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Econ 1000: Mod 4, Lecture 8


Econ 1000: Mod 4, Lecture 8 C. L. Mattoli * (C) Red Hill Capital Corp., Delaware, USA 2008 * Non-monetary and demographic consequences of unemployment. – PowerPoint PPT presentation

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Title: Econ 1000: Mod 4, Lecture 8

Econ 1000 Mod 4, Lecture 8
  • C. L. Mattoli

Mod 4, part 2 Macroeconomics
  • Chapter 12, page 333 to end, Economic Growth,
    Macro policy
  • Chapter 13, Inflation and unemployment

Learning Objectives
  • Discuss the determinants of economic growth
  • Briefly outline causes of both inflation and
  • Discuss the measurement and causes of inflation.
  • Discuss the objective of full employment

Last Time
  • We looked at proxies for measuring macro economic
    growth, and we settled on real GDP as one
  • We also discussed the definition of GDP and other
    national accounting concepts, including some
    components consumption, savings and investment.

Last Time
  • We also discussed some of the shortcomings of
    measurements of national accounts and the
    shortcomings of using real GDP as a proxy for
  • We then went on to discuss the general trend of
    economic growth and its cyclical nature, peaks
    and troughs, recessions and expansions.
  • Next we will look at the causes of growth in a
    simple economic modeling format.

Last Time
  • After that, we will go on to discuss two other
    major macroeconomic variables on which people and
    governments focus inflation of prices of goods
    and services and employment of the people within
    an economic society.
  • Both of these macroeconomic items are concerns
    for society.
  • Inflation of prices erodes the buying power of

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
  • The person loses well-being the society loses
    production that it could have had.

Long-term Economic Growth
  • The cyclical swings of the business cycle are
    around some sort of LT growth trend of the
  • 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.

  • 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.

(No Transcript)
The results in greater detail
  • Real per capita GDP is a common international
    measure of incomes and standards of living. Thus,
    we might ask
  • Why has Japan had the greatest growth in per cap
    GDP, over a century, while India, until recently,
    and Bangladesh have had almost none?

The results in greater detail
  • Australia had the highest per cap RGDP a century
    ago, but, then, it slipped behind the U.S. and
    Germany by the end of the century.
  • Since the 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.

  • Ultimately, growth of the economy will be
    determined by growth in supply and demand.
  • In our analysis of growth we shall examine both
    sides, supply and demand, but we should always
    remember that, in the end, it is the interaction
    of the two that determines the quantity of output
    produced and consumed, invested and saved.
  • In a closed system, the demand cannot outstrip
    the productive capacity of the economy, and the
    productive capacity will have no reason to grow
    without sufficient demand.

Determinants of Growth the Solow model
  • In lecture 5 (chapter 6), we introduced the idea
    of the production function for a company. Now, we
    imagine a production function for a whole
  • 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
  • In the following discussion, we shall refer to
    the non-labor inputs to production as, just,
    production factors.

Determinants of Growth the Solow model
  • Then, the aggregate production function, Y, 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

The Production Function and Technological Change
Aggregate Production Function (output/worker),
fixed technology
Aggregate Production Function (output/worker),
changed technology
More input more output
Same input techno advance more output
Graph Analysis
  • In the preceding slide, we show how output per
    person might vary with factor inputs for an
    economy and that an improvement in technological
    methods of production would move the whole curve,
    upward, so that more output could be produced per
    person with given factor inputs.
  • We can also use such graphical displays to
    analyze the differences in outputs of different
    countries (economies).

Graph Analysis
  • In the next slide, we use production function
    graphs to show how the outputs of 2 different
    countries might turn out to be different.
  • The comparisons are revealing because they adjust
    for size of the economies by focusing on output
    per person.
  • The graphs examine how differences might come
    from differences in the other input factors
    available to workers (factor accumulation), labor
    productivity differences, or both.

