CYCLICAL INSTABILITY:

ECONOMIC GROWTH & BUSINESS CYCLES

LONG-RUN ECONOMIC GROWTH

MACRO & INTERNATIONAL ECONOMICS

ECON 6644
Managing in a Global Economy
Dr. Claude J. Chereau
September 25, 2019
Economics &
Data Analytics

Faculty-Student
Coffee Klatch

Open house

This THSURDAY 330-

540pm

Where:
Bartels Alumni Hall –
Annex
(up the stairs & to the
right, in back)
AGGREGATE
DEMAND/SUPPLY
UNEMPLOYMENT/INFLATION
Contd…
INFLATION

MACRO STABILITY: PRICE STABILITY

Absence of significant changes in the average price level

Inflation: Officially defined as a rate of inflation less than 3 percent

Established by Full Employment and Balanced Growth Act of 1978
(Humphrey-Hawkins)
What Is Inflation?
• Increase in the average level of prices,
not a change in any specific price of a
good
• Not a market function

• Prices of a specific market basket of goods are collected and computed into an
average price level for that basket in a year
• A rise in that average price level is inflation
• A decrease in that average price level is deflation

• Core problems of inflation

• What kind of price increases are referred to as “inflation”?
• Who is hurt and who is helped by inflation?
• What is an appropriate goal for “price stability”?
 Measuring Inflation
• Inflation rate • Other measures of inflation
• Annual percentage rate of increase in
the average price level
• Producer price index (PPI):
• Changes in the average prices at
• Measuring inflation serves two purposes: intermediate steps of production
• gauging the average rate of inflation
• identifying its principal victims
• GDP deflator:
• Changes in prices of all goods and
• Consumer price index (CPI): services included in GDP
• Measure (index) of the average price of • Used to adjust nominal GDP to real
consumer goods and services GDP.
• Used to calculate the inflation rate
• Core inflation: changes in CPI,
excluding food and energy prices,
which are volatile
Creating a Price Index
• Select a “market basket” of goods
• standardized list of goods and services a typical consumer buys

• Select a base year

• reference year whose dollar value will be used

• Set the price index in the base year equal to 100

• Measure the prices for the basket of goods in both the current year
and in the base year.

Price index in current year Basket price in current year

Price index base year = Basket price in base year

CPI year 2 – CPI year 1

Inflation rate = X 100
CPI year 1
 Measurement concerns
• From year to year, quality improvements
in the basket of goods

• The market mechanism causes prices of

individual goods/services to rise/fall

• Relative price: price of one good compared to the price of other goods
• Buyers switch from one good to another when relative prices diverge

• New products change the content of the basket of goods

Causes & Effects of Inflation
Causes Effects

• Demand-pull inflation: • Some prices rise & some fall

• Results from excessive pressure to
buy on the demand side of the
• If prices rise, need to reallocate
economy
purchasing power to ensure most
• A booming economy creates
satisfaction per spent dollar
shortages
• Too much money pumped into the
economy by the Federal Reserve • Difference between nominal
income and real income
• Cost-push inflation:
• Results from higher production
costs putting pressure on suppliers
to push up prices
 Exercise in Money Illusion

• The inflation rate in 1980 was 13.5%

• In 1979, income was $10,000

• In 1980, income was $11,000

• Did purchasing power increase? Decrease? Stay the same?

• Decrease! income went up 10% while prices went up 13.5%

 Redistributive Effects of Inflation
Price effects Income effects
People who buy products that are increasing in price People with nominal incomes rising
• the fastest end up worse off • more slowly than inflation end up worse off
• the slowest end up better off
• faster than inflation end up better off.
People who sell products that are increasing in price
• the fastest end up better off
• the slowest end up worse off

Wealth effects Money illusion

Those who own assets that are Using nominal dollars rather than real dollars
• declining in real value end up worse off to gauge changes in one’s income or wealth
• increasing in real value end up better off
Inflation & Interest Rate

