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

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

Econ 1000: Mod 4, Lecture 8

C. L. Mattoli (C) Red Hill Capital Corp., Delaware, USA 2008 1

Mod 4, part 2: Macroeconomics

 Chapter 12, page 333 to end, Economic Growth, Macro policy  Chapter 13, Inflation and unemployment (C) Red Hill Capital Corp., Delaware, USA 2008 2

Learning Objectives

 Discuss the determinants of economic growth  Briefly outline causes of both

inflation

and

unemployment

 Discuss the measurement and causes of inflation.

 Discuss the objective of full employment (C) Red Hill Capital Corp., Delaware, USA 2008 3

Last Time

 We looked at proxies for measuring macro economic growth, and we settled on real GDP as one possibility.

 We also discussed the definition of GDP and other national accounting concepts, including some components: consumption, savings and investment.

Last Time

 We also discussed some of the shortcomings of measurements of national accounts and the shortcomings of using real GDP as a proxy for growth.

 We then went on to discuss the general trend of economic growth and its cyclical nature, peaks and troughs, recessions and expansions.

 Next we will look at the causes of growth in a simple economic modeling format.

Last Time

 After that, we will go on to discuss two other major

macroeconomic variables

on which people and

governments focus

inflation

of prices of goods and services and

employment

of the people within an economic society.

 Both of these macroeconomic items are

concerns for society



Inflation of prices erodes the buying power

of people. (C) Red Hill Capital Corp., Delaware, USA 2008 6

Last Time

 If prices increase by 10% in a year, for example, and people are paid the same wages, they will be able to buy 10% less, in goods and services, with their money.

 If

people who want to work

and earn a living are

unable to find employment

, they will not be able to buy anything or they will have to dip into their savings from past earnings, if they have any.  The

person loses well-being;

the

society loses production

that it could have had.

Long-term Economic Growth

Intro

 The

cyclical swings

of the business cycle are

around

some sort of

LT growth trend

of the economy.

 LT

trends vary

from country to country and can vary over longer periods of time for one particular country or another.

 LT growth trends have a

significant impact on the standard of living,

the average “buying power”, of people in a society.

Intro

 For example a growth rate of 3% in per capita (per person) real GDP, a common proxy for standard of living, can mean the

standard of living

will double in 25 years (a generation) and will triple at 5%.

 Thus, a central concern in macro is to understand the determinants of LT growth and to investigate whether or not government policies can affect it.

Country

Japan Brazil W. Germany U.S.

China U.K.

Australia Thailand Indonesia India Bangladesh

RGDP/p Period

1890-1990

begin (1985 $)

842 1900-87 436 1870-1990 1223 1870-1990 2244 1900-87 401 1870-1990 2693 1870-1990 3143 1900-87 626 1900-87 499 1900-87 378 1900-87 (C) Red Hill Capital Corp., Delaware, USA 2008 349

RGDP/p End Annual growth

16144 3417 14288 18258 1748 13589 13514 2294 1200 662 375 3.00

2.39

2.07

1.76

1.71

1.36

1.22

1.09

1.01

0.65

0.08

The results in greater detail



Real per capita GDP

is a common international

measure of incomes and standards of living.

Thus, we might ask:  Why has Japan had the greatest growth in per cap GDP, over a century, while India, until recently, and Bangladesh have had almost none?

The results in greater detail

 Australia had the highest per cap RGDP a century ago, but, then, it slipped behind the U.S. and Germany by the end of the century.

 Since the 1960’s, the Asian Tigers, S. Korea, Singapore, HK, and Taiwan, have experienced incredible growth, and China has joined them since the 1980’s, increasing per cap RGDP by 500% in just one generation.

Background

 Ultimately, growth of the economy will be determined by growth in supply and demand.

 In our analysis of growth we shall examine both sides, supply and demand, but we should always remember that, in the end, it is the interaction of the two that determines the quantity of output produced and consumed, invested and saved.

 In a closed system, the demand cannot outstrip the productive capacity of the economy, and the productive capacity will have no reason to grow without sufficient demand.

Determinants of Growth: the Solow model

 In lecture 5 (chapter 6), we introduced the idea of the production function for a company. Now, we imagine a production function for a whole economy.

 From the supply side, output growth is the result of change over time in the factor inputs of (productive) land, and capital, mixed with improvements in technology, into the production process.  In the

following discussion

, we shall refer to the

non-labor inputs

to production as,

just, production factors

Determinants of Growth: the Solow model

  Then, the

aggregate production function, Y,

the country is

output per worker

versus the

quantity of production factors per worker, Q PF

of As shown in the next several slides, the

output per worker increases

but at a

decreasing rate

diminishing marginal productivity

operates on the macro scale.

 In the next slide we show the production function and how it will change with improved production technology.

The Production Function and Technological Change

Aggregate Production Function (output/worker), fixed technology Y Y 2 Y 1 Aggregate Production Function (output/worker), changed technology Y Y 2 Y 1 1 2 More input: more output Q PF 1 Q PF Same input + techno advance = more output

Graph Analysis

 In the preceding slide, we show how output per person might vary with factor inputs for an economy and that an improvement in technological methods of production would move the whole curve, upward, so that more output could be produced per person with given factor inputs.

 We can also use such graphical displays to analyze the differences in outputs of different countries (economies).

Graph Analysis

 In the next slide, we use production function graphs to show how the outputs of 2 different countries might turn out to be different.  The comparisons are revealing because they adjust for size of the economies by focusing on output per person.

