Download Chapters 12 and 13 Economic Indicators

Chapters 12, 13, and 16
Economic Stability
KEY IDEAS YOU NEED TO KNOW:
List what indicators do economists use to measure the health of the economy.
Describe the characteristics of a peak, recession, trough, and expansion in the business cycle.
Explain how the government tries to stabilize the economy.
Describe the advantages and disadvantages of fiscal and monetary policies.
The primary goals of government economic policy are to ensure stable prices, full
employment, and economic growth. Most economies are subject to business cycles,
which are characterized by fluctuations in the level of economic activity. These business
cycles have occurred in the past and they will persist. They can be caused by changes in
economic conditions, international events, political decisions, war, and changes in
technology. Governments try to minimize these fluctuations by intervening before high
unemployment or inflation endangers the economy. Information that can provide early
detection of changes in the economy allows elected and appointed policymakers to take
action.
This information is gathered and analyzed by economists, business managers, and
government officials who study unemployment rates, price levels, stock market trends,
interest rates, and many other statistics to measure activity in the economy as a whole.
They rely on these economic indicators to tell them where the economy has been and
where it seems to be heading. Although they know that economics is not a precise
science, observers of the economy use these indicators to help them make better decisions
and more accurate predictions about the future.
There are three classifications of economic indicators. Leading economic
indicators show early signs of recessions and expansions based on their movement. For
this reason, they are of special interest to economists. Examples, of these are “average
weekly hours” which measures the length of the workweek in private, non-agricultural
industries stock prices, real money supply, average weekly initial claims for
unemployment insurance (inverted), index of consumer expectations, manufacturers’ new
orders for non-defense capital goods, and manufacturers’ new orders for consumer goods
and materials. An upward movement of this indicator (more hours worked) will mean
greater income for employees, as well as more goods produced. These two factors would
contribute to an economic expansion. Coincidence indicators reflect the current pace of
the economy. Examples would be: employees on nonagricultural payrolls, industrial
production, and personal income less transfer payments, and manufacturing and trade
sales. Lagging indicators shift direction after the economy changes. Examples would
be: average prime rate charged by banks, change in CPI for services, ratio of
manufacturing and trade inventories to sales, and ratio of consumer installment credit to
personal income.
Gross Domestic Product (GDP)
The GDP is the total market value of all final goods and services the economy
produces in a single year. The GDP reveals much about the nation’s economic health. If
the U.S. GDP increases, Americans are producing more goods and services. If the GDP
decreases, they are producing less. Economists as well as government officials, news
reporters, and business decision-makers pay attention to the GDP. And because the GDP
is mentioned so frequently in the news, we need to review exactly what it includes and
what it omits.
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 The GDP includes only final goods. To avoid overstating the GDP
by counting the same item two or more times, only final goods are
included. Let’s suppose a bicycle manufacturer pays $300 for the parts
and labor used in making a mountain bike. The manufacturer sells the
bike to a bicycle shop for $400. The bike store sells the bike for $750.
How much of the production of a single mountain bike add to the GDP?
Since only the final goods are counted, the answer is $750. The $300 paid
to the parts suppliers and the $400 paid to the manufacturer was not added
to the final count because the $750 included these costs.

 The GDP includes production only within our borders. The GDP
does not include goods and services produced overseas, even by
companies owned by U.S. citizens or firms. Products produced in the
United States by foreign firms are counted.

 Inflation can distort the significance of growth in the GDP. When
prices are rising, as occurs during periods of inflation, the GDP may
increase even though the production of goods is unchanged. This is
because GDP is measured in terms of current prices.

 Population changes. The GDP is like a huge pie that contains
everything produced in a year. The portion of that pie available to every
American depends on the size of the GDP and the population that intends
to consume that pie. If the pie (GDP) were to grow by 5%, and consumers
were to increase by 10%, the amount of pie available to each person would
decrease, if it were equally shared.

