Economic Growth


Measuring Economic Growth

Calculating GDP

There are three ways to calculate either nominal or real GDP, each yielding identical results:

  1. The final goods approach - which relies on data from the production of final goods and services

  2. The value-added approach - which relies on data from the production of intermediate goods and services

  3. The income approach - which looks at incomes of workers and employers.

The final goods approach. First we should distinguish between a final good and an intermediate good. Intermediate goods are used in the production of final goods. Suppose you suddenly have the urge to race to the nearest auto dealer and buy a new convertible. You will see glistening under the lights a final good. Probably the first thing you will do is kick the tires of the car. This will be followed by sitting in the fresh driver's seat and giving the horn a few toots. The tires, the seat, the horn, the steel of which the car body is made are intermediate goods used in the production of the automobile that you drive off into the setting sun.

The goods we buy are a collection of intermediate goods, assembled in a unique way to produce the final good. The final goods approach to calculating GDP only counts the price that consumers pay for the good. It does not include the price the manufacturer paid for intermediate goods, as that would be double counting. The value of the intermediate goods are included in the price of the final good.

The final goods calculation of GDP adds up the monetary value of all goods and services produced during a given time period (either a year or a quarter). Rather than tracking the value of goods and services produced, the price paid by end users goes into the GDP calculation. End users of goods and services fall into one of four categories:

1. Individual consumers buy approximately 70% (in the United States) of all final goods and services. This activity is known as consumption (C).

Consumption (C)

The consumption of goods and services falls under one of the following categories:

  1. Durable goods - The consumption of durable goods is considered similar to a consumer investment. Durable goods are purchased with the intention of keeping them for a sustained duration of time. Examples of durable consumer purchases include washing machines, refrigerators, automobiles, and toaster ovens.

  2. Nondurable goods - In contrast to durable goods, nondurable items have a shorter life span. An example of a nondurable consumer purchase is groceries. The life span of the typical food is short, especially compared with the refrigerator (durable item) in which perishable foods are kept. Other examples of purchases that are considered nondurables include newspapers, magazines, clothing, and hats (which are always flying off with the wind).

  3. Services - Since the 1960s the fastest growing component of consumer purchases has been the area of services. Services include medical treatment, lawyers, and dry cleaners.

2. Businesses buy final goods to assist in the production process. Anything from staples and computers to heavy machinery is purchased and used by firms to produce other goods. Since business purchases aid in the production process this activity is known as Investment (I).

Investment (I)

Businesses and corporations undertake investment activity that involves the purchase of goods which themselves assist in the production process. The categories of investment are:

  1. Business Investment - This includes the actual purchases of goods used in the production process. Business investment includes the construction of new offices and factories, and the purchase of machinery, computers, and any other equipment used to assist labor in the production of goods and services.

    Business investment counts as gross investment, which includes purchases of machinery to replace worn-out equipment. If a firm replaces one machine with another that does not increase output, then nothing is added to the nation's economy. To correct for this, net investment can be used, which subtracts out depreciation of existing capital from the gross (total) business investment made by firms.

  2. Residential Construction - This part of overall investment tracks the actual construction of housing, not the sale of homes. A new home that is built during a given year is counted in that year's GDP, while the purchase of a previously owned house has already been counted in the GDP of the year it was constructed. In this way, only those residences that add to the overall housing stock count towards GDP.

  3. Changes in inventories - Firms invest in inventories, which are produced goods held in storage in anticipation of later sales. Firms also stockpile raw materials and intermediate goods used in the production process. Goods held in inventories are counted for the year produced, not the year sold.

    Although inventories are a relatively small portion of the overall investment sector, inventories are a critical component of changes in GDP over the business cycle. If the economy is slowing down, possibly entering a recession, the bearer of the bad news will often be an undesired accumulation of inventories. As consumers reduce their purchases, sales of goods and services slow, inventories build up, and firms slash production (laying off employees) to reduce unwanted (and costly) inventories.

Inventories can be considered a part of a group of leading indicators of business cycles. By leading indicator, we mean that changes in a variable such as business inventories can lead to changes in the future condition of the economy. To explain the linkage between changes in the level of business inventories in many economic sectors and economic growth, let us consider two cases: an undesired accumulation of inventory, and an undesired decrease in business inventories. We will look at the economy as a whole.

  • The economic impact of an undesired accumulation or increase in business inventories. Businesses plan ahead and forecast future sales. Based on their expectations, they stockpile inventories of goods expected to sell in the near future. The reason is simple. Businesses want the goods available to meet customer demands or else they will lose the sale, and most likely lose it to a competitor. If there is a slowdown in consumption in many economic sectors, then many businesses will not sell as many goods as they had planned to. As a result, businesses will not sell off their inventories of goods as they had planned and inventories will accumulate.

    When inventories accumulate due to a decrease in consumption, businesses respond by reducing orders of goods from producers. In turn, as producers face a cutback in demand for their goods, they will decrease output. When inventories are accumulating in many sectors of the economy, reductions in the production of goods becomes widespread, and as firms reduce their output, many workers are laid off. As payrolls are reduced, the number of unemployed swells and the unemployment rate rises. With the reduction in output, GDP growth falls and if the drop in production is sharp enough, the economy goes into a recession.

  • The opposite occurs with an undesired or unanticipated decrease in inventories. If the demand for goods is greater than businesses had forecast, inventories will be rapidly depleted. As firms restock their inventories and adjust for a higher level of sales, they increase their production. Increases in output require firms to employ more workers. If this is occurring throughout the economy, the unemployment rate will fall as more individuals find jobs and economic output will increase. This leads to a jump in economic growth as measured by GDP.

    The surge in demand for goods and services as well as the responding hike in production and employment comes at a possible cost. As more jobs are created, incomes rise, further contributing to an increase in the demand for goods and services. The potential result is a rise in the inflation rate due to demand-pull effects. Demand-pull inflation results from price pressures caused by rising demand for a good. In addition, cost-push pressures may also lead to greater inflation. As firms increase their output and demand for labor, wages may rise, especially if the economy was already near or at full-employment. Higher wages increase production costs that may be passed on to the consumer in the form of higher prices for goods.

