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Chapter 6

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. Policy makers need to have goals in order to decide what to do: Full Employment Stable Prices

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Chapter 6

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  1. Chapter 6 The Goals of Macroeconomic Policy When men are employed, they are best contented. BENJAMIN FRANKLIN Inflation is repudiation. CALVIN COOLIDGE

  2. Goals of Macroeconomic Policy Policy makers need to have goals in order to decide what to do: Full Employment Stable Prices Full Production

  3. Goals of Macroeconomic Policy - Production • Macroeconomics policy • Growth policy (long run) • Sustainable growth • Stabilization policy (short run) • Manage aggregate demand • Avoid high unemployment • Avoid high inflation

  4. Potential GDP & Production Function Potential GDP Real GDP the economy would produce if labor and other resources were fully employed Depends on: growth rate of labor force growth rate of K stock technological progress

  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 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 prosperity

  8. 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. Figure 1 The economy’s production function K1 M Real GDP Real GDP B A A K K0 Y1 Y1 Y0 Y0 L0 L0 0 0 Labor input (hours) Labor input (hours) (a) Effect of better technology (b) Effect of more capital

  10. Potential GDP & Production Function Along production function Constant • Capital • Technology Production function – shifts upward Improved technology More capital

  11. 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

  12. 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

  13. Table 1 Recent growth rates of real GDP in the United States

  14. Figure 2 Actual and potential GDP in United States since 1954

  15. Table 2 The economic costs of high unemployment

  16. Human Costs of High Unemployment • Human costs of unemployment • Income loss • Hunger, cold, ill health • Psychological cost • Unemployment insurance • Social welfare programs

  17. 2. The Goal of Low Unemployment Bureau of Labor Statistics collects data : # unemployed = total noninstitutional population - not employed - employed

  18. 2. The Goal of Low Unemployment Unemployment rate = # unemployed labor force If GDP grows slower than potential • Unemployment rate – rises If GDP grows faster than potential • Unemployment rate – falls

  19. Human Costs of High Unemployment • Unemployment rates • Lower • Married men • Whites • Well-educated people • Higher • Teenagers • Nonwhites • Blue-collar workers

  20. Figure 3 Unemployment rates for selected groups, 2007

  21. 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

  22. 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

  23. Types of Unemployment Frictional unemployment unemployment due to the normal turnover in the labor market Structural unemployment unemployment affecting specific industries or groups of workers Cyclical unemployment unemployment due to generally poor business conditions

  24. Full Employment • Full employment • Everyone willing & able to work • Can find a job • Unemployment rate • Positive

  25. Unemployment Insurance • Unemployment insurance • Government program • Replaces some wages lost • Eligible workers who lose their jobs • Benefits • Unemployed • Economy • Greater spending

  26. Unemployment Insurance • Payroll taxes & Unemployment benefits • Spread cost of unemployment • Doesn’t eliminate basic economic cost • Higher unemployment benefits • Disincentive to look for job

  27. 3. The Goal of Low Inflation Inflation is a sustained increase in the overall price level purchasing power of our money falls

  28. Inflation: Myth and Reality • Myth: inflation erodes real wages wages typically rise faster than prices in general Real wage = nominal wage divided by a price index

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

  30. 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

  31. Inflation: Redistributor of Income & Wealth • Inflation redistributes wealth and income with no regard for the workings of free markets and governments • Redistribution caused by inflation • Harm: lenders • Gain: borrowers • Arbitrarily

  32. Real vs. Nominal Interest Rates • Expected inflation • Unexpected inflation • Real rate of interest percentage increase in purchasing power the borrower pays to lender for borrowing • Nominal rate of interest stated or actual interest rate

  33. Real vs. Nominal Interest Rates • 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

  34. Inflation Distorts Measurements • Confusing real and nominal interest rates • Malfunctioning tax system • Taxes on nominal interest • Taxes on nominal capital gain • Usury Laws • Capital gain – difference • Selling price of asset • Buying price of asset

  35. Other Costs of Inflation • High inflation, even correctly anticipated, is more destructive than low inflation • With rapidly changing prices • Riskier to enter long-term contracts • Economic stagnation • Shop around more

  36. 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

  37. 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

  38. How statisticians measure inflation • Index number • Cost of market basket of goods • Relative to its cost in “base” period

  39. Index numbers • Express the cost of a market basket of goods and services relative to its cost in a base year • Consumer Price Index • uses items purchased by “typical urban household” • Producer Price Index • uses goods and services producers purchase • GDP deflator • uses goods and services throughout economy

  40. Example calculation for CPI CPI = cost of market basket in current year X 100 cost of market basket in base year = 231 / 210 x 100 = 110 “what cost $100 in base year costs $110 in current year” Inflation rate = change in price index X 100 original price index = (110 – 100) ) x 100 = 10% 100

  41. Using price index: ”deflate” monetary figures • Deflating • Process - find real value • Some monetary magnitude • Divide by some appropriate price index

  42. GDP deflator • GDP deflator • Price index • Used to deflate nominal GDP • Broad measure of economy-wide inflation • Includes prices • All goods & services in economy

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