Economic Growth and Business Cycles - ch10

Chapter Ten
Economic Growth
and Business Cycles
Trends in Economic Growth
A long-run trend in real GDP growth is easily

discernible, although erratic
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Measuring 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
Why Study 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

Economic Growth & Labor
• 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 (cont’d)
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

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

Hours Worked
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

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

Labor Productivity (cont’d)
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
Contributions of Labor AND Capital
• 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

Total Factor Productivity
• 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.
a 1 a
Y  A K  L
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

TFP & Output Growth (cont’d)
Changes in TFP growth parallel those changes in labor

productivity growth, suggesting the same factors are
responsible for both measures
Business Cycles
• 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 (cont’d)
Over the course of the business cycle, economic growth

(as measured by output) varies around its long-term trend

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

The Causes of Business Cycles
• 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 Monetarists
• 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 Keynesians
• 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 Real Business Cycle Theorists
• 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

Changing Resource Prices
• 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

Economic Growth & Income Potential
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

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Chapter Ten

A long-run trend in real GDP growth is easily

• The trend in economic growth has differed

• If we can understand the variables that cause

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 4

• Labor is measured both in terms of how many

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 5

The labor-force participation rate has been fairly steady,

The working-age population is further divided into those in

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 7

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 8

The actual amount of work provided by employed workers

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 9

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 10

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 11

Again, an overall trend that is upward, yet slightly erratic,

• Labor is not the only factor of production that

• Capital (i.e., buildings, equipment, etc.)

• Unfortunately, capital is difficult to quantify

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 13

• Economists use total factor productivity

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 15

Changes in TFP growth parallel those changes in labor

Over the course of the business cycle, economic growth

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• The National Bureau of

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 20

Many economic variables move together over the business

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 21

• While not definitive, some of the causes

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 22

• Led by Milton Friedman, the monetarists

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 23

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 24

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 25

• Business cycles may be caused by abrupt

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The table shows that workers’ compensation tends to grow

Copyright © Houghton Mifflin Company. All rights reserved. 10 | 27

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