Macroeconomic goals

Copyright © 2002 by Thomson Learning, Inc.

to accompanyto accompanyExploring EconomicsExploring Economics

33rdrd Edition Editionby Robert L. Sextonby Robert L. Sexton

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A Lecture PresentationA Lecture Presentation


Macroeconomic GoalsMacroeconomic Goals

Chapter 17Chapter 17


17.1 Macroeconomic Goals17.1 Macroeconomic Goals Three major macroeconomic goalsThree major macroeconomic goals

maintain employment of human maintain employment of human resources at relatively high levelsresources at relatively high levels

meaning that jobs are relatively plentiful and meaning that jobs are relatively plentiful and financial suffering from lack of work is financial suffering from lack of work is

relatively uncommonrelatively uncommon maintain relatively stable price level maintain relatively stable price level

so that consumers and producers can make so that consumers and producers can make better decisionsbetter decisions

achieve a high rate of economic growthachieve a high rate of economic growth with growth in real, per-capita total output with growth in real, per-capita total output

over timeover time


We use the term We use the term real gross real gross domestic product (RGDP)domestic product (RGDP) to to measure output or production.measure output or production.

The term The term realreal is used to indicate that is used to indicate that the output is adjusted for the general the output is adjusted for the general increase in prices over time.increase in prices over time.


Technically, Technically, gross domestic gross domestic product (GDP)product (GDP) is defined as the total is defined as the total value of all final goods and services value of all final goods and services produced in a given period, such as a produced in a given period, such as a year or a quarter.year or a quarter.


What Other Goals Are Important?What Other Goals Are Important?

Concern has been expressed at Concern has been expressed at various times and places about other various times and places about other economic issues:economic issues: the "quality of life" the "quality of life" reducing “bads” such as pollutionreducing “bads” such as pollution fairness in the distribution of income or fairness in the distribution of income or

wealthwealth becoming self‑sufficient in the production becoming self‑sufficient in the production

of certain goods or servicesof certain goods or services


How Do Value Judgments How Do Value Judgments Affect Economic Goals?Affect Economic Goals?

Individuals differ considerably in evaluating Individuals differ considerably in evaluating the issues, or whether certain "problems" the issues, or whether certain "problems" are really problems. are really problems. Economic growth is viewed positively by most Economic growth is viewed positively by most

people but negatively by some. people but negatively by some. Some think the income distribution is about Some think the income distribution is about

right; others think the poorer members of right; others think the poorer members of society have insufficient incomes. society have insufficient incomes.

Others think confiscation of the income of the Others think confiscation of the income of the relatively rich reduces incentives to income-relatively rich reduces incentives to income-producing activities.producing activities.


Acknowledging Our Goals: Acknowledging Our Goals: The Employment Act of 1946The Employment Act of 1946

Many economic problems are Many economic problems are pressing concerns for the U.S. pressing concerns for the U.S. government, particularly government, particularly unemploymentunemployment price instabilityprice instability economic stagnationeconomic stagnation


The concern over both unemployment The concern over both unemployment and price instability led to the passage and price instability led to the passage of the of the Employment Act of 1946Employment Act of 1946, in , in which the United States committed which the United States committed itself to policies designed to reduce itself to policies designed to reduce unemployment in a manner consistent unemployment in a manner consistent with price stability. The government with price stability. The government was holding itself responsible for short-was holding itself responsible for short-run economic fluctuations.run economic fluctuations.


17.2 Employment and 17.2 Employment and Unemployment Unemployment

Nearly everyone agrees that it is Nearly everyone agrees that it is unfortunate when a person who wants unfortunate when a person who wants a job cannot find one. a job cannot find one.

A loss of a job can mean financial A loss of a job can mean financial insecurity and a great deal of anxiety. insecurity and a great deal of anxiety.

High rates of unemployment in a High rates of unemployment in a society can lead to increased tensions society can lead to increased tensions and despair. and despair.


The Consequences Of High The Consequences Of High UnemploymentUnemployment

Society loses some potential output of Society loses some potential output of goods when some of its productive goods when some of its productive resources—human or non‑human— resources—human or non‑human— remain idle, and potential remain idle, and potential consumption is also reduced.consumption is also reduced.

Clearly, there is a loss in efficiency Clearly, there is a loss in efficiency when people are willing to work but when people are willing to work but productive equipment remains idle. productive equipment remains idle.


Hence, other things equal, relatively Hence, other things equal, relatively high rates of unemployment are high rates of unemployment are almost universally viewed as almost universally viewed as undesirable.undesirable.


What Is The Unemployment What Is The Unemployment Rate?Rate?

The unemployment rate is one The unemployment rate is one measure of labor market conditions. measure of labor market conditions.

The The unemployment rateunemployment rate is the is the number of people officially number of people officially unemployed divided by the labor unemployed divided by the labor force.force.


Official unemployment measures Official unemployment measures those over the age of 16 who are those over the age of 16 who are able for employment, but are unable able for employment, but are unable to obtain a job. to obtain a job.

The The labor forcelabor force is the number of is the number of people over the age of 16 who are people over the age of 16 who are either employed or unemployed. either employed or unemployed.


