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The Goals of
Macroeconomic Policy
When men are employed, they are best contented.
BENJAMIN FRANKLIN
Inflation is repudiation.
CALVIN COOLIDGE
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Goals of Macroeconomic Policy
• Economic growth – ingredients
– Aggregate supply
– Aggregate demand
• Inputs
– Labor, machinery, other resources
– Used to produce outputs
• Output
– Goods and services
– Produced in economy
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2
Goals of Macroeconomic Policy
• Macroeconomics policy
– Growth policy
• Make the economy grow faster in the long-
run
– Stabilization policy
• Manage aggregate demand
• Avoid high unemployment
• Avoid high inflation
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Productivity and Growth
• Small differences in growth rates
– Enormous difference in the long run
• 109 years; 1870 – 1979
– GDP per capita annual growth
• U.S. – 2.3%
• U.K. – 1.8%
• Japan – 3%
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4
Productivity and Growth
• Labor productivity
– Amount of output
– One worker produces
• In an hour (or a week, or a year) of labor
– If output is measured by GDP
• Labor productivity = GDP per hour of work
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Productivity Growth
• Productivity growth
– Almost everything in long run
• Rising productivity
– Raising standard of living – long run
• Long periods of time
– Small differences in rates of productivity
growth - compound over time
– Enormous difference to society’s
prosperity
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Productivity Growth
• Productivity growth
– Reduction of poverty
– Increases in leisure time
– Increases in country’s ability to finance
• Education
• Public health
• Environmental improvement
• Arts
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Potential GDP
• The capacity to produce: potential GDP
and the production function
• Potential GDP
– Real GDP the economy would produce
– If labor and other resources were fully
employed
• Labor force
– Number of people holding or seeking jobs
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Potential GDP
• Estimate potential GDP
– Count up the available supplies of labor,
capital, and other productive resources
• Estimate how much output these inputs could
produce if they were all fully utilized
– Transformation of inputs into outputs
• Assessment of the economy’s technology
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9
Potential GDP
• Production function
– Shows the volume of output that can be
produced
– From given inputs (such as labor and
capital)
– Given the available technology
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Potential GDP
• Along the production function
– Constant capital and technology
• Better technology or more capital
– Shift upward the production function
– Raise the potential GDP
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Figure 1
M
K
Y1
Real GDP
Real GDP
The Economy’s Production Function
B
K0
Y1
A
A
Y0
Y0
0
K1
L0
Labor input
(hours)
(a) Effect of better technology
0
L0
Labor input
(hours)
(b) Effect of more capital
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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
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13
Growth Rate of Potential GDP
• Growth rate of potential GDP =
= Growth rate of labor input +
+ Growth rate of labor productivity
• Growth rates: actual and potential GDP
– Over long periods of time: similar
– Over short periods of time
• Diverge sharply due to cyclical fluctuations
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Table 1
Recent Growth Rates of Real GDP in the United States
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The Goal of Low Unemployment
• Unemployment rate
– Number of unemployed people
– As percentage of labor force
• If GDP grows slower than the economy’s
potential
– Unemployment rate rises
• If GDP grows faster than the economy’s
potential
– Unemployment rate falls
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16
Table 2
The Economic Costs of High Unemployment
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17
Figure 2
Actual and Potential GDP in the United States since 1954
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The Goal of Low Unemployment
• Cumulative gap between actual and
potential GDP
– Over the three years 2008 to 2010
• Evaluated in 2005 prices
– Is roughly $2.3 trillion
– At 2010 levels, this loss in output as a
result of unemployment
• Over two months worth of production
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High Unemployment
• Human costs of high unemployment
– Income loss
– Hunger, cold, ill health
– Psychological cost
• Some help for the unemloyed
– System of unemployment insurance
– Social welfare programs
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High Unemployment
• Unemployment rates
– Lower for
• Married men
• Whites
• Well-educated people
– Higher for
• Teenagers
• Nonwhites
• Blue-collar workers
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21
Figure 3
Unemployment Rates for Selected Groups, 2009
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Counting the Unemployed
• Employed
– Everyone currently at work, including part
time workers
• Unemployed
– People not currently working
• Temporarily laid-off, expected to return
• Actively looking for a job (4 weeks)
• Out of the labor force
– Nor looking for work
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23
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
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Types of Unemployment
• Frictional unemployment
– Due to normal turnover in the labor market
– People who are temporarily between jobs
• Moving or changing occupations
• Unemployed for similar reasons
• Structural unemployment
– Workers displaced by automation
– Their skills are no longer in demand
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Types of Unemployment
• Cyclical unemployment
– Portion of unemployment that is
attributable to a decline in the economy’s
total production
– Rises during recessions