Output per person differences for 2 Economies, A
Differences due to Factor Accumulation
Differences due to Labor productivity
Differences due To Both
Country A
Country B
Both countries
Country B
Country A
Graphical Implications
  • In the first graph, we see that countries with
    the same production technologies can have
    different outputs per person (per capita real
    GDP) if they have different amounts of other
    input factors per person.
  • The second graph shows that 2 countries can have
    different outputs per person, even if they have
    the same amounts of other input factors per
    person but one is more technologically advanced
    than the other.

Application to Growth
  • Thus, we can explain, in simple terms, the
    reasons that one country might experience
    different growth in real per capita GDP than
  • It might be that one country manages to
    accumulate more production factors per worker
    than another.
  • Alternatively, one country might be able to
    improve its worker productivity (better
    technology) more than another country.

Application to Growth
  • Most probably, both have been factors that have
    accounted for differing growth of countries.
  • In order to discover how countries have managed
    different growth rates over time, we must examine
    how countries can increase the quantity of
    productive factors available per person, or how
    they might improve productivity.

Production factor accumulation the Golden Rule
  • Our previous discussion focused on the supply
    side of the economic equation.
  • If we want to consider how a country might
    increase its production factors, we must look at
    the question of (economic) investment per person.
  • Then, we are really asking about the demand side
    of the economic growth equation.
  • In that regard, a nations output is either
    consumed or used for investment.

Consumption, savings investment
  • The output that is not part of consumption is the
    savings of the people, and their savings can be
    used by firms to make investment (forgetting
    about foreign savings, for simplicity). Thus,
    savings is crucial for investment.
  • Then, higher savings results in higher investment
    results in a greater quantity of production
    factors per worker and higher levels of output
    per person.

Consumption, savings investment
  • This begs the question is there an optimal level
    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).

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.

Factor accumulation the Golden Rule
  • The so-called Golden Rule quantity of productions
    factors/capita will induce an optimal savings
  • We shall examine the logic behind the golden
  • 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.

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.

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.

Factor accumulation the Golden Rule
  • Thus, it will not be rational to increase the
    savings rate beyond that point.
  • The point where consumption/capita cannot be
    increased by increasing savings is referred to as
    the Golden Rule savings rate.
  • Indeed, there is no reason that a country would
    naturally arrive at this perfect savings rate,
    and it is one place that policy might be
    necessary to induce it.

Factor accumulation the Golden Rule
  • However, it might be difficult, even policy-wise,
    because arrival at this golden perfection might
    require raising the savings rate, which will
    lower current consumption.
  • People might be averse to the current sacrifice,
    even if it means that they would be better off in
    the long run.

Factor accumulation the Golden Rule
  • Moreover, it might be difficult, politically, for
    a politician to try to change, by force, the
    current consumption habits of the populace since
    he will not want to alienate them and lose a
    future election.
  • There are examples of such situations in
    Southeast Asia of countries below the golden rule
    savings rate, while Japan, in the last century,
    is an example of a country that has been above
    the perfect savings rate.

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

Technological Change
  • Our discussion of the golden rule assumed that
    technology 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.

Technological Change Plus..
  • The factors of production per cap, having
    increased will get to a point at which savings
    per cap will just replace existing per cap stock,
    and consumption per cap will become a constant.
  • Fortunately, technological change can move the
    production function to a new path by affecting
    the other factor of production, labor, and labor
    productivity will increase output per worker
    given the other factors of production per cap and
    will result in growth.

Technological Change Plus..
  • It is simply the shifting out of the PPF per cap
    that we attributed, earlier, to changing
  • Models of growth, like the Solow model,
    implicitly assume technological advancement, in
    that they allow that new investment in factors
    can include more technologically-advanced
    equipment that replaces the old.

Technological Change Plus..
  • This technological change that increases per cap
    labor productivity results in increased per cap
    output, which is increased standard of living,
    over time.
  • In addition, other things, beyond technology, per
    se, can result in increased per cap output.
  • Although we shall group such extra-technological
    things under the broad heading of techno change,
    they include things, like better labor
    organization, better management, and better
    education and training of the workforce.

