical of recessions after World War 2 (except the one in 1974-75).
Recessions have caused disinflation, but, so far, not sustained deflation. (Note:
Japan suffered significant recessions and stagnant growth after 1990. Things got
bad enough to create deflation, but nearly as bad as the Great Depression.)
 A strong recovery began in 1983 and 1984. GDP growth was significantly higher
than the rate most economists associate with the long-term trend (especially in
1984 with a growth rate above 7 percent). This fast growth allows the economy
to "catch up" with the trend that it fell away from in the recession.
 Inflation remained moderate in comparison with the 1970s, in the 2-4% range for
the rest of the decade. Inflation rates actually fell much more quickly than
economists had predicted. Unemployment, though declining, remained fairly
high through the end of the 1980s. (It never fell below 5 percent, and was above
6 percent for most of the decade.)
g) The 1990 – 1991 recession
 By 1989, the U.S. had entered a growth recession. Real GDP growth in the final
three quarters of 1989 was between one and three percent, clearly below the longterm trend. The economy entered an official recession in the third quarter of
1990, with three consecutive quarters of very low or negative real GDP growth.
 There was also disinflation during and after this recession.
 Unemployment: reached nearly 7 percent during the recession, but continued to
rise and remained high throughout 1993. This is a perfect example of
unemployment being a lagging indicator, meaning that unemployment peaks after
real GDP hits its trough.
 After the 1990-1991 recession, the economy did not recover very quickly, which
was a change in the pattern of business cycles from the deep recessions of 197475 and 1980-82. Although the recession had ended by the middle of 1991, real
GDP growth was never really high until the fourth quarter of 1993.
 The poor economic performance was an important issue in the 1992 Clinton /
Bush election (that is, Bush “senior,” George H.W. Bush). Clinton chose to
emphasize the poor economy during the election, blaming Bush’s policies. It is
difficult to say whether one can blame Bush for the poor economy, as the slow
economic growth started immediately after Bush took office. Bush hadn’t even
implemented new policies at the time the economy started to look weak.
Furthermore, we now know that the economic recovery started to pick up in 1992.
But these data were too late to help Bush in the 1992 election. Also, the
unemployment rate remained near its peak (7.6 percent) until the election.
 The labor market weakness in the aftermath of the 1990-91 recession led it to be
called “the jobless recovery.” Data charts discussed in class show how the jobs
recovery stretched out longer after this recession than after the more severe
downturns in 1974-75 and 1980-82. As it turns out, the jobless recovery problem
became even more severe after the 2001 recession and it seems to be a major
problem in the aftermath of the Great Recession, even into early 2011.
h) The 1990s boom: a “New Economy”
 Unlike the first Bush, Clinton was a lucky guy (politically speaking of course).
Just as poor economic performance began as soon as Bush took office, the
economy started to look better as soon as Clinton took office (far too early for
Clinton's policies to be responsible).
 Unemployment began to fall in the summer before Clinton took office and
continued to fall down to approximately 4 percent late in his presidency.
 Inflation was very low: 1.5 – 2.5%
 This period now ranks as the longest expansion in U.S. history. Real growth rates
were quite high. Many economists believed the long-term trend growth rate of
the economy was around 3 percent, but growth in the late 1990s was usually well
above this level. (Annualized real GDP growth from 1995 to 2000 was about
4.3%.)
 The high growth and low inflation make this period quite remarkable: it led to
talk of a "new economy" which could grow faster with lower inflation and
unemployment than most macroeconomists thought possible through the 1980s
and early 1990s. (The term “New Economy” was most famously used in a speech
by Alan Greenspan at this time.) Indeed, many economists encouraged the Fed to
raise interest rates because they believe inflation was about to break out due to
such low unemployment.
-
The term “New Economy” was most famously used in a speech by
Alan Greenspan at this time. Greenspan resisted calls to raise interest
rates until 2000.
-
After the fact, it seemed that Greenspan was correct to keep interest
rates low through the late 1990s boom. There was no significant rise
of inflation. Indeed, not long after Greenspan ultimately did raise
rates, the economy slowed into the 2001 recession. Again after the
fact, it seems that even the interest rate increases in 2000 were not
necessary.
i) Bursting “tech bubble” and the recession of 2001

End of the 1990s boom
o The 1990s boom was truly remarkable, with high GDP growth, the lowest
unemployment since the 1960s, and very low inflation.
o During the late 1990s, there was a remarkable run up in stock prices,
especially for high technology companies. The tech-heavy NASDAQ
stock price index peaked in the spring of 2000 and then fell rapidly.
Investment by high-technology industries decline rapidly and aggregate
capital investment fell substantially.

After the fact, the remarkably high stock prices for technology
companies in the late 1990s looks like a “bubble.” In a bubble,
prices remain high because people expect them to rise (so they buy
the asset) even though the “fundamental” earning power behind the
asset may not justify such a high price.

It’s much easier to diagnose a bubble after the fact. While it is
going on, there is often a story for why it should continue. In the
late 1990s, this story was that technology was fueling a new
economy with rapid growth as far as the eye could see that would
drive higher profits, especially in tech industries.
o Growth began to slow, however, in late 2000. The most obvious reason
was the decline in investment, led downward by tech industries.
o The slowing economy was not much of an issue in the 2000 campaign
leading up to the presidential election because there was little evidence at
that time of any trouble. But immediately after the election, the incoming
Bush administration criticized economic weakness and changed the
motivation of its tax cut proposals to emphasize simulating the weak
economy.
o Real growth was negative or very low during 2001, and the National
Bureau of Economic Research (NBER) declared a recession.
Unemployment began to rise and inflation fell.
o The tax cuts proposed by the Bush administration and passed by the
Congress in the spring of 2000 where remarkably timely. Usually, it takes
longer for fiscal policy to respond to a recession. But the Bush
administration already had a tax package on the table when Bush took
office.

