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11/24/2018
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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
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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
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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
Economic cycles : The fluctuation of the economy between periods
of expansion (growth) and contraction (recession)
achieving rapid but relatively smooth economic growth with low unemployment and low inflation.
the goals of macroeconomic policy can be summarized as:
Three main questions need an answer:
1How fast can/should—the
economy grow?
2
Why does a rise in unemployment cause such social distress?
3Why is inflation so Bad?
Inflation
Growth
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Summary
Growth
PolicyObjectives of Macroeconomic
Policy
Stabilization
Policy
Avoiding the economic
cyclesHigher living standards
Expanding productive
capacity
Three main
questions
How fast the economy grow?
Why is inflation so Bad?Why does unemployment cause
social distress?
I) The Goal of Economic Growth
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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
labor productivityDefinition 1
• The amount of output a typical worker turns out in an hour of work.
labor productivityRule 1
• labor productivity =GDP
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.
Potential GDPDefinition 2
• 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.
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Steps to estimate potential GDP:
Step 1we count up the available supplies of
labor, capital, and other productive resources.
Step 2Transforming 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
Production FunctionDefinition 3
• 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.
Output rises as Labor increases
GDPRule 2
GDP = Hours of work x Output per hour
= Hours of work x Labor productivity
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Graphically,
(b)
L0
Real
GD
P
Labor input
(hours)
K0
O
Y0
Y1
(a)
L0
Real
GD
P
Labor input (hours)
K
O
Y0
Y1
A
M
K1 B
A potential GDP
Technological advance: the production
function will shift upward (OM)
At L0, the same amount of labor input will now producemore output. potential GDP increases to Y1
At L0, the same amount of labor input will now producemore output. potential GDP increases to Y1
potential GDP
More Capital: the production function will
shift upward (OM)
Better Technology More Capital
If Labor increases, Output rises (moving outward along the curve)
The Growth Rate of Potential GDP
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
Growth rate of potential GDP Rule 3= Growth rate of labor input + Growth rate of labor productivity
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Do growth rates of potential GDP and actual GDP match up?
The growth rates of actual and potential GDP are
normally quite similar.
Over long periods of time,
The two often diverge sharply owing to cyclical
fluctuations.
Over short periods of time,
The Business Cycle
Summary
Factor
productivity The Economic GrowthThe economy’s
capacity
Potential GDP
The Production Function Labor productivity
two steps to estimate
potential GDP
counting up the available supplies
of factors of production
Transforming inputs into outputs
Growth rate of
potential GDP
✓ labor force
✓ capital stock
✓ technical progress
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II) The Goal of Low Unemployment
The Goal of Low Unemployment
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.
High unemployment is socially wasteful.
The shortfall between potential and actual real GDP is called
“Real GDP Loss due to Idle Resources”
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Counting the Unemployed
Employed Unemployed Labor Force
The EmployedDefinition 4
• It includes everyone currently at work, including part-time
workers.
The UnemployedDefinition 5
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.
Unemployment rateDefinition 6
• the ratio of the number of unemployed people to the total
labor force.
• Unemployment rate = No.unemployed
labor force
Out of the Labor ForceDefinition 7
• If workers failed to look for a job, they are classified as out of
the labor force rather than unemployed. Such as discouraged
worker
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Discouraged Worker Definition 8
• 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.
Full employment Definition 9
• 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
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Frictional UnemploymentDefinition 10
• 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.
Structural UnemploymentDefinition 11
• Workers who have lost their jobs because they have been
displaced by automation, because their skills are no longer in
demand.
Cyclical UnemploymentDefinition 12
• 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.
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Summary
Real GDP
growth <potential
GDP growth
The Low UnemploymentCounting the
Unemployed
Unemployed
Employed Cyclical
Unemployment
Frictional
Unemployment
Types of
Unemployment
Labor Force
Structural
Unemployment
labor turnover
Displacement by
automation
Economic
downturn
III) The Goal of Low Inflation
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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.
Purchasing Power Definition 13
• The purchasing power of a given sum of money is the volume of
goods and services that it will buy.
Inflation and Real Wages
Workers as a group are not usually
victimized by inflation.
During a period of inflation
wages also rise
The real wage rate Definition 14
• The wage rate adjusted for inflation.
• It indicates the volume of goods and services that the nominal
wages will buy.
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Real wage Rule 4
Real wage = Nominal Wage
Price levelx100
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
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.
Relative Price Definition 15
• An item’s relative price is its price in terms of some other item
rather than in terms of dollars.
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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 • are often victimized by inflation
Borrowers • are often gain from inflation
Fixed income group (pensions or salary) • are often victimized by inflation
Business men(profits)
• are often gain by inflation
Workers(wages)
• may gain by inflation
Real Versus Nominal Interest Rates
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.
The Nominal Interest Definition 16
• 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.
The Nominal Interest Rule 5
• Nominal interest rate = Real interest rate + Expected inflation
rate
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The Real Interest Definition 17
• 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.
The Real Interest Rule 6
• Real interest rate = Nominal interest rate - Expected inflation
rate
Other Costs of Inflation
• The uncertainty created by inflation may inhibit long-termcontracts.
• 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.
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Summary
lower
standard of
living- lower
purchasing
power
The Low InflationInflation and
Real Wages
Relative Price
The real wage rateWhen wages rise faster than prices
The Real Interest
Two
Cases
Interest rate
Nominal Interest ✓ Lenders
✓ Borrowers
✓ Fixed income group
✓ Business men
✓ Workers
When wages rise faster than prices
Two
types
Inflation as a
Redistributor of Income Five
groups
IV) How Statisticians Measure Inflation
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Index Numbers for Inflation
Nominal values can be deflated by the CPI in order to estimate real
changes.
The price index Definition 18
• 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.
Note:
The CPI is defined to equal 100 for the reference base
period.
Consumer Price IndexRule 7
• CPI = Cost of basket in current period
Cost of basket in base period𝑥100
GDP DeflatorRule 8
• GDP deflator = Nominal GDP
Real GDPx100
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✓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.
How could we Construct the CPI?
ItemQuantity
(1990)
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 period𝑥100
The CPI is 40 percent higher in the current period than in
the base period.
CPI = ($70)($50)
𝑥100 = 140
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The inflation rate
The inflation rate Definition 19
• The percentage change in the price level from one year to the
next.
Inflation RateRule 9
• Inflation Rate = CPI year (2)− CPI year (1)
CPI year (1)x100
• 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.
How to Use a Price Index to “Deflate” Monetary Figures
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.
GDP DeflatorRule 10
• Real GDP = Nominal GDPGDP deflator
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V) Questions
True or False
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• False (Over long periods)
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.
• True
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 sameamount of labor if workers have more capital to work with.
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• False (macroeconomic fluctuations)
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 (GDP is less than potential GDP)
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 (the lower unemployment rate is)
Q6) The higher the number of discouraged workers is, the higher unemployment rate is.
•True
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.
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• True
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.
Problem solving
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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%.
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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 = 13.01163
𝑥100= $7.98
Real wage in 2007 = 17.41207.3
𝑥100= $8.40
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