Technological Change Plus..
  • The Solow model assumes that all such
    technological innovation is exogenous, i.e., they
    come from without (exo means outside), not
    within the economic system. It is not part of
    the model.
  • That is one of the faults of the model, which we
    shall patch up with a look at the endogenous
    possibilities for technological advancement.
  • This endogenous growth model is a more up-to-date
    model of macro growth.

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.

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.

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
  • 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.

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
  • Even so, there might be spillovers from knowledge
    that represent positive externalities for society
    but that might be disincentives for a firm who
    created the knowledge.

The Endogenous Growth Model knowledge as a
factor of production
  • In that regard, governments might also offer tax
    incentives to encourage 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.

The Endogenous Growth Model knowledge as a
factor of production
  • The acquisition of new knowledge might, instead
    of having diminishing returns, have increasing
  • Thus, there might be justification for
    governments to actually subsidize development of
    knowledge, as in the case of publicly funded
    basic research at universities.

The Endogenous Growth Model knowledge as a
factor of production
  • Even though some of that research is esoteric, it
    might have long term benefits to the community.
  • For example, the internet evolved as a result of
    some university researchers wanting to find a
    faster way of communicating with one another
    using their computers and telephone lines.

Government policy and growth
  • 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.

  • When machinery sits idle, it can dusty and
  • 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.

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

Productivity and Unemployment
  • Another area in which government must play a role
    in fostering development of technology is job
    obsolescence and displacement.
  • Technological change can result in people being
    put out of their jobs (structural unemployment),
    in the short-term, and societys concerns may
    cause governments to take the wrong actions
    because of political concerns.

Productivity and Unemployment
  • Consider, for example, a small island where
    fishermen catch fish with spears and the other
    industry is coconut, fruit and nuts. A third
    industry supplies fishermen with fishing spears.
  • One day, some boats with fishing nets wash up on
    shore and some of the fishermen experiment with
    the boats and find that they can go out to deep
    water and catch many fish with the nets.

Productivity and Unemployment
  • In the mean time, the other fishermen who 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.

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.

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

The Importance of Political Infrastructure and
  • 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
  • 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

The Importance of Political Infrastructure and
  • 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.

The Importance of Political Infrastructure and
  • 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.

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

Break time
  • 10 minute break

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.

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

CPI one measure
  • The most widely talked about measure of inflation
    is the consumer price index (CPI), also, called
    the cost of living index.
  • It is an index that measures average price of a
    normal basket of goods and services that the
    average consumer buys.
  • Then, changes in the index over time give the
    rate of consumer price inflation.

CPI one measure
  • It is strictly for consumer prices and not
    business or government.
  • Indeed there are other price indexes. We have
    already discussed the GDP deflator, which covers
    an entire economy, and there are usually also
    wholesale price indexes, for prices at the
    wholesale as opposed to the retail level, like
    for the CPI, and producer price indexes computed
    in various countries.
  • In the next slide we show the broad categories of
    inclusion in the consumer basket.

Makeup of CPI
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.

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.

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.

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

Example CPI calc simple economy
  • Assume a typical family in a mythical country
    purchased the following items for subsistence, in
    one year, and that they will do the same, every
    year 100 packages of noodles, 300 liters of
    gasoline for their automobile, and 4 tunics for
    family members to wear.
  • To construct a price index, we sum up their
    purchase and follow the cost of the same
    purchases year after year. That will give us a
    total cost.

Example CPI calc simple economy
  • We, then, choose a year as the base year and
    divided all years total cost by the cost in the
    base year.
  • The result will be an index that is equal to one
    in the base year (cost in the base year/cost in
    the base year), and another small number for
    other years.

Example CPI calc simple economy
  • Then, we can compute year-over-year or
    other-period percentage changes of the index to
    find the rate of inflation of the price of the
    basket of goods.
  • We show the sample index computation in the next
  • You will be expected to be able to calculate
    simple CPIs for the final exam in this course.

Sample CPI construction
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).

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.

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
  • Food prices increased by 3/2 1 50 gas
    prices, 2/1 1 100 and clothing, 25/20 1
  • Indeed it is common to hear reports, these days,
    of CPI inflation ex-food and energy prices.

