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Macroeconomics Study Sheet • Potential Real GDP Trough Time SHORT TERM FLUCTUATIONS IN OUTPUT AND EMPLOYMENT (BUSINESS CYCLE) - In the short run, employment fluctuates with output. → Unemployment rate = percentage of people in the labour force who are unemployed. - Inflation refers to the process of rising prices. → Inflation rate = annual percentage change in the price level. - The real interest rate is equal to the nominal interest rate, adjusted for inflation. - The exchange rate is defined as the number of units of domestic currency required to purchase one unit of foreign currency. Households C S M Financial sector NT Government I Abroad G X Y Firms SALARIES, AND SUPPLEMENTAR Y LABOUR INCOME INTEREST AND MISCELLANEOUS INVESTMENT INCOME BUSINESS PROFITS INDIRECT TAXES LESS SUBSIDIES CAPITAL → The output gap widens. → Adjustments in factor prices bring the factor utilization rate back to it normal level. → The output gap closes. $ Potential GDP Positive output Total payments by firms for labour services. Net interest payments to households. Payments for the use of land (incl. rent for housing). Total profits made by corporations. Net income of farmers and nonfarm unincorporated businesses To account for the difference between factor cost and market prices. To account for the difference between net and gross domestic product. Actual GDP Negative output Time Potential GDP and actual GDP THE SIMPLEST SHORT-RUN MACRO MODEL • WAGES, GROSS DOMESTIC PRODUCT $ NET DOM. PRODUCT AT MARKET PRICES Macroeconomics studies the determination of economic aggregates. − Output tends to rise in the long run (longterm economic growth), but fluctuates in the short run (business cycles). GROSS DOMESTIC PRODUCT • GDP from the income side: Factor payments + depreciation + indirect taxes (net of subsidies). • Implicit GDP deflator = Nominal GDP * 100 Real GDP CONSUMPTION Expenditures by households on goods and services. (C) Expenditures on capital equipment and buildings by firms. INVESTMENT (I) Expenditures on new homes by households. Change in business inventories. Expenditures on goods and GOV´T services by all levels of the government. EXPENDITURES Does not include transfer (G) payments! NET EXPORTS Value of exports minus value of imports. (XA – IMA) GDP from the Expenditure Side NET DOM. INCOME AT FACTOR COST MACROECONOMICS • Aggregate desired expenditure (AE) = C + I + G + (X – IM). Assume that consumption expenditure (C) is solely determined by disposable income (YD). - C(YD) = autonomous consumption + MPC * YD. C 500 Slope = MPC = 150/200 = 0.75 C(YD) 400 ∆C = 150 300 ∆YD = 200 200 100 Autonomous consumption 100 200 300 400 Circular flow of income and expenditure (Y = C + I + G + NX). THE MEASUREMENT OF NATIONAL INCOME • • • • GDP = value of all final goods and services produced in an economy during a specified period of time Volumes Value of domestic output (GDP) = value of the expenditure on that output = total claims to income that are generated by producing that output. → Three alternative ways to measure income. GDP by value added: Value of a firm´s production – value of intermediate goods bought from other firms. GDP from the expenditure side: Ca + Ia + Ga + (Xa – IMa). CONSUMPTION ALLOWANCE (DEPRECIATION) • C(YD) 400 SHORT RUN VS. LONG RUN MACROECONOMICS Potential GDP depends on the amount of factors available, the normal factor utilization rate, and factor productivity. → Changes in any of these variables change potential and actual GDP. → There is little, or no effect on the output gap. Actual GDP may differ from potential GDP because the factor utilization rate is different from its normal level. → Changes in aggregate demand change the factor utilization rate. 45° Saving 500 GDP from the income side • YD C More free study sheet and practice tests at: C+I+G+N 500 Marginal Propensity to Consume: Slope of the consumption function 300 Dissaving 200 100 100 200 300 400 500 YD The Consumption Function: Savings and Dissavings • Aggregate desired expenditure depends on national income. More free Study Sheets and Practice Tests at: www.prep101.com More free study sheets and practice tests at - C, I, and IM tend to increase as national income increases. • Eqm occurs when aggregate desired expenditure = actual national income. - This condition implies that desired saving = desired investment. Aggregate planned 45° Planned exp. < real exp. 1,000 AE 800 Planned exp. = real 600 400 • 200 400 600 • 800 1,000 Real GDP • An increase in autonomous expenditure results in an even larger increase in real GDP. - Multiplier effect. Multiplier = 1/(1 – slope of AE) > 1. ADDING GOVERNMENT AND TRADE TO THE SIMPLE MACRO MODEL • • • Public saving = net taxes (T) – government purchases (G). → Public saving increases as eqm national income rises. Net exports (NX) = exports (X) – imports (IM). → Net exports decrease as eqm national income