Macroeconomic Issues: Economic Growth

CHAPTER 11

MACROECONOMIC ISSUES: ECONOMIC GROWTH AND THE BUSINESS CYCLE

After reading Chapter 11, MACROECONOMIC ISSUES: ECONOMIC GROWTH AND THE BUSINESS CYCLE, you should be able to:

 Describe the two sources of economic growth and tell how nations can affect their economic growth rate.  Understand production functions as they apply to aggregate output.  Be able to express the production function in terms of annual growth rates.  Understand the law of diminishing returns.  Discuss the phases of the business cycle.  Define GROSS DOMESTIC PRODUCT (GDP) and its four expenditure categories.  Relate Gross National Product, GNP, and the various measures of income to GDP.  Tell the difference between real and nominal GDP.  Define INFLATION, be able to calculate the inflation rate, and discuss the historical trends of inflation.  Explain why inflation can harm the economy.  Give the official definition of UNEMPLOYMENT.  Calculate the unemployment rate and discuss its historical trends.  Define the concepts of FRICTIONAL UNEMPLOYMENT, CYCLICAL UNEMPLOYMENT, STRUCTURAL UNEMPLOYMENT, and the NATURAL RATE OF UNEMPLOYMENT.

CHAPTER OUTLINE

I. ECONOMIC GROWTH

A. ECONOMIC GROWTH consists of rightward shifts in the production possibilities frontier, since this means that more of all goods and services can be produced. B. There are two sources of economic growth: Increases in the nation's productive resources, which often takes the form of CAPITAL ACCUMULATION (investment in new capital stock) and technological progress. 1. EXTENSIVE GROWTH refers to growth created by increases in factor inputs. 2. INTENSIVE GROWTH occurs when more output can be produced from the same amount of inputs. Advances in technology is a source of intensive growth. C. Advanced nations grow primarily through intensive growth. Hence, government policies that are designed to increase productivity can raise a nation's growth rate. D. Economic growth is explained by aggregate PRODUCTION FUNCTIONS, which relate the amount of output to labor and capital inputs and to the state of TECHNOLOGY. The production function can be expressed in terms of annual growth rates, where the growth rate of output depends on the growth rates of labor and capital (each weighted by its share of income) and by technological improvements. The shape of the production function is determined by the LAW OF DIMINISHING RETURNS. The Output-per-Worker Production Function shows that output per worker depends on the amount of capital per worker and upon technological progress.

77 II. BUSINESS CYCLES

A. The BUSINESS CYCLE is the fluctuation of increases and decreases in economic activity. B. The business cycle is divided into four phases: 1. RECESSION: the period after the peak, when the production of output declines and the unemployment rate rises. 2. TROUGH: at the end of the recession, when output reaches its low point. 3. RECOVERY: the period after the trough, when the production of output increases. 4. PEAK: at the end of the recovery, when output reaches its maximum before sliding into another recession. C. Business cycles average about 5 years in length and have important effects on politics as well as the economy.

III.GROSS DOMESTIC PRODUCT AND NATIONAL INCOME

A. GROSS DOMESTIC PRODUCT (GDP) is the market value of all of the final goods and services produced in a country in a year. B. GDP can be divided into four final use categories: 1. PERSONAL CONSUMPTION EXPENDITURES are the goods and services purchased by households for their consumption. 2. GOVERNMENT EXPENDITURES FOR GOODS AND SERVICES are the goods and services purchased by the government at all levels (federal, state and local). Government transfer payments are not included because they do not (directly) purchase a good or service. 3. INVESTMENTS are the goods purchased, mainly by business firms, to add to the nation's capital stock. 4. NET EXPORTS are the domestically produced goods purchased by foreigners minus domestic purchases of foreign produced goods. C. NOMINAL GDP is the value of the output of final goods and services expressed using prevailing prices; REAL GDP measures the amount of goods and services produced. It removes the effect of changing prices from nominal GDP. D. The circular flow demonstrates that the value of GDP produced equals the amount of income created by this production. E. GROSS NATIONAL PRODUCT (GNP) equals GDP plus income generated by U.S.-owned factors located in other nations minus income paid in the United States to foreign-owned factors of production. F. NATIONAL INCOME equals GNP minus depreciation and indirect business taxes (such as sales taxes). National income also equals the sum of payments made to the factors of production. 1. PERSONAL INCOME is all the income people actually receive. 2. PERSONAL DISPOSABLE INCOME equals personal income minus personal income tax payments. Thus, personal disposable income is all the income people actually have to spend.