The civilian labor force figure excludes:The civilian labor force figure excludes: those in the armed servicesthose in the armed services prisonprison mental hospitalsmental hospitals as well homemakersas well homemakers retireesretirees full-time studentsfull-time studentsbecause they are not considered currently because they are not considered currently available for employment.available for employment.



The Worst Case Of U.S. The Worst Case Of U.S. UnemploymentUnemployment

By far the worst employment By far the worst employment downturn in U.S. history was the downturn in U.S. history was the Great Depression, which began in late Great Depression, which began in late 1929 and continued until 1941. 1929 and continued until 1941. Unemployment fell from only 3.2 percent Unemployment fell from only 3.2 percent

of the labor force in 1929 to more than of the labor force in 1929 to more than 20 percent in the early 1930s, and 20 percent in the early 1930s, and

double-digit unemployment persisted double-digit unemployment persisted through 1941.through 1941.


The debilitating impact of having The debilitating impact of having millions of productive persons out millions of productive persons out of work led Americans (and people of work led Americans (and people in other countries too) to say in other countries too) to say "Never again." "Never again."


Some economists would argue that Some economists would argue that modern macroeconomics, with its modern macroeconomics, with its emphasis on the determinants of emphasis on the determinants of unemployment and its elimination, unemployment and its elimination, truly began in the 1930s.truly began in the 1930s.


Variations In The Unemployment Variations In The Unemployment RateRate

Unemployment since 1960 has Unemployment since 1960 has ranged from a low of 3.5 percent in ranged from a low of 3.5 percent in 1969 to a high of 9.7 percent in 1982. 1969 to a high of 9.7 percent in 1982.

Unemployment in the worst years is Unemployment in the worst years is twice or more what it is in good years. twice or more what it is in good years.

Before 1960, variations tended to be Before 1960, variations tended to be even more pronounced.even more pronounced.



Are Unemployment Statistics Accurate Are Unemployment Statistics Accurate Reflections Of The Labor Market?Reflections Of The Labor Market?

In periods of prolonged recession, In periods of prolonged recession, some individuals feel that the some individuals feel that the chances of landing a job are so chances of landing a job are so bleak that they quit looking. bleak that they quit looking.

These "These "discouraged workersdiscouraged workers," ," who have not actively sought work who have not actively sought work for four weeks, are not counted as for four weeks, are not counted as unemployed; instead they fall out unemployed; instead they fall out of the labor force. of the labor force.


Also, people looking for full-time work Also, people looking for full-time work who grudgingly settle for a part-time who grudgingly settle for a part-time job are counted as “fully” employed, job are counted as “fully” employed, yet they are only “partly” employed. yet they are only “partly” employed.


However, at least partially balancing However, at least partially balancing thesethese biases in government biases in government employment statistics is the number of employment statistics is the number of people who are overemployed—that is, people who are overemployed—that is, working overtime or extra jobs. working overtime or extra jobs.

Also, there are a number of jobs in the Also, there are a number of jobs in the underground economy that are not underground economy that are not reported at all. reported at all.


In addition, there may be many In addition, there may be many people who claim they are actually people who claim they are actually seeking work when, in fact, they seeking work when, in fact, they may just be going through the may just be going through the motions so that they can continue motions so that they can continue to collect unemployment to collect unemployment compensation or receive other compensation or receive other government benefits.government benefits.


Who Are The Unemployed?Who Are The Unemployed?

Unemployment usually varies greatly Unemployment usually varies greatly between different segments of the between different segments of the population and over time.population and over time. unemployment rate is significantly lower unemployment rate is significantly lower

for college graduates than for college graduates than those without a high-school diploma across those without a high-school diploma across

sex and race, or sex and race, or for those with some college education, but for those with some college education, but

who have not completed a bachelor’s degree. who have not completed a bachelor’s degree.


Unemployment tends to be greater Unemployment tends to be greater among among the very young, the very young, blacks and other minorities, blacks and other minorities, less-skilled workers. less-skilled workers.

Adult female unemployment tends Adult female unemployment tends to be higher than adult male to be higher than adult male unemployment. unemployment.


Considering the great variations in Considering the great variations in unemployment for different groups unemployment for different groups in the population, we calculate in the population, we calculate separate unemployment rates for separate unemployment rates for groups classified by sex, age, race, groups classified by sex, age, race, family status, and type of occupation.family status, and type of occupation.



Categories For Unemployed Categories For Unemployed WorkersWorkers

There are four main categories of There are four main categories of unemployed workersunemployed workers job losersjob losers (temporarily laid off or fired) (temporarily laid off or fired) job leaversjob leavers (quit) (quit) reentrantsreentrants (worked before and now (worked before and now

reentering labor force)reentering labor force) new entrantsnew entrants (entering the labor force (entering the labor force

for first time—primarily teenagers). for first time—primarily teenagers).


Job losers typically account for 50 Job losers typically account for 50 to 60 percent of the unemployed, to 60 percent of the unemployed, but sizeable fractions are also due but sizeable fractions are also due to job leavers, new entrants, and re-to job leavers, new entrants, and re-entrants.entrants.



How Much Unemployment?How Much Unemployment?

While unemployment is painful, reducing While unemployment is painful, reducing unemployment is not costless. unemployment is not costless. In the short run, reducing unemployment may In the short run, reducing unemployment may

generate a higher inflation rate, especially if generate a higher inflation rate, especially if resources are fully employed. resources are fully employed.

