Chapter 6

The Goals of Macroeconomic Policy

When men are employed, they are best contented.

BENJAMIN FRANKLIN

Inflation is repudiation.CALVIN COOLIDGE

Goals of Macroeconomic Policy

• Economic growth – ingredients– Aggregate supply (Chapter 7 and 10)

– Aggregate demand (Chapter 8 and 9)

2

Goals of Macroeconomic Policy

• Macroeconomics policy– Growth policy (target: long-run growth)

• Make economy grow faster in long-run

– Stabilization policy (target: short-run business cycles)• Manage aggregate demand• Avoid high unemployment• Avoid high inflation

3

Goals of Macroeconomic Policy

• Achieving rapid growth while keeping Achieving rapid growth while keeping both unemployment and inflation lowboth unemployment and inflation low

1. The Goal of Economic Growth

• Economic growth– Increasing standard of living

• Roman Empire to Industrial Revolution– Little economic growth

• Per-capita income– Decreased

» Former Soviet Union» Poorest African countries

• U.S. standard of living – Increased – factor of 8 since 1900

5

Productivity Growth: From Little Acorns…

• Small differences in growth rates– Enormous difference – long run

• 109 years; 1870 – 1979– Compound annual growth

• U.S. – 2.3%• U.K. – 1.8%• Japan – 3%

6

Productivity Growth: From Little Acorns…

• Labor productivity– Amount of output

– One worker produces• In an hour (or a week, or a year) of labor

– Output = GDP• Labor productivity = GDP per hour of workGDP per hour of work

7

Productivity Growth

• Productivity growth– Almost everything in long run

• Rising productivity– Raising standard of living – long run

• Long periods of time– Small differences

• Rates of productivity growth• Compound over time

– Enormous difference to society’s prosperity8

Productivity Growth

• Productivity growth– Reduction of poverty

– Increases in leisure time

– Increases in country’s ability to finance• Education• Public health• Environmental improvement• Arts

9

Potential GDP & Production Function

• Potential GDP– Real GDP

– Economy would produce

– Labor & other resources - fully employed

• Labor force– Number of people

– Holding or seeking jobs

10

Potential GDP & Production Function

• Estimate potential GDP– Available inputs

• Produce output

– Available technology

• Production function– Volume of output produced

– Given inputs

– Given available technology

11

The economy’s production function

Figure 1

12

0 Labor input

(hours)

Rea

l GD

P

(a) Effect of better technology (b) Effect of more capital

L0

Y0

K

M

Y1

A

0 Labor input

(hours)

Rea

l GD

PL0

Y0

K0

K1

Y1

A

B

Potential GDP & Production Function

• Along production function: depends on labor input– Holding constant

• Capital• Technology

• Production function – shifts upward– Improved technology

– More capital

13

Growth Rate of Potential GDP

• Growth rate of potential GDP– Depends on

• Growth rate of labor forcelabor force• Growth rate of capital stockcapital stock• Rate of technical progresstechnical progress

