Unit 2

I. Macroeconomic Questions

Why does output fluctuate? How can these factors be controlled?

What determines economic growth? Number of workers Their education and training Technological advances Available machinery and labor Material resources How can we encourage the development of

these?

Why do we have unemployment, and why is it a problem?

Why do we have inflation, and why is inflation a problem?

Which government policy affects output, growth, unemployment and inflation?

How do changes in the amount of money in the economy affect output, growth, unemployment and inflation?

How do domestic economic activities affect other countries and our trade?

A. U.S. Economic Goals The Employment Act of 1946

◦ Full Employment◦ Price Stability◦ Economic Growth

The Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins Act )◦ Unemployment rate of 4%◦ 0% inflation rate

II. Measuring Macroeconomic Goals

B. Measuring Employment Civilian unemployment

◦ 60,000 households are surveyed Groups people (age 16+) into categories:

◦ Employed◦ Unemployed◦ Not in the labor force (too old to work, unable to

work, choose not to work)

Unemployment Rate (UR)

UR = number of unemployed x 100 labor force

Labor Force Participation Rate (LFPR)

LFPR = number in labor force x 100 adult population

C. Measuring Price Changes – Price Indexes Consumer Price Index (CPI)

◦ Measures changes in the prices of a “Market Basket” – about 400 goods and services commonly bought by consumers.

◦ Items the average consumer spends more money on are given more weight (than items consumers spend comparatively less on)

The Producer Price Index◦ Measures changes in prices of consumer goods

before retail Gross Domestic Product (GDP) Price Deflator

◦ Most inclusive – takes into account all goods and services produced

How to construct a price index◦ Select a time period for the base year◦ Prices of any subsequent period are a percentage of

the base period (the base is set at 100)

Formula to measure price change from the base period:

CPI = weighted cost of base period items in current year prices x 100 weighted cost of base period items in base year prices

Rate of change:

Price Change = change in CPI x 100beginning CPI

D. Measuring Short-Run Economic Growth Fluctuations in output (short-run economic

growth) Gross Domestic Product (GDP) is used to

measure this.

How is GDP measured?◦ Add up the value of expenditures on final (sold to the

end user) goods and services.◦ These are divided into four categories:

Consumption (C) - spending by households on goods and services

Investment (I) – spending on capital equipment, inventories, and structures.

Government purchases (G) – spending on goods and services by all levels of government

Net exports (NX) – value of exports minus value of imports (imports must be subtracted because C,I, G purchases include expenditures on all goods, foreign and domestic, and the foreign component must be removed to only spending on domestic production remains)

◦ What goods/services are NOT counted? Spending on stocks and bonds. Spending on welfare, social security, etc. Sale of illegal drugs Household production (ex. When homeowners clean

their houses) Intermediate goods – goods produced by one firm to be

further processed by another firm

GDP: Is it counted and where? (Consumption, Investment, Government, Net Exports, Not counted)◦ You spend $7.00 to attend a movie.◦ A family pays a contractor $100,000 for a house he

built for them this year.◦ An accountant pays a tailor $175 to sew a suit for her.◦ The government increases its defense expenditures by

$1,000,000,000.◦ The government makes a $300 Social Security payment

to a retired person.◦ You buy GM stock for $1,000 in the stock market◦ A homemaker works hard caring for her spouse and ten

children.◦ Ford Motor Co. buys new auto-making robots.◦ You buy a new Toyota that was made in Japan◦ You pay tuition to attend college.

GDP must be adjusted for price changes before Short-run economic growth can be measured

◦Real GDP – has been adjusted for price changes◦Nominal GDP – has NOT been adjusted for price

changes

Real GDP in Year 1 =

nominal GDP x 100 price index

Real output growth in GDP from year to another =

(real GDP in Year 2 – real GDP in Year 1) x 100 real GDP in Year 1

To understand the impact of output changes, we look at real GDP per capita.

Real GDP per capita = Year 1 real GDP population in Year 1

A. Historical background High inflation rates of the late 1960s and

1970s led to the severe recession of the early 1980s.

Impact on Monetary policy - Alan Greenspan’s time as the chair of the Federal Reserve revolved around controlling inflation.

III. Inflation

B. Anticipated Inflation Level of inflation people expect to occur and

have built into their economic decisions Economic costs of high levels

◦ Boot Leather costs People running around trying to avoid losses from the

declining value of money Ex) In 1985 the inflation rate in Bolivia reached almost

8,000%. The value of the peso changed daily. One day 25 million pesos was worth $50 (US). Within a few days, 25 million pesos was worth $27 (US).

(Cont - Economic costs of high levels)◦ Tax Distortions

Raises the tax burden on income earned from savings Example

You invest $10 in stock in 1990. You sell the stock for $50 in 2000. You have earned a capital gain of $40, which you must

include in your income taxes. BUT, the $10 in 1990 had more purchasing power than it

does in 2000. $10 in 1990 might be equivalent to $20 today. So your Real Gain is only $30.

◦ Confusion and Inconvenience Ex) it is difficult for investors to determine which firms

are successful

C. Unanticipated Inflation The level of inflation that is not expected. Economic Costs

◦ People have not adjusted earnings and expenditures for this level of inflation.

Who is hurt?◦ Savers, people on fixed incomes

Who is helped?◦ Borrowers with fixed interest rates

Contestant Gain/ Hurt

Reasoning

Priscilla (homeowner/worker)Mayor Peter (store owner)Theresa (auto worker/union member)Jerry (real estate developer)Elmer (retiree)Mr. Sad Class (teacher)Lucy (high school senior)Bernie (bank president)Helga (retiree)Jerome (potential homeowner/borrower)Lawrence (British business owner)

The Inflation Game – Examples of Unanticipated Inflation

A. Includes people who are actively looking for work.

IV. Unemployment

B. Issues

Discouraged workers – people who gave up looking for work because they couldn’t find a job. Leads to underestimation of the number of people who would like to work.

Underemployed – people who are working part time but want a full time job

Different groups experience different rates of unemployment

C. Types Frictional unemployment – people who are

temporarily between jobs

Cyclical unemployment – people who are not working because firms do not need their labor due to a lack of demand or a downturn in the business cycle

Structural unemployment – involves mismatches between job seekers and job openings. Unemployed people who lack skills or do not have sufficient education

For each of the following, label it Frictional, Cyclical, Structural

A computer programmer is laid off because of a recession.

A literary editor leaves her job in New York to look for a new job in San Francisco.

An unemployed college graduate is looking for his first job.

Advances in technology make the assembly-line workers job obsolete.

Slumping sales lead to the cashier being laid off An individual refuses to work for minimum wage. A high school graduate lacks the skills necessary

for a particular job

V. Business Cycles

A. Refers to alternating rises and declines in the level of economic activity

• A cycle is one “up” followed by one “down”

B. There are 4 phases to the business cycle1) Expansionary/Recovery • Real output is increasing• Unemployment is declining• As expansion continues, inflation may begin to

accelerate

2) Peak• Real output (GDP) is at its highest point of the

business cycle

3) Contractionary/Recession• Real output in the economy is decreasing• Unemployment rate is rising• As contraction continues, inflationary

pressures subside• If the recession continues long enough,

deflation may occur (falling prices)

4) Trough• Lowest point of Real GDP reached during the

business cycle• If very deep, it may be called a depression• Very low output• Very high levels of unemployment• There is no precise decline when a recession becomes

a depression