Matching employees with jobs quickly may Matching employees with jobs quickly may lead to mismatches between the worker’s lead to mismatches between the worker’s skill level and that required for a job. skill level and that required for a job.

The skills of the employee may be higher than that The skills of the employee may be higher than that necessary for the job, resulting in necessary for the job, resulting in underemploymentunderemployment..


The Average Duration Of The Average Duration Of UnemploymentUnemployment

The duration of unemployment is The duration of unemployment is equally as important as the amount equally as important as the amount of unemployment in determining its of unemployment in determining its financial consequences. financial consequences.

Therefore, it is useful to look at the Therefore, it is useful to look at the average duration of unemployment.average duration of unemployment.


The duration of unemployment tends toThe duration of unemployment tends to be greater when the amount of unemployment be greater when the amount of unemployment

is high, and is high, and be smaller when the amount of unemployment be smaller when the amount of unemployment

is low. is low. Unemployment of any duration, of course, Unemployment of any duration, of course,

means a potential loss of output that is means a potential loss of output that is permanent; it is not made up when permanent; it is not made up when unemployment starts falling again.unemployment starts falling again.



Labor Force Participation RateLabor Force Participation Rate The percentage of the population that The percentage of the population that

is in the labor force is called the is in the labor force is called the labor labor force participation rateforce participation rate.. Since 1950 it has increased from 59.2% Since 1950 it has increased from 59.2%

to 67.1%, mostly between 1970 & 1990. to 67.1%, mostly between 1970 & 1990. The increase can be attributed in large The increase can be attributed in large

part to the entry of the baby boom into part to the entry of the baby boom into the labor force and a 14.2 percentage the labor force and a 14.2 percentage point increase in women’s labor force point increase in women’s labor force participation rate.participation rate.



17.3 Types of Unemployment17.3 Types of Unemployment Frictional unemploymentFrictional unemployment

people are temporarily between jobspeople are temporarily between jobs is short term and results from the normal is short term and results from the normal

turnover in the labor marketturnover in the labor market Structural unemploymentStructural unemployment

people lack the necessary skills for available people lack the necessary skills for available jobsjobs

Cyclical unemploymentCyclical unemployment results from short-term cyclical fluctuations in results from short-term cyclical fluctuations in

the economythe economy


Should We Worry About Should We Worry About Frictional Unemployment?Frictional Unemployment?

With frictional unemployment, With frictional unemployment, geographic and occupational mobility geographic and occupational mobility are considered good for the economy, are considered good for the economy, generally leading human resources generally leading human resources from activities of relatively low from activities of relatively low productivity or value to areas of productivity or value to areas of higher productivity, increasing output higher productivity, increasing output in society as well as the wage income in society as well as the wage income of the mover. of the mover.


Hence, frictional unemployment, Hence, frictional unemployment, while not good in itself, is a while not good in itself, is a byproduct of a healthy phenomenon, byproduct of a healthy phenomenon, and because it is short-lived, it is and because it is short-lived, it is therefore not generally viewed as therefore not generally viewed as a serious problem.a serious problem.


It is unusual for it to be much less It is unusual for it to be much less than 2 percent of the labor force. than 2 percent of the labor force.

It tends to be somewhat greater in It tends to be somewhat greater in periods of low unemployment, when periods of low unemployment, when job opportunities are plentiful. job opportunities are plentiful.


Structural UnemploymentStructural Unemployment Structural un employment makes it wise to Structural un employment makes it wise to

look at both unemployment and job look at both unemployment and job vacancy statistics in assessing labor market vacancy statistics in assessing labor market conditions. conditions.

Like frictional unemployment, it reflects the Like frictional unemployment, it reflects the dynamic dimension of a changing economy. dynamic dimension of a changing economy.

Over time, new jobs open up that require Over time, new jobs open up that require new skills, while old jobs that required new skills, while old jobs that required different skills disappear.different skills disappear.


Many persons advocate government-Many persons advocate government-subsidized retraining programs as a subsidized retraining programs as a means of reducing structural means of reducing structural unemployment.unemployment.

The dimensions of structural unemploy-The dimensions of structural unemploy-ment are debatable, in part because of ment are debatable, in part because of the difficulty in precisely defining the the difficulty in precisely defining the term in an operational sense. Structural term in an operational sense. Structural unemployment varies considerably. unemployment varies considerably.


To a considerable extent, one can To a considerable extent, one can view both frictional and structural view both frictional and structural unemployment as phenomena unemployment as phenomena resulting from imperfections in the resulting from imperfections in the labor market.labor market.

Labor Market Imperfections Labor Market Imperfections And UnemploymentAnd Unemployment


If individuals seeking jobs and If individuals seeking jobs and employers seeking workers had better employers seeking workers had better information about each other, the information about each other, the amount of frictional unemployment amount of frictional unemployment would be considerably lower.would be considerably lower.

But because information and job search But because information and job search are costly, the bringing of demanders are costly, the bringing of demanders and suppliers of labor services together and suppliers of labor services together does not occur instantaneously.does not occur instantaneously.


Cyclical UnemploymentCyclical Unemployment

In years of relatively high unemploy-In years of relatively high unemploy-ment, cyclical unemployment may ment, cyclical unemployment may result from the short-term cyclical result from the short-term cyclical fluctuations in the economy. fluctuations in the economy.

