8
C HAPTE R
Introduction to Economic
Growth and Instability
8-1
ECONOMIC GROWTH
Two definitions of economic growth:
 The increase in real GDP, which occurs over a
period of time.
 The increase in real GDP per capita, which
occurs over time.
Economic growth is calculated as a percentage rate
of growth per year or quarter.
8-2
Per-capita GDP = GDP/population
It is the share of each inhabitant of the GDP
on average.
• This definition is superior if comparison
of living standards is desired.
For Example:
• China’s 2001 GDP was $1131 billion
compared to Kuwait’s $36 billion,
• But per capita GDP’s were $890 and
$18000 respectively.
8-3
Growth in real GDP does not guarantee growth
in real GDP per capita.
• If the growth in population exceeds the growth in
real GDP, real GDP per capita will fall (lower
standards of living).
• Expansion of total output relative to population
results in:
– Rising real wages and income
– Higher standards of living
8-4
Arab Countries:
Growth Rates in Real GDP
Annual Average Growth Rate (2000 - 2005)
10.0
9.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
8-5
Dr. Reyadh Faras
5
Kuwait: The rate of growth of real GDP
year GDP constant GDP current Growth of real
prices
prices
GDP
1993
1994
1995
1996
1997
1998
1999
2000
8702.5
7379.8
9453.2
8113.9
9583.4
9429.1
9323.9
9206.7
9435.2
7906.5
9733.2
9169.7
9255.2
11356.7
9946.1
10445.7
average
33.759
8.626
1.377
-2.708
1.194
3.158
-4.911
7.465
5.995
Note:
Growth rate excluding 1993 equals 2.029
8-6
War and
liberation
effect
Growth as a Goal




Growth is an important economic goal because it
means more material abundance and ability to
meet the economizing problem.
Expansion of output relative to population results
in rising real wages and incomes and thus higher
standards of living.
A growing economy is better able to meet people’s
wants and resolve socioeconomic problems.
In sum, growth lessens the burden of scarcity and
enable a nation to attain its economic goals more
readily.
8-7
Arithmetic of Growth: Rule of 70




The “rule of 70” uses the absolute value of a rate of
change, divides it into 70, to tell us about the number of
years it will take for some measure to double (in
compound rates).
For Example:
If growth rate = 3%. It will take 23 years to double GDP
Small changes in the rate of growth are important.
If the rate of growth increased to 4%. It will take about
18 years only to double GDP.
In USA with a $12.5 trillion GDP, the difference
between the rate of 3% and 4% equals 125 billion.
8-8
Main sources of growth
Society can increase its real output and income in two
ways, by:
 Increasing its inputs of resources (Quantity).
 Increasing productivity of resources (Quality).
productivity = real output per unit of input
productivity of labor
productivity of labor = real output / No. labor units
• Two thirds of growth in USA result from improved
productivity.
• Only one-third of U.S. growth comes from more inputs
8-9
Main Sources of Growth
How can we improve productivity of labor??
Productivity rises with:
1) improvement in: health, training, education, and
motivation of workers.
2) use of more and better machines and resources.
3) better organization and management of production.
4) reallocation of labor from less to more efficient firms.
8 - 10
The Business Cycle
The term business cycle refers to alternating
rises and declines in economic activity.
• Individual cycles vary substantially in duration
and intensity:
- short cycle
- medium cycle
- long term cycle
8 - 11
The Business Cycle
Peak
Level of Real Output
Peak
Peak
Trough
Trough
Time
8 - 12
Durable and nondurable industries
affected differently
26-
•
Phases of the Business Cycle
Four phases of the business cycle are identified
over a several-year period.
1. A peak is when business activity reaches a
temporary maximum with near/full
employment and near full capacity output.
•
-
At peak:
Full employment
Real output is close to capacity
Prices likely to be high
8 - 13
2. A recession
• There is a decline in total output, income, and
employment, lasting six months or more.
• It is marked by a widespread concentration of
business activity in many sectors of the
economy
• Prices fall only if a depression occurs
(many prices are sticky)
8 - 14
3. A trough (recession or depression)
• is the bottom of the recession period. Output
and employment bottom out at their lowest
levels
4. A recovery
• is when output and employment are expanding
toward the full-employment level. Price level
may increase before full employment.
8 - 15
There are several theories about causation
1. Momentous innovations:
Major innovations may trigger new investment
and/or consumption spending.
• Railroads, automobiles, and micro-chips, have
great impact on investment spending and thus
on output, employment and prices.
• Contribute to variability of economic activity
8 - 16
2. Changes in productivity may be a related
cause:
• When productivity expands, the economy
booms.
• When productivity falls the economy recedes.
3. Monetary causes:
•
•
Too much money leads to inflationary boom
Too little money triggers recession
8 - 17
4. Changes in total spending:
•
•
Most economists agree that the level of
aggregate spending is important, especially
changes on capital goods and consumer
durables.
When total spending sinks, output, income and
employment fall.
When total spending rises, output, income and
employment rise.
