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CHAPTER 6
Measuring Domestic Output and National Income
123
12. KEY QUESTION The following table shows nominal GDP
and an appropriate price index for a group of selected years.
Compute real GDP. Indicate in each calculation whether
you are inflating or deflating the nominal GDP data.
d. The income of a dentist.
e. The money received by Smith when she sells her econom-
ics textbook to a book buyer.
f. The monthly allowance a college student receives from
home.
g. Rent received on a two-bedroom apartment.
h. The money received by Josh when he resells his current-
year-model Honda automobile to Kim.
i. The publication of a college textbook.
j. A 2-hour decrease in the length of the workweek.
k. The purchase of an AT&T corporate bond.
l. A $2 billion increase in business inventories.
m. The purchase of 100 shares of GM common stock.
n. The purchase of an insurance policy.
14.
LAST WORD What government agency compiles the U.S.
NIPA tables? In what U.S. department is it located? Of the
several specific sources of information, name one source for
each of the four components of GDP: consumption, invest-
ment, government purchases, and net exports.
Nominal GDP, Price Index Real GDP,
Year Billions (2000 ⴝ 100) Billions
1964 $ 663.6 22.13 $_______
1974 1500.0 34.73 $_______
1984 3933.2 67.66 $_______
1994 7072.2 90.26 $_______
2004 11,734,3 109.10 $_______
Web-Based Questions
1. UPDATE THE KEY NATIONAL INCOME AND PRODUCT
ACCOUNT NUMBERS Go to the Bureau of Economic Anal-
ysis Web site, www.bea.gov , and access the BEA interac-
tively by selecting National Income and Product Account
Tables. Select Frequently Requested NIPA Tables, and find
Table 1.1 on GDP. Update the data in the left column of the
text’s Table 6.3 , using the latest available quarterly data.
Search the full list of NIPA tables to find the latest reported
data for national income (NI), personal income (PI), and
disposable income (DI). Update the data in the text’s Table
6.4 for these three items. By what percentages are GDP, NI,
PI, and DI higher (or lower) than the numbers in the table?
2.
NOMINAL GDP AND REAL GDP—BOTH UP? Visit the
Bureau of Economic Analysis Web site, www.bea.gov , and
access the BEA interactively by selecting National Income
and Product Account Tables. Select Frequently Requested
NIPA Tables, and use Tables 1.1 and 1.2 to identify the
GDP (nominal GDP) and real GDP for the past four quar-
ters. Why was nominal GDP greater than real GDP in each
of those quarters? What were the percentage changes in
nominal GDP and real GDP for the most recent quarter?
What accounts for the difference?
3.
GDPS IN THE AMERICAS—HOW DO NATIONS COM-
PARE? Visit the World Bank Web site, www.worldbank.
org , and type “GDP” in the search space. Find the latest
data for total GDP (not PPP GDP) for the North and South
America countries listed. Arrange the countries by highest
to lowest GDPs, and express their GDPs as ratios of U.S.
GDP. What general conclusion can you draw from your
ratios?
13. Which of the following are included in this year’s GDP?
Explain your answer in each case.
a. Interest on an AT&T corporate bond.
b. Social Security payments received by a retired factory
worker.
c. The unpaid services of a family member in painting the
family home.
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7
Introduction to Economic
Growth and Instability
Between 1996 and 2000, real GDP in the United States expanded briskly and the price level rose only
slowly. The economy experienced neither significant unemployment nor inflation. Some observers
felt that the United States had entered a “new era” in which the business cycle was dead. But that
wishful thinking came to an end in March 2001, when the economy entered its ninth recession since
1950. Since 1970, real GDP has declined in the United States in five periods: 1973–1975, 1980,
1981–1982, 1990–1991, and 2001.
Although the U.S. economy has experienced remarkable economic growth over time, high unem-
ployment or inflation has sometimes been a problem. For example, between March 2001 and Decem-
ber 2001, unemployment rose by 2.2 million workers. The U.S. rate of inflation was 13.5 percent in
1980 and 5.4 percent in 1990. Further, other nations have suffered high unemployment rates or
IN THIS CHAPTER YOU WILL LEARN:
• How economic growth is measured and why it is
important.
