Goals: What’s a “Good” Economy Look Like?
We can never “solve” the economic problem — we’ll always face unlimited wants but only have limited or scarce resources to use in satisfying those wants. Although we can’t ever have everything that we want, it’s certainly possible to do better — or worse. Individually, our standard of living depends on what we individually produce, what resources we have available, and what opportunities we have. Much of how well off we are and what opportunities we have depends on the functioning of our economic system. So what makes for a good economic system or policy? We also want to know how to measure an economy so that we know how well our policies are performing, but before we measure anything we need to know what our goals are.
In broad terms, we want an economic system to accomplish four things on a regular basis:
- achieve full employment of all our productive assets,
- keep the value of our money stable so that prices & markets can function,
- grow the amount of goods & services
- make the growth somewhat predictable and steady, not erratic and unpredictable.
Economic Measures and Economic Goals
Any economic policy or system that achieves these goals is a really successful one. People will thrive, prosper, and live long under it. Of course, there’s a catch (this is economics, after all). Individually, it’s not too hard to design policies that will substantially achieve each goal. Unfortunately, it’s tremendously difficult to design and implement policies that achieve all four at the same time.
It’s important to look at how we calculate these measures so we can understand what the data and the constantly changing numbers are really telling us. Sometimes, it isn’t obvious. For example, an increasing unemployment rate does not necessarily mean that increasing numbers of people have lost their jobs! But it might. The data and measures discussed in these chapters are widely publicized. We hear the latest numbers on the radio or TV news. We read about them in the newspaper or business magazines. After you read these chapters, you should be able to better understand what the data tell us about what’s happening in the economy. I don’t expect that many of my students will ever have a need to calculate these types of data in their career. But, you will all need to understand what they mean.
Goal: Economic Growth
More and faster is better — that means we have more stuff, more goods, more needs being satisfied.. No real surprise here. What’s difficult about monitoring the economy’s ability to achieve this goal is simply the sheer magnitude of the task: how in the world can we actually count how much stuff we produce? All 297+ million of us in the U.S? The answer is a measure called GDP and a process called National Income Accounting. Gross Domestic Product, GDP, is a measure calculated as part of a system called National Income Accounting.
Goal: Economic Stability (Business Cycle)
We established earlier that the basic macroeconomic goals include growth, full employment, stable price level, and stable, predictable growth. The national income accounting system you studied in the previous chapter helps provide very useful, though not precise, information about growth. Simply put, if Real GDP increases from year-to-year, then it implies that we have more goods and services being produced and available to consume. In other words, we can evaluate whether our system has achieved our first goal: growth. If we track the ongoing changes in Real GDP over the years, we also have a way to measure how stable the growth is. In other words, if Real GDP never declines and consistently increases, then we will know how well we have achieved the last goal: stable growth (no recessions). We will look closer at this goal in a later unit.
Goal: Full Employment
There are still two major goals left: full employment and a stable price level. This chapter looks at the definitions and issues involved in measuring performance toward these goals. Both of these goals are very important to the political stability of a society, as well as the economic performance of the society. History shows that whenever any society lets either unemployment or inflation get too high, the society and it’s governments collapse, sometimes violently.
Typically, we measure how well a society achieves its goal of full employment of resources by looking at either the labor unemployment rate and/or the amount of total worker employment. Labor is the most important resource of any society, and it’s the resource that can’t be “stored up”. If we fail to utilize all the labor available to us, we won’t produce as many goods and services as possible. We will look closer at this goal in a later unit.
Goal: Price Stability
Here, the goal is really nothing. That is, the goal is to not have any inflation (rising price level) or deflation (decreasing price level). When the price level keeps changing (up=inflation, down=deflation), then the market system doesn’t work very well. The ability of relative prices and changes in relative prices to coordinate producers and consumers efficiently breaks down when inflation or deflation occurs. Compounding the problem is the tendency of both inflation and deflation to “spiral” – that is, to get worse over time, leading to hyperinflation or a crushing deflation.
Price indices are simply attempts to estimate approximately how much all prices have increased during a period of time. Think of it as a calculation of the “average” price of range of particular goods. Technically, it is a very sophisticated weighted averaging of prices, but the technical detail isn’t important. In any given year prices of goods change for two reasons: one, prices of different goods change relative to each. This is the kind of price change that a microeconomist observes people reacting to by changing buying habits. If the price of beef goes up relative to the price of chicken, people switch to eating more chicken.
