Economic Growth
Lesson 16

Economic Growth

1. Economic growth -

1. Real GDP is increasing each year
   • Economy is producing more goods and services each year
   • Population may be increasing or decreasing
2. Real GDP per capita - adjusts GDP for population
   • If real GDP per capita is increasing, on average each person has more goods and services

Many consider a growing economy important

• People have more products and services
• People have more wealth, so society becomes wealthier
• Poverty should be declining

2. Rule of 70

• Easy way to determine how long it takes something to double in size
• (Growth rate) X (time) = 70
• Examples
  • China's economy is growing 10% per year; divide 70 by 10, which means China's economy will double every 7 years
  • United States is growing 1% per year, divide 70 by 1 and the U.S. economy will double in 70 years
  • If your bank deposit is earning 5% per year, divide 70 by 5, and your bank account will double in 14 years
• Conclusion - small increase in a growth rate can mean a large change in the time required to double
  • If the U.S. grows at 3% per year, the economy doubles in size in 23.3 years
  • However, if the U.S. grows at 4%, then the economy doubles in size in 17.5 years

3. Sources of growth - same factors that shifts PPC outward

1. More resources
   • Economy can grow faster if society has more labor, capital, land, and entrepreneurs
2. Improved legal structure - commonly ignored by economists
   • A better legal structure encourages economic growth
   • A society with rigid regulations, high taxes, and constant interference by government tends to grow slowly or not at all
3. Technology - society implementing new technology may encourage economic growth
   • U.S. grew during 1990s as schools, universities, government, and businesses implemented the internet and new forms of communication
   • Electronic banking, cell phones, e-commerce, etc.
4. Increase in productivity
   • Productivity - more output given the same level of inputs
   • Could result from using new technology
     • Workers are more productive when using computers
     • Technology is not the only source
   • Better employee training
   • Workers become more motivated
   • Improved management practices
   • Most gains from economic growth come from productivity

4. Problems with GDP growth rates

1. From last lesson - GDP had problems
   • Pollution
   • Resource depletion
   • Who gets the new production?
   • Example 1 - Philippines is growing at 7% per year in 2012 but the Philippine economy is not creating jobs
     • Economic growth is a wave that lifts all boats
   • Example 2 - Macau is ranked 4th in GDP per capita
     • Wealth and income from its casinos may be not trickling down to its citizens
     • Macau has large slums surrounding the city
2. Improvements in products and services
   • All electronic devices have better quality and more features than older products
   • Not included in GDP growth rates
3. The U.S. citizens gained more leisure
   • Workers worked 50 hours in 1900s and now work 40 hours per work
   • Not included in GDP growth rates
4. Economists do not talk about this
   • Instructor's observations
   • Countries with great GDP per capita have expensive real estate
     • Businesses must charge greater prices to cover leases, rent, and mortgages on property and real estate
     • Wealth effects - new comers are at a disadvantage
       • They must pay high prices for real estate
       • Incumbents could have advantage if they acquired real estate decades ago before property values had soared
   • Extreme materialism
     • High GDP per capita indicates greater income for its citizens
     • Relationships are more superficial and depend on a person's wealth
   • Confounding - GDP aggregates across a country's markets
     • A society can undergo structural changes that does not appear in the country's GDP
     • Example - United States has transformed from a manufacturing society to a service society

Business Cycles

Business Cycle - all economies go through cycles of growth and recessions

• Economic Expansion (Business Cycle)
  • Real GDP is increasing, so economy is growing
  • Businesses are investing in more machines and equipment
  • Businesses earn economic profits
  • Households may invest in more durable goods like houses, cars, and appliances
  • Unemployment decreases
  • Inflation increases (Demand pull inflation)
  • Nominal interest rates increase
• Recession
  • Real GDP is flat or decreasing
    • Economy is slowing down
    • Recession - official definition is two consecutive quarters of negative growth
  • Businesses decrease investment; may use up their capital
  • Business and household bankruptcies increase
  • Households hold off on investing of durable goods, like houses, cars, and appliances
  • Unemployment increases
    • Unemployed workers can find jobs within 15 weeks, but this duration becomes longer during a recession
  • Inflation decreases
  • Nominal interest rates fall
• Characteristics - refer to graph
  • Peak - the maximum amount of growth of a cycle
  • Trough - the minimum amount of growth of a cycle
  • Trend - the average growth over time
    • Most countries experience growth over time in 20th century

Unemployment

1. The U.S. Bureau of Labor Statistics (BLS) estimates the unemployment rate

• Samples 60,000 households
• Defines 3 categories
  1. Not in labor force
     • Under 16 years old
     • People in mental health hospitals and prisons
     • Homemakers
     • Students
     • Retirees
     • Soldiers and sailors serving in the military
     • Slackers - people who are not working and not looking for employment
     • Discouraged workers - labor market is so bad, people give up looking for work
  2. Unemployed - person is actively searching for work and is not working
  3. Employed - person who is working part time or full time

2. Unemployment rate is calculated by:

Example:

• Number of employed workers is 100 million
• Number of unemployed workers is 15 million
• The unemployment rate is:

Problems: * Part-time workers may want to work full time * Discouraged workers are not counted; unemployment rate could decrease if unemployed give up looking for a job.