• About the business cycle and its primary phases.
• How unemployment and inflation are measured.
• About the types of unemployment and inflation
and their various economic impacts.
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CHAPTER 7
Introduction to Economic Growth and Instability
125
Economic Growth
Economists define and measure economic growth as
either:
• An increase in real GDP occurring over some time
period.
• An increase in real GDP per capita occurring over
some time period.
With either definition, economic growth is calculated as
a percentage rate of growth per quarter (3-month period)
or per year. For the first definition, for example, real
GDP in the United States was $10,755.7 billion in 2004
and $11,134.8 billion in 2005. So the rate of economic
growth in the United States for 2005 was 3.5 percent
{ [$11,134.8 billion $10,755.7 billion)兾$10,755.7
bilion] 100}.
The second definition takes into consideration the
size of the population. Real GDP per capita (or per capita
output) is found by dividing real GDP by the size of the
population. The resulting number is then compared in
percentage terms with that of the previous period. For
example, in the United States real GDP was $10,755.7
billion in 2004 and population was 293.9 million. So that
year real U.S. GDP per capita was $36,596. In 2005, real
per capita GDP rose to $37,536. So the rate of growth of
GDP per capita for 2005 was 2.6 percent { [$37,536
$36,596兾$36,596] 100}.
For measuring expansion of military potential or
political preeminence, the growth of real GDP is more
useful. Unless specified otherwise, growth rates reported
in the news and by international agencies use this definition
of economic growth. For comparing living standards,
however, the second definition is superior. While China’s
GDP in 2004 was $1938 billion compared with Denmark’s
$220 billion, Denmark’s real GDP per capita was $40,750
compared with China’s meager $1500. And in some cases
growth of real GDP can be misleading. Madagascar’s real
GDP grew at a rate of 1.7 percent per year from 1990–
2004. But over the same period its annual population
growth was 2.9 percent, resulting in a decline in real
GDP per capita of roughly 1.2 percent per year. (Key
Question 2)
Growth as a Goal
Growth is a widely held economic goal. The expansion of
total output relative to population results in rising real
wages and incomes and thus higher standards of living. An
economy that is experiencing economic growth is better
able to meet people’s wants and resolve socioeconomic
problems. Rising real wages and income provide richer
opportunities to individuals and families—a vacation trip,
a personal computer, a higher education—without sacri-
ficing other opportunities and pleasures. A growing econ-
omy can undertake new programs to alleviate poverty
embrace diversity, cultivate the arts, and protect the envi-
ronment without impairing existing levels of consump-
tion, investment, and public goods production.
In short, growth lessens the burden of scarcity. A growing
economy, unlike a static economy, can consume more to-
day while increasing its capacity to produce more in the
future. By easing the burden of scarcity—by relaxing soci-
ety’s constraints on production—economic growth enables
a nation to attain its economic goals more readily and to
undertake new endeavors that require the use of goods
and services to be accomplished.
Arithmetic of Growth
Why do economists pay so much attention to small changes
in the rate of economic growth? Because those changes re-
ally matter! For the United States, with a current real GDP
of about $12.5 trillion, the difference between a 3 percent
and a 4 percent rate of growth is about $125 billion of out-
put each year. For a poor country, a difference of one-half
of a percentage point in the rate of growth may mean the
difference between starvation and mere hunger.
The mathematical approximation called the rule of
70 provides a quantitative grasp of the effect of economic
growth. It tells us that we can find the number of years it
will take for some measure to double, given its annual per-
centage increase, by dividing that percentage increase into
the number 70. So
Approximate
number of years
required to double
real GDP
inflation rates in recent years. For example, the unemployment rate in Germany reached 10.7 percent
in 2005. The inflation rate was 585 percent in Zimbabwe in 2005.
