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Monetary Fund (IMF), consumer prices in Zimbabwe rose 132 per- was “like looking for a snowflake in the Sahara desert.” Why? Be-
cent in 2002, 350 percent in 2004, and a stunning 1,017 per- cause the government™s only licensed meat processor was slaugh-
cent in 2006. Then things really got out of control, with inflation tering only 100 cattle per day”to feed a population of 12 million
rising month after month. At this writing, the IMF estimates that people!
inflation in Zimbabwe reached the astonishing rate of 16,000 per- And meat was by no means a special case. Within weeks after
cent for 2007 as a whole, and press reports state that it topped price controls were instituted, such basics as bread, cornmeal,
66,000 percent at an annual rate in December! The root cause, sugar, salt, flour, and even matches were difficult to find, thou-
of course, was what it always is in hyperinflations: the Zimbab- sands of shopkeepers had been arrested, and many stores were
wean government was printing colossal amounts of money to pay opening only at night to avoid the inspectors. Zimbabwe was bar-
its bills. reling full-speed-ahead toward economic chaos.
While printing too much money was bad enough, Zimbabwe™s
dictator, Robert Mugabe, decided to compound the sin by insti-
tuting price controls in July 2007. After all, if inflation is running
too high, he apparently reasoned, why not just decree that it
stop? Well, even an absolute dictator must contend with the laws
of economics”especially if he keeps running the printing presses
at full tilt. (In the summer of 2007, Zimbabwe™s central bank was
forced to introduce a 200,000 Zimbabwean dollar (Z$) bill so
SOURCE: © AP Images




that people could conduct business.) The result was predictable:
commodities, including basic foodstuffs, quickly disappeared
from the shelves. Long queues and even riots developed as Zim-
babwe™s starved citizens scrambled to purchase what little there
was to buy. Neighboring South Africa reported Zimbabweans
pouring over the border”some to flee the chaos, but some just
to shop. SOURCE: “Zimbabwe's Shopping Nightmare,” The Scotsman, July 26, 2007.




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Chapter 6 125
The Goals of Macroeconomic Policy



LOW INFLATION DOES NOT NECESSARILY LEAD TO
HIGH INFLATION
We noted earlier that inflation is surrounded by a mythology that bears precious little
relation to reality. It seems appropriate to conclude this chapter by disposing of one par-
ticularly persistent myth: that low inflation is a slippery slope that invariably leads to
high inflation.
There is neither statistical evidence nor theoretical support for the belief that low
inflation inevitably leads to high inflation. To be sure, inflations sometimes speed
up. At other times, however, they slow down.




SOURCE: © Camera Press/Globe Photos, Inc.
Although creeping inflations have many causes, runaway inflations have occurred
only when the government has printed incredible amounts of money, usually to fi-
nance wartime expenditures. In the German inflation of 1923, the government finally
found that its printing presses could not produce enough paper money to keep pace
with the exploding prices. Not that it did not try”by the end of the inflation, the daily
output of currency exceeded 400 quadrillion marks! The Hungarian authorities in
1945“1946 tried even harder: The average growth rate of the money supply was more
than 12,000 percent per month. Needless to say, these are not the kind of inflation prob-
lems that are likely to face industrialized countries in the foreseeable future.
These children in Germany
But that does not mean there is nothing wrong with low inflation. We have spent
during the hyperinflation of
several pages analyzing the very real costs of even modest inflation. A case against the 1920s are building a
moderate inflation can indeed be built, but it does not help this case to shout slogans pyramid with cash, worth no
like “Creeping inflation always leads to galloping inflation.” Fortunately, it is simply more than the sand or sticks
not true. used by children elsewhere.