During a recession, or whenever the During a recession, or whenever the unemployment rate is greater than unemployment rate is greater than the natural rate, there is cyclical the natural rate, there is cyclical unemployment.unemployment.


Given its volatility and dimensions, Given its volatility and dimensions, governments have viewed unemploy-governments have viewed unemploy-ment resulting from inadequate demand ment resulting from inadequate demand to be especially correctable through to be especially correctable through government policies.government policies.

Most attempts to solve the Most attempts to solve the unemployment problem have placed unemployment problem have placed an emphasis on increasing aggregate an emphasis on increasing aggregate demand. demand.


The Natural Rate Of UnemploymentThe Natural Rate Of Unemployment

The median, or typical annual The median, or typical annual unemployment rate has been at or unemployment rate has been at or slightly above 5 percent. slightly above 5 percent. Some economists call this the natural Some economists call this the natural

rate of unemployment. rate of unemployment. When unemployment rises well above When unemployment rises well above

5 percent, we have abnormally high 5 percent, we have abnormally high unemployment; when it falls below unemployment; when it falls below 5 percent, we have abnormally low 5 percent, we have abnormally low unemployment.unemployment.


The 5 percent The 5 percent natural rate of natural rate of unemploymentunemployment roughly equals the roughly equals the sum of frictional and structural sum of frictional and structural unemployment at a maximum. unemployment at a maximum. Unemployment rates below the natural Unemployment rates below the natural

rate reflect a below-average level of rate reflect a below-average level of frictional and structural unemployment. frictional and structural unemployment.

Unemployment above the natural rate, Unemployment above the natural rate, however, reflects cyclical unemployment.however, reflects cyclical unemployment.


Today, economists, for the most part, Today, economists, for the most part, have come to accept a current range have come to accept a current range somewhere between 5 and 5.5 percent somewhere between 5 and 5.5 percent for the natural rate of unemployment. for the natural rate of unemployment.

The natural rate of unemployment may The natural rate of unemployment may change over time as technological, change over time as technological, demographic, institutional, and other demographic, institutional, and other conditions vary. conditions vary.


When all of the economy’s labor When all of the economy’s labor resources, and other resources like resources, and other resources like capital are fully employed, the capital are fully employed, the economy is said to be producing at economy is said to be producing at its potential level of output. its potential level of output.

That is, at the natural rate of That is, at the natural rate of unemployment, all resources are fully unemployment, all resources are fully employed and the economy is employed and the economy is producing its producing its potential outputpotential output..


When the economy is experiencing When the economy is experiencing cyclical unemployment,cyclical unemployment, unemployment rate > the natural rate.unemployment rate > the natural rate.

The economy can also temporarily The economy can also temporarily exceed potential output as workers exceed potential output as workers take on overtime or moonlight by take on overtime or moonlight by taking on extra employment.taking on extra employment.


17.4 Reasons for 17.4 Reasons for Unemployment Unemployment

Obstacles in labor markets prevent Obstacles in labor markets prevent wages from adjusting to bring into wages from adjusting to bring into balance the quantity of labor supplied balance the quantity of labor supplied and the quantity of labor demanded. and the quantity of labor demanded.

When wages are higher than the When wages are higher than the market equilibrium wage, the quantity market equilibrium wage, the quantity of labor supplied is greater than the of labor supplied is greater than the quantity of labor demanded, leading to quantity of labor demanded, leading to unemployment.unemployment.



Why Does Unemployment Why Does Unemployment Exist?Exist?

Economists have cited three reasons Economists have cited three reasons for the failure of wages to balance for the failure of wages to balance labor demand and labor supplylabor demand and labor supply minimum wagesminimum wages unionsunions the efficiency wage theory the efficiency wage theory

Each results in wage rates above Each results in wage rates above their equilibrium level.their equilibrium level.


Minimum Wages And Minimum Wages And UnemploymentUnemployment

A A minimum wage rateminimum wage rate can set the can set the wage for unskilled workers above its wage for unskilled workers above its equilibrium level, leading to a surplus equilibrium level, leading to a surplus of unskilled workers and higher of unskilled workers and higher unemployment.unemployment.


The Impact Of Unions On The Impact Of Unions On The Unemployment RateThe Unemployment Rate

Unions negotiate wages and benefits Unions negotiate wages and benefits through collective bargaining.through collective bargaining. If the union wage exceeds the equilibrium level, If the union wage exceeds the equilibrium level,

union labor supplied will exceed union labor union labor supplied will exceed union labor demanded, leading to higher unemployment. demanded, leading to higher unemployment.

Union workers who keep their jobs are better Union workers who keep their jobs are better off; the unemployed either seek nonunion work off; the unemployed either seek nonunion work or wait to be recalled. or wait to be recalled.

Many economists believe union jobs have a wage Many economists believe union jobs have a wage premium over comparable nonunion jobs. premium over comparable nonunion jobs.


This has led to the This has led to the insider-outsider insider-outsider hypothesishypothesis:: Those who keep the union wage above Those who keep the union wage above

the equilibrium level—the insiders—have the equilibrium level—the insiders—have little or no concern for outsiders—little or no concern for outsiders—nonmembers or previous members. nonmembers or previous members.


