PRINCIPLES OF MACROECONOMICS
Ranjit Dighe
WEEK 6 (LECTURES 15 & 16)
March 1 & 3, 2000

[The subject matter for this week was a continuation of the Big Three of Macro -- we finished up real GDP and moved on to unemployment.  (We will tackle the third item in the Big Three, inflation, next week.  There was only one in-class lecture, on Fri., March 3, since I was sick on Monday and Wednesday.  Makeup lecture notes for one of those two missed lectures appear below; makeup notes for the other missed lecture will be posted in the weeks to come.  The corresponding chapters of Case & Fair's textbook are Chapters 7 & 8.]

LECTURE 15 (makeup for one missed lecture)
Originally posted on the web on Wed., March 1, 2000

* Today:
I. Calculating real GDP and the GDP price index: An example
II. Contractions, recessions and depressions

I. CALCULATING REAL GDP AND THE GDP PRICE INDEX: AN EXAMPLE

In class last Friday (Feb. 25) we calculated nominal GDP for a small island economy (call it Lakeland) that produced just three goods -- beer, pretzels, and bicycles. Given hypothetical prices and quantities of those goods, we computed nominal GDP as follows by multiplying each good's price (p) times the quantity produced of it (q), then adding all those products (p*q) together. Repeating that example, let's now assume that those prices and quantities were from 1998, and that we also have prices and quantities for the same economy in 1999. The first three numerical columns of the table below are the same as from last Friday's class and go with 1998. The next three are new, and go with 1999:
 
1998 1998 1998 1999 1999 1999
Commodity p q p * q p q p * q
Cases of beer  $20  100  $2000 $22 95 $2090
Bags of pretzels $1 100 + $100 $1.20 90 + $108
Bicycles $200  10 + $2000 $210 10 +$2100
====== =====
NOMINAL GDP  $4100 
in 1998
$4298
in 1999

Lakeland's nominal GDP was $198 (=$4298-$4100) higher in 1999 than in 1998, an increase of 4.8% [= 100% * (($4298-$4100)/$4100))], but we can see that the quantities produced two of the commodities (beer, pretzels) are actually smaller than before and the quantity of the other commodity (bicycles) is the same as before. Thus the increase in nominal GDP gives the misleading impression that Lakeland's economy has gotten bigger, when in fact it has gotten smaller. To make a valid comparison between 1998 and 1999, we should calculate real GDP, which we do for each year by multiplying that year's quantities by the base-year's prices. Let us use 1998 as our base year.
-- Since we are using 1998 as our base year, then, for 1998, real GDP will be the same as nominal GDP, $4100, since we are multiplying those 1998 quantities by the same prices as before.
-- Let us now calculate real GDP for 1999, with 1998 prices (since 1998 is the base year):
 
1998 price 1999 quantity
Commodity (p1998) (q1999) p1998 * q1999
Cases of beer $20 95 $1900
Bags of pretzels $1  90 + $90
Bicycles $200 10 + $2000
=========
1999 REAL GDP (IN 1998 DOLLARS) $3990

Real GDP fell by $110 (=$4100-$3990, a drop of 2.7%) from 1998 to 1999; the drop accurately reflects the fact that production did not rise for any of the three goods and actually fell for two of them.

We can also calculate the GDP price index (or "GDP price deflator") for any given year t, which tells us how much it costs to buy all of the base year's GDP at year t prices, relative to how much it cost in the base year. We multiply that ratio by 100 so as to "normalize" it to 100, so that we can make easy comparisons between different years:

GDP price index for year t
= 100* (cost of buying base-year's GDP at year t prices)/(cost of buying base-year's GDP at base-year's prices)

In 1998, when GDP was $4100, it would have cost $4100 to purchase 100 cases of beer, 100 bags of pretzels, and 10 bicycles. Since 1998 is the base year, the GDP price index for 1998 must be 100. Let us check on that:

GDP price index for 1998
= 100* (cost of buying base-year's GDP at 1998 prices)/(cost of buying base-year's GDP at base-year's prices)
= 100 * $4100/$4100
= 100 * 1
= 100

Now let us compute the GDP price index for 1999. To do so, we must multiply the base-year quantities by 1999 prices (just the opposite of what we did in calculating real GDP for 1999), and then add up all of those products:
 
1999 price 1998 quantity
Commodity (p1999) (q1998) p1999 * q1998
Cases of beer $22 100 $2200
Bags of pretzels $1.20  100 + $120
Bicycles $210 10 + $2100
=========
COST OF BUYING 1998'S GDP IN 1999 PRICES $4420

Now, to get the GDP price index for 1999, take that number and divide it by the base-year's GDP (which is also what it cost to purchase every item in the base-year's GDP, at the base-year prices), and multiply by 100:

GDP price index for 1999
= 100* (cost of buying base-year's GDP at 1999 prices)/(cost of buying base-year's GDP at base-year's prices)
= 100 * $4420/$4100
= 100 * 1.078
= 107.8

So buying that entire "bundle of goods" in 1999 would cost 107.8% as much as it cost in 1998. Alternatively, that bundle of goods cost 7.8% more in 1999 than it did in 1998.

