The Goals of Macroeconomic Policy

The Goals of Macroeconomic Policy Dr. Ashraf Samir Website: ashraffeps.yolasite.com Contents Introduction I) The Goal of Economic Growth II) The Goal of Low Unemployment III) The Goal of Low Inflation V) Questions 1

Introduction Introduction Objectives of macroeconomic policy: 1. Policy makers should create an environment in which the economy can expand its productive capacity rapidly That is the ultimate source of higher living standards Growth Policy Productive Capacity: the maximum possible output of an economy 2

2. Policy makers should manage aggregate demand so that it grows in line with the economy s capacity to produce To avoid as much as possible the economic cycles Stabilization Policy the goals of macroeconomic policy can be summarized as: achieving rapid but relatively smooth economic growth with low unemployment and low inflation. Economic cycles : The fluctuation of the economy between periods of expansion (growth) and contraction (recession) Three main questions need an answer: Growth 1 2 3 How fast can/should the economy grow? Why does a rise in unemployment cause such social distress? Why is inflation so Bad? Inflation 3

Avoiding the economic cycles Summary Expanding productive capacity Higher living standards Stabilization Policy Objectives of Macroeconomic Policy Growth Policy How fast the economy grow? Why is inflation so Bad? Three main questions Why does unemployment cause social distress? I) The Goal of Economic Growth 4

I) The Goal of Economic Growth In the long run, it is the growth rate of factor productivity that determines whether living standards will rise rapidly or slowly. rising productivity raise standards of living Definition 1 labor productivity The amount of output a typical worker turns out in an hour of work. Rule 1 labor productivity GDP labor productivity = The total number of hours of work But, how fast our economy can/should grow? The Capacity to Produce In order to answer the previous question How fast our economy can/should grow?, it is necessary to introduce the Potential GDP and the Production Function. Definition 2 Potential GDP It is the real gross domestic product (GDP) an economy could produce if its labor force was fully employed. It is used to measure the economy s capacity to produce goods and services. 5

Steps to estimate potential GDP: Step 1 Step 2 we count up the available supplies of labor, capital, and other productive resources. Transforming inputs into outputs by utilizing the available technology The more technologically advanced an economy, the more output will be produced from any given bundle of inputs The Production Function Definition 3 Production Function A mathematical or graphical depiction of the relationship between inputs and outputs. It shows how GDP depends on labor input, holding both capital and technology constant. Rule 2 GDP GDP = Hours of work x Output per hour = Hours of work x Labor productivity Output rises as Labor increases 6

Real GDP Real GDP 11/24/2018 Graphically, If Labor increases, Output rises (moving outward along the curve) Better Technology At L0, the same amount of labor input will now produce more output. potential GDP increases to Y1 M Y 1 More Capital At L0, the same amount of labor input will now produce more output. potential GDP increases to Y1 B K 1 Y 1 potential GDP Y 0 A K potential Y GDP 0 A K 0 O (a) Technological advance: the production function will shift upward (OM) L 0 Labor input (hours) O L 0 (b) Labor input (hours) More Capital: the production function will shift upward (OM) The Growth Rate of Potential GDP Rule 3 Growth rate of potential GDP = Growth rate of labor input + Growth rate of labor productivity The growth rate of potential GDP depends on: The growth rate of the labor force (migration and population) The growth rate of the capital stock The rate of technical progress 7

Do growth rates of potential GDP and actual GDP match up? Over long periods of time, The growth rates of actual and potential GDP are normally quite similar. Over short periods of time, The two often diverge sharply owing to cyclical fluctuations. The Business Cycle Summary two steps to estimate potential GDP counting up the available supplies of factors of production Transforming inputs into outputs Potential GDP The Production Function Growth rate of potential GDP labor force capital stock technical progress Labor productivity The economy s capacity The Economic Growth Factor productivity 8

II) The Goal of Low Unemployment The Goal of Low Unemployment High unemployment is socially wasteful. When the economy grows more slowly than its potential, the unemployment rate rises. When GDP grows faster than the economy s potential, this leads to a falling unemployment rate. The shortfall between potential and actual real GDP is called Real GDP Loss due to Idle Resources 9

