The Goals of Macro Economic Policy- Part 1

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Part 1

The Goals of Macroeconomic Policy

Macroeconomics

Prof. Rushen Chahal

2/12/2012 Prof. Rushen Chahal



Chapter 5: Part 1

Potential GDP

Three measures of economic growth

±

Real GDP ± Real GDP per capita

± Labor Productivity

How much growth is good?




The Goals of Macroeconomic Policy

Rapid Growth

Low unemployment

Low inflation




Potential GDP

Potential GDP is the real gross domestic product

(output) an economy could produce if its labor force

were fully employed.

Output ± the goods and services that the economy

produces.

How do we calculate potential GDP?




Potential GDP

To calculate potential GDP:

Count up all the available supplies of labor, capital, andother productive resources. Estimate how much output

these inputs could produced if they were fully utilized

One can best illustrate this with a production function ±

shows the volume of output that can be produced fromgiven inputs (such as labor and capital) with the availabletechnology.




Potential GDP

Labor input(hours)

R e a l G D P

L0 L1

Y0

Y1

In the productionfunction PF0 when labor

input equals L0 GDPequals Y 0.

If labor increases to L0

however, then GDPincreases to Y 1.

Thus holding capitaland technologyconstant, output willincrease as labor input

increases2/12/2012 Prof. Rushen Chahal



Potential GDP

Labor input(hours)

R e a l G D P

L1

Y0PF0

PF1

A ssume an economy has aproduction function PF0.

A country is fully employedwhen it supplies labor L1

A t labor L1, total output is at Y o, which is equal topotential GDP.

But what if a change intechnology pushes theproduction function up?




Potential GDP

Labor input(hours)

R e a l G D P

L1

Y0

Y1

PF0

PF1

Thus you can see how anincrease in technologicalcapabilities can increase thepotential GDP, without anincrease in labor input.

This is now the new potentialGDP for this economy

Now at the same amount of labor input, L1, output increases to Y 1




Potential GDP

Labor input(hours)

R e a l G D P

L1

Y0

Y1

PF0

PF1

The same effect can be seen

when there is an increase incapital stock K.

A n increase in capital stockwill push the productionfunction up, thus increasingpotential GDP




Potential GDP

But What Does It All Mean?

Stated Simply:

An increase in available capital or improvement intechnology will shift the production function

upwards, and thus raise potential GDP.




Growth Rate of Potential GDP

Given these rules about potential GDP, what

can we assume about the gr owth of potential

GDP depends on?

1. The growth rate of the labor force

2. The growth rate of the nation¶s capital stock

3. The rate of technological progress





The capital stock and technological progress help

determine how productive a worker is. We combine

them into one factor: labor productivity.

Labor Productivity ± the amount of output a worker

makes in a specific period of time (for example, a

hour or a year). If output is measured by GDP, it is

GDP per hour or work.





I make CDs for my friends. On average I can

make 10 CDs an hour. If I work for 8 hours:

10 CDs/hour X 8 hours = 80 CDs

Output Hours of WorkOutput/hour





If we aggregate this to apply it to an entire

economy:

GDP = Hours of Work X Output per hour

GDP = Hours of Work X Labor Productivity

Or:





Thus, the growth rate of potential GDP is the

sum of the growth rate of labor input and the

growth rate of labor productivity

Growth Rate of Potential GDP= Growth rate of labor input

(hours of work)

+ Growth rate of labor productivity(output per hourof work)

If labor input in an economy is growing 1 percent a year, and laborproductivity is growing at about 3 percent a year, it follows that potential GDP should be growing at about 4 percent a year




Growth Rates of GDP

Small differences in growth rates make little

difference over a short period of time. However, over

a long period of time, they make a HUGE difference.

Example: Growth rates from 1870 - 1979

± England: 1.8%; U.S.: 2.3%; Japan: 3.0%

± These small differences allowed the U.S. and Japan to far

exceed the economy of England




Three Measures of Economic

GrowthReal GDP

Real GDP per capita

Labor Productivity




Real GDP

Most, if not all, nations of the world computethe value of real GDP for their economies.

The size of a nation¶s real GDP is probably thebest indicator of the size of a country¶seconomy

-Ayers, 2005




China¶s Real GDP




Real GDP: China - 2005

GDP - $1.79 Trillion

PPP - $8.182 trillion

PPP per capita - $6,300Composition of GDP:

agr iculture: 14.4%

indust ry & const r uction: 53.1%serv ices: 32.5%




Real GDP per Capita

Real GDP per capita gives a better picture of how

well each individual in a country is, or the standard

of living.

If China (pop. 1 billion+) and country B (population

100 million) have the same Real GDP, the citizens of

country B, on average, get more stuff than the

citizens of China.




Real GDP per Capita

Real GDP per capita divides Real GDP by

population.

Real GDP per capita disregards any

growth that occurs in an economy due to

population growth




China Real GDP Per Capita




GDP Per Capita

World

Rank Country try GDP Per Capita Year

10 United States $ 43,800 2006 est.

14 Hong Kong $ 37,300 2006 est.

22 Australia $ 33,300 2006 est.

23 Japan $ 33,100 2006 est.

28United

Kingdom$ 31,800 2006 est.

34 EuropeanUnion

$ 29,900 2006 est.

36 Taiwan $ 29,600 2006 est.

45 Korea, South $ 24,500 2006 est.

46 Macau $ 24,300 2005






Labor Productivity Growth

If the focus is on productivity growth,

then we can measure the growth of an

economy in terms of growth of laborproductivity

Labor productivity focuses on the

amount of output per hours worked








Economists generally agree that faster growthis usually better (not always).

Accepted rates of growth in America arearound 2.5%.

It is believed that rates of growth up to 5% aresustainable.





China¶s GDP growth rate in 2005:

9.3%

China had hoped to slow growth a bit, aiming

for a 8% growth rate in 2005

(source, Associated Press, 2005)





Why might China want to avoid growing too

quickly?

To avoid inflation.

Opportunity cost: to grow faster, currentconsumption must be reduced.





Faster growth may lead to greater pollution,crowding, and waste production.

Greater consumption may not necessarily make

people happier. Growth may drive people to work longer hours.

Faster growth may generate higher inflation, in somecases.

To have faster growth, current consumption must bereduced.


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The Goals of Macro Economic Policy- Part 1