Another legacy of economists’ revitalized interest in the supply side of the economy is real business cycle theory: the belief that real changes (as opposed to nominal changes that involve only changes in dollar values) such as technology shocks, new products, new government regulations (regarding such things as pollution), weather changes, changes in consumer preferences, natural resource discoveries, labor supply changes, tax rate changes, large changes in relative prices (such as that or oil), and other supply-side factors are primarily responsible for flucturations in economic activity. Also, according to this theory, traditional demand-side shocks play a secondary and very transitory role in affecting the economy. Real business cycle theory could be viewed as the most recent variant of supply-side economics because these real shocks primarily affect the supply curve rather than the demand curve. Although few economists feel that business cycles can adequately be explained by such supply-side phenomena alone, real business cycle theory has undoubtedly improved our understanding of business cycles by drawing economists’ attention to the wide range of real phenomena that affect the economy and forcing them to think carefully about how they should be incorporated into an overall theory of how the macroeconomy operates.

A rule of thumb, called Okun’s law, is used to translate unemployment greater than the natural rate into an output gap and thereby to measure the cost to society of excessive unemployment An extra percentage point of unemployment, above the natural rate, corresponds to an output gap of about 2 percentage points of potential GDP. This rule implies, for example, that if the NRU is 6 percent, an unemployment rate of 8 percent gives rise to an output gap of 4 percent of potential GDP, or about 300 billion dollars!

It may seem odd that an extra 1 percent of unemployment is associates with more than a 1 percent change in GDP. This result occurs because firms find it more profitable to meet demand fluctuations by varying the workload of current workers rather than by varying the number of employees. Firms have a tendency to hoard labor as the economy moves into a recession, electing not to lay off as many workers as the drop in their sales would dictate. They make this choice because they do not want to risk losing workers whose skills and experience make them particularly valuable to their firm when the recession ends, and this policy allows firms to avoid the costs of hiring and training new workers. Consequently, output falls by more than unemployment rises when the economy moves into a recession, and during a recovery output can increase by making fuller use of the hoarded labor. Furthermore, when hoarded labor no longer exists, firms meet many fluctuations in demand by varying overtime, rather than by varying the number of employees. This response also reflects rational behavior on the part of the firm, since existing employees are more productive than new employees, hiring and training costs can be avoided, fringe benefit costs are unaffected, and layoff costs are not incurred.

To an economist full employment does not mean a position in which the unemployment rate is zero. Zero unemployment is not realistic, for several reasons. First, at any point in time some people are temporarily unemployed because they are in the midst of changing jobs or looking for an initial job. The unemployment corresponding to this ongoing process of improving the occupational and geographical match of workers and jobs is referred to as frictional unemployment.

Second, many people may be unemployed because technological progress has made their skills obsolete or because new trade agreements have changed the nature of what is produced domestically. They must retrain to obtain jobs. Both frictional unemployment and this structural unemployment are healthy because they mean that the economy is responding to the forces of change. Some workers are switching jobs to produce the goods and services that the changing tastes of society are demanding or to find jobs they will be happier doing. Other workers are retraining to keep up with technological innovations that improve productivity. Part of frictional and structural unemployment, however, reflects demographic factors such as the increased participation rate of females and the young. Many of the former need more training, having spent time as homemakers, and the latter are both unskilled and at a stage in life when switching jobs is more common.

The third reason that zero unemployment is unrealistic is that institutional phenomena may affect unemployment. For example, minimum wage laws may make it too costly to hire extra labor; generous unemployment benefits may make it easier to stay or become unemployed; government regulations, such as restrictions on how many hours per day a store can be open, may decrease job availability; and there may be racial or gender discrimination.

Economists do not pay much heed to the usual complaints about inflation. For most people the impact of rising prices is offset by rising wages. Those living on fixed incomes, such as welfare recipients or old-age pensioners, can (although may not) be protected through appropriate policy action. Arbitrary redistribution of wealth, such as rises in real estate values, comes about mainly if an inflation is unanticipated, in which case economists would condemn it.

From their study of microeconomics economists know that our economic system works well because prices act as signals to induce producers to produce the things we value most at the lowest cost—the right prices ensure that the economy maximizes the total welfare of its participants. This is what is meant when it is said that the price system is a very efficient way of allocating and distributing goods and services. To economists, the main cost of inflation is the resource misallocation it causes—the loss of efficiency that results because inflation distorts price signals. This happens in many different ways, some examples of which follow.

In the early 1990s Governor John Crow of the Bank of Canada aimed for zero percent inflation. Most economists felt that this target was extreme; so did the Canadian government, which did not reappoint crow. Alan Greenspan, chairman of the Board of Governors of the Federal Reserve System, the U.S. central bank, offered a more flexible target in a statement to the U.S. Committee on Banking, Housing and Urban Affairs in February 1989:

Maximum sustainable economic growth over time is the U.S. Federal Reserve’s ultimate objective. The primary role of monetary policy in the pursuit of this goal is to foster price stability. For all practical purposes, price stability means that expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household financial decisions.