 Quality changes. Suppose you paid $500 for a bicycle last year, and
the price of a similar bike was $500 again this year. One might assume
the price is unchanged. However, the manufacturer may have lowered the
bike’s quality. The GDP doe not always show these changes in quality
because only the price is taken into account. The opposite can be true too,
especially with products using technology. A computer you buy today for
$2,000 may have more power and be of higher quality than a computer
purchased last year for $2,500.

 Used goods are not included in the GDP. If you sold your old bike
for $250, how much was added to the GDP? Zero. Only new goods are
counted; used goods add nothing to the nation’s wealth.
Unemployment
During the middle of any month, specialists from the Bureau of the Census survey over
50,000 households all over the country taking count of the number of unemployed. After
the Census workers collect their data, they turn it over to the Bureau of Labor Statistics
for analysis and publication. Unemployment also is expressed in the terms of the
unemployment rate, the number of unemployed the civilian labor force.
Types of Unemployment
Partially from the data collected by the Bureau of the Census, economists have identified
several different kinds of unemployment. One kind is frictional unemployment, which
accounts for workers who are "between" jobs. If these workers do not work for one week
between jobs, they can be classified as unemployed.
A second type of unemployment is structural unemployment, which occurs when a
fundamental change in the operations of the economy reduces the demand for workers
and their skills. Sometimes consumer tastes change and certain goods and services are no
longer required. Also, industries may change the way they operate. During the 1990-1991
recession, a series of mergers and cost reductions trimmed the white-collar labor forces in
the banking and computer industries. Sometimes the government contributes to structural
unemployment when it changes the way it does business. An example would be the
closing of a military base.
A third kind of unemployment is cyclical unemployment, which is directly related to
swings in the business cycle. During a recession many people put off buying certain
durable goods resulting in durable goods industries laying off workers until the economy
recovers.
A fourth kind of unemployment is seasonal unemployment, which results from changes
in the weather of changes in the demand for certain products. Construction is one of those
industries affected, where carpenters and builders have less work during the winter than
in the summer. Other workers for retail stores are in demand during the holiday season.
A fifth kind of unemployment is technological unemployment, which is caused when
workers with less skills, talent, or education are replaced by machines that do their jobs.
This process is often referred to as automation.
Full Employment
Contrary to popular belief, full unemployment does not mean zero unemployment, it
instead means the lowest possible unemployment rate with the economy growing and all
factors of production being used as efficiently as possible. There has been no percentage
that has been classified as the lowest unemployment rate because over time the rate of
unemployment has fluctuated from 4% to 6% to 9% and then down to 5.1%. If I
remember correctly, today our economy has a 3% unemployment rate- one of the best
ever. However, economists believe that full employment is reached when the
unemployment rate drops below 5%.
Consumer Price Index
The consumer price index (CPI) is the most commonly used measure of price changes
over a period of time. The CPI is reported monthly, and it attempts to measure price
changes in approximately 400 goods and services
Policy makers use the CPI and other indicators of price change to measure the rate of
inflation. Inflation indicates a rise in the general level of prices, which results in the
decreased purchasing power of the dollar. If inflation appears to be rising too rapidly, the
government may seek to use monetary or fiscal policy to slow the economy.
The CPI is based on a “market basket” of goods and services purchased by typical urban
consumers between 1982-84. This includes food and beverages, housing (including
utilities and repair), clothing, transportation, medical and personal care, entertainment,
education, and tobacco products. The consumer prices in 1982-84 make up a “base
year” and the index was set to 100. As prices increased in subsequence years, the index
rose. At the end of 1999, the consumer price index was at 168.3, indicating that prices
had risen 68.3% since the base period.
The CPI is an accurate measurement of the change in prices, but not necessarily a good
estimate of changes in the cost of living. One reason is that the CPI does not account for
changes in consumer buying habits. Since the base year of 1982-84, consumers are
obviously purchasing different kinds and quantities of products. Examples of these
changes in purchasing patterns are computer games and video rentals.
The CPI also fails to account for improvements in product quality. Safety and new
electronic features in automobiles increase the cost, but they also make the product more
useful and valuable than in the past.
The chart below shows the U.S. economy in the 20th century. Although it may not look
much like a picture, it shows a pattern of ups and downs. This pattern often is referred to
as the business cycle. But unlike most cycles, the business cycle is very irregular, and it
is better to think of the ups and downs as economic fluctuations.