Historical Australian Inflation in the CPI
CPI shortcomings
  • Just as in the measurement of any aggregate macro
    statistic, CPI has its faults.
  • First, there is the problem of the typical basket
    of goods. That is based on what an average view
    of that basket will contain, while it might not
    fit all households.
  • In particular, retirees will have a basket very
    different from a typical family more medical,
    less child-related items.

CPI shortcomings
  • Second, just like in the case of GDP, it is
    difficult to adjust for quality changes.
  • Thus, while a portion of price change might be
    due to increased or decreased quality, that might
    be lost in the index.
  • The ABS does try to make adjustments for quality
    in automobiles, electronics and other items in
    the basket, but complete accuracy is a problem.
  • Third, fixed weighting does not take account of
    the basic laws of supply and demand.

CPI shortcomings
  • For example, if there is a drought, and there is
    less rice available, the price will rise, demand
    will fall, consumers will eat more noodles, and
    the basket of consumer goods will shift to less
    rice and more noodles, while the official basket
    will remain the same.
  • Thus, CPI will not give an accurate picture of
    consumer price inflation of the real basket.
  • The ABS makes basket adjustments about every 5 to
    7 years.

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

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).

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.

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.

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

Approximation formula
  • We can also find an approximate formula for
    breaking down increase in nominal income (or
    nominal anything) into a real change and an
    inflation change as follows
  • Percentage change in real income ?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)

Inflation and Wealth
  • If income is one measure of well-being, wealth is
  • While income is the flow of money earned from
    selling factors of production (i.e., the sweat of
    your brow), wealth is the value of the stock of
    assets owned at some point in time.
  • Wealth includes such things real estate, stocks
    bonds, bank accounts, art, cash, cars, and other
    valuable things.

Inflation and Wealth
  • Wealth, in some cases, offers a hedge against
    inflation since the nominal value of some assets
    may increase at rates that exceed the rate of
  • Indeed, that is one reason why people purchase
    such things.
  • On the other hand, there is an implicit penalty
    from inflation for those who have little or no
    accumulated wealth since such people must rely on
    nominal income.

Inflation and interest rates
  • Borrowers and savers will also feel the impact of
    inflation, as inflation is part of the nominal
    rate of interest.
  • Just like in the case of income and GDP, there
    are nominal and real interest rates.
  • Formally, the nominal interest rate, I, is
    related to the real interest rate, R, and the
    inflation rate, INF, by the formula, 1 I
  • Again, the approximation formula is I RINF.

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
  • If inflation is 5, for example, and a
    certificate of deposit earns 7 per year, real
    interest is about 2, and purchasing power of the
    money invested in this financial asset increases
    during the investment time.
  • If you borrow money at 5 and it turns out that
    inflation, during the time to maturity of the
    loan, increases to an annual rate of 7, you will
    again receive a benefit, as the money that you
    use to pay for the loan is worth more than your
    cost of borrowing.

Inflation, investment business decisions
  • Investment and business decisions should be based
    on the relative real rates of return from
    investing economic resources in alternative
  • 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
  • When inflation rates are high, they also tend to
    be less stable, and it becomes difficult for
    business agents to forecast returns.

Inflation, investment business decisions
  • That leads, ultimately, to some inappropriate
    decisions, which result in inefficient allocation
    of resources.
  • Moreover, the interaction of taxes and inflation
    can also lead to investment that, while not the
    most beneficial for the community, will be
    favored because of after-tax considerations.

Inflation, investment business decisions
  • For example, in the early 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.

Demand-pull Inflation
  • Since price is determined by the interaction of
    supply and demand, there are two sides to
  • We shall use the cause-and-effect relationships,
    total spending, and the business cycle, from the
    preceding lecture (chapter 12), for our analysis
    of these topics.
  • Demand-pull inflation, too much money chasing too
    few goods, result from an excess of total
    spending (demand).