The important point made here is that although inventories are a relatively minor component of GDP, rapid changes from their desired levels can have important economic consequences. When inventories accumulate beyond desired levels, an economic slowdown may be on the horizon as producers reduce their output. Or if inventories are rapidly being depleted, then economic growth and possibly inflation may soon rise as wage and price pressures build. Economic analysts monitor the divergence of inventories from desired levels as a leading indicator of potential changes in future economic growth rates.

3. Government spending (G) includes purchases by federal, state, and local governments. The focus of this course will be on federal government spending.

Government Spending (G)

The government sector tracks what the government actually spends money on. Government purchases of goods and services include stealth bombers, government-funded research, space shuttles, salaries, and toasters. Many of these items are seldom sold in markets; as a result, they are valued at the price the government pays for them. The calculation of government spending for GDP purposes excludes several tremendous categories of actual spending: transfer payments, which redistribute income primarily to individuals who are potential consumers, and interest payments on the debt.

4. Net Exports. Some of the goods produced domestically are sold abroad to foreign consumers in the form of exports. However, a portion of the goods consumed in our country are made by foreign producers and imported. The difference between exports and imports is known as Net Exports.

Net Exports = Value of exports - Value of imports

If Net Exports are positive, the country runs a trade surplus where exports > imports.

If Net Exports are negative, the country runs a trade surplus where exports < imports.

Using GDP as an Economic Indicator

Despite the use of GDP as the foremost indicator of economic prosperity, the measure does have a number of noticeable faults.

A better measure of international economic health is the purchasing power parity index (PPP), which gives an indicator of what people can afford in their own country given market and cultural differences. Another alternative to using GDP for international comparisons is the System of National Accounts (SNA), which is the result of a joint effort by the United Nations, the International Monetary Fund, the World Bank, the OECD and others. Another consideration is the attempt by the World Bank to include natural resource endowments and development as a source of national wealth. This information can be accessed by choosing the next option below.

In order to better estimate the relative consumer purchasing power between nations, the International Monetary Foundation (IMF) revised its estimates of the comparative size of economies in the spring of 1993. Traditional benchmarks of GDP per capita convert each country's GDP into dollars using market exchange rates. The resulting figures indicate what the average resident in India or China can purchase compared to the typical inhabitant of the United States. This provided an international comparison of purchasing power but ignored differences in home markets regarding the cost of goods and market structure (the presence of barter and other nontraditional markets).

Comparing GDP per capita in dollars causes the real output of many developing countries to be underestimated, as markets are not as well defined as in developed countries. Furthermore, changes in exchange rates could help or hinder a country's GDP per capita. Countries with an appreciating currency were given a boost to GDP per capita, the opposite occurring for countries with deflating currencies. To help correct these distortions, the IMF now uses purchasing power parities (PPP). The PPP takes account of what money can buy in each country's home market, accounting for international differences in prices. It is especially useful in capturing differences in the prices of non-internationally traded goods such as housing, domestic transport, and energy, items that make up a large percentage of consumer expenditures.

In theory, if the prices of traded goods were equal everywhere, then wages in each country would depend on the productivity of its traded-goods industries. We would expect that countries with low productivity would have low wages, while countries that are abundant in capital and workforce skills would have greater productivity and higher wages. The same reasoning applies for producers of non-traded goods in high vs. low worker-productivity countries. Low productivity and low wages result in a minimal GDP per capita in comparison to the more productive countries. Yet for the majority of developing countries, the prices of many services, housing, energy, and other consumer goods will be cheaper in these developing countries, partially offsetting the wage disparity with developed economies.


An International Look at Economic Growth: Resource Endowments and Long-Run Economic Growth

Recently, the World Bank released data on per capita wealth. The measure was a compilation of the value from the following sources:

As a result of the inclusion of unconventional measures of wealth, such as the endowment of natural resources, the World Bank arrives at a unique ranking of per capita wealth by country.

A surprising result shows that three of the world's top five wealthiest countries include resource-poor Japan, Luxembourg, and Switzerland. What the table and history have exhibited is that natural resource endowments are no guarantee of economic success. Using conventional measures of GDP per head demonstrates that even the world's wealthiest nation, the United States, relies primary on human capital to generate wealth, not natural resources.

History has shown that there is little correlation between natural resource endowments and economic prosperity. The Soviet Union, perhaps at one time the world's most wealthy group of nations when considering stocks of natural resources, collapsed in an economically deficient heap. Turning back the pages of time, Russia lost a war and territory to Japan, a country which has succeeded by importing what it does not have on their land. Despite the wealth generated by cotton, the American South failed in a civil war against the industrial North. And at one time, the value of Haiti's exports (mostly sugar) was of greater value than the sum of exports from the original 13 American colonies.

The Correlation between Natural Resource Endowments and Economic Growth

Empirical evidence points to a negative correlation between resource endowments and economic growth. Countries with scarce natural resources, such as Hong Kong, Taiwan, South Korea, and others, lead the world in growth and development, while resource abundant nations such as Nigeria and Venezuela are economic basket cases. In a recent study(1), empirical results reveal that economic growth is higher among countries that are relatively lacking in natural resources than in those with abundant natural resources. The study finds that of the 18 most rapidly growing economies, only two - Malaysia and Mauritius - have ample supplies of natural resources.

The study by Sachs and Warner gives empirical support to what is known as the "Dutch disease." Holland is a country where much of the land has been created by rolling back the sea with a system of dikes; an interesting choice for an example of the relationship of economic growth and plentiful natural resources. Yet in the 1950s, huge reserves of natural gas were discovered in Holland at a time when demand for this fuel source by utilities was growing rapidly. Yet even with generous natural gas reserves, Holland has not become an economic power like its neighbor Germany, which built its strength through industry, not resources.

