Download Econ 1000: Mod 4, Lecture 8 - Leona Craig Art Gallery, Red

Econ 1000: Mod 4, Lecture 8
C. L. Mattoli
(C) Red Hill Capital Corp., Delaware, USA
2008
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Mod 4, part 2: Macroeconomics
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Chapter 12, page 333 to end, Economic
Growth, Macro policy
Chapter 13, Inflation and unemployment
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Learning Objectives
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Discuss the determinants of economic
growth
Briefly outline causes of both inflation and
unemployment
Discuss the measurement and causes of
inflation.
Discuss the objective of full employment
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Last Time
We looked at proxies for measuring
macro economic growth, and we
settled on real GDP as one
possibility.
 We also discussed the definition of
GDP and other national accounting
concepts, including some
components: consumption, savings
and investment.
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Last Time
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We also discussed some of the
shortcomings of measurements of national
accounts and the shortcomings of using
real GDP as a proxy for growth.
We then went on to discuss the general
trend of economic growth and its cyclical
nature, peaks and troughs, recessions and
expansions.
Next we will look at the causes of growth
in a simple economic modeling format.
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Last Time
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After that, we will go on to discuss two
other major macroeconomic variables
on which people and governments
focus: inflation of prices of goods and
services and employment of the people
within an economic society.
Both of these macroeconomic items are
concerns for society.
Inflation of prices erodes the buying
power of people.
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Last Time
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If prices increase by 10% in a year, for
example, and people are paid the same
wages, they will be able to buy 10% less, in
goods and services, with their money.
If people who want to work and earn a
living are unable to find employment,
they will not be able to buy anything or they
will have to dip into their savings from past
earnings, if they have any.
The person loses well-being; the society
loses production that it could have had.
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Long-term Economic
Growth
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Intro
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The cyclical swings of the business cycle are
around some sort of LT growth trend of the
economy.
LT trends vary from country to country and
can vary over longer periods of time for one
particular country or another.
LT growth trends have a significant impact
on the standard of living, the average
“buying power”, of people in a society.
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Intro
For example a growth rate of 3% in per
capita (per person) real GDP, a common
proxy for standard of living, can mean the
standard of living will double in 25
years (a generation) and will triple at 5%.
 Thus, a central concern in macro is to
understand the determinants of LT
growth and to investigate whether or not
government policies can affect it.
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RGDP/p
RGDP/p Annual
growth
Country
Period begin (1985 $) End
1890-1990
Japan
842
16144
3.00
1900-87
Brazil
436
3417
2.39
W. Germany 1870-1990
1223
14288
2.07
1870-1990
U.S.
2244
18258
1.76
1900-87
China
401
1748
1.71
1870-1990
U.K.
2693
13589
1.36
1870-1990
Australia
3143
13514
1.22
1900-87
Thailand
626
2294
1.09
1900-87
Indonesia
499
1200
1.01
1900-87
India
378
662
0.65
Bangladesh 1900-87
349
375
0.08
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The results in greater detail
Real per capita GDP is a common
international measure of incomes and
standards of living. Thus, we might ask:
 Why has Japan had the greatest growth in
per cap GDP, over a century, while India,
until recently, and Bangladesh have had
almost none?
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The results in greater detail
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Australia had the highest per cap RGDP a
century ago, but, then, it slipped behind the
U.S. and Germany by the end of the century.
Since the 1960’s, the Asian Tigers, S. Korea,
Singapore, HK, and Taiwan, have
experienced incredible growth, and China has
joined them since the 1980’s, increasing per
cap RGDP by 500% in just one generation.
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Background
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Ultimately, growth of the economy will be
determined by growth in supply and demand.
In our analysis of growth we shall examine both
sides, supply and demand, but we should always
remember that, in the end, it is the interaction of
the two that determines the quantity of output
produced and consumed, invested and saved.
In a closed system, the demand cannot outstrip the
productive capacity of the economy, and the
productive capacity will have no reason to grow
without sufficient demand.
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Determinants of Growth: the Solow model
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In lecture 5 (chapter 6), we introduced the idea of
the production function for a company. Now, we
imagine a production function for a whole
economy.
From the supply side, output growth is the result
of change over time in the factor inputs of
(productive) land, and capital, mixed with
improvements in technology, into the production
process.
In the following discussion, we shall refer to the
non-labor inputs to production as, just,
production factors.
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Determinants of Growth: the Solow model
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Then, the aggregate production function, Y, of
the country is output per worker versus the
quantity of production factors per worker,
QPF.
As shown in the next several slides, the output
per worker increases but at a decreasing rate as
diminishing marginal productivity operates on
the macro scale.
In the next slide we show the production function
and how it will change with improved production
technology.
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The Production Function and
Technological Change
Aggregate Production Function
(output/worker), fixed technology
Aggregate Production Function
(output/worker), changed technology
Y
Y
Y2
Y2
Y1
Y1
1
2
1
QPF
More input: more output
QPF
Same input + techno advance
= more output
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Graph Analysis
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In the preceding slide, we show how output per
person might vary with factor inputs for an
economy and that an improvement in
technological methods of production would move
the whole curve, upward, so that more output
could be produced per person with given factor
inputs.
We can also use such graphical displays to
analyze the differences in outputs of different
countries (economies).
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Graph Analysis
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In the next slide, we use production function
graphs to show how the outputs of 2 different
countries might turn out to be different.
The comparisons are revealing because they
adjust for size of the economies by focusing on
output per person.
The graphs examine how differences might come
from differences in the other input factors
available to workers (factor accumulation), labor
productivity differences, or both.
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Output per person differences for 2
Economies, A & B
Differences due to
Factor Accumulation
Differences due to
Labor productivity
Y
Y
Differences due
To Both
Y
YB
YA
Country A Country B
QPF
Both countries
QPF
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Country A Country B
QPF
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Graphical Implications
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In the first graph, we see that countries with the
same production technologies can have different
outputs per person (per capita real GDP) if they
have different amounts of other input factors per
person.
The second graph shows that 2 countries can
have different outputs per person, even if they
have the same amounts of other input factors per
person but one is more technologically
advanced than the other.
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Application to Growth
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Thus, we can explain, in simple terms, the
reasons that one country might experience
different growth in real per capita GDP than
another.
It might be that one country manages to
accumulate more production factors per
worker than another.
Alternatively, one country might be able to
improve its worker productivity (better
technology) more than another country.
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Application to Growth
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Most probably, both have been factors that
have accounted for differing growth of
countries.
In order to discover how countries have
managed different growth rates over time, we
must examine how countries can increase the
quantity of productive factors available per