As you can see by even a cursory examination of the graph there have been periods of
great productivity as well as growth. In general you can note that we have had our ups
and downs. I am sure what jumps out at you is the Great Depression. This chart really
shows how low productivity really was and how little spending was going on. Of course
huge government spending on World War II that essentially got us out of the Depression
followed this.
Further examination notes that almost every time there is a war our economy's
productivity and spending go up to correspond to the wartime spending. You can also
note typical post war declines.
You should also pay attention to the longest period of continued economic growth and
prosperity. The interpretation that can be drawn is that either WWII or Vietnam was the
longest sustained growth and that was buoyed by wartime spending. Either way the
longest period would be 2 to 4 years tops. Now figure this, since 1992, the end of the
graph, our production has risen every year. That puts us smack in the middle of the
longest period of sustained economic growth in our nations history.
THE PHASES OF THE BUSINESS CYCLE
Economists have certain ways of labeling the business cycle. The business cycle may be
defined as the changes that occur to the real GDP because of alternating periods of
expansion and contraction. The phases are:
1. Recession. It is defined as a decline in the real GDP that occurs for at least two or
more quarters. Recessions feed on themselves. During a recession, business people spend
less than they once did. Because sales are failing, businesses do what they can to reduce
their spending. They lay off workers, buy less merchandise, and postpone plans to
expand. When this happens, business suppliers do what they can to protect themselves.
They too lay off workers and reduce spending.
As workers earn less, they spend less, and business income and profits decline still more.
Businesses spend even less than before and lay off still more workers. The economy
continues to slide.
2. Troughs, or Depression. State of the economy where there are large unemployment
rates, a decline in annual income, and overproduction. It is the time at which the real
GDP stops its decline and starts expanding; the lowest point. Sooner or later, the
recession will reach the bottom of the business cycle. How long the cycle will remain at
this low point varies from a matter of weeks to many months. During some depressions,
such as the one in the 1930s, the low point has lasted for years.
3. Expansions and Recovery. A period in which the real GDP grows; recovery from a
recession. When business begins to improve a bit, firms will hire a few more workers and
increase their orders of materials from their suppliers. Increased orders lead other firms to
increase production and rehire workers. More employment leads to more consumer
spending, further business activity, and still more jobs. Economists describe this upturn in
the business cycle as a period of expansion and recovery.
4. Peak. The point at which the real GDP stops increasing and begins its decline; the
highest point. At the top, or peak, of the business cycle, business expansion ends its
upward climb. Employment, consumer spending, and production hit their highest levels.
A peak, like a depression, can last for a short or long period of time. When the peak lasts
for a long time, we are in a period of prosperity.
One of the dangers of peak periods is that of inflation. During periods of inflation, prices
rise and the value of money declines. Inflation is more of a threat during peak periods
because employment and earnings are at high levels. With more money in their pockets,
people are willing to spend more than before. In this way, demand is increased and prices
rise.
Graphically the phases would look like so
HOW DO ECONOMISTS KEEP TRACK OF THE BUSINESS CYCLE?
For many years, economists have tried to understand why there are ups and downs in that
nation's economy. They want to learn what can be done to prevent recessions and
maintain prosperity. Therefore, they ask the following questions: (1) In what phase of the
business cycle is our economy at the present time? (2) Where is the business cycle
heading?
To date, economists believe that there are five causes of the business cycle.
The first cause is changes in capital expenditures. When the economy is strong,
businesses have expectations of sales growth; they invest heavily in capital goods. After a
while, businesses may decide that they have expanded to their limit, so they begin to pull
back on their capital investments and cause an eventual recession.
The second cause of the business cycle is inventory adjustments. At the first sign of an
economy reaching its peak, there are some businesses that cut back their inventories and
then build them back up again at the first sign of a trough. Either action causes the real
GDP to fluctuate.