In general, countries with abundant natural resources may experience slower long-run economic growth for the following reasons:

Economic theory points to rent-seeking behavior as an explanation for the tendency for governments to rapidly exploit natural resource endowments. For the owner of a resource, rent is the surplus of the market price received over the minimum price required to bring forth production. Rent-seeking governments will favor the income from the sale of resources that command a relatively high market price over alternative sources. As a result, public policy will encourage resource development and the associated rents. Since short-run rents connected with improvements in the manufacturing, service, and other traded goods sectors are lower, the development of these sectors will receive secondary attention from public policymakers. Industry and infrastructure will be orientated to the exploitation of the natural resource to the long-run detriment of other sectors of the economy.

In poorer, less-developed countries, rent-seeking behavior often leads to government irresponsibility and corruption. The inefficiencies will not be noticed by the public in the short-run because of the resource-generated windfall. In the long run, entrenched government inefficiencies and corruption are difficult to reduce. There are many examples of governments that have used natural resource revenues to finance the buildup of a large military and a totalitarian state. Money that should be spent in building up a nation's infrastructure in critical areas such as communications and productive industry are diverted into the pockets of officials and their supporters. Those excluded from the benefits often respond with civil war, coups, and the long-run devastation of the economy.

An Applied Example: Diamonds and Oil in Angola

If natural resource endowments were the primary determinant of wealth, Angola with its plentiful oil reserves and substantial diamond mining industry would be one of the world’s richest countries. In reality, diamonds have been a curse to Angola rather than any type of blessing.

The recent origins of Angola’s trouble began in 1975 when Jonas Savimbi, Angola’s leader at that time, lost an election. Rather that give up power peacefully, Savimbi formed a rebel group known as Unita. Realizing that the source of power was control of the natural resources, Unita took control of most of the diamond territory in Angola. Diamond exports provided a steady stream of revenues (about $3 billion in legal diamond sales) to finance Unita’s continuous war against the government.

After losing control of the diamond mines, the government needed to find an alternative source of revenues and turned to oil. Western oil companies paid about $3.5 billion to rights to oil located off the coast of Angola.

Angola fell into an extremely violent and prolonged civil war financed by the export of Angola’s natural resources. Both the government and Unita fought for control of those natural resources since whomever controlled the resources, had the power to rule the country. Angola’s abundant diamond and oil resources were plundered to purchase weapons that were in turn used against many innocent people in the country. Only about 5% of the money gained from exports was used by the government for productive social purposes such as housing, education, health care, building up the national infrastructure, and other positive contributions.

When Savimbi died in February of 2002, roughly 25% of Angola’s people were homeless, over million citizens have died in the fighting over the past decades, many others have been maimed by land mines, rare diseases like leprosy and polio are spreading. With the death of Savimbi, perhaps Angola will find peace and be able to use the revenues from diamond and oil exports to build an economy and a country.

In 2010, almost a $1 trillion of natural resources (at current market values) have been discovered in Afghanistan. The following link provides some perspective on how these resources may affect development in Afghanistan.

Labor Markets and Unemployment, Inflation and Economic Growth

Labor Markets

In this section we will take a look at household consumption and saving decisions. Individuals can use their disposable income for either consumption or savings.

Household Consumption and Saving

We examine the individual's decision to save and the market for funds. The decision to save can also be considered a tradeoff between present and future consumption. By not spending a portion of our disposable income today, we have money available for future consumption. Assume you decide to take $100 of your income today and save it. If the return on savings, r (the interest rate), is 10%, then you will have $110 available for consumption in a year from now.

 

 

 

Figure 3-1 shows the supply of savings curve. The curve has a positive slope due to the substitution effect of higher interest rates. As the interest rate r increases, the return from saving also rises. People reduce their present consumption and substitute in favor of savings, thus allowing for greater future consumption.

Savings is undertaken by individuals, businesses, the government and foreign savers may also supply savings to the domestic market. Savings is provided in the loanable funds (capital market) and refers to savings with financial institutions such as banks, in the form of a bond or stock purchase or with some other type of financial intermediary.

Total Domestic Savings  = Private Savings + Public Savings + Net Foreign Savings.

Equilibrium in the Capital Market

 

 

 

The demand for loanable funds is generated by businesses that wish to borrow money to undertake investment in capital. Investment is undertaken by firms to add to their capital stock. Capital is considered to be the machinery, tools, buildings, computers, and other equipment used in the production of goods and services. The capital market is where firms and other institutions borrow money. Firms use this borrowed money to purchase (invest in) capital. Figure 3-2 shows equilibrium in the capital market where borrowers (the Demand for Loanable Funds curve) and savers (the Savings curve) determine the market interest rate, r*, and the quantity of capital.

The Labor Market - Household Supply and Employer Demand

The labor market looks at the decisions of individuals to work and the demand by employers for workers. The household labor supply decision will have a positive correlation to the wage rate. The higher the wage we can obtain, the greater our desire to work (especially when all households in the economy are included in this decision process). The demand for labor by businesses, governments, and other employers will have a negative relationship to the wage rate. As the wage rate increases, the cost of hiring workers rises. With higher wage rates, employers increasingly seek lower-cost alternatives to labor, such as capital.

 

 

 

In Figure 3-3 we show the labor market. This is where households supply labor and employers demand workers. In the graph we have the equilibrium wage, w*, and the level of employment QL* determined.

Bringing the Markets Together

In the above two graphs we showed how the capital market determined the equilibrium interest rate, r*, and the labor market set the wage rate, w*. We also include the product market on the left, where the market price, p*, is determined by the equilibrium of supply and demand for a good.

We conclude this section by recognizing that markets are interrelated: changes in one market have an impact on other markets. Consider the three markets discussed here (capital, labor, and product). Assume that economic growth is increasing the demand for goods and services, including the item produced in the product market graphed above. The demand curve for the good shifts to the right, raising the market price. As producers increase their quantity supplied they increase their demand for inputs of labor and capital. An increase in the demand for labor increases the wage rate, and greater demands for capital bid up the interest rate.