In this chapter we provide an introductory look at the trend of real GDP growth in the United
States and the macroeconomic instability that has occasionally accompanied it. Our specific topics
are economic growth, the business cycle, unemployment, and inflation.
70
____________________
annual percentage rate
of growth
125
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PART TWO
Macroeconomic Measurement and Basic Concepts
126
Examples: A 3 percent annual rate of growth will double
real GDP in about 23 ( 70 3) years. Growth of 8 per-
cent per year will double real GDP in about 9 ( 70 8)
years. The rule of 70 is applicable gener-
ally. For example, it works for estimating
how long it will take the price level or a
savings account to double at various per-
centage rates of inflation or interest. When
compounded over many years, an appar-
ently small difference in the rate of growth
thus becomes highly significant. Suppose
China and Italy have identical GDPs, but China grows at
an 8 percent yearly rate, while Italy grows at 2 percent.
China’s GDP would double in about 9 years, while Italy’s
GDP would double in 35 years.
Main Sources of Growth
Society can increase its real output and income in two
fundamental ways: (1) by increasing its inputs of re-
sources, and (2) by increasing the productivity of those
inputs. Other things equal, increases in land, labor, capi-
tal, and entrepreneurial resources yield additional output.
But economic growth also occurs through increases in
productivity—measured broadly as real output per unit
of input. Productivity rises when the health, training,
education, and motivation of workers are improved;
when workers have more and better machinery and natu-
ral resources with which to work; when production is
better organized and managed; and when labor is reallo-
cated from less efficient industries to more efficient in-
dustries. About one-third of U.S. growth comes from
more inputs. The remaining two-thirds results from im-
proved productivity.
Growth in the United States
Table 7.1 gives an overview of economic growth in the
United States over past periods. Column 2 reveals strong
growth as measured by increases in real GDP. Note that
between 1950 and 2005 real GDP increased about 6 fold.
But the U.S. population also increased. Nevertheless, in
column 4 we find that real GDP per capita rose more than
threefold over these years.
What has been the rate of U.S. growth? Real GDP
grew at an annual rate of about 3.5 percent between 1950
and 2005. Real GDP per capita increased 2.3 percent per
year over that time. But we must qualify these raw num-
bers in several ways:
• Improved products and services Since the numbers
in Table 7.1 do not fully account for the improve-
ments in products and services, they understate the
growth of economic well-being. Such purely quanti-
tative data do not fully compare an era of iceboxes
and LPs with an era of refrigerators and CDs.
• Added leisure The increases in real GDP and per
capita GDP identified in Table 7.1 were accom-
plished despite increases in leisure. The standard
workweek, once 50 hours, is now about 35 hours
(excluding overtime hours). Again the raw growth
numbers understate the gain in economic well-
being.
• Other impacts These measures of growth do not
account for any effects growth may have had on the
environment and the quality of life. If growth
debases the physical environment and creates a
stressful work environment, the bare growth
numbers will overstate the gains in well-being that
result from growth. On the other hand, if growth
leads to stronger environ mental protections and
greater human security, these numbers will
understate the gains in well-being.
Relative Growth Rates
Viewed from the perspective of the last half-century, eco-
nomic growth in the United States lagged behind that in
Japan, Germany, Italy, Canada, and France. Japan’s annual
growth rate, in fact, averaged twice that of the United
States. But more recent economic growth is quite another
matter. As shown in Global Perspective 7.1, in the late
1990s the U.S. growth rate exceeded those in several other
industrial countries, including Japan and Germany. After
stalling in 2001, the U.S. growth rate again climbed above
the rates in those nations.
TABLE 7.1 Real GDP and Per Capita Real GDP, Selected
Years, 1950–2005
Source: Data are from the Bureau of Economic Analysis, www.bea.doc.gov, and the
U.S. Census Bureau, www.census.gov.
