Macroeconomics Answers Questions About the Overall Economy. Although There Is Some Disagreement

Ch. 14

Macroeconomics answers questions about the overall economy. Although there is some disagreement among economists about how to make the macroeconomy perform well, there is widespread agreement about our goals: rapid economic growth, full employment, and stable prices. Economists monitor economic growth by tracking real gross domestic product. When real GDP rises faster than the population, output per person rises, and so does the average standard of living. Although growth does not necessarily benefit everyone equally, it is important to our economic well-being. High employment is important, both because it helps us achieve our full productive potential, and because it affects the distribution of economic well-being among our citizens. Employment rates vary with the business cycle. The four phases of the business cycle are the expansion phase, the peak, the recession phase, and the trough. Severe and long-lasting recessions are called depressions. Stable prices or low inflation rates are important because coping with inflation uses up resources that could otherwise be used to produce goods and services. Macroeconomics uses the tool of aggregation to apply the four-step procedure to all markets simultaneously. Macroeconomists often disagree with each other. Some disputes are positive in nature, based on different views of how the macroeconomy works. Other disagreements are normative, based on different values individuals place on different macroeconomic outcomes. Most macroeconomists, however, agree on many basic principles and agree on the approach that should be taken to resolve their differences. The macro portion of this text is organized as follows. The next two chapters examine three of the most important economic aggregates: output, employment, and the price level. Then the text turns to what causes these aggregates to change, beginning with the long run and then moving to the short run. Finally, the text will examine the macroeconomy in a global setting.

Gross Domestic Product (GDP) and the unemployment rate are important because they describe aspects of the economy that dramatically affect each of us individually and our society as a whole. This chapter describes what these statistics tell us about the economy, how the government obtains them, and how they are sometimes misused. GDP is the total value of all final goods and services produced for the marketplace during a given year, within the nation’s borders. Three ways to measure GDP are the expenditure approach, the value-added approach, and the factor payments approach. Understanding these approaches tells us much about the structure of our economy. In the expenditure approach to measuring GDP, we add up the value of the goods and services purchased by each type of final user: households, businesses, government, and foreigners. When measuring private investment spending, it is important to include changes in business inventories, in order to adjust GDP for output sold this year that was produced in previous years, and to adjust GDP for output produced this year but not sold during the year. Actual private investment includes any unplanned inventory changes, while planned private investment does not. Total investment spending has two components: private investment spending and government investment spending. Net investment spending is equal to total investment minus depreciation. Positive net investment indicates that our capital stock is growing. Private investment excludes three categories of non-business production that add to the nation’s capital stock: government investment, consumer durables, and human capital. Since our economic well-being depends, in large part, on the goods and services we can buy, it is important to translate nominal GDP, which is measured in current dollars, to real GDP, which is measured in purchasing power. In general, all nominal variables must be translated into real variables to make meaningful statements about the economy. GDP is used to guide the economy in two ways. In the short run, changes in real GDP alert us to recessions, and give us a chance to stabilize the economy. In the long run, changes in real GDP tell us whether our economy is growing fast enough to raise output per capita and our standard of living, and fast enough to generate sufficient jobs for a growing population. Although GDP is extremely useful, it suffers from measurement problems. It doesn’t take quality changes into account, it can’t accurately measure underground production, and it does not include nonmarket production. Because of these problems, we must be careful when interpreting long-run changes in GDP. There are four types of unemployment: frictional, seasonal, structural, and cyclical. Our economy is at full employment when there is no cyclical unemployment. Unemployment is costly for individuals and for our society. The purely economic cost of unemployment can be measured as the difference between potential GDP (the amount of GDP that can be produced at full employment) and actual GDP. There are also broader costs of unemployment, both to individuals (psychological and physical effects) and to society (the unemployment burden is not shared equally among different groups). The unemployment rate is defined as the percentage of the labor force that is unemployed, and is calculated each month based on a survey conducted by the U.S. Census Bureau. This measure understates unemployment because it fails to account for involuntary part-time employment and discouraged workers. On the other hand, it also overstates unemployment by including as unemployed some people who are not in the labor force. Regardless of these problems, the unemployment rate provides valuable information about conditions in the macroeconomy. This chapter ends with a Using the Theory section on GDP after 9-11. The destruction caused by the terrorist attacks of September 11 had almost no direct impact on the U.S. economy or U.S. GDP, because the scale of destruction was small relative to our capital stock and our GDP. However, indirect losses to GDP resulting from our response to the attacks were significant. In the short run, consumption and investment spending dropped, causing real GDP to drop by 1.3% in the third quarter of 2001. As the nation shifts production away from other goods and services and toward security, our potential output—and over the long run, our actual output—will grow more slowly than it otherwise would have.

