Economics Assignment

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Economics: Principles and Policy

William J. Baumol, Alan S. Blinder, John L. Solow

14th edition

Powerpoint Slides prepared by: Philip Heap, James Madison University

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in part.

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Part 2

The Macroeconomy: Aggregate Supply and Demand

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Chapter 6

The Goals of Macroeconomic Policy

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An Opening Quote

When men are employed, they are best contented

Benjamin Franklin

Inflation is repudiation

Calvin Coolidge

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Introduction 1 of 2

• Two ingredients for economic growth

1. Aggregate supply

• Inputs - Labor, machinery, other resources used to produce outputs

• Output - Goods and services produced in economy

2. Aggregate demand

• The number of goods and services people and businesses want to buy

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Introduction 2 of 2

• Two tasks of macroeconomic policy

1. Growth policy

• Intended to make the economy grow faster in the long-run

2. Stabilization policy

• Manage aggregate demand to avoid high unemployment and high inflation

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The Goal of Economic Growth 1 of 3

• Economic growth over the very very long run

• For much of our existence, living standards barely changed

• Then took off around the start of the Industrial Revolution

• On an annual basis growth rates fairly small, 1-2%, but make a big difference over time

• From 1870-1979:

• U S growth: 2.3% per year

▶ 100 x (1 + 0.023)109 = 1,192.46

• U K growth: 1.8% per year

▶ 100 x (1 + 0.018)109 = 699.05

• Japan growth: 3% per year

▶ 100 x (1 + 0.03)109 = 2,507.06

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The Goal of Economic Growth 2 of 3

• A convenient “doubling rule”

• How long does it take for something to double in size?

• Rule of 70

• If something grows at rate g, it takes 70/g for it to double

• g = 5%, 14 years

• g = 2%, 35 years

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The Goal of Economic Growth 3 of 3

• Labor Productivity

• The amount of output a worker turns out in an hour (or a week, or a year) of labor.

• If output is measured by G D P, it is G D P per hour of work.

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Ideas for Beyond the Final Exam

• Productivity growth is almost everything in long run

• Only rising productivity, raises standard of living

• Over long periods of time, small differences in productivity growth rates make a big difference for a society’s prosperity

• It reduces poverty, increase leisure time, increases in country’s ability to finance education, public health, environmental improvement, arts . . .

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The Capacity to Produce: Potential G D P and the Production Function 1 of 3

• Potential G D P

• A measure of the economy’s normal capacity to produce goods and services

• Real GDP the economy would produce if labor and other resources were fully employed

• Labor force

• Number of people holding or seeking jobs

• Estimate potential G D P in two steps

1. Count up the available supplies of labor, capital, and other productive resources

2. Estimate how much output these inputs could produce if they were all fully utilized

• This transformation is an assessment of the economy’s technology

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The Capacity to Produce: Potential G D P and the Production Function 2 of 3

• Production function

• Shows the volume of output that can be produced from given inputs, given the available technology

• What happens to potential G D P if there is technological improvement or more capital?

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Figure 1: The Economy’s Production Function

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The Capacity to Produce: Potential G D P and the Production Function 3 of 3

• Production function

• Shows the volume of output that can be produced from given inputs, given the available technology

• What happens to potential GDP if there is technological improvement or more capital?

• Better technology or more capital increase potential GDP

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The Growth Rate of Potential G D P 1 of 2

• Growth rate of potential G D P depends on what three factors?

• Growth rate of labor force

• Growth rate of capital stock

• Rate of technical progress

• G D P = Hours of work x Output per hour

• = Hours of work x Labor productivity

• Growth rate of potential G D P = Growth rate of labor input + Growth rate of labor productivity

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The Growth Rate of Potential G D P 2 of 2

• What does the future growth rate look like?

• Growth of labor: 0.50%

• Why slower than in the past?

• Growth of labor productivity: 1.2 – 1.5%

• Growth rate of potential G D P: 1.70 – 2.0% per year

• Do growth rates of actual and potential G D P match up?