rises. Eqm national income occurs where … … desired aggregate expenditure (AE) = actual national income (Y). … desired national saving = national asset formation. Aggregate planned exp. • AE AE0 1,200 …1… 1–z 1,000 - MPC 1–z 1 – MPC 1-z 800 E0 ∆A 600 Y0 Y1 Real GDP Price level 130 120 E1 110 Aggregate planned exp. Decrease in price level 1,400 1,200 45° AE2 AE0 AE1 100 90 ∆Y Y0 1,000 Y1 AD0 Real GDP Shifts in the AD curve (aggregate demand shocks) • 800 600 Increase in price level 600 AD0 800 1,000 1,200 1,400 Real GDP 130 The short-run aggregate supply curve (SRAS) illustrates the positive relationship between price level and quantity of aggregate output supplied, holding technology and factor prices constant. → Changes in input prices result in a shift of SRAS. Price level Increase in price level 45° 1,000 AE = AE1 E1 1,400 The aggregate demand curve (AD) illustrates the negative relationship between eqm real GDP and the price level. → Changes in AE (other than changes in the price level) result in a shift of AD. Price level Desired AE < Y Desired AE OUTPUT AND PRICES IN THE SHORT RUN 200 Aggregate planned Expenditure vs. Real GDP The government expenditure multiplier is smaller than the government tax multiplier. → Balanced-budget increase in government purchases has a mild expansionary effect. → However, effect is smaller than that of deficitfinanced increase in expenditure. Government expenditure (simple) multiplier Government tax multiplier Balanced budget multiplier Multipliers Planned exp. > real www.prep101.com More free study sheet and practice tests at: 120 800 Desired AE = Y 600 Decrease in price level 110 100 400 Desired AE > Y 90 200 200 400 600 800 1,000 Real GDP Expressing desired aggregate expenditure as a function of Y as well. AD 600 800 1,000 1,200 1,400 Real GDP Aggregate Demand Curve Y0 • • The presence of imports and income taxes reduce z and thus the size of the multiplier: → z = (1 – t)MPC – m. Real GDP Supply side of the Economy Macroeconomic equilibrium: → Intersection of AD and SRAS. Helping students since 1999 www.prep101.com More free study sheets and practice tests at Price level • SRAS Excess → Potential output is equal to an economy´s long-run aggregate supply (LRAS). Both aggregate demand and aggregate supply are subject to continual random shocks. → These shocks lead to temporary changes in real GDP. → Real GDP returns to potential GDP through adjustment in input prices. Price level SRAS1 AD Excess Long run eqm is given by the intersection of AD and LRAS. → LRAS is vertical at Y = Y*. → In the long run, total output is determined solely by conditions of aggregate supply. LRAS Price level P0 • SRAS0 P0 Y0 Real GDP • New short-run eqm if price 45° level was fixed Aggregate planned exp. 1,400 1,200 E2 P1 Aggregate demand and aggregate supply shocks result in shifts of AD and SRAS, respectively. → The steeper SRAS, the smaller the size of the multiplier. E1 AD1 AD0 Y0=Y* Y1 AE1 AE2 AE0 Price level SRAS0 P2 Y1 Y1´ Real GDP AD0 AD0 Y1 Y0=Y* Real GDP Contractionary AD Shocks 120 Price level Real GDP SRAS0=SRAS2 Fiscal policy may be used to stabilize output and employment. → Discretionary fiscal policy: Change in government expenditure or taxes initiated by an act of parliament. → Automatic stabilization: Change in government expenditure or taxes triggered by the state of the economy More free study sheet and practice tests at: OF MONEY THE NATURE SRAS1 100 AD1 90 AD0 Y0 P0 E0 = • • OUTPUT AND PRICES IN THE LONG RUN Y0=Y* Y1 Real GDP Supply Shocks Output gap = difference between actual output (Y) and potential output (Y*). • E1 P1 Y1 Y1´ Real GDP Long-run effect of a positive aggregate supply shock Aggregate Demand Shock • Y0* Long run and Short Run Equilibrium • SAS0 130 E0 E0 P0 P1 AD1 110 P1 P0 600 Price level Real GDP LRAS SRAS1 AD0 Y0 Real GDP Y0* Y1* Price level Expansionary AD Shocks Long-run eqm 800 AD0 P0 New short-run eqm 1,000 E1 P1 P2 • Short run eqm is given by the intersection of AD and SRAS. Most economists today believe that changes in the supply of money … … have important short-run effects on real GDP and employment. … have no real effects in the long-run, i.e. in the long run, only the price level changes. Money serves as medium of exchange, store of value, and unit of account. The banking system in Canada consists of two main elements: - Bank of Canada (Canada´s central bank). - Commercial banks. Assets Liabilities Gov´t of Canada securities Notes in circulation Helping students since 1999 More free study sheets and practice tests at Advances to banks Gov´t of Canada deposits Foreign-currency Deposits of banks assets (reserves) Other assets Foreign-currency liabilities Other liabilities and capital Assets and Liabilities of the Central bank in Canada: Bank of Canada Assets Liabilities Reserves Mortgage and non-mortgage loans Canadian securities Foreigncurrency assets Other assets Demand deposits Savings deposits • • Gov´t