IV. INFLATION

A. INFLATION is a general rise in prices. The ANNUAL INFLATION RATE is the rate of increase in the level of prices over a year. B. A PRICE INDEX shows the current cost of buying a bundle of goods as a percentage of its cost in an earlier year. 1. The inflation rate can be calculated using the consumer price index (CPI) or the GDP deflator.

78 C. Prior to 1930, deflations were as common as inflations; after 1940, most years have been marked with inflation. D. Inflation can be a problem for three reasons: 1. Inflation can redistribute income. This occurs primarily when inflation surprises people. 2. Inflation can have an adverse effect on the economy's efficiency as people divert resources from productive areas to uses designed to insulate them from inflation's effects. 3. Unanticipated inflation can deceive people and firms into altering their decisions about the amount they produce.

V. UNEMPLOYMENT AND EMPLOYMENT

A. The Bureau of Labor Statistics classifies a person as unemployed if: 1. the person did not work during the previous week, 2. AND the person looked for work during the preceding four weeks, 3. AND the person is available for work, 4. OR, regardless of the above three criteria, if the person is temporarily laid off from work and waiting to be recalled to his or her job. B. The UNEMPLOYMENT RATE equals the number of unemployed divided by labor force, which is the sum of employed plus unemployed workers. C. Since 1950, the unemployment rate in the United States has tended to increase. Over this time, employment has also risen strongly. During recessions, the unemployment rate increases and employment generally falls. D. FRICTIONAL UNEMPLOYMENT is the unemployment caused by the normal amount of people changing jobs and entering the labor force; CYCLICAL UNEMPLOYMENT is created by general downturns in business conditions; STRUCTURAL UNEMPLOYMENT results from long-term declines of certain industries. E. The NATURAL RATE OF UNEMPLOYMENT occurs when the number of jobs created approximately equals the number of qualified workers searching for the jobs. 1. The level of GDP produced when the economy is at the natural rate of unemployment is called the NATURAL LEVEL OF REAL GDP. 2. At the natural rate of unemployment, there is no tendency for inflation to increase or decrease.

REVIEW QUESTIONS

True or False

If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question give a short statement that supports your answer.

____ 1. Extensive economic growth can occur if more people decide to work rather than retire early or continue in school.

____ 2. A government policy that encourages investment in human capital, such as providing below- cost college educations, can help increase a nation's growth rate.

____ 3. Intensive growth refers to economic growth that is the result of increases in the amount of a nation's productive inputs.

79 ____ 4. Real GDP can fall even if nominal GDP rises.

____ 5. The business cycle refers to the upward and downward movements in the general level of economic activity.

____ 6. The average business cycle has a length of about fifteen years.

____ 7. Inflation is a general increase in prices.

____ 8. A price index shows the current cost of buying a particular bundle of goods as related to the bundle's cost in an earlier year.

____ 9. The consumer price index (CPI) measures the rate at which consumers are buying consumption goods.

____ 10. The GDP deflator includes only the prices of goods and services purchased by consumers.

____ 11. Persistent inflation has been a feature of the American economy throughout its history.

____ 12. Generally, inflation redistributes income only when people do not anticipate it.

____ 13. An unemployed individual is counted as part of the labor force.

____ 14. The unemployment rate equals the total number of unemployed workers divided by the total number of employed workers.

____ 15. At the natural rate of unemployment, the inflation rate is high and rising.

____ 16. Frictional unemployment is, in part, the result of people shifting from one job to another in response to changes in the economy.

____ 17. When an economy is fully employed, everyone who is seeking work has a job.

Multiple Choice

Circle the letter corresponding to the correct answer.

1. Which of the following is not a test a person must pass to be counted as unemployed by the Bureau of Labor Statistics? a. The person did not work during the previous week.. b. The person did not turn down a job offer during the previous four weeks. c. The person actively looked for work during the previous four weeks. d. The person is currently available for work. e. They are all necessary requirements for a person to be counted as unemployed.

80 2. The stage of the business cycle during which output is at its lowest point is a. the recession. b. when the stock market is falling. c. the peak. d. the recovery. e. the trough.

