26Introduction to Economic Growth and Instability

CHAPTER OBJECTIVES

The Business Cycle and its Primary Phases

How Economic Growth is Measured and Why is it Important

How Unemployment and Inflation are Measured

The Types of Unemployment and Inflation and their Various Economic Impacts

ECONOMIC GROWTH Increase in Real GDP Increase in Real GDP Per Capita Growth as a Goal

GROWTH LESSENS THE BURDEN OF SCARCITY What is scarcity? How can growth help overcome it ? An economy experiencing economic

growth is better able to meet people’s wants and resolve socioeconomic problems

A growing economic, unlike a static economy, can consume more today while increasing its capacity to produce more in the future!!!

RULE OF 70 Mathematical approximation of the

effect of growth

Approximate number of years required to double GDP = 70/ (annual percentage rate of growth)

SOURCES OF GROWTH 1. Increasing its inputs of resources2. Increasing productivity of inputs

Productivity (real output per unit of input) rises by increasing health, sanitation, training, education, motivation etc

THE BUSINESS CYCLE Does growth take place persistently?

Case of Pakistan: episodic growth between 2000-2005

Now?

Phases of economic growth/ activity are characterized as business cycles

THE BUSINESS CYCLE Business cycle is the alternate rise and

decline in the level of economic activity, sometimes over several years

PHASES OF BUSINESS CYCLE Peak: temporary maximum in activity.

Economy is near or at full employment, and the level of real output is at or very close to the economy’s capacity. Price level is likely to rise

Recession: a period of decline in total output, employment, trade, income.

Trough: bottom lowest in the temporary cycle

Recovery: rise in output and employment towards full employment. A recession is usually followed by a recovery and expansion

THE BUSINESS CYCLE

Level of

Real O

utp

ut

Time

Peak

Peak

Peak

Recession

Recession

Expa

nsio

n

Expan

sion

Trough

Trough

Growth

Trend

Phases of the Business Cycle

Cyclical Impact:Durables and Nondurables

WHY BUSINESS CYCLES Causes of business cycles Shocks to the economy

Changes in productivity changes in spending levels

Growth trend is the overall trend of the business cycles Expansionary Contractionary

CYCLICAL IMPACTS Who is affected the most through a

cycle?Capital goods/ consumer durables can be

put off to a later date e.g. car industry in the US

Whereas, Non-durable consumer goods (services)

harder to remove oneself from e.g. medical, legal services

Twin Problems of the Business CycleUnemployment Inflation

UNEMPLOYMENTUnder 16

And/orInstitutionalized

(70.5 Million)

Labor Force, Employment, and Unemployment, 2005

TotalPopulation

(296.6 Million)

Not inLabor Force

(76.8 Million)

Employed(141.7 Million)

LaborForce(149.3 Million)

Unemployed(7.6 Million)

UNEMPLOYMENT Measurement of Unemployment Labor Force Unemployment Rate

Part-Time EmploymentDiscouraged Workers

Unemployment RateUnemployed

Labor Force= x100

UNEMPLOYMENT Those part of the labor force which are

not employed must be actively seeking work to be

considered unemployed

Unemployment rate = unemployed * 100

labor force

TYPES OF UNEMPLOYMENT1. Frictional

In search of employment In between jobs, fresh graduates

2. Structural Changes in consumer preferences, consumer

demand and in technology e.g hand made products

Structurally unemployed find hard to obtain new jobs without retraining, additional education or relocating

3. Cyclical Caused by changes in spending , less demand

and less income causes higher unemployment e.g. Credit Crunch 2008. Typically begins in the recession phase of the business cycle

FULL EMPLOYMENT The maximum population that can be

employed at a time (considering only structural and frictional unemployment)

Natural Rate of Unemployment (NRU)unemployment rate at full employment

level. When number of job seekers equal the number of job vacancies. This is always a positive percentage.

UNEMPLOYMENT

Economic Cost of Unemployment Potential Output GDP Gap and Okun’s Law

GDPGap Actual GDPPotential GDP= -

ECONOMIC COST OF UNEMPLOYMENT Large unemployment has costs

Causes a GDP gap The amount by which actual GDP falls short of

potential GDP (at full employment levels) Okun’s law: for every 1percentage point

unemployment rises above NRU a GDP gap of 2 percent occurs

Cost of unemployment is unequally distributedDifferent groups experience different

unemployment rates

NONECONOMIC COSTS Unemployment varies by

Occupation Age Race and ethnicity Gender Education Duration

Non-economic costs: depression, socio-political unrest, lowering

morale, poverty, ethnic and racial tension

INFLATION Rise in the general level of prices Each dollar buys fewer goods and

services Reduces the purchasing power of

money

MEASURING INFLATION

Price indicesConsumer price index

Each month or each yearMarket basket of some 300

consumer goods and services

CPIPrice of the Most Recent Market

Basket in the Particular Year

Price of the Same MarketBasket in 1982-1984

= x 100

Quantit

y in

Basket

2006 2007 2008

(kg or

litre) PriceCost of

basketPrice

Cost of

basketPrice

Cost of

basket

Flour 6 Rs. 200 1200 Rs. 300 Rs. 150

Oil 1.5 Rs. 80 120 Rs. 150 Rs. 50

Milk 1 Rs. 40 40 Rs. 55 Rs. 30

Rice 3 Rs. 300 900 Rs. 250 Rs. 250

Total cost 2260

Price

index100

CONSUMER PRICE INDEX

TYPES OF INFLATION Demand-pull

Excess of total spending beyond the economy’s capacity to produce

Excess demand for goods, can push up prices

“too much spending chasing too few goods” Cost-push

Supply or cost side of economyRising per-unit production costsReduces profits and thus reduces output Prices riseAlso known as supply shocks

REDISTRIBUTIVE EFFECTS

Inflation hurt some people , leaves others unaffected, and actually helps still others

Anticipations Anticipated Inflation, avoid or lesson effects of

inflation Unanticipated Inflation( not expected)

Nominal vs. Real income Nominal income is the number of dollars

received as wages, rent, interest, profits Real income = Nominal income / price

index

Real income is measures the amount of goods & services nominal income can buy. It is the purchasing power of nominal income

% change in real income = % change in nominal income - % change in price level

REDISTRIBUTION EFFECTS OF INFLATION

INFLATION Who is Hurt by Inflation?

Fixed-Income ReceiversSaversCreditors

Who is Unaffected or Hurt by Inflation?Flexible-Income Receivers

Cost-of-Living Adjustments (COLAs)BusinessDebtors

INFLATION Deflation: the effects of unanticipated

declines in the price level. People with fixed nominal incomes will benefit. Creditors and Savers will benefit.

Hyperinflation is extraordinarily rapid inflation. Money loses its value and status as medium of exchange

INFLATION Anticipated Inflation

Nominal Interest Rate Real Interest Rate Inflation Premium

NominalInterest

Rate

RealInterest

Rate

InflationPremium

11%

5%

6%

= +

BasicMacroeconomicRelationships