Innovation and imitation are the third causes of the business cycle. Innovations include
new products, new inventions, or a new way of performing a task. When a business
innovates, it often gains an edge on its competitors because its costs decrease or its sales
increase. Whatever the case, profits increase and the business grows. If other business in
the same industry wants to keep up, they then copy what the innovator has done
(imitation) or they come up with something better. Imitation companies usually invest
heavily and an investment boom follows. Once the innovation spreads to another
industry, the situation changes. Further investments are unnecessary and economic
activity may slow.
The fourth cause of the business cycle is the credit and loan policies of commercial
banking. When "easy money" policies are in effect, interest rates are low and loans are
easy to get. They encourage the private sector to borrow and invest, thus stimulating the
economy. Eventually the increased demand for loans causes the interest rates to rise,
which discourage new borrowers. As borrowing and spending slow down, the level of
economic activity declines. The economy keeps declining until interest rates fall and the
business cycle begins over again.
The fifth and final cause of the business cycle is external shocks. Shocks such as
increases in oil prices, wars, and international conflict, have the potential to either drive
the economy up, or drive it down. The economy may benefit when a new supply of
natural resources is discovered. Such was the case with Great Britain in the 1970's when
an oil field was discovered off its coast in the North Sea. The British economy of course
profited seeing that world oil prices were at an all time high, but the high prices hurt the
United States at the same time.
Efforts to stabilize the economy
Despite the patterns of peak, recession, trough, and expansion the main story of economic
history has been growth. This has been especially true in the United States since World
War II. Government efforts to stabilize the economy date back to the Great Depression,
but it was not until the end of World war II that the federal government’s responsibility
for the nation’s economic performance was made a matter of law. As stated in the
Employment Act of 1946, “It is the continuing policy and responsibility of the federal
government…to promote maximum employment, production, and purchasing power.”
To achieve the goals of full employment, stable prices, and economic growth, the
government relies on two sets of strategies: fiscal policy and monetary policy.
Monetary and Fiscal Policy
In the past, when America embraced a philosophy of Laissez Faire, the government did
little to monitor and control the economy. After the depression, however, that philosophy
changed radically. Today we all have come to understand that one of the federal
governments most important roles is regulating and ensuring the stability of the economy.
The government has two major ways of doing this. The government can enact fiscal
policy changes or they can enact monetary policy changes.
Fiscal Policy - The power of the federal government to tax and spend in order to achieve
its goals for the economy.
Monetary Policy - Programs that try to increase or decrease the nations level of business
by regulating the supply of money and credit.
What both of these policy options have as a goal is increasing or decreasing the level of
business activity. It is most always preferable to have a productive growing economy but
an economy can also be too productive. In that case the government may enact policies to
slow down the economy.
Inflation
Inflation is a rise in the general price level and is reported in rates of change. Essentially
what this means is that the value of your money is going down and it takes more money
to buy things. Therefore a 4% inflation rate means that the price level for that given year
has risen 4% from a certain measuring year (currently 1982 is used). The inflation rate is
determined by finding the difference between price levels for the current year and
previous given year. The answer is then divided by the given year and then multiplied by
100. To measure the price level, economists select a variety of goods and construct a
price index such as the consumer price index (CPI). By using the CPI, which measures
the price changes, the inflation rate can be calculated. This is done by dividing the
CPI by the beginning price level and then multiplying the result by 100.
Causes of Inflation
There are several reasons as to why an economy can experience inflation. One
explanation is the demand-pull theory, which states that all sectors in the economy try to
buy more than the economy can produce. Shortages are then created and merchants lose
business. To compensate, some merchants raise their prices. Others don't offer discounts
or sales. In the end, the price level rises.
A second explanation involves the deficit of the federal government. If the Federal
Reserve System expands the money supply to keep the interest rate down, the federal
deficit can contribute to inflation. If the debt is not monetized, some borrowers will be
crowded out if interest rates rise. This results in the federal deficit having more of an
impact on output and employment than on the price level.
A third reason involves the cost-push theory which states that labor groups cause
inflation. If a strong union wins a large wage contract, it forces producers to raise their
prices in order to compensate for the increase in salaries they have to pay. The fourth
explanation is the wage-price spiral, which states that no single group is to blame for
inflation. Higher prices force workers to ask for higher wages. If they get their way, then
producers try to recover with higher prices. Basically, if either side tries to increase its
position with a larger price hike, the rate of inflation continues to rise.
