Economic Instability and Business Cycles

Session 10 Economic Instability Disclaimer: The views expressed are those of the presenters and do not necessarily reflect those of the Federal Reserve Bank of Dallas or the Federal Reserve System.

TEKS (10) Economics. The student understands key economic measurements. The student is expected to: (A) interpret economic data, including unemployment rate, gross domestic product, gross domestic product per capita as a measure of national wealth, and rate of inflation; and (B) analyze business cycles using key economic indicators.

Teaching the Terms Unemployment Recession Frictional Structural Cyclical Inflation Deflation Price index Indexing Hyperinflation

Macroeconomic Issues Recessions Unemployment Inflation Distribution

Business Cycle Long-Run Growth Trend Real GDP Peak Expansion Recession Trough Time

Recession A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. http://www.nber.org/dec2008.pdf

An Economic Bar Code? 1855 1858 1862 1866 1870 1874 1878 1882 1886 1890 1894 1898 1902 1905 1909 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 1999 2003 2007 2011 Federal Reserve Bank of Dallas, FIRM (Financial

U.S. Business Cycle Black = Months in Contraction (Recession) 1984 1988 1992 1855 1858 1862 1866 1870 1874 1878 1882 1886 1890 1894 1898 1902 1905 1909 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1952 1956 1960 1964 1968 1972 1976 1980 1996 1999 2003 2007 2011 Federal Reserve Bank of Dallas, FIRM (Financial

Labor Force Employed Labor Force Population Civilians over 16 and not institutionalized Unemployed Not in labor force

Unemployment Every person who is 16 years old or older (the working-age population) and not institutionalized falls into one of three categories Employed a person who has worked full- or part-time during the past week or is on vacation/sick leave Unemployed a person who did not work in the past week but sought work in the past four weeks Out of the labor force did not work or seek employment

Unemployment Labor force = Employed + Unemployed Unemployment rate = Unemployed Labor Force Participation rate = Labor force Working Age (16+) Population

Criticisms of Measurement Discouraged workers Involuntary part-time workers Underemployed Types of employment

Unemployment Frictional Total Structural Unemployment Cyclical

Types of Unemployment: Frictional Short-term unemployment associated with matching workers with jobs Costs are small (may even be negative)

Types of Unemployment: Structural Long-term and chronic unemployment that exists when an economy is producing at a normal rate Mismatch of unemployed workers and available jobs Very high costs related to its long-term nature

Types of Unemployment: Cyclical Occurs during a period of recession (unusually low production) High costs both to worker and to society Lost production (output) Lost income for unemployed workers Lost tax revenue and increased government support

Natural Rate of Unemployment Frictional Natural Rate of Unemployment Structural Full employment zero unemployment Full employment = no cyclical unemployment

Inflation Inflation is an increase in the overall level of prices. Inflation is not an increase in the price of a specific good or service relative to the prices of other goods and services.

Measuring Inflation Use a price index that measures the cost of a fixed market basket of goods relative to the cost of the same basket in a base year Examples Consumer Price Index (CPI) BLS GDP Deflator BEA Personal Consumption Expenditures Price Index BEA

Computing a Price Index Select a market basket Compute the price of the basket in each year Select a base year Current year price Base year price = Price index Simulation Candy Price Index Denise Hazlett athttp://people.whitman.edu/~hazlett/econ/

Simulation: Step 1 Individually Select a mix of candy that costs 30 for each of the periods As a group Agree to a market basket that is representative

Simulation: Step 2 Period 1 Item Price Calculate the total price of a market basket in each period, using a basket of: 2 Kisses 3 Reese's 1 Lifesaver Total Price Item 2 Kisses 5 10 3 Reese s 10 30 1 Lifesaver 5 5 Price of basket 45

Simulation Instructions Calculate the Candy Price Index for each period CPI = (Price current / Price base ) * 100 For Period 1: CPI = (45 / 30 ) * 100= 150 Calculate the inflation rate between each period. Inflation rate = (CPI2 CPI1) / CPI1 Inflation between period 1 and 2 = (117 150) / 150 = -22%