 The graphs examine how differences might come from differences in the other input factors available to workers (

factor accumulation

), labor productivity differences, or both. (C) Red Hill Capital Corp., Delaware, USA 2008 19

Output per person differences for 2 Economies, A & B

Y Differences due to Factor Accumulation Y Differences due to Labor productivity Y Differences due To Both Y B Y A Country A Country B Q PF Country A Country B Q PF Both countries Q PF

Graphical Implications

 In the

first graph

, we see that countries with the

same production technologies

can have different outputs per person (per capita real GDP) if they have different amounts of other input factors per person.

 The

second graph

shows that 2 countries can have different outputs per person, even if they have the same amounts of other input factors per person but

one is more technologically advanced

than the other.

Application to Growth

 Thus, we can explain, in simple terms, the reasons that one country might experience different growth in real per capita GDP than another.

 It might be that one country manages to accumulate more production factors per worker than another.

 Alternatively, one country might be able to improve its worker productivity (better technology) more than another country.

Application to Growth

 Most probably, both have been factors that have accounted for differing growth of countries.

 In order to discover how countries have managed different growth rates over time, we must examine how countries can increase the quantity of productive factors available per person, or how they might improve productivity.

Production factor accumulation & the Golden Rule

 Our previous discussion focused on the supply side of the economic equation.

 If we want to consider how a country might increase its production factors, we must

look at

the question of (economic)

investment per person

  Then, we are really asking about the

demand side

of the economic growth equation. In that regard, a nation’s output is either consumed or used for investment.

Consumption, savings & investment

 The output that is not part of consumption is the

savings

of the people, and their savings can be used by firms to make investment (forgetting about foreign savings, for simplicity). Thus, savings is crucial for investment.

 Then,

higher savings

results in

higher investment

results in a

greater quantity of production factors

per worker and

higher levels of output

per person.

Consumption, savings & investment

 This begs the question:

is there an optimal level

per capita savings

for an economy, which would allow the community to

maximize

its

consumption over time

 In fact, since

savings

foregone present consumption

, the

motivation

for savings is to

increase

ones

future standard of living

(recall Tin tin's savings from a previous lecture). (C) Red Hill Capital Corp., Delaware, USA 2008 26

Consumption, savings & investment

 So,

what is

optimal level

of savings?

 It is

not zero

because, then,

factors

would actually

wear out

and the result would be a

decrease in factors



Nor

would it be

100%

because people will want to

consume

and there is no reason to invest for only investment sake.

 Finding

if there is

an optimal level is an

important question

since government

policy can

actually

influence savings

Factor accumulation & the Golden Rule

 The so-called

Golden Rule quantity productions factors/capita

will of

induce

optimal savings rate

.   We shall

examine the logic

behind the golden rule.

The

larger the store

of an economy’s production

factors

, the

larger

will be the amount

wearing out

(depreciating) in each period.  Thus, a

higher level

output

will be

required each period

, just to

cover depreciating

production factors.

Factor accumulation & the Golden Rule

 In turn, a

higher level

investment

will be

required

, in each period, inducing a

higher level

of per capita

savings

 With a

higher capital stock

, the economy will also have the

capability to produce more

output, so the society might also enjoy

higher consumption

per capita, resulting in a higher standard of living.  There is a

logical limit

to which the

per cap production factors can be raised

because of

decreasing marginal productivity

Factor accumulation & the Golden Rule

 As a result, we can conclude that

the

total stock

factors increases

, the

marginal output

that can be

achieved by increasing

the capital stock

decreases

.  Therefore, there

will also be a point

where the

marginal savings/capita

out of the higher output that will be required to simply replace the existing stock of production factors

will result in a decrease in consumption/capita

, leaving the society worse off.

Factor accumulation & the Golden Rule

 Thus, it will not be rational to increase the savings rate beyond that point.



The point

where consumption/capita cannot be increased by increasing savings is referred to as the

Golden Rule savings rate

 Indeed, there is no reason that a country would naturally arrive at this perfect savings rate, and it is one place that policy might be necessary to induce it.

Factor accumulation & the Golden Rule

 However, it might be difficult, even policy-wise, because arrival at this golden perfection might require raising the savings rate, which will lower current consumption.

 People might be averse to the current sacrifice, even if it means that they would be better off in the long run.

Factor accumulation & the Golden Rule

 Moreover, it might be difficult, politically, for a politician to try to change, by force, the current consumption habits of the populace since he will not want to alienate them and lose a future election.

 There are examples of such situations in Southeast Asia of countries below the golden rule savings rate, while Japan, in the last century, is an example of a country that has been above the perfect savings rate.

Factor accumulation & the Golden Rule



In the latter case, not only would it be good, in the long run, for a country that is above the perfect rate, but an immediate increase in consumption would also be a benefit.

Technological Change

 Our discussion of the

golden rule assumed

that

technology

constant

 In fact, as the economy moves towards the

golden rule

savings rate, output per cap will increase as savings and investment per cap increase, and eventually, a

level

of consumption per cap would be reached

beyond which

the economy

could not move

, and

growth

would

stop

Technological Change Plus..

 The factors of production per cap, having increased will get to a point at which savings per cap will just replace existing per cap stock, and consumption per cap will become a constant.

 Fortunately,

technological change

can

move

the

production function

to a

new path

by affecting the other factor of production, labor, and

labor productivity

will increase output per worker given the other factors of production per cap and will result in

growth

Technological Change Plus..

