Aspects of Economic Growth, Unemployment and Inflation - Research Paper Example

Among the of macroeconomic indicators, Economic Growth, Unemployment and Inflation are arguably the most important in the sense that given information on these aspects, it is possible to generate a quite clear snapshot of the economy that facilitates inter-temporal as well as cross country comparisons regarding the performance of the economy in question. As this essay will show, this holds true due to the nature of the relationship between the variables that determine the state of these macroeconomic indicators. The present essay will attempt to analyze, compare and contrast these concepts to illustrate the way in which the interactions in the determinant variables are reflected through them so that the nature of relation shared among these indicators is identified. First, the concept of economic growth shall be introduced followed by a discussion on its computation and implications of certain arbitrary results to facilitate proper understanding. Then we shall move on to a similar discussion regarding the concepts of Unemployment and Inflation. The essay will attempt to present the discussion in a fashion such that the significances of each compared to the other two is highlighted and the implications that movements in the indicators reflect are understood. Economic growth refers to the increase in real Gross Domestic Product over time. Since Gross Domestic Product in real terms reflects the aggregate output produced within the domestic territory of an economy during a given period of time (usually one year), growth in the real Gross Domestic Product over any given time period represents the change in the total output produced within that particular time interval. Therefore economic growth in essence reflects the changes in the capacity to produce of any given economy and the extent of utilization of the available resources. Calculating economic growth involves a few simple steps. First, nominal Gross Domestic Product has to be computed at a price level that corresponds to the current year or some other year taken as the base. The second step is to obtain the real Gross Domestic Product by dividing the nominal Gross Domestic Product by the given price level, current or base year as chosen in the computation of the nominal Gross Domestic Product. Finally, to calculate economic growth as a percentage within any time period, one is to be subtracted from the ratio of the Gross Domestic Product at the endpoint of the time interval to the Gross Domestic Product at the initial point of the time interval. i.e., real GDP growth rate for the period (n-1) to n= [real GDP for time point n / real GDP for time point (n-1)] – 1 It should be noted that economic growth refers to the growth in real Gross Domestic Product and not that in nominal Gross Domestic Product as the latter may grow in spite of the same value of goods and services being produced through increases in price levels and thus in spite of the production capacity and utilization of the available resources remaining unaltered. Thus, we find that economic growth is primarily determined by the capacity of a nation to produce coupled with the extent and optimality of the utilization of the available resources. These factors in turn are determined by the productivity of the factors of production. By productivity of any factor of production, we refer to the amount of output that can be produced by any given factor with other factors including capital - physical and human, remaining fixed. The more productive the factors become, greater the capacity of the nation to produce and thus with proper utilization of resources, higher the real output, or real Gross Domestic Product. The productivity of factors of production in turn depends upon the technology of production or the amount of physical capital or human capital available per unit of labor. Through investing in technological improvements, a unit of labor can produce more in any given time using any given capital stock. Alternatively raising the capital stock available per capita for each worker can also increase the amount he is able to produce in any given time period. Therefore, what emerges is that the growth rate crucially depends upon productivity growth which in turn depends upon capital accumulation. An important question at this stage would be whether economic growth implies better living for the populace of the economy. However, it is not an extensive measure of a nation’s welfare. Welfare depends upon aspects like equality in the distribution of income, employment opportunities as well as real income of the members of the economy. While rise in economic growth implies a rise in income per capita, it does not imply better living conditions for the majority until the distribution of income is ascertained as not being unequal. It is due to such deficiencies that we need other indicators such as unemployment and inflation to generate a truer picture of an economy. As economic growth is fuelled through enhanced utilization of resources, it is likely that employment has risen. Indeed, as output expands, unemployment falls. However, this strongly depends upon the structure of the economy and the creation of job opportunities. Unemployment is in essence a state of joblessness. However, it can be voluntary as well as involuntary depending upon whether the individual in question is willing to be employed at the present wage rate or not. Evidently, voluntary unemployment may increase in spite of economic growth if the wage rates do not rise accordingly so that more people may not be motivated to seek employment. There are three further important classifications of unemployment. People in between jobs, i.e., people who have left a job and will join another soon are identified a belonging to the class of frictional unemployment. Unemployment generated due to changing technologies of production is known as structural unemployment as such unemployment is caused due to evolving structures of production. Finally, the unemployment created during downturns in the business cycle is known as cyclical unemployment. This type of unemployment is the most important in the sense that it is created due to the lack of effective demand for workers and may require government intervention to solve. Economic growth can be associated with frictional as well as structural unemployment, as it may lead to better jobs created that motivates the movement from a previous job, or alternatively lead to technological