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Introduction to Economic Growth and Instability
CHAPTER EIGHT
INTRODUCTION TO ECONOMIC GROWTH AND INSTABILITY
CHAPTER OVERVIEW
This chapter previews economic growth, the business cycle, unemployment, and inflation. It sets the
stage for the analytical presentation in later chapters.
Economic growth is defined and the arithmetic and sources of economic growth are examined. The
record of growth in the U.S. is viewed from several perspectives including an international comparison
in Global Perspective. The business cycle is introduced in historical perspective and is presented in
stylized form (Figure 8-1). While hinting at various business cycle theories, the authors stress the
general belief that changes in aggregate spending, especially durable goods and investment spending,
are the immediate cause of economic instability. Noncyclical fluctuations are also treated briefly before
the analysis of unemployment and inflation.
In the section on unemployment, the various types of unemployment—frictional, structural, and
cyclical—are described. Then the problems involved in measuring unemployment and in defining the
full-employment unemployment rate are considered. The economic and noneconomic costs of
unemployment are presented, and finally, Global Perspective 8-2 gives an international comparison of
unemployment rates.
Inflation is accorded a rather detailed treatment from both a cause and an effect perspective.
International comparisons of inflation rates in the post-1992 period are given in Global Perspective 8-3.
Demand-pull and cost-push inflation are described. Considerable emphasis is placed on the fact that the
redistributive effects of inflation will differ, depending on whether inflation is anticipated or
unanticipated. The chapter ends with historical cases of extreme inflation to remind students that
inflationary fears have some basis in fact.
WHAT’S NEW
A number of subtle but significant changes have been made from the previous edition. In addition to
dates and data, terminology and theoretical presentation has been revised.
Material from Chapter 7 on real per capita GDP and the Consumer Price Index has been moved to this
chapter. In the discussion of the GDP price index and CPI, the previous focus on “fixed” v. “variable”
weighting has been dropped in favor of a focus on the different scope of the GDP price index and CPI
market baskets.
The wording relating to the GDP gap has been revised to conform to contemporary usage. A positive
GDP gap refers to a situation where actual GDP exceeds potential GDP. A negative GDP represents a
shortfall in actual GDP relative to potential GDP.
A new “Consider This” box on clipping coins has been added. It provides a nice illustration of the
connection between money and demand-pull inflation, and appeared in the previous edition website
“Analogies, Anecdotes, and Insights” section.
The discussion of demand-pull inflation has been shortened, and the use of the three-range curve
(essentially an aggregate supply curve) in the explanation has been dropped. The AD-AS curve will
makes it first appearance in the text in Chapter 11.
End-of-chapter-questions have been added and revised.
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The “Last Word” on the stock market and macroeconomic instability has been updated.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to
1. Define two measures of economic growth.
2. Explain why growth is a desirable goal.
3. Identify two main sources of growth.
4. Explain the “rule of 70.”
5. Give average long-term growth rates for the U.S. and qualifications of raw data.
6. Summarize Global Perspective 8-1.
7. Explain what is meant by a business cycle.
8. Describe the four phases of an idealized business cycle.
9. Identify two types of noncyclical fluctuations in business activity.
10. Describe how innovation and/or random events might cause business cycles.
11. Explain why business cycles affect capital and consumer durable goods industries more than nondurable goods and service industries.
12. Describe how the Bureau of Labor Statistics (BLS) measures unemployment.
13. Evaluate the strengths and limitations of BLS unemployment statistics.
14. State the causes of frictional, cyclical, and structural unemployment.
15. Identify full employment or the natural rate of unemployment.
16. Identify the economic costs of unemployment and the groups that bear unusually heavy
unemployment burdens.
17. Define inflation and list two types of inflation.
18. List three groups who are hurt and two groups who may benefit from unanticipated inflation.
19. Present three possible effects of inflation on output and employment.
20. Compare U.S. inflation and unemployment rates to one or more industrialized nations.
21. Define and identify terms and concepts at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. Many students will benefit from the use of numeric examples (real or hypothetical). A good
springboard into the discussion of unemployment is to provide students with a set of profiles of
individuals, where information is given as to employment status and reasons for unemployment or
lack of participation in the labor force.
2. Most students have a vague idea of what is meant by unemployment or inflation. Few have
considered how these problems impact the economy or themselves. Having students collect prices
(at the beginning and end of term) not only provides the opportunity to construct a price index and
calculate inflation, it also puts them more in tune with market conditions.
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3. It makes this chapter more relevant to have students find the latest data on these measures. See
web-based questions at the end of the chapter or an Internet source such as www.dismal.com.
4. To help students better understand the types of unemployment, you may want to use the following
“Concept Illustration” (that appeared in the previous edition’s “Analogies, Anecdotes, and
Insights.”)
Concept Illustration … Types of Unemployment
Imagine a fictitious country named Miniature that has a stable population of 120 people, of which
100 are in the labor force. Of these 100 people, 95 are employed and 5 are unemployed. That
means Miniature’s unemployment rate is 5 percent (= 5/100).