• Yes, over long periods of time

• No, over short periods of time due to cyclical fluctuations

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The Goal of Low Unemployment 1 of 2

• If G D P grows slower (faster) than the economy’s potential

• Unemployment rate rises (falls)

• Unemployment rate

• Number of unemployed people as a percentage of the labor force

• What is the economic cost of unemployment?

• Potential goods and services that might have been produced and enjoyed by consumers

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Table 1: The Economic Costs of High Unemployment

Year Civilian Unemployment

Rate

Capacity Utilization Rate

Real GDP Lost Due to Idle Resources

1958 6.8% 75.0% 4.8%

1961 6.7 77.3 4.1

1975 8.5 73.4 5.4

1982 9.7 71.3 8.1

1992 7.5 79.4 2.6

2003 6.0 73.4 2.2

2009 9.3 70.0 7.6

2010 9.6 74.3 6.5

2013 7.4 77.3 2.8

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Figure 2: Actual and Potential GDP in the U.S. since 1960

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The Goal of Low Unemployment 2 of 2

• Cumulative gap between actual and potential G D P

• From 2008 – 2016 (2012 prices) roughly $4 trillion

• Close to three months worth of production at 2017 levels

• This loss cannot be recovered since labor wasted in the past cannot be used in future

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The Human Costs of High Unemployment

• “In our society, it is murder, psychologically, to deprive a man of a job. . . . You are in substance saying to that man that he has no right to exist.” Martin Luther King, Jr.

• From abstract costs of unemployment to human costs

• Output that could have been produced if no unemployment

• Psychological and physical disorders, divorces, suicides, crime

• Unemployment rates different for different groups

• Lowest, highest for which groups?

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Figure 3: Unemployment Rates for Selected Groups

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Counting the Unemployed: Official Statistics 1 of 2

• B L S survey of 60,000 household classifies persons as:

• Employed

• Everyone currently at work, including part time workers (even 1 hr per week)

• Unemployed

• Temporarily laid-off, expected to return

• Actively looking for a job in last 4 weeks

• Out of the labor force

• Not looking for work

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Counting the Unemployed: Official Statistics 2 of 2

• Discouraged worker

• Unemployed person who gives up looking for work

• No longer counted as part of labor force

• Disguised unemployment

• Involuntary part-time

• Loss of overtime or shortened work hours

• Discouraged workers

• Does the official unemployment rate over or under estimate unemployment?

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Types of Unemployment 1 of 2

• Three types of unemployment:

1. Frictional

• Due to normal turnover in the labor market.

• Temporarily between jobs: changing occupations, moving etc.

• Tends to be short term

2. Structural

• Workers who lose jobs because skills are no longer in demand, replaced by automation

• Tends to be long term

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Types of Unemployment 2 of 2

• Three types of unemployment continued:

3. Cyclical

• Portion unemployment that is due to decline in the economy’s total production

• Rises during recessions; falls during expansions

• Why does it matter what type of unemployment?

• Policies to reduce are different

• Frictional and structural micro related

• Cyclical macro related

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How Much Employment is “Full Employment”

• Full employment

• Everyone who is willing and able to work can find a job

• Unemployment rate is still positive

• Always frictional and structural

• 2012 estimate: 5.2% - 6.0%

• 2018 estimate: 4.0% - 5.0%

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Unemployment Insurance: The Invaluable Cushion 1 of 2

• Unemployment insurance

• Program that replaces some wages lost by eligible workers who lose their jobs

• Administered by the states under federal guidelines

• Average weekly benefit in 2017 was $323, 36% earnings

• Normally last for 6 months

• Extended to 99 weeks during Great Recession

• Purpose of the program

• Limits the severity of recessions by providing additional purchasing power

• Aggregate demand does not fall as much

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Unemployment Insurance: The Invaluable Cushion 2 of 2

• Payroll taxes and unemployment benefits

• Spread the cost of unemployment over the entire population

• But basic economic cost of lost output still exists

• What is a problem with paying higher unemployment benefits?

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The Goal of Low Inflation 1 of 4

• Does the decrease of purchasing power make everyone worse off?

• Purchasing power of a given amount of money

• Volume of goods and services that it will buy

• Real wage rate

• Wage rate adjusted for inflation.

