For Sheryl Hogan Economics-2

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MBA 530 ECONOMICS

Unit 11: An Introduction to Measures of Macroeconomic Performance Part 2: Economic Growth and Unemployment

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Topics in this lecture:

1. Economic growth 2. Business Cycles 3. Unemployment

In the last lecture we learned how gross national output and income are measured in an economy. The goal of this lecture is to understand how changes in U.S. real GDP are related to employment and standards of living. Along the way we’ll need to further refine our definition of economic growth and introduce measures of unemployment.

Economic Growth refers to changes in measures of real per capita income or output and is measured by the annual percentage increase in real GDP. If real GDP is growing faster than population over time, the country is producing more output over time, earning more income and is said to be experiencing “economic growth”.

Recall the definitions of GDP (the value of production within the physical borders of a nation) and GNP (the value of production in a given year by citizens of a nation). Dividing either of these by population gives us a measure of per capita income. Increases in per capita income over time imply improved employment opportunities, higher average incomes and higher average standards of living.

It is important to distinguish economic growth (which is a long-term phenomenon) and changes in real GDP that occur as a result of business cycles which are short- run fluctuations in output.

For example, the boom in production during World War 2 was not a contributor to true economic growth, because it was a short-run phenomenon. Similarly, it would

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be incorrect to state that during the recessions of the 1930’s, 1974, 1982, 1991 and 2007-2009 were indicative of decreasing economic growth. U.S. real GDP decreased by nearly 5 percent, but this short-run down turn does not indicate a decline in overall economic growth.

It’s easy to see this with historical data – look at a trend line and ignore the minor ups and downs. These ups and downs do show that real GDP does not increase steadily. Rather, there are irregular (and unpredictable) fluctuations, which are referred to as the Business Cycle, because they show how the overall economy reacts to conditions in markets.

Elements of the Business Cycle include periods of expansion and periods of contraction. The turning points (high points and low points) in these periods are referred to as peaks and troughs.

During a period of economic expansion, real GDP is increasing from year to year. The endpoints of a period of expansion are the most recent trough and the subsequent peak.

During a period of economic contraction, real GDP is decreasing from year to year. The endpoints of a period of contraction are the most recent peak and the subsequent trough.

Real GDP

Period of expansion

Period of contraction

Actual real GDP

General trend

Time

Peaks

Troughs

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During periods of economic expansion, output as measured by real GDP is increasing, and we can expect that factor inputs will be experiencing improvements in productivity. These periods may be referred to as economic “booms” if they last a sufficiently long time. The longest period of economic expansion in the U.S. took place from 1991 to 2001, during which time real GDP increased from $9 trillion to $12.7 trillion.

During periods of economic contraction, output (real GDP) is decreasing and we can expect that factor inputs will be underutilized. These periods will be characterized by above average unemployment, lower incomes and lower demand. If the period of contraction (decreasing real GDP, or negative growth in real GDP) lasts more than six months, many economists consider the economy to be in a recession. If a recession is “severe” and lasts more than a couple of years, economists may label it a depression. Thankfully this has only happened once.

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In Unit 12 we will consider the market forces of supply and demand at the aggregate level in an attempt to understand possible causes of economic expansion and contraction as well as the associated consequences. The consequences of economic growth include changes in employment and the overall price level.

Before we get to discussing and modeling cause-and-effect, let’s first consider measures of unemployment and prices so we have a good grasp of the concepts that we’re studying.

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Unemployment During periods of economic contraction or recession, the demand for many goods and services will decline, resulting in a decreased demand for labor across many markets. Unemployment will therefore increase during these periods. Similarly, we should see unemployment decrease during periods of expansion. To understand how economic growth and unemployment are related we need to carefully define how unemployment is measured.

The labor force is defined as the number of people who are of legal working age (16 years or older) and are either employed or actively seeking employment.

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An individual is classified as “unemployed” if the following four conditions are met:

1. The individual is of legal working age, 2. They do not have a job, 3. They are available for work, and 4. They have actively sought employment during the past four weeks.

The unemployment rate is the percentage of the total labor force that is unemployed, and as calculated as the ratio of the number of unemployed people to the total number of people in the labor force.

Unemployment Rate = 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑈𝑈𝑈𝑈𝑁𝑁𝑁𝑁𝑈𝑈𝑈𝑈𝑜𝑜𝑈𝑈𝑁𝑁𝑈𝑈 𝑃𝑃𝑁𝑁𝑜𝑜𝑈𝑈𝑈𝑈𝑁𝑁 Number of People in the Labor Force

𝑋𝑋 100

The unemployment rate is estimated every month by the U.S. Census Bureau through the Current Population Survey (CPS). This survey is administered to 60,000 U.S. households each month and contains an array of questions related to employment activities for each member of the household.

Full-time students, stay-at-home parents, retired people, people who cannot work because they are disabled or incarcerated are not unemployed because they are not part of the labor force. People who have their work hours cut (even if it is a drastic cut) are not counted as unemployed if they have worked at all over the prior week.

Types of Unemployment There are many reasons that people might be unemployed. Because people do not immediately find jobs upon entering the labor force or when switching between jobs, there will always be some level of unemployment in an economy. That is, the unemployment rate will never be zero.

Frictional Unemployment is the type of unemployment that occurs when people are searching for jobs because they left a job that did not work out, or they just (re)entered the labor force. For example, a new college graduate that is looking for their first job is among the frictionally unemployed. A stay-at-home parent,

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reentering the labor force and searching for employment is also frictionally unemployed, as is a worker who quits a job and is searching for a new job.

Structural Unemployment occurs when there is a reduction in the demand for a particular skillset. This can occur for many reasons, including changes in technology, changes in trade patterns, or changes in consumer preferences. For example, the reduction in demand for manufacturing labor in the U.S. that started around the year 2000, principally due to increased import competition from China, would be an example of structural unemployment. People who lose their jobs as part of structural unemployment may have to learn new skills or accept jobs in other industries. As a result, structural unemployment may last a long time for some individuals.

Cyclical Unemployment is unemployment that results from downturns in overall demand in an economy, such as that which occurs during periods of economic contraction. Cyclical unemployment is often accompanied by other factor inputs such as capital and equipment being underutilized as well. This indicates that the economy is not producing as much output as is possible. Actual real GDP is therefore lower than potential GDP.

It is important to note that because it takes time to find employment and because technology and consumer preferences are always changing, there will always be some frictional and structural unemployment.

The Natural Rate of Unemployment is the unemployment rate that occurs in an economy due to these two sources. When an economy is operating at the natural rate of unemployment (i.e. cyclical unemployment is zero) the economy is said to be operating at “Full Employment”. Historically, the natural rate of unemployment has been around 5 percent since around 2000.

Based on the above ideas, one way to define cyclical unemployment is any unemployment that represents a deviation from the natural rate of unemployment.