– Falls as prosperity is restored
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Full Employment
• Full employment
– Everyone who is willing and able to work
can find a job
– Unemployment rate is still positive
• Difficult to estimate
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27
Unemployment Insurance
• Unemployment insurance
– Government program
– Replaces some wages lost by eligible
workers who lose their jobs
– Helps prop up aggregate demand during
recessions
– Benefits the unemployed
• And the economy - greater spending
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Unemployment Insurance
• Payroll taxes and unemployment benefits
– Spreads the cost of unemployment over
the entire population
– Doesn’t eliminate the basic economic cost
• Higher unemployment benefits
– Disincentive to look for job
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The Goal of Low Inflation
• Purchasing power of a given sum of
money
– Volume of goods and services that it will
buy
• Real wage rate - purchasing power of
wages
– Wage rate – adjusted for inflation
– Nominal wage divided by price index
• Volume of goods and services that the
nominal wages will buy
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30
Figure 4
Rates of Change of Wages and Prices in the United States
since 1948
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31
Inflation: Myth and Reality
• Myth: inflation erodes real wages
– No inflation, and wages increase 2% per
year due to increased labor productivity
– Inflation 3%, and wages increase 5%
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32
Inflation: Myth and Reality
• Inflation
– Increase in “average price”
• Relative price of an item
– Its price in terms of some other item
• Inflation
– Not to blame when some goods become
more expensive relative to other goods
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33
Table 3
Pure Inflation
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34
Table 4
Real-World Inflation
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35
Inflation as Redistributor
• Inflation as a redistributor of income and
wealth
• Redistribution caused by inflation
– Harm: lenders
– Gain: borrowers
– Arbitrarily
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36
Real vs. Nominal Interest Rates
• Expected rate of inflation
– Anticipated inflation
• Unexpected inflation
• Real rate of interest
– Percentage increase in purchasing power
• That the borrower pays to the lender for the
privilege of borrowing
– Increased ability to purchase goods and
services that the lender earns
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37
Real vs. Nominal Interest Rates
• Nominal rate of interest
– Percentage by which the money the
borrower pays back
– Exceeds the money that was borrowed
– Making no adjustment for any decline in
the purchasing power of this money that
results from inflation
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38
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
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39
Inflation Distorts Measurements
• Capital gain
– Difference between the price at which an
asset is sold
– And the price at which it was bought
• Malfunctioning tax system
– Taxes on nominal interest
– Taxes on nominal capital gain
– High tax rates when inflation is high
• Discourage saving, lending, and investing
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40
Other Costs of Inflation
• Rapidly changing prices
– Riskier to enter long-term contracts
– Economic stagnation
– Shop around more
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41
Costs of Low vs. High Inflation
• Steady inflation
– More predictable than variable inflation
– Smaller social and economic costs
• Average level of inflation
– Steady inflation at 6% per year
• More damaging than steady inflation at 3%
per year
• Hyperinflation
– Very high inflation
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42
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
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43
How statisticians measure inflation
• Index numbers for inflation
• Index number
– Cost of a market basket of goods relative
to its cost in some “base” period
• Base year
– Year used as a basis of comparison
Cost of market basket
in given year
CPI in given year 
 100
Cost of market basket
in base year
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44
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 for some
families
• Overstate increase in cost of living for other
families
– Index - “average” family
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45
Consumer price index
• Consumer price index (CPI)
– Bureau of Labor Statistics (BLS)
– Monthly
– Representative typical urban household
budget
– Same bundle of goods and services
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46
Table 5
Results of Student Expenditure Survey, 1983
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47
Table 6
Prices in 2009
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48
Table 7
Cost of 1983 Student Budget in 2009 Prices
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Consumer price index
• Student price index (SPI)
Cost of budget in 2009
SPI=
 100
Cost of budget in 1983
$142
SPI=
 100  142
$100
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Using price index to ”deflate” monetary
figures
• Deflating
– Process of finding the real value of some
monetary magnitude
– By dividing by some appropriate price
index
Real spending Nominal spending in 2009

100
Price index of 2009
in 2009
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51
Using a price index to measure inflation
• Inflation
– Rate of increase in price level
– CPI2009 = 214.5
– CPI2010 = 218.1
– CPI2010 / CPI2009 = 218.1/214.5 = 1.017
– Inflation rate = 1.7%
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GDP deflator
• GDP deflator
– Price index used to deflate nominal GDP
– Broad measure of economy-wide inflation
• Includes the prices of all goods and services
in the economy
Nominal GDP
Real GDP 
 100
GDP deflator
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