There is another source of price changes in goods, though. It is inflation. It is when the price everything goes up because money itself is becoming less valuable. Price indices try to measure how much inflation is occurring in a group of products and while ignoring the relative-price changes.
More and faster is better — that means we have more stuff, more goods, more needs being satisfied.. No real surprise here. Just as most people would rather have more and/or better goods and services for them to consume, as a society we want more also. So, the first goal for an economy is to produce a growing supply of goods and services for us to consume.
A Jim’s Observation:
Mainstream economics assumes that more-and-more goods is the goal; that’s it’s a good thing for society. Some critics (myself included) have criticized this assumption, particularly environmentalists and a growing minority of economists called “ecological economists” have criticized it. They maintain that the goal of society should be a sustainable, improved quality of life, not just more consumption of more goods. To a degree, these critics have a valid criticism. Mainstream macroeconomics is largely the result of 200 years of study, during which time nations clearly did not have enough goods. Mainstream macro has not fully developed theories for economies that are mature in their ability to provide goods and a high-living standard for all. This is clearly an opportunity for new research and theorizing. On the other hand, the criticism is not completely valid since our methods of measuring the amount of goods actually measures the value of the goods – not the physical quantity. In other words, an economy which produces the same physical quantity of goods each year, but increases the quality and value of those goods each year would still show as having a growing GDP. For this course, we will stick to the mainstream approach.
While you, I, and even individual firms don’t usually have a hard time measuring whether or not we are more productive than in the past, it is a difficult question when asked in the aggregate. For example. suppose an economy only produced four goods: pounds of beef, gallons of Coke, movies, and automobiles. We could actually count the physical quantities of these four goods produced each year. If next year we produce more of all four goods, then fine, we know we have grown our aggregate output. But what if we produce more movies and Coke, but less beef, and the same number of cars? Do we conclude that total output has increased or decreased? It’s the old “adding apples and oranges problem” that your elementary math teacher always warned you about. Now think about the problems involved when there aren’t four goods, but there are millions of different products! How do we add Buicks and pizzas? Or add haircuts-provided and schools-built?
Economists have developed a solution to this “apples-and-oranges, Buicks-and-pizzas” problem. Instead of counting the physical quantities of output, we count the value of what was produced. How do we know the value of each item produced? We use the money price when the item was sold. So, if a new Buick is sold for $35,000 and a new pizza is sold for $5, then it takes 7,000 pizzas to equal one Buick. In other words, we don’t really count the physical quantities of goods produced, we count and add up the dollar value of the goods produced. The process of counting and reporting the value of all these things produced in the economy is a task of the Census Bureau and Commerce Dept. of the Federal Government (they don’t just count people!). They actually produce a set of records for the economy, much like a business produces accounting statements. The process and logic involved is called National Income Accounting. And, the bottom line, the total number for the whole economy is a number called GDP – Gross Domestic Product.
Growth Over The Long-Run
Of course being able to measure increases in Real GDP over the years doesn’t ensure that there will be increases in Real GDP and increases in living standards. In this unit we also want to look at what causes an economy to grow over the long-run. The single biggest determinant of an economy’s living standard is it’s labor productivity: the ability of its workers to produce goods and services. This is why it is so important for an economy to have full employment – all its available workers working. Improvements in productivity will increase Real GDP.
But what causes productivity to improve? Three factors will increase labor productivity:
- increased physical capital (business machines and equipment and factories) available for workers
- improved human capital (knowledge and skills of workers)
- improved technology
Why do growth rates differ between nations? In short, because nations differ in their ability and willingness to accumulate physical capital, human capital and acquire technology. Go back to the circular flow diagram. Imagine if there were no savings – consumers spent 100% of their income. Then since there would be no savings, there would be no money for businesses to borrow to finance their investment spending. If there’s no investment spending, then businesses aren’t acquiring new physical capital. No new physical capital and there’s no increase in productivity or real GDP. In contrast, a nation with high investment spending is likely accumulating physical and human capital and acquiring new technology. It’s ability to produce will grow over time and Real GDP will grow with it.
