chapter ten

Chapter Ten

Economic Growth and

Business Cycles

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A long-run trend in real GDP growth is easily discernible, although erratic

Trends in Economic Growth


• Economic growth is important because it is the primary cause of increased living standards

• The trend in economic growth has differed across historical periods

Measuring Economic Growth


• If we can understand the variables that cause economic growth, we may be able to enact policies to encourage such

• Studying growth is easier said than done!• The study is difficult for many reasons

– Measurements are inaccurate– Depreciation is difficult to estimate precisely– Difficult to measure the quality of capital goods

accurately

Why Study Economic Growth?


• Labor is measured both in terms of how many people work, and for how long

Labor force = employed people + unemployed people

• The labor force is not the whole population, as only members of the working-age population who are actively seeking employment are counted

• Thus the labor-force participation rate is the most useful measure, as it tells is what percentage of the population is engaged in work

Economic Growth & Labor


The labor-force participation rate has been fairly steady, except from the mid-1960s to the early 1990s

Economic Growth & Labor (cont’d)


The working-age population is further divided into those in and out of the labor force. The labor force is then divided

between the employed and unemployed

Economic Growth & Labor (cont’d)


The unemployment rate is the number of unemployed workers as a fraction of the overall labor force

The Unemployment Rate


The actual amount of work provided by employed workers depends not just on the number of workers, but also on

the number of hours they work

Hours Worked


Labor Productivity

• Labor productivity measures the average amount of output produced per worker

• Productivity gains enable to economy to enjoy more goods and services, even with fewer hours worked


The table suggests that changes in labor productivity growth are the driving force behind overall growth. It does not, however, tell us the

reasons behind the productivity gains

Labor Productivity (cont’d)


Again, an overall trend that is upward, yet slightly erratic, can be seen. Productivity gains result in higher standards of living for members of the economy

Labor Productivity (cont’d)


• Labor is not the only factor of production that can lead to productivity gains

• Capital (i.e., buildings, equipment, etc.) entrepreneurs, etc. can also contribute

• Unfortunately, capital is difficult to quantify

Contributions of Labor AND Capital


• Economists use total factor productivity (TFP) to measure contributions to productivity beyond only those of labor and capital.

• TFP estimates the contributions of the quantity of capital (K) and the quantity of labor (L) and solves for the remainder.

1a aY A K L

Total Factor Productivity


TFP & Output Growth

• Increases in growth rates of just labor or just capital do not have the same effect on the overall growth rate

• TFP calculations account for not just hours worked, but also for the quality of those hours


Changes in TFP growth parallel those changes in labor productivity growth, suggesting the same factors are

responsible for both measures

TFP & Output Growth (cont’d)


• Business cycles are short-term fluctuations in the economy based on the movement of key economic variables

• Business cycles are a repetition of four phases– Expansion: A period of rising income, output, and

employment– Peak: The end of an expansionary period, when the

above variables begin to decline– Recession: A period of declining income, output, and

employment– Trough: The end of a recessionary period, when the

above variable once again begin to increase

Business Cycles


Over the course of the business cycle, economic growth (as measured by output) varies around its long-term trend

Business Cycles (cont’d)


Actual data supports the business cycle. While all three periods experienced both expansions and recessions, the most (and longest)

recessions occurred during the reorganization period



• The National Bureau of Economic Research (NBER) announces business cycle phases after the fact. The NBER defines a recession as lasting more than one quarter



Many economic variables move together over the business cycle, such as output growth and unemployment



• While not definitive, some of the causes of business cycles may be

1. Erratic growth of the nation’s money supply

2. Swings of optimism and pessimism that cause investment in capital goods to fluctuate

3. Sudden changes in productivity growth

4. Changes in the prices of key factors of production

The Causes of Business Cycles


• Led by Milton Friedman, the monetarists believe that the money supply should be directed to grow formulaically

• The most compelling argument for monetarism is the sharp decline in the money supply during the Depression

• Opponents argue that while money indeed affects prices and inflation, it is not so significant as to cause fluctuations in the business cycle

The Monetarists


• Based on the work of John Maynard Keynes, the Keynesians believe that changes in aggregate demand are the main cause of business cycles

• Because wages and prices are “sticky”, the economy is unable to return to macroeconomic equilibrium immediately

• Opponents argue that it is less costly to adjust wages or prices than to lay off workers, so wage and price stickiness could not influence the business cycle

The Keynesians


• Based on the work of Edward Prescott, RBC theory states that changes in the business cycle are brought about by productivity shocks

• Productivity is susceptible to many sudden changes, or shocks, which may explain up to 70% of business cycle fluctuations

• Opponents argue that what RBC theorists dub productivity shocks are not changes in productivity at all, but rather simple responses to changes in product demand

The Real Business Cycle Theorists


• Business cycles may be caused by abrupt changes in the price of productive resources, especially oil

• Economists are unsure whether the relationship between oil prices and business cycle phases is one of causation, or only correlation

Changing Resource Prices


When the economy’s output is higher, someone must be earning more income…Why not you???

The table shows that workers’ compensation tends to grow alongside productivity gains

Economic Growth & Income Potential

chapter ten

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