Is the story over? Hardly. Prices, wages, and interest rates have all increased due to economic growth. What happens next requires good analytical skills, as there are several options. For example, higher wages allow for the consumer to buy more, although the increase in interest rates encourages savings. If few substitutes in consumption are available for the consumer, higher prices in the product market for this good illustrated here may erode the wage gains enjoyed by workers.

Fortunately, cataloging the possible permutations is not the essence of this course. We need to understand the relationships that markets have to each other and have a working knowledge of the fundamentals of markets. You should be able to verbally and graphically describe what happens in each market if the demand or supply of either the product, labor, or capital changes. If you are uncertain, review the basics of market equilibrium in Unit 4.

Unemployment

Unemployment is a measure of those people who are actively seeking work but cannot find a job which matches their qualifications. 

Before giving the details of unemployment we should note that macroeconomic policies do not desire to provide all individuals with jobs. Some people choose to be unemployed voluntarily. Individuals may choose to be unemployed as they switch jobs, move from on region of the country to another, or for various other reasons. The goal of macroeconomic policy is to achieve full employment. Full employment is described as the absence of involuntary unemployment. Involuntary unemployment is that characterized by individuals who would like a job that matches their skills, but none are available.

Measuring Unemployment

To measure unemployment we must first consider those people who are considered eligible to work. The definition of the labor force is all employed or unemployed civilians (16+ years of age) plus armed forces stationed in the US. Excluded from the labor force are students, housekeepers for a working spouse, those who have given up looking for work, and others who are considered non-labor force participants. The unemployment rates is defined as the ratio of the number of unemployed to the labor force:

unemployment rate = number unemployed

labor force

It is important to note that actual number of unemployed is higher than reported due to discouraged workers who have given up actively seeking work and have dropped out of the labor force. Individuals may be unable to work for such reasons as disabilities, personal hardship, bad luck, a lack of skills, and other reasons. Sometimes an economy is too weak to provide jobs for its citizens. During the Great Depression of the 1930s, over 24% of the United States workforce lacked employment.

Types of Unemployment

We begin by categorizing the common definitions of unemployment. Those individuals who find themselves unemployed most often are considered one of the following:

  1. Frictionally unemployed
  2. Seasonally unemployed
  3. Structurally unemployed
  4. Cyclically unemployed

Frictional unemployment represents job turnover as people change jobs, move to different areas, and for other reasons that are generally temporary, and voluntary.

Seasonal unemployment refers to changes in employment that follow recurring patterns through the years. Construction workers, people who fish for a living, and lifeguards all face layoffs during the winter months. Consequently, the number of unemployed rises and statistics need to be adjusted accordingly to deal with temporary changes in the number of unemployed. This will prevent needless volatility in the unemployment rate that does not accurately reflect the status of the economy.

Structural unemployment represents a mismatch between supply of labor and demand for workers. Of all the unemployment categories listed here, structural unemployment represents the most significant long-term problem for economic policymakers. Individuals who fall into this category have trouble finding jobs because of a lack of adequate skills or regional employment problems. These people have the greatest potential to eventually become discouraged workers.

Within the category of structural unemployment, there are three subgroups:

Occupational unemployment results from a mismatch between the demand and supply of labor in specific industries. The demand for workers in growing fields such as health care may exceed the supply of available workers, while the supply of labor in declining areas may be in surplus. As a result, there is high unemployment in stagnant or declining job areas, while demand is strong for alternative occupations. An important recent trend in the United States and some other developed countries is the transition from manufacturing to service employment

An imbalance between the supply and demand for labor also occurs geographically, and is known as regional unemployment. For many countries, growth is not uniform across the landscape. Some areas may enjoy rapid growth and thus have a strong demand for labor, while other locations are stagnant and the surplus labor leads to high local unemployment rates. In the recession of 1981-82, the middle part of the United States was called the 'rust belt' due to its large manufacturing economy having fallen on hard times in competing with more efficient foreign producers. In contrast, the recession had a minimal impact on the southwestern region of the United States, which supported many jobs in the fast-growing energy, technology, and defense sectors.

International competition is an additional source of long-term structural unemployment. The argument is that less-skilled workers in developed countries are increasingly being displaced by foreign workers in less-developed countries (LDCs) who are paid significantly lower wages. In developed countries the average wage for less-skilled workers is relatively high compared to that in LDCs due to greater living costs, union and worker power, and tradition. As the world economy has evolved, businesses and corporations have increasingly sold their goods in a global marketplace. In order to compete internationally, firms need to produce at the lowest possible costs. With wages comprising 2/3 of the cost of production of the average good, one way for producers in developed countries to compete is to transfer production abroad, where labor costs are lower. While this argument does have merit, it is often twisted to support the goals of politicians who wish to play on the fears of the electorate. This is a complex issue; if you would like to read further, link here

Structural unemployment is the most difficult for economic policymakers to deal with, and solutions evolve slowly. Individuals stuck in occupations that allow for little future growth need to be retrained and educated to gain the skills necessary to work productively in areas where they are needed. Time, information, and money are required to deal with structural unemployment. The government can take an active role in providing vital information about jobs and help in financing education and training for displaced workers. In the long run, governments will find it more cost-effective to help people gain skills than to deal with the consequences of individuals with no future. Link here for further information about recent changes to the welfare system in the United States.

Cyclical Unemployment is the type of unemployment that we focus on in a macroeconomics course. Resulting from fluctuations in the business cycle, cyclical unemployment rises significantly during economic downturns (recessions) and falls during growth phases, both having dramatic impacts on the national rate of unemployment. In this course we will discuss in detail how economic policymakers use fiscal policy and monetary policy to deal with the macroeconomic issues of unemployment, inflation, and economic growth.

What is the Full Employment Rate of Unemployment?


Full employment, or the natural rate of unemployment, is considered to be consistent with a level of unemployment that predominantly comprises voluntarily unemployed workers. In other words, those members of the labor force who really want a job have one. Leaving the nuances of who is part of the labor force for the main text, the rate of unemployment consistent with full employment is a major issue for economic policymakers. Small differences in the perceived rate of full employment lead to significant variations in the policy response to economic growth.