What determines a nation’s ability to invest in capital accumulation? The following factors help determine how fast a nation accumulates capital and improves productivity:
- the rate of savings and investment spending
- the amount of foreign investment capital attracted
- the education of its people (education is human capital)
- the state of its infrastructure: roads, power lines, ports, networks
- the amount it devotes to R&D (this doesn’t show up well in the circular flow)
- the degree of political stability and property rights that exist
Measuring the “Price Level” – Tricky Business
In the course of looking at how to measure the aggregate output (production) of goods and services, we realized that we needed to adjust the “nominal GDP”, the amount of spending we can observe, for changes in a thing we called a “price level” so that we could arrive at a measure we called “real GDP”. Now we need to look closer at this measure we called a price index.
In reality, an economy has multiple price indexes. In the U.S. for example, there are multiple versions of the Consumer Price Index, the Producer Price Index, the GDP Deflator Index, and numerous others. Some magazines even research and publish their own indexes, such as a Fast Food Price Index. The reason there are so many slightly different price indexes is because a price index is a very imperfect measure. What we want to measure is the degree to which all prices in an economy are going up or going down together. This would tell us how much the level of overall prices, what we call the aggregate price level, has changed.
Of course measuring the change in all prices is an impossibility. We cannot directly measure changes in the aggregate price level. At any one time some prices are going up and some going down – that’s the working of a microeconomics, supply and demand in action. What we’re concerned with though, is whether in the midst of some prices going up and some down, there’s an underlying trend of all prices to go up. For example, suppose there are only 4 products in the economy. Microeconomic supply-and-demand suggests that if we observed say 2 products go up in price by 3% each, the other 2 products should go down in price by an offsetting amount. That’s the micro price mechanism in action. Some products became cheaper and some more expensive.
But suppose, one product went down 1%, and the other three products went up in price by 7%, 9% and 10% respectively. Just looking at these price changes we might suspect that there’s something else going on. It appears that there’s an underlying tendency for all the prices to go up. Somehow the up-and-down of price changes created by supply-and-demand in each micro market is getting confused with a general tendency for all prices to go up. This general tendency of all prices to go up we call inflation. Or, if there’s a general tendency for all prices to go down, we call it deflation. It’s impossible to directly and accurately measure inflation or deflation in prices. So, instead we have to create a measure called a price index. Then we call changes in the price index either inflation or deflation.
Conceptually, we can think of the aggregate price level as being the “average price” of goods. Of course, it is practically impossible to actually calculate the true “average” of all prices. If nothing else, there are simply too many different products and prices to be able to calculate it. So economists have created a proxy measure called a price index. What happens with a price index is that an economist defines a small artificial list of products that are supposed to representative of the economy. It’s called a market basket. The market basket is a pre-defined list of fixed quantities of particular items. The economist then goes out into the economy and finds out what the prices of these goods are. She calculates what it would cost to actually purchase that market basket at the prices in effect in the economy then. The economist then compares what the market basket costs at that point in time to what it would cost to purchase the same identical goods and quantities at another point in time. She arbitrarily picks one point in time as a “base year” and assigns a value of 100 to the cost of the market basket in the base year. When the total cost of the market goes up, she calculates how much it went up relative to the base year. Suppose the market basket costs 10% more the year after the base year. Then the price index would now read 110 because 110 is 10% higher than 100.
You could create a price index of your own very easily. Suppose you created a shopping list of certain items and quantities. You go out and price all the items and calculate what it costs to buy your list. This is your “base year”. You assign a value of 100 to this total cost in the “base year”. Next you go shopping each week (or month, or year) and price what it would cost to buy the full, exact same shopping list. As the total cost of the shopping list changes, you adjust the price index the same relative change. You would have your price index for the goods you buy. If the total cost of the shopping list hardly changes, in other words, the price index stays very close to 100, then you are experiencing “price level stability”. You are NOT experiencing inflation or deflation, even though the price of some individual products may have gone up and others gone down. But, if the overall cost of the shopping list keeps going up, then you are experiencing inflation. And inflation is not a good thing.
In this course, I do not ask you to calculate a price index itself or to calculate changes to a price index from the raw prices in the market basket. You will have to calculate an inflation rate from price index data. What is important to is understand the concept of a price index and how it depends on the market basket of goods chosen.