• Real interest rate: the nominal interest rate minus the anticipated inflation rate
• The borrower pays the nominal rate

Real interest rate = Nominal interest rate – Anticipated rate of inflation

• The inflation-adjusted (real) rate of interest:

• protects the lenders. Hurts the borrowers
• borrowers will pay back loan using more lower-valued dollars, but lenders
receive the same purchasing power
 Macro Consequences of Inflation
• Uncertainty
• Not knowing the prices of goods in the future makes purchasing &
production decision making more difficult

• Speculation
• Decisions to shift from standard economic activity to betting on the future
prices of goods

• Bracket creep
• In a progressive tax system, when nominal incomes rise, the taxpayer gets
pushed into a higher tax bracket

• Yet, a little inflation might be a good thing

• Challenge is to find the optimal rate of inflation
• High enough to encourage more spending
• Low enough not to raise the specter of an inflationary flashpoint
Some Protective Mechanisms

• Cost of living adjustment (COLA)

• Automatic adjustments of nominal income to the rate of inflation
– COLA protects real income from inflation
– help those on fixed incomes, such as Social Security recipients

• Adjustable-rate mortgage (ARM)

• A mortgage (home loan) that adjusts the nominal interest rate to changing rates of
inflation
• ARMs protect lenders (not mortgagees) so they do not lose money
The virtues of inflation

• A little inflation might be a good thing

• The challenge for tomorrow is to find the optimal rate of inflation

• High enough to encourage more spending
• Low enough not to raise the specter of an inflationary flashpoint
 Runaway Inflation
• Inflation rate in excess of 200 percent, • Hyperinflation exercise
lasting at least 1 year
• Spending accelerates & production • The current price of a good is $1.
declines
• If its price doubles every day,
what will its price be in 10 days?
• In 1923, prices in Germany more than 20 days?
doubled every day
• No one saved, invested, or made long-run
plans • In 10 days, $512.
• Production came to a haf
• Unemployment increased by a factor of 10 • In 20 days, $524,288.
• The economy collapsed
• Ultimately Hitler came to power

• Zimbabwe and Venezuela experienced a

similar economic disaster in 2007-2008
and 2015-2017 respectively
 Deflation
• General decrease in average prices

• Redistribution effects opposite of those for inflation

• This has macro consequences also

• Sellers are reluctant to stock inventory
• Buyers are reluctant to buy now
• Businesses are reluctant to borrow funds or invest
• Incomes fall, and asset values decrease
INFLATION-UNEMPLOYMENT
TRADE-OFF
The Phillips curve
Inflation-Unemployment Trade-Off
• Upward-sloping AS curve suggests demand-side policies will always cause
some unwanted inflation or unemployment
• This is the inflation-unemployment trade-off, which is expressed in the Phillips curve

• As the economy moves from point A to B to C (left picture), the inflation-

unemployment trade-off shifts from point a to b to c (right picture) on the
Phillips curve.
 Shifts of the AS Curve
• When AS shifts right, the Phillips curve
shifts left
• Reduces unemployment and inflation
at the same time
• Also increases output
• Shifting AD cannot do this

• When AS shifts left, the Phillips curve

shifts right
• Both unemployment and inflation increase
• Output decreases
• Inflation-unemployment trade-off much
more severe

.
The US Phillips curve has been flattening
since the 90s

• Why?
Fears of out-of-control inflation have proven
unfounded
• Central banks commitment: to keep
inflation low
• 80s: + 13%
• With 2008 crisis, 0% interest rate +
quantitative easing
• Inflation was expected to rise up
• Did not happen
• Did supply shocks (temporary or
permanent) keep inflation low?
• Globalization
• Weaker workers and unions
• More competition
• Technological innovations
• Still low oil and commodity prices
• Temporary factors
• So,
• What should be the central banks’
response to this inflation shortfall?
Keep on normalizing policy as labor
market is tighter or try to fight the
low inflation?
• Answer depends on whether the
shocks are temporary or permanent
• But even if the shocks are
permanent, some believe that policy
normalization should continue as
there is the risk of financial
instability (asset and credit bubbles)
 CYCLICAL INSTABILITY
ECONOMIC GROWTH & BUSINESS CYCLES
LONG-RUN ECONOMIC GROWTH
Macroeconomics objective:
Foster economic growth
Full employment
Price stability
Business cycles
• Alternating periods of economic growth and contraction
• Long-term growth rate of the U.S. economy is approximately 3 percent a year
• Some years GDP grows much faster; in other years growth is slower