Suppose we could take a group photo of the unemployed workers each month so as to obtain a
continuing record of their monthly numbers and reveal whom they are. By comparing the monthly
photos over long periods, we could sort out the types of unemployment occurring in Miniature.
Suppose that in a typical month there are 5 people in the photo. Also, suppose that 4 of these
people are never the same individuals who were in the photo the previous month and the other
person never shows up in the photo for more than two or three consecutive months.
We can reasonably conclude that Miniature is experiencing frictional unemployment and
structural unemployment. The frictionally unemployed workers are quickly finding jobs, and
after retraining or relocation, the structurally unemployed workers are obtaining new jobs within a
few months. Taking the places of these formerly unemployed persons are newly unemployed
people who are looking for new jobs, waiting for future jobs, retraining, or relocating. Five
percent of the labor force is unemployed each month, but nobody is unemployed for any
substantial length of time. Miniature is not suffering an “unemployment problem.”
In contrast, suppose that over a six-month period we observe that the number of people in the
unemployment photo increases from 5 to 10, with no change in the size of the labor force.
Thereafter, the 10 percent unemployment rate continues for a full year. A comparison of the
monthly photos reveals that it is mainly the same people who are employed month after month.
We can reasonably conclude that Miniature is now experiencing cyclical unemployment. Total
spending must have declined, reducing production and employment. The increase in the
unemployment rate from 5 percent to 10 percent has accompanied this recession. Miniature now
has a serious “unemployment problem.” Cyclical unemployment is involuntary, relatively long
lasting, and creates serious financial hardship for those people unemployed. It also results in an
irretrievable loss of output to society.
5. Table 8-3 can be used to discuss the definition of unemployment and its limitations. Current data
to update the table can be found in the Monthly Labor Review, Employment and Earnings,
Economic Indicators, or see Web-based question 16. Make it clear that a portion of each
unemployment statistic is due to frictional and structural unemployment, which are found even in a
“full employment” economy. Frictional unemployment indicates a healthy economy with labor
mobility. Structural unemployment is viewed as serious, but not responsive to economic policies
alone.
6. Have students consider the losses from unemployment. Perhaps they could write a feature article
on losses due to GDP gap, higher inflation, or the social and personal losses incurred by those
unemployed.
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7. Try web-based question 17 for current inflation data. While we have been concerned with inflation
since World War II, it is interesting to note that past (and now current) economists have been as
concerned about deflation. A good topic is to ask students how deflation can be a problem, as it is
in Japan and threatens to be in the U.S.
8. For a deeper understanding of the costs of inflation, you may wish to share the following “Concept
Illustration” with your students:
Concept Illustration … Costs of Inflation
On page 147 examples of the costs of inflation are given. The following metaphors may help you
distinguish and remember the three examples listed.
Menu costs Inflation requires firms to change the prices they charge from one period to another.
This new pricing of products and the communication of the new prices to customers requires time
and effort that could otherwise be used for more productive purposes. These inflation costs are
sometimes called menu costs, because they are similar to the costs incurred by restaurants that
need to print new menus when prices rise. Menu costs include all costs associated with the
inflation-caused need to change prices.
Yardstick costs Inflation interferes with money functioning as a measure of value and thus
requires more time and effort to determine what something is worth (in real terms). Dollar price
tags lose some of their meaning when inflation occurs, because the dollar’s value has declined
relative to before. It is as if a yardstick that formerly measured 36 inches now measures 34, 33, or
even fewer inches. All inflation-caused costs associated with determining real versus nominal
values can be thought of as yardstick costs.
Shoe-leather costs We have noted that people try to protect their financial assets against erosion
from inflation by limiting the amounts of money they hold in their billfolds and in their noninterest-bearing checking accounts, putting those funds instead into interest-bearing saving
accounts or stock and bond funds. But people actually need more money to buy the higher priced
goods and services. So, they figuratively walk to and from financial institutions much more often
in order to move money from these latter accounts to checking accounts or to get cash when it is
needed. In the process they wear out their shoes—they incur so-called shoe-leather costs. These
costs include all time and resource costs associated with the inflation-induced need to make more
financial transactions.
9. The Wall Street Journal is a good source of information on the most current economic situation.
They have a “Newspaper-in-Education” program that provides various teaching aids, in addition to
favorable subscription rates for students. Call 1-800-JOURNAL contact their website for more
information. Among their aids is a stylized Wall Street Journal Education edition, which gives
information on dates on which important economic statistics are announced each month or each
quarter. Your local newspaper and periodicals may have similar education programs. The
Economist includes up-to-date macroeconomic information and presents stories of U.S.
macroeconomic policies and conditions that are detailed but accessible.
10. Unemployment and inflation have a human face. A dramatic reading of quotes from a book such
as Studs Terkel’s Hard Times can be used to bring statistics to life. You or your students may be
acquainted with individuals who lived through the depression years or who have suffered from
periods of unemployment. Inviting them to discuss the impact of these experiences also helps to
make this material more interesting for students.
