Session 10 Economic Instability Disclaimer The views expressed

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 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/dec 2008. pdf

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

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

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

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 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 2 Kisses 3 Reese’s 1 Lifesaver Item Price Total Price 5¢ 10¢ 30¢ 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 = (CPI 2 – CPI 1) / CPI 1 – Inflation between period 1 and 2 = (117 – 150) / 150 = -22%

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

Results with 2 K, 2 R and 2 L Period Base 1 2 3 4 5 6 CPI Inflation Rate 100 133 133 167 167 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) Revenue (in millions) Movie Title Year Released CPI 1983=100 Real Revenue 1983=100 Rank $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 = (PI 2 – PI 1) / PI 1

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?