• GDP = Hours of work ˣ Output per hour

= Hours of work ˣ Labor productivity

14

Growth Rate of Potential GDP

• Growth rate of potential GDP = = Growth rate of labor input +

+ Growth rate of labor productivity

• Capital is incorporated into labor productivity

• 1995-2007 actual GDP growth rate = 3.1%– Growth rate of labor input = 1%

– Growth rate of labor productivity = 2.1%15

Recent growth rates of real GDP in the united states

Table 1

16

YearsGrowth Rate

per Year

1995-19971997-19991999-20012001-20032003-20052005-20071995-2007

4.1%4.32.22.13.42.53.1

Actual vs Potential GDP

• Growth rates: Actual & Potential GDP– Over long periods of time

• Similar

– Over short periods of time• Diverge sharply• Cyclical fluctuations

Actual and potential GDP in United States since 1954

Figure 2

18

2. The Goal of Low Unemployment

• Unemployment rate– Number of unemployed people / labor

force

• If actual GDP grows slower than potential– Unemployment rate – rises

• If actual GDP grows faster than potential– Unemployment rate – falls

19

The economic costs of high unemployment

Table 2

20

Year

CivilianUnemployment

Rate

CapacityUtilization

Rate

Real GDP LostDue to IdleResources

195819611975198219922003

6.8%6.78.59.77.56.0

75%77.373.471.379.473.4

4.8%4.15.48.12.62.2

Human Costs of High Unemployment

• Unemployment rates– Lower

• Married men• Whites• Well-educated people

– Higher • Teenagers • Nonwhites • Blue-collar workers

21

Human Costs of High Unemployment

• Human costs of unemployment– Income loss

– Hunger, cold, ill health

– Psychological cost

– Unemployment insurance

– Social welfare programs

22

Unemployment rates for selected groups, 2007

Figure 3

23

Counting the UnemployedBLS Category:• Employed

– People currently working• Full time or part time

• Unemployed– People not currently working

• Temporarily laid-off, expected to return• Actively looking for a job (4 weeks)

• Not in labor force (discouraged workers)– Not looking for work

• When they quit, unemployment rate ↓ 24

Counting the Unemployed

• Hidden / disguised unemployment– Involuntary part-time

– Loss of overtime

– Shortened work hours

– Discouraged workers

– Not included in official unemployment statistics

25

Types of Unemployment

• FrictionalFrictional unemployment• Normal turnover in labor market• Temporarily between jobs

– Moving / changing occupations

• StructuralStructural unemployment • Displaced by automation• Skills - no longer in demand (US textile and

manufacturing industries)

• CyclicalCyclical unemployment• Decline in economy’s total production• Rises during recessions 26

Full Employment

• Full employment– Everyone willing & able to work can find a

job

– Only frictional and structural unemployment exist

– “Full Employment” = zero cyclical unemployment zero unemployment

– 4-6%

27

Unemployment Insurance

• Unemployment insurance– Government program

– Replaces some wages lost (average weekly benefit check is $288 in 2007)• Eligible workers who lose their jobs

• Benefits of UI– Cushion to unemployed, prop up

aggregate demand during recession

– “built-in stabilization”

28

Unemployment Insurance

• Payroll taxes & Unemployment benefits– Spread cost of unemployment

– Doesn’t eliminate basic economic cost

• Higher unemployment benefits– Disincentive to look for job

– Unemployment rate even higher

29

3. The Goal of Low Inflation

• Purchasing power– Of a given sum of money

– Volume of goods & services

• Real wage rate– Purchasing power of wages

– Wage rate – adjusted for inflation

– Nominal wage divided by price index

30

Rates of change of wages and prices in the United States since 1948

Figure 4

31

Inflation: Myth and Reality

• Myth: inflation erodes real wages

• Wage rate tends to rise with inflation, so realreal wage rate is not systematically eroded by inflation.

32

Reason for Nominal Wages to Increase

Amount

Higher productivityCompensation for higher prices

2%3%

Total 5%

Inflation: Myth and Reality

• Inflation– Increase in “average price”

• Relative price of item– In terms of price of other item

• Inflation– Not to blame

– Some goods become more expensive• Relative to others

33

Pure inflation

Table 3

34

Item Last Year’s Price This Year’s Price Increase

Candy barMovie ticketAutomobile

$0.506.00

9,000

$0.556.60

9,900

10%1010

Real-world inflation

Table 4

35

Item Last Year’s Price This Year’s Price Increase

Candy barMovie ticketAutomobile

$0.506.00

9,000

$0.507.50

9,450

0%255

Inflation: Redistribution of Income & Wealth

• Redistribution caused by inflation– Harm: lenders

– Gain: borrowers

– Inflation does not systematically steal from the rich to the poor, nor the reverse

36

Real vs. Nominal Interest Rates

• Expected inflation• Unexpected inflation• Real rate of interest

– Percentage increase in purchasing power• Borrower pays to lender• For borrowing

