Session 10 Economic Instability

1. 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.

2. 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.

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

4. Macroeconomic Issues Recessions Unemployment Inflation Distribution

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

6. 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

7. An Economic Bar Code? Federal Reserve Bank of Dallas, FIRM (Financial Institution Relationship Management)

8. U.S. Business Cycle Federal Reserve Bank of Dallas, FIRM (Financial Institution Relationship Management)

9. Labor Force

10. 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

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

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

13. Unemployment

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

15. 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

16. 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

17. Natural Rate of Unemployment • Full employment ≠ zero unemployment • Full employment = no cyclical unemployment

18. 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.

19. 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

20. 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/

21. 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

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

23. 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%

24. Results with 2K, 3R and 1L

25. Results with 2K, 2R and 2L

26. 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

27. 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

28. 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

29. 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

30. 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

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

32. 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

33. 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

34. Box Office Winners (and Losers)

35. 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

36. 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

37. 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

38. 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.

39. 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

40. 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

41. Questions?