6 6 The Goals of Macroeconomic Policy When men are employed, they are best contented. BENJAMIN...

6

The Goals of

Macroeconomic Policy

When men are employed, they are best contented.BENJAMIN FRANKLIN

Inflation is repudiation.CALVIN COOLIDGE

Part 1: The Goal of Economic Growth

●Is faster growth always better for an economy?

Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

The Capacity to Produce: Potential GDPThe Capacity to Produce: Potential GDP

● Potential GDP = the real GDP that the economy could produce if the labor force and other resources were fully employed

● Production Function = Mathematical depiction of the relationship between an economy’s inputs and outputs.

● Potential GDP = the real GDP that the economy could produce if the labor force and other resources were fully employed

● Production Function = Mathematical depiction of the relationship between an economy’s inputs and outputs.

FIGURE 1: The Economy’s Production Function

FIGURE 1: The Economy’s Production Function

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

(b)

L0 R

eal G

DP

Labor input

(hours)

K0

0

Y0

Y1

(a)

L0

Rea

l GD

P

Labor input (hours)

K

0

Y0

Y1

A

M

K1 B

A


The Capacity to Produce: Potential GDPThe Capacity to Produce: Potential GDP

● The growth rate of potential GDP depends on:♦ The growth rate of the labor force

♦ The growth rate of the nation’s capital stock

♦ The rate of technical progress

● The growth rate of potential GDP depends on:♦ The growth rate of the labor force

♦ The growth rate of the nation’s capital stock

♦ The rate of technical progress


The Growth Rate of Potential GDPThe Growth Rate of Potential GDP

Labor productivity♦ Labor productivity = total output/total hours

♦ This measures output per hour of work

●GDP can be expressed as:GDP = total hours * total output/total hours

= total hours * Labor productivity

Labor productivity♦ Labor productivity = total output/total hours

♦ This measures output per hour of work

●GDP can be expressed as:GDP = total hours * total output/total hours

= total hours * Labor productivity


The Growth Rate of Potential GDPThe Growth Rate of Potential GDP

● The equation above in growth rates is:Growth rate of potential GDP = Growth rate of labor

input + Growth rate of labor productivity

♦ In the data, labor increases by 1% and labor productivity increases by 2.8% over the last 10 years.

● The equation above in growth rates is:Growth rate of potential GDP = Growth rate of labor

input + Growth rate of labor productivity

♦ In the data, labor increases by 1% and labor productivity increases by 2.8% over the last 10 years.

TABLE 1: Recent Real GDP Growth in the U.S.

TABLE 1: Recent Real GDP Growth in the U.S.



Issue Revisited: Is Faster Growth Always Better?Issue Revisited: Is Faster Growth Always Better?

● Faster growth may lead to greater pollution, crowding, and waste.

● Greater consumption may not necessarily make people happier.

● Growth may drive people to work longer hours.

● Faster growth may generate higher inflation, in some cases.

● Faster growth may lead to greater pollution, crowding, and waste.

● Greater consumption may not necessarily make people happier.

● Growth may drive people to work longer hours.

● Faster growth may generate higher inflation, in some cases.


Issue Revisited: Is Faster Growth Always Better?Issue Revisited: Is Faster Growth Always Better?

● Generates money to combat past environmental problems and poverty (worldwide).

● Generates money to combat past environmental problems and poverty (worldwide).

Part 2: The Goal of Low Unemployment

●Is this a worry?


The Human Costs of High UnemploymentThe Human Costs of High Unemployment

● Unemployment rate = the number of unemployed people, expressed as a percentage of the labor force

● Unemployment entails a loss in output for the society as a whole, a loss that can never be recovered.♦ University of MN?

● Unemployment rate = the number of unemployed people, expressed as a percentage of the labor force

● Unemployment entails a loss in output for the society as a whole, a loss that can never be recovered.♦ University of MN?

TABLE 2: The Economic Costs of High Unemployment

TABLE 2: The Economic Costs of High Unemployment


FIGURE 2: Actual and Potential GDP in the United States

FIGURE 2: Actual and Potential GDP in the United States


1957 –1958Recession


1960sBoom



Actual GDP

Potential GDP

1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2004

10,000

2,500

3,000

3,500

4,000

4,500

5,000

5,500

6,000

6,500

7,000

8,000

9,000

Year

7,500

8,500

9,500

11,000

10,500

2,000

Billion

s o

f 2

00

0 D

ollars



● Unemployment is a serious personal problem for the unemployed.♦ Income forgone

♦ Psychological distress

● Unemployment is a serious personal problem for the unemployed.♦ Income forgone

♦ Psychological distress



● In good times and bad some groups suffer more than others from unemployment♦ Below average unemployment rates:

■Married men ■Well-educated workers

♦ Above average unemployment rates:■Teenagers ■Nonwhites■Blue-collar workers

● In good times and bad some groups suffer more than others from unemployment♦ Below average unemployment rates:

■Married men ■Well-educated workers

♦ Above average unemployment rates:■Teenagers ■Nonwhites■Blue-collar workers

FIGURE 3: Unemployment Rates for Selected Groups, 2004

FIGURE 3: Unemployment Rates for Selected Groups, 2004

0

5

10

15

20

25

30

35

40

Teenagers BlackMale

Teenagers

AdultsWho Did Not

Graduate fromHigh School

WomenWho

MaintainFamilies

MarriedMen

BlacksCollegeGraduates

2.7 3.1

8.5

17.0

10.48.0

31.7

Perc

ent


Counting the Unemployed: The Official StatisticsCounting the Unemployed: The Official Statistics

● The BLS estimates the labor force, the employed, and the unemployed.♦ These distinctions cannot deal very well with

the problems of discouraged workers and of “hidden” or “disguised” unemployment.

♦ Discouraged Worker: An unemployed person who gives up looking for work and is therefore no longer counted as part of the labor force.

● The BLS estimates the labor force, the employed, and the unemployed.♦ These distinctions cannot deal very well with

the problems of discouraged workers and of “hidden” or “disguised” unemployment.

♦ Discouraged Worker: An unemployed person who gives up looking for work and is therefore no longer counted as part of the labor force.


Types of UnemploymentTypes of Unemployment

● Frictional unemployment is the normal movement of workers from one job to another.

● Structural unemployment exists when workers’ characteristics do not fit with employers’ requirements.

● Cyclical unemployment occurs when the level of economic activity declines

● Frictional unemployment is the normal movement of workers from one job to another.

● Structural unemployment exists when workers’ characteristics do not fit with employers’ requirements.

● Cyclical unemployment occurs when the level of economic activity declines


How Much Unemployment is “Full Employment”?How Much Unemployment is “Full Employment”?

● It was once thought that 4% was a good target.

● Events from the early 1990s through 2002 have left economists uncertain of the full-employment unemployment rate.♦ Government reports estimate full employment

unemployment is slightly above 5 percent.

● It was once thought that 4% was a good target.

● Events from the early 1990s through 2002 have left economists uncertain of the full-employment unemployment rate.♦ Government reports estimate full employment

unemployment is slightly above 5 percent.


Unemployment Insurance: The Invaluable CushionUnemployment Insurance: The Invaluable Cushion

● Unemployment insurance cushions (but does not completely prevent) the monetary loss to some (but not all) unemployed people.

● Payroll taxes and unemployment benefits ♦ Spread the costs of unemployment over the

entire population

♦ Do not eliminate its basic economic cost

● Unemployment insurance cushions (but does not completely prevent) the monetary loss to some (but not all) unemployed people.

● Payroll taxes and unemployment benefits ♦ Spread the costs of unemployment over the

entire population

♦ Do not eliminate its basic economic cost

Part 3: The Goal of Low Inflation


Inflation: The Myth and the Reality Inflation: The Myth and the Reality

● The costs of inflation are less obvious than those of unemployment, yet people certainly fear it.

● Inflation and Real Wages: Inflation does not typically erode real wages, because increases in nominal wages compensate for the rising prices.

● The costs of inflation are less obvious than those of unemployment, yet people certainly fear it.

● Inflation and Real Wages: Inflation does not typically erode real wages, because increases in nominal wages compensate for the rising prices.

FIGURE 5: Rates of Change of Wages and Prices in the U.S.

FIGURE 5: Rates of Change of Wages and Prices in the U.S.


Prices

0

2

4

6

8

10

1

3

5

7

9

11

19501955

19601965

19701975

19801985

19901995

2000

Year

Wages

0

2

4

6

8

10

1

3

5

7

9

11


Amount

Higher productivity

Compensation for higher prices

Total

Reasons for Wages

to Increase

2%

3%

5%


Inflation: The Myth and the Reality Inflation: The Myth and the Reality

● The Importance of Relative Prices: Inflation is not usually to blame when some goods become more expensive relative to others.

● The Importance of Relative Prices: Inflation is not usually to blame when some goods become more expensive relative to others.

TABLE 3: Pure InflationTABLE 3: Pure Inflation


TABLE 4: Real-World InflationTABLE 4: Real-World Inflation



Inflation as a Redistributor of Income and WealthInflation as a Redistributor of Income and Wealth

● Because inflation does not proceed evenly, it redistributes income and wealth in arbitrary, unfair ways.

● It systematically discriminates against people on fixed incomes, and it may favor borrowers at the expense of lenders.

● Because inflation does not proceed evenly, it redistributes income and wealth in arbitrary, unfair ways.

● It systematically discriminates against people on fixed incomes, and it may favor borrowers at the expense of lenders.


Real versus Nominal Interest Rates Real versus Nominal Interest Rates

● Real rate of interest = percentage increase in purchasing power that the borrower pays the lender in exchange for the loan.

● Nominal rate of interest = Real interest rate + expected rate of inflation

● Real rate of interest = percentage increase in purchasing power that the borrower pays the lender in exchange for the loan.

