Download Econ 204 Topic 6

Topic 6 – Introduction
To Macroeconomics
19.a Introduction to Macroeconomics
19.b Output
19.c Macroeconomic Variables
20.a Value Added
20.b GDP
20.c GDP Issues
19.a Macroeconomics
The study of economic aggregates or
averages; the study of how the broad
economy behaves.
Includes variables such as total output, total
investment, total exports, price level, and the
effect of government policy
MICROECONOMICS = The study of individual
(consumer, firm, etc) decisions
MACROECONOMICS = The study of group
(industry, country, etc) results
Short Run vs. Long Run
Short Run – study of macroeconomic variables
in the short run (when some decisions are
fixed) and how the government impacts these
variables
Involves analysis of business cycles
Long Run - study of macroeconomic variables in
the long run (when no decision is fixed)
Involves analysis of growth and the impact of
investment and technological change
19.b Output
National Economic Activity is often
summarized by National Product or simply
Output
Since wages come from production,
National Product = National Income
The are a variety of ways to calculate output,
and short-run vs. long-run output reveals
different things about the economy
19.b National Income
The current dollar values of all goods
produced in an economy is nominal national
income: ∑PQ
This is also called current-dollar national income
This changes when prices or production changes
To ignore the effects of price fluctuations,
economics calculate real national income
based on prices in a base year: ∑PbaseQ
This is also called constant-dollar national income
This changes when production changes
Fig. 19-1
Growth and Fluctuations in Real GDP, 1965–2011
 A common
measure of
National Income
is Gross
Domestic
Product (GDP)
 Long run GDP
can show longterm economic
growth
(i) The level of real GDP
Fig. 19-1
Growth and Fluctuations in Real GDP, 1965–2011
 Short-run GDP
shows the
business cycle –
fluctuations of
national income
around its trend
value
 Recession – two
consecutive
quarters where
GDP falls
(ii)
Annual growth rate
of real GDP
19.b National Income
Real GDP fluctuates around a rising trend:
the trend shows long-run economic growth
the short-run fluctuations show the business
cycle
Potential output is what the economy could
produce if all resources were employed at
their normal levels of utilization.
 often called full-employment output
The Terminology of Business
Cycles
Output Gap
The output gap measures the difference
between potential output and actual output.
Output Gap = Y – Y*
When Y < Y*, there is a recessionary gap
The economy’s resources are not fully employed
(ie: there is excess unemployment)
When Y > Y*, there is an inflationary gap
The economy’s resources are more than fully
employed (ie: there is overtime and extra shifts)
This causes inflation
Fig. 19-2
Potential GDP and the Output Gap, 1985–2011
(i)Potential and actual
GDP
11
(ii)
The output gap
Why Mind The Gap?
Recession:
There is economic waste and human hardship
(ie: unemployment and low wages; low returns on
investment)
Boom:
There is low unemployment and wages are high
BUT
Inflation is high and the coming recession will be
more severe (plus the average person will be
less prepared for it)
19.b – Macro Variables Unemployment
14.5 Million Canadians covered by
Unemployment Insurance in 2008-09
$9.5 billion on regular benefits
$2.9 billion on family benefits (maternity and
parental leave)
$1 billion on sickness
$246 million on fishing benefits
$1.6 billion on training, job creation, selfemployment assistance, wage subsidies, and labor
market agreements
Unemployment Definitions
There are 3 key categories needed to
understand unemployment in Canada:
Employed – adult workers (over 15) who have a
job (regardless of hours), are off work due to
illness, vacation, or industrial dispute
Unemployed – workers who were available for
work and made an effort to find a job during the
previous 4 weeks, or who were available for
work and waiting to be recalled from a layoff
within 26 weeks, or reporting to a new job within
4 weeks
Unemployment Defintions
Labour Force = Employed +Unemployed
Not in labor force = those who did not have a job
and did not actively search for employment (ie:
students, early retired, etc)
Unemployed
Unemployme nt Rate 
100%
Labor Force
Unemployment in Canada
When Y = Y*, the economy is at FULL
EMPLOYMENT
BUT some unemployment exists:
 frictional unemployment (natural turnover)
 structural unemployment (mismatch between jobs
and workers)
Therefore @ full employment,
unemployment ≠0
Unemployment in Canada
When Y < Y*, there is cyclical unemployment
This is caused by the business cycle
Industries with seasonal business cycles
(fisheries, parks and recreation, ice cream
sales, retailers at Christmas, etc) may have
seasonal unemployment
Therefore Statistics Canada publishes seasonally
adjusted unemployment values
Fig. 19-3 Labour Force, Employment,
and Unemployment, 1960–2011
 In general,
employment grows
with the labor force
 Some frictional and
structural
unemployment
always exists
(i)Labour force and
18 employment
Fig. 19-3 Labour Force, Employment,
and Unemployment, 1960–2011
 Unemployment was
highest at 12% during
1982’s depression and
lowest at 3.4% in 1966
 Excess unemployment
represents permanent
loss in production;
goods that could supply
needs and wants
 Unemployment also
causes income hardship
(ii) Unemployment rate
Macro Variables - Productivity
Productivity: a measure of output per unit of
input
Real GDP
Labor Productivi ty 
Worker
or
Real GDP
Labor Productivi ty 
Hours Worked
Increases in productivity are probably the
single largest determinant of long-run
increases in material living standards
Higher Productivity => Higher Real wages
Fig. 19-4
Canadian Labour Productivity, 1976–2011
Real GDP per
worker
is measured in
thousands of
dollars!
21
Macro Variables - Inflation
Price level: the average level of all prices in
the economy.