Efficiency WageEfficiency Wage In the In the efficiency wage modelefficiency wage model, employers , employers

pay their employees more than the pay their employees more than the equilibrium wage to be more efficient equilibrium wage to be more efficient because they believe that higher wages willbecause they believe that higher wages will

lead to greater productivitylead to greater productivity attract the most productive workersattract the most productive workers reduce job turnoverreduce job turnover increase worker moraleincrease worker morale lower hiring and training costslower hiring and training costs reduce absenteeismreduce absenteeism reduce shirkingreduce shirking


But because the wage is above the But because the wage is above the equilibrium level, the quantity of equilibrium level, the quantity of labor supplied exceeds the quantity labor supplied exceeds the quantity of labor demanded, and greater of labor demanded, and greater amounts of unemployment result.amounts of unemployment result.


Job SearchJob Search

Because of frictional unemployment, Because of frictional unemployment, we would have some unemployment we would have some unemployment even if there were a balance between even if there were a balance between labor supply and labor demand, as labor supply and labor demand, as workers and employers engage in workers and employers engage in search for costly information about search for costly information about abilities, opportunities, compensation abilities, opportunities, compensation packages, tastes, and preferences. packages, tastes, and preferences.


In a dynamic economy, jobs are In a dynamic economy, jobs are constantly being destroyed and constantly being destroyed and created. created.

This leads to lots of temporary This leads to lots of temporary unemployment as workers search unemployment as workers search for the best job for their skills.for the best job for their skills.


Unemployment InsuranceUnemployment Insurance It partially offsets the hardships of It partially offsets the hardships of

unemployment. unemployment. Those who have worked a certain period Those who have worked a certain period

of time and lost their job because the of time and lost their job because the employer no longer needed their skill get employer no longer needed their skill get compensation that is typically half salary for compensation that is typically half salary for up to 26 weeks.up to 26 weeks.

However, it also leads to prolonged periods However, it also leads to prolonged periods of job search because it lowers the of job search because it lowers the opportunity cost of being unemployed. opportunity cost of being unemployed.


It has been estimated that this may It has been estimated that this may raise unemployment rates by as much raise unemployment rates by as much as 1 percentage point. as 1 percentage point.

A longer search might mean a better A longer search might mean a better match, but it comes at the expense match, but it comes at the expense of lost production and greater of lost production and greater amounts of tax dollars.amounts of tax dollars.


Does New Technology Lead Does New Technology Lead To Greater Unemployment?To Greater Unemployment?

Although many believe technological Although many believe technological advances displace workers, this is advances displace workers, this is not necessarily the case.not necessarily the case.


If new equipment is a substitute for If new equipment is a substitute for labor, then it might displace workers. labor, then it might displace workers. e.g., self-service beverage barse.g., self-service beverage bars

However, new capital equipment However, new capital equipment means that new workers will be means that new workers will be needed to manufacture and repair it, needed to manufacture and repair it, and it may generate a whole new and it may generate a whole new growth industry that creates jobs.growth industry that creates jobs.


New inventionsNew inventions Generally produce cost saving Generally produce cost saving Cost savings generate higher incomes for Cost savings generate higher incomes for

producers and lower prices and better products producers and lower prices and better products for consumers for consumers

Ultimately result in the growth of other Ultimately result in the growth of other industries industries

But it is easy to just see the initial effect But it is easy to just see the initial effect (displaced workers) without recognizing the (displaced workers) without recognizing the implications of that invention throughout the implications of that invention throughout the whole economy over time.whole economy over time.


17.5 Inflation17.5 Inflation

Overall stable Overall stable price levelprice level increases increases security. security. InflationInflation is a continuing rise in the overall price is a continuing rise in the overall price

level. level. DeflationDeflation is a falling overall price level. is a falling overall price level. In both cases, a country’s currency unit changes In both cases, a country’s currency unit changes

in purchasing power.in purchasing power. Without price stability, consumers and Without price stability, consumers and

producers will experience more difficulty in producers will experience more difficulty in coordinating their plans and decisions.coordinating their plans and decisions.


Stable Price Level As A Stable Price Level As A Desirable GoalDesirable Goal

In general, the only thing that can In general, the only thing that can cause a sustained increase in the rate cause a sustained increase in the rate of inflation is a high rate of growth in of inflation is a high rate of growth in money.money.

Unanticipated and sharp price changes Unanticipated and sharp price changes are almost universally considered to are almost universally considered to be a "bad" thing that needs to be be a "bad" thing that needs to be remedied by some policy. remedied by some policy.


The Price Level Over The YearsThe Price Level Over The Years

The The Consumer Price IndexConsumer Price Index is the is the standard measure of inflation.standard measure of inflation.

The CPI from 1914 to 2003 is The CPI from 1914 to 2003 is presented in the next slide.presented in the next slide.



Who Loses With Inflation?Who Loses With Inflation? Erodes the purchasing power of retirees on Erodes the purchasing power of retirees on

fixed pensions, creditors, and those whose fixed pensions, creditors, and those whose incomes are tied to long-term contracts. incomes are tied to long-term contracts.

Debtors and those who can quickly raise the Debtors and those who can quickly raise the prices on their goods can gain from prices on their goods can gain from inflation. inflation.