person, or how they might improve
productivity.
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Production factor accumulation & the
Golden Rule
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Our previous discussion focused on the supply side
of the economic equation.
If we want to consider how a country might
increase its production factors, we must look at the
question of (economic) investment per person.
Then, we are really asking about the demand side
of the economic growth equation.
In that regard, a nation’s output is either consumed
or used for investment.
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Consumption, savings & investment
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The output that is not part of consumption is
the savings of the people, and their savings
can be used by firms to make investment
(forgetting about foreign savings, for
simplicity). Thus, savings is crucial for
investment.
Then, higher savings results in higher
investment results in a greater quantity of
production factors per worker and higher
levels of output per person.
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Consumption, savings & investment
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This begs the question: is there an optimal
level of per capita savings for an economy,
which would allow the community to
maximize its consumption over time?
In fact, since savings is foregone present
consumption, the motivation for savings is
to increase ones future standard of living
(recall Tin tin's savings from a previous
lecture).
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Consumption, savings & investment
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So, what is an optimal level of savings?
It is not zero because, then, factors would
actually wear out and the result would be a
decrease in factors.
Nor would it be 100% because people will want
to consume and there is no reason to invest for
only investment sake.
Finding if there is an optimal level is an
important question since government policy can
actually influence savings.
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Factor accumulation & the Golden Rule
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The so-called Golden Rule quantity of
productions factors/capita will induce an
optimal savings rate.
We shall examine the logic behind the golden
rule.
The larger the store of an economy’s production
factors, the larger will be the amount wearing
out (depreciating) in each period.
Thus, a higher level of output will be required
each period, just to cover depreciating
production factors.
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Factor accumulation & the Golden Rule
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In turn, a higher level of investment will be
required, in each period, inducing a higher level
of per capita savings.
With a higher capital stock, the economy will
also have the capability to produce more output,
so the society might also enjoy higher
consumption per capita, resulting in a higher
standard of living.
There is a logical limit to which the per cap
production factors can be raised because of
decreasing marginal productivity.
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Factor accumulation & the Golden Rule
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As a result, we can conclude that as the total
stock of factors increases, the marginal output
that can be achieved by increasing the capital
stock decreases.
Therefore, there will also be a point where the
marginal savings/capita out of the higher output
that will be required to simply replace the existing
stock of production factors will result in a
decrease in consumption/capita, leaving the
society worse off.
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Factor accumulation & the Golden Rule
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Thus, it will not be rational to increase the
savings rate beyond that point.
The point where consumption/capita cannot
be increased by increasing savings is referred
to as the Golden Rule savings rate.
Indeed, there is no reason that a country
would naturally arrive at this perfect savings
rate, and it is one place that policy might be
necessary to induce it.
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Factor accumulation & the Golden Rule
However, it might be difficult, even
policy-wise, because arrival at this golden
perfection might require raising the
savings rate, which will lower current
consumption.
 People might be averse to the current
sacrifice, even if it means that they would
be better off in the long run.
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Factor accumulation & the Golden Rule
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Moreover, it might be difficult, politically, for
a politician to try to change, by force, the
current consumption habits of the populace
since he will not want to alienate them and
lose a future election.
There are examples of such situations in
Southeast Asia of countries below the golden
rule savings rate, while Japan, in the last
century, is an example of a country that has
been above the perfect savings rate.
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Factor accumulation & the Golden Rule
 In
the latter case, not only would it be
good, in the long run, for a country
that is above the perfect rate, but an
immediate increase in consumption
would also be a benefit.
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Technological Change
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Our discussion of the golden rule
assumed that technology is constant.
In fact, as the economy moves towards
the golden rule savings rate, output per
cap will increase as savings and
investment per cap increase, and
eventually, a level of consumption per cap
would be reached beyond which the
economy could not move, and growth
would stop.
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Technological Change Plus..
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The factors of production per cap, having
increased will get to a point at which savings
per cap will just replace existing per cap stock,
and consumption per cap will become a
constant.
Fortunately, technological change can move
the production function to a new path by
affecting the other factor of production, labor,
and labor productivity will increase output
per worker given the other factors of
production per cap and will result in growth.
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Technological Change Plus..
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It is simply the shifting out of the PPF
per cap that we attributed, earlier, to
changing technology.
Models of growth, like the Solow
model, implicitly assume
technological advancement, in that
they allow that new investment in
factors can include more
technologically-advanced equipment
that replaces the old.
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Technological Change Plus..
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This technological change that increases per cap
labor productivity results in increased per cap
output, which is increased standard of living, over
time.
In addition, other things, beyond technology,
per se, can result in increased per cap output.
Although we shall group such extratechnological things under the broad heading
of techno change, they include things, like better
labor organization, better management, and
better education and training of the workforce.
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Technological Change Plus..
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The Solow model assumes that all such
technological innovation is exogenous, i.e.,
they come from without (“exo” means
outside), not within the economic system. It
is not part of the model.
That is one of the faults of the model, which
we shall patch up with a look at the
endogenous possibilities for technological
advancement.
This endogenous growth model is a more
up-to-date model of macro growth.
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The Endogenous Growth Model:
knowledge as a factor of production
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While the Solow model did not include an
internal mechanism to create technological
development to promote growth, a more
modern view is that technological
innovation is endogenous to the
economic growth, itself.
In that regard, not only does new
technology increase productivity, it also
adds to the knowledge base of the society.
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The Endogenous Growth Model:
knowledge as a factor of production
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This increased knowledge base, in turn,
might provide a framework for inventing even
more advanced technology.
For example, space technology of the 1960’s
led to the development of microprocessors to
build better mainframe computers in the
1970’s which led to development of PC’s in
the 1980’s, which has resulted in many new
technologies in production and
communications in the 1990’s.
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The Endogenous Growth Model:
knowledge as a factor of production
In light of that, it may be possible for
government to have a positive
impact in the process.
 In order to create new knowledge,
large expenditures may be required for
R&D, but it is difficult to maintain a
monopoly on knowledge once it
becomes part of the economic
process.