A monetary system establishes a unit of value and a means of payment. A unit of value is a common unit for measuring how much something is worth, while a means of payment is a thing one can use as payment when buying a good or service. The U.S. dollar fulfills both of these functions. The Federal Reserve System creates and regulates our monetary system. Early forms of money were called commodity money, because they had an important non-money use. Today, money in virtually all countries is fiat money—it has value because the government declares that it can be used as a means of payment. The value of the dollar—its purchasing power—changes from year to year as the price level changes. Most measures of the price level are reported as an index. Index numbers compress and simplify information, so that we can see how things are changing at a glance. Two major price indices are the Consumer Price Index (CPI) and the GDP price index. The CPI tracks the prices paid by the typical consumer. It excludes goods and services not directly purchased by consumers, such as raw materials, wholesale goods and machinery that firms buy, and goods and services purchased by the government. On the other hand, it includes the purchases of some things, like used cars and imported goods, that are not included in GDP. The CPI’s approach is to look at a typical consumer’s “basket of goods,” and compare the basket’s cost in the current period with the cost in some base period. While a price index tells us the overall price level, the inflation rate tells us how fast the price level is changing, in percentage terms. When the price level is rising, the inflation rate is positive. Deflation occurs when the price level is falling. The CPI is an important measure in the economy. It is used to index payments, as a policy target, and to translate nominal variables into real variables. It is important to translate nominal variables, such as wages, into real variables when we study the macroeconomy, because we care not about the number of dollars we are counting, but the purchasing power those dollars represent. The GDP price index, rather than the CPI index, is used to translate nominal GDP into real GDP. The GDP price index measures the prices of all final goods and services produced in the United States, while the CPI measures the prices of all goods and services bought only by households. Inflation is costly. The common idea that inflation imposes a cost on society by decreasing the average level of income in the economy is incorrect. It can, however, redistribute purchasing power from one group to another, to the extent that inflationary expectations are inaccurate. (If inflation is fully anticipated, and if there are no restrictions on contracts, then inflation will not redistribute purchasing power.) Also, when people must spend time and other resources coping with inflation, they sacrifice the other goods and services those resources could have produced. Several conceptual problems and resource limitations make the CPI fall short of the ideal measure of inflation. In the past, because the CPI updated its market basket infrequently, it routinely overestimated the relative importance of goods whose prices were rising most rapidly and underestimated the relative importance of goods whose prices were falling or rising more slowly. Infrequent updating also meant that new products that lower the cost of living are not included in a timely manner. The CPI also fails to recognize that prices may rise because of quality improvements, not because the cost of living has risen. Finally, the CPI omits reductions in the prices people pay from more frequent shopping at discount stores and so overstates the inflation rate. These problems all lead to overstatement of the inflation rate. Overstating the inflation rate has some serious consequences. First, it means that our estimates of real variables are unreliable. Second, it may lead to unnecessary sacrifices to curb inflation. Third, since many payments are indexed to the CPI, overstatement can result in overindexing. This shifts purchasing power toward those who are indexed and away from those who aren’t. An appendix to this chapter demonstrates how the BLS calculates the CPI. In recent years, the Bureau of Labor Statistics (BLS) has taken steps to reduce this overstatement. Beginning in 2002, it will update the market basket every two years instead of every 10 years. Since January 1999, the CPI recognizes the possibility of substitution within categories of goods. Also, the BLS has developed techniques to account for quality improvements in computers and peripherals, clothing, rental apartments, and televisions. In the past, the CPI has mostly tracked the cost of a fixed basket of goods, but has not done a good job tracking the cost of living. The repairs that have been made to the CPI— and others that many economists believe the BLS should make—are moving the index closer to a cost of living indicator. However, fixing the CPI is controversial, because of problems deciding how to measure advances that improve our quality of live and because some groups stand to lose from any fix that will reduce the reported inflation rate, and argue strongly against changing it.