Wage earners can lose if wages rise more Wage earners can lose if wages rise more slowly than the price level.slowly than the price level.

Inflation’s uncertainties discourages Inflation’s uncertainties discourages investment and economic growth.investment and economic growth.


Inflation brings about changes in real Inflation brings about changes in real incomes of persons, and these incomes of persons, and these changes may be either desirable or changes may be either desirable or undesirable.undesirable.

The redistributional impact of inflation The redistributional impact of inflation is not the result of conscious public is not the result of conscious public policy; it just happens.policy; it just happens.


Inflation can raise one nation's price Inflation can raise one nation's price level relative to price levels in other level relative to price levels in other countries, which can lead to countries, which can lead to difficulties in financing the purchase of difficulties in financing the purchase of

foreign goods or foreign goods or to a decline in the value of the national to a decline in the value of the national

currency relative to that of other currency relative to that of other countries.countries.


In its extreme form, inflation can lead In its extreme form, inflation can lead to a complete erosion in faith in the to a complete erosion in faith in the value of money.value of money. as in Germany after both world wars, as in Germany after both world wars,

or hyperinflation, or hyperinflation, as in Argentina in the 1980s andas in Argentina in the 1980s and Brazil in the 1990s. Brazil in the 1990s.


Unanticipated Inflation Distorts Unanticipated Inflation Distorts Price SignalsPrice Signals

In periods of high and variable In periods of high and variable inflation, households and firms have inflation, households and firms have a difficult time distinguishing changes a difficult time distinguishing changes in the in the relative pricerelative price from changes from changes in the general price level, distorting the in the general price level, distorting the information that flows from price information that flows from price signals. signals.

This undermines good decision-making.This undermines good decision-making.


Menu And Show-Leather CostsMenu And Show-Leather Costs Another cost of inflation is the cost that Another cost of inflation is the cost that

firms incur as a result of being forced to firms incur as a result of being forced to change their prices more often. change their prices more often. MenuMenu costscosts—the costs of changing posted —the costs of changing posted

pricesprices Shoe-leatherShoe-leather costscosts—the costs of checking on —the costs of checking on

your assets. your assets. These costs are modest with low inflation These costs are modest with low inflation

rates, but can be quite large where inflation rates, but can be quite large where inflation is substantial.is substantial.


Inflation And Interest RatesInflation And Interest Rates Nominal interestNominal interest raterate—not adjusted —not adjusted

for inflationfor inflation Real interest rates- Real interest rates- nominal interest nominal interest

rate – inflation raterate – inflation rate For example, if the nominal interest rate For example, if the nominal interest rate

was 5 percent and the inflation rate was was 5 percent and the inflation rate was 3 percent, the real interest rate would be 3 percent, the real interest rate would be 2 percent.2 percent.


If people correctly anticipate inflation, If people correctly anticipate inflation, they will behave in a manner that will they will behave in a manner that will largely protect them against loss. largely protect them against loss.

To protect themselves, creditors will To protect themselves, creditors will demand a rate of interest that is large demand a rate of interest that is large enough to compensate for the enough to compensate for the deteriorating value of the dollar.deteriorating value of the dollar.


Failure to understand the difference Failure to understand the difference

between real and nominal interest rates is between real and nominal interest rates is critical.critical.

In most economic decisions, it is the real In most economic decisions, it is the real rate of interest that matters because it is rate of interest that matters because it is this rate that shows how much borrowers this rate that shows how much borrowers pay and lenders receive in terms of pay and lenders receive in terms of purchasing power—goods and services purchasing power—goods and services money can buy. money can buy.

When the real interest rate is negative the When the real interest rate is negative the lender pays the borrower rather than the lender pays the borrower rather than the borrower paying the lender!borrower paying the lender!





In the last exhibit, we saw that when the In the last exhibit, we saw that when the

when the nominal interest rate is high the when the nominal interest rate is high the inflation rate is high and when the nominal inflation rate is high and when the nominal interest rate is low the inflation rate is low. interest rate is low the inflation rate is low. Why?Why?

When inflation is high, borrowers offer and When inflation is high, borrowers offer and lenders demand higher nominal interest lenders demand higher nominal interest rates to compensate for the falling value of rates to compensate for the falling value of money in the future. money in the future.


An interest rate is, in effect, the price An interest rate is, in effect, the price that one pays for the use of funds. that one pays for the use of funds. Like other prices, interest rates are Like other prices, interest rates are determined by the interaction of determined by the interaction of demand and supply forces. demand and supply forces.

The lower the interest rate (price), the The lower the interest rate (price), the greater the quantity of loanable funds greater the quantity of loanable funds demanded, demanded, ceteris paribus.ceteris paribus.

Anticipated Inflation And The Anticipated Inflation And The Nominal Interest RateNominal Interest Rate



The lower the interest rate, the greater the The lower the interest rate, the greater the quantity of loanable funds demanded. The quantity of loanable funds demanded. The higher the interest rate, the greater the higher the interest rate, the greater the quantity of loanable funds supplied by quantity of loanable funds supplied by individuals and institutions like banks, individuals and institutions like banks, ceteris paribusceteris paribus. .

The equilibrium interest rate will be where The equilibrium interest rate will be where the quantity demanded equals the quantity the quantity demanded equals the quantity supplied.supplied.