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STUDENT STUMBLING BLOCKS
1. This chapter includes lots of descriptive detail. Help your students sort out the forest from the
trees—be clear about what you expect them to know from this chapter.
2. Struggling students often have difficulty because they lack very basic math skills. Sometimes,
they simply have not used fractions, percentages or decimals lately. Do not take it for granted that
college students will be prepared for the simple calculations in this chapter. One skill that is
frequently missing is the ability to make reasonable estimates of a correct answer (a ball park
guess) without actually crunching the numbers. Give students practice with simple questions first
– for example, GDP loss when the unemployment rate is 1% above the natural rate (applying
Okun’s Law). Then demonstrate the gap for every 1% beyond that.
3. Students often confuse being “unemployed” with being “not in the labor force.” You may need to
stress to some that just because one of their parents is “not employed” (e.g. a homemaker) doesn’t
mean they don’t work hard – simply that they don’t work in the paid labor force. Some students
will be bothered that those in the underground economy are counted as “not in the labor force” or,
in some cases, “unemployed.” Emphasize that the classification is based on the BLS survey and
may not accurately represent their true status (such as we do in the discussion of discouraged
workers). Keep students from reaching the conclusion that the underground economy is excluded
because it produces economic “bads”. It also produces “goods,” just as the measured economy
produces “bads.”
4. In anticipation of future chapters, the sections on demand-pull and cost-push inflation will be
helpful. Emphasize the analysis of Figure 8-5. It also helps to reinforce Chapter 7’s distinction
between nominal and real GDP.
5. Students are often confused between terms like “deflation” (falling prices) and “disinflation” (a
falling rate of inflation). There may be similar confusion between “rising prices” and a “rising
inflation.” As you look ahead to the policy chapters, you need to decide whether it is better now or
later to define disinflation and distinguish between it and deflation, especially given that one is
feared and the other is often considered desirable.
LECTURE NOTES
I.
Introduction: This chapter provides an introductory look at trends of real GDP growth
and the macroeconomic problems of the business cycle, unemployment, and inflation.
II.
Economic Growth-How to increase the economy’s productive capacity over time.
A. Two definitions of economic growth are given.
1. The increase in real GDP, which occurs over a period of time.
2. The increase in real GDP per capita, which occurs over time. This definition is superior
if comparison of living standards is desired. For example, China’s 2001 GDP was $1131
billion compared to Denmark’s $166 billion, but per capita GDP’s wee $890 and
$31,090 respectively.
3. Growth in real GDP does not guarantee growth in real GDP per capita. If the growth in
population exceeds the growth in real GDP, real GDP per capita will fall.
B. Growth is an important economic goal because it means more material abundance and ability
to meet the economizing problem. Growth lessens the burden of scarcity.
C. The arithmetic of growth is impressive. Using the “rule of 70,” a growth rate of 2 percent
annually would take 35 years for GDP to double, but a growth rate of 4 percent annually
would only take about 18 years for GDP to double. (The “rule of 70” uses the absolute value
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of a rate of change, divides it into 70, and the result is the number of years it takes the
underlying quantity to double.)
D. Main sources of growth are increasing inputs or increasing productivity of existing inputs.
1. About one-third of U.S. growth comes from more inputs.
2. About two-thirds comes from increased productivity.
E. Growth Record of the United States (Table 8-1) is impressive.
1. Real GDP has increased almost tenfold since 1940, and real per capita GDP has risen
over fourfold. (See columns 2 and 4, Table 8-1)
2. The rate of growth record shows that real GDP has grown 3.5 percent per year since
1950 and real GDP per capita has grown 2.3 percent per year. But the arithmetic needs
to be qualified.
a. Growth doesn’t measure quality improvements.
b. Growth doesn’t measure increased leisure time.
c. Growth doesn’t take into account adverse effects on environment or human security.
d. International comparisons are useful in evaluating U.S. performance. For example,
Japan grew more than twice as fast as U.S. until the 1990s when the U.S. far
surpassed Japan. (see Global Perspective 8-1). There is also some tendency for
growth rates to move together, reflecting the interdependence of the global economy.
III.
Overview of the Business Cycle
A. Historical record.
1. The United States’ impressive long-run economic growth has been interrupted by periods
of instability.
2. Uneven growth has been the pattern, with inflation often accompanying rapid growth,
and declines in employment and output during periods of recession and depression (see
Figure 8-1 and Table 8-2).
B. Four phases of the business cycle are identified over a several-year period. (See Figure 8-1)
1. A peak is when business activity reaches a temporary maximum with full employment
and near-capacity output.
2. A recession is a decline in total output, income, employment, and trade lasting six
months or more.
3. A trough is the bottom of the recession period.
4. A recovery is when output and employment are expanding toward the full-employment
level.