 It is simply the shifting out of the PPF per cap that we attributed, earlier, to changing technology.

 Models of growth, like the

Solow model

implicitly assume technological advancement

, in that they allow that

new investment

in factors

can include

more technologically-advanced equipment that

replaces the old

Technological Change Plus..

 This technological change that increases per cap labor productivity results in increased per cap output, which is increased standard of living, over time.

 In addition,

other things, beyond technology

, per se, can result in increased per cap output.  Although we

shall group such extra technological

things under the

broad heading

techno

change, they include things, like better

labor organization

, better

management

, and better

education and training

of the workforce.



Technological Change Plus..

The

Solow model

assumes that all such technological innovation is

exogenous

, i.e., they come from without (“exo” means outside), not within the economic system. It is not part of the model.

 That is one of the faults of the model, which we shall patch up with a look at the endogenous possibilities for technological advancement.

 This

endogenous growth model

is a more up-to-date model of macro growth. (C) Red Hill Capital Corp., Delaware, USA 2008 39

The Endogenous Growth Model: knowledge as a factor of production

 While the Solow model did not include an internal mechanism to create technological development to promote growth, a more

modern view

is that

technological innovation

endogenous

to the economic growth, itself.

 In that regard, not only does new technology increase productivity, it also adds to the knowledge base of the society.

The Endogenous Growth Model: knowledge as a factor of production

  This increased knowledge base, in turn, might provide a framework for inventing even more advanced technology.

For example, space technology of the 1960’s led to the development of microprocessors to build better mainframe computers in the 1970’s which led to development of PC’s in the 1980’s, which has resulted in many new technologies in production and communications in the 1990’s.

The Endogenous Growth Model: knowledge as a factor of production

 In light of that, it may be

possible government

to have a positive

impact

in the process.

for  In order to create new knowledge, large expenditures may be required for R&D, but it is difficult to maintain a monopoly on knowledge once it becomes part of the economic process. (C) Red Hill Capital Corp., Delaware, USA 2008 42

The Endogenous Growth Model: knowledge as a factor of production

 Thus, governments can encourage knowledge development through the issue of patents to grant

temporary monopolies

to the developers of knowledge.  Even so, there might be spillovers from knowledge that represent

positive externalities

for society but that might be

disincentives

for a firm who created the knowledge.

The Endogenous Growth Model: knowledge as a factor of production

 In that regard, governments might also offer

tax incentives

to encourage R&D.

 If we consider knowledge as a true factor of production, its character is different from other factors of production.



Normally

, adding production factors will

increase production

at a

decreasing rate

, but the same is

not true

for the

addition of knowledge

The Endogenous Growth Model: knowledge as a factor of production

 The acquisition of new knowledge

might

, instead of having diminishing returns, have

increasing returns

 Thus, there might be justification for governments to actually

subsidize development of knowledge

, as in the case of publicly funded

basic research at universities

The Endogenous Growth Model: knowledge as a factor of production

 Even though some of that research is esoteric, it might have long term benefits to the community.

 For example, the internet evolved as a result of some university researchers wanting to find a faster way of communicating with one another using their computers and telephone lines.

Government policy and growth

Overview

   Governments are concerned both about long term economic growth and the ups and downs of the shorter-term business cycles.

First, in the business cycle, it is a concern to limit the severity of downturns because they cause unemployment.

In addition, many economists believe that there are

long-term effects

from

downturns

because of the affects

on both

the

capital stock

and the

skills of

may have an affect on the long-term growth path of the economy. the

workforce

, which (C) Red Hill Capital Corp., Delaware, USA 2008 48

Overview

 When machinery sits idle, it can dusty and creaky.  When people sit idle, their skills can dull.  It is also important to not allow an economy to overheat in the expansion phase because that can lead to poor investment decisions that will, eventually, lead to wasted money or a recession.

Overview

 Government policies should, therefore, be pursued that will aid the economy in achieving its proper long-term growth trajectory: not too fast but not too slow.  Policies to affect long-term growth will be macroeconomic and microeconomic, in nature: targeting the whole economy, in some cases, and specific industries that can help growth.

Productivity and Unemployment

 Another area in which government must play a role in fostering development of technology is

job obsolescence and displacement

 Technological change can result in people being put out of their jobs (

structural unemployment

), in the short-term, and society’s concerns may cause governments to take the wrong actions because of political concerns.

Productivity and Unemployment

 Consider, for example, a small island where fishermen catch fish with spears and the other industry is coconut, fruit and nuts. A third industry supplies fishermen with fishing spears.

 One day, some boats with fishing nets wash up on shore and some of the fishermen experiment with the boats and find that they can go out to deep water and catch many fish with the nets.

Productivity and Unemployment

 In the mean time, the other fishermen who didn’t find a boat are extremely disadvantaged and the spear industry is also threatened.

 As a result, some of the community members go to the island elders (the politicians) and complain of these “unfair practices”, and the elders order the burning of the boats and nets.

Productivity and Unemployment

  In the end, the community is no worse off than it was before, but it has foregone the longer-term well-being of the entire community because of the short-term disruption and displacement from beneficial technology.

A better long-sighted alternative would have been for members of the society to embrace the new technology and dedicate productive resources to its duplication. (C) Red Hill Capital Corp., Delaware, USA 2008 54

Productivity and Unemployment

  Spear makers and some of the gatherers and fishermen could have begun new businesses making nets and small boats.