3. Which of these statements about employment and unemployment is correct? a. The total number of employed people has declined since the 1950s. b. The unemployment rate has generally declined over the last forty years. c. The unemployment rate rises in a recovery and falls in a recession. d. Even though the unemployment rate generally has risen over the past forty years, the number of employed workers also generally increased over the same period. e. Whenever employment rises, the unemployment rate invariably falls.

4. Which of the following is not a final use of GDP? a. Consumption expenditures b. Government expenditures for goods and services c. Government expenditures for transfer payments to individuals d. Investment e. Net exports of goods and services

5. Which of the following is an example of intensive growth? a. Growth caused by an increase in technology that allows more output to be produced without any change in the inputs utilized b. Growth caused by an expansion of the nation's capital stock that takes place as a result of changes in the nation's tax laws c. Growth caused by an increase in the nation's labor force d. All of the above e. None of the above

6. The amount of goods and services produced by an economy is measured by a. national income. b. depreciation. c. consumption. d. the business cycle. e. real GDP.

7 Which of the following people would the Bureau of Labor Statistics classify as unemployed? a. Someone who has a part-time job but wants full-time work b. A person who has given up searching for a job because he or she is convinced that a job cannot be found c. A high school graduate who, though looking for a job, has yet to find one d. A retired person under the age of 65 e. None of the above

81 8. In a period with inflation, nominal GDP rises a. more rapidly than real GDP. b. at a rate equal to real GDP. c. less rapidly than real GDP. d. at a rate that bears no relationship to real GDP. e. more rapidly than real GDP only if the inflation rate is at least 5 percent.

9. At the natural rate of unemployment, real GDP ____ the natural level of real GDP and the inflation rate is ____. a. is greater than; rising b. is greater than; rising c. is equal to; rising, constant, or falling, depending on other factors d. is equal to; not changing e. is less than; falling

10. The production function says that a. real GDP depends on the economy’s capital stock.. b. real GDP should increase when labor inputs increase. c. real GDP rises when there are technological improvements. d. a, b, and c. e. None of the above

11. The Law of Diminishing Returns states that growth will a. decline no matter what. b. increase as the labor force expands. c. increase as the capital stock expands and labor contracts. d. eventually fall if there are no technological improvements. e. None of the above

Essay Questions

Write a short essay or otherwise answer each question.

1. Suppose there are 10,000 unemployed workers and 90,000 employed workers in a nation. What is the size of the labor force? What is the unemployment rate?

2. Suppose a nation has initially 10,000 unemployed people and 90,000 employed workers. If 5,000 of the unemployed people decide they cannot find a job and stop searching for work, what will be the size of the officially measured labor force? The officially measured unemployment rate?

3. What is the difference between real and nominal GDP?

82 4. Complete the following table.

Year Price Level Inflation Rate 1995 100.00 XX 1996 112.00 1997 123.20 1998 147.84

5. Suppose the price level in 1995 is 210.00. If the inflation rate between 1995 and 1996 is 5 percent, what will be the price level in 1996?

6. What are the four final use categories of GDP?

7. What are the four phases of the business cycle?

8. Use the production function analysis, where the production function is expressed in terms of rates of growth, to calculate the rate of growth of technological change when real GDP is growing at 5% per year, and capital and labor are both growing at 2% per year.

9. Write an essay on the reasons why we are possibly overstating the rate of inflation.

ANSWERS TO REVIEW QUESTIONS

True or False

True 1. Extensive growth occurs when productive inputs increase. By retiring later or leaving school earlier, people increase the nation's labor force and so labor, a productive resource, increases.

True 2. This sort of productivity-enhancing policy can raise intensive growth.

False 3. The definition of intensive growth is growth caused by more output per input, not growth caused by possessing more inputs.

True 4. Even if the number of goods and services produced in an economy declines (so that real GDP falls), it is possible for the inflation rate to be high enough so that nominal GDP, which includes both the effects of higher prices and lower output, rises.

True 5. This is the definition of the business cycle.

False 6. The average business cycle has a duration of about five years.

True 7. Inflation occurs when most or all prices are increasing.

True 8. Price indices can be used to measure the rate of inflation.

False 9. The CPI measures the cost of a bundle of goods purchased by a typical consumer.

83 False 10. The CPI includes only goods purchased by consumers; the GDP deflator includes prices of goods purchased by all sectors of the economy.