Demand-pull Inflation
  • When demand is high and it is difficult to
    satisfy, the typical response is for sellers to
    raise their prices.
  • If this excess demand is widespread across the
    spectrum of goods and services in the economy,
    the general level of prices will be pulled up by
    the excess demand.
  • Demand-pull inflation occurs when the economy is
    operating near its full capacity. Thus capacity
    is near the limit and aggregate demand is also
    very high.

Demand-pull Inflation
  • In the long run, if demand remained at this high
    level, producers would respond by expanding
    output, but they cannot do so in the short-run.
  • In the short run, prices will be bid up as
    demanders try to get goods in short supply.
  • Indeed, prices may grow at a slower pace or even
    fall once the short-term pressure of demand

Demand-pull Inflation
  • To get the full picture, remember that aggregate
    spending is composed of C, I, G and X M.
  • Thus, even foreigners can contribute to the
    demand-pull affect by bidding up prices of
    exports, thus putting more money in the hands of
    domestic people, which will feed through to
    domestic spending and demand.

Cost-push Inflation
  • When OPEC increased the price of oil,
    dramatically, in the 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
  • That could be the price of labor, raw materials,
    construction, equipment, or the cost of borrowing.

Expectations and Inflation
  • Expectations can play a role in either cost-push
    or demand pull inflation.
  • If consumers expect the price of homes to rise,
    they may begin to get nervous and start bidding
    up the prices of housing to hedge against future

Expectations and Inflation
  • If producers expect prices of inputs to
    production or even the cost of funds to increase
    in the near future, they may very well begin to
    raise prices in anticipation of expected higher
    costs, and cost-push inflation will result.
  • In the next module we shall use a model of
    aggregate supply and demand to further
    investigate both sides of inflation.

Inflation around the world
  • Inflation rates are different at different times
    for one country and are different at the same
    time for different countries (see page 369).
  • In 2003, for example, from among a small sample
    of countries, Brazil had double-digit inflation
    of around 15 per year.
  • 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

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

  • 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.

Unemployment defined
  • In Australia, each month, the ABS conducts a
    survey of employment from a random sample of
  • 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
  • If a person is not employed but has looked for
    work in the past month, they are counted as
  • Unemployment rate is the of people in the labor
    force who are not employed but are actively
    seeking employment.

The labor force and its unemployed
  • Babies, disabled people, students and retirees
    are not counted as unemployed.
  • The civilian labor force is, then, all people,
    excluding students, between 15 and 65 who are
    employed or unemployed, excluding people in the
    military or in institutions, such as prisons or
    mental hospitals.
  • The civilian unemployment rate (the unemployment
    rate) is the ratio of unemployed to the total
    civilian labor force.
  • Unemployment is a hot political issue.

(No Transcript)
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

Unemployment rate shortcomings
  • The unemployment rate might also understate
    unemployment because of discouraged persons, who
    are people who want to work but have given up the
    job search because after repeated rejection they
    believe that they cannot find a job.
  • The ABS counts a discouraged person as anyone who
    has looked for a job in the last 6 months but has
    given up.
  • The ABS counts discouraged persons as not in
    labor force.

Unemployment rate shortcomings
  • The problem of their exclusion exacerbates the
    underestimation of unemployment during economic
    downturns because more people become discouraged.
  • Unemployment may also be understated because the
    ABS lumps part-time and full time workers as
    employed, even though some part-time workers
    might want to work full time but cannot find a
    full-time job.
  • Then, those workers are at least underemployed.
    And that figure rises during recessions.

Seasonal unemployment
  • The reason that the graph in an earlier slide
    showed much variation on the short-term scale was
    because of seasonal patterns of employment.
  • Many industries are tied to the seasons, like
    farm work.
  • Other seasonal industries are work at ski or
    summer resorts and some types of construction.
  • Employment also increases at Christmas time in
    the wholesale and retail sectors.

Frictional unemployment
  • Sometimes the unemployment of a person is only
  • 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

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
  • Thus, this type of unemployment is sometimes
    called search unemployment or transitional
  • Frictional unemployment is part of normal
    economic life due to freedom of choice.
  • It can vary, and it can be lessened with better
    information distribution about jobs.