(1)
Year
(2)
Real
GDP,
Billions
of 2000 $
(3)
Population,
Millions
(4)
Real Per
Capita
GDP,
2000 $
(2) ⴜ (3)
1950 $ 1773.3 152 $11,666
1960 2501.8 181 13,822
1970
3771.9 205 18,400
1980
5161.7 228 22,639
1990
7112.7 250 28,451
2000
9817.0 267 36,768
2005
11,134.8 297 37,491
W 7.1
GDP growth
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CHAPTER 7
Introduction to Economic Growth and Instability
127
The Business Cycle
We have seen that the long-run trend of the U.S. econ-
omy is one of economic growth. But growth has been
interrupted by periods of economic insta-
bility usually associated with business
cycles. Business cycles are alternating
rises and declines in the level of economic
activity, sometime over several years. Indi-
vidual cycles (one “up” followed by one
“down”) vary substantially in duration and
intensity.
Phases of the Business Cycle
Figure 7.1 shows the four phases of a generalized business
cycle:
• At a peak, such as the middle peak shown in
Figure 7.1, business activity has reached a temporary
maximum. Here the economy is near or at full
employment and the level of real output is at or very
close to the economy’s capacity. The price level is
likely to rise during this phase.
• A recession is a period of decline in total output,
income, and employment. This downturn, which
lasts 6 months or more, is marked by the widespread
contraction of business activity in many sectors of the
economy. Along with declines in real GDP, signifi-
cant increases in unemployment occur. Table 7.2
documents the 10 recessions in the United States
since 1950.
• In the trough of the recession or depression, output
and employment “bottom out” at their lowest levels.
The trough phase may be either short-lived or quite
long.
• A recession is usually followed by a recovery and
expansion, a period in which real GDP, income, and
employment rise. At some point, the economy again
GLOBAL PERSPECTIVE 7.1
Average Annual Growth Rates, 1997–2005,
Selected Nations
Between 1997 and 2005, economic growth in the United States
generally was greater than that in several other major coun-
tries.
France
Germany
U.S.
U.K.
Japan
Italy
6
4
2
2
4
0
Percent change (annual rate)
1999 2000 2001 2002 2003 2004 2005
Year
1997 1998
Gr
owth Tr
e
n
d
Peak
Peak
Peak
Trough
Trough
R
e
c
e
s
s
i
o
n
R
e
c
e
s
s
i
o
n
E
x
p
a
n
s
i
o
n
Level of real output
Time
E
x
p
a
n
s
i
o
n
FIGURE 7.1 The business cycle. Economists distinguish
four phases of the business cycle; the duration and strength of each phase
may vary.
O 7.1
Business cycles
Source: Economic Report of the President, 2006.
TABLE 7.2 U.S. Recessions since 1950
Source: Economic Report of the President, 1993, updated.
Period
Duration,
Months
Depth
(Decline in Real
Output)
1953–54 10
3.7%
1957–58 8
3.9
1960–61 10
1.6
1969–70 11
1.0
1973–75 16
4.9
1980 6
2.3
1981–82 16
3.3
1990–91 8
1.8
2001 8
0.5
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Macroeconomic Measurement and Basic Concepts
128
approaches full employment. If spending then ex-
pands more rapidly than does production capacity,
prices of nearly all goods and services will rise. In
other words, inflation will occur.
Although business cycles all pass through the same
phases, they vary greatly in duration and intensity. Many
economists prefer to talk of business “fluctuations” rather
than cycles because cycles imply regularity while fluctua-
tions do not. The Great Depression of the 1930s resulted
in a 40 percent decline in real GDP over a 3-year period
in the United States and seriously impaired business activ-
ity for a decade. By comparison, more recent U.S. reces-
sions, detailed in Table 7.2, were relatively mild in both
intensity and duration.
Recessions, of course, occur in other countries, too.
At one time or another during the past 10 years Argentina,
Brazil, Colombia, Japan, Indonesia, Mexico, Germany,
and South Korea experienced recessions.