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The Endogenous Growth Model:
knowledge as a factor of production
Thus, governments can encourage
knowledge development through the
issue of patents to grant temporary
monopolies to the developers of
knowledge.
 Even so, there might be spillovers
from knowledge that represent
positive externalities for society but
that might be disincentives for a firm
who created the knowledge.
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The Endogenous Growth Model:
knowledge as a factor of production
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In that regard, governments might also
offer tax incentives to encourage R&D.
If we consider knowledge as a true factor
of production, its character is different
from other factors of production.
Normally, adding production factors will
increase production at a decreasing
rate, but the same is not true for the
addition of knowledge.
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The Endogenous Growth Model:
knowledge as a factor of production
The acquisition of new knowledge
might, instead of having diminishing
returns, have increasing returns.
 Thus, there might be justification for
governments to actually subsidize
development of knowledge, as in
the case of publicly funded basic
research at universities.
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The Endogenous Growth Model:
knowledge as a factor of production
Even though some of that research is
esoteric, it might have long term
benefits to the community.
 For example, the internet evolved as
a result of some university
researchers wanting to find a faster
way of communicating with one
another using their computers and
telephone lines.
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Government policy and
growth
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Overview
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Governments are concerned both about longterm economic growth and the ups and
downs of the shorter-term business cycles.
First, in the business cycle, it is a concern to
limit the severity of downturns because they
cause unemployment.
In addition, many economists believe that
there are long-term effects from downturns
because of the affects on both the capital
stock and the skills of the workforce, which
may have an affect on the long-term growth
path of the economy.
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Overview
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When machinery sits idle, it can dusty and
creaky.
When people sit idle, their skills can dull.
It is also important to not allow an
economy to overheat in the expansion
phase because that can lead to poor
investment decisions that will, eventually,
lead to wasted money or a recession.
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Overview
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Government policies should, therefore, be
pursued that will aid the economy in
achieving its proper long-term growth
trajectory: not too fast but not too slow.
Policies to affect long-term growth will be
macroeconomic and microeconomic, in
nature: targeting the whole economy, in
some cases, and specific industries that
can help growth.
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Productivity and Unemployment
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Another area in which government must
play a role in fostering development of
technology is job obsolescence and
displacement.
Technological change can result in people
being put out of their jobs (structural
unemployment), in the short-term, and
society’s concerns may cause
governments to take the wrong actions
because of political concerns.
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Productivity and Unemployment
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Consider, for example, a small island
where fishermen catch fish with spears
and the other industry is coconut, fruit and
nuts. A third industry supplies fishermen
with fishing spears.
One day, some boats with fishing nets
wash up on shore and some of the
fishermen experiment with the boats and
find that they can go out to deep water and
catch many fish with the nets.
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Productivity and Unemployment
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In the mean time, the other fishermen who
didn’t find a boat are extremely
disadvantaged and the spear industry is
also threatened.
As a result, some of the community
members go to the island elders (the
politicians) and complain of these “unfair
practices”, and the elders order the
burning of the boats and nets.
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Productivity and Unemployment
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In the end, the community is no worse
off than it was before, but it has
foregone the longer-term well-being of
the entire community because of the
short-term disruption and displacement
from beneficial technology.
A better long-sighted alternative would
have been for members of the society
to embrace the new technology and
dedicate productive resources to its
duplication.
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Productivity and Unemployment
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Spear makers and some of the
gatherers and fishermen could have
begun new businesses making nets and
small boats.
Thus, governments in modern society
may feel the same pressures, but their
response should be along the lines of
retraining and relocating the members
of the labor force who have been
displaced, rather than resisting
technological change.
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The Importance of Political Infrastructure
and Institutions
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In a recent study by Roll and Talbott
(Political and Economic Freedoms and
Prosperity, 2003), the authors found that the
real variables that have great affect on
wealth are institutional, in nature.
Many economists have asserted that growth
depends on a high investment rate, heavy
R&D expenditures and foreign trades, but
Roll and Talbott find that these are
consequences of deeper underlying policy.
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The Importance of Political Infrastructure
and Institutions
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In their study, they found that the huge
differences in GNI/capita across the world
are 80 % explained by political, structural
and institutional variables.
Property rights and black markets have
the largest influence.
Also important are civil liberties, freedom
of the press, political rights and reduction
of trade barriers.
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The Importance of Political Infrastructure
and Institutions
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In their study over the long term, they found
that there is a direct relationship between
liberalization, which results in substantial
growth, versus dictatorial retrenchment,
which has the opposite affect on growth.
Their study concludes that countries can
develop faster by enforcing strong property
rights, fostering an independent judiciary,
attacking corruption, dismantling
burdensome regulation, allowing press
freedom, and protecting political rights and
civil liberties.
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The Importance of Political Infrastructure
and Institutions
Other conclusions are that foreign aid
to less developed countries should be
tied to institutional reform.
 Then, greater economic freedoms will
quite naturally lead to an environment
that promotes investment and internal
growth, so that dependence on aid
will no longer be necessary.