improvements that lead to labor being replaced by machines (identified as labor saving technological progress). Unemployment is calculated as a rate. The population is sorted into three groups – the involuntarily unemployed, the employed and those not participating in the labor market. The rate of unemployment is then calculated as the ratio of the involuntarily unemployed to the total members of the labor market (involuntarily unemployed + employed). The level of employment that corresponds to the economy working at its full capacity is identified as the full employment level. However, there is still some level of frictional or structural unemployment. This level of unemployment that corresponds to the full employment level of output is called the natural rate of unemployment. Primarily the causes of unemployment in a healthy mature economy are minimum wage laws or trade union movements that set wages above market clearing levels and thus creating excess supplies. Alternatively the efficiency wage hypothesis states that firms pay workers higher than the equilibrium level to ensure happy, fit and healthy workers to ensure high productivity. This leads to another excess supply situation. Further, unemployment is caused by the time lag involved in starting to look for a job and actually finding it. However, it is pertinent to note that by its very nature, if there is economic growth, cyclical unemployment falls. This direct relationship was first hypothesized by what is known as the Okun’s Law. This states that the percentage change in real Gross Domestic Product = 3% - 2 x (change in the rate of unemployment). It was derived based on empirical data and predicts that if employment rises, i.e., unemployment turns negative then the growth rate (assumed to be steady at 3 percent) will be higher than 3 percent by the double of the rise in the rate of employment. Therefore we find a direct relationship between economic growth and employment. The fundamental reason is that as an economy expands through increased output, the increased production necessitates greater employment. This is actually a two way relation. With the growth in employment, consumption expenditure increases and thus aggregate demand increases thereby motivating further expansion of output. While it may be argued that growth spurted by productivity surges may cause reduced labor requirements and thus increase unemployment, it has been observed empirically that higher growth stems higher demand that is high enough to generate labor demands stronger than the reduction caused by productivity surges. However, faster expansion of demand can cause price levels to rise. A continuous rise in the price level over time is known as inflation. Inflation is detrimental for the well being of the economy in the sense that it reduces the purchasing power of the consumers and thus reduces the real income. Inflation rate is calculated by observing changes in any given price index over time. The most common indices used for this purpose are the Consumer Price Index and the GDP deflator. The Consumer Price Index is simply an index that measures the cost of the basket of goods and services purchased by the average consumer by indexing the related prices. A change in the CPI over time therefore reflects how the prices of the goods included in the basket changed over any given period of time. It is one of the most popular measures of inflation as the effect of the hike in the general price level on the average consumer is visible. The GDP deflator in essence shows the extent to which the growth in nominal Gross Domestic Product is due to changes in price levels. It therefore is a strong measure of the price level. Changes in the GDP deflator over time reflect the changes in the price levels, i.e., inflation. Inflation can have distinct effects depending upon the actual rate being within the bounds of the expected inflation level or not. In case of the inflation rate being at the level expected, customers realize that money held would lose value fast and thus opt to invest the money bonds and stocks. This may lead to a problem of reduced liquidity that is identified as shoe-leather costs ridiculing the fact that expected inflation raises the number of trips made to the banks and thus withers the shoe soles faster. However if inflation rates exceed the expected bounds, the economy faces graver problems. The value of money falls fast and thus there is an advantage for borrowers in that the sum they have to return in effect has lower real value. This possibility reduces lender buyer interactions and thus the money market shrinks opening up the possibility of significantly reduced activity in the economy overall thereby potentially hindering economic growth. Building on Okun’s Law, A.W. Phillips showed that an inverse relationship existed between unemployment and inflation. The reasoning was that with higher employment there is growth in output (provided employment is below full employment level), and this leads to higher wages and thus higher planned consumer expenditure thereby leading to demand spurts that increase the price level overall. However, the phenomenon of falling employment coupled with rising inflation (called stagflation) observed in the 1970s and 1980s invalidated the Phillips prediction. This period is better explained as a case of the inflation rates moving beyond expected levels strongly enough to shrink economic activity and thus reduced jobs. Therefore we find that the aspects of Economic Growth, Unemployment and inflation combined can create a sketch of the economy that can be extremely useful to compare it with itself to asses the performance of the economy over time or to compare it with other similar economies. We have found that while economic growth stems employment, it can also lead to inflation. Inflation may be simply inconvenient or become a major problem depending upon whether its actual rate exceeds normally expected rates. Unemployment and economic growth are generally directly related over the long run as the strength of demand generation to overcome the reduced labor demand from productivity surges is greater. Inflation and Unemployment are related so that in general the planners have to choose between reducing inflation or unemployment at the cost of the other. However, through realizing the implications movements in these indicators have it is possible to form quite a detailed idea about any economy being studied. These are therefore most important among the class of macroeconomic indicators. Read More