Structural Unemployment
  • Unlike frictional and seasonal unemployment,
    structural unemployment 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
  • 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

Structural Unemployment
  • The first is lack of skills. This is true for
    teenagers and minorities but also for others. For
    example, if green groups persuade the government
    to allow less tree cutting, there will be less
    jobs in the timber industry and people will need
    to be retrained for other jobs.
  • The consumer may change their demand patterns.
    For example, if people begin to prefer imported
    cars, there will be people out of work in the
    domestic auto industry, and they will need to
    retrain for jobs in other industries.

Structural Unemployment
  • Technological changes may leave less jobs or jobs
    that need new skills, and it might be particular
    to a region of the country, too. For example, to
    compete with cheap imports, the textile industry
    might buy new machinery and leave less jobs in
    the area. People might be reluctant to move to a
    new place and become structurally unemployed.
  • Structural employment is part of modern economic
    life, as technology advances, products change and
    competition comes from imported goods. Good
    retraining programs are the key to fighting it.

Structural Unemployment
  • 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.

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
  • 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
  • A focus of macro policy is to moderate cyclical

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
  • Full employment is the state in which
    unemployment equals, exactly, seasonal,
    frictional, and structural unemployment.
  • Full employment is, thus, equal, to the state in
    which there is no cyclical unemployment.
  • It is difficult to actually come up with a proper
    figure for it.

The goal of full employment
  • Full employment unemployment is sometimes
    referred to as natural unemployment or
    non-accelerating inflation rate unemployment
    (NAIRU), and it will change over time with
    changes in the economic framework.
  • In Australia, it was around 2 in the 1960s, 4
    in the 1970s, 6-7 in the 1980s 90s, and
    around 4 in the new century.

The goal of full employment
  • One reason for the change is attributed to more
    women entering the labor force over the period.
  • Typically, women have a higher unemployment rate
    than men.
  • Another explanation has been the interaction of
    tax and welfare, making unemployment less
  • The final piece of the puzzle is called
    hysteresis, which we discuss in more detail, in
    the next slide.

  • Hysteresis is a concept from physics whereby, if
    you rub a pin, for example, with a magnet, the
    pin will become magnetized, so retaining a memory
    of what happened to it.
  • In economics the concept is loosely applied to
    unemployment as follows. Please note that our
    wording is slightly different from that in the
    book, which is incorrectly worded.

  • Hysteresis 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.

  • 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.

  • Thus, after unemployment increased due to a
    downturn, the full employment rate of
    unemployment increased.
  • Another explanation is the insider/outsider
  • 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.

  • Thus, after the economy picks up, unemployment
    begins to decrease but insiders bid up wages
    making costs for firms higher allowing them to
    spend less for new people. Thus, more people are
    employed, bringing down unemployment, but some
    are still out of jobs.
  • As a result, the natural rate of unemployment
    might actually increase, even though actual
    current unemployment is decreasing.

Non-monetary and demographic consequences of
  • Unemployment leads to more than just loss of
    potential economic output.
  • People who are out of work loses their sense of
    self-worth, and the results are family problems
    and break-ups, suicide, mental illness, crime,
    political unrest, and health problems.
  • Unemployment is different for different
    demographic groups. Teenagers with little
    experience and high quit rates and people over 55
    show the highest levels of unemployment.

Non-monetary and demographic consequences of
  • For people who are unemployed we also define a
    time of being out of work.
  • Those who have been out of work for more than a
    year are referred to as long-term unemployed, and
    they face great difficulty getting new jobs just
    because they have been out of jobs for so long
    and employers, then, wonder why, and the
    unemployed lack self-confidence that they can get
    a job.

Ask yourself
  • What factors could increase/decrease seasonal,
    structural, and frictional unemployment?
  • Which measure of inflation do you think better
    reflects price rises in an economy? Which
    measure do you think people care more about?
  • What is hysteresis and what might cause it?
  • In terms of the production function, why can one
    country have higher output per person than

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.
  • 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

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
  • 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?

  • 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.

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

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