Econ 1000: Mod 4, Lecture 8

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Econ 1000 Mod 4, Lecture 8

• C. L. Mattoli

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Mod 4, part 2 Macroeconomics

• Chapter 12, page 333 to end, Economic Growth,
  Macro policy
• Chapter 13, Inflation and unemployment

3
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

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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.

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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.

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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.

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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.

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Long-term Economic Growth
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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.

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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.

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(No Transcript)
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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?

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

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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.

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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.

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Determinants of Growth the Solow model

• Then, the aggregate production function, Y, of
  the country is output per worker versus the
  quantity of production factors per worker, QPF.
• As shown in the next several slides, the output
  per worker increases but at a decreasing rate as
  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.

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The Production Function and Technological Change
Aggregate Production Function (output/worker),
fixed technology
Aggregate Production Function (output/worker),
changed technology
Y
Y
Y2
Y2
Y1
Y1
QPF
1
2
1
QPF
More input more output
Same input techno advance more output
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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).

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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.

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Output per person differences for 2 Economies, A
B
Differences due to Factor Accumulation
Differences due to Labor productivity
Differences due To Both
Y
Y
Y
YB
YA
QPF
QPF
Country A
Country B
QPF
Both countries
Country B
Country A
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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.

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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.

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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.

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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 nations output is either
  consumed or used for investment.

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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.

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Consumption, savings investment

• This begs the question is there an optimal level
  of per capita savings for an economy, which would
  allow the community to maximize its consumption
  over time?
• In fact, since savings is foregone present
  consumption, the motivation for savings is to
  increase ones future standard of living (recall
  Tin tin's savings from a previous lecture).

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Consumption, savings investment

• So, what is an 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.

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Factor accumulation the Golden Rule

• The so-called Golden Rule quantity of productions
  factors/capita will induce an optimal savings
  rate.
• We shall examine the logic behind the golden
  rule.
• The larger the store of an economys production
  factors, the larger will be the amount wearing
  out (depreciating) in each period.
• Thus, a higher level of output will be required
  each period, just to cover depreciating
  production factors.

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Factor accumulation the Golden Rule

• In turn, a higher level of 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.

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Factor accumulation the Golden Rule

• As a result, we can conclude that as the total
  stock of 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.

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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.

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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.

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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.

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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.

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Technological Change

• Our discussion of the golden rule assumed that
  technology is 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.

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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.

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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.

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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 of techno change,
  they include things, like better labor
  organization, better management, and better
  education and training of the workforce.

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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.

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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 is 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.

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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 1960s led
  to the development of microprocessors to build
  better mainframe computers in the 1970s which
  led to development of PCs in the 1980s, which
  has resulted in many new technologies in
  production and communications in the 1990s.

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The Endogenous Growth Model knowledge as a
factor of production

• In light of that, it may be possible for
  government to have a positive impact in the
  process.
• In order to create new knowledge, large
  expenditures may be required for RD, but it is
  difficult to maintain a monopoly on knowledge
  once it becomes part of the economic process.

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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.

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The Endogenous Growth Model knowledge as a
factor of production

• In that regard, governments might also offer tax
  incentives to encourage RD.
• 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.

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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.

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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.

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Government policy and growth
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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 the workforce, which may have an affect
  on the long-term growth path of the economy.

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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.

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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.

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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 societys concerns may
  cause governments to take the wrong actions
  because of political concerns.

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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.

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Productivity and Unemployment

• In the mean time, the other fishermen who didnt
  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.

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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.

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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.

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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 RD expenditures
  and foreign trades, but Roll and Talbott find
  that these are consequences of deeper underlying
  policy.

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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.

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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.

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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.

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Break time

• 10 minute break

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Inflation
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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.

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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.

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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 is erosion of
  both purchasing power and 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.

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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.

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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.

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Makeup of CPI
68
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
  GS, and home owners and renters.

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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.

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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 1970s, while vinyl recordings of music
  and record players would not be part of it today.
  
• CPIs are usually also available for specific
  urban areas, not just the whole country.

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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.

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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.

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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.

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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 CPIs for the final exam in this course.

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Sample CPI construction
76
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) CPI(last year)/CPI(last
  year) CPI(this year)/CPI(last year) 1 (times
  100 to convert to percentage number).

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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) 11/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.

78
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.

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Historical Australian Inflation in the CPI
80
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.

81
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.

82
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.

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Consequences of inflation

• Inflation can erode the standard of living, shift
  income distribution and impede the efficiency of
  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.

84
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 real income by
  adjusting for inflation (division by an inflation
  index). RI x PI NI (real income times price
  index equals nominal income).

85
Consequences of inflation

• Real income measures the amount of GS 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 GS as you could before. Your
  purchasing power declines, and your standard of
  living falls.

86
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.

87
Purchasing Power and real income

• Then last year your putative real income was
  100,000/1.00 100,000 last years 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.

88
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 ?NI
• NIN (1 ?PI)(1 ?RI)NIN 1
• 1 ?PI ?RI ?RI x ?PININ 1
• (1 ?NI)NIN 1
• So, we can approximate as ?NI ?RI ?PI,
  since the product of the two percentages will be
  a small number (e.g., 5 x 5 0.25)

89
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.

90
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.

91
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
  (1R)(1INF).
• Again, the approximation formula is I RINF.

92
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.

93
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.

94
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.

95
Inflation, investment business decisions

• For example, in the early 1970s, 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 PPE
  for production.

96
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).

97
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.

98
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.

99
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.

100
Cost-push Inflation

• When OPEC increased the price of oil,
  dramatically, in the 1970s, 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.

101
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.

102
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.

103
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.
• Indonesias 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.

104
Hyper-inflation

• In the 20th 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.

105
Hyper-inflation

• Third, a wage-price spiral is set in motion.
  Increased wages causes increased prices, which
  need to be offset with increased wages, etc.
• 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.

106
Unemployment
107
Unemployment defined

• In Australia, each month, the ABS conducts a
  survey of employment from a random sample of
  HHs.
• 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.

108
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 of unemployed to the total
  civilian labor force.
• Unemployment is a hot political issue.

109
(No Transcript)
110
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.

111
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.

112
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.

113
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.

114
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.

115
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 or transitional
  unemployment.
• 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.

116
Structural Unemployment

• Unlike frictional and seasonal unemployment,
  structural unemployment is 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.

117
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.

118
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.

119
Structural Unemployment

• An 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.

120
Cyclical Unemployment

• Cyclical unemployment occurs because of the lack
  of production during economic downturns,
  resulting in unemployment.
• In the great depression of the 1930s 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.

121
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.

122
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 1960s, 4
  in the 1970s, 6-7 in the 1980s 90s, and
  around 4 in the new century.

123
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.

124
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.

125
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.

126
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.

127
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.

128
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.

129
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.

130
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.

131
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?

132
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 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 percent.
  Peter
• 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

133
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?

134
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.

135
Homework

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

136
END