| SUMMARY |
1. Macroeconomic policy strives to achieve rapid and rea- 6. Although some psychologists, environmentalists, and
sonably stable growth while keeping both unemploy- social critics question the merits of faster economic
ment and inflation low. growth, economists generally assume that faster growth
of potential GDP is socially beneficial.
2. Only rising productivity can raise standards of living in
the long run. And seemingly small differences in pro- 7. When GDP is below its potential, unemployment is
ductivity growth rates can compound to enormous dif- above “full employment.“ High unemployment exacts
ferences in living standards. This is one of our Ideas for heavy financial and psychological costs from those who
Beyond the Final Exam. are its victims, costs that are borne quite unevenly by
different groups in the population.
3. The production function tells us how much output the
economy can produce from the available supplies of la- 8. Frictional unemployment arises when people are be-
bor and capital, given the state of technology. tween jobs for normal reasons. Thus, most frictional un-
employment is desirable.
4. The growth rate of potential GDP is the sum of the
growth rate of the labor force plus the growth rate of 9. Structural unemployment is due to shifts in the pattern
labor productivity. The latter depends on, among of demand or to technological change that makes certain
other things, technological change and investment in skills obsolete.
new capital. 10. Cyclical unemployment is the portion of unemploy-
5. Over long periods of time, the growth rates of actual and ment that rises when real GDP grows more slowly than
potential GDP match up quite well. But, owing to potential GDP and falls when the opposite is true.
macroeconomic fluctuations, the two can diverge 11. Today, after years of extremely low unemployment,
sharply over short periods. economists are unsure where full employment lies.




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Part 2
126 The Macroeconomy: Aggregate Supply and Demand



Many think it may be at a measured unemployment rate 16. The real rate of interest is the nominal rate of interest
around 5 percent. minus the expected rate of inflation.
12. Unemployment insurance replaces about half of the 17. Because the real rate of interest indicates the command
lost income of unemployed persons who are insured. over real resources that the borrower surrenders to the
But barely over one-third of the unemployed actually lender, it is of primary economic importance. But public
collect benefits, and no insurance program can bring attention often is riveted on nominal rates of interest,
back the lost output that could have been produced had and this confusion can lead to costly policy mistakes.
these people been working. 18. Because nominal”not real”capital gains and interest
13. People have many misconceptions about inflation. For ex- are taxed, our tax system levies heavy taxes on income
ample, many believe that inflation systematically erodes from capital when inflation is high.
real wages and blame inflation for any unfavorable 19. Low inflation that proceeds at moderate and fairly pre-
changes in relative prices. Both of these ideas are myths. dictable rates year after year carries far lower social
14. Other costs of inflation are real, however. For example, costs than does high or variable inflation. But even low,
inflation often redistributes income from lenders to bor- steady inflations entail costs.
rowers. 20. The notion that low inflation inevitably accelerates into
15. This redistribution is ameliorated by adding the ex- high inflation is a myth with no foundation in economic
pected rate of inflation to the interest rate. But such ex- theory and no basis in historical fact.
pectations often prove to be inaccurate.



| KEY TERMS |
Inputs 105 Unemployment rate 111 Real wage rate 117
Outputs 105 Discouraged workers 114 Relative prices 119
Growth policy 106 Frictional unemployment 114 Redistribution by inflation 120
Economic growth 106 Structural unemployment 114 Real rate of interest 121
Labor productivity 107 Cyclical unemployment 114 Nominal rate of interest 121
Potential GDP 108 Full employment 115 Expected rate of inflation 121
Labor force 108 Unemployment insurance 116 Capital gain 122
Production function 108 Purchasing power 117



| TEST YOURSELF |
1. Two countries start with equal GDPs. The economy of productivity grows at a rate of 2 percent in Country A
Country A grows at an annual rate of 3 percent while the and a rate of 2.5 percent in Country B. What are the
economy of Country B grows at an annual rate of 4 per- growth rates of potential GDP in the two countries?
cent. After 25 years, how much larger is Country B™s 5. What is the real interest rate paid on a credit card loan
economy than Country A™s economy? Why is the answer bearing 18 percent nominal interest per year, if the rate
not 25 percent? of inflation is
2. If output rises by 35 percent while hours of work in- a. zero?
crease by 40 percent, has productivity increased or de-
b. 4 percent?
creased? By how much?
c. 8 percent?
3. Most economists believe that from 2000 to 2003, actual
d. 15 percent?
GDP in the United States grew slower than potential
GDP. What, then, should have happened to the unem- e. 20 percent?
ployment rate over those three years? Then, from 2003 to 6. Suppose you agree to lend money to your friend on the
2006, actual GDP likely grew faster than potential GDP. day you both enter college at what you both expect to be
What should have happened to the unemployment rate a zero real rate of interest. Payment is to be made at
over those three years? (Check the data on the inside graduation, with interest at a fixed nominal rate. If infla-
back cover of this book to see what actually happened.) tion proves to be lower during your college years than
4. Country A and Country B have identical population what you both had expected, who will gain and who
growth rates of 1 percent per annum, and everyone in will lose?
each country always works 40 hours per week. Labor