C. There are several theories about causation.
1. Major innovations may trigger new investment and/or consumption spending.
2. Changes in productivity may be a related cause.
3. Most agree that the level of aggregate spending is important, especially changes on
capital goods and consumer durables.
D. Cyclical fluctuations: Durable goods output is more volatile than nondurables and services
because spending on latter usually cannot be postponed.
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IV.
Unemployment (One Result of Economic Downturns)
A. Measuring unemployment (see Figure 8-2 for 2002):
1. The population is divided into three groups: those under age 16 or institutionalized,
those “not in labor force,” and the labor force that includes those age 16 and over who
are willing and able to work, and actively seeking work (demonstrated job search activity
within the last four weeks).
2. The unemployment rate is defined as the percentage of the labor force that is not
employed. (Note: Emphasize not the percentage of the population.)
3. The unemployment rate is calculated by random survey of 60,000 households
nationwide. (Note: Households are in survey for four months, out for eight, back in for
four, and then out for good; interviewers use the phone or home visits using laptops.)
Two factors cause the official unemployment rate to understate actual unemployment.
a. Part-time workers are counted as “employed.”
b. “Discouraged workers” who want a job, but are not actively seeking one, are not
counted as being in the labor force, so they are not part of unemployment statistic.
B. Types of unemployment
1. Frictional unemployment consists of those searching for jobs or waiting to take jobs
soon; it is regarded as somewhat desirable, because it indicates that there is mobility as
people change or seek jobs.
2. Structural unemployment is due to changes in the structure of demand for labor; e.g.,
when certain skills become obsolete or geographic distribution of jobs changes.
a. Glass blowers were replaced by bottle-making machines.
b. Oil-field workers were displaced when oil demand fell in 1980s.
c. Airline mergers displaced many airline workers in 1980s.
d. Foreign competition has led to downsizing in U.S. industries and a loss of jobs.
e. Military cutbacks have led to displacement of workers in military-related industries.
3. Cyclical unemployment is caused by the recession phase of the business cycle, which is
sometimes called deficient demand unemployment.
4. It is sometimes not clear which type describes a person’s unemployment circumstances.
C. Definition of “Full Employment”
1. Full employment does not mean zero unemployment.
2. The full-employment unemployment rate is equal to the total of frictional and structural
unemployment.
3. The full-employment rate of unemployment is also referred to as the natural rate of
unemployment.
4. The natural rate is achieved when labor markets are in balance; the number of job
seekers equals the number of job vacancies. At the end of the last century the economy’s
potential output was being achieved. The natural rate of unemployment is not fixed, but
depends on the demographic makeup of the labor force and the laws and customs of the
nations. The recent drop in the natural rate from 6% to 4 or 5% has occurred mainly
because of the aging of the work force, improved information flows in job markets, work
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requirements enacted with welfare reform, and a doubling of the U.S. prison population
since 1985.
5. The natural rate of unemployment is not fixed but depends on the demographic makeup
of the labor force and the laws and customs of the nations.
6. Recently the natural rate has dropped from 6% to 4 or 5%. This is attributed to:
a. The aging of the work force as the baby boomers approach retirement.
b. Improved job information through the Internet and temporary-help agencies.
c. New work requirements passed with the most recent welfare reform.
d. The doubling of the U.S. prison population since 1985.
D. Economic cost of unemployment
1. GDP gap and Okun’s Law: the GDP gap is the difference between potential and actual
GDP. (See Figure 8-3) Economist Arthur Okun quantified the relationship between
unemployment and GDP as follows: For every 1 percent of unemployment above the
natural rate, a negative GDP gap of 2 percent occurs. This is known as “Okun’s law.”
2. Unequal burdens of unemployment exist. (See Table 8-3)
a. Rates are lower for white-collar workers.
b. Teenagers have the highest rates.
c. Blacks have higher rates than whites.
d. Rates for males and females are comparable, though females had a lower rate in
2002.
e. Less-educated workers, on average, have higher unemployment rates than workers
with more education.
f.
The “long-term” (15 weeks or more) unemployment rate is much lower than the
overall rate, although it has nearly doubled from 1.1% in 1999 to 2% in 2002.
E. Noneconomic costs include loss of self-respect and social and political unrest.
F. International comparisons. (See Global Perspective 8-2)
V.
Inflation: Defined and Measured
A. Definition: Inflation is a rising general level of prices (not all prices rise at the same rate,
and some may fall).
B. The main index used to measure inflation is the Consumer Price Index (CPI). To measure
inflation, subtract last year’s price index from this year’s price index and divide by last
year’s index; then multiply by 100 to express as a percentage.
C. The “rule of 70” permits quick calculation of the time it takes the price level to double:
Divide 70 by the percentage rate of inflation and the result is the approximate number of
years for the price level to double. If the inflation rate is 7 percent, then it will take about ten
years for prices to double. (Note: You can also use this rule to calculate how long it takes
savings to double at a given compounded interest rate.)
D. Facts of inflation
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1. In the past, deflation has been as much a problem as inflation. For example, the 1930s
depression was a period of declining prices and wages. The prospect of deflation is a
recent concern of economic policymakers.