Counting the Unemployed Employed Unemployed Labor Force Definition 4 The Employed It includes everyone currently at work, including part-time workers. Definition 5 The Unemployed It includes persons not currently working. It includes the following cases: Persons who are laid off from a job to which they expect to return. Persons actively sought work during the previous four weeks Note: The unemployment rate does not include discouraged workers. Definition 6 Unemployment rate the ratio of the number of unemployed people to the total labor force. Unemployment rate = No.unemployed labor force Definition 7 Out of the Labor Force If workers failed to look for a job, they are classified as out of the labor force rather than unemployed. Such as discouraged worker 10

Definition 8 Discouraged Worker An unemployed person who gives up looking for work and is therefore no longer counted as part of the labor force. Involuntary part-time work, loss of overtime or shortened work hours, and discouraged workers are all examples of hidden or disguised unemployment. Definition 9 Full employment A situation in which everyone who is willing and able to work can find a job. At full employment, the measured unemployment rate is still positive. Types of Unemployment Frictional Unemployment Structural Unemployment Cyclical Unemployment 11

Definition 10 Frictional Unemployment Unemployment that is due to normal turnover in the labor market. It includes people who are temporarily between jobs because they are moving or changing occupations. Definition 11 Structural Unemployment Workers who have lost their jobs because they have been displaced by automation, because their skills are no longer in demand. Definition 12 Cyclical Unemployment The portion of unemployment that is attributable to a decline in the economy s total production. Cyclical unemployment rises during recessions and falls as prosperity is restored. 12

Summary Labor Force Unemployed Types of Unemployment Frictional Unemployment Structural Unemployment labor turnover Displacement by automation Employed Cyclical Unemployment Economic downturn Counting the Unemployed The Low Unemployment Real GDP growth < potential GDP growth III) The Goal of Low Inflation 13

The Goal of Low Inflation High inflation makes everyone worse off. Why? During inflationary times people pay higher prices for the same quantities of goods and services they had before. So more and more income is needed just to maintain the same standard of living This implies a lower purchasing power. Definition 13 Purchasing Power The purchasing power of a given sum of money is the volume of goods and services that it will buy. Inflation and Real Wages During a period of inflation wages also rise Workers as a group are not usually victimized by inflation. Definition 14 The real wage rate The wage rate adjusted for inflation. It indicates the volume of goods and services that the nominal wages will buy. 14

Rule 4 Real wage Nominal Wage Real wage = x100 Price level Notes: 1) Real wage is an important economic variable since it shows the purchasing power of wages. 2) Sometimes wages rise faster than prices, and sometimes prices rise faster than wages. When wages rise faster than prices this reflects the steady advance of labor productivity 3) There is a strong association (correlation) between the rise in prices and the rise in wages, but association doesn t imply causality. The Importance of Relative Prices Definition 15 Relative Price An item s relative price is its price in terms of some other item rather than in terms of dollars. Example a rise in the general price level and a change in relative prices Pure Inflation Item Price (2000) Price (2017) Change Candy bar 0.50 0.55 10% Movie ticket 6.00 6.60 10% Automobile 9,000 9,900 10% Pure Inflation increased by 10% (10 percent general inflation, average price rises by 10 percent), while relative prices remain unchanged. 15

Inflation as a Redistributor of Income and Wealth Some people gain from inflation and others lose. What is the effect of the rise in the price level on income groups? Lenders Borrowers Fixed income group (pensions or salary) Business men (profits) Workers (wages) are often victimized by inflation are often gain from inflation are often victimized by inflation are often gain by inflation may gain by inflation Real Versus Nominal Interest Rates Definition 16 The Nominal Interest The 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. Rule 5 The Nominal Interest Nominal interest rate = Real interest rate + Expected inflation rate Note: Expected inflation is added to compensate the lender for the loss of purchasing power that the lender expects to suffer as a result of inflation. 16

Definition 17 The Real Interest The percentage increase in purchasing power that the borrower pays to the lender for the privilege of borrowing. It indicates the increased ability to purchase goods and services that the lender earns. Rule 6 The Real Interest Real interest rate = Nominal interest rate - Expected inflation rate Other Costs of Inflation The uncertainty created by inflation may inhibit long-term contracts. Inflation may impose real costs on buyers, whose level of information about relative prices deteriorates. 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. 17

Summary Interest rate Inflation as a Redistributor of Income Relative Price The real wage rate Two types Five groups Two Cases Nominal Interest The Real Interest Lenders Borrowers Fixed income group Business men Workers When wages rise faster than prices When wages rise faster than prices Inflation and Real Wages The Low Inflation lower standard of living- lower purchasing power IV) How Statisticians Measure Inflation 18