• Macroeconomics tries to explain

• Alternating periods of growth and contraction that characterize the business cycle
• How & why economies grow
• What causes the recurrent ups and downs known as the business cycle

• Three central questions

• How stable is a market-driven economy?
• What forces cause instability?
• What, if anything, can the government do to promote steady economic growth?

International trade & financial flows tie nations together

 Business Cycle
• Variations around a growth trend that slopes upward

• 4 parts
• The peak, where GDP maximizes
• Contraction, where GDP declines
• The trough, where GDP minimizes
• Recovery, where GDP increases
Terms Associated with the Business Cycle

• Economic growth
• Real GDP grows faster than 3%

• Growth recession
• Real GDP grows, but slower than 3%
• The economy expands too slowly

• Recession
• Real GDP contracts (for two or more consecutive quarters)

• Depression
• An extremely deep recession
The Business Cycle in U.S. History

Growth rate averages 3%, but the economy fluctuates around that average,
occasionally achieving negative GDP growth or decline.
US business slumps: 1929-2009
Dates Duration (months) % decline real GDP Peak unemployment
%
Aug 1929 - Mar 1933 43 35.4% 24.9
May 1937 - June 1938 13 9.4 20.0
Feb 1945 – Oct 1945 8 23.8 4.3
Nov 1948 – Oct 1949 11 9.9 7.0
Jul 1953 – May 1954 10 10.0 6.1
Aug 1957 – Apr 1958 8 14.3 7.5
Apr 1960 – Feb 1961 10 7.2 7.1
Dec 1969 – Nov 1970 11 8.1 6.1
Nov 1973 – Mar 1975 16 14.7 9.0
Jan 1980 – Jul 1980 6 8.7 7.6

Jul 1981 – Nov 1982 16 12.3 10.8

Jul 1990 – Feb 1991 8 2.2 6.5
Mar 2001 – Nov 2001 8 0.6 5.6
Dec 2007 – June 2009 18 4.1 10.0
The global economy after the global
financial crisis (GFC)
• The economic recovery after the GFC was two-speed:

• Developed markets: anemic, sub-par, below trend

• U-shaped

• Emerging markets: strong with return to potential or above trend

• V-shaped
Why U shape recovery in Developed
Markets
• The 2008-09 crisis was a recession caused by a financial crisis
• Financial crisis caused initially by too much debt & leverage in the private
sector (households, banks and some corporates)
• Then during crisis, surge in public debt and deficits

• History & theory suggest that recovery from balance sheet crises is
anemic for up to a decade
• Need to spend less and save more to reduce debt and leverage over time
• Thus, anemic recovery

• Actually, a double dip recession in some developed markets

• Euro-zone, UK, Japan
Why V-shape recovery in emerging
markets

• Less balance sheet problems of too much private and public debt
• Cleanup after EM crises of the 1990s

• Higher potential growth

• 5% in emerging markets vs 1-2% in developed markets

• More room for policy response

How was a Great Depression 2.0 avoided?

• Learning the lessons of the Great Depression and avoiding policy mistakes

=>
• Large conventional/unconventional monetary easing
• Massive fiscal stimulus for a while
• Backstop and bailout of the private sector
• financial system, households, corporations
A Model of the Macro Economy
 A Model of the Macro Economy
• Macro outcomes • Determinants of macro performance
• Output • Internal market forces
• population growth, spending behavior,
• total value of goods and services
invention & innovation
produced (real GDP)
• Jobs • External shocks
• levels of employment & • wars, natural disasters, terrorist attacks,
unemployment trade disruptions
• Prices
• Average price of goods and • Policy levers
services (inflation) • tax policy, government spending,
• Growth changes in the availability of money,
regulation
• year-to-year expansion in
production capacity
• International balances
• value of the dollar; trade balances
 The Crucial Controversy
• Are pure, market-driven economies inherently stable or unstable?