8 - 18
Cyclical Impact: Durables and Nondurables
• Durable goods output is more volatile than nondurables and services because spending on the latter
usually cannot be postponed. Capital goods and
consumer durables are affected the most.
• In recessions, firms delay the purchase of new machines
and equipments and consumers repair their old
appliances.
• In booms, firms replace their capital and consumers buy
new appliances.
• Nondurable consumer goods are little affected by
recessions.
8 - 19
Unemployment
(One Result of Economic Downturns)
The population is divided into three groups:
• Those under age 16: “not potential members of
the labor force”
• Adults not looking for work: not in the labor
force.
• Labor force: includes those in age 16 and over
who are willing and able to work, and actively
seeking work.
8 - 20
Unemployment (USA 2007)
Under 16
And/or
Institutionalized
(71.8 Million)
Not in
Labor Force
(78.7 Million)
Total
Population
(303.6 Million)
8 - 21
Employed
(146.0 Million)
Unemployed
(7.1 Million)
Labor
Force
(153.1 Million)
Source: Bureau of Labor Statistics
26-
•
The unemployment rate is defined as the
percentage of the labor force (not of
population) that is not employed.
Unemployment
rate
8 - 22
unemployed
=
labor force
x 100
Unemployment Rates in Five
Industrial Nations: 1995-2005
8 - 23
Source: Bureau of Labor Statistics
26-
• In USA the unemployment rate is calculated by
random survey of 60,000 households nationwide.
• Two factors cause the official unemployment rate
to understate actual unemployment:
a. Part-time workers are counted as “employed.”
b.“Discouraged workers” who want a job, but are
not actively seeking one, are not counted as
being in the labor force, so they are not part of
unemployment statistic.
8 - 24
Types of unemployment
1. Frictional unemployment: Workers between
jobs. Consists of those searching for jobs or
waiting to take jobs soon; it is regarded as
somewhat desirable, because it indicates that
there is mobility as people change or seek jobs.
Types:
• Voluntarily moving from one job to another
• Fired and seeking another job
• Housewives who decided to work
• New graduates looking for jobs for the first time
Note:
this
type
of
unemployment
is
unavoidable
8 - 25
2. Structural unemployment is due to changes in
the structure of demand for labor; e.g., when
certain skills become obsolete or geographic
distribution of jobs changes.
•
Difference between frictional and structural is
that frictional unemployed have salable skills.
Structurally unemployed will find it difficult to
find a job
8 - 26
3. Cyclical unemployment is caused by the
recession phase of the business cycle, which is
sometimes called deficient demand
unemployment.
•
When demand for goods and services falls,
employment falls and unemployment increases.
8 - 27
GDP (billions of 1996 dollars)
Unemployment (USA – 1985-2006)
12,000
12,000
The GDP Gap
11,000
11,000
GDP gap
(positive)
Potential GDP
10,000
10,000
9,000
9,000
8,000
8,000
GDP gap
(negative)
7,000
7,000
6,000
6,000
Actual GDP
5,000
5,000
1985
1985
1987
1987
1989
1989
1991
1991
1993
1993
1995
1995
1997
1997
1999
1999
2001
2003
2001
2003
1999 2001
20012003
2005
2005
Unemployment
(percent of civilian
Labor force)
10 10
8
8
6
6
4
4
2
2
0
0
1985
8 - 28
The Unemployment Rate
1985
19871987
1989
1989
1991
1991
1993
1993
1995
1995
19971997 1999
2005
2003
2005
Source: Congressional Budget Office & Bureau of Economic Analysis
26-
Definition of “Full Employment”
1. Frictional and structural unemployment is
unavoidable, hence, full employment is something
less than 100%. Full employment does not mean
zero unemployment.
2. The unemployment rate consistent with
full-employment is equal to the total of frictional
and structural unemployment.
3. The “full-employment” rate of unemployment is
also referred to as the natural rate of
unemployment NRU.
8 - 29
4.The natural rate is achieved when labor markets
are in balance; the number of job seekers equals
the number of job vacancies.
• Hence at NRU
• The economy is producing its potential output
Note:
• It is not necessary that the economy will work at
NRU. At times of recession unemployment will
be greater than NRU.
8 - 30
• The natural rate of unemployment is not fixed, but
depends on the demographic makeup of the labor force
and the laws and customs of the nations.
• Recently in USA the natural rate has dropped from 6%
to 4 or 5%. This is attributed to:
a. The aging of the work force as the baby boomers
approach retirement.
b. Improved job information through the Internet and
temporary-help agencies.
c. The doubling of the U.S. prison population since
1985.
8 - 31
Economic cost of unemployment
1. Foregone output. Failure to create enough jobs leads
to loss of potential output (NRU). This is measured by
GDP gap: the difference between potential and actual
GDP.
GDP gap = Actual GDP - Potential GDP
•
GDP gap and Okun’s Law: Economist Arthur Okun
quantified the relationship between unemployment
and GDP as follows: For every 1 percent of
unemployment above the natural rate, a negative GDP
gap of 2 percent occurs. This is known as “Okun’s
law.”
8 - 32
2. Unequal Burdens: Burden of unemployment is
unequally distributed.
