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The Goals of

Macroeconomic PolicyWhen men are employed, they are best contented.

BENJAMIN FRANKLIN

Inflation is repudiation.CALVIN COOLIDGE

Goals of Macroeconomic Policy

• Economic growth – ingredients– Aggregate supply

– Aggregate demand

• Inputs– Labor, machinery, other resources

– Used to produce outputs

• Output – Goods and services

– Produced in economy2© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Goals of Macroeconomic Policy

• Macroeconomics policy– Growth policy

• Make the economy grow faster in the long-run

– Stabilization policy• Manage aggregate demand• Avoid high unemployment• Avoid high inflation

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Productivity and Growth

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

• 109 years; 1870 – 1979– GDP per capita annual growth

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


Productivity and Growth

• Labor productivity– Amount of output

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

– If output is measured by GDP• Labor productivity = GDP per hour of work


Productivity Growth

• Productivity growth– Almost everything in long run

• Rising productivity– Raising standard of living – long run

• Long periods of time– Small differences in rates of productivity

growth - compound over time

– Enormous difference to society’s prosperity


Productivity Growth

• Productivity growth– Reduction of poverty

– Increases in leisure time

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


Potential GDP

• The capacity to produce: potential GDP and the production function

• Potential GDP– Real GDP the economy would produce

– If labor and other resources were fully employed

• Labor force– Number of people holding or seeking jobs


Potential GDP

• Estimate potential GDP– Count up the available supplies of labor,

capital, and other productive resources• Estimate how much output these inputs could

produce if they were all fully utilized

– Transformation of inputs into outputs• Assessment of the economy’s technology


Potential GDP

• Production function– Shows the volume of output that can be

produced

– From given inputs (such as labor and capital)

– Given the available technology


Potential GDP

• Along the production function– Constant capital and technology

• Better technology or more capital– Shift upward the production function

– Raise the potential GDP


Figure 1The Economy’s Production Function

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)R

eal G

DP

L0

Y0

K0

K1

Y1

A

B

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Growth Rate of Potential GDP

• Growth rate of potential GDP– Depends on

• Growth rate of labor force• Growth rate of capital stock• Rate of technical progress

• GDP = Hours of work ˣ Output per hour

= Hours of work ˣ Labor productivity


Growth Rate of Potential GDP

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

+ Growth rate of labor productivity

• Growth rates: actual and potential GDP– Over long periods of time: similar

– Over short periods of time• Diverge sharply due to cyclical fluctuations


Table 1Recent Growth Rates of Real GDP in the United States


The Goal of Low Unemployment

• Unemployment rate– Number of unemployed people

– As percentage of labor force

• If GDP grows slower than the economy’s potential– Unemployment rate rises

• If GDP grows faster than the economy’s potential– Unemployment rate falls


Table 2The Economic Costs of High Unemployment


Figure 2Actual and Potential GDP in the United States since 1954


The Goal of Low Unemployment

• Cumulative gap between actual and potential GDP – Over the three years 2008 to 2010

• Evaluated in 2005 prices

– Is roughly $2.3 trillion

– At 2010 levels, this loss in output as a result of unemployment • Over two months worth of production


High Unemployment

• Human costs of high unemployment– Income loss

– Hunger, cold, ill health

– Psychological cost

• Some help for the unemloyed – System of unemployment insurance

– Social welfare programs


High Unemployment

• Unemployment rates– Lower for

• Married men• Whites• Well-educated people

– Higher for• Teenagers • Nonwhites • Blue-collar workers


Figure 3Unemployment Rates for Selected Groups, 2009


Counting the Unemployed

• Employed– Everyone currently at work, including part

time workers

• Unemployed– People not currently working

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

• Out of the labor force– Nor looking for work


Counting the Unemployed

• Discouraged worker– Unemployed person

– Gives up looking for work

– No longer counted as part of labor force

• Hidden / disguised unemployment– Involuntary part-time

– Loss of overtime

– Shortened work hours

– Discouraged workers 24© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Types of Unemployment

• Frictional unemployment– Due to normal turnover in the labor market

– People who are temporarily between jobs• Moving or changing occupations• Unemployed for similar reasons