• 2 perspectives:
• Classical economists
• The economy to self-adjust
• No need for government intervention
• Policy levers are ineffective and not necessary

• Keynesian economists
• Market economy is inherently unstable, necessitating government intervention
• Policy levers are effective and therefore necessary
A Self-Adjust Mechanism of the Economy
• Classical economics
• The economy “self-adjusts” to any deviations from its long-term growth

• Wages and prices are flexible

=> Producers can:
• Lower prices to sell off excess goods
• Decrease output and lay off workers
• Laid-off workers compete for jobs by asking for lower wages
• At lower wages, firms will hire more workers

• Say’s Law: supply creates its own demand

• Whatever is produced will be sold
• All workers who seek employment will be hired
• This occurs because people have time to adjust prices & wages downward

• The economy, therefore, is self-regulating

• Laissez faire:
• Doctrine of “leave it alone,” of nonintervention by government in the market
mechanism.
 The failure of the self-adjustment
mechanism
• The self-adjustment mechanism did
not work during the Great Depression.
• The British economist John Maynard
Keynes developed an alternative to
the classical view
• Economy was inherently unstable
• Argued that self-adjustment could not
occur because of “an insufficiency of
effective demand”
• Concluded that the government must
intervene by increasing aggregate
demand
• For an underperforming economy,
Keynes proposed the government
intervene to:
• buy more output
• employ more people
• provide more income transfers
• make more money available
• For an overheated economy, Keynes
proposed the opposite action of:
• raising taxes
• cutting government spending
• reducing the availability of money
DEFINING ECONOMIC
GROWTH
Growth & Productivity
Long-Run Possibilities
 Two types of growth
Economic
Growth
Economic growth is
the fundamental
determinant of the
long-run success of
any nation, the basis
source of rising living
standards, and the
key to meeting the
needs of the
American people.
Economic
Report of the
President, 1992
Measures of Growth
• Growth rate
• Percentage change in real GDP from
one year to the next
• Economic growth is an exponential
process.
• Small changes compound from year to
year
• A shortcut method of indicating growth rate
is to use the Rule of 72:
• To find how many years it takes to
double GDP, divide 72 by the growth rate
• At 3.5% growth rate, GDP will double in
about 20 years
• GDP per capita
• GDP per worker
• Real GDP divided by the labor force
=> a measure of productivity
• If the labor force grows faster than
the population, GDP per capita grows
and living standards rise
• Productivity is better measured by
output per labor-hour
• Increases in GDP per capita over
recent decades are due to the rising
productivity of the average American
worker.
Causes & Sources of economic growth
• Little understanding about causes of growth
• Role of social and political influences
https://www.economist.com/finance-and-
economics/2018/04/12/economists-understand-little-about-the-causes-of-
growth

• Productivity gains are the principal sources of economic growth

• Other sources include

• Better labor quality
• Increased capital investment
• Development of new products and production techniques
• Improved management
• Supportive government policies
Productivity growth
• When long-run growth of the labor force has stabilized
• Continued growth in real GDP must rely on productivity growth

Growth rate of Growth rate of Growth rate of

total output = labor force + productivity

• Technology
 Sources of Productivity gains
• Increase in labor skills

• More capital
• An increase in the ratio of capital to labor
• Primary determinant of labor productivity

• Technological advancements
• Scientific research
• Product development
• Innovations in production techniques

• Improved management:
• Better use of available resources in the production process
• Fostering new entrepreneurship
Effects of Economic Growth
• Growth is usually biased: it occurs in one sector more than others,
causing relative supply to change
• Rapid growth has occurred in U.S. computer industries but relatively little
growth has occurred in U.S. textile industries