• Occupations: workers in lower skilled
occupations have higher unemployment rates
• Age: teenagers have much higher
unemployment rates than adults (less skills and
less experience).
• Race and ethnicity: rate is high among AfricanAmericans and Hispanics.
• Education: rate is higher among less educated.
• Duration: most unemployment lasts shorter
periods.
8 - 33
3. Non-economic costs
•
•
•
•
•
•
Loss of skills
Loss of self respect
Family disintegration
Sociopolitical unrest
Racial and ethnic tensions
Other diseases include suicide, homicide, fatal
heart attacks and mental illness.
8 - 34
Inflation: Defined and Measured
Definition: Inflation is continuous rise in the
general level of prices.
- A continuous rise: a one shot rise in the price
level is not inflation (price rise).
- The general price level: it is not necessary that all
prices must increase at the same time. During
inflation some prices can go down.
8 - 35
• The main index used to measure inflation is the
Consumer Price Index (CPI).
• Measuring Inflation: the percentage change in CPI
 2002 CPI = 123
 2003 CPI – 127
 Inflation = ((127-123)/123)% = 3.25%
• The “rule of 70” permits quick calculation of the time it
takes the price level to double: Divide 70 by the
percentage rate of inflation and the result is the
approximate number of years for the price level to
double. If the inflation rate is 7 percent, then it will take
about ten years for prices to double.
8 - 36
Inflation Rates in Five Industrial
Nations: 1995-2005
8 - 37
Source: Bureau of Labor Statistics
26-
Kuwait: Inflation Rate (2001 – 2008)
12
Inflation Rate (%)
10
8
6
4
2
0
2001
2002
2003
2004
2005
2006
2007
Year
8 - 38
Dr. Reyadh Faras
38
2008
Types of inflation
Demand-pull inflation:
• When resources are already fully employed,
businesses cannot respond to excess demand by
expanding output.
• So excess demand bids up the prices of the
limited output.
• Spending increases faster than production.
8 - 39
Cost-Push inflation:
• Prices rise because of a rise in per-unit
production costs.
• Per unit cost = total input cost/units of output.
• Rising costs squeeze profits and reduce output
firms are willing to produce at current prices.
• Supply of goods decreases and prices go up
8 - 40
Note
a. Output and employment decline while the price
level is rising.
b.Supply shocks (due to higher cost of inputs) have
been the major source of cost-push inflation.
These typically occur with dramatic increases in
the price of raw materials or energy.
8 - 41
Redistributive effects of inflation
•
Nominal and real income
•
Nominal income is the number of KDs received as
wages, rent, interest and profits
•
Real income is a measure of the amounts of goods and
services income can buy. Therefore;
Real income = nominal income / price level
•
% change in real income = % change in nominal
income – percentage change in price
level
8 - 42
• Unanticipated inflation has stronger impacts;
those expecting inflation may be able to adjust
their work or spending activities to avoid or
lessen the effects.
Who is hurt by inflation?
Fixed income receivers: People whose incomes
are fixed see their real incomes fall when
inflation occurs.
8 - 43
Savers
• will be hurt by unanticipated inflation, because
interest rate returns may not cover the cost of
inflation. Their savings will lose purchasing
power.
e.g.,
- A 1000 CD with a 6% interest and inflation 13%,
after one year
- Nominal value = 1060
- Real value = (1060/1.13) = 938
8 - 44
•
•
•
Creditors:
They can be harmed by unanticipated inflation.
Interest payments may be less than the inflation
rate.
Borrowers are paying back money that have
less purchasing power for the lender.
If inflation is anticipated, the effects of inflation
may be less severe, since wage and pension
contracts may have inflation clauses built in,
and interest rates will be high enough to cover
the cost of inflation to savers and lenders.
8 - 45
Who is Unaffected by inflation?
• Flexible-Income receivers: they can avoid
inflation’s harm or even benefit from it.
• They benefit more from unanticipated inflation.
Debtors: they pay back less valuable money
whose purchasing power has been eroded by
inflation.
• Real income is redistributed away from creditors
to debtors.
• The government, as a debtor, benefits as it pays
back its debt with money that has less purchasing
than the original money it borrowed.
8power
- 46
•
•
Anticipated Inflation
Redistribution effects of inflation are less severe if
inflation was expected.
People can adjust their nominal incomes to reflect the
expected rise in the price level.
•
“Inflation premium” is amount that the interest rate is
raised to cover effects of anticipated inflation.
•
“Real interest rate” is defined as nominal rate minus
inflation premium.
8 - 47
ANTICIPATED INFLATION
11%
=
+
5%
Nominal
Interest
Rate
8 - 48
Real
Interest
Rate
6%
Inflation
Premium
Output Effects of Inflation
A. Cost-push inflation, where resource prices rise
unexpectedly, could cause both output and employment
to decline. Real income falls.
B. Mild inflation (<3%) has uncertain effects. It may be a
healthy by-product of a prosperous economy, or it may
have an undesirable impact on real income.
C. Danger of creeping inflation turning into hyperinflation,
which can cause speculation, reckless spending, and
more inflation
8 - 49