2. All industrial nations have experienced the problem (see Global Perspective 8-3).
3. Some nations experience astronomical rates of inflation (Angola’s was 4,145 percent in
1996).
4. The inside covers of the text contain historical rates for the U.S.
E. Causes and theories of inflation
1. Demand-pull inflation: Spending increases faster than production. It is often described
as “too much spending chasing too few goods.”
2. CONSIDER THIS … Clipping Coins
a. Princes would clip coins, paying peasants with the clipped coins and using the
clippings to mint new coins.
b. Clipping was essentially a tax on the population as the increased money supply
caused inflation and reduced the purchasing power of each coin.
3. Cost-push or supply-side inflation: Prices rise because of a rise in per-unit production
costs (Unit cost = total input cost/units of output).
a. Output and employment decline while the price level is rising.
b. Supply shocks have been the major source of cost-push inflation. These typically
occur with dramatic increases in the price of raw materials or energy.
4. Complexities: It is difficult to distinguish between demand-pull and cost-push causes of
inflation, although cost-push will die out in a recession if spending does not also rise.
VI.
Redistributive effects of inflation
A. The price index is used to deflate nominal income into real income. Inflation may reduce the
real income of individuals in the economy, but won’t necessarily reduce real income for the
economy as a whole (someone receives the higher prices that people are paying).
B. Unanticipated inflation has stronger impacts; those expecting inflation may be able to adjust
their work or spending activities to avoid or lessen the effects.
C. Fixed-income groups will be hurt because their real income suffers. Their nominal income
does not rise with prices.
D. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the
cost of inflation. Their savings will lose purchasing power.
E. Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest
payments may be less than the inflation rate, so borrowers receive “dear” money and are
paying back “cheap” dollars that have less purchasing power for the lender.
F. If inflation is anticipated, the effects of inflation may be less severe, since wage and pension
contracts may have inflation clauses built in, and interest rates will be high enough to cover
the cost of inflation to savers and lenders.
1. “Inflation premium” is amount that the interest rate is raised to cover effects of
anticipated inflation.
2. “Real interest rate” is defined as nominal rate minus inflation premium. (See Figure 8-6)
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G. Final points
1. Unexpected deflation, a decline in price level, will have the opposite effect of
unexpected inflation.
2. Many families are simultaneously helped and hurt by inflation because they are both
borrowers and earners and savers.
3. Effects of inflation are arbitrary, regardless of society’s goals.
VII.
Output Effects of Inflation
A. Cost-push inflation, where resource prices rise unexpectedly, could cause both output and
employment to decline. Real income falls.
B. Mild inflation (<3%) has uncertain effects. It may be a healthy by-product of a prosperous
economy, or it may have an undesirable impact on real income.
C. Danger of creeping inflation turning into hyperinflation, which can cause speculation,
reckless spending, and more inflation (see examples in text of Hungary and Japan following
World War II, and Germany following World War I).
VIII.
LAST WORD: The Stock Market and The Economy: How, if at all, do changes in stock
prices relate to macroeconomic stability?
A. Do changes in stock prices and stock market wealth cause instability? The answer is yes, but
usually the effect is weak.
1. There is a wealth effect: Consumer spending rises as asset values rise and vice versa if
stock prices decline substantially.
2. Also, there is an investment effect: Rising share prices lead to more capital goods
investment and the reverse in true for falling share prices.
B. Stock market “bubbles” can hurt the economy by encouraging reckless speculation with
borrowed funds or savings needed for other purposes. A “crash” can cause unwarranted
pessimism about the underlying economy.
C. A related question concerns forecasting value of stock market averages. Stock price
averages are included as one of ten “Leading Indicators” used to forecast the future direction
of the economy. (See Last Word, Chapter 12.) However, by themselves, stock values are
not a reliable predictor of economic conditions.
ANSWERS TO END-OF-CHAPTER QUESTIONS
8-1
Why is economic growth important? Why could the difference between a 2.5 percent and a 3.0
percent annual growth rate make a great difference over several decades?
Economic growth means a higher standard of living, provided population does not grow even
faster. And if it does, then economic growth is even more important to maintain the current
standard of living. Economic growth allows the lessening of poverty even without an outright
redistribution of wealth.
If population is growing at 2.5 percent a year—and it is in some of the poorest nations—then a
2.5 percent growth rate of real GDP means no change in living standards. A 3.0 percent growth
rate means a gradual rise in living standards. For a wealthy nation, such as the United States,
with a GDP in the neighborhood of $10 trillion, the 0.5 percentage point difference between 2.5
and 3.0 percent amounts to $50 billion a year, or more than $150 per person per year.
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Using the “Rule of 70,” it would take 28 years for output to double with a 2.5 percent growth
rate, and just over 23 years with 3.0 percent growth.
8-2
(Key Question) Suppose an economy’s real GDP is $30,000 in year 1 and $31,200 in year 2.
