Lecture Notes

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Lecture Notes

• October 7, 2003

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Reminder

• Midterm on Thursday
• Last years midterm on the class page
• On lecture notes, Ch. 5,6
• Krugman not covered this midterm
• start reading after midterm, if you havent
  already

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Web site

• Try the Prentice Hall web site for a PowerPoint
  presentation
• (very slick compared to my lecture notes)
• Also, self-correcting problem sets
• Go to www.prenhall.com/osullivan
• Choose our text (Macroeconomics Principles and
  Tools), Study Guide
• Most of the questions are very easy!

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Nominal, Real GDP

• Nominal GDP GDP in current dollars
• Thats what we have been talking about up to now.
• Problem cant interpret it as an increase in
  real production prices might have been rising
• Real GDP
• Nominal GDP corrected for price change

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How do you correct for price change?

• Compute real GDP by valuing date-2 output USING
  DATE-1 PRICES.
• That way changes in (real) GDP only occur as
  quantities produced change not prices.

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Example
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• GDP deflator ratio of nominal to real GDP
• Expressed as a
• In the preceding example, GDP deflator would be
  110
• Interpretation 10 inflation overall
• This is the same inflation youd get if you just
  looked at the price of computers.
• Calculation of GDP deflator is trivial if theres
  just one good.

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Another example
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Calculating GDP deflator

• In this case nominal GDP is 20 in year 1, 39 in
  year 2
• Real GDP is 27 in year 2
• So the GDP deflator is 44.4.
• You can think of this as an average of the rate
  of change of apple price (zero) and orange price
  (100).

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Does GDP measure welfare?

• Yes and no
• Ignores non-market transactions
• Think of the Montecito divorcee who marries the
  pool boy
• Ignores externalities
• Air pollution increases GDP through dry cleaners

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• Illegal transactions
• Productivity change new products
• Leisure isnt counted

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• You have to be careful about making international
  comparisons based on measured real GDP because of
  these distortions.
• You might think you could compare Indias GDP per
  capita with US (adjusting by the exchange rate),
• Can you live in the US on 1000/yr?
• This would be very misleading
• Conclusion dont take GDP too seriously

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GDP (and other macroeconomic) data

• FRED (Federal Reserve Economic Data), compiled by
  Federal Reserve Bank of St. Louis
• http//www.stls.frb.org/fred/

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Chapter 6. Unemployment and Inflation

• Unemployed doesnt have a job and (according to
  questionnaire) is actively seeking work.
• Employed unemployed labor force
• Unemployment rate unemployed / labor force
• Labor force participation rate labor force as a
  of population over 16.

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Issues in measuring, interpreting unemployment

• To be unemployed, you have to be actively
  looking.
• Discouraged workers quit looking, so theyre no
  longer unemployed.
• They drop out of the labor force.
• So discouraged worker effect may cause
  unemployment rate to drop!
• In recessions unemployment rate may not rise
  much labor force drops.

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Unemployment

• Differs by groups
• Young workers high
• Minorities high
• Men and women about the same
• Single mothers have high unemployment rate
• Reported unemployment is usually seasonally
  adjusted

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Types of unemployment

• Cyclical associated with the state of the
  economy (recession, prosperity)
• Frictional Inevitable periods of temporary
  unemployment for people who are between jobs.
• Structural Due to mismatch between workers and
  available jobs
• The breakdown is frequently ambiguous,
  particularly between frictional and structural

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Natural Rate of Unemployment

• Economists dont associate full employment with
  an unemployment rate of 0
• Because theres no way to achieve full employment
  so defined
• Cant reduce frictional unemployment beyond a
  certain point
• so its not a useful way to define full
  employment

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• By full employment economists often mean that the
  employment rate equals the natural rate.
• Natural rate zero cyclical unemployment
• So actual employment can be higher than full
  employment
• Suggests measuring cyclical unemployment by
  defining an interval of time as full employment
• The difference between actual unemployment in
  2003 (for example) and unemployment in the
  reference interval is cyclical unemployment.

