Introduction: Thinking Like an EconomistCHAPTER

6

Economic Growth, Business Cycles, and Structural Stagnation

Remember that there is nothing stable in human affairs; therefore avoid undue elation in prosperity, or undue depression in adversity.

— Socrates

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Chapter Goals

Discuss the history of macro, distinguishing Classical and Keynesian macroeconomists

Distinguish a business cycle from structural stagnation

Define growth and discuss its recent history

Relate unemployment to business cycles and distinguish cyclical unemployment from structural unemployment

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The Historical Development of Macro

Classical economists believe that business cycles are temporary glitches, and generally favor laissez-faire, or nonactivist policies

Keynesian economists believe that business cycles reflect underlying problems that can be addressed with activist government policies

By the 1980s, Classical and Keynesian economics merged in a new conventional macroeconomics

Following the 2008 crash, the U.S. economy experienced structural stagnation that conventional economists did not anticipate

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Two Frameworks: The Long Run and the Short Run

The long-run growth framework focuses on incentives for supply

• Sometimes called supply-side economics• Issues of growth are considered in a long-run

framework The short-run business cycle focuses on demand

• Sometimes called demand-side economics• Business cycles are generally considered in

a short-run framework

Inflation and unemployment fall within both frameworks

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Two Frameworks: The Long Run and the Short Run

The stark division between the short-run and the long-run frameworks is problematic

Both frameworks have to be blended into a composite framework in which both supply and demand influence long-run and short-run forces

The long run is just a combination of short runs that cannot be separated

The economy is simultaneously in the long run and short run

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Growth

Economists measure growth with changes in total output over a long period of time

Even if total output is increasing, the population may be growing even faster, so per capita output would be falling

Potential output is the highest amount of output an economy can sustainably produce and sell using existing production processes and resources

Per capita output is output divided by the total population

U.S. economic output has grown at an annual 2.5 to 3.5 percent rate since World War I that represents the rise in potential output. What it will be in the future is uncertain.

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The Benefits and Costs of Growth

• Per capita economic growth allows everyone in society, on average, to have more: but is this necessarily an increase in well-being?

• Growth, or the prediction of growth, allows governments to avoid hard questions

• Growth comes with costs:• Pollution• Resource exhaustion• Destruction of natural habitat

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Business Cycles and Structural Stagnation

A business cycle is the upward or downward movement of economic activity that occurs around the growth trend

• Classical economists argue that the government should just accept that business cycles occur and take a laissez-faire stance

• Keynesians economists argue that government can temper these fluctuations with policy actions

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Business Cycle Phases Total Output

Quarters21 3 4 21 3 4 21 3

Secular Growth Trend

Uptur

n

Downturn

Peak

Trough

Boom

Recession ExpansionExpansion

Uptur

n

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The Phases of the Business Cycle

The four phases of the business cycle are: • The peak• The downturn• The trough• The upturn

A recession is a decline in real output that persists for more than two consecutive quarters of a year

An expansion is an upturn that lasts at least two consecutive quarters of a year

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Structural Stagnation

Structural stagnation is a cyclical downturn that we do not expect to end any time soon with major changes in the structure of the economy

Unemployment is not due to temporary layoffs, but to longer-term changes

A depression is a deep and prolonged recession

The distinction between a business cycle and structural stagnation goes to the heart of the modern macro policy debates

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Unemployment and Jobs

The unemployment rate is the percentage of people in the economy who are willing and able to work but who cannot find jobs

Cyclical unemployment is that which results from fluctuations in economic activity

Structural unemployment is that caused by the institutional structure of an economy or by economic restructuring making some skills obsolete

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Unemployment Rate since 1900

Percentage of labor force unemployed

1900 1920 1940 1960 1980 2000

30

20

10

0

In the mid-1940s, the U.S. government started focusing on the unemployment rate as a goal, and initially chose 2%, but it was

gradually increased to around 3 to 5%

Target rate

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Unemployment as a Social Problem

The Industrial Revolution changed the nature of work and introduced unemployment as a problem for society

There was a shift to wage labor and to a division of responsibilities

The Industrial Revolution created the possibility of cyclical unemployment and changed how families dealt with unemployment

Early capitalism had an unemployment solution: the fear of hunger

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Unemployment as Government’s Problem

In the Employment Act of 1946, the U.S. government took responsibility for unemployment

Full employment is an economic climate where nearly everyone who wants a job has one

Frictional unemployment is unemployment caused by people entering the job market and people quitting a job just long enough to look for and find another job

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Target Rate of Unemployment

The target rate of unemployment is the lowest sustainable rate of unemployment that policy makers believe is achievable under existing conditions

The appropriate target rate of unemployment was debatable until the downturn of 2008, but, for the US, most economists place it around 3 to 5%

The target rate of unemployment changes due to:• Inflation rates• Demographics• Social and institutional structures• Changing government institutions

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CALCULATION EXAMPLES1. Calculating Economic Growth Rates:

• Annual Percentage Change in Real GDP • To calculate this growth rate, we use the formula:

Growth of real GDP =

Real GDP in current year

Real GDP in previous year

x 100

Real GDP in previous year

–

For example, if real GDP in the current year is $8.4 trillion and if real GDP in the previous year was $8.0 trillion, then the growth rate of real GDP is :

Growth of real GDP =

$8.4 trillion – $8.0 trillion

$8.0 trillionx 100 = 5%

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CALCULATION EXAMPLES2. To calculate Real GDP Per Capita (per person), we use the formula:

Real GDP

Population

• In current year, when real GDP is $8.4 trillion, and the population is 202 million, then Real GDP per capita = $41,584

$8.4 trillion

202 million

• In the previous year, when real GDP was $8.0 trillion, the population was 200 million, real GDP per capita was $8.0 trillion divided by 200 million, or $40,000.

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CALCULATION EXAMPLES3. To calculate growth in Real GDP Per Capita (per person):

- Use the formula from (1), replacing real GDP with real GDP per person

-Use the two values of real GDP per person calcluated in (2):

Growth rate of real GDP per person

$41,584 – $40,000

$40,000

x 100 = 4%=

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CALCULATION EXAMPLES

4. Growth in Real GDP Per can also be estimated by using the formula (accurate enough for rates of 10% or less):

Growth of real GDP per person

Growth rate of real GDP

Growth rate of population– =

Growth of population

202 million – 200 million

200 millionx 100 = 1 %.=

Growth of real GDP per person

5 % – 1 % = 4 %.=

Recall, growth rate of real GDP from (1) was 5 %, so:

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Links for Overview of Macro

Potential output:CBO Budget OutlookGDP report from BEA:BEA-Dept of Commerce GDP ReportGDP per capita:World Bank Report on global GDPUnemployment and employment:BLS-Dept of Labor Report