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
Real Long-Run
GDP Growth Trend

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
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1930
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1945

Federal Reserve Bank of

1948
An Economic Bar Code?

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 1855
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U.S. Business Cycle

1930
Black = Months in Contraction (Recession)

1933
1936
1939
1942
1945

Federal Reserve Bank of

1948
1951
1954
1957
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
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1996
1999
2002
2005
2008
2011
Labor Force

Employed
Population Labor Force
Civilians over Unemploye
16 and not
d
institutionalize Not in labor
d 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
Fricti
onal

Natural Rate
of
Unemploym
ent

Struc
tural

• 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 1 • Calculate the total price
Item
Item Total of a market basket in
Price Price each period, using a
2 Kisses 5¢ 10¢ basket of:
3 Reese’s 10¢ 30¢ – 2 Kisses
1 Lifesaver 5¢ 5¢
– 3 Reese's
– 1 Lifesaver
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 CPI Inflation Rate
Base 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 Rate
Base 100 NA
1 133 33%
2 133 0
3 133 0
4 167 25%
5 167 0
6 167 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 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 Year CPI
Movie Title Revenue Rank
(in millions) Released 1983=100
1983=100

$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 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?