Chapter 2

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 Aggregate demand

Inputs
Labor, machinery, other resources Used to produce outputs

Output
Goods and services Produced in economy
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Goals of Macroeconomic Policy

Macroeconomics policy
Growth policy
Make economy grow faster in long-run

Stabilization policy
Manage aggregate demand Avoid high unemployment

Avoid high inflation

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
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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%

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 work

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 societys prosperity

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Productivity Growth
Productivity growth
Reduction of poverty Increases in leisure time Increases in countrys ability to finance
Education Public health

Environmental improvement
Arts

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

Potential GDP & Production Function

Estimate potential GDP
Available inputs
Produce output

Available technology

Production function
Volume of output Produced Given inputs Given available technology
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Figure 1
The economys production function
Real GDP Real GDP M K1

Y1 A Y0

B Y1 A Y0

K0

L0

Labor input (hours)

L0

Labor input (hours)

(a) Effect of better technology

(b) Effect of more capital

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Potential GDP & Production Function

Along production function
Constant
Capital Technology

Production function shifts upward

Improved technology More capital

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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 Output per hour = Hours of work Labor productivity

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Growth Rate of Potential GDP

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

Growth rates: Actual & Potential GDP

Over long periods of time
Similar

Over short periods of time

Diverge sharply Cyclical fluctuations
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Table 1
Recent growth rates of real GDP in the united states
Years
1995-1997 1997-1999 1999-2001 2001-2003 2003-2005 2005-2007 1995-2007 Growth Rate per Year 4.1% 4.3 2.2 2.1 3.4 2.5 3.1

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2. The Goal of Low Unemployment

Unemployment rate
Number of unemployed people As percentage of labor force

If GDP grows slower than potential

Unemployment rate rises

If GDP grows faster than potential

Unemployment rate falls

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Table 2
The economic costs of high unemployment
Civilian Unemployment Rate Capacity Utilization Rate Real GDP Lost Due to Idle Resources

Year

1958 1961 1975 1982 1992 2003

6.8% 6.7 8.5 9.7 7.5 6.0

75% 77.3 73.4 71.3 79.4 73.4

4.8% 4.1 5.4 8.1 2.6 2.2

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Figure 2
Actual and potential GDP in United States since 1954

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Human Costs of High Unemployment

Human costs of unemployment
Income loss Hunger, cold, ill health Psychological cost Unemployment insurance Social welfare programs

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Human Costs of High Unemployment

Unemployment rates
Lower
Married men Whites Well-educated people

Higher
Teenagers
Nonwhites Blue-collar workers
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Figure 3
Unemployment rates for selected groups, 2007

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Counting the Unemployed

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

Nor looking for work
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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
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Types of Unemployment
Frictional unemployment
Normal turnover in labor market Temporarily between jobs Moving / changing occupations

Structural unemployment
Displaced by automation Skills - no longer in demand

Cyclical unemployment
Decline in economys total production

Rises during recessions

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Full Employment
Full employment
Everyone willing & able to work
Can find a job

Unemployment rate
Positive

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Unemployment Insurance
Unemployment insurance
Government program Replaces some wages lost
Eligible workers who lose their jobs

Benefits
Unemployed Economy
Greater spending

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Unemployment Insurance
Payroll taxes & Unemployment benefits
Spread cost of unemployment Doesnt eliminate basic economic cost

Higher unemployment benefits

Disincentive to look for job

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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

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Inflation: Myth and Reality

Myth: inflation erodes real wages
Reason for Wages to Increase Higher productivity Compensation for higher prices Total Amount 2% 3% 5%

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Figure 4
Rates of change of wages and prices in the United States since 1948

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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

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Table 3
Pure inflation
Item Candy bar Movie ticket Automobile Last Years Price $0.50 6.00 9,000 This Years Price $0.55 6.60 9,900 Increase 10% 10 10

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Table 4
Real-world inflation
Item Candy bar Movie ticket Automobile Last Years Price $0.50 6.00 9,000 This Years Price $0.50 7.50 9,450 Increase 0% 25 5

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Inflation: Redistributor of Income & Wealth

Redistribution caused by inflation
Harm: lenders Gain: borrowers Arbitrarily

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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

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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

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Real vs. Nominal Interest Rates

Nominal interest rate =
= Real interest rate + + Expected inflation rate

If inflation accurately predicted

No income redistribution Expected rate of inflation = = Actual rate of inflation

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Inflation Distorts Measurements

Confusing real and nominal interest rates Malfunctioning tax system
Taxes on nominal interest Taxes on nominal capital gain

Capital gain difference

Selling price of asset Buying price of asset

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Other Costs of Inflation

Rapidly changing prices
Riskier to enter long-term contracts Economic stagnation Shop around more

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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
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Costs of Low vs. High Inflation

Low inflation
Doesnt necessarily lead to high inflation

Inflation
Sometimes speeds up Sometimes slows down

Runaway inflations
When government prints incredible amounts of money
Finance wartime expenditure
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APPENDIX

How statisticians measure inflation Index number

Cost of market basket of goods
Relative to its cost in base period

Cost of market basket in given year CPI in given year 100 Cost of market basket in base year

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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 family

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APPENDIX

Consumer price index Consumer price index (CPI)

Bureau of Labor Statistics (BLS) Monthly Representative
Typical urban household budget

Same bundle of goods & services

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Table 5
Results of Student Expenditure Survey, 1983
Item Hamburger Jeans Movie ticket Total

Average Price
$0.80 24.00 5.00

Average Quantity Purchased per Month

70 1 4

Average Expenditure per Month

$56 24 20 $100

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Table 6
Prices in 2007
Item
Hamburger Jeans Movie ticket Total

Price
$1.20 30.00 7.00

Increase over 1983

50% 25 40

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Table 7
Cost of 1983 student budget in 2007 prices

70 Hamburgers at $1.20 1 pair of jeans at $30 4 movie tickets at $7 Total

$84 30 28 $142

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APPENDIX

Using price index: deflate monetary figures

Real spending Nominal spending in 2007 100 Price index of 2007 in 2007

Deflating
Process - find real value
Some monetary magnitude

Divide by some appropriate price index

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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%

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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

Nominal GDP Real GDP 100 GDP deflator

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