• Structural unemployment – Workers displaced by automation

– Their skills are no longer in demand


Types of Unemployment

• Cyclical unemployment– Portion of unemployment that is

attributable to a decline in the economy’s total production

– Rises during recessions

– Falls as prosperity is restored


Full Employment

• Full employment– Everyone who is willing and able to work

can find a job

– Unemployment rate is still positive• Difficult to estimate


Unemployment Insurance

• Unemployment insurance– Government program

– Replaces some wages lost by eligible workers who lose their jobs

– Helps prop up aggregate demand during recessions

– Benefits the unemployed• And the economy - greater spending


Unemployment Insurance

• Payroll taxes and unemployment benefits– Spreads the cost of unemployment over

the entire population

– Doesn’t eliminate the basic economic cost

• Higher unemployment benefits– Disincentive to look for job


The Goal of Low Inflation

• Purchasing power of a given sum of money– Volume of goods and services that it will

buy

• Real wage rate - purchasing power of wages– Wage rate – adjusted for inflation

– Nominal wage divided by price index• Volume of goods and services that the

nominal wages will buy 30© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Figure 4Rates of Change of Wages and Prices in the United States since 1948


Inflation: Myth and Reality

• Myth: inflation erodes real wages– No inflation, and wages increase 2% per

year due to increased labor productivity

– Inflation 3%, and wages increase 5%


Inflation: Myth and Reality

• Inflation– Increase in “average price”

• Relative price of an item– Its price in terms of some other item

• Inflation– Not to blame when some goods become

more expensive relative to other goods


Table 3Pure Inflation


Table 4Real-World Inflation


Inflation as Redistributor

• Inflation as a redistributor of income and wealth

• Redistribution caused by inflation– Harm: lenders

– Gain: borrowers

– Arbitrarily


Real vs. Nominal Interest Rates

• Expected rate of inflation– Anticipated inflation

• Unexpected inflation• Real rate of interest

– Percentage increase in purchasing power• That the borrower pays to the lender for the

privilege of borrowing

– Increased ability to purchase goods and services that the lender earns



• Nominal rate of interest– 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



• Nominal interest rate =

= Real interest rate + Expected inflation rate

• If inflation is accurately predicted– No income redistribution

– Expected rate of inflation = Actual rate of inflation


Inflation Distorts Measurements

• Capital gain – Difference between the price at which an

asset is sold

– And the price at which it was bought

• Malfunctioning tax system– Taxes on nominal interest

– Taxes on nominal capital gain

– High tax rates when inflation is high• Discourage saving, lending, and investing


Other Costs of Inflation

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

– Economic stagnation

– Shop around more


Costs of Low vs. High Inflation

• Steady inflation– More predictable than variable inflation

– Smaller social and economic costs

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

• More damaging than steady inflation at 3% per year

• Hyperinflation – Very high inflation


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


Appendix How statisticians measure inflation

• Index numbers for inflation• Index number

– Cost of a market basket of goods relative to its cost in some “base” period

• Base year– Year used as a basis of comparison

44

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 for some

families• Overstate increase in cost of living for other

families

– Index - “average” family45© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Appendix Consumer price index

• Consumer price index (CPI)– Bureau of Labor Statistics (BLS)

– Monthly

– Representative typical urban household budget

– Same bundle of goods and services


Table 5Results of Student Expenditure Survey, 1983


Table 6Prices in 2009


Table 7Cost of 1983 Student Budget in 2009 Prices


Appendix Consumer price index

• Student price index (SPI)


100

100 142

Cost of budget in 2009SPI=

Cost of budget in 1983$142

SPI=$100

Appendix Using price index to ”deflate” monetary figures

• Deflating– Process of finding the real value of some

monetary magnitude

– By dividing by some appropriate price index

51

100Real spending Nominal spending in 2009

Price index of 2009 in 2009


Appendix Using a price index to measure inflation

• Inflation– Rate of increase in price level

– CPI2009 = 214.5

– CPI2010 = 218.1

– CPI2010 / CPI2009 = 218.1/214.5 = 1.017

– Inflation rate = 1.7%


Appendix GDP deflator

• GDP deflator– Price index used to deflate nominal GDP

– Broad measure of economy-wide inflation• Includes the prices of all goods and services

in the economy

53

100deflator GDP

GDP Nominal GDP Real