When people start expecting future When people start expecting future inflation, creditors become less willing inflation, creditors become less willing to lend funds at any given interest rate to lend funds at any given interest rate because they fear they will be repaid in because they fear they will be repaid in dollars of lesser value than those they dollars of lesser value than those they loaned. loaned.

This is depicted by a leftward shift in This is depicted by a leftward shift in the supply curve of loanable funds (a the supply curve of loanable funds (a decrease in supply).decrease in supply).


Likewise, demanders of funds Likewise, demanders of funds (borrowers) are more anxious to (borrowers) are more anxious to borrow because they think they will borrow because they think they will pay their loans back in dollars of pay their loans back in dollars of lesser purchasing power than the lesser purchasing power than the dollars they borrowed. Thus, the dollars they borrowed. Thus, the demand for funds increases. demand for funds increases.


Both the decrease in supply and the Both the decrease in supply and the increase in demand push up the increase in demand push up the interest rate to a new, higher interest rate to a new, higher equilibrium level. equilibrium level.

Whether the equilibrium quantity Whether the equilibrium quantity of loanable funds will increase or of loanable funds will increase or decrease depends on the relative sizes decrease depends on the relative sizes of the shifts in the respective curves.of the shifts in the respective curves.


Do Creditors Always Lose Do Creditors Always Lose During Inflation?During Inflation?

Often, lenders are able to anticipate Often, lenders are able to anticipate inflation with reasonable accuracy. inflation with reasonable accuracy.

If the inflation rate is accurately If the inflation rate is accurately anticipated, new creditors do not lose, anticipated, new creditors do not lose, nor do debtors gain, from inflation.nor do debtors gain, from inflation.


Nominal interest rates and real Nominal interest rates and real interest rates do not always move interest rates do not always move together.together.

In periods of high unexpected In periods of high unexpected inflation, the nominal interest rates inflation, the nominal interest rates can be very high while the real can be very high while the real interest rates are low or even interest rates are low or even negative.negative.


Protecting Ourselves From Protecting Ourselves From InflationInflation

Increasingly, laborers, pensioners, Increasingly, laborers, pensioners, etc. try to protect themselves from etc. try to protect themselves from inflation by using cost-of-living inflation by using cost-of-living clauses in contracts. clauses in contracts.

Personal income taxes are also now Personal income taxes are also now indexed for inflation. indexed for inflation.


Some have argued that we should go Some have argued that we should go one step further and index one step further and index everything. everything. All contractual arrangements would be All contractual arrangements would be

adjusted frequently to take account of adjusted frequently to take account of changing prices. changing prices.

Such an arrangement might reduce the Such an arrangement might reduce the impact of inflation, but it would also impact of inflation, but it would also entail additional contracting costs (and entail additional contracting costs (and not every good—notably currency—can not every good—notably currency—can be indexed). be indexed).


Approaches to try to stop inflation Approaches to try to stop inflation include include various policies relating to the amount various policies relating to the amount

of government spending, tax rates, or of government spending, tax rates, or the amount of money created, the amount of money created,

as well as as well as wage and price controlswage and price controls——legislation limiting wage and price legislation limiting wage and price increases. increases.


17.6 Economic Fluctuations17.6 Economic Fluctuations

Business cyclesBusiness cycles refer to the refer to the short‑term fluctuations in economic short‑term fluctuations in economic activity, not to the long‑term trend activity, not to the long‑term trend in output, which in modern times in output, which in modern times has usually been upward.has usually been upward.



The Phases Of A Business CycleThe Phases Of A Business Cycle

ExpansionExpansion PeakPeak ContractionContraction TroughTrough



ExpansionExpansion Usually is longer than the contraction. Usually is longer than the contraction. In a growing economy, output (real GDP) will In a growing economy, output (real GDP) will

rise from one business cycle peak to the next.rise from one business cycle peak to the next. When output is rising significantly, When output is rising significantly,

unemployment is falling and both consumer unemployment is falling and both consumer and business confidence is high. and business confidence is high.

Investment is rising, as well as expenditures for Investment is rising, as well as expenditures for expensive durable consumer goods, such as expensive durable consumer goods, such as automobiles and household appliances. automobiles and household appliances.


PeakPeak when the expansion comes to an endwhen the expansion comes to an end when output is at the highest point in the when output is at the highest point in the

cycle. cycle. ContractionContraction

a period of falling real outputa period of falling real output rising unemployment and declining rising unemployment and declining

business and consumer confidence business and consumer confidence investment spending and consumer investment spending and consumer

durable expenditures fall sharplydurable expenditures fall sharply


Contraction phase can also be called Contraction phase can also be called a a recessionrecession. .

Usually a recession is said to occur Usually a recession is said to occur if there are two quarters of declining if there are two quarters of declining real GDP.real GDP.


TroughTrough the point in time when output stops the point in time when output stops

decliningdeclining the moment when business activity is the moment when business activity is

at its lowest point in the cycle at its lowest point in the cycle Unemployment is relatively high at the Unemployment is relatively high at the

trough, although the actual maximum trough, although the actual maximum amount of unemployment may not occur amount of unemployment may not occur exactly at the trough. exactly at the trough.