Role of September 11, 2001 terrorist attack
o Many commentators were concerned that the Sept. 11 attacks would
greatly weaken the economy. It is clear, however, that the recession was
well underway before the attacks.
o Somewhat ironically, the economy starts to recover in the fourth quarter of
2001, right after the attack. Consumers seemed to begin high spending
remarkably quickly, with some help from incentives such as zero-percent
financing on new cars.
o The attack obviously hurt some industries at the "micro level" (airlines
and hotels, for example), but the overall macroeconomic statistics were
actually stronger immediately after the attack than they were before the
attack.

Another "jobless" recovery
o The economy resumed positive growth in the fourth quarter of 2001 and
did not had a negative growth quarter in 2002 or 2003. Therefore, the
recession, as it's usually defined relative to a "zero growth benchmark" has
been over since late 2001.
o However, growth has been slow in many of the quarters since the end of
2001. The economy has not had a strong rebound that allows it to catch
up with the previous trend.
o The most obvious manifestation of this fairly weak performance is that the
unemployment rate continued to rise, or at least it did not fall much
through 2003. Also, the number of people working has declined (job
creation) in almost every month through 2002 and 2003, even though the
economy was officially in a recovery stage.
o Just to keep up with growth in the labor market due to higher population,
the economy needs to create about 125,000 to 150,000 jobs every month.
The new job numbers were well below this figure for every quarter from
the middle of 2000 through 2003. Most of these quarters had negative job
growth. This stretch of poor job performance is unusually long, even
though the recession was relatively mild. The first part of the recovery
after the 2001 recession was, once again, labeled "jobless."

Looking back on the period from the middle 1980s until the middle of the first
decade of the 21st century, economists began to talk about something that has
been called the “Great Moderation.” The volatility of the economy declined
substantially. It seemed that recessions were more shallow, although recoveries
tended to be slower.
o Some economists believed that better policy was responsible for a more
stable, less volatile economy. Monetary policy, in particular, was given
credit for working better.
o Other economists argued that we were just lucky, and the random
disturbances (usually called “shocks”) that hit the economy just tended to
be small in the Great Moderation period. (These points suggest a debate
between a “good policy” explanation and a “good luck” explanation.)
o Regardless of the reason for the Great Moderation, it encouraged
macroeconomists to believe that the U.S. economy had entered a new era
of relative stability. This perspective spilled over to business, and
especially financial markets. There seemed to be less concern about risk.
o This Great Moderation optimism would be severely challenged by
financial instability and the very deep recession that began in December of
2007.

A closer look at the profile of the 2001 downturn and the slow recovery after it,
especially in the labor market, also suggests a somewhat different interpretation
than the general optimism of the Great Moderation discussion.
o It is true the drop in real GDP during the 2001 recession was quite “mild.”
Look at the data on real GDP growth presented in class the negative
numbers in 2001 are much tiny (in absolute value) compared to earlier
recession (and what was to come in 2008 and 2000). So, if the only worry
were true “recessions” with negative real GDP growth, this event would
look minor, consistent with Great Moderation thinking.
o But also look at the job profile for 2001 to 2005 in the charts discussed in
class. The job losses 25 to 30 months after the beginning of the downturn,
well after the official recession with declining GDP was over, are almost
as bad as what occurred at the worst part of the 1982 recession. (The latter
was, at the time, widely regarded as the worst event since the Depression.)
o Furthermore, the recovery was very slow. Employment does not return to
the level it had attained prior to the downturn until almost four years.
o The economy was less “volatile” in the early 2000s, than in the early
1980s. That’s the narrow meaning of the Great Moderation. But the job
situation from 2001 through 2004 was pretty bad by historical standards.

Another factor to keep in mind about the early 2000s is that economic policy
became very expansionary. Monetary policy lowered interest rates to historic
levels. The combination of the Bush tax cuts, various government spending
initiatives, and the drop in tax revenue due to the recession (when incomes fall,
tax revenues go down automatically), led to a massive expansion of the
government deficit. Despite all of this economic “stimulus,” the economy turned
to recovery very slowly.
o The difficulty of turning things around, even with dramatic policy shifts,
foreshadows the difficulty the economy is about to face in just a few years.

George W. Bush was up for re-election in 2004 (his Democratic opponent was
John Kerry). The economy did seem to finally rebound rather strongly in the
second half of 2003 and early 2004, in terms of GDP growth. Job creation was
finally pretty good in the first half of 2004. But some slowing occurred over the
summer of 2004.

A few economists began to talk about a big risk to economic growth from the
dramatic rise in consumer debt. (Indeed, the 2007 version of Fazzari’s 1021
course notes mentioned this concern.) Consumption spending held up rather well
in the 2001 recession and subsequent slow growth period. This fact kept
economic performance from being even worse. But to keep consumption
reasonably strong in a weak economy, households borrowed a lot. If they were
forced to re-pay some of this debt quickly, or even just to stop borrowing as
quickly, consumption spending will have to slow and the recovery will be
threatened.
j) The “Great Recession” and financial crisis

Discussed in class
k) Perspectives on “Great Moderation” and future prospects

The Great Moderation is the reduced volatility of macro data following the early
1980s recession. Recessions were fairly shallow in 1990-91 and 2001. Inflation
was on a downward trend and less variable. Unemployment also trended
downward through the late 1990s.

Is this favorable period over with the Great Recession?

Further discussion in class