Goals of macroeconomic policy MacroEc notes

Chapter 6: Goals of macroeconomic policy
6.1 Goal of Economic Growth:
1- Let Y represent the real GDP, then the rate of growth of GDP from period 0 to 1 Will be:
r = (Y1-Y0)/ Y0 (To get the rate in percentages, r= [(Y1-Y0)/Y0] x 100)
2- We can always write Y = (Y/L) x
where Y represents the real GDP and L is labor input or labor use (hours of work).
Here, Y/L is called labor productivity. It represents the value generated by an average hour of labor use.
Therefore, above equation suggests that the GDP is the product of labor productivity and labor input or
labor use. The following table gives us the rate of growth of labor productivity (percent change from
previous quarter at annual rate) for the U.S. during the 2010-2020 period.
Year Qtr1 Qtr2 Qtr3 Qtr4 Annual
2010 2.0 1.0
2.2 1.4 3.4
2011 -2.8 0.8
-1.5 2.6 0.0
2012 1.5 1.9
-0.9 -1.4 0.9
2013 2.4 -1.4
1.9 3.1 0.5
2014 -3.9 4.2
3.9 -1.9 0.9
2015 3.7 1.5
1.1 -2.2 1.6
2016 0.9 -0.1
1.2 2.5 0.3
2017 1.0 -0.1
2.5 1.3 1.2
2018 2.3 1.1
0.5 0.8 1.4
2019 3.7 2.0
0.3 1.6 1.7
2020 -0.3 10.1(R)
R : revised
(Extracted: 9/28/2020, Source: BLS)
3- We can write equation 2 in terms of the rates of growth of the factors involved:
Rate of growth of real GDP = Rate of growth of labor productivity + rate of growth of L
4- Production function is an equation relating the total output to: Labor input (L), existing stock of
capital (K) and technology. We can have a graphical representation of production function, with L being
measured along the horizontal axis and Y (real output or GDP) along the vertical axis- assuming K and
technology remained constant. Changes in K or technology will shift (rotate) production function
upward (see Fig. 1, p.106 of the text) An upward shift (or rather rotation) of the production function
indicates that with higher K or (better technology) same hours of labor can produce more output.
5- Compounding of interest.
Relationship between present value and future value:
r= rate of growth per period
r= %2
100 + .02 x 100 =102
102 + .02 x 102
100 (1 + .02) = 102
102 (1 +.02)
100 (1+ .02) (1 + .02)
100 (1 + .02)2
In general, we have: FVn = PV (1 + r)n
6.2- Goal of low unemployment rate:
1- The percentage rate of unemployment is calculated as:
[number of officially unemployed/ labor force]x 100
To calculate the size of the labor force, we start from population size. The first adjustment that needs to
be made is to subtract the number of individuals who are either too young or too old to work from the
size of population. This gives us the size of the “working age population”.
Next, we need to subtract from the working-age population, the number of individuals who are not
working because they are attending school, are hospitalized, or are incarcerated- the “institutionalized
population”. The result is the size of the labor force.
The labor Department (DoL) defines “unemployed” as someone who: a- is not working, and b- who has
been actively seeking employment. Individuals who have given up looking for work (the “discouraged
workers”) are classified as “not in labor force”. Therefore:
the labor force = employed + officially unemployed.
“Employed” category includes full-time as well as part time workers.
2- Types of unemployment: All data on unemployment are “seasonally-adjusted data”.
Therefore, there are three types of unemployment: Frictional, Structural, and Cyclical. Macroeconomic
policies primarily target the “cyclical” type of unemployment since frictional and structural
unemployment are not related to the state of the economy and even when the economy is doing quite
well, we still have some workers who are frictionally or structurally unemployed. In fact, “Full
Employment” is defined as a situation in which we have managed to eliminate cyclical unemploymentwhile structural and frictional unemployment are still present.
3- Unemployment Insurance Program. This program was introduced in the aftermath of the “Great
Depression”. The goal of the program is to prop up the aggregate demand. The idea is that workers,
while they are employed (and their employers) make contributions to the unemployment fund. If and
when a worker loses her job, the fund could be used to pay her monthly “unemployment benefits”
thereby cushioning the potential impact of loss of income on the aggregate demand. Obviously, the
ability of the Program to stabilize aggregate demand depends on, 1- the qualification ratio, and 2, the
replacement ratio. In recent years, roughly 1/3 of the unemployed have qualified to receive benefits.
The replacement ratio (the ratio of the average unemployment benefits received to the average
earning) is about 36%.