3. Types of Unemployment

1. Frictional unemployment - friction results from matching workers to jobs; takes time and not a perfect process
   • Laid off workers
   • Students graduated or dropped out and looking for jobs
   • Worker is fired and searching for new employment
   • Homemakers are entering workforce
2. Structural unemployment - the job types change in the labor market
   • Geographical changes
     • Manufacturing shifted in the United States from the North to the South
       • From the snow belt to the sun belt
     • Businesses relocated from urban areas to suburban
   • Compositional changes
     • Some industries went into decline
       • U.S. is losing manufacturing jobs to Asian countries
     • Consumer preferences changed
       • Example - Simplicity made sewing patterns and many young women do not sew
   • Labor market does not respond immediately to changes in employers' needs; retraining workers takes time
3. Cyclical unemployment - occurs when the economy enters a recession
   • Recession lengthens the duration to find a new job
4. Seasonal unemployment - a country experiences seasons that impact industries
   • Theme parks shut down during the winter
   • Ski resorts shut down during the summer
   • Tourists from the United States and Europe visit Thailand during the winter months because Thailand is a tropical country.

4. Full-Employment economy is producing at its full capacity

• Occurs when cyclical unemployment is zero
• Also called the natural rate of unemployment
• Economy is moving along the trend line
  • Economy experiences frictional, structural, and seasonal unemployment
  • The economy could grow faster than full-employment
    • The frictional unemployment are hired quickly
    • Businesses help retrain or relocate the structurally unemployed
• For U.S.
  • Full-employment was 6% during 1980s
  • Full-employment was 4-5% during 1990s
  • Natural rate of unemployment can change over time
• Why?
  • Government incarcerates more people
  • More temporary employment agencies
    • Help move workers into jobs quickly
  • The baby boomers are aging in the United States
    • Less young workers are entering the labor force while older people are retiring
  • Growth of more part-time and service oriented jobs
  • Men and women enter military service and fight in wars

5. Okun's Law - for every 1% increase in the unemployment rate that exceeds the natural unemployment rate, GDP on average is 2% lower than full-employment.

• Opportunity costs of unemployment for the country
• Workers are not working and contributing to society
• Example - If the natural unemployment rate is 5% and the current unemployment is 6%, then GDP is 2% less
  • The employment gap is 6% - 5% = 1%
  • Multiply the gap by 2 to get the decline in GDP in percent
  • We are within the interior of the Production Possibilities Curve

6. Distributional Impacts of Unemployment - unemployment hurt certain types of workers more than others

• Occupations - low-skilled occupations are hit harder than skilled
  • Employers may retain skilled workers, because these workers may be hard to find during a business expansion
• Age - teenagers and people over 40 are hit harder than other age groups
• Race - minorities are hit harder than Caucasian, especially African-Americans and Hispanics
• Education - workers with low levels of education are hit harder than educated workers
• Negative impact of unemployment
  • Loss of skills as labor is unemployed for a length of time
  • Family disintegration
  • Racial tensions
    • Paris had race riots a couple of years ago
  • Severe unemployment can lead to a revolution or public unrest

Redistribution Effects of Inflation

1. Definitions

• Nominal Income - the amount of income a person earns
  • No adjustment to income
• Real Income - a person's income is adjusted for the price level
  • P is a price index
• The equation is below:

Using some advance mathematics, we can change the formula to percentage changes.

• The dots above the variables means percent change. Ir is real income, In is nominal income and P dot is inflation rate
  • Example - if a person's nominal income increases by 4% and inflation is 10%, then his real income decreases by 6%
    • He has 4% more money, but prices on average are 10% higher
  • Example - if a person's nominal income increases by 2% and inflation is 2%, then his real income does not change

2. Distributional impact of inflation

• Unanticipated inflation - people are caught off guard about inflation or cannot do anything about it
  1. People on fixed income or receiving trust accounts
     • Personal retirement fund
     • Fixed annuity - people pay a premium monthly; when they retire, they get a fixed monthly rate
  2. Landlords - receive the same amount of rent per month
     • Landlords set the rent in the contract
  3. Workers on rigid wage schedules
  4. Problem
     • Income is fixed so nominal income is not changing
     • Inflation raises prices
     • Thus, real income is falling
  5. Savers are hurt by inflation
     • Inflation erodes the interest earned on savings
  6. Inflation can hurt / help the government
     • Inflation erodes the interest on government bonds, so investors do not invest in the government
     • Government debt loses value each year
     • Called the Fisher Equation
       • i is nominal interest rate
       • r is real interest rate
       • p is expected inflation rate

The nominal interest rate is what the investor earns. If the nominal interest rate, i, is 5% and the expected inflation rate, p, is 10%, then the real interest rate , r, is -5%. The investor's investment is growing 5% per year, but prices on average are 10%, so the investor's change in income is a 5% loss.

