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 Economic growth – ingredients –Aggregate supply (Chapter 7 and 10) –Aggregate demand (Chapter 8 and 9) 2

3. Goals of Macroeconomic Policy Macroeconomics policy –Growth policy (target: long-run growth) Make economy grow faster in long-run –Stabilization policy (target: short-run business cycles) Manage aggregate demand Avoid high unemployment Avoid high inflation 3

4. Goals of Macroeconomic Policy Achieving rapid growth while keeping both unemployment and inflation lowAchieving rapid growth while keeping both unemployment and inflation low

5. 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 5

6. 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

7. 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 GDP per hour of work Labor productivity = GDP per hour of work 7

8. 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

9. 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

10. 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 10

11. Potential GDP & Production Function Estimate potential GDP –Available inputs Produce output –Available technology Production function –Volume of output produced –Given inputs –Given available technology 11

12. The economy’s production function Figure 1 12 0 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

13. Potential GDP & Production Function Along production function: depends on labor input –Holding constant Capital Technology Production function – shifts upward –Improved technology –More capital 13

14. Growth Rate of Potential GDP Growth rate of potential GDP –Depends on labor force Growth rate of labor force capital stock Growth rate of capital stock technical progress Rate of technical progress GDP = Hours of work ˣ Output per hour = Hours of work ˣ Labor productivity 14

15. Growth Rate of Potential GDP Growth rate of potential GDP = = Growth rate of labor input + + Growth rate of labor productivity Capital is incorporated into labor productivity 1995-2007 actual GDP growth rate = 3.1% –Growth rate of labor input = 1% –Growth rate of labor productivity = 2.1% 15

16. Recent growth rates of real GDP in the united states Table 1 16 Years Growth Rate per Year 1995-1997 1997-1999 1999-2001 2001-2003 2003-2005 2005-2007 1995-2007 4.1% 4.3 2.2 2.1 3.4 2.5 3.1

17. Actual vs Potential GDP Growth rates: Actual & Potential GDP –Over long periods of time Similar –Over short periods of time Diverge sharply Cyclical fluctuations

18. Actual and potential GDP in United States since 1954 Figure 2 18

19. 2. The Goal of Low Unemployment Unemployment rate –Number of unemployed people / labor force If actual GDP grows slower than potential –Unemployment rate – rises If actual GDP grows faster than potential –Unemployment rate – falls 19

20. The economic costs of high unemployment Table 2 20 Year Civilian Unemployment Rate Capacity Utilization Rate Real GDP Lost Due to Idle Resources 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

21. Human Costs of High Unemployment Unemployment rates –Lower Married men Whites Well-educated people –Higher Teenagers Nonwhites Blue-collar workers 21

22. Human Costs of High Unemployment Human costs of unemployment –Income loss –Hunger, cold, ill health –Psychological cost –Unemployment insurance –Social welfare programs 22

23. Unemployment rates for selected groups, 2007 Figure 3 23

24. Counting the Unemployed BLS Category: 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 (discouraged workers) –Not looking for work When they quit, unemployment rate ↓ 24

25. Counting the Unemployed Hidden / disguised unemployment –Involuntary part-time –Loss of overtime –Shortened work hours –Discouraged workers –Not included in official unemployment statistics 25

26. Types of Unemployment FrictionalFrictional unemployment Normal turnover in labor market Temporarily between jobs –Moving / changing occupations StructuralStructural unemployment Displaced by automation Skills - no longer in demand (US textile and manufacturing industries) CyclicalCyclical unemployment Decline in economy’s total production Rises during recessions 26

27. Full Employment Full employment –Everyone willing & able to work can find a job –Only frictional and structural unemployment exist –“Full Employment” = zero cyclical unemployment  zero unemployment –4-6% 27

28. Unemployment Insurance Unemployment insurance –Government program –Replaces some wages lost (average weekly benefit check is $288 in 2007) Eligible workers who lose their jobs Benefits of UI –Cushion to unemployed, prop up aggregate demand during recession –“built-in stabilization” 28