• The volume of goods and services that nominal wages will buy

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Figure 4: Rates of Change of Wages and Prices in the U.S. since 1948

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The Goal of Low Inflation 2 of 4

• Does the decrease of purchasing power make everyone worse off?

• In the long run real wages increase because

• new capital equipment and innovations increase workers’ productivity

• and remember, productivity growth is what matters

• But why do many people believe that inflation erodes real wages?

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Why do many people believe that inflation erodes real wages?

Reasons for Wage Increase Amount

Higher productivity 2%

Compensation for higher prices 3%

Total 5%

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The Goal of Low Inflation 3 of 4

• Another misperception. Failure to see the difference between:

• A rise in general price level

• An increase in relative prices

• An items price in terms of some other item

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Table 2: Pure Inflation

Item Last Year’s Price This Year’s Price Increase

Candy Bar $2.00 $2.20 10%

Movie Ticket 10.00 11.00 10

Automobiles 20,000 22,000 10

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Table 3: Real World Inflation

Item Last Year’s Price This Year’s Price Increase

Candy Bar $2.00 $2.00 0%

Movie Ticket 10.00 12.50 25

Automobiles 20,000 21,000 5

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The Goal of Low Inflation 4 of 4

• With pure inflation of 10%:

• 1 ticket = 5 candy bars, 1 car = 2,000 tickets

• With average inflation of 10%

• 1 ticket = 6.25 bars, 1 car = 1,680 tickets

• Who gains and who loses?

• Inflation is not usually to blame when some goods become more expensive relative to others

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Inflation as a Redistributor of Income and Wealth

• The average person is neither helped not harmed by inflation.

• What about senior citizens on fixed income?

• Inflation does cause redistribution

• Lenders lose since the dollars they receive back are worth less in real terms

• Borrowers gain since the dollars they pay back are worth less in real terms

• Inflation redistributes in an arbitrary way

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Real Versus Nominal Interest Rates 1 of 5

• Go back to lender/borrower argument. What have we missed?

• Expected inflation versus unexpected inflation

• Two interest rates:

• Real rate of interest

• Percentage increase in purchasing power that the borrower pays to the lender for the privilege of borrowing

• Indicates the increased ability to purchase goods and services that the lender earns

• The borrower needs to compensate the lender for giving up current consumption

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Real Versus Nominal Interest Rates 2 of 5

• Two interest rates continued:

• 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

• The borrower needs to compensate the lender for the loss in purchasing power

• Nominal interest rate = Real interest rate + Expected inflation rate

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Real Versus Nominal Interest Rates 3 of 5

• Nominal interest rate = Real interest rate + Expected inflation rate

• When does inflation cause a redistribution from borrower to lender? From lender to borrower?

• An example:

• Suppose Kim lends Matt $100 for one year

• To compensate her for giving up $100 for one year, she wants to be paid back 5% in real terms

• Matt and Kim expect an inflation rate of 3%

• Nominal interest rate = 5% + 3% = 8%

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Real Versus Nominal Interest Rates 4 of 5

• An example:

• Nominal interest rate = 5% + 3% = 8%

• Suppose at the end of the year:

• Inflation turns out to be higher than expected: 6% > 3%

▶ In real terms, Matt pays back 2% interest: 8% - 6%

▶ Matt gains and Kim loses

• Inflation turns out to be less than expected: 1% < 3%

▶ In real terms, Matt pays back 7%: 8% - 1%

▶ Kim gains and Matt loses

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Real Versus Nominal Interest Rates 5 of 5

• When does inflation cause a redistribution from borrower to lender? From lender to borrower?

• If the expected rate of inflation > actual rate of inflation

• Lenders lose and borrowers gain

• If the expected rate of inflation < actual rate of inflation

• Lenders gain and borrowers lose

• If the expected rate of inflation = actual rate of inflation

• Inflation creates no distortion

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Inflation Distorts Measurements

• Confusing real and nominal interest rates

• In 1980, mortgage rates were 12% with 10% inflation

• In 2016,mortgage rate were 3.5% with 1.5% inflation

• Which is a better bargain?

• Malfunctioning tax system

• Taxes paid on nominal interest earned and nominal capital gains

• Tax rates are high when inflation is high

• Discourages saving and investment, therefore, reducing economic growth

• Why do these laws remain on the books?

