Objectives And Instruments Of Macroeconomics

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Having surveyed the principal issues of macroeconomics, we now turn to a discussion of th& major goals and instruments of macroeconomic policy.

How do economists evaluate the success of an economy's overall performance? What are the tools that governments can use to pursue their economic goals?

Measuring Economic Success n general, economists judge macroeconomic performance by looking at a few key variables — the most important being grosses domestic product (GDP), the unemployment rate, and inflation.

Output. The ultimate objective of economic activity is to provide the goods and services that the population desires. What could be more important for an economy than to produce ample shelter, food, education, and recreation for its people?

The most comprehensive measure of the total output in an economy is the gross domestic product (GDP). GDP is the measure of the market value of all final goods and services — oatmeal, beer, cars, rock concerts, airplane rides, health care, and so on produced in a country during a year. There are two ways to measure GDP. ...
... Nominal GDP is measured in actual market prices. Real GDP is calculated in constant or invariant prices (say, prices for the year 1992).

Movements in real GDP are the best widely available measure of the level and growth of output; they serve as the carefully m monitored pulse of a nation's economy. Despite the short-term fluctuations in GDP seen in business cycles, advanced economies generally exhibit a steady long-term growth in real GDP and an improvement in living standards; this process is known as economic growth.

Potential GDP represents the maximum amount the economy can produce while maintaining reasonable price stability. Potential output is also sometimes called the high-employment level of output. When an economy is operating at its potential, unemployment is low and production is high.

Potential output is determined by the economy's productive capacity, which depends upon the inputs available (capital, labor, land, etc. ) and the economy's technological efficiency.

Potential GDP tends to grow slowly and steadily because inputs like labor and capital and the level of technology change quite slowly over time. By contrast, actual GDP is subject to large business cycle swings if spending patterns change sharply.

Economic policies (like monetary and fiscal policy) can affect actual output quickly, but the impact of policies on potential output trends operates slowly over a number of years.

Economic downturns are called recessions when real output declines for a year or two and the gap between actual and potential output is small; they are called depressions when the output decline is protracted with a large gap between actual and potential output.

High Employment, Low Unemployment. Of all the macroeconomic indicators, employment and unemployment are most directly felt by individuals. People want to be able to find high-paying jobs without searching or waiting too long, and they want to have job security and good benefits when they are working.

In macroeconomic terms, these are the objectives of high employment, which is the counterpart of low unemployment. The unemployment rate is the percentage of the labor force that is unemployed.

The labor force includes all employed persons and those unemployed individuals who are seeking jobs. It excludes those without work who are not looking for jobs.

The unemployment rate tends to reflect the state of the business cycle: When output is falling, the demand for labor falls and the unemployment rate rises. Unemployment reached epidemic proportions in the Great Depression of the 1930s, when as much as one-quarter of the work force was idled. Since World War II, unemployment in the United States has fluctuated but has avoided the high rates associated with depressions and the low levels that would trigger great inflations.

Stable Prices. The third macroeconomic objective is to maintain stable prices. To understand this goal, we need some background on measuring overall price trends. The most common measure of the overall price level is the consumer price index, known as the CPI.

The CPI measures the cost of a fixed basket of goods (including items such as food, shelter, clothing, and medical care) bought by the average urban consumer. The overall price level is often denoted by the letter P. We call changes in the level of prices the rate of inflation, which denotes the rate of growth or decline of the price level from one year to the next.

A deflation occurs when prices decline (which means that the rate of inflation is negative). At the other extreme is a hyperinflation, a rise in the price level of a thousand or a million percent a year. In such situations, as in Weimar Germany in the 1920s, Brazil in the 1980s, or Russia in the 1990s, prices are virtually meaningless and the price system breaks down.

The advantage of price stability is subtler than is the case with the other objectives. History has shown that rapid price changes distort the economic decisions of companies and individuals. With high inflation, taxes become highly variable, the real values of people's pensions are eroded, and people spend real resources to avoid holding depreciating currency.

At the same time, slowing inflation generally requires contracting economic activity and raising unemployment. Most nations therefore seek a golden mean between completely stable prices and high inflation, allowing a gentle upward creep of prices as the best way of allowing the price system to function efficiently.

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