Definition 18 Index Numbers for Inflation The price index 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. E.g., The Consumer Price Index (CPI) and GDP Deflator. It shows the cost of living, since it measures of the overall cost of the goods and services bought by a typical consumer. When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. Nominal values can be deflated by the CPI in order to estimate real changes. Rule 7 Consumer Price Index Cost of basket in current period CPI = Cost of basket in base period x100 Note: The CPI is defined to equal 100 for the reference base period. Rule 8 GDP Deflator Nominal GDP GDP deflator = x100 Real GDP 19

For a simple economy that consumes only oranges and haircuts, we can calculate the CPI. The CPI-basket is 10 oranges and 5 haircuts. The table shows the prices in the base and current period. Item Quantity (1990) How could we Construct the CPI? Prices (1990) Quantity (2000) Prices (2000) Cost of CPI basket (P_1990) Cost of CPI basket (P_2000) Oranges 10 $1.00 12 $2.00 $10 $20 Haircuts 5 $8.00 7 $10.00 $40 $50 Cost of CPI basket $50 $70 The cost of the CPI basket in the base period is $50 and in current period is $70. CPI = Cost of basket in current period Cost of basket in base period x100 CPI = ($70) x100 = 140 ($50) The CPI is 40 percent higher in the current period than in the base period. 20

The inflation rate Definition 19 The inflation rate The percentage change in the price level from one year to the next. Rule 9 Inflation Rate CPI year (2) CPI year (1) Inflation Rate = x100 CPI year (1) How to Use a Price Index to Deflate Monetary Figures We can use a price index to deflate monetary figures (i.e., obtaining the real values). This can be done by dividing the monetary figures by the price index. Notes: GDP deflator is usually used to deflated nominal value of GDP. This is because the GDP deflator reflects the prices of all goods and services produced domestically. While, the consumer price index reflects the prices of all goods and services bought by consumers. Rule 10 GDP Deflator Nominal GDP Real GDP = GDP deflator 21

V) Questions True or False 22

Q1) Over short periods of time, small differences in rates of productivity growth can make an enormous difference to a society s prosperity, and hence a higher country s ability to finance education, public health, environmental improvement, and the arts than its productivity growth rate. False (Over long periods) Q2) Either more capital or better technology will shift the production function upward and therefore raise potential GDP. True Q3) The economy can produce more output with the same amount of labor if workers have more capital to work with. True 23

Q4) Actual GDP growth can differ sharply from potential GDP growth over periods as long as several years. Such difference is called microeconomic fluctuations. False (macroeconomic fluctuations) Q5) When the economy does not create enough jobs to employ everyone who is willing to work, a valuable resource is lost. Thus, Actual GDP is larger than potential GDP. False (GDP is less than potential GDP) Q6) The higher the number of discouraged workers is, the higher unemployment rate is. False (the lower unemployment rate is) Q7) Wages normally rise rapidly when prices rise rapidly, and they rise slowly when prices rise slowly. But, this doesn t imply that rising prices cause rising wages or that rising wages cause rising prices. True 24

Q8) In case of a pure inflation in which every price rises by 10 percent during the year, so that relative prices may not change. True Q9) Inflation does not always steal from the rich to aid the poor, nor does it always do the reverse. True Problem solving 25

1) In the United States today, GDP is about $14 trillion and total hours of work per year are about 250 billion. What is labor productivity? Ans. labor productivity is 14 (trillion) 250 (Billion) = $56 (per hour). 2) In the United States in recent years, labor input has been increasing at a rate of about 1 percent per year. But labor productivity growth, which was very slow until the mid- 1990s, has leaped upward since then averaging about 2.8 percent per annum from 1995 to 2008. What is the estimated growth rate of potential GDP? Ans. The estimated growth rate of potential GDP= Growth rate of labor input + Growth rate of labor productivity = 1%+2.8%= 3.8%. 26

3) Between 1998 and 2007, the average hourly wage in the United States rose from $13.01 to $17.41, an increase of 34 percent over nine years. Sounds pretty good for American workers. But over those same nine years, the Consumer Price Index (CPI), the most commonly used index of the price level, rose by 27 percent, from 163.0 to 207.3. What were real wages in years 1998 and 2007? What was the rate of change in real wage in 2007 compared with 1998? Ans. Real wage in 1998 = 13.01 x100= $7.98 163 Real wage in 2007 = 17.41 x100= $8.40 207.3 27