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The Goals of Macroeconomic Policy

Dr. Ashraf Samir

Website: ashraffeps.yolasite.com

Contents

Introduction

I) The Goal of Economic Growth

II) The Goal of Low Unemployment

III) The Goal of Low Inflation

V) Questions

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Introduction

Introduction

Objectives of macroeconomic policy:

1. Policy makers should create an environment in which the economy can

expand its productive capacity rapidly

That is the ultimate source of higher living standards

Growth Policy

Productive Capacity: the maximum possible output of an economy

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2. Policy makers should

manage aggregate demand so that it grows in line

with the economy’s capacity to produce

To avoid as much as possible the economic cycles

Stabilization Policy

Economic cycles : The fluctuation of the economy between periods

of expansion (growth) and contraction (recession)

achieving rapid but relatively smooth economic growth with low unemployment and low inflation.

the goals of macroeconomic policy can be summarized as:

Three main questions need an answer:

1How fast can/should—the

economy grow?

2

Why does a rise in unemployment cause such social distress?

3Why is inflation so Bad?

Inflation

Growth

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Summary

Growth

PolicyObjectives of Macroeconomic

Policy

Stabilization

Policy

Avoiding the economic

cyclesHigher living standards

Expanding productive

capacity

Three main

questions

How fast the economy grow?

Why is inflation so Bad?Why does unemployment cause

social distress?

I) The Goal of Economic Growth

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I) The Goal of Economic Growth

In the long run, it is the growth rate of factor productivity that

determines whether living standards will rise rapidly or slowly.

rising productivity raise standards of living

labor productivityDefinition 1

• The amount of output a typical worker turns out in an hour of work.

labor productivityRule 1

• labor productivity =GDP

The total number of hours of work

But, how fast our economy can/should grow?

The Capacity to Produce

In order to answer the previous question “How fast our

economy can/should grow?”, it is necessary to introduce the

Potential GDP and the Production Function.

Potential GDPDefinition 2

• It is the real gross domestic product (GDP) an economy could

produce if its labor force was fully employed.

• It is used to measure the economy’s capacity to produce goods

and services.

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Steps to estimate potential GDP:

Step 1we count up the available supplies of

labor, capital, and other productive resources.

Step 2Transforming inputs into outputs by

utilizing the available technology

The more technologically advanced an

economy, the more output will be

produced from any given bundle of

inputs

The Production Function

Production FunctionDefinition 3

• A mathematical or graphical depiction of the relationship

between inputs and outputs.

• It shows how GDP depends on labor input, holding both

capital and technology constant.

Output rises as Labor increases

GDPRule 2

GDP = Hours of work x Output per hour

= Hours of work x Labor productivity

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Graphically,

(b)

L0

Real

GD

P

Labor input

(hours)

K0

O

Y0

Y1

(a)

L0

Real

GD

P

Labor input (hours)

K

O

Y0

Y1

A

M

K1 B

A potential GDP

Technological advance: the production

function will shift upward (OM)

At L0, the same amount of labor input will now producemore output. potential GDP increases to Y1

At L0, the same amount of labor input will now producemore output. potential GDP increases to Y1

potential GDP

More Capital: the production function will

shift upward (OM)

Better Technology More Capital

If Labor increases, Output rises (moving outward along the curve)

The Growth Rate of Potential GDP

The growth rate of potential GDP depends on:

The growth rate of the labor force (migration and population)

The growth rate of the capital stock

The rate of technical progress

Growth rate of potential GDP Rule 3= Growth rate of labor input + Growth rate of labor productivity

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Do growth rates of potential GDP and actual GDP match up?

The growth rates of actual and potential GDP are

normally quite similar.

Over long periods of time,

The two often diverge sharply owing to cyclical

fluctuations.

Over short periods of time,

The Business Cycle

Summary

Factor

productivity The Economic GrowthThe economy’s

capacity

Potential GDP

The Production Function Labor productivity

two steps to estimate

potential GDP

counting up the available supplies

of factors of production

Transforming inputs into outputs

Growth rate of

potential GDP

✓ labor force

✓ capital stock

✓ technical progress

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II) The Goal of Low Unemployment

The Goal of Low Unemployment

When the economy grows more slowly than its potential, the

unemployment rate rises.

When GDP grows faster than the economy’s potential, this

leads to a falling unemployment rate.

High unemployment is socially wasteful.

The shortfall between potential and actual real GDP is called

“Real GDP Loss due to Idle Resources”

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Counting the Unemployed

Employed Unemployed Labor Force

The EmployedDefinition 4

• It includes everyone currently at work, including part-time

workers.

The UnemployedDefinition 5

It includes persons not currently working. It includes the following

cases:

➢Persons who are laid off from a job to which they expect to return.

➢Persons actively sought work during the previous four weeks

Note: The unemployment rate does not include discouraged

workers.

Unemployment rateDefinition 6

• the ratio of the number of unemployed people to the total

labor force.

