The Goals of Macroeconomic Policy Chapter 6 – Part 1Growth and Low Unemployment

Economic Growth

• Two ingredients for economic growth1. Aggregate supply

• Inputs – Labor (L) , machinery , physical capital (K), other resources (land) and entrepreneurship) used to produce outputs :

• Output - Goods and services produced in economy

2. Aggregate demand• The number of goods and services people and businesses

want to buy

2

Economic Growth

• Two tasks of macroeconomic policy1. Growth policy

• Intended to make the economy grow faster in the long-run• Primarily aimed at aggregate supply

2. Stabilization policy• Manage aggregate demand to avoid high unemployment

and high inflation • short-run stabalization policy

3

The Goal of Economic Growth• Small differences in growth rates make enormous

difference in the long run • GDP per capita annual growth: 1870-1979

• U.S. 2.3%, U.K. 1.8%, Japan 3%• Suppose each country had $1 of output in 1870

• U.S. in 1979 = $1 x (1.023)109 = $11.92• U.K. in 1979 = $1 x (1.018)109 = $6.99• Japan in 1979 = $1 x (1.03)109 = $25.07

• Labor productivity• Amount of output a worker produces in an hour (or a

week, or a year) of labor• GDP per hour of work 4

The Goal of Economic Growth

• Productivity growth is almost everything in long run• Only rising productivity raises standard of living• Small differences in productivity growth rates

compound (see previous slide)• Enormous difference to society’s prosperity• Reduce of poverty• Increase leisure time• Increases in country’s ability to finance education,

public health, environmental improvement, arts . . .

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Capacity to Produce: Potential GDP

• Potential GDP• Is the level of real GDP the economy would

produce if labor (L) and other resources such as capital (K) were fully employed

• Labor force• Number of people holding or seeking jobs

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Capacity to Produce: Potential GDP

• Estimate potential GDP in two steps1. Count up the available supplies of labor (L),

capital (K), and other productive resources

2. Estimate how much output these inputs could produce if they were all fully utilized• This transformation is an assessment of the

economy’s technology

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Capacity to Produce: Potential GDP

• The production function• Shows the amount of output that can be

produced from given inputs (such as labor and capital) given the available technology

• Along any production function constant capital and technology

• Better technology or more capital will shift the production function up and raise potential GDP

8

Figure 1 The Economy’s Production Function

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0 Labor input (hours)

Rea

l GD

P

(a) Effect of better technology (b) Effect of more capital

L0

Y0

K

M

Y1

A

0 Labor input (hours)

Rea

l GD

P

L0

Y0

K0

K1

Y1

A

BB

GDP = Hours of work x Output per hour = Hours of work x Labor productivity

Growth Rate of Potential GDP

• Growth rate of potential GDP depends on• Growth rate of labor force • Growth rate of capital stock• Rate of technical progress

• Growth rate of potential GDP = Growth rate of labor input + Growth rate of labor productivity• U.S. 1995-2010

• Growth of labor input ≈ 1%• Growth of labor productivity ≈ 2.6%• Growth rate of potential GDP ≈ 3.5%

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Growth Rate of Actual and Potential GDP

• Over long periods of time: similar

• Over short periods of time diverge sharply due to cyclical fluctuations

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Figure 2 Actual and Potential GDP in U.S.

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Unemployment

• Unemployed– Not working and actively seeking a job

• Three types of unemployment– Frictional– Structural– Cyclical

13

Types of Unemployment• Frictional unemployment includes

people who are between jobs people who are just entering or reentering

the labor market

• Critical point is this is short-term unemployment

• These people have skills and they will get jobs

14

Types of Unemployment• Structural unemployment

• Skill mismatch between workers’ skills and employers’ requirements

• Geographic mismatch between workers’ locations and employers’ locations

• Workers displaced by automation• Skills no longer in demand.

• Unemployed due to structural changes in the economy that eliminate some jobs and create other jobs for which the unemployed do not have required skills.

• This is a stubborn, long-term problem

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Types of Unemployment• Cyclical unemployment

Portion of unemployment attributed to changes in production over the business cycle

• Rises during recessions• Falls during expansion

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Employment and Unemployment• Natural Rate of Unemployment

– Sum of Frictional and Structural

• Full employment is defined as:– Zero cyclical unemployment– Unemployment at full employment is equal to the

frictional + structural unemployment – the natural rate of unemployment– 2014 estimate: 5.2% - 5.8%

• Potential output – Level of output the economy could produce if operating

at full employment

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The unemployment rate rises during recessions (shaded) and falls during expansions. Unemployment related to the business cycle is cyclical unemployment

U.S. Quarterly Unemployment Rate, 1970-2011

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5

Natural rate of Unemployment

The Costs of Unemployment• When real GDP is above potential output

– Unemployment is below the natural rate– Employment is higher than full-

employment• When real GDP is below potential output

– Unemployment rises above the natural rate and

– Employment falls below full-employment rate

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The Costs of Unemployment• Slump

– A period during which real GDP is below potential and/or the employment rate is below normal

• Recession– From end of 2007 through June 2009

• Slump– The book states 2008 through the first half

of 2011. We are still in a “slump”

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21

Potential GDP

Actual GDP

Real GDP in 2009 Dollars

• Cumulative gap between actual and potential GDP • From 2008 – 2014 (2009 dollars) roughly $5.5 trillion• About four months worth of production at 2014 levels

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Potential GDP

Actual GDP

Real GDP in 2009 Dollars

The growth in potential GDP has slowed down

The Costs of Unemployment• Economic cost

opportunity cost of lost output, output produced is less than the economy’s potential output

which means less Income and

less consumption

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The Costs of Unemployment• Broader costs