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Unemployment

• Other things equal, low unemployment will lead to
  wage increases, inflation
• High unemployment will lead to deflation
  (negative inflation)
• At least according to some theories
• Great Depression 25 unemployment deflation

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Natural rate another definition

• Leads to another definition of natural rate of
  unemployment that rate of unemployment at which
  there is no tendency for inflation to accelerate
  or decelerate
• Note not zero inflation this definition deals
  with zero inflation change
• Careful this makes clear that the natural rate
  of unemployment is a theoretical term you have
  to buy into some theories to use this term
• If you dont think theres any relation between
  unemployment an inflation, you wouldnt want to
  try to answer the question What is the natural
  rate?

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• Most macroeconomists think there is a relation,
  so they are comfortable with the question.
• Numerically, what is the natural rate?
• Use statistical procedures to estimate natural
  rate
• 4 to 5.5.

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Conclusion

• Even at full employment there is still
  frictional and structural unemployment
• Natural rate may change over time
• Example posting job vacancies might reduce
  frictional unemployment, thereby lowering the
  natural rate.
• Education, relocation assistance
• Natural rate hypothesis that change in
  inflation is related to the level of unemployment
• If you allow for the possibility that the natural
  rate changes, its hard to test it.

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• Well see later in the course that aggregate
  demand management affects the actual unemployment
  for sure (at least in the short run)
• It may or may not affect the natural rate (for
  example, because of loss of skills due to
  unemployment)

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Inflation

• Increase in prices
• Dont confuse with high prices
• Deflation decrease in prices
• Measuring inflation
• Why do it?
• Because we want to distinguish real from nominal
  variables
• We already spoke about GDP deflator
• Its computed by dividing nominal GDP by a
  quantity index
• CPI computes a price index directly

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Consumer Price Index

• Takes a fixed basket of goods
• CPI at each year the cost of the basket that
  year relative to a base year
• One measure of inflation change of CPI
• Another measure of real GDP nominal GDP divided
  by CPI
• Contrast deflator
• Fixed basket of goods with CPI
• CPI may overstate inflation
• People buy less of goods with rising prices.

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Example
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CPI

• Suppose that a market basket consists of 2 apples
  and 1 orange
• Then CPI goes from 3 to 5, or a 67 increase
• Compute the GDP deflator for this economy
• Nominal GDP goes from 300 to 450
• Real GDP as computed by a quantity index (as last
  week) stays at 300 (in 1998 dollars)
• So the GDP deflator increases 50
• Conclusion real GDP, and therefore real GDP
  growth, is different depending on whether its
  computed via the deflator or the CPI.

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What happened here?

• Price of apples went up, so people bought fewer
  apples and more oranges
• CPI takes no account of this substitution away
  from the good with the rising price.
• because its using a fixed market basket of goods
• But the GDP deflator does.
• In general, different price indices (here
  including the GDP deflator as a price index,
  which is a bit loose) give different rates of
  inflation, as this example indicates.

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Importance of CPI

• COLAs in labor contracts
• (Cost of living adjustment)
• Social security has a COLA

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Bias in inflation measurement

• Quality change sometimes easy to measure
  (haircuts)
• Sometimes virtually impossible (particularly with
  services)
• Think of bank services
• Or medical care -- what if pills replace surgery?
• Sometimes difficult but maybe possible (computers)

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What the BLS does about quality change

• (Bureau of Labor Statistics)
• They do their best to measure quality change
  where theres some objective basis
• One computer now is actually the equivalent of 2
  computers 3 years ago ...
• Most economists think they underestimate quality
  change
• Therefore overestimate inflation.

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This is important

• CPI defines COLA in social security benefits
  American Association of Retired People thinks
• COLA Cost-of-living adjustment
• Argument CPI growth is biased downward (old
  folks consume more medical care than average, and
  prices of medical care have been rising more than
  most other prices)
• Or have they? Quality change is a big problem
  here.

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Inflation

• Right now, its around 2
• Inflation was about zero for most of US history
• This has to do with the monetary regime
• Under the gold standard, govt couldnt just
  print money
• US went off the gold standard in the 1970s

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Inflation in the US

• Inflation was high (10-15 per year) in the 70s.
  Peak around 1982
• Dropped in 80s, 90s
• South America has been on the order of 100 per
  year many times
• Hyperinflation 100/month or more
• US has never had it
• Europe after WW I

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Looking Ahead

• Classical economics
• The economics of the long run
• Economics of business fluctuations
• Keynesian economics (according to some)