Understanding Macroeconomics: Measuring Economic Health

1. Chapter 11 – Introduction to Macroeconomics • This chapter starts our coverage of Macroeconomics, the study of how the economy works as a whole. • The chapter defines the key variables to measure the “health” of an economy, and briefly discusses how the variables are measured and interpreted.

2. Microeconomics Versus Macroeconomics • Microeconomics -- the “web of connections” of all the individual interdependent markets that make up an economy. • Macroeconomics – putting the microscope away and looking at the overall economy as its own entity, imperfections and all.

3. The Macro Goal Variables • Measures of Economy’s “Health” • Definitions and Realistic Goals (US, for the most part).

4. Goal #1 – Sufficient Production or Output • Measured by Real Gross Domestic Product (Real GDP). • Real GDP (Y) -- The total production or output of final goods and services over a period of time, expressed in constant prices of a base year.

5. Real Versus Nominal GDP • Nominal GDP (unadjusted GDP) -- Total production at current prices. • Real GDP (GDP adjusted for changes in prices) -- Total production at constant prices of a base year.

6. Why is Production or Output Important? • Real GDP – the sum total of production of final goods and services across all markets of the economy, it measures total production or output. • By definition, Real GDP identically measures total income to all the factors derived from production and sales.

7. Real GDP -- Realistic Goal • Realistic Goal for Real GDP -- to be as high as possible without accelerating inflation (overstimulated economy).

8. The Full Sustainable Level of Real GDP (Potential GDP) • The Full Sustainable Level of Real GDP(YF) – the maximum level of Real GDP the economy can produce without bringing on accelerating inflation or overstimulation.

9. Characterizing the Economy: Y versus YF Y < YF -- sluggish economy Y > YF -- economy with accelerating inflation Y = YF -- economy with constant inflation rate (desired state)

10. Characteristics of YF • Unobservable. • Has grown at 2.5% per year for the US historically since World War II. • Maybe for the US, it has grown 3% per year in most recent decade. • Growth rate is not the same for all countries (Europe, Canada is less).

11. Recession -- A Special Case • Recession -- The situation where the level of real GDP decreases, or exhibits negative growth, for at least two consecutive quarters. • Clearly, in a recession, Y < YF.

12. Goal Variable #2 -- Inflation • Measured by the Inflation Rate -- the growth or percentage change in the overall price level. • First, measure the price level (P): Consumer Price Index (CPI). • Inflation Rate = Percentage Change in P.

13. Why is Inflation a Problem? • Inflation erodes the purchasing power of money, causes distortions in decisions. -- Why hold money? -- Why lend money? • Inflation can erode people’s standard of living, put pressure on labor markets. -- Fixed incomes. -- Workers with insufficient raises.

14. Realistic Goal -- Inflation • Ideal Goal: Inflation Rate = 0%. • Realistic Goal (US): |Inflation Rate| < 3%.

15. The Consumer Price Index (CPI) • Key measure of the price level (P). • Computed based upon a Market Basket: comprehensive set of goods and services purchased by consumers. • Fixed Weight Index

16. Computing a CPI Example -- Compute the CPI for 2008 with 1992 as the base year. CPI2008 = (Cost of 1992 Market Basket Purchased in 2008) (Cost of Actual Consumer Purchases in 1992)

17. Computing The Inflation Rate (Given the CPI) • Example -- Compute the Inflation Rate for 2008, given that the CPI for 2007 and 2008 have been calculated. Inflation = CPI2008 – CPI2007 x 100% Rate2008 CPI2007

18. Biases in the CPI (as a Fixed Weight Index) • Entry Bias -- goods leaving and entering the market basket. • Quality Bias -- different quality of the same goods over time. • Outlet Bias -- retail vs outlet prices? • Commodity Substitution Bias -- changing quantities over time due to demand response to goods that have become relatively expensive.

19. The GDP Deflator • An alternative measure of the price level (P). • Market Basket: comprehensive set of goods and services purchased by all spenders in the economy (consumers, businesses, government, and foreigners on US exports and imports). • Chain Weighted Index – alleviates some of the biases of the CPI due to being a fixed weight index.

20. Converting Nominal GDP to Real GDP • Example -- find Real GDP2008 Real GDP2008 = Nominal GDP2008 P2008 • Real GDP for other years is computed the same way. • Real GDP Growth = Percentage Change in Real GDP.

21. Goal Variable #3 -- Unemployment Measured by the Unemployment Rate (u). u = (# of people unemployed) x 100% (labor force) Unemployed -- those people out of work and seeking work. Labor Force -- people employed + people unemployed

22. What the Unemployment Rate Does Not Measure • discouraged workers, those who drop out of the labor force • part-time versus full-time employment • compensation of those working • people with multiple jobs

23. Realistic Goal -- Unemployment Rate • Realistic Goal -- as low as possible without inflation accelerating (overstimulated economy). • Natural Rate of Unemployment (uN) -- The lowest unemployment rate the economy can achieve without accelerating inflation. • Realistic Goal: u = uN

24. Interpretation: u versus uN • u = uN Desired State of Economy • u > uN Sluggish Economy • u < uN Accelerating Inflation (Overstimulated Economy)

25. Types of Unemployment • Total Unemployment = Frictional + Structural + Demand-Deficient • Frictional Unemployment -- Unemployment due to time involved to matching unemployed and appropriate jobs.

26. Structural and Demand-Deficient Unemployment • Structural Unemployment -- Unemployment due to a mismatch of available workers and jobs. • Demand-Deficient Unemployment -- Unemployment due to a generally sluggish economy. There are not enough jobs for everyone who wants one.

27. The Natural Rate of Unemployment Revisited • Natural Rate of Unemployment (uN) -- The unemployment rate in which inflation has no tendency to accelerate or decelerate. • Another Interpretation -- uN is the unemployment rate with zero demand-deficient unemployment. • Economy at uN: “full employment”.

28. Where is uN for the US? • Historically, uN = 5.5% • Is uN now maybe 5%? • Most other countries: uN is higher than US measure.

29. Real GDP and the Unemployment Rate • u = uN Y = YF, (Desired State of Economy) • u > uN Y < YF, (Sluggish Economy) • u < uN Y > YF, (Accelerating Inflation)

30. Unemployment -- Not an Independent Problem • Real GDP Growth  Employment Growth  u • Real GDP and unemployment -- not independent problems. • Focus on getting one of them to the desired goal, and the other one will automatically follow (although not a perfect correlation).