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Break time
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10 minute break
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Inflation
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Inflation: meaning
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When I was a little boy, a candy bar cost 5¢.
Now the same candy bar costs more than
50¢. But the candy bar is certainly not more
valuable today than it was when I was
younger.
What has occurred is a specific example of a
general inflation in the prices of goods and
services in the economy. Prices change
although nothing else, like value, has really
changed.
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Inflation: meaning
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Although price inflation is the general trend of
the entire basket of goods and services over
time, there can also be price deflation, an
example of which is the prices of computers and
other electronic devices.
Usually, we talk of inflation rates or rates of
inflation, which means the percentage change
in prices, usually given in annualized terms.
Another term in the language of inflation
disinflation, which is a reduction in the rate of
inflation.
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Inflation: meaning
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The effect of inflation is, obviously, that the
money that you have will be able to buy less
and less.
Thus, the true effect of inflation is erosion
of both purchasing power and wealth.
In that regard, high inflation is a bad thing,
while some inflation is, basically, built into
the system:
Prices rise, so people demand higher
wages, which make prices rise, etc.
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CPI: one measure
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The most widely talked about measure of
inflation is the consumer price index
(CPI), also, called the cost of living
index.
It is an index that measures average price
of a normal “basket” of goods and
services that the average consumer buys.
Then, changes in the index over time give
the rate of consumer price inflation.
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CPI: one measure
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It is strictly for consumer prices and not
business or government.
Indeed there are other price indexes. We
have already discussed the GDP deflator,
which covers an entire economy, and there
are usually also wholesale price indexes, for
prices at the wholesale as opposed to the
retail level, like for the CPI, and producer price
indexes computed in various countries.
In the next slide we show the broad categories
of inclusion in the consumer basket.
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Makeup of CPI
Category
Percentage weight in index
Food
17.7
Alcohol & tobacco
7.4
Housing
19.7
Home furniture, supplies & services
8.1
Clothing and footwear
5.2
Transportation
15.3
Health
4.7
Recreation
10.3
Education
2.7
Communication
2.9
Other G&S
4.0
Total
100.0
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CPI discussion


As you can see from the preceding slide,
there are various items from a typical
household basket of consumption items,
given in the proportion for the “average”
household in urban areas.
Surveys are performed at a sample of
retail outlets, other businesses that supply
household G&S, and home owners and
renters.
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CPI discussion


The percentage weights are usually
kept constant in calculations of the
index from period to period, so it is
referred to as a fixed-weight price
index.
Weightings of the consumer basket do
change over time, so the weightings
are adjusted for index calculations
about every 5 years in Australia.
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CPI discussion


Indeed, things become part of the index,
while others drop out. For example,
mobile phones and computers would not
have been part of the index in the 1970’s,
while vinyl recordings of music and record
players would not be part of it today.
CPI’s are usually also available for
specific urban areas, not just the whole
country.
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CPI discussion

The indexes are also broken down into
many component indexes, like housing
prices, which are further broken down into
rental and home purchase mortgage
payments, or food, which will have meat,
then, beef, pork, lamb, etc.; vegetables;
fruit; starches, such as rice and noodles;
transportation, which will include trains
and buses as well as automobile purchase
and maintenance; etc.
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Example CPI calc: simple economy


Assume a typical family in a mythical country
purchased the following items for subsistence,
in one year, and that they will do the same,
every year: 100 packages of noodles, 300
liters of gasoline for their automobile, and 4
tunics for family members to wear.
To construct a price index, we sum up their
purchase and follow the cost of the same
purchases year after year. That will give us a
total cost.
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Example CPI calc: simple economy
We, then, choose a year as the base
year and divided all years’ total cost
by the cost in the base year.
 The result will be an index that is
equal to one in the base year (cost in
the base year/cost in the base year),
and another small number for other
years.