• Unemployment rate = No.unemployed

labor force

Out of the Labor ForceDefinition 7

• If workers failed to look for a job, they are classified as out of

the labor force rather than unemployed. Such as discouraged

worker

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Discouraged Worker Definition 8

• An unemployed person who gives up looking for work and is

therefore no longer counted as part of the labor force.

Involuntary part-time work, loss of overtime or shortened

work hours, and discouraged workers are all examples of

“hidden” or “disguised” unemployment.

Full employment Definition 9

• A situation in which everyone who is willing and able to work

can find a job. At full employment, the measured unemployment

rate is still positive.

Types of Unemployment

Frictional Unemployment

Structural Unemployment

Cyclical Unemployment

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Frictional UnemploymentDefinition 10

• Unemployment that is due to normal turnover in the labor

market.

It includes people who are temporarily between jobs because

they are moving or changing occupations.

Structural UnemploymentDefinition 11

• Workers who have lost their jobs because they have been

displaced by automation, because their skills are no longer in

demand.

Cyclical UnemploymentDefinition 12

• The portion of unemployment that is attributable to a decline

in the economy’s total production.

Cyclical unemployment rises during recessions and falls as

prosperity is restored.

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Summary

Real GDP

growth <potential

GDP growth

The Low UnemploymentCounting the

Unemployed

Unemployed

Employed Cyclical

Unemployment

Frictional

Unemployment

Types of

Unemployment

Labor Force

Structural

Unemployment

labor turnover

Displacement by

automation

Economic

downturn

III) The Goal of Low Inflation

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The Goal of Low Inflation

High inflation makes everyone worse off. Why?

During inflationary times

people pay higher prices for the same quantities of goods and services they had before.

So more and more income is needed just to maintain the same standard of living

This implies a lower purchasing power.

Purchasing Power Definition 13

• The purchasing power of a given sum of money is the volume of

goods and services that it will buy.

Inflation and Real Wages

Workers as a group are not usually

victimized by inflation.

During a period of inflation

wages also rise

The real wage rate Definition 14

• The wage rate adjusted for inflation.

• It indicates the volume of goods and services that the nominal

wages will buy.

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Real wage Rule 4

Real wage = Nominal Wage

Price levelx100

Notes:

1) Real wage is an important economic variable since it shows

the purchasing power of wages.

2) Sometimes wages rise faster than prices, and sometimes prices

rise faster than wages.

When wages rise faster than prices→ this reflects the steady

advance of labor productivity

3) There is a strong association (correlation) between the rise in

prices and the rise in wages, but association doesn’t imply

causality.

The Importance of Relative Prices

Example “a rise in the general price level and a change in relative prices

Pure Inflation

Item Price (2000) Price (2017) Change

Candy bar 0.50 0.55 10%

Movie ticket 6.00 6.60 10%

Automobile 9,000 9,900 10%

Pure Inflation increased by 10% (10 percent general inflation, “average

price” rises by 10 percent), while relative prices remain unchanged.

Relative Price Definition 15

• An item’s relative price is its price in terms of some other item

rather than in terms of dollars.

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Inflation as a Redistributor of Income and Wealth

Some people gain from inflation and others lose.

What is the effect of the rise in the price level on income groups?

Lenders • are often victimized by inflation

Borrowers • are often gain from inflation

Fixed income group (pensions or salary) • are often victimized by inflation

Business men(profits)

• are often gain by inflation

Workers(wages)

• may gain by inflation

Real Versus Nominal Interest Rates

Note:

Expected inflation is added to compensate the lender for the loss of

purchasing power that the lender expects to suffer as a result of inflation.

The Nominal Interest Definition 16

• The percentage by which the money the borrower pays back

exceeds the money that was borrowed, making no adjustment

for any decline in the purchasing power of this money that

results from inflation.

The Nominal Interest Rule 5

• Nominal interest rate = Real interest rate + Expected inflation

rate

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The Real Interest Definition 17

• The percentage increase in purchasing power that the

borrower pays to the lender for the privilege of borrowing. It

indicates the increased ability to purchase goods and services

that the lender earns.

The Real Interest Rule 6

• Real interest rate = Nominal interest rate - Expected inflation

rate

Other Costs of Inflation

• The uncertainty created by inflation may inhibit long-termcontracts.

• Inflation may impose real costs on buyers, whose level of information about relative prices deteriorates.

The Costs of Low versus High Inflation

Inflation creates fewer social problems if

• It is low rather than high.

• It is steady (and therefore relatively predictable) rather than variable.

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Summary

lower

standard of

living- lower

purchasing

power

The Low InflationInflation and

Real Wages

Relative Price

The real wage rateWhen wages rise faster than prices

The Real Interest

Two

Cases

Interest rate

Nominal Interest ✓ Lenders

✓ Borrowers

✓ Fixed income group

✓ Business men

✓ Workers

When wages rise faster than prices

Two

types

Inflation as a

Redistributor of Income Five

groups

IV) How Statisticians Measure Inflation

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Index Numbers for Inflation

Nominal values can be deflated by the CPI in order to estimate real

changes.