What is the growth rate of its real GDP? Assume that population was 100 in year 1 and 102 in
year 2. What is the growth rate of GDP per capita?
Growth rate of real GDP = 4 percent (= $31,200 - $30,000)/$30,000). GDP per capita in year 1 =
$300 (= $30,000/100). GDP per capita in year 2 = $305.88 (= $31,200/102). Growth rate of
GDP per capita is 1.96 percent = ($305.88 - $300)/300).
8-3
Briefly describe the economic growth record of the United States. Compare the rates of growth
in real GDP and real GDP per capita, explaining any differences. Compare the average growth
rates of Japan and the U.S. between 1992 and 2002. To what extent might growth rates
understate or overstate economic well-being?
The growth record of the United States, as seen in Table 8-1, shows that real GDP grew from
$822 billion in 1929 to $9440 billion in 2002 (14.4% per year), while per capita GDP (in 1996
constant dollars) grew from $6,738 in 1929 to $32,664 in 2002 (5.2% per year). It is evident that
real GDP grows more rapidly than real GDP per capita because the population is growing at the
same time that GDP is growing. Since GDP per capita is GDP/population, this will show a
smaller rate of growth than GDP if the denominator, population, is expanding.
Looking at Global Perspective 8-1, we can see that the average annual growth rates of real GDP
have been more rapid in the U.S., averaging almost 3 percent in the 1992-2002 period.
Meanwhile, Japan’s growth has been sluggish (and negative for three of the years during the
period), following years of growth nearly double that of the U.S.
The real GDP and per capita real GDP figures may understate economic well-being to the extent
they do not fully take into account improvements in product quality; and they take no account at
all of the very considerable increase in leisure since 1929. On the other hand, the measures of
growth also leave out increases in pollution and the possible increase in stress caused by growth,
and also do not measure the extent of inequality in distribution. If inequality is great, many may
have less GDP per capita than shown..
8-4
(Key Question) What are the four phases of the business cycle? How long do business cycles
last? How do seasonal variations and secular trends complicate measurement of the business
cycle? Why does the business cycle affect output and employment in capital goods and
consumer durable goods industries more severely than in industries producing nondurables?
The four phases of a typical business cycle, starting at the bottom, are trough, recovery, peak, and
recession. As seen in Table 8-2, the length of a complete cycle varies from about 2 to 3 years to
as long as 15 years.
There is a pre-Christmas spurt in production and sales and a January slackening. This normal
seasonal variation does not signal boom or recession. From decade to decade, the long-term
trend (the secular trend) of the U.S. economy has been upward. A period of no GDP growth thus
does not mean all is normal, but that the economy is operating below its trend growth of output.
Because capital goods and durable goods last, purchases can be postponed. This may happen
when a recession is forecast. Capital and durable goods industries therefore suffer large output
declines during recessions. In contrast, consumers cannot long postpone the buying of
nondurables such as food; therefore recessions only slightly reduce nondurable output. Also,
capital and durable goods expenditures tend to be “lumpy.” Usually, a large expenditure is
needed to purchase them, and this shrinks to zero after purchase is made.
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8-5
What factors make it difficult to determine the unemployment rate? Why is it difficult to
distinguish between frictional, structural, and cyclical unemployment? Why is unemployment an
economic problem? What are the consequences of a negative GDP gap? What are the
noneconomic effects of unemployment?
Measuring the unemployment rate means first determining who is eligible and available to work.
The total U.S. population is divided into three groups. One group is made up of people less than
16 years of age and people who are institutionalized. The second group, labeled “not in the labor
force” are adults who are potential workers but for some reason—age, in school, or homemakers
– are not seeking work. The third group is the labor force, those who are employed and those
who are unemployed but actively seeking work.
It is not easy to distinguish between these three types and since the unavoidable minimum of
frictional and structural unemployment is itself changing, it is difficult to determine the
full-employment unemployment rate. For example, a person who quits a job in search of a better
one would normally be considered frictionally unemployed. But suppose the former job then
disappears completely because the firm is in a declining industry and can no longer make money.
Our still jobless worker could now be considered structurally unemployed. And then suppose the
economy slips into a severe recession so that our worker cannot find any job and has become
cyclically unemployed. The unavoidable minimums of frictional and structural unemployment
fluctuate as the labor force structure changes. In other words, there is no automatic label on the
type of unemployment when someone is counted as unemployed.
Unemployment is an economic problem because of the concept of opportunity cost. Quite apart
from any idea of consideration for others, unemployment is economic waste: A unit of labor
resource that could be engaged in production is sitting idle.
The “GDP gap” is the difference between what the economy could produce at its potential GDP
and what it is producing at its actual GDP. The consequence of a negative GDP gap is that what
is not produced – the amount represented by the gap—is lost forever. Moreover, to the extent
that this lost production represents capital goods, the potential production for the future is
impaired. Future economic growth will be less.
The noneconomic effects of unemployment include the sense of failure created in parents and in
their children, the feeling of being useless to society, of no longer belonging.