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Example CPI calc: simple economy



Then, we can compute year-over-year or
other-period percentage changes of the
index to find the rate of inflation of the
price of the basket of goods.
We show the sample index computation in
the next slide.
You will be expected to be able to
calculate simple CPI’s for the final exam in
this course.
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Sample CPI construction
Item
Quantity 1990 Basket
2000 Basket
purchased prices cost 1990 prices cost 2000
Packs of noodles
100
$2
$200
$3
$300
Liters of gas
300
$1
$300
$2
$600
4
$20
$80
$25
$100
Tunics
Totals
Index values
(1990 $)
$580
$1,000
580/580
=1
1000/580
= 1.7241
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Index construction details




The construction, first, finds total cost of the
consumer basket, in each year.
Next, we divide all years’ costs by the base
year, 1990, cost of $580 to create an index,
rather than the raw costs in dollars.
Then, the index will be 1 in 1990, and
$1,000/$580 = 1.7241 in 2000.
Percentage changes in the index are inflation
rates. For a year, percentage change is
computed as [CPI(this year) – CPI(last
year)]/CPI(last year) = CPI(this year)/CPI(last
year) – 1 (times 100 to convert to percentage
number).
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Index construction details



For periods of more than a year, n years, we
can find an annual rate from annual inflation
= [CPI(N)/CPI(0) – 1]1/n (the nth root).
Thus, the total percentage change over the
ten-year period was 72.41 %, or a compound
annual rate of inflation equal to [(1.7241)1/10 –
1] = 5.6%/year over the period.
CPI reports are usually monthly, and the
percentage changes are usually quoted as
year-over-year, going from, e.g., May of last
year to May of this year.
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Index construction details



We could also examine inflation of each of the
components of the basket and considering their
weightings, in order to get a better picture of
what is causing the rise in general CPI inflation.
Food prices increased by 3/2 – 1 = 50%; gas
prices, 2/1 – 1 = 100%; and clothing, 25/20 – 1
= 10%.
Indeed it is common to hear reports, these
days, of CPI inflation ex-food and energy
prices.
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Historical Australian Inflation in the CPI
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CPI shortcomings



Just as in the measurement of any
aggregate macro statistic, CPI has its
faults.
First, there is the problem of the typical
basket of goods. That is based on what
an average view of that basket will
contain, while it might not fit all
households.
In particular, retirees will have a basket
very different from a typical family: more
medical, less child-related items.
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CPI shortcomings




Second, just like in the case of GDP, it is
difficult to adjust for quality changes.
Thus, while a portion of price change might be
due to increased or decreased quality, that
might be lost in the index.
The ABS does try to make adjustments for
quality in automobiles, electronics and other
items in the basket, but complete accuracy is
a problem.
Third, fixed weighting does not take account
of the basic laws of supply and demand.
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CPI shortcomings



For example, if there is a drought, and there
is less rice available, the price will rise,
demand will fall, consumers will eat more
noodles, and the basket of consumer goods
will shift to less rice and more noodles, while
the official basket will remain the same.
Thus, CPI will not give an accurate picture
of consumer price inflation of the real
basket.
The ABS makes basket adjustments about
every 5 to 7 years.
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Consequences of inflation


Inflation can erode the standard of living,
shift income distribution and impede the
efficiency of allocation of resources.
Inflation, first, erodes the standard of living
through the reduction of purchasing
power of the money you have and earn.
The greater the rate of inflation, the greater
are prices of goods and services, and the
money that you have can, therefore, buy
less goods and services.
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Consequences of inflation


In that regard, nominal income, income
stated in current dollars, does not truly
measure your purchasing power.
In order to truly understand where you
stand, purchasing-power-wise, given the
money that you are earning, you must
convert (deflate) the nominal dollars of
your income to real income by adjusting
for inflation (division by an inflation
index). RI x PI = NI (real income times
price index equals nominal income).
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Consequences of inflation
Real income measures the amount of
G&S that you can actually purchase,
and provides a better measure of how
well off you are.
 If your nominal income does not
increase as fast as the rate of
inflation, you will not be able to buy as
many G&S as you could before. Your
purchasing power declines, and your
standard of living falls.

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Purchasing Power and real income
Suppose, for example, that you
earned $100,000, last year, and the
CPI stood at 1.00.
 Imagine that, this year, you earned
$105,000 but that the CPI has risen to
1.10.
 We compute your real income, in
each year, by dividing nominal
income by the price index.

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Purchasing Power and real income
Then last year your putative real
income was $100,000/1.00 = $100,000
last year’s fixed dollars. This year your
income is $105,000/1.10 = $95,455.
 Thus, your decrease in purchasing
power (PP) is found as the percentage
change from last year to this year:
($95,455 – $100,000)/100,000 x 100(to
make it a percentage) = – 4.54%.