How Long Does A Business How Long Does A Business Cycle Last?Cycle Last?

Often, unemployment remains fairly Often, unemployment remains fairly high well into the expansion phase.high well into the expansion phase.

There is no uniformity to a business There is no uniformity to a business cycle's length. In both the 1980s and cycle's length. In both the 1980s and 1990s, the expansions were quite 1990s, the expansions were quite long by historical standards.long by historical standards.


The contraction phase is one of The contraction phase is one of recession, a decline in business recession, a decline in business activity. activity.

Severe recessions are called Severe recessions are called depressions. Likewise, a prolonged depressions. Likewise, a prolonged expansion in economic activity is expansion in economic activity is sometimes called a sometimes called a boomboom. .

Contractions seem to be getting Contractions seem to be getting shorter over time.shorter over time.



Seasonal Fluctuations Affect Seasonal Fluctuations Affect Economic ActivityEconomic Activity

Some fluctuation in economic activity Some fluctuation in economic activity also reflects seasonal patterns. also reflects seasonal patterns. Business activity tends to be high in the Business activity tends to be high in the

two months before the winter holidays, two months before the winter holidays, and somewhat lower in summertime, and somewhat lower in summertime, when many families are on vacation. when many families are on vacation.

Within individual industries, of course, Within individual industries, of course, seasonal fluctuations in output often are seasonal fluctuations in output often are extremely pronounced, agriculture being extremely pronounced, agriculture being the best example.the best example.


Often, key economic statistics, like Often, key economic statistics, like unemployment rates, are seasonally unemployment rates, are seasonally adjusted, meaning the numbers are adjusted, meaning the numbers are modified to take account of normal modified to take account of normal seasonal fluctuations. seasonal fluctuations.


Thus, seasonally adjusted Thus, seasonally adjusted unemployment rates in summer unemployment rates in summer months are below actual months are below actual unemployment rates because unemployment rates because unemployment is normally high in unemployment is normally high in summertime as a result of the inflow summertime as a result of the inflow of school-age workers into the labor of school-age workers into the labor force.force.


Political Business CyclesPolitical Business Cycles Studies have shown a strong correlation Studies have shown a strong correlation

between economic performance and an between economic performance and an incumbent’s bid for re-election. incumbent’s bid for re-election. The incumbent might do everything in his power The incumbent might do everything in his power

to stimulate the economy in the period leading to stimulate the economy in the period leading up to the election. up to the election.

pressure the Federal Reserve System to lower the pressure the Federal Reserve System to lower the interest rateinterest rate

press Congress to cut taxes or increase government press Congress to cut taxes or increase government spendingspending

anything that might generate more spending and thus anything that might generate more spending and thus greater employment greater employment


Of course, the negative side to all of Of course, the negative side to all of this is that although the incumbent this is that although the incumbent may get re-elected, the economy may may get re-elected, the economy may have been overstimulated, causing have been overstimulated, causing inflationary problems.inflationary problems.


Forecasting Cyclical ChangesForecasting Cyclical Changes

Businesses, government agencies, Businesses, government agencies, and to a lesser extent, consumers, and to a lesser extent, consumers, rely on economic forecasts to learn rely on economic forecasts to learn of forthcoming developments in the of forthcoming developments in the business cycles.business cycles.


Economists gather statistics on Economists gather statistics on economic activity in the immediate past, economic activity in the immediate past, and use past historical relationships and use past historical relationships between these factors and the overall between these factors and the overall level of economic activity (which form level of economic activity (which form the basis of the economic theories used) the basis of the economic theories used) to formulate econometric models. to formulate econometric models.

Statistics from the immediate past are Statistics from the immediate past are plugged into the models and forecasts plugged into the models and forecasts are made.are made.


Because human behavior changes, Because human behavior changes, we cannot correctly make assumptions we cannot correctly make assumptions

about certain future developments,about certain future developments, economists’ numbers are imperfect andeconomists’ numbers are imperfect and econometric forecasts are not always econometric forecasts are not always

accurate. accurate. But while they are not perfect, they But while they are not perfect, they

are helpful.are helpful.


One less sophisticated but very One less sophisticated but very useful forecasting tool is watching useful forecasting tool is watching trends in trends in leading economic leading economic indicatorsindicators, which tend to change , which tend to change before the economy as a whole before the economy as a whole changes. changes.


There are about a dozen such leading There are about a dozen such leading indicators, which are compiled into an indicators, which are compiled into an index of leading indicators. index of leading indicators.

If the index rises sharply for two or If the index rises sharply for two or three months, it is likely (but not three months, it is likely (but not certain) that increases in the overall certain) that increases in the overall level of activity will follow.level of activity will follow.


Since the development of the index Since the development of the index of leading economic indicators, it has of leading economic indicators, it has never failed to give some warning of never failed to give some warning of an economic downturn. an economic downturn.

Unfortunately, the lead time has Unfortunately, the lead time has varied widely, which makes it less varied widely, which makes it less accurate and can cause timing and accurate and can cause timing and expectation problems with policy.expectation problems with policy.


While the economic indicators do While the economic indicators do provide a warning of a likely provide a warning of a likely downturn, they do not provide downturn, they do not provide accurate information on the depth accurate information on the depth or duration of the downturn.or duration of the downturn.

Macroeconomic goals

Education