The definition of full employment is critical, because as unemployment rates reach and fall below this level, inflationary pressures start to build. The further that the unemployment rate falls below the natural rate, the greater the pressure on inflation. This is a result of modern production methods. Even in a capital-favoring production country like the United States, worker wages represent over 70% of all production costs. Rising wages increase costs, which are usually passed on to consumers as price increases, leading to climbing inflation.

To understand the relationship between full employment and wage increases, let us assume that the agreed upon natural unemployment rate is 4%. If the unemployment rate is 6%, then there are workers who desire jobs but cannot obtain one (known as involuntary unemployment). With high unemployment rates, the existing labor surplus implies that employers have little trouble finding people to work at the prevailing wage. But as economic growth accelerates, the labor surplus diminishes as more workers are hired, and the unemployment rate falls. Finally, due to strong economic growth, the unemployment rate falls to a level consistent with full employment.

As the story unfolds, economic growth remains persistently bullish, but now everyone (give or take) who wants a job has one. Yet increases in the demand for labor continue to grow and employers must pay existing workers overtime and entice non-labor force participants into the labor force by offering them higher wages. As wages increase, more people are willing to work (reaching their reservation wage), but production costs rise. If strong economic growth persists, wages pressures continue to build, leading to increasing inflation (also known as cost-push inflation).

OK you say; no big deal. When the unemployment rate reaches full employment, use restrictive economic policies to slow economic growth to a level consistent with labor force growth (and labor productivity). That way the unemployment rate will stay constant at the full employment rate, and wage pressures will remain muted. That's a great idea. However, what is the full employment rate of unemployment?

Certainly, full employment in the United States has changed over the years. During the 1950s and 1960s it remained low, consistent with 3-5% unemployment rates. In the 1970s two main changes swept through the American labor force:

  1. The post-World War II baby boomers began to enter the labor force.
  2. Females increased their participation rate to 50% of the total women of working age.

Since both boomers and the wave of new females entering the labor force tended to be younger and less experienced job turnover, increased. By the late 1970s the natural unemployment rate had risen to the 7% range.

During the 1980s the increasing participation rates of women stabilized and the boomers were followed by the baby bust. The natural unemployment rate fell into the 6% range. The consensus among policymakers today is that the full employment rate of unemployment is roughly 4.5% to 5%. Once unemployment rates reach that level, economic growth needs to be slowed (we will see how later in this course), in order to level out the changes in the unemployment rate.

The problem with this analysis is what if economic policymakers are wrong? Many argue that the natural unemployment rate has fallen to about 4%. If during an expansion, economic growth is slowed to maintain a 5% rate of unemployment, while 4% is consistent with non-inflationary growth, then there are still plenty of people (over 1.4 million in the US) who want to work at prevailing wages but cannot find a job. By putting on the growth brakes too soon, many involuntarily unemployed workers will still be denied meaningful work.

Evidence indicates that the natural unemployment rate is equal to about 5% and that businesses are increasingly effective in keeping labor costs low. Higher worker productivity helps maintain the nation's standard of living by keeping inflation under control and boosting the competitiveness of U.S. products overseas. Regardless, policy makers are content with a non-accelerating inflationary growth rate consistent with an unemployment rate of around 5%.

The Shift of Employment from Manufacturing


One of the most dramatic changes that have occurred in the workplace of many developed countries during the last half of the twentieth century is the decline in the rate of job growth in the manufacturing sector. Manufacturing jobs that typically produce durable goods such as autos, home appliances and many others have been considered the foundation of a country's economic base. Yet today, manufacturing firms only employ 1/6 of all workers in the United States, 1/5 in Britain, and 1/3 in Germany and Japan. In all four of these countries, manufacturing jobs as a percentage of total workforce employment has been declining steadily. In the United States, manufacturing employment comprised almost 25% of the workforce in 1970 but had fallen by almost 33% by the early 1990s. The declines in the other industrialized countries have been equally dramatic.

Within the manufacturing sector, there have been major shifts in employment. For developing countries, jobs in relatively low-skilled metal-producing industries, such as steel and aluminum, along with employment in textiles, leather, and footwear have all decreased by 25% or more. Picking up some of the slack is job growth in high-technology areas of manufacturing such as computers and aerospace. Consistent with this trend of the movement of jobs into medium (chemical) and high-technology manufacturing has been the transition from labor-intensive to capital-intensive production methods.

For workers in low-technology manufacturing production in developed countries, wages have been falling along with the departure of jobs. For those workers without the skills and education to make the move to high-technology areas, the combination of reduced employment and falling wages has been severe. The low-skilled manufacturing jobs have left the developed economies for the less-developed countries where wages are substantially lower. Over the past decades, the developing countries have increased their share of world manufacturing output, especially in low-skilled production.

For the developed countries, the loss of manufacturing jobs has not been a disaster in the aggregate due to the growth of the service industry. During the same time period that employment (as a percentage of total employment) has fallen in manufacturing, it has grown steadily in the service sector by more than enough to offset the declines in manufacturing employment. In developed countries (OECD), the service sector accounts for more than half of all jobs and also over 50% of all GDP (output). For the United States, the following table shows the rapid shift between the service and manufacturing sectors:

% of employment

 

Manufacturing

Services

1970

27%

66%

1993

16%

78%

2005

12%

83%

2010

9%

86%
Services are the new engine of job growth

Wages in the manufacturing sector have historically been relatively high in the United States and other developed countries. Part of the reason was the higher level of unionization of manufacturing employees. As employment in the manufacturing sector has given way to the service industry, there is concern that overall wage rates will fall. In reality, the service sector is very broad, including occupations from fast food worker to investment banker. Many workers in the service industry will find jobs that pay on the same level or higher than employees in the manufacturing sector. Overall, there should be no decline in wages due to the transition of employment from manufacturing to services.

