Module 3 open ended question study guide

Using historical evidence, what seems to be the "recipe for economic growth".

The "recipe for economic growth" includes investing in the country's workers, including spending sufficient money on research and development to develop new technologies, education to develop the workers, and infrastructure to facilitate the production and movement of goods and services within and between countries. Combine this with predictable and fair rule of law and contracts and a minimum of graff and you give people the incentive and means to thrive.

When tracking GDP overtime, why does it make more sense to look at real GDP instead of nominal GDP?

When tracking GDP overtime, it makes more sense to look at real GDP instead of nominal GDP. Generally money inflates over time, so a dollar today is worth less than a dollar in a previous year. So if nominal GDP increases overtime- is this because there is more output being produced, the value of money has inflated, or a combination of both? It is unclear. By looking at real GDP overtime, we're holding the value of money constant overtime, so increases in GDP must be due to actual increases in output overtime.

Describe how economist measure the inflation rate using a basket of goods and services. Include the role of index numbers and base years in your answer

Inflation is a broad measure of the change in the price level over time. To measure the consumer price level, for example, economists consider a typical basket of goods and services that a household might purchase in a month (food, rent, gasoline, entertainment, healthcare, etc.). The base year always is 100. From there, as the price level rises, the price index rises, and calculating the percentage change from one year to the next can give an estimate of the degree of inflation that has occurred for a typical family.

Why could it be difficult to measure CPI overtime?

The assumption behind this "basket of goods" is that it is relatively stable overtime, even over long periods of time. However, we have good reason to believe that the goods in this basket aren't stable over time, for two main reasons: The substitution bias: If the price of a related goods changes, economic theory predicts that it will impact the demand for the other good. This is simply rationale behavior by consumers. Yet the CPI implicitly assumes that the basket of goods doesn't change. The quality/new goods bias- New goods must enter the basket of goods and obsolete goods must necessarily leave. The quality of goods could change so much that they are basically different in kind.

Discuss what is meant by and included in the consumer price index (CPI)

The consumer price index (CPI) is one metric used to measure inflation and is specifically focused on price inflation that would impact a "typical" household (but which household is "typical"?). It is composed of eight items of different weights (influence) on the total index, reflecting roughly how much of a typical household's income is spends in that area. 1. Food and beverages 2. Housing 3. Apparel 4. Transportation 5. Medical care 6. Recreation 7. Education and communication 8. Other goods and services

Identify the major elements of the business cycle, define what this means.

The economy (as measured by real GDP) tends to expand, peak contract, trough, recover, and expand again over a period of time, which is known as the business cycle. During the boom/expansion portion, new heights of real GDP are being reached as economic activity continues a brisk pace, creating more income for the factors of production (labor, capital, land, etc.), which leads households to purchase more goods and services, which leads to more job hiring, etc. At some point the peak is reached, at which point the economy is running above it's fundamental capacity to sustainably produce and some businesses begin to falter, leading to job losses, which leads to reduced income and spending, which results in additional job losses. A recession sets into the economy- and occasionally, if it is particularly long and hard, a depression, until the economy hits rock bottom at a trough. Here, prices are so low and tempting that entrepreneurs scoop up resources to start producing, leading to an economic recovery. The recovery (back to the previous peak) will turn into an expansion, and the business cycle repeats.

Discuss what is meant by the period of modern economic growth, making sure to address the role of the Industrial Revolution.

The steady underlying increase in real GDP over time that we have grown accustomed to is actually a relatively recent phenomenon (since around the early to mid 1800s). For most of human history, it simply has been too gradual to even notice- real GDP between the previous generation and the next generation was nearly imperceptible. Modern economic growth really began around the time of the Industrial Revolution. Not only was the ability to harness relatively cheap and abundant energy from fossil fuels to run machines free the economy from the natural constraints of human and animal power, just as importantly the scientific revolution and modern economic systems allowed these changes to flourish and incentivize further innovation.

Discuss ways that individuals or institutions can protect themselves from the threat of inflation.

There are multiple ways that individuals can mitigate the risk caused by unanticipated inflation. One example is in terms of cost-of-living-adjustments (COLAs), where a salary or guaranteed payout is indexed to the inflation rate. For example, Social Security payments are tied to the CPI, so as inflation increases, so do Social Security payments; in this way the average pensioner does not lose purchasing power. Another example is adjustable-rate mortgages (ARMs), where the interest rate that you pay on a loan (such as a mortgage) adjusts with the rate of inflation (the interest rate increases as inflation increases, leaving the lender safe but harming the borrower).