● Nominal rate of interest = Real interest rate + expected rate of inflation


Real versus Nominal Interest Rates Real versus Nominal Interest Rates

● Inflation that is accurately anticipated need not redistribute wealth between borrowers and lenders.♦ The nominal interest rate will include an

adequate inflation premium, above the real interest rate.

● If the actual inflation rate turns out to be different from the expected rate unanticipated redistribution will occur.

● Inflation that is accurately anticipated need not redistribute wealth between borrowers and lenders.♦ The nominal interest rate will include an

adequate inflation premium, above the real interest rate.

● If the actual inflation rate turns out to be different from the expected rate unanticipated redistribution will occur.


Inflation Distorts MeasurementsInflation Distorts Measurements

● Confusing Real and Nominal Interest Rates♦ Hides true economic cost of borrowing money.

■Many Americans viewed the 12% mortgage interest rates that banks charged in 1980 as scandalously high while they saw the 6% mortgage rates of 2004 as a great bargain.

■In truth, however, the real interest rate in 2004 (about 4%) was well above the bargain-basement real rates in 1980 (about 2%).

● Confusing Real and Nominal Interest Rates♦ Hides true economic cost of borrowing money.

■Many Americans viewed the 12% mortgage interest rates that banks charged in 1980 as scandalously high while they saw the 6% mortgage rates of 2004 as a great bargain.

■In truth, however, the real interest rate in 2004 (about 4%) was well above the bargain-basement real rates in 1980 (about 2%).


Inflation Distorts MeasurementsInflation Distorts Measurements

● Many laws and regulations that were designed for an inflation-free economy malfunction when inflation is high.

● These costs of inflation are not purely redistributive.

● Society as a whole loses when mutually beneficial transactions are prohibited by dysfunctional legislation.

● Many laws and regulations that were designed for an inflation-free economy malfunction when inflation is high.

● These costs of inflation are not purely redistributive.

● Society as a whole loses when mutually beneficial transactions are prohibited by dysfunctional legislation.


Other Costs of InflationOther Costs of Inflation

● The uncertainty created by inflation may inhibit long-term contracts.

● Inflation may impose real costs on shoppers, whose level of information about relative prices deteriorates.

● The uncertainty created by inflation may inhibit long-term contracts.

● Inflation may impose real costs on shoppers, whose level of information about relative prices deteriorates.


The Costs of Low versus High InflationThe Costs of Low versus High Inflation

● Inflation creates fewer social problems if ♦ It is low rather than high.

♦ It is steady (and therefore relatively predictable) rather than variable.

● Inflation creates fewer social problems if ♦ It is low rather than high.

♦ It is steady (and therefore relatively predictable) rather than variable.


Low Does Not Necessarily Lead to High InflationLow Does Not Necessarily Lead to High Inflation

● Low inflation does not necessarily lead to high inflation♦ Creeping inflation sometimes accelerates, but it

sometimes decelerates.

♦ While creeping inflations have many causes, galloping inflations have occurred only when the government has printed incredible amounts of money.

● Low inflation does not necessarily lead to high inflation♦ Creeping inflation sometimes accelerates, but it

sometimes decelerates.

♦ While creeping inflations have many causes, galloping inflations have occurred only when the government has printed incredible amounts of money.

Appendix: How Statisticians Measure

Inflation


● The price index is a measure of the cost of a basket of goods in a current year, relative to the cost of the same basket in a base year.

● There is no perfect price index.

● The price index is a measure of the cost of a basket of goods in a current year, relative to the cost of the same basket in a base year.

● There is no perfect price index.

Index Numbers for InflationIndex Numbers for Inflation

TABLE 5: Results of Student Expenditure Survey, 1983

TABLE 5: Results of Student Expenditure Survey, 1983



● The Consumer Price Index (CPI), often known as "the cost of living," is the most widely cited index.

● Nominal values can be deflated by the CPI in order to estimate real changes.

● The Consumer Price Index (CPI), often known as "the cost of living," is the most widely cited index.

● Nominal values can be deflated by the CPI in order to estimate real changes.

The Consumer Price IndexThe Consumer Price Index

TABLE 6: Prices in 2004TABLE 6: Prices in 2004



● The GDP deflator is somewhat different from the CPI, in that its basket includes all the components of GDP, not just consumer goods.♦ It is usually, although not always, very close to

the CPI.

● The GDP deflator is somewhat different from the CPI, in that its basket includes all the components of GDP, not just consumer goods.♦ It is usually, although not always, very close to

the CPI.

How to Use a Price Index to “Deflate” Monetary FiguresHow to Use a Price Index to “Deflate” Monetary Figures

TABLE 7: Cost of 1983 Student Budget in 2004 Prices

TABLE 7: Cost of 1983 Student Budget in 2004 Prices


6 6 The Goals of Macroeconomic Policy When men are employed, they are best contented. BENJAMIN...

Documents

Transcript of 6 6 The Goals of Macroeconomic Policy When men are employed, they are best contented. BENJAMIN...