8-6
(Key Question) Use the following data to calculate (a) the size of the labor force and (b) the
official unemployment rate: total population, 500; population under 16 years of age or
institutionalized, 120; not in labor force, 150; unemployed, 23; part-time workers looking for
full-time jobs, 10.
Labor force  230  500 - 120  150; official unemployme nt rate  10% 23/ 230 100
8-7
Since the U.S. has an unemployment compensation program, which provides income for those
out of work, why should we worry about unemployment?
The unemployment compensation program merely gives the unemployed enough funds for basic
needs. Furthermore, many of the unemployed do not qualify for unemployment benefits. The
programs apply only to those workers who were covered by the insurance, and this may be as
few as one-third of those without jobs. Most of the unemployed get no sense of self-worth or
accomplishment out of drawing this compensation. Moreover, from the economic point of view,
unemployment is a waste of resources; when the unemployed go back to work, nothing is forgone
except undesired leisure. Finally, unemployment could be inflationary and costly to taxpayers:
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The unemployed are producing nothing—their supply is zero – but the compensation helps keep
demand in the economy high.
8-8
(Key Question) Assume that in a particular year the natural rate of unemployment is 5 percent
and the actual rate of unemployment is 9 percent. Use Okun’s law to determine the size of the
GDP gap in percentage-point terms. If the nominal GDP is $500 billion in that year, how much
output is being foregone because of cyclical unemployment?
GDP gap = 8 percent [=(9-5)] x 2; forgone output estimated at $40 billion (=8% of $500 billion).
8-9
Explain how an increase in your nominal income and a decrease in your real income might occur
simultaneously. Who loses from inflation? Who loses from unemployment? If you had to
choose between (a) full employment with a 6 percent annual rate of inflation or (b) price stability
with an 8 percent unemployment rate, which would you choose? Why?
If a person’s nominal income increases by 10 percent while the cost of living increases by 15
percent, then her real income has decreased from 100 to 95.65 (= 110/1.15). Alternatively
expressed, her real income has decreased by 4.35 percent (= 100 - 95.65). Generally, whenever
the cost of living increases faster than nominal income, real income decreases.
The losers from inflation are those on incomes fixed in nominal terms or, at least, those with
incomes that do not increase as fast as the rate of inflation. Creditors and savers also lose. In the
worst recession since the Great Depression (1981-82), those who lost the most from
unemployment were, in descending order, blacks (who also suffer the most in good times),
teenagers, and blue-collar workers generally. In addition to the specific groups who lose the
most, the economy as a whole loses in terms of the living standards of its members because of
the lost production.
The choice between (a) and (b) illustrates why economists are unpopular. Option (a) spreads the
pain by not having a small percentage of the population bear the burden of employment. There is
the risk, however, that inflationary expectations will give rise to creeping inflation and ultimately
hyperinflation; or that the central bank will raise interest rates to reduce inflation, stalling
economic growth. If one chooses (b) the central bank will have no cause to raise interest rates
and cut off the economic expansion needed to get unemployment down from the unforgivable 8
percent. However, the weakness in spending resulting from an 8% unemployment rate might
push the economy into deflation, which would ultimately exacerbate the weak economic
conditions.
8-10
What is the Consumer Price Index (CPI) and how is it determined each month? How does the
Bureau of Labor Statistics (BLS) calculate the rate of inflation from one year to the next? What
effect does inflation have on the purchasing power of a dollar? How does it explain differences
between nominal and real interest rates? How does deflation differ from inflation?
The CPI is constructed from a “market basket” sampling of goods that consumers typically
purchase. Prices for goods in the market basket are collected each month, weighted by the
importance of the good in the basket (cars are more expensive than bread, but we buy a lot more
bread), and averaged to form the price level.
To calculate the rate of inflation for year 5, the BLS subtracts the CPI of year 4 from the CPI of
year 5, and then divides by the CPI of year 4 (percentage change in the price level).
Inflation reduces the purchasing power of the dollar. Facing higher prices with a given number
of dollars means that each dollar buys less than it did before.
The rate of inflation in the CPI approximates the difference between the nominal and real interest
rates. A nominal interest rate of 10% with a 6% inflation rate will mean that real interest rates
are approximately 4%.
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Deflation means that the price level is falling, whereas with inflation overall prices are rising.
Deflation is undesirable because the falling prices mean that incomes are also falling, which
reduces spending, output, employment, and, in turn, the price level (a downward spiral).
Inflation in modest amounts (<3%) is tolerable, although there is not universal agreement on this
point.
8-11
(Key Question) If the price index was 110 last year and is 121 this year, what is this year’s rate
of inflation? What is the “rule of 70”? How long would it take for the price level to double if
inflation persisted at (a) 2, (b) 5, and (c) 10 percent per year?
This year’s rate of inflation is 10% or [(121 – 110)/110] x 100.
Dividing 70 by the annual percentage rate of increase of any variable (for instance, the rate of
inflation or population growth) will give the approximate number of years for doubling of the
variable.