There is also concern that as services dominate domestic production there will be less demand for a nation's exports. In contrast, trade in services is booming worldwide. Services' share of total world trade increased from 17% in 1980 to 22% in 1992. Services such as banking, consulting, computer software, and tourism are growing in demand throughout the world.

Some analysts have pointed to a decline in productivity growth during the 1980s and early 1990s in the United States as a consequence of the transfer of jobs from manufacturing to low-productivity services. In reality, growth rates of productivity slowed down in the 1980s as the industrial era began to fade. Much of the innovative changes in production due to better machinery had been incorporated into the production process, leaving a slower pace of improvement. In contrast, the growth in services associated with computers and telecommunications will lead to a new revolution in the way work is conducted. As a result, starting in 1993 U.S. productivity growth has sprung back. The next decades should see a resurgence of 2% and over annual increases in worker productivity as business adapts to the knowledge revolution.

Part of the decline in manufacturing employment is due to an increase in service-related production. An increasing part of the value added in the production of a final product is due to services. Many manufacturing firms are contracting out accounting, advertising, design, and other business services that were formally done in-house. Statistics show a transfer of jobs from manufacturing to services, where, in reality, production is becoming increasingly specialized.


Inflation & Economic Growth


Inflation

As prices for goods and services that we consume increase, inflation is the result. The inflation rate is used to measure the rate of change in the overall price level of goods and services that we typically consume. While inflation is a regular annual occurrence in modern economic systems, it only becomes a policy concern when reaching unacceptably high levels. As we shall see, many modern economic policymakers have developed a short fuse for reacting to potential increases in inflation.

To the majority of us, small doses of annual inflation seem normal and uneventful. Historically, despite bursts of sustained inflation during the Roman Empire, the Middle Ages and the reign in England of Queen Elizabeth I, prices remained broadly stable over long periods, including periods of falling prices. In fact, the average price level in Britain in the early 1930s was no higher than in the 1660s.

Measuring Inflation

An inflation rate gives us a consensus or aggregate measure of the price changes occurring for a number of different goods and services. When we look at individual goods, price changes often vary greatly. During the past decades the price of goods such as automobiles, gasoline, movies, health care, and housing have increased significantly. In contrast, the price of calculators and computing power has decreased substantially.

There are many different measures of inflation; we will focus on the most common index known as the consumer price index (CPI). There are several steps taken in calculating the current CPI:

  1. Measuring the price changes of all goods is complex if not impossible. Instead a market basket of goods is used which represents many of the goods and services that we consume frequently. Items such as housing, food, transportation, communication, etc. are represented by specific goods whose price changes can be accurately recorded over time.
  2. The individual items in the market basket are weighted as to their relative importance. The price of gasoline will receive a more significant weighting than that of tomatoes since we spend a greater percentage of our budget on fuel.
  3. The prices of individual items and their respective weights are used in calculating the CPI.

The inflation rate for 2002 represents the rate of price increases of the weighted basket of goods (the CPI) since 2001. The calculation is:

Inflation rate (2010) =

CPI (2010) - CPI (2009)


x 100

CPI (2009)

 

Although the consumer price index receives the lion's share of publicity and is the most closely followed price index, astute inflation watchers expand their horizons to include other price indexes. The two most important are the producer price index (PPI) and the wholesale price index. The PPI measures the average price level of goods sold by producers to wholesalers. This is a leading indicator, as higher producer prices are often translated into higher consumer prices. The wholesale price index measures the average price level of goods sold by wholesalers to retailers.

The CPI May Overestimate Inflation

The CPI is the most commonly used price index to measure the inflation rate. However, the CPI has several limitations that may cause it to report higher inflation rates than are actually occurring. The main flaws with using the CPI as a measure of consumer prices are:

a.       The CPI fails to adjust for improvements in quality.

Over time we often pay more for a good. Compare the price of a Chrysler LeBaron convertible in 1995 to its price in 1985. However, along with the price increase have come substantial improvements in quality. After putting out dismal products in the 1980s, Chrysler made substantial quality improvements in the 1990s. The modern LeBaron buyers enjoy features such as CD stereo players, safety air bags, and a number of other quality improvements that add to the car's value. According to the CPI, we pay more for the LeBaron, contributing to inflation. Adjusting for quality improvements, the price has not increased nearly as much.

Although the prices of some goods have increased over time, the prices of others have consistently fallen, especially when measured in terms of the labor required to purchase that good. In 1908 is took 4,696 hours in terms of factory wages to purchase an automobile. By 1970, the hours required by the average factory worker to buy an new car had fallen to 1,397 hours. The price in terms of factory hours continued to decrease to 1,365 hours by 1997. Although the absolute price of a new car has steadily risen over time, in terms of labor effort prices have fallen, and the typical 1997 model boasted significant quality improvements over its 1970 counterpart.

In 1915, it cost $20.70 to make a coast-to-coast three-minute long-distance telephone call on the AT&T network - equivalent to 90 hours in factory wages. Today, the typical factory worker can pay for the cost of the same call by working two minutes.

In 1915, a factory worker needed to put in 3,162 hours in order to afford a refrigerator for his home. Today, it takes a week and a few days, 68 hours in total, to make the purchase.

b.      The weights used to add together the prices of different goods and services that go into the index are often out-of-date.

The basket of goods is revised about every decade and lags changes in consumer tastes and preferences that influence consumption behavior. Over time, the CPI becomes increasingly outdated, failing to accurately reflect changing consumer spending patterns.

c.       Consumers often substitute away from goods that are increasing in price.

This idea is closely related to #2 above but also reflects more immediate consumption patterns. If the price of a good is increasing, the consumer will seek out cheaper substitutes. The wise food shopper will adjust his grocery list to reflect changes in fresh food prices. Either rich or flippant is the shopper who insists on buying peaches in a drought year. During the 1970s oil shocks sent energy prices soaring by 218% between 1972 and 1980. Consumers flocked to alternatives such as fuel-efficient automobiles, insulation for their houses, and public transportation. Consequently, consumer outlays for energy during this period increased by only 140%. The CPI overestimates inflation by failing to allow for substitutes in consumption as relative prices change. Of course, these changes can be accounted for in the reevaluation of the CPI market basket that occurs every decade, but only after the fact.