There are different price indexes because there are different “market baskets” defined. Any price index, no matter what market basket is based upon, is only an approximation of what the true, actual inflation or deflation has been in economy. We don’t have a means to accurately, directly measure inflation or deflation. Changes in a price index are the best we can do. Economists try to refine their methodology and to refine the selection of goods in the market basket, but it is still imperfect. So any given price index may tend to overstate or understate the true, actual rate of inflation . For example, in the late 1990′s a change was made to how the Consumer Price Index was calculated. As a result, inflation as calculated from the CPI has been lower since the change than it was before. See here if you want to know more about this particular change and how it affects today’s data as reported in the news.
What’s Money Good For Anyway?
A market-based economy runs into big trouble if inflation or deflation happens. Inflation and deflation are not good phenomena. The reason is because inflation, the general rise in all/most prices, is only a symptom of other real problems. Inflation often indicates an economy is “overheating” and that collectively all of us are trying to buy more goods/services than all of us together are capable of producing, and thus we bid up the prices of everything. Deflation usually indicates that collectively we are not willing to buy all the goods or services we are capable of producing, thus prices of everything drop due to a lack of aggregate demand.
In general inflation or deflation indicates a sick monetary and financial system. For a market-based economy to work well and efficiently, we all need to have money we can count on. Literally. Think about it. We actually use money as a way to measure and count the value of goods. Even though we learned in microeconomics that goods get their true value because of the utility consuming them provides, in reality we use money as the way to measure and compare the value we put on different goods. We assume that the money we are using is an objective, unchanging standard of value. We assume a “dollar is a dollar is a dollar”. We assume that when the price of something goes up it has become scarcer and more valuable. We use money as a yardstick or meter stick to measure the value of goods. And, like a good ruler, we assume that the ruler stays the same size all the time. We assume the measure is constant itself.
But, money doesn’t always keep it’s value. Money, at times, is a very poor measure because it sometimes loses (or gains) value over time. Imagine trying to measure the height of child year-by-year as the child grows when the yardstick or meter stick you use to measure their height keeps shrinking each year. You might conclude the child grew a full 12 inches, when in fact they only grew 3 inches and the yardstick shrank by nine inches. Trying to understand prices in a market when inflation exists is like measuring height with a shrinking ruler. It doesn’t work.
When an economy experiences inflation (or deflation), what is really happening is that the money the society uses is changing in value. Inflation means that dollars (or whatever the society uses for money) are becoming less valuable as time goes by. Deflation means dollars (money) are actually gaining in value. Ideally, a society wants neither inflation nor deflation. Whether a society experiences either inflation or deflation is largely determined by what the society chooses to use as money and how it regulates it’s financial and banking sector – a topic for a later unit in this course.
Inflation/Deflation Creates Unequal Winners and Losers
In real-life, very few societies are able to have zero inflation or deflation. There’s almost always some degree. In modern economies (the developed nations since the mid-20th century), deflation rarely happens. Instead, what is more common is mild to moderate amounts of inflation. As a result, most people expect inflation to happen to some degree and try to adjust their behavior accordingly. For example, most banks in the U.S. expect some inflation of around 2% per year. So, when they loan money to someone, they increase the interest rate to reflect their expected inflation. The banks know that they will get paid back dollars that aren’t as valuable as the dollars they loaned out. So they increase the interest rate so that the bank gets paid back with even more dollars.
One of the worst aspects of inflation/deflation is that it doesn’t affect everybody the same. For example, when inflation exists, borrowers borrow valuable dollars one year and pay back with less-valuable dollars in future years. Borrowers gain from inflation. Lenders lose from inflation. In deflation, the reverse happens. The borrower loses and the lender gains.
When inflation happens, people living on fixed dollar-amount incomes suffer. There incomes stay fixed while the prices of what they buy goes up. But when there is inflation, people who own real assets (houses, land, machinery, etc) gain. The value of what they own in dollar terms goes up.
