1. 22 The Goals of Macroeconomic Policy When men are employed, they are best contented. BENJAMIN FRANKLIN Inflation is repudiation. CALVIN COOLIDGE The Goals of Macroeconomic Policy When men are employed, they are best contented. BENJAMIN FRANKLIN Inflation is repudiation. CALVIN COOLIDGE

2. ●Part 1: The Goal of Economic Growth ♦Productivity Growth: From Little Acorns... ♦The Capacity to Produce: Potential GDP and the Production Function ♦The Growth Rate of Potential GDP ♦Alternative Measures of Economic Growth ♦What Determines the Growth Rate? ●Part 1: The Goal of Economic Growth ♦Productivity Growth: From Little Acorns... ♦The Capacity to Produce: Potential GDP and the Production Function ♦The Growth Rate of Potential GDP ♦Alternative Measures of Economic Growth ♦What Determines the Growth Rate? Contents Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

3. ●Part 2: The Costs of Unemployment ♦The Human Costs of High Unemployment ♦Counting the Unemployed: the Official Statistics ♦Types of Unemployment ♦How Much Employment is “Full Employment” ♦Unemployment Insurance: The Invaluable Cushion ●Part 2: The Costs of Unemployment ♦The Human Costs of High Unemployment ♦Counting the Unemployed: the Official Statistics ♦Types of Unemployment ♦How Much Employment is “Full Employment” ♦Unemployment Insurance: The Invaluable Cushion Contents (continued) Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

4. ●Part 3: The Costs of Inflation ♦Inflation: The Myth and the Reality ♦Inflation as a Redistribution of Income and Wealth ♦Real Versus Nominal Interest Rates ♦Inflation Distorts Measurements ♦Other Costs of Inflation ♦The Costs of Low Versus High Inflation ●Part 3: The Costs of Inflation ♦Inflation: The Myth and the Reality ♦Inflation as a Redistribution of Income and Wealth ♦Real Versus Nominal Interest Rates ♦Inflation Distorts Measurements ♦Other Costs of Inflation ♦The Costs of Low Versus High Inflation Contents (continued) Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

5. ♦Low Inflation does Not Necessarily Lead to High Inflation ●Appendix: How Statisticians Measure Inflation ♦Low Inflation does Not Necessarily Lead to High Inflation ●Appendix: How Statisticians Measure Inflation Contents (continued) Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

6. Part 1: The Goal of Economic Growth

7. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The 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.

8. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The 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

9. FIGURE 22-1 The Economy’s Production Function Copyright © 2003 South-Western/Thomson Learning. All rights reserved. (b) L 0 Real GDP Labor input (hours) K 0 0 Y 0 Y 1 (a) L 0 Real GDP Labor input (hours) K 0 Y 0 Y 1 A M K 1 B A

10. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Growth Rate of Potential GDP ●Labor productivity = the amount of output a worker turns out in an hour (or a week, or a year) of labor. ●Over long periods of time, the growth rates of actual and potential GDP are normally quite similar. ●But the two often diverge sharply over short periods. ●Labor productivity = the amount of output a worker turns out in an hour (or a week, or a year) of labor. ●Over long periods of time, the growth rates of actual and potential GDP are normally quite similar. ●But the two often diverge sharply over short periods.

11. TABLE 22-1 Recent Growth Rates of Real GDP in the U.S. Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

12. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Alternative Measures of Economic Growth ●Growth rate of Real GDP ●Growth rate of Real GDP per capita; ●Real GDP per capita = ratio of real GDP to population. ●Growth rate of Labor productivity ●Growth rate of Real GDP ●Growth rate of Real GDP per capita; ●Real GDP per capita = ratio of real GDP to population. ●Growth rate of Labor productivity

13. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Alternative Measures of Economic Growth ●These last two measures of economic progress differ only in their denominators: one divides GDP by population, the other by hours of work. ●The right measure to use depends on the purpose. ●These last two measures of economic progress differ only in their denominators: one divides GDP by population, the other by hours of work. ●The right measure to use depends on the purpose.

14. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ?Issue Revisited: Is Faster Growth Always Better? ●Faster growth may lead to greater pollution, crowding, and waste production. ●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 production. ●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.

15. Part 2: The Costs of Unemployment

16. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The 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. ●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.

17. TABLE 22-2 The Economic Costs of High Unemployment Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

18. FIGURE 22-2 Actual and Potential GDP in the United States Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 9,500 8,500 7,500 Year 9,000 8,000 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 199919951991198719831979197519711967196319591955 Billions of 1996 Dollars Potential GDP Actual GDP 1982–1983 Recession 1974–1975 Recession 1960s Boom 1960–1961 Recession 1957–1958 Recession

19. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Human Costs of High Unemployment ●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

20. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Human Costs of High Unemployment ●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

21. FIGURE 22-3 Unemployment Rates for Selected Groups, 2001 30.5 6.6 14.7 8.0 7.3 2.7 2.3 College Graduates BlacksMarried Men Women Who Maintain Families Adults Who Did Not Graduate from High School Black Male Teenagers Percent 40 35 30 25 20 15 10 5 0

22. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Counting 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.

23. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Types 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

24. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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. ●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.

25. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Unemployment 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

26. Part 3: The Costs of Inflation

27. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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.

28. FIGURE 22-4 Rates of Change of Wages and Prices in the U.S. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 13 14 Percentage Change in Wages –2 –1 11 9 7 5 3 1 12 10 8 6 4 2 0 Wages Year 2000 1995 1990 1985 1980 1975 1970 1965 1960 1955 1950 13 14 –2 –1 11 9 7 5 3 1 12 10 8 6 4 2 0 Prices Percentage Change in Prices

29. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Amount Higher productivity Compensation for higher prices Total Reasons for Wages to Increase 2% 3 5%

30. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Inflation: The Myth and the Reality ●The Illusion of Traditional “Fair” Prices: Inflation does not necessarily lead to unfair prices. ●The Importance of Relative Prices: Inflation is not usually to blame when some goods become more expensive relative to others. ●The Illusion of Traditional “Fair” Prices: Inflation does not necessarily lead to unfair prices. ●The Importance of Relative Prices: Inflation is not usually to blame when some goods become more expensive relative to others.

31. TABLE 22-3 Pure Inflation Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

32. TABLE 22-4 Real-World Inflation Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

33. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Inflation 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.

34. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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

35. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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.

36. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Inflation 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 7% mortgage rates of 1998 as a great bargain. ■In truth, however, the real interest rate in 1998 (about 5%) 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 7% mortgage rates of 1998 as a great bargain. ■In truth, however, the real interest rate in 1998 (about 5%) was well above the bargain-basement real rates in 1980 (about 2%).

37. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Inflation 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.

38. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Other 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.

39. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The 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.

40. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Low 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.

41. Appendix: How Statisticians Measure Inflation

42. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●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 Inflation

43. TABLE 22-5 Results of Student Expenditure Survey, 1983 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

44. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●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 Index

45. TABLE 22-6 Prices in 2001 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

46. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●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 Figures

47. TABLE 22-7 Cost of 1983 Student Budget in 2001 Prices Copyright © 2003 South-Western/Thomson Learning. All rights reserved.