Due to the above factors, the best guess is that the CPI overstates inflation by 1% to 1.5% on an annual basis. This is an important point, since economic policy often strives to achieve the lowest inflation rate possible. The implications are important for policy-makers, who could mistakenly aim for an inflation rate equal to zero, which could cause economic growth to disappear.

The CPI is calculated by the Bureau of Labor Statistics. It is based on a basket of 211 goods and services such as health care, education, entertainment, many of the items that we place in our shopping carts as we cruise the aisles of the grocery store and so on. To find current prices, Bureau agents go on a simulated shopping trip each month, tabulating prices.

Comparing actual apples to apples is simple, but consider the case where a shopper wants to trade in his 1998 Chevy for a 2002 model. The price for a new model may have increased by several thousand dollars between 2002 and 1998, but the 2002 may also have standard features that include an improved electrical system, additional safety features, include a theft alarm, and most importantly, a deluxe CD sound system is now standard, while in 1998 Chevy may have been trying to cut costs by making the then-extinct 8 track tape player as the standard. For reasons that include the failure of the index to fully account for consumer substitution when the prices of some goods rise and improvements in quality (e.g. 2002 cell phones vs. 1992 cell phones), an independent commission found that the CPI overstated the actual inflation rate by 1.1. percent.

In 2002, The Bureau of Labor Statistics, undertook an overhaul of the CPI statistic. The goal of the revisions are to better reflect consumer behavior and to give economic policy makers a better estimate of how social and technological changes affect the inflation rate.

New weights will be used for the consumption of goods and services reflecting purchases made in 1999 and 2000. The weighting will be increased for goods and services such as college tuition (no surprise), cable TV, prescription drugs and nursing home care, while weights for full-service restaurant meals and men's suits among other goods, were reduced. The change in weights reflects consumer outlays for different goods and services. In 2000, a greater proportion of consumer spending went to pay the cable TV bill, than in 1990 while less money was spent on suits.

 

The Effects of Unanticipated Inflation

In many ways the problem with inflation is not the higher prices, but the way it can creep up, suddenly creating a big stir and causing us to lose our balance and spill our cup of tea. Or put another way, as long as we properly anticipate inflation, we can prepare and absorb much of its shock. Problems occur when inflation is greater than we predicted, when it is unanticipated. When the actual inflation rate is greater than the anticipated (planned for) rate, several problems may arise.

A redistribution of income and wealth within the economy. Institutions that lend money, such as banks, hate inflation. When a bank makes a loan, it charges an interest rate based on projections of future inflation, tacking on a few percentage points for profit. If inflation rises above the anticipated level, then profits are eroded or even eliminated.

Profits are hurt because of the way banks make money. Banks pay depositors interest to attract funds, which they can loan out at a higher rate. However, the rate paid to depositors adjusts more quickly to market conditions than the interest rate that banks charge borrowers. If inflation shoots upward, interest rates immediately follow. Banks are forced to quickly raise the return to depositors, while the rate on the overall portfolio of loans lags behind. Although banks are increasingly making flexible-rate loans and taking other defensive actions (such as interest rate swaps) they still prefer a low, steady, and predictable inflation rate.

The three things we can conclude:

  • bank profits fall during periods of rising interest rates (caused by increased inflation);

  • in general,unanticipated jumps in inflation hurt lenders while helping borrowers who pay off their debts with money, the value of which has been eroded by inflation; and

  • if inflation is properly anticipated lenders can raise the interest rates that they charge borrowers in order to maintain a positive rate of return.

Later in this course we will look at the issue of interest rate determination in more detail.

Another problem caused by unanticipated inflation is for workers on fixed contracts. If a labor union makes a long-term agreement for salary increases based on the projected inflation rate, then the real wage may actually decline if the inflation rate shifts up. The definition of the real wage is:

real wage = nominal wage - inflation rate

For an example, assume the nominal wage increases at a 5% rate. If inflation is 3%, the real gain in wages is 2%. But if inflation unexpectedly jumps to 8%, the real wage gain is -3% (the real wage falls by 3%).

Other Consequences of Inflation

There are several other economic impacts to consider as a consequence of high inflation. Inflation has an impact on the output and employment decisions by firms that are altered by high inflation. Some possibilities include:

  1. Inflation distorts the price mechanism by making it difficult to distinguish changes in relative prices from changes in the general price level.

    Changes in relative prices may be offset by the substitution of lower price inputs used in production. If almost all prices are rising rapidly, there is little incentive to search for cheaper substitutes that could help keep production costs low.

  2. Inflation creates uncertainty.

    If businessmen are unsure about the future level of prices, and thus of real interest rates, they will be less willing to take risks and invest, especially in long-term projects. As investment is reduced, so is the long-run growth potential of the economy.

  3. There may be a redistribution of resources and production into areas less affected by high inflation rates.

    Inflationary hedges are used to try to keep up with the effects of inflation, possibly to the detriment of the economy. The classic inflationary hedge is gold (and other precious metals). Gold is desirable in times of high inflation because the paper currency issued by the government rapidly loses its value (purchasing power), while gold prices tend to keep pace with inflation. The reason is that inflation increases the opportunity cost of holding paper currency (which loses its value) and gold is the closest available substitute. As the demand for gold increases, the price of gold rises (along with inflation). As savers shift their assets into gold, they reduce their holdings of stocks and bonds. This reduces the supply of funds available for businesses to borrow, raising the cost of investment (r, the interest rate). The result is less business investment and a reduction in the economic growth rate.

  4. Inflationary uncertainty pushes up real interest rates, as lenders demand a bigger risk premium on their money.

    Longer-term interest rates are especially punished as a high inflation premium is added to account for inflationary uncertainty. As a result, the cost of borrowing by businesses and consumers increases substantially, reducing the rate of real economic growth.

