Unit 2 Macroeconomics Exam Notes 2018 PDF

UNIT II ECONOMIC FLUCTUATIONS, UNEMPLOYMENT AND INFLATION Business Cycles A Typical Business Cycle Diagram Business Cycle The cycle of short term ups and downs in the economy. Recession is a period during which ag...

UNIT II ECONOMIC FLUCTUATIONS, UNEMPLOYMENT AND INFLATION Business Cycles A Typical Business Cycle Diagram Business Cycle The cycle of short term ups and downs in the economy. Recession is a period during which aggregate output declines. Conventionally, a period in which aggregate output declines for two consecutive quarters. Depression is a prolonged and deep recession. Expansion or Boom is a general increase in output and employment. Contraction, Recession or Slump - period in the business cycle from a peak down to a trough during which output and employment fall. Peak: This represents a period when aggregate demand reaches a Peak and , as a result, the economy ‘s output is growing faster than its long–term (Potential) trend and is therefore unsustainable. Trough: The phase when the level of economic activity is at its lowest point in the business cycle. Recovery stage: The phase after the trough, when the economy starts growing, but it is below the recent peak. Causes of Business cycles Political factors: are generally associated with pre-election spending increases and tax cuts by governments and a reversal of these policies after an election. International economic factors: focus on the international transmission of economic activity, including the globalization of product and financial markets in general. Domestic economic factors: The multiplier-accelerator model is central to an explanation of the business cycle based on domestic economic factors, with particular emphasis on stock (inventory) adjustment. Who are the employed? Individuals are defined as being employed if they are 14 years and over and engaged in some economic activity for at least one hour in the week before the start of the survey by STATIN (reference period). The employed are classified in the following categories: 1. Paid employment: comprising persons who, during the reference period performed some form of work for wage or salary in cash or kind. 2. Paid self-employment: Persons with an enterprise, which may be a business enterprise, a farm or a service undertaking who during the reference period performed some work for profit or family gain, in cash or in kind. 3. Unpaid workers: Persons who during the reference period worked without pay in an economic enterprise operated by a related or non-related person regardless of the number of hours worked. Who are the unemployed? Individuals are defined as unemployed if they are 14 years and over and during the reference period satisfy the following three conditions simultaneously: 1. ‘without work’, i.e. were not in paid employment or self-employment. 2. ‘currently available for work’, i.e. were available for paid employment or self-employment during the reference period; and 3. ‘seeking work’, i.e. had taken specific steps in a specified recent period to seek paid employment or self-employment. For the "strict" definition of unemployment, all three conditions of 'without work', 'available for work' and 'seeking work' must be met simultaneously before a person can be considered to be unemployed. For the 'relaxed' definition however, a person is defined as unemployed if he/she is 'without work' is 'currently available for work' but has not taken any step to seek work. In Jamaica, the 'relaxed' definition of unemployment is used given that conventional means of seeking work is of minor relevance to the Jamaican labour market. The Jamaican labour market is less organised and a large percentage of the labour force is self-employed. Unemployment rate and how is it calculated? The unemployment rate is widely regarded as one of the key labour market indicators and a good measure of current economic activity. It is defined as the percentage of the unemployed to the total labour force (sum of the employed and unemployed). How is the labour force defined (in Jamaica, by STATIN? The employed and the unemployed persons aged 14 years and over, together constitute the country’s labour force and includes the following: All persons who were employed in any form of economic activity for one hour or more during the survey week; All persons who had jobs but were absent from work during the reference period; All persons who although they had no job, or worked less than one hour during the survey week, were looking for work; All persons who although not looking for work, wanted work and were in a position to accept work during the survey week. Who are classified as 'outside the labour force' or the economically inactive? The labour force is the sum of the employed and the unemployed. Therefore, all persons 14 years and older who are not classified as employed or unemployed, are considered to be ‘outside the labour force’ or economically inactive. There are a variety of reasons why some individuals do not participate in the labour force: they may be engaged in caring for family members; retired, sick, disabled or attending school. Additionally, some may simply be uninterested in working. What is the Labour Force Participation rate? The labour force participation rate, is a measure of the proportion of the working-age population that is actively engaged in the labour market, either by working or looking for work. It provides an indication of the size of the supply of labour available to engage in the production of goods and services, relative to the working age population. The labour force participation rate is defined as the ratio of the total labour force to the working age population and is expressed as a percentage. Discouraged