Thus, governments in modern society may feel the same pressures, but their response should be along the lines of retraining and relocating the members of the labor force who have been displaced, rather than resisting technological change.

The Importance of Political Infrastructure and Institutions

 In a recent study by Roll and Talbott (Political and Economic Freedoms and Prosperity, 2003), the authors found that the

real variables

that have

great affect on wealth

are

institutional

, in nature.

 Many economists have asserted that growth depends on a

high investment rate

, heavy R&D expenditures and foreign trades, but Roll and Talbott find that these are

consequences

of deeper underlying policy.

The Importance of Political Infrastructure and Institutions

 In their study, they found that the huge differences in GNI/capita across the world are 80 % explained by political, structural and institutional variables.  Property rights and black markets have the largest influence.

 Also important are civil liberties, freedom of the press, political rights and reduction of trade barriers. (C) Red Hill Capital Corp., Delaware, USA 2008 57

The Importance of Political Infrastructure and Institutions

 In their study over the long term, they found that there is a direct relationship between liberalization, which results in substantial growth, versus dictatorial retrenchment, which has the opposite affect on growth.

 Their study concludes that countries can develop faster by enforcing strong property rights, fostering an independent judiciary, attacking corruption, dismantling burdensome regulation, allowing press freedom, and protecting political rights and civil liberties. (C) Red Hill Capital Corp., Delaware, USA 2008 58

The Importance of Political Infrastructure and Institutions

 Other conclusions are that foreign aid to less developed countries should be tied to institutional reform.  Then, greater economic freedoms will quite naturally lead to an environment that promotes investment and internal growth, so that dependence on aid will no longer be necessary.

Break time

 10 minute break (C) Red Hill Capital Corp., Delaware, USA 2008 60

Inflation

Inflation: meaning

 When I was a little boy, a candy bar cost 5 ¢. Now the same candy bar costs more than 50¢. But the candy bar is certainly not more valuable today than it was when I was younger.  What has occurred is a specific example of a general

inflation

in the prices of goods and services in the economy. Prices change although nothing else, like value, has really changed. (C) Red Hill Capital Corp., Delaware, USA 2008 62

Inflation: meaning

 Although price inflation is the general trend of the entire basket of goods and services over time, there can also be

price deflation

, an example of which is the prices of computers and other electronic devices.

 Usually, we talk of

inflation rates

or rates of inflation, which means the

percentage change

in prices, usually given in annualized terms.

 Another term in the language of inflation

disinflation

, which is a

reduction

in the

rate of inflation

Inflation: meaning

 The effect of inflation is, obviously, that the money that you have will be able to buy less and less.

 Thus, the true effect of

inflation of

both

purchasing power

and is

erosion wealth

 In that regard, high inflation is a bad thing, while some inflation is, basically, built into the system:  Prices rise, so people demand higher wages, which make prices rise, etc.

CPI: one measure

 The most widely talked about measure of inflation is the

consumer price index (CPI

), also, called the

cost of living index

 It is an index that measures average price of a normal

“basket”

of goods and services that the average consumer buys.

 Then, changes in the index over time give the rate of consumer price inflation.

CPI: one measure

 It is strictly for consumer prices and not business or government.

 Indeed there are other price indexes. We have already discussed the GDP deflator, which covers an entire economy, and there are usually also wholesale price indexes, for prices at the wholesale as opposed to the retail level, like for the CPI, and producer price indexes computed in various countries.  In the next slide we show the broad categories of inclusion in the consumer basket.

Makeup of CPI

Category Percentage weight in index

Food Alcohol & tobacco Housing Home furniture, supplies & services Clothing and footwear Transportation Health Recreation Education Communication Other G&S

Total

7.4

19.7

8.1

5.2

15.3

4.7

10.3

2.7

2.9

4.0

100.0

CPI discussion

 As you can see from the preceding slide, there are various items from a

typical household basket

of consumption items, given in the proportion for the

“average” household in urban areas



Surveys

are performed at a

sample

of retail outlets, other businesses that supply household G&S, and home owners and renters.

CPI discussion

 The percentage weights are usually kept constant in calculations of the index from period to period, so it is referred to as a

fixed-weight price index

 Weightings of the consumer basket do change over time, so the

weightings

are

adjusted

for index calculations

about every 5 years

in Australia. (C) Red Hill Capital Corp., Delaware, USA 2008 69

CPI discussion

 Indeed, things

become part

of the index, while

others drop out

. For example, mobile phones and computers would not have been part of the index in the 1970’s, while vinyl recordings of music and record players would not be part of it today.  CPI’s are usually also available for specific urban areas, not just the whole country.

CPI discussion

 The indexes are also broken down into many component indexes, like housing prices, which are further broken down into rental and home purchase mortgage payments, or food, which will have meat, then, beef, pork, lamb, etc.; vegetables; fruit; starches, such as rice and noodles; transportation, which will include trains and buses as well as automobile purchase and maintenance; etc.

Example CPI calc: simple economy

 Assume a typical family in a mythical country purchased the following items for subsistence, in one year, and that they will do the same, every year: 100 packages of noodles, 300 liters of gasoline for their automobile, and 4 tunics for family members to wear.

 To construct a price index, we sum up their purchase and follow the cost of the same purchases year after year. That will give us a total cost.

Example CPI calc: simple economy

 We, then, choose a year as the base year and divided all years’ total cost by the cost in the base year.  The result will be an

index

that is equal to one in the base year (cost in the base year/cost in the base year), and another small number for other years.