6.3 The goal of price stability:
1-Inflation is defined as a persistent increase in the average price level. Note that even during
recessions, some pries may rise. Therefore, the critical factor is the rise in the average price level. When
the average price level rises, the purchasing power of wages and salaries (and money balances- funds
kept in bank accounts for instance) falls. Therefore, in the absence of any concurrent rise in wages and
salaries, inflation would result in a decline in the purchasing power (or real value) of wages and salaries.
Note also that wages and salaries themselves are prices (price of labor,) and will tend to rise during the
inflationary periods. therefore, for a typical wage earner, the ultimate impact of inflation on the
person’s real wage will depend on the rate of increase in the person’s wages vs. the inflation rate. If an
individual’s salary increases at a faster rate than the inflation rate, then that person’s real wage is not
adversely affected by inflation.
2- The broadest measure of inflation is the GDP Deflator: The deflator measures the inflation rate for the
items used by the consumers (consumption goods) as well as the rate of increase in the prices of labor,
raw materials, machineries and equipment- in other words, the inflation rate for all goods and services
If we are interested in measuring the impact of inflation on consumers, then the GDP deflator is not the
proper measure of inflation. The CPI (consumer Price Index) which measures the inflation rate for
consumption items will be the appropriate measure of inflation for such cases.
Finally, If we are interested in measuring the rate of increase in the prices of raw materials, energy,
labor, and capital (items used by firms in their production processes), then we should concentrate on
the input prices instead. The PPI (producers’ price index) is the relevant measure of inflation for such
items. Given the fact that producers will ultimately try to transfer the burden of such inflation onto
consumers, PPI is considered to be a forward-looking indicator of the future values of the CPI. As we are
going to see, the methodology used in calculation of the Deflator, the CPI, and the PPI is the same. The
BLS (Bureau of Labor Statistics) is the government agency that is responsible for calculation of all three
indexes. The BLS conducts large-scale sample surveys (throughout the country) to calculate and publish
monthly estimates of the inflation rate.
3- In the case of CPI, the BLS first needs to identify the basket of goods and services that an average
household buys during a specific time period (a month or a year). The problem is that the consumption
habits change over time. Consumers may stop buying an item completely or reduce the weight of the
item in their consumption expenditures; they may start buying new items that were not previously
included in their consumption baskets. Therefore, every few years, the BLS conducts large-scale surveys
intended to identify the composition of the representative “basket of goods and services” consumed by
a typical household. Once the composition of the representative basket (which items and how many
units of each item) is determined, the BLS then buys the same basket in different markets (large
metropolitan areas as well as medium-sized towns and rural areas) and calculates the average cost of
the basket for the country as a whole. The average cost of the consumption basket in the base year is
then used as a base-line factor for measuring the inflation rate in the subsequent (target)periods.
CPIfor the target period= [Cost of the basket in the target period/cost of the basket in the base period] x100
[The same methodology is used in the calculation of the GDP deflator and the PPI]
4- Inflation does not affect the standard of living of everyone uniformly. Obviously if an individual or a
social group is on fixed income (for instance, the bondholders or retirees with fixed income), inflation
would clearly victimize such a person or social group. [Social Security benefits have COLA (cost of living
adjustment) feature.]
Inflation (if it is not is not fully anticipated) will victimize the lenders and benefit the borrowers (best
example would be the S &L institutions in the 1980s and early 90s.) But once inflation is fully
anticipated, the transfer of wealth from lenders to borrowers will end: The nominal (contract) rate of
interest on loans will adjust to reflect the real rate of interest and the expected inflation rate(the “Fisher
Occasionally, the existing laws result in a group to be victimized by inflation. The text, for instance,
refers to the existing tax laws that may victimize those who make capital gains: Suppose an individual
buys 1000 shares of IBM at $150 per share and sells them a year later at $155 per share. His capital
gains will be equal 1000 (155-150) = $5,000 But this is a nominal capital gain. Let’s assume that the
inflation rate during the same year was 4%. Then the real value of $155,000 received as a result of the
stock sale will be equal to (155,000/ 104) x100 = $149,038. In other words, this individual actually had a
real capital loss of $961. But since the IRS levies taxes on nominal capital gains, this individual will have
to pay taxes on the $5,000 nominal gains he made as well.
As a general rule, in order to measure the impact of inflation on a particular social group (or person), we
need to compare the rate of increase in the average salary of that social group (or person) with the rate
of inflation. If the inflation rate is higher than the rate of increase in the average salary of the social
group, then, and only then, can we credibly argue that that social group (or person) is adversely affected
by the inflation.