Causation: A First Glance
Economists have suggested many theories to explain
fluctuations in business activity. Some say that momentous
innovations, such as the railroad, the automobile, synthetic
fibers, and microchips, have great impact on investment
and consumption spending and therefore on output,
employment, and the price level. Such major innovations
occur irregularly and thus contribute to the variability of
economic activity.
Some economists see major changes in productivity as
causes of business cycles. When productivity expands, the
economy booms; when productivity falls, the economy
recedes. Still others view the business cycle as a purely
monetary phenomenon. When government creates too
much money, they say, an inflationary boom occurs. Too
little money triggers a decline in output and employment
and, eventually, in the price level.
Most economists, however, believe that the immedi-
ate cause of cyclical changes in the levels of real output
and employment is changes in the level of total spending.
In a market economy, businesses produce goods or ser-
vices only if they can sell them at a profit. If total spend-
ing sinks, many businesses find that producing their
current volume of goods and services is no longer profit-
able. As a consequence, output, employment, and incomes
all fall. When the level of spending rises, an increase in
production becomes profitable, and output, employment,
and incomes will rise accordingly. Once the economy
nears full employment, however, further gains in real out-
put become more difficult to achieve. Continued increases
in spending may raise the price level as consumers bid for
the limited amount of goods available.
We have seen that the long-run growth trend of the
U.S. economy is one of expansion. Note that the stylized
cycle in Figure 7.1 is drawn against a trend of economic
growth.
Cyclical Impact: Durables and
Nondurables
Although the business cycle is felt everywhere in the econ-
omy, it affects different segments in different ways and to
different degrees.
Firms and industries producing capital goods (for ex-
ample, housing, commercial buildings, heavy equipment,
and farm implements) and consumer durables (for exam-
ple, automobiles, personal computers, refrigerators) are
affected most by the business cycle. Within limits, firms
can postpone the purchase of capital goods. As the
economy recedes, producers frequently delay the
purchase of new equipment and the construction of new
plants. The business outlook simply does not warrant
increases in the stock of capital goods. In good times,
capital goods are usually replaced before they depreciate
completely. But when recession strikes, firms patch up
their old equipment and make do. As a result, investment
in capital goods declines sharply. Firms that have excess
plant capacity may not even bother to replace all the
capital that is depreciating. For them, net investment
may be negative. The pattern is much the same for con-
sumer durables such as automobiles and major appli-
ances. When recession occurs and households must trim
their budgets, purchases of these goods are often
deferred. Families repair their old cars and appliances
rather than buy new ones, and the firms producing these
products suffer. (Of course, producers of capital goods
and consumer durables also benefit most from
expansions.)
In contrast, service industries and industries that
produce nondurable consumer goods are somewhat insu-
lated from the most severe effects of recession. People
find it difficult to cut back on needed medical and legal
services, for example. And a recession actually helps
some service firms, such as pawnbrokers and law firms
that specialize in bankruptcies. Nor are the purchases of
many nondurable goods such as food and clothing easy
to postpone. The quantity and quality of purchases of
nondurables will decline, but not so much as will pur-
chases of capital goods and consumer durables. (Key
Question 4)
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Introduction to Economic Growth and Instability
129
Unemployment
The twin problems that arise from the business cycle are
unemployment and inflation. Let’s look at unemployment
first.
Measurement of Unemployment
The U.S. Bureau of Labor Statistics (BLS) conducts a na-
tionwide random survey of some 60,000 households each
month to determine who is employed and who is not
employed. In a series of questions it asks which members of
the household are working, unemployed and looking for
work, not looking for work, and so on. From the answers it
determines an unemployment rate for the entire nation.
Figure 7.2 helps explain the mathematics. The BLS
divides the total U.S. population into three groups. One
group is made up of people under 16 years of age and
people who are institutionalized, for example, in mental
hospitals or correctional institutions. Such people are not
considered potential members of the labor force.
A second group, labeled “Not in labor force,” is com-
posed of adults who are potential workers but are not em-
ployed and are not seeking work. For example, they are
homemakers, full-time students, or retirees.