Example CPI calc: simple economy

 Then, we can compute year-over-year or other-period percentage changes of the index to find the rate of inflation of the price of the basket of goods.

 We show the sample index computation in the next slide.

 You will be expected to be able to calculate simple CPI’s for the final exam in this course.

Sample CPI construction

Item Packs of noodles Quantity purchased 1990 prices Basket cost 1990 2000 prices Basket cost 2000 100 $2 $200 $3 $300 Liters of gas Tunics 300 4 $1 $20 $300 $80 $2 $25 $600 $100 Totals Index values (1990 $) $580 580/580 = 1 (C) Red Hill Capital Corp., Delaware, USA 2008 $1,000 1000/580 = 1.7241

Index construction details

    The construction, first, finds total cost of the consumer basket, in each year.

Next, we divide all years’ costs by the base year, 1990, cost of $580 to create an index, rather than the raw costs in dollars.

Then, the index will be 1 in 1990, and $1,000/$580 = 1.7241 in 2000.

Percentage changes in the index are inflation rates. For a year, percentage change is computed as [CPI(this year) year) number).

– CPI(last year)]/CPI(last year) = CPI(this year)/CPI(last – 1 (times 100 to convert to percentage (C) Red Hill Capital Corp., Delaware, USA 2008 76

Index construction details

   For periods of more than a year, n years, we can find an annual rate from annual inflation = [CPI(N)/CPI(0) – 1] 1/n (the nth root).

Thus, the total percentage change over the ten-year period was 72.41 %, or a compound annual rate of inflation equal to [(1.7241) 1/10 – 1] = 5.6%/year over the period.

CPI reports are usually monthly, and the percentage changes are usually quoted as year-over-year, going from, e.g., May of last year to May of this year.

Index construction details

  We could also examine inflation of each of the components of the basket and considering their weightings, in order to get a better picture of what is causing the rise in general CPI inflation.

Food prices increased by 3/2 – 1 = 50%; gas prices, 2/1 – 1 = 100%; and clothing, 25/20 – 1 = 10%.

 Indeed it is common to hear reports, these days, of CPI inflation ex-food and energy prices.

Historical Australian Inflation in the CPI

CPI shortcomings

 Just as in the measurement of any aggregate macro statistic, CPI has its faults.



First

, there is the problem of the

typical basket of goods

. That is based on what an average view of that basket will contain, while it might not fit all households.

 In particular, retirees will have a basket very different from a typical family: more medical, less child-related items.



CPI shortcomings

Second

, just like in the case of GDP, it is difficult to adjust for

quality changes

.  Thus, while a portion of price change might be due to increased or decreased quality, that might be lost in the index.  The ABS does try to make adjustments for quality in automobiles, electronics and other items in the basket, but complete accuracy is a problem.



Third

fixed weighting

does not take account of the basic laws of supply and demand. (C) Red Hill Capital Corp., Delaware, USA 2008 81

CPI shortcomings

 For example, if there is a drought, and there is less rice available, the price will rise, demand will fall, consumers will eat more noodles, and the basket of consumer goods will shift to less rice and more noodles, while the official basket will remain the same.

 Thus, CPI will not give an accurate picture of consumer price inflation of the real basket.  The ABS makes basket adjustments about every 5 to 7 years.

Consequences of inflation

 Inflation can

erode the standard of living

, shift income distribution and

impede the efficiency

allocation of resources



Inflation

, first, erodes the standard of living through the

reduction of purchasing power

of the money you have and earn. The greater the rate of inflation, the greater are prices of goods and services, and the money that you have can, therefore, buy less goods and services.

Consequences of inflation

 In that regard,

nominal income

, income stated in

current dollars

, does not truly measure your purchasing power.

 In order to truly understand where you stand, purchasing-power-wise, given the money that you are earning, you

must convert (deflate)

the

nominal dollars

of your income to

for inflation real income

adjusting

(division by an inflation index). RI x PI = NI (real income times price index equals nominal income).

Consequences of inflation

 Real income measures the amount of G&S that you can actually purchase, and provides a better measure of how well off you are.

 If your nominal income does not increase as fast as the rate of inflation, you will not be able to buy as many G&S as you could before. Your purchasing power declines, and your standard of living falls.

Purchasing Power and real income

 Suppose, for example, that you earned $100,000, last year, and the CPI stood at 1.00.

 Imagine that, this year, you earned $105,000 but that the CPI has risen to 1.10.

 We compute your

real income

, in each year, by

dividing nominal income by

the

price index

. (C) Red Hill Capital Corp., Delaware, USA 2008 86

Purchasing Power and real income

 Then last year your putative real income was $100,000/1.00 = $100,000 last year’s fixed dollars. This year your income is $105,000/1.10 = $95,455.

 Thus, your decrease in purchasing power (PP) is found as the percentage change from last year to this year: ($95,455 – $100,000)/100,000 x 100(to make it a percentage) = – 4.54%.

Approximation formula

   We can also find an approximate formula for breaking down increase in nominal income (or

nominal anything

) into a

real

change and an

inflation

change as follows: Percentage change in real income = % ΔNI

NI N = (1 + % ΔPI)(1 + %ΔRI)NI N – 1 = [1 + % ΔPI + %ΔRI + %ΔRI x %ΔPI]NI N – 1 = (1 + % ΔNI)NI N – 1

So, we can approximate as =

% ΔNI = %ΔRI + % ΔPI

, since the product of the two percentages will be a small number (e.g., 5% x 5% = 0.25%) (C) Red Hill Capital Corp., Delaware, USA 2008 88

Inflation and Wealth

 If income is one measure of well-being, wealth is another.