Expected inflation (anticipated inflation) - people are aware of inflation and incorporate it into their business dealings

1. People hold less money and hold assets like cars, houses, etc.
   • The price of assets increase along with inflation
2. Landlords - can add a clause to the renter's contract, allowing the landlord to adjust the rent upward for inflation
3. Workers - have Cost-of-Living-Adjustments (COLAs)
   • Employers automatically increase a worker's wages every year for inflation
   • Example: Social security payments are adjusted for inflation using the CPI
   • Financial institutions - adjust interest rates higher
     • From the Fisher equation, the banks increase the nominal interest rate by the inflation premium (p dot), so the real rate of return is positive
     • Government can issue inflation indexed bonds
       • U.S. Treasury does offer these type of bonds

3. Distributional impacts still can occur when the public anticipates inflation

• Workers with COLAs - inflation occurs daily while the adjustment to the wages are yearly; workers can still have their real income decrease until the adjustment is made
• Not all prices increase evenly
  • Urban areas have higher price increases than rural, so urban dwellers are hit more by inflation
  • Prices for medical services increases faster than price of electronics
    • Households that require more medical services are hit harder by inflation
  • Electronic devices like cellphones, computers, etc. are falling

Note - deflation can occur. Deflation is prices are continuously falling. Deflation would have the opposite impact than inflation. Deflation occurred under the gold standard or during severe contractions in the economy.

Inflation's Impact on National Output

Several different types of Inflation

1. Cost-Push Inflation - prices are increasing on critical resources

• Can cause a recession
  • Higher unemployment and lower national output
  • Also called supply shocks
  • Also called stagflation - high inflation and unemployment rates
• Example - Organization of Petroleum Exporting Countries (OPEC)
  • Rapidly increased prices during 1973-1975 and 1979-1980
  • Petroleum is used to produce fertilizers, plastics, gasoline, diesel, etc.
  • As petroleum price increases, all these products become expensive
  • Prices increases on all goods and services
    • Higher prices cause consumers to cut back on goods and services (Law of Demand)
    • Trucks use diesel fuel and transport all goods to the market
    • People were hurt by rising fuel costs
    • Cut back on spending on other goods
    • All food becomes more expensive
• Usually quickly rising petroleum prices causes a U.S. recession about a year later

2. Demand-Pull Inflation - consumers have too much money and are buying goods, bidding up the prices

• "Too much money chasing too few goods"
• If the inflation is low, it can cause the economy to grow faster
• Causes - if inflation is low
  1. The central bank can be increasing the money supply at a small pace
  2. Government rapidly increases its spending
     • U.S. government bailout of the U.S. banks in 2008
  3. Commercial banks are granting more loans
  4. A large industry increases workers' wages
     • Example - A labor union successfully negotiates higher wages for workers
       • Workers have higher incomes and spend more money

3. Hyperinflation - inflation rate exceeds over 100% per year

• Can disrupt the economy
• National output could drop
• Unemployment could increase
• Hyperinflation hurts many different types of workers
  • Creditors are harmed - value of debt drops quickly
    • Debtors can pay off debt with worthless money
    • Financial sector collapses
  • Investors do not invest in government securities
    • Investors are creditors and the government is a debtor
  • Stores and restaurants have trouble setting prices
    • They pay for workers and resources first and with a time delay receive revenue when sold to consumers
    • Wreaks havoc on finances
  • Bad money drives good money out of circulation
    • People hoard assets like gold, silver, and strong currencies like Euros and U.S. dollars
• During 1920s, Germany had a million percent inflation rate
  • Middle class went into poverty over night
  • Experienced a 50% unemployment rate
  • Paved the way for Adolph Hitler
• Government (or central bank) creates hyperinflation by printing large amounts of currency and spending
  • Once currency stabilizes, central bank may redefine currency
  • Example: Turkey
    • Before January 1, 2005, the exchange rate was $1 = 1,000,000 Turkish Lira
    • After January 1, 2005, the exchange rate was $1 = 1 Turkish Lira
• Inflation for several countries

Source: CIA. 2013. The World Factbook. Available at https://www.cia.gov/library/publications/the-world-factbook/ (accessed date 10/29/2013).

Note - Malaysia imposed price controls over 30% of the products

Terminology