Session 10Economic 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 CycleReal GDP

Time

Long-Run Growth Trend

Recession

Expansion

Trough

Peak

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

Federal Reserve Bank of Dallas, FIRM (Financial Institution Relationship Management)

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An Economic Bar Code?

Federal Reserve Bank of Dallas, FIRM (Financial Institution Relationship Management)

U.S. Business Cycle18

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Black = Months in Contraction (Recession)

Labor Force

Population Civilians over

16 and not institutionalize

d

Labor ForceEmployed

UnemployedNot 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

Structural

Cyclical

Total Unemployment

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 UnemploymentFrictional

Structural

Natural Rate of

Unemployment

• 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 at

http://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 1Item Item

PriceTotal Price

2 Kisses 5¢ 10¢3 Reese’s 10¢ 30¢1 Lifesaver 5¢ 5¢

Price of basket 45¢

• Calculate the total price of a market basket in each period, using a basket of:– 2 Kisses– 3 Reese's– 1 Lifesaver

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 CPI Inflation RateBase 100 NA

1 150 50%2 117 -22%3 133 14%4 150 13%5 167 11%6 183 10%

Results with 2K, 2R and 2L

Period CPI Inflation RateBase 100 NA

1 133 33%2 133 03 133 04 167 25%5 167 06 167 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 pricesHow much does it cost to buy the old basket this year?

• GDP – a current basket at historic pricesHow 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)

Revenue(in millions) Movie Title Year

ReleasedCPI

1983=100

RealRevenue1983=10

0Rank

$260 Jaws 1975 54.0 $481.5 1$400 E.T. The Extra-Terrestrial 1982 97.5 $410.3 2$162 Close Encounters of the Third Kind 1977 61.0 $265.6 3$242 Raiders of the Lost Ark 1981 91.6 $264.2 4$357 Jurassic Park 1993 144.4 $247.2 5

$77 The Terminal 2004 188.9 $40.8 17$44 Always 1990 130.7 $33.7 18$44 Amistad 1998 163.2 $27.0 19$47 Munich 2005 195.3 $24.1 20$22 Empire of the Sun 1987 113.6 $19.4 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 wealthCreditors / Debtors and Employees (on contract) / Employers

• Interference with long-term planningFuture purchasing power is uncertain

• “Noise” in the price systemInformation conveyed by prices becomes difficult to interpret

• Shoe leather costsTime 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?