 While income is the flow of money earned from selling factors of production (i.e., the sweat of your brow), wealth is the value of the stock of assets owned at some point in time.

 Wealth includes such things real estate, stocks & bonds, bank accounts, art, cash, cars, and other valuable things.

Inflation and Wealth

 Wealth, in some cases, offers a hedge against inflation since the nominal value of some assets may increase at rates that exceed the rate of inflation.

 Indeed, that is one reason why people purchase such things.

 On the other hand, there is an implicit penalty from inflation for those who have little or no accumulated wealth since such people must rely on nominal income.

Inflation and interest rates

 Borrowers and savers will also feel the impact of inflation, as inflation is part of the nominal rate of interest.

 Just like in the case of income and GDP, there are nominal and real interest rates.   Formally, the nominal interest rate, I, is related to the real interest rate, R, and the inflation rate, INF, by the formula, 1 + I = (1+R)(1+INF).

Again, the approximation formula is: I ≈ R+INF.

Inflation and interest rates

   Thus, borrowers and savers might be winners or losers, depending on how inflation works out afterwards. Real rates can be positive or negative.

If inflation is 5%, for example, and a certificate of deposit earns 7% per year, real interest is about 2%, and purchasing power of the money invested in this financial asset increases during the investment time.

If you borrow money at 5% and it turns out that inflation, during the time to maturity of the loan, increases to an annual rate of 7%, you will again receive a benefit, as the money that you use to pay for the loan is worth more than your cost of borrowing.

Inflation, investment & business decisions

 Investment and business decisions should be based on the relative real rates of return from investing economic resources in alternative activities.

 When inflation rates are relatively stable, business can forecast future price changes with a fair amount of certainty and form a good idea of real rates of return from alternative investments.

 When inflation rates are high, they also tend to be less stable, and it becomes difficult for business agents to forecast returns.

Inflation, investment & business decisions

 That leads, ultimately, to some inappropriate decisions, which result in inefficient allocation of resources.

 Moreover, the interaction of taxes and inflation can also lead to investment that, while not the most beneficial for the community, will be favored because of after-tax considerations.

Inflation, investment & business decisions

 For example, in the early 1970’s, in Australia, housing prices were increasing rapidly. Interest on mortgage loans for rental properties is a tax-deductible expense, and nominal capital gains on sale of such properties was non-taxable.  The result was overinvestment in rental properties at the expense of investment in PP&E for production.

Demand-pull Inflation

 Since price is determined by the interaction of supply and demand, there are

two sides to inflation.

 We shall use the cause-and-effect relationships, total spending, and the business cycle, from the preceding lecture (chapter 12), for our analysis of these topics.



Demand-pull inflation, too much money chasing too few goods

, result from an

excess of total spending (demand)

Demand-pull Inflation

 When demand is high and it is difficult to satisfy, the typical response is for sellers to raise their prices.

 If this excess demand is widespread across the spectrum of goods and services in the economy, the general level of prices will be pulled up by the excess demand.

 Demand-pull inflation occurs when the economy is operating near its full capacity. Thus capacity is near the limit and aggregate demand is also very high.

Demand-pull Inflation

 In the long run, if demand remained at this high level, producers would respond by expanding output, but they cannot do so in the short-run.

 In the short run, prices will be bid up as demanders try to get goods in short supply.  Indeed, prices may grow at a slower pace or even fall once the short-term pressure of demand subsides.

Demand-pull Inflation

 To get the full picture, remember that aggregate spending is composed of C, I, G and X – M.  Thus, even

foreigners

can contribute to the demand-pull affect by bidding up prices of exports, thus putting more money in the hands of domestic people, which will feed through to domestic spending and demand.

Cost-push Inflation

 When OPEC increased the price of oil, dramatically, in the 1970’s, production costs, across the board, also rose and resulted in cost-push inflation (happening again now).

 Cost-push inflation does not have to arise from such an unusual event as the one above. Any rise in the prices that suppliers must pay can be the cause.

 That could be the price of labor, raw materials, construction, equipment, or the cost of borrowing.

Expectations and Inflation



Expectations

can play a role in

either

cost-push or demand pull inflation.



If consumers expect the price of homes to rise, they may begin to get nervous and start bidding up the prices of housing to hedge against future expectations .

Expectations and Inflation

 If producers expect prices of inputs to production or even the cost of funds to increase in the near future, they may very well begin to raise prices in anticipation of expected higher costs, and cost-push inflation will result.

 In the next module we shall use a model of aggregate supply and demand to further investigate both sides of inflation.

   

Inflation around the world

Inflation rates are different at different times for one country and are different at the same time for different countries (see page 369).

In 2003, for example, from among a small sample of countries, Brazil had double-digit inflation of around 15% per year. Indonesia’s inflation rate was above 6%, while the US, India, France, Greece, Malaysia, Australia, S. Korea, and NZ had rates between 1 and 4%.

Taiwan actually experienced deflation in that year.

  

Hyper-inflation

In the 20 th century, various countries at various times have experienced

hyperinflation, which is loosely defined as an inflation rate of 1000% annual

: prices rise

10-fold in a year

, e.g., fro $1 to $10 (=$1 x 1000%).

