Principle #8 Fiscal and Monetary Policies Influence People’s decisions
Objectives:
Investigate the goals of U.S. economic policy
Calculate a rate of change
Use a price index to convert nominal to real data
Up to this point, we have concentrated on individual decision-making and individual markets. Now it’s time to turn to the big picture, the national economy, and the goals of a national economy.
Why you want to learn this We will address questions such as the impact of changes in national economic conditions on your ability to find work or borrow money for a car, the fact that a raise may not be much help if prices increase by a greater amount than your raise.
Changes in the national economy affect you directly and indirectly. This and the following summaries will help you better plan your future.
National economic goals
We told you earlier that economics is about making choices concerning using your resources to achieve your goals. The same thing can be said about using our resources to achieve national economic goals. There are four goals that are often mentioned as national economic goals: economic growth, full employment, price level stability, and an acceptable distribution of income. Economic growth occurs when the economy is producing more goods and services than in previous time periods. Full employment means that all people who are willing and able to work are working. Price stability does NOT mean that relative prices don’t change (the price of beef vs. the price of chicken) but that the overall price level doesn’t change much. The most controversial of the goals is income distribution but it is generally agreed that an economy depends on a large middle class. To the extent that the middle class shrinks (as is appears to be doing now) the economy grows more slowly and employment falls. There is also the moral question, “Is it right (morally) if an increase in the wealth and income of the upper class causes a decrease in the wealth and income of the lower class?
We will look more closely at each of these goals in the next few summaries, but it will be helpful to explain some statistical adjustments to the data and some rates of change
Real vs. nominal data…adjusting for changes in the price level
A person who receives her paycheck in the mail and discovers that it has doubled is likely to be very happy, unless she goes to the grocery store to celebrate and discovers that the price of groceries has doubled. On his way home, he stops to get gas and finds that the price of gasoline has doubled. He wants a break from his sticker shock so he heads towards the local coffee shop to calm down, but discovers that the price of his latte has doubled. Sadly, he discovers that he is no better off than he was before his income doubled.
A politician proudly announces to her constituents that she has doubled the amount spent on education during her term in office. Obviously, anyone who cares so much for our children should be reelected…unless the price level has doubled. If twice as much money buys the same amount of services, this politician hasn’t increased any of the services going to our children. The point is that the amount of money a person earns or the amount of money spent is meaningless if the overall price level has changed. To account for these changes, economists and statisticians convert “nominal data” (data unadjusted for changes in the overall price level) to “real data” (data adjusted for changes in the overall price level). The good news is that the arithmetic is easy.
Calculating a rate of change
To calculate a rate of change for any variable, simply take the change and divide it by the original number. For example, if a firm sold 500 units of a particular item last week, and 600 units this week, the change is 100. 100 divided by 500 is 20%.
Rate of change = (new – old) / old
(600 – 500)/500 = 100/500 = .2 = 20%
The rate of change is an important concept in macroeconomics. Economic growth is the rate of change of Real GDP, inflation is measured by the rate of change of either the Consumer Price Index (CPI) or the Implicit Price Deflator (IPD). Often analysts will investigate the rate of growth of different variables in order to get a “read” on the economy.
Real vs. nominal data
If the Consumer Price Index (CPI) increases by 4% in a year, it means that prices of the goods and services bought by consumers have increased by 4% over the year. Both the CPI and the IPD compare prices in the current year to prices in a “base year.” If the IPD is 102, that means that prices today are 2% higher than prices in the base year. If it is 105, it means that prices today are 5% higher than they were in the base year.
Now for the arithmetic. Assume that defense expenditures have gone from $220 billion to $280 billion over a year’s period. How much more defense goods and services do we have now than we did last year? The answer is that you can’t tell unless you know what has happened to the overall price level. To find out, a formula is used.
Real defense expenditures = nominal defense expenditures x 100
IPD
The GDP price deflator (IPD) is like a conversion factor that transforms nominal GDP into real GDP. In order to understand how the conversion works, it is important to note that, in the base year, real GDP is by definition equal to nominal GDP. Therefore, the GDP price deflator in the base year is always equal to 100.
The IPD can be used to “deflate” many different types of numbers. If nominal defense expenditures last year were $220 billion and the IPD was 110, then real defense expenditures last year were $200 billion. If, this year, nominal defense expenditures were $280 billion and the IPD is 120, real defense expenditures this year are $233 billion.
Year 1 | Year 2 | Difference | % change | |
Nominal | 220 | 280 | 60 | 27% |
IPD | 110 | 120 | ||
Real | 200 | 233 | 33 | 16.5% |
Looking at nominal data would indicate an increase of 27%, while the real data show that the real increase was a lower 16.5%
Bottom line:
Four major national economic goals are economic growth, full employment, price stability and an acceptable distribution of income.
The data that measure these goals must be adjusted to account for overall price changes.
1. Assume that real GDP increased from $10 trillion to $10.5 trillion. What is the rate of economic growth
a. .5% b. 5% c. 50% d. Can’t tell without the IPD.
2. The difference between nominal and real data is:
a. Nominal data is always higher than real data. b. Nominal data is adjusted for inflation or deflation while real is not. c. Nominal data comes in the form of a number while real is in the form of percentage d. Real data is adjusted for changes in the price level while nominal is not.
Refer to the data below to answer the next 3 questions. The data represent an economy of hot dogs and movies. The base year is 2002.
Year | Nominal GDP | IPD | Real GDP | Economic Growth |
2018 | $140 | 100 | ||
2019 | $160 | 110 | $145 | |
2020 | $175 | 120 | $145 |
3. Real GDP for 2018 is:
a. $100 b. $120 c. *$140 d. insufficient information
4. Inflation in 2020 is:
a. *9% b. 10% c. 20% d. insufficient information
5. Economic growth in 2020 is:
a. *0% b. 4% c. 10% d. 20%
6. A student works in a hamburger shop. Her pay has doubled. She is delighted. She goes to the gas station and gets gas. The price of gas has increased by 110%. Ouch. She goes to get a latte to calm down and finds that the latte has doubled. Ouch twice! Everywhere she goes, she finds that prices have doubled or more than doubled. What can you tell her?
a. There is a plot by all businesses to rip her off. b. At least her real income has increased. c. Actually, her real income has fallen. d. Real is a subjective concept.
7. The Secretary of Education states that education expenditures by the federal government have increased by 8% over the last fiscal year. What question(s) would you want to ask?
a. What was the rate of inflation during the same period? b. Was that figure nominal or real? c. If the figure is nominal, what is the real rate of increase? d. All of the above
Go to the Federal Reserve Economic Data (FRED) and find the value of the Federal Minimum wage https://fredblog.stlouisfed.org/2015/07/the-real-minimum-wage/
What would you have concluded about the minimum wage using nominal data for the period 1980 to 2000?
What can you conclude about the value of the minimum wage using “real” data for the same period?