  5. Overall redistribution of productive and financial resources may lead to a loss in efficiency.

    As economic efficiency falls, so does the production of goods and services.

Certain elements of the tax code are deficient in adjusting for inflation. A capital gain represents an appreciation in the price of an asset, such as real estate. The capital gain is the difference between today's price and the purchase price (assuming that the market price has increased since the date of purchase). During times of high inflation, real estate prices usually appreciate, reflecting an inflationary adjustment among other factors. When the capital gain is realized (the asset is sold) the amount of the gain is taxed. However, tax rates fail to properly adjust for the part of capital gains due to inflation. Individuals are taxed on both their real and inflationary capital gains, while optimally they should only pay a tax on their real (after- inflation) capital gain.

We can observe a positive correlation of interest rates to inflation rates. Not surprisingly, empirical evidence shows that since 1973 countries with low inflation have tended to accomplish slightly faster GNP/GDP growth than those with higher inflation levels. In addition, countries with low inflation rates enjoyed the lowest unemployment rates.

We can conclude that inflation may cause many economic distortions, including slower growth and higher unemployment. Many policymakers advocate attempting to sustain the lowest possible rate of inflation. It is argued that low inflation rates yield benefits of:

  1. Making possible the fastest long-term growth.

  2. Eliminating the distorting consequences of unpredicted inflation.

  3. Reducing the uncertainty and inefficiency associated with inflation.

Types of Inflation

There are three main types of inflation:

  1. Demand-pull inflation

  2. Cost-push inflation

  3. Hyperinflation

Demand-Pull Inflation

fig15.gif (7172 bytes)

Figure 3-5 illustrates the concept of demand-pull inflation. Consider the demand for automobiles. If economic growth is strong, consumer income rises and the demand for cars as shown graphically. The rightward shift in the demand curve for automobiles drives up auto prices from Po to P1. This is known as demand-pull inflation: inflation resulting from the increased demand for goods and services throughout the economy. As this example shows, demand-pull inflation is generally driven by purchases of final goods and services.


You may have noticed in the above graph that an increase in the demand for automobiles drove up auto prices and increased the quantity supplied by auto manufacturers. An important component used in the production of any automobile is steel. As auto producers increase their output of autos, they will demand more steel used in producing those cars. The price of steel and other inputs used in the production of autos will also rise. The graph is not shown here but the analysis for the steel market is the same as shown above.

Cost-Push Inflation

fig16.gif (6469 bytes) 

Figure 4-6 shows the idea behind cost-push inflation: higher production costs shift the supply curve to the left, causing prices to rise. Following our previous example, as Chrysler and other automobile producers increase their output to meet a surge in demand, they must pay higher prices for inputs such as steel. In addition, they will add extra production shifts, incurring increased overtime expenses for labor. As a result, the cost of producing an auto increases. Higher production costs cause the supply curve to shift inward resulting in higher prices for automobiles. The main cause of cost-push inflation is increasing prices of inputs used in production.

A potential leading indicator of cost-push, or supply-side, inflation is commodity prices. Economists track the prices of various commodities, from oil to gold. As the prices of inputs such as copper rise, the prices of outputs such as home wiring and plumbing will soon follow. To date there is no consensus as to which commodities to track and their relative weights (importance) in a commodity price basket. Although commodity prices do respond positively to increases in demand, they are also subject to noneconomic influences such as mining strikes and oil embargoes. For this reason commodity prices can undergo large swings for nondemand reasons, and their individual price spikes may not be a prolonged contributor to future inflation. Furthermore, raw materials represent only about 10% of total production costs, easily dwarfed by labor, which accounts for approximately 70% of the cost of production in the United States (a country with relatively capital-intensive production processes).

Commodities can yield an important leading indicator of future inflation, when their prices rise due to greater demand. Since the effects of short-lived supply problems (which are more easily compensated for) are hard to separate, commodities have failed to become a consistent and reliable leading indicator of future inflation.

On a larger, macroeconomic scale, cost-push inflation is a result of supply-side shocks. A well-known example of a supply-side shock was the OPEC oil embargoes during the early and late 1970s. The economic effect of the oil embargoes was a surge in the price of oil and other petroleum products. Higher oil prices caused energy prices to soar, which translated into electricity price spikes. As the producers of goods and services saw their utility bills climb, the increased cost of production led to a scenario as shown above by energy-intensive industries such as steel. Higher production costs led to a contraction of supply and higher prices of inputs and consumer goods.

Hyperinflation

As unappealing as demand-pull and cost-push inflation sound, they are a drop in the bucket compared to the grandest of all inflations, hyperinflation. The best definition of hyperinflation is price increases that are so out of control as to make the concept of inflation meaningless. For example, in Germany between January 1922 and November 1923 (less than two years!) the average price level increased by a factor of about 20 billion.

The German hyperinflation had its roots in the Treaty of Versailles, where the victorious allied nations imposed impossible war "reparation" payments on Germany. Faced with financial debts beyond its economic capacity to generate the required amount of payment, the German government started printing money to meet its obligations. As you see in this course, a major cause of inflation is printing money in large quantities, which can lead to an inflationary spiral.

During the hyperinflation, German workers would be paid in three shifts during the day. For example, after working the morning shift, workers would race to spend their fresh salary, which would be worthless within another few hours. There are pictures of children building play forts with bricks of worthless currency. Observers told stories of how Germans would order two beers at once, fearing that beer prices would rise before they finished their first one. Another story does have a silver lining. If a person purchased a bottle of wine, they could sell the empty bottle the next day for more than the purchase price - wine included.

As you might imagine, the value of domestically held savings was wiped out, and the German middle class eroded substantially. The economic chaos opened up an opportunity for Hitler and his brown shirts to take over, leading Germany and the world into World War II. Fortunately, the victorious allies learned their lesson and helped rebuild the devastated Axis governments through the Marshall Plan.