The third group is the labor force, which constituted
about 50 percent of the total population in 2005. The la-
bor force consists of people who are able and willing to
work. Both those who are employed and those who are
unemployed but actively seeking work are counted as be-
ing in the labor force. The unemployment rate is the
percentage of the labor force unemployed:
Unemployment rate
unemployed
___________
labor force
100
The statistics included in Figure 7.2 show that in 2005 the
unemployment rate averaged
7,591,000
____________
149,320,000
100 5.1%
Unemployment rates for selected years ap-
pear on the inside covers of this book.
Despite the use of scientific sampling
and interviewing techniques, the data col-
lected in this survey are subject to criticism:
• Part-time employment The BLS lists all part-time
workers as fully employed. In 2005 about 28 million
people worked part-time as a result of personal
choice. But another 4.4 million part-time workers
either wanted to work full-time and could not find
suitable full-time work or worked fewer hours
because of a temporary slack in consumer demand.
These last two groups were, in effect, partially
employed and partially unemployed. By counting
them as fully employed, say critics, the official BLS
data understate the unemployment rate.
QUICK REVIEW 7.1
• Economic growth can be measured as (a) an increase in real
GDP over time or (b) an increase in real GDP per capita
over time.
• Real GDP in the United States has grown at an average
annual rate of about 3.5 percent since 1950; real GDP per
capita has grown at roughly a 2.3 percent annual rate over
that same period.
• The typical business cycle goes through four phases: peak,
recession, trough, and expansion.
• During recession, industries that produce capital goods and
consumer durables normally suffer greater output and
employment declines than do service and nondurable
consumer goods industries.
Employed
(141.7 million)
Not in
labor
force
(76.8 million)
Under 16
and/or
institutionalized
(70.5 million)
Unemployed
(
7.6 million
)
To t a l
population
(296.6
million)
Labor
force
(149.3
million)
Source: Bureau of Labor Statistics, www.bls.gov (civilian labor force data,
which excludes military employment).
FIGURE 7.2 The labor force, employment, and
unemployment, 2005. The labor force consists of persons
16 years of age or older who are not in institutions and who are
(1) employed or (2) unemployed but seeking employment.
W 7.2
Unemployment
rate
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• Discouraged workers You must be actively seeking
work in order to be counted as unemployed. An
unemployed individual who is not actively seeking
employment is classified as “not in the labor force.”
The problem is that many workers, after unsuccess-
fully seeking employment for a time, become dis-
couraged and drop out of the labor force. The
number of such discouraged workers was 436,000
in 2005. By not counting discouraged workers as un-
employed, say critics, the official BLS data understate
the unemployment problem. (Key Question 6)
Types of Unemployment
There are three types of unemployment: frictional, struc-
tural, and cyclical.
Frictional Unemployment At any given time
some workers are “between jobs.” Some of them will be
moving voluntarily from one job to another. Others will
have been fired and will be seeking reemployment. Still
others will have been laid off temporarily because of sea-
sonal demand. In addition to those between jobs, many
young workers will be searching for their first jobs.
As these unemployed people find jobs or are called
back from temporary layoffs, other job seekers and laid-off
workers will replace them in the “unemployment pool.”
So even though the workers who are unemployed for such
reasons change from month to month, this type of unem-
ployment persists.
Economists use the term frictional unemployment—
consisting of search unemployment and wait unemployment—
for workers who are either searching for jobs or waiting to
take jobs in the near future. The word “frictional” implies
that the labor market does not operate perfectly and instan-
taneously (without friction) in matching workers and jobs.
Frictional unemployment is inevitable and, at least in
part, desirable. Many workers who are voluntarily between
jobs are moving from low-paying, low-productivity jobs to
higher-paying, higher-productivity positions. That means
greater income for the workers, a better allocation of labor
resources, and a larger real GDP for the economy.
Structural Unemployment Frictional unem-
ployment blurs into a category called structural unem-
ployment. Here, economists use “structural” in the sense
of “compositional.” Changes over time in consumer de-
mand and in technology alter the “structure” of the total
demand for labor, both occupationally and geographically.