Results with 2K, 3R and 1L Period Base 1 2 3 4 5 6 CPI 100 150 117 133 150 167 183 Inflation Rate NA 50% -22% 14% 13% 11% 10%

Results with 2K, 2R and 2L Period Base 1 2 3 4 5 6 CPI 100 133 133 133 167 167 167 Inflation Rate NA 33% 0 0 25% 0 0

Issues with Market Baskets Substitution bias a fixed basket ignores consumers ability to substitute away from items that have become relatively more expensive New product bias a fixed basket does not account for the value to consumers of newly available goods and services Quality bias a fixed basket does not adequately account for change in the quality of goods and services

Constructing a Market Basket Questions What is the scope of the market basket? How often is the market basket updated? Different baskets CPI the purchases of a typical urban consumer GDP Deflator the entire production of the economy PCE personal consumption expenditures

Computing the Indexes CPI a historic basket at current prices How much does it cost to buy the old basket this year? GDP a current basket at historic prices How much would it have cost to buy this year s GDP at some point in the past? PCE combines both measurement techniques and takes an average of the two

Comparing Indexes The fixed basket used by CPI might not account for Improvements in the quality of goods and services The ability of consumers to substitute cheaper goods and services for more expensive ones The changing basket of GDP might not reflect the loss of welfare from substitutions PCE price index is a blend of the fixed basket and the changing basket

PCE Price Index Since 2000, PCE has been the Fed s preferred inflation measure Advantages Bigger basket of goods & services than CPI Expenditure weights updated monthly (CPI updates every 2 years) Disadvantages Slower to release than CPI Subject to data revisions

Using a Price Index Deflate nominal value Index values to reflect changing price level Calculate the rate of inflation

Nominal vs. Real Variables Nominal variables are measured using current prices Real variables have been adjusted for inflation by using prices from a base year Examples Real wages Real GDP Real interest rate

Deflating a Nominal Value Convert a nominal value to a real value to remove the effect of inflated prices allows values to be compared over time. Real = Nominal (Price Index/100) Handout: Inflation at the Movies

Box Office Winners (and Losers) Real Revenue 1983=100 $481.5 $410.3 $265.6 $264.2 $247.2 Revenue (in millions) Year Released CPI Movie Title Rank 1983=100 $260 $400 $162 $242 $357 Jaws E.T. The Extra-Terrestrial Close Encounters of the Third Kind Raiders of the Lost Ark Jurassic Park 1975 1982 1977 1981 1993 54.0 97.5 61.0 91.6 144.4 1 2 3 4 5 $77 $44 $44 $47 $22 The Terminal Always Amistad Munich Empire of the Sun 2004 1990 1998 2005 1987 188.9 130.7 163.2 195.3 113.6 $40.8 $33.7 $27.0 $24.1 $19.4 17 18 19 20 21

Indexing Converts a real value to a nominal value by increasing a nominal quantity by an amount equal to the percentage increase in a price index Allows an employer or government to maintain purchasing power of salaries and benefits Examples Candy consumption Indexed labor contracts (COLAs) Social Security payments

Rate of Inflation Shows the rate of change of prices over time Rate of inflation is the percentage rate of change in a price index Rate of inflation = (PI2 PI1) / PI1

Costs of Unexpected Inflation Redistributions of wealth Creditors / Debtors and Employees (on contract) / Employers Interference with long-term planning Future purchasing power is uncertain Noise in the price system Information conveyed by prices becomes difficult to interpret Shoe leather costs Time and effort spent to minimize the effect of inflation Distortions of the tax system Bracket creep and future value of depreciation allowances

Hyperinflation Excessive monetary growth hyperinflation Examples Nicaragua (1988) 33,000% inflation Germany (1923) 102 million% inflation Hungary (1945) 3.8 * 1027% inflation Harm of inflation is magnified.

Causes of Inflation Long-run Too much money chasing too few goods Inflation is always and everywhere a monetary phenomenon (Milton Friedman) Short-run Expectations Excess demand Supply shocks

Distribution of Income Lorenz curve is a curve showing how the actual distribution of income differs from an equal distribution of income in a nation

Questions?