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Approximation formula



We can also find an approximate formula for
breaking down increase in nominal income
(or nominal anything) into a real change
and an inflation change as follows:
Percentage change in real income = %ΔNI
NIN = (1 + %ΔPI)(1 + %ΔRI)NIN – 1
= [1 + %ΔPI + %ΔRI + %ΔRI x %ΔPI]NIN – 1
= (1 + %ΔNI)NIN – 1
So, we can approximate as = %ΔNI = %ΔRI
+ %ΔPI, since the product of the two
percentages will be a small number (e.g., 5%
x 5% = 0.25%)
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Inflation and Wealth



If income is one measure of well-being,
wealth is another.
While income is the flow of money earned
from selling factors of production (i.e., the
sweat of your brow), wealth is the value of
the stock of assets owned at some point in
time.
Wealth includes such things real estate,
stocks & bonds, bank accounts, art, cash,
cars, and other valuable things.
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Inflation and Wealth



Wealth, in some cases, offers a hedge
against inflation since the nominal value of
some assets may increase at rates that
exceed the rate of inflation.
Indeed, that is one reason why people
purchase such things.
On the other hand, there is an implicit
penalty from inflation for those who have
little or no accumulated wealth since such
people must rely on nominal income.
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Inflation and interest rates




Borrowers and savers will also feel the impact
of inflation, as inflation is part of the nominal
rate of interest.
Just like in the case of income and GDP, there
are nominal and real interest rates.
Formally, the nominal interest rate, I, is related
to the real interest rate, R, and the inflation
rate, INF, by the formula, 1 + I = (1+R)(1+INF).
Again, the approximation formula is: I ≈ R+INF.
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Inflation and interest rates



Thus, borrowers and savers might be winners or
losers, depending on how inflation works out
afterwards. Real rates can be positive or negative.
If inflation is 5%, for example, and a certificate of
deposit earns 7% per year, real interest is about 2%,
and purchasing power of the money invested in this
financial asset increases during the investment time.
If you borrow money at 5% and it turns out that
inflation, during the time to maturity of the loan,
increases to an annual rate of 7%, you will again
receive a benefit, as the money that you use to pay
for the loan is worth more than your cost of
borrowing.
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Inflation, investment & business decisions



Investment and business decisions should be
based on the relative real rates of return from
investing economic resources in alternative
activities.
When inflation rates are relatively stable,
business can forecast future price changes
with a fair amount of certainty and form a
good idea of real rates of return from
alternative investments.
When inflation rates are high, they also tend
to be less stable, and it becomes difficult for
business agents to forecast returns.
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Inflation, investment & business decisions
That leads, ultimately, to some
inappropriate decisions, which result
in inefficient allocation of resources.
 Moreover, the interaction of taxes and
inflation can also lead to investment
that, while not the most beneficial for
the community, will be favored
because of after-tax considerations.

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Inflation, investment & business decisions
For example, in the early 1970’s, in
Australia, housing prices were
increasing rapidly. Interest on
mortgage loans for rental properties is
a tax-deductible expense, and
nominal capital gains on sale of such
properties was non-taxable.
 The result was overinvestment in
rental properties at the expense of
investment in PP&E for production.

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Demand-pull Inflation



Since price is determined by the interaction
of supply and demand, there are two sides
to inflation.
We shall use the cause-and-effect
relationships, total spending, and the
business cycle, from the preceding lecture
(chapter 12), for our analysis of these topics.
Demand-pull inflation, too much money
chasing too few goods, result from an
excess of total spending (demand).
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Demand-pull Inflation



When demand is high and it is difficult to satisfy,
the typical response is for sellers to raise their
prices.
If this excess demand is widespread across the
spectrum of goods and services in the economy,
the general level of prices will be pulled up by
the excess demand.
Demand-pull inflation occurs when the economy
is operating near its full capacity. Thus capacity
is near the limit and aggregate demand is also
very high.
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Demand-pull Inflation



In the long run, if demand remained at this
high level, producers would respond by
expanding output, but they cannot do so in
the short-run.
In the short run, prices will be bid up as
demanders try to get goods in short
supply.
Indeed, prices may grow at a slower pace
or even fall once the short-term pressure
of demand subsides.
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Demand-pull Inflation
To get the full picture, remember that
aggregate spending is composed of
C, I, G and X – M.
 Thus, even foreigners can contribute
to the demand-pull affect by bidding
up prices of exports, thus putting
more money in the hands of domestic
people, which will feed through to
domestic spending and demand.

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Cost-push Inflation



When OPEC increased the price of oil,
dramatically, in the 1970’s, production costs,
across the board, also rose and resulted in
cost-push inflation (happening again now).
Cost-push inflation does not have to arise
from such an unusual event as the one
above. Any rise in the prices that suppliers
must pay can be the cause.
That could be the price of labor, raw
materials, construction, equipment, or the
cost of borrowing.
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Expectations and Inflation
 Expectations
can play a role in
either cost-push or demand pull
inflation.
 If consumers expect the price of
homes to rise, they may begin to
get nervous and start bidding up
the prices of housing to hedge
against future expectations.
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Expectations and Inflation
If producers expect prices of inputs to
production or even the cost of funds
to increase in the near future, they
may very well begin to raise prices in
anticipation of expected higher costs,
and cost-push inflation will result.
 In the next module we shall use a
model of aggregate supply and
demand to further investigate both
sides of inflation.