Occupationally, the demand for certain skills (for
example, sewing clothes or working on farms) may decline
or even vanish. The demand for other skills (for example,
designing software or maintaining computer systems) will
intensify. Unemployment results because the composition
of the labor force does not respond immediately or com-
pletely to the new structure of job opportunities. Workers
who find that their skills and experience have become ob-
solete or unneeded thus find that they have no marketable
talents. They are structurally unemployed until they adapt
or develop skills that employers want.
Geographically, the demand for labor also changes over
time. An example: migration of industry and thus of em-
ployment opportunities from the Snow Belt to the Sun Belt
over the past few decades. Another example is the move-
ment of jobs from inner-city factories to suburban industrial
parks. As job opportunities shift from one place to another,
some workers become structurally unemployed.
The distinction between frictional and structural un-
employment is hazy at best. The key difference is that fric-
tionally unemployed workers have salable skills and either
live in areas where jobs exist or are able to move to areas
where they do. Structurally unemployed workers find it
hard to obtain new jobs without retraining, gaining addi-
tional education, or relocating. Frictional unemployment
is short-term; structural unemployment is more likely to
be long-term and consequently more serious.
Cyclical Unemployment Unemployment that is
caused by a decline in total spending is called cyclical
unemployment and typically begins in the recession
phase of the business cycle. As the demand for goods and
services decreases, employment falls and unemployment
rises. Cyclical unemployment results from insufficient de-
mand for goods and services. The 25 percent unemploy-
ment rate in the depth of the Great Depression in 1933
reflected mainly cyclical unemployment, as did significant
parts of the 9.7 percent unemployment rate in 1982, the
7.5 percent rate in 1992, and the 5.8 percent rate in 2002.
Cyclical unemployment is a very serious problem
when it occurs. We will say more about its high costs later,
but first we need to define “full employment.”
Definition of Full Employment
Because frictional and structural unemployment is largely
unavoidable in a dynamic economy, full employment is
something less than 100 percent employment of the labor
force. Economists say that the economy is “fully em-
ployed” when it is experiencing only frictional and struc-
tural unemployment. That is, full employment occurs
when there is no cyclical unemployment.
Economists describe the unemployment rate that is
consistent with full employment as the full-employment
rate of unemployment, or the natural rate of
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CHAPTER 7
Introduction to Economic Growth and Instability
131
unemployment (NRU). At the NRU, the economy is
said to be producing its potential output. This is the real
GDP that occurs when the economy is “fully employed.”
The NRU occurs when the number of job seekers equals
the number of job vacancies. Even when labor markets are in
balance, however, the NRU is some positive percentage
because it takes time for frictionally unemployed job seek-
ers to find open jobs they can fill. Also, it takes time for the
structurally unemployed to achieve the skills and geo-
graphic relocation needed for reemployment.
“Natural” does not mean, however, that the economy
will always operate at this rate and thus realize its potential
output. When cyclical unemployment occurs, the economy
has much more unemployment than that which would occur
at the NRU. Moreover, the economy can operate for a while
at an unemployment rate below the NRU. At times, the de-
mand for labor may be so great that firms take a stronger
initiative to hire and train the structurally unemployed. Also,
some homemakers, teenagers, college students, and retirees
who were casually looking for just the right part-time or
full-time jobs may quickly find them. Thus the unemploy-
ment rate temporarily falls below the natural rate.
Also, the NRU can vary over time. In the 1980s, the
NRU was about 6 percent. Today, it is 4 to 5 percent. Why
the decline?
• The growing proportion of younger workers in the
labor force has declined as the baby-boom generation
has aged. The labor force now has a larger propor-
tion of middle-aged workers, who traditionally have
lower unemployment rates.
• The growth of temporary-help agencies and the
improved information resulting from the Internet
have lowered the NRU by enabling workers to find
jobs more quickly.
• The work requirements under the new welfare laws
have moved many people from the ranks of the
unemployed to the ranks of the employed.