False 11. Persistent inflation has been a feature of the U.S. economy since 1950, but in earlier years deflation was as common as inflation.

True 12. If people anticipate the inflation, they can take actions to protect themselves.

True 13. The labor force includes both unemployed and employed workers.

False 14. The unemployment rate equals the number of unemployed workers divided by the total labor force, which is the sum of employed plus unemployed workers.

False 15. At the natural rate of unemployment, the inflation rate neither increases nor decreases.

True 16. Because it is helpful to society for people to leave dead-end jobs for other more productive work, this type of unemployment can benefit society.

False 17. The economy is fully employed well before everyone who is looking for work finds it; that is, the unemployment rate remains above zero even when the economy is fully employed.

Multiple Choice

1. b. Even if a person has recently declined a job offer, as long as the other three criteria are met the person officially is counted as unemployed.

2. e. The trough is the moment when the economy is at the bottom of the business cycle, passing from the recession phase into the recovery phase.

3. d. As the economy has grown, total employment has increased. The number of unemployed workers has increased a little more rapidly so that the unemployment rate has been generally higher in recent years than during earlier periods.

4. c. The final use breakdown of GDP depends on who or what purchases the goods and services. Transfer payments are given to people, but nothing—that is, no good or service—is received in exchange. Thus, transfer payments are not part of the government expenditure on goods and services. (Transfer payments can be spent by the recipients to help finance some of the consumption part of GDP.)

5. a. This is virtually the definition of intensive growth: Growth that occurs when more output can be produced from the same amount of inputs.

6. e. Real GDP measures the number of goods and services produced by an economy.

7. c. The other situations do not pass all three criteria; the person in part a. has a job while the people in parts b. and d. are not actively engaged in searching for work.

84 8. a. Nominal GDP includes the effects of both changes in the level of actual production (measured by real GDP) and changes in the prices of goods (measured by the inflation rate).

9. d. When the economy is at the natural rate of unemployment, employment is not changing and so there is no wage pressure either upwards or downwards. Because employment does not change, the economy is producing at the natural level of real GDP. And, because there is no wage pressure, the inflation rate is constant.

10. d. The production function says output depends on labor, capital, and technology.

11. d. The law states that output growth will decline unless technology improves.

Essay Questions

1. The labor force equals 100,000, the sum of the employed workers plus the unemployed workers. The unemployment rate equals 10 percent, the number of unemployed divided by the labor force.

2. The labor force now equals 95,000. The unemployment rate is 5.3 percent or (5,000 unemployed) / (95,000 labor force). In comparison with Question 1, if unemployed workers become discouraged about finding jobs and leave the labor force, the unemployment rate declines.

3. Real GDP measures the number of goods and services produced by an economy. Nominal GDP is the market value of these goods and services. Nominal GDP depends on the quantities produced as well as on their prices. Real GDP depends on only the quantities.

4. Year Price Level Inflation Rate 1995 100.00 XXX 1996 112.00 12.0% 1997 123.20 10.0% 1998 147.84 20.0% For an example of how these answers are calculated, take the inflation rate for 1998. To calculate the inflation rate for 1998, use (147.84 - 123.20) / (123.20) = 20%. The other inflation rates are calculated similarly.

5. The price level will be 220.5. If the inflation rate is 5 percent, the price level in 1996 will be 5 percent higher than in 1995. Five percent of 210.0 is 10.5. Thus, the price level in 1996 equals 210.0 + 10.5 = 220.5.

6. The four final use categories of GDP depend on the sector that purchases the good. a. Consumption: Goods purchased by the household sector. b. Government purchases of goods and services: Goods purchased by the government sector. c. Investment: Goods purchased by firms to add to their capital stock. d. Net exports of goods and services: Goods purchased by foreign residents less the purchase of foreign goods by domestic residents.

85 7. The four phases of the business cycle are the recovery (when the economy is growing most rapidly), the peak (when the economy is poised at its highest level of output), the recession (when the economy is declining) and the trough (when the economy is at its lowest point).

8. The production function, expressed in annual rates of growth, says that the growth of output will equal the growth rate of inputs plus the growth rate of technology. With inputs both rising at 2% per year, this means that technology is growing at the rate of 3% per year.

9. The boxed example in the text discusses the findings of the Boskin Commission, which concludes that we are overstating inflation because we do not properly account for the changing shape of consumer budgets and cannot properly adjust for quality improvements.