worker A discouraged worker is an unemployed person who gives up looking for work and is no longer counted as part of the labour force. Types of unemployment Unemployment can be divided into the following four categories: Frictional Unemployment Structural Unemployment Cyclical Unemployment Seasonal Unemployment Frictional unemployment This unemployment is due to normal turnover in the labour market. It includes people who are temporarily between jobs because they are moving or changing occupations, or are unemployed for similar reasons. A major advantage of frictional Unemployment is that people move from lower to higher paying jobs and is very common during periods of economic growth or when individual acquires higher or better skills. Structural unemployment This type of unemployment refers to workers who have lost their jobs because they have been displaced by automation, because their skills are no longer in demand, or because of similar reasons. Frictional and structural unemployment together is called natural unemployment. Cyclical unemployment This type of unemployment is due to a decline in the economy’s total production. Cyclical unemployment rises during recessions and falls as prosperity is restored. Seasonal unemployment This type of unemployment is due to change in seasons, for e.g. Jamaican cane cutters are employed in Florida during cane harvesting season but become unemployed when the season is over. The same applies for individuals who work in certain sectors of the Tourism industry. One of the aims of macroeconomic policy is to keep cyclical unemployment to a minimum. Full employment Full employment refers to the condition that exists in an economy when the unemployment rate is equal to the natural rate of unemployment. Full employment denotes the optimum employment level of an economy. It does not refer to zero unemployment. In a market economy, where shifts in demand, technology, and products are constantly occurring, there will always be some unemployment as workers transition from one job to another. Impact of high unemployment on a developing economy  Loss output.  Crime and violence  Anxiety and depression  Suicide  Decline in health levels  Loss of human capital  Loss of revenue by way of tax to the government  Increase in expenditure by way of transfer payments to the government Methods to alleviate high unemployment  Unemployment insurance  Social welfare programs (unemployment benefits)  Increase government spending  reduction in tax rates  Increasing exports Labour productivity Labour productivity is the amount of output a worker turns out in an hour (or a week or a year) of labour. If output is measured by GDP, it is GDP per hour of work. It is the growth rate of productivity that determines whether living standards will rise rapidly or slowly. Labour Productivity per hour = (GDP/Total Hours worked) Output per Worker = (GDP/Employed Labour) Calculation: Labour Force = #Employed + #unemployed. Unemployment rate = (#Unemployed/ Labour force) x 100 Labour force participation rate = (Labour force /working age population) x 100 Employment to population ratio = (#Employed/population) x 100 Natural rate of unemployment = (# Frictionally unemployed + #Structurally unemployed)/Labour force) x 100 Okun’s law Okun’s law states that a 1% increase in cyclical (demand deficient) unemployment is associated with a 2.5% loss of full employment output. There is an inverse relationship between unemployment rate and GDP. In other words, the loss of national output estimated on the basis of Okun’s law not only reflects the direct impact of increased unemployment, but other labour market developments that arise during periods of demand deficiency (as in an economic recession), including shorter working week, a reduced labour force participation and lower labour productivity. The loss of national output estimated on the basis of Okun’s law is possibly excessive – but there is no escaping the reality that unemployment does produce a significant economic cost. Phillips curve: The Phillips curve shows the statistical relationship between inflation and unemployment over time. That is, there is an inverse relationship between unemployment and inflation rate in the short-run. It suggested that governments could trade-off a particular level of unemployment against a particular rate of inflation. For example, if aggregate demand is stimulated, this would reduce unemployment but at the expense of a higher rate of inflation and vice-versa. In other words, the governments could ‘fine-tune’ aggregate demand and push the economy up and down the Phillips curve (from A to B and then back to A again). Further, it was suggested that unemployment could not be reduced below the rate shown as point A in figure, without triggering inflationary pressures. This rate is associated with equilibrium in the labour market where the demand for labour at a given real wage rate is equal to the supply of labour. Inflation % B A O Unemployment % In the long run, there is no relationship between inflation and unemployment. Increasing inflation to drive down unemployment will not be successful. In the long run actual output = potential output. Potential GDP Potential GDP is the real GDP that the economy could produce if its labour and other resources were fully employed. The actual level of output (and income) can be below the potential level, if for some reason there is a high degree of unemployment of labor and underutilization of the capital stock. On the other hand, in times of very strong demand, productive factors may be employed in quantities exceeding their normal intensities, pushing total output beyond its potential level for a limited time. Over long periods of time, the growth rates of actual