We could conclude that Lakeland was in a recession in 1999, since real output fell 2.7%, and also experienced fairly high inflation in 1999, since the GDP price index rose 7.8%.
 

II. CONTRACTIONS, RECESSIONS, AND DEPRESSIONS

Now that we know what real GDP is (i.e., inflation-adjusted GDP, or GDP in constant-valued dollars, or GDP at constant prices), Week 1's definition of CONTRACTIONS and RECESSIONS should make a bit more sense.

Defn. CONTRACTION: a period over which real GDP steadily falls.
-- Defining a contraction as a period over which nominal GDP falls would not make as much sense, since it is possible for nominal GDP to fall while real GDP is rising, if prices fall faster than quantities rise. (This actually appears to have happened a few times in the 19th century, though not in the 20th century.)

The more common, but less precise, term for an economic slump is a RECESSION.  There are at least two competing definitions of what a recession is:

Defn. RECESSION:
(1) conventionally, a period in which real GDP declines for at least two consecutive quarters. By this definition, a recession would be marked by rising unemployment, since the unemployment rate rises when real GDP falls.
(2) alternatively, a period in which real GDP is declining or simply falls way short of its "normal" level. By this definition, a recession would be marked by high unemployment.

A very severe recession (by the second definition) is called a DEPRESSION.
-- When does a recession become severe enough to be a depression? There's an old saying that a recession is when your neighbor loses his job and a depression is when you lose your job. In the U.S., a good rule of thumb might be that it's a depression if the unemployment rate is over 10% for a prolonged period.
---- The last time the U.S. unemployment rate rose above 10% was in the recession of 1981-82, for a period of several months. [See Case & Fair, Table 8.1, p. 157.]
---- The last time the U.S. unemployment rate was above 10% for years at a time was during the Great Depression of the 1930s.

The Great Depression lasted roughly from late 1929 until early 1941. The U.S. unemployment rate was over 10% for most of that time, and peaked at 25% in 1933. Even when the economy grew, in 1933-37 and 1938-40, it grew much too slowly to bring the unemployment rate below 10%. (Thus the second definition of recession seems preferable to the first, since the first would imply that there was no Great Depression in 1933-37 because real GDP was rising then, however slowly.)

***

PRINCIPLES OF MACROECONOMICS
WEEK 6, LECTURE 16
Fri., March 3, 2000

0. IMPEDIMENTA

* PICK UP PROBLEM SET 4 (you should do it by next Friday, not Wednesday)
* Today: Unemployment
* QUIZ

UNEMPLOYMENT

Unemployment refers to the condition of being unable to find a job. "Unemployed" is not quite the same thing as "jobless," because the official definition of unemployment includes only those jobless persons who are looking for work.

A flurry of definitions:

* UNEMPLOYED: a person 16+ years old who is not working, is available for work, and has made specific efforts to find work over the past four weeks.
-- By contrast, someone who isn't working and isn't looking for work is categorized as OUT OF THE LABOR FORCE (exs.: stereotype of welfare recipients, full-time students, full-time homemakers, retirees).

* LABOR FORCE: the number of people employed plus the number of unemployed;

Labor force = Employed + Unemployed

--     (WORK FORCE = total number of employed.
        People who are working part time, even if they'd prefer to be working full time, are still counted as employed.)

* UNEMPLOYMENT RATE (UR): the ratio of the number of people unemployed to the total number of people in the labor force

UR = Unemployed/(Labor force) = Unemployed/(Employed + Unemployed)

* LABOR FORCE PARTICIPATION RATE (LFPR): the ratio of the labor force to the total population 16+ years old.