List and describe the determinants of economic growth, both in terms of GDP and GDP per capita. How are these related to labor productivity?

1. More natural resources 2. Better use or extraction of natural resources through 3. technology 4. More labor 5. Better labor (more education or experience) 6. More capital 7. Better capital (technology improvements) Better incentives for entrepreneurial activities The above will increase real GDP, but to increase real GDP per capita, you must increase real GDP relative to the underlying population. Generally this occurs through better uses of resources, such as: 1. Technology 2. Education/training 3. Advances in capital 4. More capital per worker

Discuss the limitations of using GDP as a measure of the standard of living of individuals between countries.

Amount of leisure time. If one country has a higher per capita GDP but the average worker works more per week, they won't get to enjoy as much leisure time, which isn't captured in the GDP figures. Environmental quality. If one country has a higher per capita but has polluted their environment in order to do so, the average citizen may not enjoy living there as much. Income/wealth inequality. If one country has a higher per capita GDP but there is extreme income or wealth inequality, such that a very few people are extraordinarily wealthy and most are poor, this may show a high per capita GDP but the "average" person may not be very wealthy. Furthermore the "average" person may be resentful of the inequality, causing a loss of utility.

How does a predictable and fair rule of law and enforceable contractual rights contribute to economic growth?

As mundane as it may appear, having predictable and fair rule of law and enforceable contractual rights is a key linchpin in economic growth. The reason is because of predictability and fostering of trustworthiness. In order to be relatively sure that an investment today will be return dividends in the future, you must be reasonably sure that the government or goons will not re-appropriate the gains for itself/themselves at a later point. Contracts allow economic actors to trust each other and engage in mutually beneficial interactions, such as trade or work for pay.

Describe how the US Unemployment rate varies over time (i.e., what seems to be the minimum and maximum value), and how it varies sex, age, as well as race and ethnicity. What are the primary ways that people can find themselves unemployed?

Based on historical data over the last 50 years, the unemployment rate seems to range from a low of 4% to 10% for the overall labor force. However, there are differences among groups, and some groups experience substantially higher unemployment rates. Female vs. Male - These tend to mirror movements that correspond with the business cycle, but occasionally one is higher than the other. For example, women tended to have higher rates up until the 1980s, and then men tended to through 2016 (women have experienced higher unemployment during the last pandemic-induced downturn, however). Age - There are clear differences in unemployment by age, with the younger groups experiencing higher rates of unemployment in every year relative to the older groups. Older workers have more experience, and a longer time in which to get more training and education, which tends to make them more attractive to employers. Race & Ethnicity - Blacks tend to have higher rates of unemployment than Hispanics, which tend to have higher rates than Whites. Evidence suggest that the gap between groups becomes even more prominent during economic recessions, suggesting people of color tend to get laid off at higher rates (and slower to be rehired) relative to Whites. This could be influenced by racism of among employers as well as more systemic conditions that impact groups differently, such as access to education or geography.

Discuss what is meant by capital deepening in the context of physical capital and human capital.

Capital deepening refers to more capital per person in the economy. More physical capital per person indicates that the individual worker can be more productive per hour as they have more and better tools to choose from to get work done. More human capital per person (education/training/experience) means that workers can get jobs done more efficiently and do jobs that weren't even possible before.

What is meant by core inflation? What are other measures of inflation?

Core inflation refers to the CPI minus energy and food. Energy (think gasoline) and food prices tend to fluctuate more widely than other components of household spending, such as housing cost or apparel. Therefore a swing higher or lower in one of these areas can push the CPI up or down, even if most other prices are relatively constant. 1. Other measures of inflation include: Producer Price index: As these prices tend to go up, costs of production go up, and this usually shows up in CPI later. In this way, PPI is considered a "leading indicator" of CPI. 2. International price index: Looks at prices of merchandise that is exported or imported. 3. Employment cost index: Measures wage inflation in the labor market. 4. GDP Price deflator- The widest measure of inflation, it looks at inflation across all goods and services in the economy. This index is most notably used for converting nominal GDP into real GDP to track output growth in a country overtime.

Contrast nominal GDP v.s Real GDP

Nominal Gross Domestic Product (GDP) is the total value of all final goods and services produced within a country over a period of time in today's dollars. Real GDP is the same as nominal GDP, only it measures the value of the output in base year dollars instead of today's dollars.

What is meant by economic convergence between rich and poor countries.

