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 Full Production 2

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 3

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 4

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% 5

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 6

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 7

Productivity Growth Productivity growth –Reduction of poverty –Increases in leisure time –Increases in country’s ability to finance Education Public health Environmental improvement Arts 8

The economy’s production function Figure Labor input (hours) Real GDP (a) Effect of better technology(b) Effect of more capital L0L0 Y0Y0 K M Y1Y1 A 0 Labor input (hours) Real GDP L0L0 Y0Y0 K0K0 K1K1 Y1Y1 A B

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

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 11

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 12

Recent growth rates of real GDP in the United States Table 1 13 Years Growth Rate per Year %

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

The economic costs of high unemployment Table 2 15 Year Civilian Unemployment Rate Capacity Utilization Rate Real GDP Lost Due to Idle Resources % % %

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

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

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 18

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

Unemployment rates for selected groups, 2007 Figure 3 20

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 21

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 22

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 23

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

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

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

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

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 28 Reason for Wages to IncreaseAmount Higher productivity Compensation for higher prices 2% 3% Total5%

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

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 30

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 31

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 32

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 33

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 34

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 35

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 36

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 37

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

APPENDIX 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 39

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 Example calculation for CPI 40 Item Base Year Price Quantity Purchased Base year Spending Current Year Price Current Year Spending Oranges Haircuts Cloth $ lb yd. $ $210 $ $ $231

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

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