Deflation is Worse than Mild Inflation
Not only does inflation (or deflation) affect different people differently, but the macroeconomic consequences of inflation as compared to deflation are not symmetric. You might think a 2% inflation rate is just as unstable as a 2% deflation, but it doesn’t work that way. The evidence is pretty strong that capitalist market economies (especially with large financial sectors) do reasonably well at 2% or so inflation. Even inflation as high as 5% is manageable. On the other hand, a deflation rate of 1% (prices drop 1% per year) or even 0.5% can wreak havoc and produce a long and severe depression. This is because of debt. When deflation happens, prices drop. But wages and incomes also drop. The only thing that doesn’t drop are payments on previously borrowed debts. The payment stays fixed in nominal terms and as income drops, the payment takes a larger and larger share of income forcing even bigger cutbacks in spending. But cutbacks in spending mean somebody else’s income drops, forcing them to make cutbacks also. This process is called debt deflation and it was a major part of the Great Depression and is also a significant part of why the U.S. and Europe have struggled for years to recover from the Great Recession/Financial Crisis of 2007-09.
Everybody Loses With High Rates of Inflation or Deflation
At times a nation’s inflation rate gets very high. As inflation increases, it tends to accelerate. In other words, suppose all prices go up 20% this year. The following year they will likely go up even faster, perhaps 40-60%. And then they will go up even faster, even 100% or even 1000% per year. When this happens, it typically means the economy collapses. We call this hyper-inflation. Despite popular belief, a hyper-inflation does not happen simply because a nation borrows money or prints money. Creating a larger supply of money is an important part of creating a hyperinflation, but it is not enough. To have a hyperinflation, a nation must experience what we call a large “supply shock” – it’s capacity to produce real goods must be suddenly reduced.
Germany in 1923 experienced a massive hyperinflation. The proximate cause was a French occupation and seizure of German coal mines and steel mills in the Ruhr valley in response to German default on paying World War I reparations to France. The German government continued to support Germans’ purchasing power by creating new money even though the supply and production of goods had drastically declined. Hyperinflation resulted. In one famous example of the price increases, two potatoes cost one Reichsmark (the German currency at the time) in early 1923. A few months later a buyer needed a wheelbarrow full of paper Reichsmarks to purchase even one potato. An economy cannot function well in such an environment, although the German economy recovered nicely once a diplomatic solution to the reparations and French occupation was achieved. But damage had been done. In Germany, in 1923 the inflation largely wiped out the cash savings of the entire middle class. Contrary to popular belief, the inflation of 1923 was not a direct cause of Germans electing the National Socialist (Nazi) Party and Adolph Hitler to power. Hitler came to power 9 years after the inflation. What happened is the painful memories of the hyperinflation made the subsequent German governments and central bankers overly afraid of any amount of inflation or money creation. When the Great Depression hit Germany in 1930, the fear of inflation caused the central bank to not respond. A deflation resulted and unemployment skyrocketed. The widespread unemployment set the stage for the Nazi electoral victory.
Other nations have suffered severe hyperinflations. Russia, Argentina, Bolivia, and Brazil have all suffered severe hyperinflations in the 1990′s-2000 period. The Spanish Empire of the 15th-16th century largely collapsed as a result of inflation. The sad reality is that, while inflation and deflation may seem like abstract economic concepts, they can be all too real. History shows that when nations experience extremely high inflation, either war or revolution often follows.
Summary: The Goal – Stable Money and A Stable “Price Level”
Money is essential for markets to function efficiently. And for money to function, it must retain its value. Unfortunately, we don’t have any way to directly measure the value of money. So the next best option is to observe the effects of money losing it’s value: changes in the overall aggregate price level.
Reading Guide – Assigned Readings
In addition to the Jim’s Guide (above), you should read and study in your Mandel Economics: The Basics textbook:
Chapter 8 – Inflation
JIm’s Comment: Read entire chapter. You will be doing some calculations in the worksheet for this unit that involve adjusting for inflation, so pay very close attention to the “How ti WOrks ” box on page 150, Table 8.3, and the “How It Works” box on page 157.
Chapter 9 – Growth
JIm’s Comment: Read entire chapter, however pay close attention to the main narrative in this chapter. Pay close attention to “How It Works” box on page 169, and tables 9.1 and 9.2. The other tables and side-boxes are less important.
Click here for the Unit 7 practice quiz. The practice quiz will open in a new tab/window.
Unit 7 Worksheet – Data and Directions. After you complete the data problems on this worksheet page, you should answer the questions and enter your answers in learning mgt system (Moodlerooms at HFCC).
If you need additional help, you may try these videos:
If you need help with calculations and the worksheet, you can try my tutorials on my macro course here:
In the next unit we’ll take a bit of detour from the main textbook to examine a model of how the macroeconomy functions. It’s called the Circular Flow of goods and services.