– Psychological and physical effects– Setbacks in achieving important social

goals– Burden of unemployment not shared

equally among different groups in the population• Most heavily: minorities, especially minority

youth

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Unemployment Rate for Various Groups

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4.6%

6.8

9.1

8.3

5.5

2.6

5.3%

July 2015

Counting the Unemployed

• Census Bureau’s Household Survey– Every month– Survey of 60,000 households across

America• In the labor force and unemployed when:

– Don’t have a job– Actively search for work during the

previous four weeks– Includes temporarily laid off, expected to

return26

How the BLS Measures Employment Status

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Includes part time workers

Counting the Unemployed

• Labor force – Those people who have a job or are

looking for one• Unemployment rate

– Fraction of the labor force that is without a job

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Employment Status of the U.S. Population—August 2011

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How Unemployment is Measured

Computing the unemployment rate for the month of July 2008: Labor force: 154.6 million Employed: 145.8 million Unemployed: 8.8 million

July 2008

8.8

145.8 + 8.8=Unemployment rate

=

5.7%

How Unemployment is Measured

unemployment rate The percentage of the labor force that is unemployed.Computing the unemployment rate for the months of July

2009, July 2011 and July 2015: 2009 2011 2015

Labor force: 154.5 million 153.2 million 157.1 millionEmployed: 140.0 million 139.3 million 148.8 millionUnemployed: 14.5 million 13.9 million 8.27 million

Unemployment rate 2009 = 14.5.094 9.4%

154.5

Unemployment rate 2011 =

13.9.091 9.1%

153.2

Unemployment rate 2015 =

8.27.053 5.3%

157.1

Average Duration of Unemployment, 1970–2009

Weeks Weeks Weeks

1970 8.6 1984 18.2 1997 15.8

1971 11.3 1985 15.6 1998 14.5

1972 12.0 1986 15.0 1999 13.4

1973 10.0 1987 14.5 2000 12.6

1974 9.8 1988 13.5 2001 13.1

1975 14.2 1989 11.9 2002 16.6

1976 15.8 1990 12.0 2003 19.2

1977 14.3 1991 13.7 2004 19.6

1978 11.9 1992 17.7 2005 18.4

1979 10.8 1993 18.0 2006 16.8

1980 11.9 1994 18.8 2007 16.8

1981 13.7 1995 16.6 2008 17.9

1982 15.6 1996 16.7 2009 24.4

1983 20.0

The Duration of Unemployment

http://www.bls.gov/news.release/pdf/empsit.pdf

Table A-12

Problems in Measuring UnemploymentOfficial measure of unemployment underestimates the extent of unemployment

• Treatment of involuntary part-time workers – Individuals who would like a full-time job but who

are working only part time– are counted as employed and in the LF

• Treatment of discouraged workers– Individuals who would like a job but have given up

searching for one– are counted as not being in the labor force

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Problems in Measuring Unemployment• BLS defines discouraged worker

1. Not working

2. Searched for a job at some point in the last 12 months

3. Currently want a job

4. State that the only reason they are not currently searching for work is their belief that no job is available for them

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• discouraged-worker effect • The decline in the measured unemployment rate

that results when people who want to work but cannot find jobs grow discouraged and stop looking, thus dropping out of the ranks of the unemployed and the labor force.

• It lowers the unemployment rate!– Suppose 10 unemployed and 90 employed

Unemployment rate = 10/100 = 10%– Suppose 1 of the 10 unemployed becomes discouraged

Unemployment rate = 9/99 = 9.09%

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Problems in Measuring Unemployment

Problems in Measuring Unemployment

• Marginally attached to the labor force– Meet the first three requirements of

discouraged workers

– But not necessarily the fourth: • They can give any reason for not currently

searching for work

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Alternative Measures of Unemployment

• The Six “U”s– Six different unemployment rates

• Each labeled with a “U” followed by a number

– “U-3”: the official unemployment rate

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The Six “U”s

http://www.bls.gov/news.release/pdf/empsit.pdf Table A-15

Unemployment Insurance

• Unemployment insurance• Government program that replaces some wages

lost by workers who lose their jobs• Administered by the states under federal

guidelines• Average weekly benefit in 2013 was $310, 45%• Normally last for 6 months• Extended to 99 weeks after Great Recession

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Unemployment Insurance

• Purpose of program• Limits the severity of recessions by providing

additional purchasing power• Props up aggregate demand during a recession

• Payroll taxes and unemployment benefits• Spreads the cost of unemployment over the

entire population• Doesn’t eliminate the basic economic cost

• Higher unemployment benefits• Disincentive to look for job

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Average Unemployment Rates in Several Countries, 1995–2005, 2007 and 2013

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Unemployment rate higher in Europe - primarily structural.• Higher unemployment benefits, for longer periods of time

which reduce incentives to accept jobs or acquire skills.• Legal obstacles laying off workers

10.8%

12.7%

7.2%

7.1%

5.2%

8.0%

6.7%

2013

Unemployment rates in the EU compared to Japan and the US

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•http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/Unemployment_statistics

Alternative Measures of Employment Conditions

• The Employment-Population Ratio– Total employment (from the household

survey) divided by the total population over age 16

– Tracks the fraction of the adult population that is working

– not affected by job-searching behavior

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The employment-population ratio often measures labor market conditions more accurately than the unemployment rate. The ratio falls during recessions, such as the deep recession of 2008 and 2009.

The Employment Population Ratio: 1996–2011

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45

The Employment Population Ratio: 1948–2014

46

The Employment Population Ratio: 1948–2014

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Labor Force Participation Rate (LF/Pop): 1948–2014

Its Not Just Demographics

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Labor Force Participation Rate: Overall in Blue Along With age 25-54 in Red