• In the Ricardian model, technological progress in one sector causes

biased growth

• In the Heckscher-Ohlin model, an increase in one factor of production

causes biased growth

• Standard trade model

Causes of lower potential growth
• Demographics • Great deleveraging high private and
• ageing in DM and EM public debt and deficits
• first US/UK
• High debt ratios that slow spending • then Europe/Eurozone
• now emerging markets
• Fall in corporate capital spending (global
investment slump)
• Wrong policy mix: too much
monetary policy, too little fiscal
• Hysteresis: the cycle affects the trend
policy

• Rise in income/wealth inequality

• Asymmetric adjustment between
creditors/savers, debtors/borrowers
• Slow structural reforms
in a way that creates a global
savings glut & a global investment
• Persistent global savings glut
slump
Reduced production: Effect on
Household Income
• Reduced production means layoffs
=> decreased household income

 Reduced income means less spending, and AD shifts further to the left away from
full employment

• A relatively small problem could snowball into a much larger

problem.
What causes slumps?
• Basically, anything

• Mid-sized bubbles, from private equity debt to emerging markets

• The 79-82 double dip: Fed tightening to bring inflation down
• 2001 was about the tech bubble
• 2007-2009 about the housing bust and the financial crisis it triggered
• One piece was a boom and bust in commercial real estate, partly connected with
the savings-and-loan crisis and aftermath, which led to a sharp drop in
nonresidential construction
• Drop in consumer confidence, brought on by oil price hikes and Gulf War jitters
• Post-Cold War drawdown in defense spending
FROM AN ECONOMY IN
EQUILIBRIUM TO A MACRO
FAILURE
Results of Shifts in AD and AS

• A shift in either AD or AS can cause the economy to:

• go into recession (AD shift to the left)
• recover from a recession (AD shift to the right)
• stagnate (AS shift to left) or overheat (excessive AD push to the right)

• Business cycles likely result from recurrent shifts of AS and AD

=> recessionary GDP gap

=> inflationary GDP gap
 Equilibrium can be eliminated if either AD
or AS shifts
AD Shifts AS Shifts

• AD will shift left if: • AS will shift left if:

• spending decreases. • business costs rise.
• expectations get worse. • business taxes rise.
• natural disaster occurs.
• taxes increase.

• AS will shift right if:

• AD will shift right if:
• business costs fall.
• spending increases.
• business taxes fall.
• expectations improve. • bounteous harvests occur.
• taxes decrease.
• On the graph, AS shifts left away from full-
• On the graph, AD shifts left away from full- employment GDP.
employment GDP
 10-054

Leakages and Injections

 The Multiplier Process
• Multiplier: the multiple by which an initial change in spending
will alter the total expenditure after all spending cycles

1
Multiplier =
1 - MPC

• If MPC = 0.75, multiplier is 1/(1-0.75) = 1/0.25 = 4

• The impact of an initial spending change will be multiplied by a
factor of 4

• The multiplier is governed by the size of the MPC

• If the MPC decreases, the multiplier gets smaller
• If the MPC increases, the multiplier gets larger
Application

Total change = Multiplier x Initial change in

in spending aggregate spending

• Let the initial change in aggregate spending be -$100 billion

• Calculate the total change in spending when:

Multiplier = 10
Total change = -$1,000 billion
Multiplier = 5
Total change = -$500 billion
Multiplier = 2.5
Total change = -$250 billion
 10-57