He did not make the mistake of aiming for an unrealistic level that in any event is inappropriate, nor did he pin himself down to a specific level, the better to deal with criticism. An inflation rate of 2 or 3 percent seems to be an acceptable target.

Each month about 1,500 employees of the Bureau of the Census, on behalf of the the Bureau of Labor statistics (BLS), interview about 60,000 households. Each civilian household member 16 years of age or older is first asked if he or she did any work for pay during the last week, and if the answer is yes, even if it was just for an hour, that person is counted as employed. Those answering no are asked if they worked 15 hours or more without pay for a family business or farm, and if the answer is yes they are counted as employed. Those answering no are asked if they are waiting to begin a confirmed job or to be called back to a job from which they have been laid off; if the answer is yes they are counted as unemployed. Those answering no are asked if they have been doing anything to find work during the last four weeks, and if they answer yes they are counted as unemployed. The others, those who have not been looking for work (because they are students or homemakers, for example, or because they have given up hope of finding a job) are classified as not in the labor force. The official unemployment rate, sometimes referred to as U3, is calculated as the ratio of the unemployed to the sum of the employed and unemployed.

The BLS publishes other unemployment rate measures. For example, U1 is based on those who have been unemployed for 15 weeks or longer and is intended to reflect unemployment with a more substantive financial loss. In addition to those counted in U3, U4 includes discouraged workers, measured as those who want work, have searched for work during the preceding year, and claim they have stopped searching because of a lack of suitable jobs. Finally, U6, intended to reflect potential labor resources, includes those claiming to want work but not searching (for whatever reason) and part-time workers wanting full-time work. In January 1999, U1 was 1.1%, U3 was 4.8%, U4 was 5.0%, and U6 was 8.5%. The gap between U3 and U4 is usually about two percentage points, but shrinks during booms (as is the case for 1999) and widens during recessions.

In addition to these overall rates of unemployment, information on a variety of characteristics of the unemployed is reported. For example, in 1998 the unemployment rate was 4.5 percent overall but 4.4 percent for males, 4.6 percent for females, 16.2 percent for males aged 16-19, 12.9 percent for females aged 16-19, 3.9 percent for whites, and 8.9 percent for blacks. About 50 percent of the unemployed had lost their job, 32 percent were reentrants to the labor force, 12 percent were job leavers, and 6 percent were new entrants. About 45 percent had been unemployed for less than 5 weeks, 29 percent for 5-14 weeks, 12 percent for 15-26 weeks, and 26 percent for longer than 26 weeks.

The GDP deflator and the CPI are both price indices. The CPI is particularly well known because it measures changes in the cost of living and so is of more personal interest to individuals, and for that reason it is the price index normally used to calculate the rate of inflation. There are three major differences between these two indices. First, the CPI reflects prices of only consumer goods and services, whereas the GDP deflator calculation includes prices of all output. Second, the CPI incorporates prices of imports, excluded from the GDP deflator calculation. And third, the GDP deflator allows the output basket to change each year, whereas for the CPI it changes only every two years and with a lag. Two minor differences are of note. First, once published the CPI is never revised, as are other statistics, because it is often used in contracts to measure cost-of-living wage adjustments. And second, these price indices have different base years, currently 1992 for the GDP deflator, and 1982-84 for the CPI. Despite these differences, both indices produce very similar inflation measures.

Here is a technical detail for those really curious about price index calculations. The GDP deflator actually used is a chained index, calculated slightly differently than described in the text (but the resulting numbers are very similar). Real growth from one year to the next, say from 1992 to 1993, is calculated first by measuring and comparing the two years’ physical outputs in 1992 prices and then by measuring and comparing the two years’ physical outputs in 1993 prices. The geometric average of these two growth rates is used to measure real growth between these two years. This procedure is done for all adjacent years, and then the base-year value of GDP is augmented by these growth rates year (i.e., “chaining” the growth rates together) to produce the real GDP series. This series is then used to produce the corresponding “chained” price index by dividing nominal GDP by real GDP. This procedure reduces bias caused by changes in output bundles from year to year.

Inflation is defined as a persistent rise in the general price level. This price level is usually measured by the consumer price index, the CPI, a price index designed to reflect growth in prices of consumer goods and services. If the prices of all consumer goods and services rise by 10 percent, the CPI rises by 10 percent to reflect these increases. The CPI is calculated by observing changes in the cost of purchasing a typical bundle of consumer goods and services. As the cost of buying this bundle rises (falls), the CPI rises (falls). Thus the CPI is a weighted average of all consumer prices, with the weights given by the relative importance of different goods or services in the typical bundle of purchases. A survey of the prices of about 80,000 items is used in calculating the CPI each month. The typical bundle currently in use is based on results from a national survey (the Consumer Expenditure Survey) of almost 36,000 people undertaken during the years 1993 to 1995. This bundle is divided into eight general categories; the following list gives their approximate weighting and examples of their components.