Finally, another reason for inflation is excessive monetary growth. When any extra
money is created, it will increase some group's buying power. When this money is spent,
it will cause a demand-pull effect that drives up prices. For inflation to continue, the
money supply must grow faster than the real GDP.
Effects of Inflation
The most immediate effects of inflation are the decreased purchasing power of the dollar
and its depreciation. Depreciation is especially hard on retired people with fixed incomes
because their money buys a little less each month. Those not on fixed incomes are more
able to cope because they can simply increase their fees. A second destabilizing effect is
that inflation can cause consumers and investors to changer their speeding habits. When
inflation occurs, people tend to spend less meaning that factories have to lay off workers
because of a decline in orders. A third destabilizing effect of inflation is that some people
choose to speculate heavily in an attempt to take advantage of the higher price level.
Because some of the purchases are high-risk investments, spending is diverted from the
normal channels and some structural unemployment may take place. Finally, inflation
alters the distribution of income. Lenders are generally hurt more than borrowers during
long inflationary periods, which means that loans made earlier are repaid later in inflated
dollars.
Fiscal Policy Actions
Taxes
Fiscal Policies include raising or lowering of taxes. If we raise taxes we are taking money
out of circulation. When one considers the impact of taxes one must look at the sector of
society being impacted by the tax hike. Does it impact on the middle class, working class
or upper class? There are differing philosophies on who should shoulder the tax burden.
Some feel it should be the wealthy while others look to the middle class. The reality is
that the middle class pay the largest amount of taxes overall. Raising taxes to the middle
class will limit consumer spending so if you are going to do that you had better have a
good reason. Clearly raising taxes will slow down spending, economic growth as well as
inflation.
The question then comes to tax cuts. You must again ask the same questions. Who do you
want to cut taxes too? Who do you want to encourage to spend? Again, recent economic
history proves that cutting taxes to the middle class is the only effective way to encourage
growth and spending.
Spending Programs
The grand daddy of all fiscal policy-spending programs was FDR's new deal. Knowledge
of the New Deal is essential to understand the importance of government spending, as
well as its shortfalls. As any student of American History knows, the New Deal did not
end the Depression, W.W.II did. It did, however, help to move the economy along and
did help millions of people. Spending programs pump money into an economy and
increase spending and growth. They also have the potential impact of increasing inflation
as more money circulates in the economy.
Again, when determining what spending programs to initiate depends on where you want
the impact to be. If you build highways you will create jobs for the working class, same
with housing projects, etc. These types of jobs employ many workers. If you build B2
bombers, however, fewer workers are employed at a much higher cost. Who gets the
money here? The large corporation that builds it does, that's who. So you see, how you
spend the money means as much as how much money you spend.
Spending cuts have the same impact. If you cut homeless shelter there are people out on
the streets. From en economic impact perspective that may not seem like much but now
you have a human-interest issue. If you close military bases you may well shut down the
town that thrives off of the existence of the base. Some bases employ up to an over
20,000 townspeople with no other viable means of support. You have to consider the
impact and the location of the base. When the federal government cut funding for the F14 Tomcat Fighter built by Grumman on Long Island it had a terrible impact on the Long
Island economy as those highly technical workers sought to find jobs. Since Long Island
is a wealthy suburb of New York City, however, those workers were more likely to find
work then if the factory had been located in a more rural area.
Monetary Policy
The Federal Reserve Board of Governors who runs the Federal Reserve System enacts
monetary policies. The Fed has several policies they can take through the Board of
Governors and the Open Market Committee. Most often the Chairman of the Federal
Reserve Board leads them in their actions, a post currently held by Alan Greenspan. The
powers of monetary policy often have immediate and forceful impact so what it does is
closely watched. Every word that comes out of Greenspan's mouth is seen as a sign for
what he thinks of the economy. Entire businesses exist just to watch the fed and Mr.