LFPR = (Labor force)/(Adult population) = (Employed + Unemployed)/(Adult population)

-- [We saw an overhead of Case & Fair's Table 8.2, "Employed Unemployed, and the Labor Force" (p. 159).]
---- Note that the labor force is much, much smaller than the total adult population. The total U.S. population altogether, including children, is about 275 million, so only half of the total U.S. population is in the labor force. Of the adult population, about two-thirds is in the labor force (LFPR = 67%).
---- The LFPR has been rising steadily since 1953; the reason why is that the LFPR of married women has risen substantially, and in fact has done so for all of the past century.)
---- In 1997, about 67 million adult Americans were not in the labor force. The rest were either employed (130 million) or unemployed (6.7 million). The number of unemployed is probably closer to 6 million today.

Unemployment is anything but an equal-opportunity affliction. The rapper Paris once said that when the American economy catches a cold, black America gets double pneumonia. He was referring to the unusually high rates of unemployment among blacks, which skyrocket even further during recessions. Other groups with higher-than-average rates of unemployment are teenagers, blue-collar workers, and people with a high school education or less. These patterns hold both in "good" times (e.g., the current expansion) and "bad" times (recession years like 1982).
-- [We saw an overhead of Case & Fair's Table 8.3, "Unemployment Rates by Demographic Group, 1982 and 1998" (p. 159).]
---- Note that in both years the highest unemployment rates by far were for black teenage males, whose jobless rates of 52.4% (in 1982) and 31.8% (in 1998) were worse than the overall unemployment rate has ever been in this country, even in the Great Depression. In the "good" year of 1998, the following groups still had unemployment rates over 10%: black teenagers, white teenage males, high school dropouts. The groups with the lowest unemployment rates were white-collar workers (3.4% in 1997) and college graduates (2.2%).

Q: If someone is looking for a job but has turned down a job or two, is she still unemployed?
A: Yes -- to be considered unemployed, one need only be jobless and looking for work. It's not a question of how picky you are. (In fact, it sometimes pays to be picky. Instead of accepting your first job offer, you might want to wait and see if any better ones come along.)
-- For the record, government unemployment benefits are not available to people who have turned down jobs in their own field. But they are available to people who've turned down jobs that they are obviously overqualified for.
---- If you're a recently minted CPA who walks by the "help wanted" sign in McDonald's on your way to the unemployment office, nobody there is going to ask you why you won't take a job flipping burgers. (They recognize that taking such a job would probably not be in your self-interest -- it signals desperation and may detract from your job-search time.)
---- On the other hand, a recently minted CPA who has turned down offers from local accounting firms in the hope of catching on with a Big Ten accounting firm would not qualify for unemployment benefits.

There is perhaps a thin line between being unemployed-and-picky and being out of the labor force altogether.
-- Ex.: If I'm out of work and actively looking for an econ professor job that pays at least $100,000 a year, I'm probably not going to find one, but I'd still be counted as unemployed. If I conclude that nobody will hire me for that kind of salary and give up looking for work altogether, then I'm "out of the labor force."
----> The "discouraged worker" effect refers to what happens when people who want to work but can't find work eventually become discouraged and stop looking for work. (The term is really a misnomer, since it doesn't refer to someone who's working. "Discouraged former job-seeker" or "discouraged jobless person" would be more like it.) Once a person stops looking for work, he is officially no longer part of the labor force and is no longer counted as unemployed. Other things equal, if a lot of people become "discouraged workers," the unemployment rate would drop, but human misery would be just as great as before. The discouraged-worker effect is a form of "phantom unemployment."

* Three types of unemployment:

(1) frictional ("search") unemployment: Arises from normal turnover (new entrants to labor force, quits) of the job market.
-- Exs.: recent college graduates, women who re-enter the labor force after having children.
-- This is the most benign, or least harmful, of the three, since it tends to be short-term and sometimes reflects a choosiness that can be a desirable quality in job-seekers.

(2) structural ("long-term mismatch") unemployment: Arises from changes in the structure of the economy that result in a significant loss of jobs in certain industries.  A "mismatch" exists between the skills of laid-off workers and the skills desired by current employers.
-- Exs.: steel/textile/auto workers after plant closings or layoffs, laid-off workers in some defense-related industries.
-- This is probably the harshest form of unemployment, because it can be difficult and costly to acquire those new skills that employers are looking for.

(3) cyclical unemployment: arises when the overall demand for labor is low because of insufficient aggregate demand.
-- Much of the unemployment in recessions and depressions is cyclical.

Parting question: Case & Fair's textbook, after going through the obvious and devastating costs of recessions, says they may have at least one important benefit. Namely,
"recessions may help to reduce inflation."
-> Q: How could a recession help to reduce inflation?