1. Food and beverages (16%): breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks.

2. Housing (40%): rent of primary residence, owners’ equivalent rent, fuel oil, bedroom furniture.

3. Apparel (5%): men’s shirts and sweaters, women’s dresses, jewelry.

4. Transportation (18%): new vehicles, airline fares, gasoline, motor vehicle insurance.

5. Medical care (6%): prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services.

Gross domestic product, GDP, is the total dollar value of all final goods and services produced in a country during a year. Several things about this definition should be noted:

1. Both goods, such as automobiles and top hats, and services, such as the help of lawyers and plumbers, are included.

2. Current market prices, reflecting the value society places on items, are used to aggregate different outputs to a dollar total. Government purchases, many of which do not occur on markets, are valued at their cost of production.

3. Only final goods and services are included. Intermediate goods, such as steel that has yet to be made into hammers and shovels, are not included. This practice avoids double-counting the steel.

4. This measure is an annual flow, a rate of production. A GDP of $6 trillion implies that the economy is producing $6 trillion worth of goods and services per year.

5. U.S. GDP measures production by U.S. citizens and foreigners alike inside the geographic borders of the United States and so unequivocally reflects economic activity in the United States.

Economists and the media use many names besides GDP to refer to the nation’s annual output of goods and services. Output, total output, national output, income, total income, national income, and aggregate supply are common. Algebraic representations use the capital letter Y. These names suggest that economists use the terminology output and income interchangeably; it is important to understand why.

The essence of why output and income are considered the same thing is that whatever is spent on a product (the value of that output) is divided up as income by those people producing it. Consider one element of GDP, a loaf of bread worth a dollar. With only a few exceptions, every penny of this dollar’s worth of bread can be traced back into somebody’s pocket as income. Some of the dollar is profit/proprietor income to the grocer, baker, miller, and farmer (or dividend income to their stockholders), some is wage and salary income to their employees, some is interest income to the banker who has financed their loans (or interest income to those who purchased their corporate bonds), and some is rental income to their landlords. It is because of this equivalence that total output, GDP, is referred to as total income.

Laypersons’ use of the word income is slightly different in that it reflects what we receive as income, regardless of whether or not it corresponds to output. There are three differences of note. First, of the dollar’s worth of bread, some money will be set aside by the grocer, baker, miller, and farmer to cover depreciation—to pay for replacing their buildings and equipment when they have worn out—and thus will never make it into anyone’s pocket as income. Second, if the grocer, baker, miller, or farmer pays any indirect taxes, such as sales taxes, as the bread makes its way through the production process, then this money goes directly to the government and thus also does not make it into anyone’s pocket as income. And third, transfer payments make up part of our income, but do not correspond to output produced. Examples are government production subsidies, welfare and unemployment insurance payments, and gifts. Interest on government and consumer debt is also classified as transfer payments because unlike interest paid by business, it does not reflect the cost of production activity. A subset of the national income accounts reports data on these kinds of measures.

As a nation, our annual income—what we have available to distribute to our citizens—is what we have produced during the year. Despite the fact that individual incomes do not quite match this concept of a nation’s aggregate income, we will use the terminologies aggregate output and aggregate income interchangeably. This thinking suggests that GDP could be measured by adding up all incomes and making adjustments for the phenomena that we have noted. For those interested, appendix 2.1 at the end of this chapter shows how this process would be carried out. Some countries use this method to help in estimating GDP, but the United States uses a different method.

When students first learn about the multiplier, they jump to the conclusion that it is better to have a large rather than a small multiplier to enable the government to push the economy out of a recession more easily. There are two main reasons why this conclusion is not warranted:

1. Our knowledge of the economy and how it operates is imperfect, so deciding when and by how much to change government spending is not an exact science. A large multiplier magnifies any mistake by the government.

2. A large multiplier means that any change in aggregate demand, not just a change in government spending, has a substantive impact on economic activity. All economies are subject to irregular changes in aggregate demand, such as changes in export demand due to changes in foreign economies, or changes in investment demand due to new inventions. With a high multiplier, these changes have a large impact on economic activity, creating instability.

In light of these two problems, anything that causes the multiplier to become smaller is considered desirable because it insulates the economy from the effects of policy errors and aggregate demand shocks. Several phenomena play this role in the economy and are consequently called automatic stabilizers, although some economists reserve that term for government policies that lower the multiplier value. Each of the following examples is explained in the context of an increase in aggregate demand. They would operate in reverse if aggregate demand were to decrease.