The price index Definition 18

• A measure of the cost of a basket of goods in a current year,

relative to the cost of the same basket in a base year. E.g., The

Consumer Price Index (CPI) and GDP Deflator.

It shows the cost of living, since it measures of the overall cost

of the goods and services bought by a typical consumer.

When the CPI rises, the typical family has to spend more dollars

to maintain the same standard of living.

Note:

The CPI is defined to equal 100 for the reference base

period.

Consumer Price IndexRule 7

• CPI = Cost of basket in current period

Cost of basket in base period𝑥100

GDP DeflatorRule 8

• GDP deflator = Nominal GDP

Real GDPx100

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✓For a simple economy that consumes only oranges and haircuts, we can calculate the CPI.

✓The CPI-basket is 10 oranges and 5 haircuts.

✓The table shows the prices in the base and current period.

How could we Construct the CPI?

ItemQuantity

(1990)

Prices

(1990)

Quantity

(2000)

Prices

(2000)

Cost of CPI

basket

(P_1990)

Cost of CPI

basket

(P_2000)

Oranges 10 $1.00 12 $2.00 $10 $20

Haircuts 5 $8.00 7 $10.00 $40 $50

Cost of CPI basket $50 $70

✓ The cost of the CPI basket in the base period is $50 and in

current period is $70.

CPI = Cost of basket in current period

Cost of basket in base period𝑥100

The CPI is 40 percent higher in the current period than in

the base period.

CPI = ($70)($50)

𝑥100 = 140

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The inflation rate

The inflation rate Definition 19

• The percentage change in the price level from one year to the

next.

Inflation RateRule 9

• Inflation Rate = CPI year (2)− CPI year (1)

CPI year (1)x100

• We can use a price index to deflate monetary figures (i.e., obtaining the real values). This can be done by dividing the monetary figures by the price index.

How to Use a Price Index to “Deflate” Monetary Figures

Notes:

• GDP deflator is usually used to deflated nominal value of GDP.

• This is because the GDP deflator reflects the prices of all goods and services produced domestically. While, the consumer price index reflects the prices of all goods and services bought by consumers.

GDP DeflatorRule 10

• Real GDP = Nominal GDPGDP deflator

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V) Questions

True or False

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• False (Over long periods)

Q1) Over short periods of time, small differences in rates of productivity growth can make an enormous difference to a society’s prosperity, and hence a higher country’s ability to finance education, public health, environmental improvement, and the arts than its productivity growth rate.

• True

Q2) Either more capital or better technology will shift the production function upward and therefore raise potential GDP.

• True

Q3) The economy can produce more output with the sameamount of labor if workers have more capital to work with.

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• False (macroeconomic fluctuations)

Q4) Actual GDP growth can differ sharply from potential GDP growth over periods as long as several years. Such difference is called microeconomic fluctuations.

• False (GDP is less than potential GDP)

Q5) When the economy does not create enough jobs to employ everyone who is willing to work, a valuable resource is lost. Thus, Actual GDP is larger than potential GDP.

• False (the lower unemployment rate is)

Q6) The higher the number of discouraged workers is, the higher unemployment rate is.

•True

Q7) Wages normally rise rapidly when prices rise rapidly, and they rise slowly when prices rise slowly. But, this doesn’t imply that rising prices cause rising wages or that rising wages cause rising prices.

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• True

Q8) In case of a pure inflation in which every price rises by 10 percent during the year, so that relative prices may not change.

• True

Q9) Inflation does not always steal from the rich to aid the poor, nor does it always do the reverse.

Problem solving

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1) In the United States today, GDP is about $14 trillion and

total hours of work per year are about 250 billion.

✓What is labor productivity?

Ans.

labor productivity is 14 (𝑡𝑟𝑖𝑙𝑙𝑖𝑜𝑛)

250 (𝐵𝑖𝑙𝑙𝑖𝑜𝑛)= $56 (per hour).

2) In the United States in recent years, labor input has been

increasing at a rate of about 1 percent per year. But labor

productivity growth, which was very slow until the mid- 1990s,

has leaped upward since then—averaging about 2.8 percent per

annum from 1995 to 2008.

✓What is the estimated growth rate of potential GDP?

Ans.

The estimated growth rate of potential GDP= Growth rate of

labor input + Growth rate of labor productivity

= 1%+2.8%= 3.8%.

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3) Between 1998 and 2007, the average hourly wage in the United States rose from $13.01 to $17.41, an increase of 34 percent over nine years. Sounds pretty good for American workers. But over those same nine years, the Consumer Price Index (CPI), the most commonly used index of the price level, rose by 27 percent, from 163.0 to 207.3.

✓What were real wages in years 1998 and 2007?

✓What was the rate of change in real wage in 2007 compared with 1998?

Ans.

Real wage in 1998 = 13.01163

𝑥100= $7.98

Real wage in 2007 = 17.41207.3

𝑥100= $8.40