(a) 35 years (  70/2); (b) 14 years (  70/5); (c) 7 years (  70/10).
8-12
Distinguish between demand-pull inflation and cost-push inflation. Which of the two types is
most likely to be associated with a (negative) GDP gap? Which with a positive GDP gap, in
which actual GDP exceeds potential GDP?
Demand-pull inflation occurs when prices rise because of an increase in aggregate spending not
fully matched by an increase in aggregate output. It is sometimes expressed as “too much
spending (or money) chasing too few goods.” Cost-push inflation describes prices rising because
of increases in per unit costs of production.
Cost-push inflation is most likely to be associated with a negative GDP gap, as the rising
production costs reduce spending and output.
Demand-pull inflation is more likely to occur with a positive GDP gap, because actual GDP will
exceed its potential only when aggregate spending is strong and rising. As the economy
produces above its potential, bottlenecks and more severe resource scarcity occur, driving up
prices.
8-13
Explain how “hyperinflation” might lead to a severe decline in total output.
With inflation running into the double, triple, quadruple, or an even greater number of digits per
year, it makes little sense to save. The only sensible thing to do with money is to spend it before
its value is cut in half within a month, a week, or a day. This very fact of everyone trying to
spend as fast as possible will speed the inflationary spiral and cause people to spend more and
more time trying to figure out what goods are most likely to go up fastest in price. More and
more people will turn away from productive activity, because wages and salaries are not keeping
up with inflation. Instead, they will spend their time speculating, transferring goods already in
existence and producing nothing.
Eventually, money may become worthless. No one will work for money. Barter and living by
one’s wits become the only means of survival. Production falls for this reason and also because
investment in productive capital practically ceases. Unemployment soars. A massive depression
is at hand.
8-14
Evaluate as accurately as you can how each of the following individuals would be affected by
unanticipated inflation of 10 percent per year:
a. A pensioned railroad worker
b. A department store clerk
c. A unionized automobile assembly-line worker
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d. A heavily indebted farmer
e. A retired business executive whose current income comes entirely from interest on
government bonds
f.
The owner of an independent small-town department store
(a) Assuming the pensioned railway worker has no other income and that the pension is not
indexed against inflation, the retired worker’s real income would decrease every year by
approximately 10 percent of its former value.
(b) Assuming the clerk was unionized and the contract had over a year to run, the clerk’s real
income would decrease in the same manner as the pensioner. However, the clerk could
expect to recoup at least part of the loss at contract renewal time. In the more likely event of
the clerk not being unionized, the clerk’s real income would decrease, possibly by as much as
the pensioned railroad worker.
(c) Since the UAW worker is unionized, the loss in the first year would be the same as in (b) but
it is likely—barring a deep recession—that the loss will be made up at contract renewal time
plus the usual real increase that may or may not be related to increased productivity. If the
contract had a cost-of-living allowance clause in it, the wage would automatically be raised
at the end of the year to cover the loss in purchasing power. Next year’s wage would rise by
10 percent.
(d) If the inflation is also in the price the farmer gets for his products, he could gain. But more
likely the price increases are mostly in what he buys, since farm machinery, fertilizer, etc.,
tend to be sold by less-competitive sellers with more power to raise their prices. The farmer
faces a lot of competition and has to rely on the market price to go up—the farmer has little
control over prices on an individual basis. Moreover, if interest rates on the farmer’s new
debts have gone up with the prices, the farmer could be even worse off. The other side of the
coin is that if no new borrowing is necessary, the inflation will reduce the real burden of the
farmer’s debt, because the purchasing power declines on the fixed payments he contracted to
make before inflation.
(e) The retired executive is in the same boat as the pensioned railroad worker, except that the
executive’s income from the bonds or other interest bearing assets is probably greater than
that of the worker from the pension. The increase in inflation has most probably been
accompanied by rising interest rates, with a proportional drop in the price of bonds.
Therefore, the retired executive would suffer a capital loss if he or she decided to cash in
some of the bonds at this time and the fixed interest received on these existing bonds is worth
less in terms of purchasing power. In other words, the executive, although wealthier than the
retired worker, may be affected just as much or more by inflation.
(f) Assuming the store owner’s prices and revenues have been keeping pace with inflation, his
or her real income will not change unless the costs have risen more than the product prices.
8-15
(Last Word) Suppose that stock prices were to fall by 10 percent in the stock market. All else
equal, would the lower stock prices be likely to cause a decrease in real GDP? How might they
predict a decline in real GDP?
GDP could be reduced if stock owners feel significantly poorer and reduce their spending on
goods and services, including investment in real capital goods. However, research indicates that
downturns in the stock market have not had major impacts on GDP.
A fall in stock prices might signal a change in expectations. Evidence does suggest that there is a
link between falling stock prices and future recessions. However, this is only one factor related
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to predicting recessions and, by itself, a fall in stock prices is not a reliable predictor of
recession.
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