of Canada deposits Foreign-currency liabilities Shareholders´ equity Other liabilities Price level PV of a perpetual R… i stream of payments Present Value and the Interest Rate • Time deposits www.prep101.com LRAS SRAS1 SRAS0 Simple model in which people can divide wealth between bonds and money: - Money: needed for transactions, precaution, and speculation. → Opportunity cost of holding money = interest rate on bonds. Nominal demand for money depends on real GDP, interest rate, and price level. Real demand for money = nominal demand for money divided by the price level. - Varies directly with real GDP and inversely with the interest rate. P2 E1 P1 AD1 P0 AD0 Y0=Y* Y1 Real GDP Effect of changes in the money supply on real GDP and the price level: long run Nominal rate of interest Assets and Liabilities of Commercial Banks in Canada • • Commercial banks can create money, because they only need to hold small reserves to back their deposit liabilities. → Desired reserve ratio (v): Fraction of its deposits that a commercial bank wants to hold as reserves. → ∆ Deposits = ∆ Reserves/v The Bank of Canada controls the money supply because it has almost complete control over reserves. Assets Cash and other reserves Loans 200 Liabilities Deposits 1000 900 Capital 100 1100 1100 Initial, hypothetical balance sheet of a commercial bank: Assets Cash and other reserves Loans 220 Liabilities Deposits 1100 980 Capital 100 1200 1200 Suppose that the Bank of Canada buys $100 worth of securities on the open market. i0 i1 LP M0 M1 Quantity of money Liquidity preference function (LP) • An increase (decrease) in the money supply leads to a fall (rise) in interest rates. → Aggregate demand rises (falls). • Effect of monetary policy on the price level and real GDP: - Long run: Only the price level is affected (neutrality of money). - Short run: Monetary policy is most effective if LP is steep, and ID and SRAS are flat. Nominal rate of interest Exces s More free study sheet and practice tests at: MONEY, OUTPUT, AND PRICES • Present value of an asset: - Sum of discounted future payments that it generates. → Inversely related to the interest rate. - Equal to the asset’s market price. PV of a single future payment in n years PV of a sequence of payments over T periods R… (1 + i)n R1.. + (1 + i) R2 + … + RT… (1 + i)2 (1 + i)T i2 E i0 i1 LP Exces s M2 M0 M1 Quantity of money Liquidity preference theory of interest Effect of changes in the money supply on real GDP and the price level: short run Helping students since 1999 www.prep101.com More free study sheets and practice tests at MONETARY POLICY IN CANADA • Major tools the Bank of Canada uses to control the money supply are: - Open market operations. - Government deposit shifting. Private households Assets Liabilities Bonds -100 Deposits +100 Commercial bank Assets Liabilities Reserves +100 Demand deposits Bank of Canada Assets Liabilities Bonds +100 Com. bank deposits Open Market Operations Commercial bank Liabilities +100 Gov´t deposits Bank of Canada Assets Liabilities Gov´t deposits Com. Bank deposits Government Deposit Shifting Assets Reserves • • • • • SRAS1 SRAS0 P2 • E2 P1 E1 P0 E0 AD2 +100 Y = Y* Only with continuing monetary validation can inflation initiated by either supply or demand shocks continue indefinitely. The Phillips curve describes the relationship between unemployment and the rate of change of wages. - Short run: Phillips curve is downward sloping. - Long run: Phillips curve is vertical at U*. Rate of change of wages AD1 AD0 NAIRU Real GDP Constant Inflation +100 +100 -100 +100 A rise (fall) in the money supply results in a fall (rise) of interest rates. - Investment and net exports rise (fall). - Aggregate demand and eqm real GDP rise (fall). The Bank of Canada’s policy variables are real GDP and the price level. - Money supply and interest rates are used as intermediate targets. Policy instruments are reserves in the banking system (or the monetary base). Long execution lag of monetary policy makes monetary fine-tunig difficult. → Policy may have a destabilizing effect. INFLATION • SRAS2 Price level Inflation = process of rising prices. Y > Y* (inflationary • U < U* (excess demand gap) for labour) • Wages and unit costs tend to rise. Y < Y* • U > U* (excess supply of (recessionary gap) labour) • Wages and unit costs tend to fall. Adding Inflation to the Model • Without monetary validation, demand (supply) shocks cause temporary bursts of inflation. → Inflationary (recessionary) gaps are removed by rising (falling) factor prices → SRAS shifts leftward (rightward). → Real GDP returns to potential GDP, the price level rises (falls). → Real GDP returns to potential GDP and the price level to its initial level. Price level W2 W1 0 U1 U* Unemployment rate Phillips Curve LRAS SRAS1 • SRAS0 Disinflation = reduction in the rate of inflation. - Cost = cost of the recession that is generated by the process (sacrifice