and potential GDP are normally quite similar. But the two often diverge sharply over short periods owing to cyclical fluctuations. The concept of potential output is basically a technical relationship between inputs and output that is analyzed and estimated using various forms of a production functions. Y= F(L,K,A), where Y is ouput, L is Labour, K is Capital and A is Technology. The equation is indicating that output is a function of Labour, Capital and Technology. The output gap is defined as the difference between the level of actual output and potential output, usually expressed as a percentage of the level of potential output: Output GAP = (Actual Output – Potential Output) x 100 Potential Output When actual output exceeds potential output, there is a positive output gap and inflation tends to rise. When actual output falls below potential output, there is a negative output gap and downward pressure on inflation. Thus, the output gap provides a measure of the degree of inflationary pressure in the economy. It is an important link between the real side of the economy - the production of goods and services - and inflation. Inflation Inflation is an increase in overall price levels. The inflation rate is the percentage change in the price level. It happens when many prices increase simultaneously. It is measured by calculating the average increase in the prices of a large number of goods during some period of time. A sustained inflation is an increase in the overall price index level that continues over a significant period of time. Inflation rate = (Price index in this period - Price index in previous period) x 100 Price index in previous period Stagflation occurs when output is falling at the same time that prices are rising. Creeping inflation refers to small and gradual rises in prices overtime. Hyperinflation describes a situation of large and accelerating price rises. Unanticipated inflation is an increase in the price level that comes as a surprise, at least to most individuals. This type of inflation has important consequences in terms of redistribution effects on income and on uncertainty. For example, suppose that based on the recent past, most people anticipate an inflation rate of 3% and if the actual inflation rate turns out to be 10% it will catch them off-guard. Anticipated inflation is a change in the price level that is widely expected. In this type of inflation, there will be no significant damaging effects on the economy or distribution of income. Purchasing power The purchasing power of a given sum of money is the volume of goods and services that it will buy. Inflation effects Inflation redistributes income. - Those who lend money are often losers by inflation. - Borrowers often gain by inflation. Impact of inflation on an individual’s purchasing power Whether a person gains or loses during a period of inflation depends on whether his or her income rises faster or slower than the prices of the things he or she buys. In some countries many social security benefits and pensions are indexed to inflation. The real wage rate The real wage rate is the wage rate adjusted for inflation. Specifically, it is the nominal wage divided by the price index. The real wage thus indicates the volume of goods and services that the nominal wages will buy. The purchasing power of wages (the real wage rate) is not systematically eroded by inflation, or vice-versa. In the long run, wages tend to outdo prices as new capital, equipment and innovation increase output per worker. Real and nominal interest rates The real rate of interest is the percentage increase in purchasing power that the borrower pays to the lender for the privilege of borrowing. It indicates the increased ability to purchase goods and services that the lender earns. The nominal rate of interest is the percentage by which the money the borrower pays back exceeds the money that she has borrowed, making no adjustment for any decline in the purchasing power of this money that results from inflation. Deflating Deflating is the process of finding the real value of some monetary magnitude by dividing by some appropriate price index (CPI). Deflating monetary figures Real spending in a given year = nominal spending in a given year x 100 CPI for that year Deflating the real wage Real wage in a given year = Nominal (money) wage in given year x 100 CPI in the given year Demand-pull inflation is the term to summarize the various factors leading to inflation that originates in the demand side of the economy or changes in the aggregate demand. Changes on the demand side may be the result of changes in fiscal or monetary policies. Cost-push inflation is the term used to describe the cost pressure due to supply-side factors that cause changes in aggregate supply. Changes on the supply side may originate from the domestic economy, for example, in terms of higher wages, or from international economy, in terms of higher import prices. Expectation-induced inflation is the inflationary pressure may result from an expectation- induced effect. If prices or costs of production are expected to rise, this may trigger demand and supply side responses in advance and thus, in effect, cause inflation. Policy implications of Inflation 1. Monetary policy is concerned with influencing aggregate demand and therefore, inflationary pressure through the use of short-term interest rates and measures to affect the level of liquidity in the economy. 2. Fiscal policy involves changes in government spending/taxation with a view to altering aggregate demand and therefore inflationary pressure. 3. Prices and income policies are sometimes used to tackle inflation and involve governments directly intervening in the setting of wages and prices in the economy. *****