• The doubling of the U.S. prison population since
1985 has removed relatively high unemployment
individuals from the labor force and thus lowered the
overall unemployment rate.
A decade ago, a 4 to 5 percent rate of unemployment would
have reflected excessive spending, an unbalanced labor
market, and rising inflation; today, the same rate is consis-
tent with a balanced labor market and a stable, low rate of
inflation.
Economic Cost of Unemployment
Unemployment that is excessive involves great economic
and social costs.
GDP Gap and Okun’s Law The basic economic
cost of unemployment is forgone output. When the
economy fails to create enough jobs for all who are able and
willing to work, potential production of goods and services
is irretrievably lost. In terms of Chapter 1’s analysis, unem-
ployment above the natural rate means that society is oper-
ating at some point inside its production possibilities curve.
Economists call this sacrifice of output a GDP gap—the
difference between actual and potential GDP. That is:
GDP gap actual GDP potential GDP
The GDP gap can be either negative (actual GDP
potential GDP) or positive (actual GDP potential GDP).
In the case of unemployment above the natural rate, it is
negative because actual GDP falls short of potential GDP.
Potential GDP is determined by assuming that the
natural rate of unemployment prevails. The growth of
potential GDP is simply projected forward on the basis of
the economy’s “normal” growth rate of real GDP.
Figure 7.3 shows the GDP gap for recent years in the
United States. It also indicates the close correlation be-
tween the actual unemployment rate (Figure 7.3b) and the
GDP gap (Figure 7.3a). The higher the unemployment
rate, the larger is the GDP gap.
Macroeconomist Arthur Okun was the first to quan-
tify the relationship between the unemployment rate and
the GDP gap. On the basis of recent estimates, Okun’s
law indicates that for every 1 percentage point by which
the actual unemployment rate exceeds the
natural rate, a negative GDP gap of about
2 percent occurs. With this information,
we can calculate the absolute loss of output
associated with any above-natural unem-
ployment rate. For example, in 1992 the
unemployment rate was 7.4 percent, or 1.4
percentage points above the 6.0 percent
natural rate of unemployment then existing. Multiplying
this 1.4 percent by Okun’s 2 indicates that 1992’s GDP
gap was 2.8 percent of potential GDP (in real terms). By
applying this 2.8 percent loss to 1992’s potential GDP of
$7337 billion, we find that the economy sacrificed $205
billion of real output because the natural rate of unem-
ployment was not achieved. (Key Question 8)
As you can see in Figure 7.3, sometimes the economy’s
actual output will exceed its potential or full-employment
output. Figure 7.3 reveals that an economic expansion in
1999 and 2000, for example, caused actual GDP to exceed
potential GDP in those years. There was a positive GDP
gap in 1999 and 2000. Actual GDP for a time can exceed
potential GDP, but positive GDP gaps create inflationary
pressures and cannot be sustained indefinitely.
W 7.3
Okun’s law
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PART TWO
Macroeconomic Measurement and Basic Concepts
132
FIGURE 7.3 Actual and potential GDP and the unemployment rate. (a) The difference between actual and potential GDP is the GDP
gap. A negative GDP gap measures the output the economy sacrifices when actual GDP falls short of potential GDP. A positive GDP gap indicates that actual
GDP is above potential GDP. (b) A high unemployment rate means a large GDP gap (negative), and a low unemployment rate means a small or even positive
GDP gap.
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
8000
9000
12,000
GDP (billions of 2000 dollars)
(a)
The GDP
g
a
p
5000
6000
7000
11,000
10,000
GDP gap
(positive)
GDP gap
(negative)
Actual GDP
Potential GDP
2003 20051985 1987 1989 1991 1993 1995 1997 1999 2001
10
8
6
4
2
0
Unemployment rate
Unemployment
(percent of civilian
labor force)
(b)
Unemployment rate
Source: Data are from the Congressional Budget Office, www.cbo.gov/, and Bureau of Economic Analysis, www.bea.gov.
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