Greenspan. I wouldn't be surprised is some economists and investors consulted psychics
to try to gain an advantage.
The Fed's basic monetary policy tools are:




Reserve Requirements
Discount Rate
Open Market Operations
Printing Money
Each policy has one basic goal, impact the money supply. All of these policy actions
work using the laws of supply and demand. The more money in circulation, the more
spending there is and the higher inflation is. The less money there is in circulation, the
less spending there is, inflation decreases. Those policies that restrict the money supply
are known as "tight" and those that put more money into circulation are known as
"loose." Lets examine each of the policy actions and their possible results.
Change in Reserve Requirements
The Federal Reserve System has the power to set an amount, or percentage, of deposits
that its member banks must keep in reserve at the Fed. If the fed raises its reserve
requirements then banks have less money on hand and thus have less to lend. This lowers
the amount of money in circulation and could have the impact of slowing the economy
and inflation. Conversely if the fed lowers the reserve requirement, banks have more
money on hand, more to lend and more money goes into circulation, thus increasing
spending and possibly inflation.
Changing The Discount Rate
One of the most important and publicly watched Fed actions, the discount rate is interest
rate that the Fed charges banks on money the banks borrow from the Fed. Member banks
borrow money from the Fed to pay out loans and other investments but they must pay a
fee, the discount rate. The reason this can be done is because the Fed acts as the central
bank and makes loans to other depository institutions. These institutions may borrow
money from the Fed because they either have an unexpected drop in their member bank
reserves or because they are faced with seasonal demands for loans. The discount
window is a teller's window at the Fed that depository institutions use to borrow member
bank reserves. For a bank to obtain a loan, it must agree on the terms of the loan in
advance. Next, the depository institution delivers collateral to the window. Then the loan
is granted and appears as an increase in the institution's member account. Currently the
Fed charges 5.3% and the banks charge 8.5%-10%. The Prime Lending Rate is lowest
rates banks are allowed to charge their customers. The Prime, as of December 31 is 8.5%.
If the Fed lowers the discount rate, banks are charged less for the money they borrow and
thus more people borrow. This increases the amount of money in circulation, speeds up
the economy and increases inflation. Conversely, if the Fed raises the discount rate this
lowers the amount of money in circulation because fewer loans are expended as the
Prime goes up. This slows the economy and lowers inflation.
Open Market Operations
Open Market Operations are the Fed's power to buy and sell government securities like
T-Bills. The Fed uses Open Market Operations more than any other tool to regulate the
economy. Most people do not pay attention to this less public action but it is very
effective.
If the Fed buys back bonds it is putting money into circulation because the money is
going from the government to the people. So if the government buys bonds it increases
inflation. Selling bonds restricts the money supply. If we do this we can lower inflation
rates.
Printing of Money
The simplest and most clear of all the Fed's operations. The government does not, as a
matter of sound economic policy, print money or destroy money in order to effect
changes in the economy. The power, however to do so, does exist. If the government
prints money it increases the amount in circulation and if it destroys money it restricts the
amount in circulation. This has a corresponding effect on inflation. To illustrate the
possible negative effects of just printing more money to counter deflation consider the
case of the Weimar Republic in Germany during the Depression. To counter deflation
and pay off reparations debts owed to France, Germany began to overprint money. This
action caused hyperinflation. Germans saw the value of the Mark plummet as prices
skyrocketed. Shoppers literally carried money in wheelbarrows. It was worthless.
Applying Monetary and Fiscal Policies
Think all this is easy...? Try solving this problem:
It is 1974. The economy is suffering from a situation economists have referred to as
"stagflation." The GNP is showing a slower than normal rate of increase, an indication of
a sluggish economy. Housing starts are low and unemployment is on the rise. To make
matters worse inflation is quite high.
This problem presents a bit of a conundrum for economists. Stagflation is a two-headed
monster. You have inflation AND a sluggish economy. This is rare but it has happened,
as recently as the mid 70's. The problem is that any action you take has the reverse affect
on the other half of the problem. The answer to the problem was to deal with inflation
first, as this is considered more problematic and eventually leads to less spending. Then
we turned our attention to the recession.