29. Unemployment Insurance Payroll taxes & Unemployment benefits –Spread cost of unemployment –Doesn’t eliminate basic economic cost Higher unemployment benefits –Disincentive to look for job –Unemployment rate even higher 29

30. 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 30

31. Rates of change of wages and prices in the United States since 1948 Figure 4 31

32. Inflation: Myth and Reality Myth: inflation erodes real wages realWage rate tends to rise with inflation, so real wage rate is not systematically eroded by inflation. 32 Reason for Nominal Wages to Increase Amount Higher productivity Compensation for higher prices 2% 3% Total5%

33. 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 33

34. Pure inflation Table 3 34 ItemLast Year’s PriceThis Year’s PriceIncrease Candy bar Movie ticket Automobile $0.50 6.00 9,000 $0.55 6.60 9,900 10% 10

35. Real-world inflation Table 4 35 ItemLast Year’s PriceThis Year’s PriceIncrease Candy bar Movie ticket Automobile $0.50 6.00 9,000 $0.50 7.50 9,450 0% 25 5

36. Inflation: Redistribution of Income & Wealth Redistribution caused by inflation –Harm: lenders –Gain: borrowers –Inflation does not systematically steal from the rich to the poor, nor the reverse 36

37. 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 37

38. 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 38

39. Real vs. Nominal Interest Rates Nominal interest rate = Expected Real interest rate + Expected inflation rate If inflation accurately predicted –No income redistribution –Expected rate of inflation = Actual rate of inflation 39

40. Real vs. Nominal Interest Rates Example: John wants to borrow $1000 from Nancy. Both agreed real interest rate = 3% If both expect inflation = 6%, nominal interest rate = 9% If actual inflation is 2%, Nancy gains. Her real interest rate = 7% If actual inflation is 8%, John gains. He only pays real interest rate = 1%

41. Inflation Distorts Measurements Confusing real and nominal interest rates –Nominal 12% in 1980 (inflation 10%) vs. 6.5% in 2006 (inflation 2.5%) Malfunctioning tax system –Taxes on nominal interest and nominal capital gain –During high inflation era, although capital gain is positive, real capital gain might be negative –Discourage saving and investment Real interest rate mattersReal interest rate matters 41

42. Other Costs of Inflation Rapidly changing prices –Riskier to enter long-term contracts –Economic stagnation –Shop around more, increases searching costs 42

43. 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 43

44. 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 44

45. Summary Dual task for macroeconomics –Growth policy on AS side –Stabilization (demand-management) policy on AD side Economic growth = productivity growth Unemployment rate: measurement and three types Cost of inflation

46. APPENDIX How statisticians measure inflation Index number –Cost of market basket of goods Relative to its cost in “base” period 46

47. 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 47

48. APPENDIX Consumer price index Consumer price index (CPI) –Bureau of Labor Statistics (BLS) –Monthly –Representative Typical urban household budget –Same bundle of goods & services 48

49. Results of Student Expenditure Survey, 1983 Table 5 49 Item Average Price Average Quantity Purchased per Month Average Expenditure per Month Hamburger Jeans Movie ticket Total $0.80 24.00 5.00 70 1 4 $56 24 20 $100

50. Prices in 2007 Table 6 50 ItemPriceIncrease over 1983 Hamburger Jeans Movie ticket Total $1.20 30.00 7.00 50% 25 40

51. Cost of 1983 student budget in 2007 prices Table 7 51 70 Hamburgers at $1.20 1 pair of jeans at $30 4 movie tickets at $7 Total $84 30 28 $142

52. APPENDIX Using price index: ”deflate” monetary figures Deflating –Process - find real value Some monetary magnitude –Divide by some appropriate price index 52

53. APPENDIX Using a price index to measure inflation Inflation –Rate of increase in price level –CPI 2006 = 201.6 –CPI 2007 = 207.3 –CPI 2007 / CPI 2006 = 207.3/201.6 = 1.028 –Inflation = 2.8% 53

54. APPENDIX GDP deflator –Price index –Used to deflate nominal GDP –Broad measure of economy-wide inflation Includes prices –All goods & services in economy 54