Economics Convergence is the idea that low income (poor) countries will eventually catch up to high income (rich) countries over time; that is, that poor countries will experience faster economic growth than rich countries, and will converge over time until eventually all countries are at the same level sometime in the future.

Why might wages by "sticky" downwards (explain what this means), and thus unemployment may not fall as fast as we might expect if there is a surplus of labor in the labor market?

Economists theorize why wages may be sticky downwards (generally wages are not sticky upwards, because if the unemployment rate is very low, employers will generally raise wages to attract enough workers to meet their needs). Some of examples of sticky wages include: 1. Efficiency Wage Theory- This theory suggests that it is a profit-maximizing strategy for employers to pay workers somewhat higher than prevailing equilibrium wages. 2. Adverse selection of wage cuts argument points- This argument suggests that if employers were to cut wages, even in times of high unemployment, then the employees most likely to quit are the ones with the most experience, education, skills, and motivation- the ones that are most easily able to find a new job that pays better. 3. Insider/outsider model- This model suggests that firms will not want to cut wages for the "insiders" (those already working for the firm and know it's processes) because this will demoralize them and cut down on productivity. However if they hire "outsiders" (those new to the organization) at a lower wage rate and maintain a two-tier employment system, that will demoralize the new insiders. Therefore they won't cut wages for either existing insiders or outsiders (potential new insiders). 4. Relative wage coordination argument- This argument suggests that employees may be willing to sacrifice wages during lean years if they were to make up for it with wage gains in prosperous years.

How does examining GDP per capita across countries give us a better sense of a country's relative standard of living?

GDP per capita (GDP divided by the country's population) can give us a reasonably accurate assessment of a country's standard of living. For example, if Country A has a per capita GDP of $4,000, and Country B has a per capita of $40,000, we can confidently say that the citizens of Country B tend to be wealthier and have a higher standard of living than Country A, ceteris paribus. Simply concluding that one county has a larger GDP than another means that the country with the larger GDP country is richer doesn't work, because if there are many more people in the higher GDP country, it can be unclear if the "average" person is better off or not.

Describe what GDP is measuring: Identify the four (or five) demand components of GDP, and for the US roughly what percentage does each category make up for the modern US economy:

Gross Domestic Product (GDP) is the total value of all new, final goods and services produced with the borders of a country within a period of time (e.g., a year). GDP looks at price and how many are produced to get a dollar value. The five spending categories that go into GDP and their percentages are: Consumers (households): 69% Investment (businesses): 16% Government purchases (the government): 18% Net Exports (imports and exports to/from other countries): -2%

Describe why high and persistent inflation is seen as undesirable.

Like deflation, hyperinflation is extremely toxic for the economy, as people are incentivized to get rid of money as fast as possible because prices for basic goods could be changing by the hour. This robs money of a useful function in terms of saving (store of value) and, just as importantly, people's trust in the economy and entering into contracts. And once the psychology of inflation becomes entrenched in the economy's people, it could be hard to dislodge. Hyperinflation robs savers of their life savings (though could be good for those in debt), and can play havoc on those on fixed incomes like pensioners, whose payments may not keep up with the inflation rate, leaving them in poverty.

What are the five main categories of the unemployed?

New entrants - First time in the labor market Re-entrants - Those that were in the labor market, stopped out, and then re-entered. Job leavers- Those that decided to leave a current job to find a new one. Job losers (temporary) - Some lose their jobs due to temporary conditions with an employer but expect to be rehired soon. Job losers (non temporary) - Generally caused by structural changes in the economy that permanently affect some companies and their employees.

Discuss how GDPs between countries that use different currencies can be measured, using both market exchange rates and PPP-equivalent exchange rates.

One might think that measuring GDP between countries using different currencies would be straightforward, but it is not. Recall that GDP is measured in a country's own currency. For example, GDP in the US is measured in dollars and GDP in Mexico is measured in pesos, while GDP in Japan is measured in yen. One way to compare GDP between countries is to use prevailing market exchange rates (e.g., the amount of pesos or yen one must exchange to get a dollar). This can work well, but exchange rates may be misleading in terms of how much goods and services a unit of a country's currency can actually purchase. For example, one may find one US dollar can purchase more goods in Mexico (after exchanging it for the equivalent number of pesos) than one might expect. This is where the idea of purchasing power parity (PPP) comes in. By adjusting the value of the currency to keep a unit of currency equivalent in terms of purchasing a standard basket of goods, one can get another measure of GDP between countries.

Describe the ranges of inflation seen in the US economy over the last 100 years as well as in the last 40 years. Discuss extreme forms of inflation such as deflation or hyperinflation - when can we see this in the data in history and/or in other countries?