The Multiplier Process

The Multiplier Process
• Steps in the multiplier process:
• 1. let investment decline.
• 2. this leaves unsold output.
• 3. production is cut back.
• 4. income decreases.
• 5. consumer spending
decreases.
• 6. go to step 2 above.
• The eventual decrease in spending
will be much larger than the initial
decline in spending
• The eventual shift of AD to the left
will be much larger than the initial
shift to the left.
• It operates in the reverse:
– 1. let investment increase and
shift AD right.
– 2. inventory depletes (a warning
sign of inflation) and prices rise.
– 3. production is increased.
– 4. income increases.
– 5. consumer spending increases.
– 6. go to step 2 above.
• The eventual increase in spending
will be much larger than the initial
increase in spending.
• The eventual shift of AD to the right
will be much larger than the initial
shift to the right.
POLICY TOOLS TO
ACCELERATE ECONOMY
Maintain consumer confidence
• Any change in spending can set off the multiplier process,
including a change in consumer spending

• If consumer confidence changes, there can be a change in

autonomous consumption
• Saving instead of spending
• Paying back debt rather than borrowing

• A decline in autonomous consumption could start AD shifting left

• An increase in confidence could start a shift of AD to the right.

• A decrease in confidence could start a shift of AD to the left.
Demand-side theories
Keynesian Theory
• A recession originates with a
deficiency of spending.
• AD is too far to the left.
• Policy: increase government
spending to shift AD back to
the right.
• Inflation originates with an excess
in spending.
• AD is too far to the right.
• Policy: increase taxes to shift
AD back to the left.
Monetary policy
• Emphasizes the role of money in
financing AD.
• “Tight” money might cause AD to
shift too far to the left.
• Policy: increase money supply
and lower interest rates to shift
AD back to the right.
• “Easy” money might cause AD to
shift too far to the right.
• Policy: decrease money
supply and raise interest rates
to shift AD back to the left.
 Supply-side theory: The policy tools
for accelerating growth.
• A shift in AS to the left causes output • Policy: devise ways to shift
& employment to decrease & inflation AS back to the right
to increase

• Increase the long-run

=> cannot be corrected by shifting AD.
capacity to produce:
• Shift AD right and unemployment
falls but inflation worsens. • Less regulation
• Shift AD left and inflation is reduced • Lower taxes
but unemployment rises. • Increased saving
• Stable political and
economic environment
 Supply-side policy fosters long-run
economic growth (not Keynesian/monetary)
1. Increasing human capital investment
• Improve the quantity and quality of
investment in education.
• Encourage employment-based
immigration, particularly of those with
skills in short supply.
2. Increasing physical capital
investment
• Expand investment incentives:
• Faster depreciation schedules.
• Tax credits for new investments.
• Lower business taxes.
• Expand saving incentives.
• Expand infrastructure development.
• Return to fiscal responsibility
• .
3. Maintaining stable expectations
• The following threats may inhibit investnt
• Increasing government regulation.
• Increasing inflation.
• Increasing budget deficits and
“crowding out.”
• Increased business taxes
4. Create a favorable Institutional context
• Greater economic freedom.
• Secure property rights.
• Open international trade.
• Lower taxes
• Less regulations
 Which approach after a financial crisis?
Keynesian Laissez-faire

• monetary & fiscal stimulus • front-load adjustment/reform

• bailout private sector
• otherwise recession can lead to
a depression as self-fulfilling
panics and runs occur while
private demand is collapsing
• restructure balance sheets and
P&Ls
• Don’t bailout as postpone
financial & operational
restructuring & cause moral
hazard

https://www.youtube.com/watch?v=d0nERTFo-Sk&t=139s (7’32)
https://www.youtube.com/watch?v=GTQnarzmTOc&t=183s (10’)
These debates are still ongoing today

• Growth versus austerity debate

• Front load fiscal austerity (as in Euro-Zone & UK) or back load it (US,
Japan)?

• Be aggressive in monetary easing (US &Japan) or less aggressive

(UK, Euro-Zone)?

• Bailout banks and recapitalize them fast (US) or go slow (Euro-Zone,

UK)?
A bit of both…
• Keynesian in the short run
• To avoid panic, animal spirits, runs and illiquidity to lead to a collapse of
the private sector
• Public demand has to substitute for collapsing private demand
• Rescue illiquid but solvent agents

• Austrian in the medium-long term

• To do economic and financial restructuring

• Problems of illiquidity or insolvency?