– Lenders• Increased ability - purchase goods & services

37

Real vs. Nominal Interest Rates

• Nominal rate of interest– Percentage

• Borrower – pays back• Exceeds money borrowed

– No adjustment for decline in purchasing power• From inflation

38

Real vs. Nominal Interest Rates

• Nominal interest rate =

Real interest rate + ExpectedExpected inflation rate• If inflation accurately predicted

– No income redistribution

– Expected rate of inflation = Actual rate of inflation

39

Real vs. Nominal Interest Rates• Example: John wants to borrow $1000

from Nancy. Both agreed real interest rate = 3%

• If both expect inflation = 6%, nominal interest rate = 9%

• If actual inflation is 2%, Nancy gains. Her real interest rate = 7%

• If actual inflation is 8%, John gains. He only pays real interest rate = 1%

Inflation Distorts Measurements • Confusing real and nominal interest rates

– Nominal 12% in 1980 (inflation 10%) vs. 6.5% in 2006 (inflation 2.5%)

• Malfunctioning tax system– Taxes on nominal interest and nominal

capital gain– During high inflation era, although capital

gain is positive, real capital gain might be negative

– Discourage saving and investment

• Real interest rate mattersReal interest rate matters 41

Other Costs of Inflation

• Rapidly changing prices– Riskier to enter long-term contracts

– Economic stagnation

– Shop around more, increases searching costs

42

Costs of Low vs. High Inflation

• Steady inflation– More predictable

• Than variable inflation

– Smaller social & economic costs

• Average level of inflation– Steady inflation at 6% per year

• More damaging than• Steady inflation at 3% per year

• Hyperinflation 43

Costs of Low vs. High Inflation

• Low inflation– Doesn’t necessarily lead to high inflation

• Inflation– Sometimes speeds up

– Sometimes slows down

• Runaway inflations– When government prints incredible

amounts of money• Finance wartime expenditure

44

Summary

• Dual task for macroeconomics – Growth policy on AS side

– Stabilization (demand-management) policy on AD side

• Economic growth = productivity growth• Unemployment rate: measurement and

three types• Cost of inflation

APPENDIX

How statisticians measure inflation• Index number

– Cost of market basket of goods• Relative to its cost in “base” period

46

100

year base in

basket market of Costyear given in

basket market of Cost

year given in CPI

APPENDIX

Index numbers for inflation• Index number problem

– Changing relative prices

– No “perfect price index”• Correct for every consumer

– Statistical index• Understate increase in cost of living

– Some families

• Overstate increase in cost of living– Other families

– Index - “average” family47

APPENDIX

Consumer price index• Consumer price index (CPI)

– Bureau of Labor Statistics (BLS)

– Monthly

– Representative• Typical urban household budget

– Same bundle of goods & services

48

Results of Student Expenditure Survey, 1983

Table 5

49

Item Average

PriceAverage Quantity

Purchased per Month Average Expenditure

per Month

HamburgerJeansMovie ticketTotal

$0.8024.005.00

7014

$562420

$100

Prices in 2007

Table 6

50

Item Price Increase over 1983

HamburgerJeansMovie ticketTotal

$1.2030.007.00

50%2540

Cost of 1983 student budget in 2007 prices

Table 7

51

70 Hamburgers at $1.201 pair of jeans at $304 movie tickets at $7Total

$843028

$142

APPENDIX

Using price index: ”deflate” monetary figures

• Deflating– Process - find real value

• Some monetary magnitude

– Divide by some appropriate price index

52

1002007 ofindex Price

2007 in spending Nominal

2007 in

spending Real

APPENDIX

Using a price index to measure inflation• Inflation

– Rate of increase in price level

– CPI2006 = 201.6

– CPI2007 = 207.3

– CPI2007 / CPI2006 = 207.3/201.6 = 1.028

– Inflation = 2.8%

53

APPENDIX

GDP deflator• GDP deflator

– Price index

– Used to deflate nominal GDP

– Broad measure of economy-wide inflation• Includes prices

– All goods & services in economy

54

100deflator GDP

GDP Nominal GDP Real