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Inflation around the world




Inflation rates are different at different times
for one country and are different at the same
time for different countries (see page 369).
In 2003, for example, from among a small
sample of countries, Brazil had double-digit
inflation of around 15% per year.
Indonesia’s inflation rate was above 6%,
while the US, India, France, Greece,
Malaysia, Australia, S. Korea, and NZ had
rates between 1 and 4%.
Taiwan actually experienced deflation in that
year.
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Hyper-inflation



In the 20th century, various countries at
various times have experienced
hyperinflation, which is loosely defined as
an inflation rate of 1000% annual: prices
rise 10-fold in a year, e.g., fro $1 to $10 (=$1
x 1000%).
When this happens, people develop an
inflation mentality where they spend as soon
as they get money and buy things in advance
to avoid higher costs.
Also, debtor-lender contracts become
jeopardized as variable rate borrowers are hit
with unexpectedly high payments.
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Hyper-inflation



Third, a wage-price spiral is set in motion.
Increased wages causes increased prices,
which need to be offset with increased wages,
etc.
Fourth, people begin to invest in more
speculative and less productive ventures in
order to try to beat inflation.
Hyperinflation can be set off by a government
overproducing paper money to try to pay its
own expenditures. Effectively, the excess
money devalues the value of money in private
hands and private property, acting as a de
facto tax.
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Unemployment
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Unemployment defined




In Australia, each month, the ABS conducts a
survey of employment from a random sample
of HH’s.
Family members 15 years of age and older who
work at least 1 hour per week for pay or 15
hours per week in a family business are said to
be employed.
If a person is not employed but has looked for
work in the past month, they are counted as
unemployed.
Unemployment rate is the % of people in the
labor force who are not employed but are
actively seeking employment.
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The labor force and its unemployed




Babies, disabled people, students and
retirees are not counted as unemployed.
The civilian labor force is, then, all people,
excluding students, between 15 and 65 who
are employed or unemployed, excluding
people in the military or in institutions, such as
prisons or mental hospitals.
The civilian unemployment rate (the
unemployment rate) is the ratio of
unemployed to the total civilian labor force.
Unemployment is a hot political issue.
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Unemployment rate shortcomings



First, unemployed people might report that
they are seeking employment, even
though they are not. They do that
because unemployment benefits depend
on a person actively trying to get a job.
Others may report that they are
unemployed although they have a job in
an illegal activity or are illegally employed.
In those cases, the unemployment rate is
overstated.
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Unemployment rate shortcomings



The unemployment rate might also
understate unemployment because of
discouraged persons, who are people
who want to work but have given up the
job search because after repeated
rejection they believe that they cannot find
a job.
The ABS counts a discouraged person as
anyone who has looked for a job in the last
6 months but has given up.
The ABS counts discouraged persons as
not in labor force.
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Unemployment rate shortcomings



The problem of their exclusion exacerbates
the underestimation of unemployment
during economic downturns because more
people become discouraged.
Unemployment may also be understated
because the ABS lumps part-time and full
time workers as employed, even though
some part-time workers might want to work
full time but cannot find a full-time job.
Then, those workers are at least
underemployed. And that figure rises during
recessions.
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Seasonal unemployment




The reason that the graph in an earlier slide
showed much variation on the short-term
scale was because of seasonal patterns of
employment.
Many industries are tied to the seasons, like
farm work.
Other seasonal industries are work at ski or
summer resorts and some types of
construction.
Employment also increases at Christmas
time in the wholesale and retail sectors.
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Frictional unemployment




Sometimes the unemployment of a person is
only temporary.
People lose their jobs or quit to look for new
ones. Students leave school and look for a first
job. Some construction workers are out of jobs
between projects.
Because jobs are available requiring their skills,
but jobs and people need to find each other, the
people are said to be between jobs.
Because of its temporary nature this type of
unemployment is referred to as fictional
unemployment.
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Frictional unemployment




It is not of great concern to policy makers or
social welfare because it is just due to normal
job search time or finding information about
jobs.
Thus, this type of unemployment is
sometimes called search unemployment or
transitional unemployment.
Frictional unemployment is part of normal
economic life due to freedom of choice.
It can vary, and it can be lessened with
better information distribution about jobs.
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Structural Unemployment




Unlike frictional and seasonal
unemployment, structural
unemployment is longer term.
It results, basically, from a mismatch of
workers skills with jobs in the economy.
Structurally unemployed require
education or training to acquire the skills
needed in the job market.
Changes in the structure of the economy
over time due to changes in demand,
tastes or production processes, results in
3 basic types of structural
unemployment.
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Structural Unemployment
1.
2.
The first is lack of skills. This is true for
teenagers and minorities but also for others.
For example, if green groups persuade the
government to allow less tree cutting, there will
be less jobs in the timber industry and people
will need to be retrained for other jobs.
The consumer may change their demand
patterns. For example, if people begin to
prefer imported cars, there will be people out of
work in the domestic auto industry, and they
will need to retrain for jobs in other industries.
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Structural Unemployment
3.

Technological changes may leave less
jobs or jobs that need new skills, and it
might be particular to a region of the
country, too. For example, to compete with
cheap imports, the textile industry might
buy new machinery and leave less jobs in
the area. People might be reluctant to
move to a new place and become
structurally unemployed.
Structural employment is part of modern
economic life, as technology advances,
products change and competition comes
from imported goods. Good retraining
programs are the key to fighting it.
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Structural Unemployment


An argument against minimum wages
has been that it creates structural
unemployment. This happens when the
minimum wage is above the productivity
of unskilled workers, and rather than
hiring them, business fills it other ways.
One approach to fixing the problem is to
allow a sub-minimum wage during a trial
and training period. Another approach is
to give employers incentives to hire longterm unemployed. Another is to use an
alternative means of supplementing low
wages with welfare payments or tax
breaks.
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Cyclical Unemployment




Cyclical unemployment occurs because of
the lack of production during economic
downturns, resulting in unemployment.
In the great depression of the 1930’s it
peaked at around 25% and took a long time
to come back down.
In more modern times there have been some
severe recession that have also caused
joblessness to peak above 10% and took
many years to come back down.
A focus of macro policy is to moderate
cyclical unemployment.
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The goal of full employment