Over the last 40 years, the US has enjoyed relatively moderate but positive inflation of between 0-5%. Over the last 100 years, however, inflation has been much more variable. In the 1970s, for example, inflation reached as high as 15%. The early part of the 20th Century was marred by extreme fluctuations in inflation from 18% to close to -10% inflation in the late 1910s and early 1930s (during the beginning of the Great Depression). On the other extreme in hyperinflation - generally consider higher than 20% inflation per year, but there are some examples of it being much higher (Russia, for example, experienced inflation of 2,500% in the early 1990s!).

Contrast Recessions from Depressions

Recessions are traditionally defined as two quarters (6 months) of decline in real GDP (negative growth) and an increase in the unemployment rate. A depression is stronger and more severe than recessions, generally lasting more than a year and characterized by severe reductions in output and substantial unemployment.

Summarize the arguments for why we are likely to see further convergence in the decades ahead, and arguments that convergence is neither inevitable nor likely.

The arguments for why this will happen is that it is easier for poorer countries, which tend to have less human and physical capital per person than rich countries, can see greater productivity gains by simply employing more capital. Consider the graph below- at relatively low levels of capital (such as a poor country might have), adding a higher set amount of capital (for a given state of technology), known as "capital deepening", will lead to faster rates of productivity growth than adding that same amount of capital to an economy that already has a lot of capital (such as a rich country); this is an example of the law of diminishing marginal returns. Furthermore, the argument goes, it is easier for a lower technology country to adopt current technology of higher tech economies than it is for high income countries to innovate and integrate new technologies. The counterargument is that technology could be the wild card that keeps the countries from converging. As technology changes, it allows higher income countries to jump to new productivity curves (say, from Tech 1 to Tech 2, or Tech 2 to Tech 3 in the diagram below). At a sufficiently high rate of technology innovation, brought about by rich countries' edge in research and development funding or a preexisting and sophisticated education system, the argument goes that rich countries can continue to maintain their edge on poor countries, and this could prevent convergence from taking place at any point in the future. Regardless, cynics point out that even if convergence is occurring, it may be too slow for us to notice within a generation of time, if the growth in low income countries is not substantially higher than in high income countries.

Discuss what is meant by cyclical unemployment (relate this to the business cycle) as a way of describing why there is short-run unemployment.

The economy is subject to business cycles, or the ups and downs of real GDP overtime. As real GDP is increasing, households are spending more and businesses hire more workers to produce and sell the goods and services, which increases incomes for households to spend more; this correlates with a lower unemployment rate as individuals looking for a job find job openings easily. However, after the business cycle peaks, the economy begins to contract and real GDP slows and begins to shrink. As businesses contract, workers lose their job, which means households have less income to spend, which leads to less spending on business and further job losses. Job losses as a result of a downturn in economic activity is referred to as cyclical unemployment.

Describe the two types of unemployment found in the long-run that contribute to the natural rate of unemployment (explain what this means), and why therefore we should not expect that unemployment will ever by 0%.

The two types of unemployment found in the long-run are frictional unemployment and structural unemployment. Frictional- The unemployment caused when people are in-between jobs, due to people moving from one job to another (due to the "friction" of a moving economy). These workers are expected to find a new job relatively quickly. Structural- The unemployment caused when workers lose their jobs due to a sustained reorientation (restructuring) of the economy, creating new jobs and destroying some existing ones. These workers may not find a new job that pays comparably without gaining new skills, education, or training. Because frictional and structural unemployment are always present in an economy, regardless of the state of the business cycle, this means that the unemployment almost certainly cannot get to 0%- there will always be some unemployment.

Explain what the unemployment rate is by examining the equation used to determine the number. Give some examples of people who are not counted in the unemployment rate.

The unemployment is rate is equal to the number of unemployed people divided by the labor force (unemployed/labor force), times 100 (to make it a percentage). The labor force is equal to the unemployed (those not working but actively looking for work) plus the employed (having a paid job) (labor force = unemployed + employed). There are many examples of individuals that do not work but are nevertheless not counted as unemployed; these individuals are not considered part of the labor force. For example, children, retired people, those in institutions (prisons, the armed forces), those going to school full-time that do not want a job, stay-at-home caretakers, those with disabilities that choose not to work, and discouraged workers (those that would like a job but have stopped looking for one as they have become discouraged). These individuals are not counted in the unemployment statistics, as they are not currently actively seeking work, even if they may want a job.