When this happens, people develop an inflation mentality where they spend as soon as they get money and buy things in advance to avoid higher costs.

Also, debtor-lender contracts become jeopardized as variable rate borrowers are hit with unexpectedly high payments.

Hyper-inflation

   Third, a etc.

wage-price spiral

is set in motion. Increased wages causes increased prices, which need to be offset with increased wages, Fourth, people begin to invest in more

speculative

and less productive ventures in order to try to beat inflation.

Hyperinflation can be set off by a government

overproducing paper money

to try to pay its own expenditures. Effectively, the excess money devalues the value of money in private hands and private property, acting as a de facto tax.

Unemployment

Unemployment defined

    In Australia, each month, the ABS conducts a

survey

of employment from a

random sample

of HH’s.

Family members 15 years of age and older who work at least 1 hour per week for pay or 15 hours per week in a family business are said to be employed.

If a person is not employed but has looked for work in the past month, they are counted as unemployed.

Unemployment rate

is the % of people in the labor force who are not employed but are actively seeking employment.

The labor force and its unemployed

 Babies, disabled people, students and retirees are not counted as unemployed.

   The

civilian labor force

is, then, all people, excluding students, between 15 and 65 who are employed or unemployed, excluding people in the military or in institutions, such as prisons or mental hospitals.

The civilian

unemployment rate

(the unemployment rate) is the

ratio

unemployed

to the total

civilian labor force

Unemployment is a hot political issue.

Unemployment rate shortcomings

 First, unemployed people might report that they are seeking employment, even though they are not. They do that because unemployment benefits depend on a person actively trying to get a job.

 Others may report that they are unemployed although they have a job in an illegal activity or are illegally employed.

 In those cases, the unemployment rate is

overstated

. (C) Red Hill Capital Corp., Delaware, USA 2008 110

Unemployment rate shortcomings

   The unemployment rate might also

understate

unemployment because of

discouraged persons

, who are people who want to work but have given up the job search because after repeated rejection they believe that they cannot find a job.

The ABS counts a discouraged person as anyone who has looked for a job in the last 6 months but has given up.

The ABS counts discouraged persons as not in labor force.

Unemployment rate shortcomings

   The problem of their exclusion exacerbates the underestimation of unemployment during economic downturns because more people become discouraged.

Unemployment may also be

understated

because the ABS lumps

part-time

and full time workers as employed, even though some part-time workers might want to work full time but cannot find a full-time job.

Then, those workers are at least underemployed. And that figure rises during recessions.

Seasonal unemployment

 The reason that the graph in an earlier slide showed much variation on the short-term scale was because of

seasonal patterns

of employment.

 Many industries are tied to the seasons, like farm work.  Other seasonal industries are work at ski or summer resorts and some types of construction.

 Employment also increases at Christmas time in the wholesale and retail sectors.

Frictional unemployment

    Sometimes the unemployment of a person is only

temporary

People

lose their jobs or quit

to look for new ones. Students leave school and look for a first job. Some construction workers are out of jobs between projects.

Because jobs are available requiring their skills, but jobs and people need to find each other, the people are said to be

between jobs

Because of its temporary nature this type of unemployment is referred to as

fictional unemployment

Frictional unemployment

 It is

not of great concern

to policy makers or social welfare because it is just due to normal job search time or finding information about jobs.

   Thus, this type of unemployment is sometimes called

search unemployment transitional unemployment

or Frictional unemployment is part of normal economic life due to freedom of choice. It can vary, and it can be

lessened

with

better information distribution

about jobs.

   

Structural Unemployment

Unlike frictional and seasonal unemployment,

structural unemployment

longer term

It results, basically, from a

mismatch

of workers skills with jobs in the economy.

Structurally unemployed require

education or training

to acquire the skills needed in the job market.

Changes in the structure of the economy over time due to changes in demand, tastes or production processes, results in

3 basic types

of structural unemployment .

Structural Unemployment

The first is

lack of skills

. This is true for teenagers and minorities but also for others. For example, if green groups persuade the government to allow less tree cutting, there will be less jobs in the timber industry and people will need to be retrained for other jobs.

The

consumer

may

change

their

demand

patterns. For example, if people begin to prefer imported cars, there will be people out of work in the domestic auto industry, and they will need to retrain for jobs in other industries.



Structural Unemployment

Technological changes

may leave less jobs or jobs that need new skills, and it might be particular to a region of the country, too. For example, to compete with cheap imports, the textile industry might buy new machinery and leave less jobs in the area. People might be reluctant to move to a new place and become structurally unemployed.

Structural employment is part of modern economic life, as technology advances, products change and competition comes from imported goods.

Good retraining programs

are the

key

to fighting it.

 

Structural Unemployment

argument against minimum wages

has been that it

creates structural

unemployment. This happens when the minimum wage is above the productivity of unskilled workers, and rather than hiring them, business fills it other ways. One approach to fixing the problem is to allow a sub-minimum wage during a trial and training period. Another approach is to give employers incentives to hire long term unemployed. Another is to use an alternative means of supplementing low wages with welfare payments or tax breaks.

 

Cyclical Unemployment

Cyclical unemployment occurs because of the lack of production during economic downturns, resulting in unemployment.

In the great depression of the 1930’s it peaked at around 25% and took a long time to come back down.   In more modern times there have been some severe recession that have also caused joblessness to peak above 10% and took many years to come back down.