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Other Costs of Inflation

• Long term contracts become riskier

• Nominal rate = Real Rate + Expected Inflation

• If prices rapidly rising, more difficult to predict what the actual inflation rate will be

• Leads to less lending and borrowing

• Less investments and economic stagnation

• Shopping by consumers and firms

• If prices rising, need to shop around more

• “Shoe leather” costs

• Real costs so reduces efficiency in the economy

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The Costs of Low Versus High Inflation

• Steady inflation

• More predictable than variable inflation

• Smaller social and economic costs

• Average level of inflation

• Steady inflation of 6% per year, worse than steady inflation of 3% per year

• Hyperinflation

• Very high inflation

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Does Low Inflation Necessarily Lead to High Inflation?

• No

• Inflation sometimes speeds up, sometimes slows down, but no evidence that low leads to high

• When do we get runaway inflations?

• When government prints incredible amounts of money

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Appendix

How Statisticians Measure Inflation

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Index Numbers for Inflation

• Price index

• Expresses the cost of a market basket of goods relative to its cost in some “base” period

• Consumer Price Index or C P I

• CPI in given year = Cost of market basket in given year / Cost of market basket in base year x 100

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Index Numbers for Inflation 1 of 2

• Consumer Price Index

• Cost of market basket in base year (1982-1984) = $2,000

• Cost of market basket in 2017 = $4,900

• C P I in base year = 100 (always)

• C P I in 2017 = ($4,900 / $2,000) x 100 = 245

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Index Numbers for Inflation 2 of 2

• Index number problem

• No “perfect price index” that is correct for every consumer when relative prices change

• Any statistical index will either understate or overstate the increase in cost of living for other families

• Index - “average” family

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Consumer Price Index

• Consumer price index

• Measured by pricing the items on a list representative of a typical urban household

• Student Price Index or S P I

• Hamburgers, jeans and movies

• By how much has a student’s cost of living increased from 1987-2017?

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Table 4: Results of Student Expenditure Survey in 1987

Item Average Price Average Quantity Purchased per

Month

Average Expenditure per

Month

Hamburger $0.80 70 $56

Jeans 24.00 1 24

Movie Ticket 5.00 4 20

Total $100

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Table 5: Prices in 2017

Item Price Increase over 1987

Hamburger $1.20 50%

Jeans 30.00 25%

Movie Ticket 7.00 40%

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Table 6: Cost of 1987 Student Budget in 2017 Prices

Item Price

70 hamburgers at $1.20 $84.00

1 pair of jeans at $30 30.00

4 movie tickets at $7.00 28.00

Total $142.00

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Student Price Index

• By how much has a student’s cost of living increased from 1987-2017?

• Cost in 1987 was $100

• Cost in 2017 was $142

• In general:

• SPI = Cost of budget in 2017 / Cost of budget in 1987 x 100

• S P I in 2017 = $142/$100 x 100 = 142

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Using a Price Index to “Deflate” Monetary Figures

• Deflating

• Process of finding the real value of some monetary magnitude by dividing by some appropriate price index

• Suppose the average student spent $100 per month in 1987 but $140 per month in 2017

• Are students today, spending more or less in real terms?

• Real spending in 2017 = (Nominal spending in 2017 / Price Index of 2017) x 100

• Real spending in 2017 = ($140 / 142) x 100 = $98.59

• So in real terms students spend less today than in 1987

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Using a Price Index to Measure Inflation

• Inflation

• Rate of increase in price level

• C P I in 1973 = 44.4, C P I in 1974 = 49.3

• C P I in 1974 / C P I in 1973 = 49.3/44.4 = 1.11

• Inflation rate = 11%

• C P I in 2016 = 240, C P I in 2017 = 245.1

• C P I in 2017 / C P I 2016 = 245.1/240 = 1.021

• Inflation rate = 2.1%

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GDP Deflator

• The price index used to deflate nominal GDP

• Broad measure of economy-wide inflation

• Includes the prices of all goods and services in the economy

• In general:

• Real G D P = Nominal G D P/G D P Deflator x 100

• May be a better measure of inflation since much broader “basket” of goods