ratio). UNEMPLOYMENT • E2 P2 E1 AD1 P1 P0 AD0 Y0=Y* Y1 Price level LRAS Real GDP SRAS2 SRAS1 SRAS0 P2 AD3 P1 AD2 E0 AD1 Cyclical unemployment is the difference between the actual level of employment and NAIRU. • Two opposing theories that try to explain causes of cyclical unemployment: - New Classical theories (no involuntary unemployment). - New Keynesian theories (involuntary employment). Tendency of employers to smooth income of employees by paying a steady money wage and Long-term letting profits and employment relationships employment fluctuate to absorb effects of temporary changes in demand. Changing prices and wages in response to minor and temporary Menu costs and changes in demand is wage contracts costly and time consuming (only infrequent adjustment). Paying a wage premium Efficiency may be profitable if it wages raises workers´ efficiency. Those already employed Union (union members) will wish to bid up wages (above bargaining eqm). • NAIRU is composed of frictional and structural unemployment. More free study sheet and practice tests at: AD0 P0 Y* Y Real GDP Demand Shocks Price level SRAS1 SRAS0 E2 P2 AD1 P1 AD0 P0 Y1 Y0=Y* Real GDP Supply Shocks Helping students since 1999 More free study sheets and practice tests at BUDGET DEFICITS AND SURPLUSES • • • CHALLENGES FACING THE DEVELOPING COUNTRIES Annual budget deficit = change in outstanding debt = (G + TR + i * D) – T Primary budget deficit = (G + TR) - T The budget deficit function (B) describes the inverse relationship between the budget deficit and real GDP. • • $ • CAD 0 • Deficits Y* www.prep101.com Surplusses The development gap describes the discrepancy between the standards of living in countries at either end of the distribution (developed vs. developing countries). Impediments to economic growth are related to resources, human capital, agriculture, population growth, cultural barriers, domestic saving, infrastructure, and foreign debt. Development policies based on the older view were inward-looking and focused on import substitution. Development policies based on the Washington consensus call for more outward-looking, international-trade oriented, and marketbased route. Production point (free trade) Consumption possibilities (free trade) Production point (autarky) ppc Slope = pwine/pwheat (free trade) Slope = pwine/pwheat (autarky) Wine Gains from trade with variable cost Real GDP THE GAINS FROM INTERNATIONAL TRADE B Budget Deficit Function • • • • • Cyclically adjusted deficit (CAD): estimate of the gov´t budget deficit for Y = Y*. → Changes in CAD determine the stance of fiscal policy. Change in debt-to-GDP ratio: ∆d = x + (r – g)d If taxpayers are not purely Ricardian, a reduction in taxes along with an increase in the budget deficit will result in crowding out of … … investment (closed economy). … net exports (open economy). → Government deficits redistribute resources away from future generations toward the current generation. An increase in government debt may impede the conduct of monetary and fiscal policy. Even with positive overall deficits the debt-to GDP ratio may be falling. • Gains from trade arise from different opportunity costs. → Specialization in the activity in which opportunity costs are lowest. → World production increases. → Consumption possibilities increase. • • • • Economic growth is the increase in potential output due to: - Increases in factor supplies. - Increases in factor productivity. Investment in productive capacity results in a rightward shift of LRAS. The neoclassical theory of growth displays … … diminishing returns when one factor is increased on its own. … constant returns when all factors are increased proportionately. Along a balanced growth path, capital and labour grow proportionately. - GDP rises, but GDP per capita is unchanged (no improvement in living standards). New growth theories treat technological change as endogenous. Some modern growth theories display constant or increasing returns to investment. → Emphasize the unlimited potential of knowledge-driven technological change. Resource exhaustion and pollution put limits to growth. • • Additional gains from trade arise in cases of: → Economies of scale, greater product variety, learning-by-doing. Patterns of trade: → Countries export goods for which they have a comparative advantage. → Countries import goods for which they have a comparative disadvantage. Terms of trade: → Ratio of the average price of a country’s exports to the average price of its imports. → Determines the division of the gains from trade. TRADE POLICY • • • ECONOMIC GROWTH • • Free trade through specialization, allows for maximization of world output. There are some national objectives that are used arguments against free trade. Common methods of protection: → Tariffs, quotas, voluntary export restrictions, non-tariff barriers. More free study sheet and practice tests at: Sources of Gains from Trade Helping students since 1999