A focus of macro policy is to moderate cyclical unemployment.

The goal of full employment

 Because of structural and frictional unemployment, ever present in the system,

full employment

does

not mean

that there is

zero unemployment

 Full employment is the state in which

unemployment equals, exactly, seasonal, frictional, and structural unemployment

 Full employment is, thus, equal, to the state in which there is

no cyclical

unemployment.

 It is difficult to actually come up with a proper figure for it.

The goal of full employment

 Full employment unemployment is sometimes referred to as

natural unemployment

or non-accelerating inflation rate unemployment (

NAIRU

), and it will change over time with changes in the economic framework.

 In Australia, it was around 2% in the 1960’s, 4% in the 1970’s, 6-7% in the 1980’s& 90’s, and around 4% in the new century.

The goal of full employment

 One reason for the change is attributed to

more women

entering the

labor force

over the period.

 Typically, women have a higher unemployment rate than men.

 Another explanation has been the

interaction of tax and welfare

, making unemployment less painful.

 The final piece of the puzzle is called

hysteresis

, which we discuss in more detail, in the next slide.

Hysteresis

 Hysteresis is a concept from physics whereby, if you rub a pin, for example, with a magnet, the pin will become magnetized, so retaining a memory of what happened to it.

 In economics the concept is loosely applied to unemployment as follows

Please note that our wording is slightly different from that in

the book

, which is

incorrectly worded

Hysteresis



Hysteresis:

The full employment rate of unemployment increases as the actual unemployment rate increases. The full employment rate of unemployment does not necessarily decrease or even stay the same as the actual unemployment rate decreases.  What that means is that the

full employment rate of unemployment

is not

necessarily stable

but

depends on where

the

actual rate

of unemployment

has been

Hysteresis

 The important point is that short run disturbances of the macro economy might have long run affects on some macro variables, like unemployment. (ref: Layton personal communiqué)  One explanation for hysteresis is that as people become unemployed during recession, they sit around and their skills dull, and it becomes hard to get a job when things pick up. (C) Red Hill Capital Corp., Delaware, USA 2008 126

Hysteresis

 Thus, after unemployment increased due to a downturn, the full employment rate of unemployment increased.

 Another explanation is the

insider/outsider problem

 After a downturn, as employment picks up, insiders bid up wages to a point where it is too expensive to hire outsiders with no experience.

Hysteresis

 Thus, after the economy picks up, unemployment begins to decrease but insiders bid up wages making costs for firms higher allowing them to spend less for new people. Thus, more people are employed, bringing down unemployment, but some are still out of jobs.

 As a result, the natural rate of unemployment might actually increase, even though actual current unemployment is decreasing.

Non-monetary and demographic consequences of unemployment.

   Unemployment leads to more than just loss of potential economic output.

People who are out of work loses their sense of self-worth, and the results are: family problems and break-ups, suicide, mental illness, crime, political unrest, and health problems.

Unemployment is different for different demographic groups. Teenagers with little experience and high quit rates and people over 55 show the highest levels of unemployment.

Non-monetary and demographic consequences of unemployment.

 For people who are unemployed we also define a time of being out of work.  Those who have been

out of work for more than a year

are referred to as

long term unemployed

, and they face great difficulty getting new jobs just because they have been out of jobs for so long and employers, then, wonder why, and the unemployed lack self-confidence that they can get a job.

Ask yourself

What factors could increase/decrease seasonal, structural, and frictional unemployment?

Which measure of inflation do you think better reflects price rises in an economy? Which measure do you think people care more about? What is hysteresis and what might cause it?

In terms of the production function, why can one country have higher output per person than another? (C) Red Hill Capital Corp., Delaware, USA 2008 131

Ask yourself

Peter is trying to decide whether or not he should lend $1,000 to Ellen for one year at a fixed nominal interest rate of 8 percent. Peter expects the inflation rate to be 4 percent for the year. If he does percent. Peter not lend the $1,000 to Ellen, Peter will purchase a bond that pays an interest rate of 4 percent, or he will put the money in a savings account earning 6 a) will earn 4 percent in real terms if he loans Ellen the money, 0 percent in real terms if he buys the bond, and 6 percent in real terms if he puts the money into a savings account b) is better off holding his money as cash c) is indifferent between lending the money to Ellen and buying the bond because the real interest rate is the same in either case d) should purchase the bond because it earns the highest real rate of interest e) earns the highest real rate of interest if he puts his $1,000 into a savings account (C) Red Hill Capital Corp., Delaware, USA 2008 132

Ask yourself

John lost his job when the gold mine in the outback closed. He wants a job, but he has given up looking for one until the economy improves. Define his status in the labor force.

What do women have to do with the increase in NAIRU in developed nations over the last several decades?

Technology is responsible for improved economic growth over the last decade. Is it also responsible for higher unemployment?

Do you think that enacting a minimum wage law would increase or decrease unemployment? Explain your reasoning. Who (what group) do you think that a minimum wage would affect most, and how would it affect them?

Assignment

 After this module, you will have the basics to answer the assignment questions.

 However, please note that the assignment also requires you to use 5 references.

 Those should not be things like definitions from Wikipedia, they should be real references about the topics of the four questions.

 Read the specific details in the intro book, the USQ forum discussions, and the email advise that I have sent.

Homework

 Chapter 12, the rest of the problems  Chapter 13, all problems.

END (C) Red Hill Capital Corp., Delaware, USA 2008 136