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Licensed to:

Chapter 6 127
The Goals of Macroeconomic Policy



| DISCUSSION QUESTIONS |
1. If an earthquake destroys some of the factories in Poor- 5. Show why each of the following complaints is based on
land, what happens to Poorland™s potential GDP? What a misunderstanding about inflation:
happens to Poorland™s potential GDP if it acquires some a. “Inflation must be stopped because it robs workers of
new advanced technology from Richland and starts us- their purchasing power.”
ing it?
b. “Inflation makes it impossible for working people to
2. Why is it not as terrible to become unemployed nowa- afford many of the things they were hoping to buy.”
days as it was during the Great Depression?
c. “Inflation must be stopped today, for if we do not
3. “Unemployment is no longer a social problem because stop it, it will surely accelerate to ruinously high rates
unemployed workers receive unemployment benefits and lead to disaster.”
and other benefits that make up for most of their lost
wages.” Comment.
4. Why is it so difficult to define full employment? What un-
employment rate should the government be shooting
for today?


| APPENDIX | How Statisticians Measure Inflation
Because the CPI in 1982“1984 is set at 100:
INDEX NUMBERS FOR INFLATION
$4,146
CPI in 2007
5 2.073
5
Inflation is generally measured by the change in some 100 $2,000
index of the general price level. For example, between
or
1977 and 2007 the Consumer Price Index (CPI), the
most widely used measure of the price level, rose CPI in 2007 = 207.3
from 60.6 to 207.3”an increase of 242 percent. The
Exactly the same sort of equation enables us to cal-
meaning of the change is clear enough. But what are
culate the CPI in any other year. We have the follow-
the meanings of the 60.6 figure for the price level of
ing rule:
1977 and the 207.3 figure for 2007? Both are index
numbers. Cost of market basket
in given year
A price index expresses the cost of a market basket of
CPI in given year 5 3 100
goods relative to its cost in some “base” period, which is Cost of market basket
simply the year used as a basis of comparison. in base year
Because the CPI currently uses 1982“1984 as its Of course, not every combination of consumer
base period, the CPI of 207.3 for 2007 means that it goods that cost $2,000 in 1982“1984 rose to $4,146 by
cost $207.30 in 2007 to purchase the same basket of 2007. For example, a color TV set that cost $400 in
several hundred goods and services that cost $100 in 1983 might still have cost $400 in 2007, but a $400
1982“1984. hospital bill in 1983 might have ballooned to $3,000.
Now in fact, the particular list of consumer goods The index number problem refers to the fact that
and services under scrutiny did not actually cost $100 there is no perfect cost-of-living index because no
in 1982“1984. When constructing index numbers, by two families buy precisely the same bundle of goods
convention the index is set at 100 in the base period. and services, and hence no two families suffer pre-
This conventional figure is then used to obtain index cisely the same increase in prices. Economists call
numbers for other years in a very simple way. Sup- this the index number problem:
pose that the budget needed to buy the hundreds of
When relative prices are changing, there is no such
items included in the CPI was $2,000 per month in
thing as a “perfect price index” that is correct for every
1982“1984 and $4146 per month in 2007 Then the
consumer. Any statistical index will understate the in-
index is defined by the following rule:
crease in the cost of living for some families and over-
state it for others. At best, the index can represent the
CPI in 2007
situation of an “average” family.
CPI in 1982“1984

Cost of market basket in 2007
5 Cost of market basket in 1982“1984




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Licensed to:
Part 2
128 The Macroeconomy: Aggregate Supply and Demand



TA BL E 6
THE CONSUMER PRICE INDEX
Prices in 2007
The Consumer Price Index (CPI), which is calculated Increase
over
and announced each month by the Bureau of Labor
Item Price 1983
Statistics (BLS), is surely the most closely watched
price index. When you read in the newspaper or see Hamburger $1.20 50%

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