Because of structural and frictional
unemployment, ever present in the system,
full employment does not mean that there
is zero unemployment.
Full employment is the state in which
unemployment equals, exactly, seasonal,
frictional, and structural unemployment.
Full employment is, thus, equal, to the state
in which there is no cyclical unemployment.
It is difficult to actually come up with a proper
figure for it.
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The goal of full employment


Full employment unemployment is
sometimes referred to as natural
unemployment or non-accelerating
inflation rate unemployment (NAIRU), and
it will change over time with changes in the
economic framework.
In Australia, it was around 2% in the
1960’s, 4% in the 1970’s, 6-7% in the
1980’s& 90’s, and around 4% in the new
century.
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The goal of full employment




One reason for the change is attributed to more
women entering the labor force over the
period.
Typically, women have a higher unemployment
rate than men.
Another explanation has been the interaction of
tax and welfare, making unemployment less
painful.
The final piece of the puzzle is called
hysteresis, which we discuss in more detail, in
the next slide.
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Hysteresis


Hysteresis is a concept from physics
whereby, if you rub a pin, for example,
with a magnet, the pin will become
magnetized, so retaining a memory of
what happened to it.
In economics the concept is loosely
applied to unemployment as follows.
Please note that our wording is slightly
different from that in the book, which is
incorrectly worded.
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Hysteresis
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Hysteresis: The full employment rate of
unemployment increases as the actual
unemployment rate increases. The full
employment rate of unemployment does not
necessarily decrease or even stay the same
as the actual unemployment rate decreases.
What that means is that the full employment
rate of unemployment is not necessarily
stable but depends on where the actual
rate of unemployment has been.
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Hysteresis
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The important point is that short run
disturbances of the macro economy might
have long run affects on some macro
variables, like unemployment. (ref: Layton
personal communiqué)
One explanation for hysteresis is that as
people become unemployed during
recession, they sit around and their skills
dull, and it becomes hard to get a job
when things pick up.
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Hysteresis
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Thus, after unemployment increased due
to a downturn, the full employment rate of
unemployment increased.
Another explanation is the
insider/outsider problem.
After a downturn, as employment picks
up, insiders bid up wages to a point where
it is too expensive to hire outsiders with no
experience.
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Hysteresis
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Thus, after the economy picks up,
unemployment begins to decrease but
insiders bid up wages making costs for
firms higher allowing them to spend less
for new people. Thus, more people are
employed, bringing down unemployment,
but some are still out of jobs.
As a result, the natural rate of
unemployment might actually increase,
even though actual current unemployment
is decreasing.
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Non-monetary and demographic
consequences of unemployment.
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Unemployment leads to more than just
loss of potential economic output.
People who are out of work loses their
sense of self-worth, and the results are:
family problems and break-ups, suicide,
mental illness, crime, political unrest, and
health problems.
Unemployment is different for different
demographic groups. Teenagers with
little experience and high quit rates and
people over 55 show the highest levels of
unemployment.
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Non-monetary and demographic
consequences of unemployment.
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For people who are unemployed we also
define a time of being out of work.
Those who have been out of work for
more than a year are referred to as longterm unemployed, and they face great
difficulty getting new jobs just because they
have been out of jobs for so long and
employers, then, wonder why, and the
unemployed lack self-confidence that they
can get a job.
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Ask yourself
1.
2.
3.
4.
What factors could increase/decrease
seasonal, structural, and frictional
unemployment?
Which measure of inflation do you think
better reflects price rises in an economy?
Which measure do you think people care
more about?
What is hysteresis and what might cause it?
In terms of the production function, why can
one country have higher output per person
than another?
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Ask yourself
Peter is trying to decide whether or not he should lend
$1,000 to Ellen for one year at a fixed nominal interest rate
of 8 percent. Peter expects the inflation rate to be 4 percent
for the year. If he does not lend the $1,000 to Ellen, Peter
will purchase a bond that pays an interest rate of 4 percent,
or he will put the money in a savings account earning 6
percent. Peter
a) will earn 4 percent in real terms if he loans Ellen the money,
0 percent in real terms if he buys the bond, and 6 percent in
real terms if he puts the money into a savings account
b) is better off holding his money as cash
c) is indifferent between lending the money to Ellen and buying
the bond because the real interest rate is the same in either
case
d) should purchase the bond because it earns the highest real
rate of interest
e) earns the highest real rate of interest if he puts his $1,000
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Ask yourself
6.
7.
8.
9.
John lost his job when the gold mine in the outback
closed. He wants a job, but he has given up
looking for one until the economy improves. Define
his status in the labor force.
What do women have to do with the increase in
NAIRU in developed nations over the last several
decades?
Technology is responsible for improved economic
growth over the last decade. Is it also responsible
for higher unemployment?
Do you think that enacting a minimum wage law
would increase or decrease unemployment?
Explain your reasoning. Who (what group) do you
think that a minimum wage would affect most, and
how would it affect them?
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Assignment
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After this module, you will have the basics to
answer the assignment questions.
However, please note that the assignment
also requires you to use 5 references.
Those should not be things like definitions
from Wikipedia, they should be real
references about the topics of the four
questions.
Read the specific details in the intro book, the
USQ forum discussions, and the email advise
that I have sent.
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Homework
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
Chapter 12, the rest of the problems
Chapter 13, all problems.
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END
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