Inflation: the rate at which the price level is
changing.
The CPI (Consumer Price Index) is based on
the price of a typical "consumption basket,”
relative to the price in some base year:
22
Macro Variables - Inflation
Inflation is the change in average prices
from one year to the next:
CPI t  CPI t -1
Inflation t 
100%
CPI t -1
CPI was 122.2 in April 2012 and 119.8 in
April 2013, therefore inflation was:
23
122.2  119.8
Inflation 2011-2012 
100%
119.8
 2.00%
Fig. 19-5 The Price
Level 1960–
2012
24
Fig. 19-5 The
Inflation
Rate,
1960–
2012
25
Copyright © 2014 Pearson
Canada Inc.
Chapter 19, Slide
Why Inflation Matters?
Inflation reduces the purchasing power of
money
$100 buys less once prices go up (inflation
occurs)
Inflation adds to economic uncertainty
Individuals make poor decisions if inflation is not
what they expected
Ie: A family saves for a house, then it costs more
than what they planned
Ie: A firm invests in Argentina, but the currency is
26 worth 10% of what they expected due to inflation
Inflation Example
Super Savings Bank Account: 2% interest
Cash on hand: $100
2 DVD players:
Basic: $100
DVD Playback
Deluxe: $102
DVD/VCD/SVCD/AVI/DVD±R/CD/CD±R
3D Blu-Ray, Wi-Fi, Memory Card Slot, Picture
Viewer, Stop Memory, Shiny Red Colour
Inflation Example
You want the deluxe, so you invest for a
year, cash on hand in a year: $102
But, due to 3% inflation, the DVD players
now cost: $103 (basic) $105.06 (deluxe)
Now you can’t afford either
You’ve LOST buying power
Macro Variables- Interest Rates
Interest rates – percentage price paid to
borrow money over a period of time
$100 borrowed at 8% interest will cost $8 a
year
they show the opportunity cost of a project
Different interest rates apply to different
situations
Different interest rates are available to
different people
1.5 Interest Rate Examples (Sept 2011)
Saving:
1 Year GIC: 1%
1 Year Cashable GIC: 0.75%
3 Year GIC: 1.35%
3 Year Cashable GIC: 1.2%
Bank Account: 0.0%
Borrowing
Bank of Canada Rate: 1%
1 year closed Mortgage: 3.5%
1 year open Mortgage: 6.3%
Interest Rate Rules
Bank of Canada rate for banks (bank rate)
Is less than
Banks’ rates for best customers (prime rate)
Is less than
Typical Bank Rate
More risk = higher rate
Real vs. Nominal Interest Rate
Nominal Interest Rate:
– Price Paid per dollar borrowed
per period of time
Real Interest Rate:
– Nominal Interest Rate adjusted
for change in purchasing power;
adjusted for inflation
Calculating real interest
rreal = (1+rnom)
--------- -1
(1+inf)
rreal= real interest rate
rnom= nominal interest rate
inf = inflation
Easy Interest Formula
rreal = (1+rnom-1-inf)
---------------(cross multiply to get…)
(1+inf)
rreal+ rreal*inf = rnom-inf
(rreal*inf is small)
rreal = rnom – inf
DVD player example: rreal = 2%-3%=-1%
Fig. 19-6
35
Real and Nominal Interest Rates, 1965–
2012
Interest Rate Importance
Low real interest rates are good for
borrowers (ie: entrepreneurs)
High real interest rates are good for
savers (ie: retirees)
Interest rates affect the level of investing
Topic 7 will investigate how the Bank of
Canada influences interest rates
Macro Variables – Exchange Rate
Exchange rate: the number of Canadian
dollars required to purchase one unit of
foreign currency.
Depreciation of the Canadian dollar means
that it is worth less on the foreign-exchange
market (more $Can for $Other)
Appreciation of the Canadian dollar means
that it is worth more on the foreign-exchange
market (less $Can for $Other)
37
Fig. 19-7
38
Canadian–U.S. Dollar Exchange Rate, 1970–2012
Macro Variables – Export and Imports
Export – Good/service sold to another
country
Import – Good/service bought from another
country
Net Exports t  Exports t - Imports t
 Trade Balance
For Canada, exports and imports are both
very large—roughly 35% of GDP—but the
trade balance is usually small.
Fig. 19-8 Canadian Imports, Exports, and Net Exports, 1970–
2011
40
Long Run Growth
Growth is generally positive in the long
run
This causes an increase in living standards
Typically gets little media attention
How should the government treat the long-run?
CAN the government affect growth?
Does controlling inflation affect growth?
Does running a deficit cause borrowing and reduce
growth?
Should government innovate or allow the private
sector to innovate?
Short Run Fluctuations
What causes the business cycle?
Why did the recession hit in 2008?
Why was unemployment so low in 2007?
How much does the Canadian business cycle
depend on the US? On Europe? On Asia?
Can the government influence the business
cycle?
If so, how much?
20.a Value Added
Production occurs in stages—most firms
produce outputs that are other firms' inputs
intermediate goods are used to produce
final goods
Each firm’s contribution to total output (final
goods) is its value added
Value Added i  Sales Revenue i
 Cost of Intermedia te Goods i
Sum of value added is an economy’s output
20.b GDP
Three methods for measuring national income
(output):
a) total value added from domestic production
(good theory, unrealistic in practice)
b) total expenditures on domestic output
c) total income generated by domestic production
Because of the circular flow of income, these
three measures yield the same total – GDP
Gross Domestic Product – total value of goods
and services produced in the economy during a
given period
Fig. 20-1 The Circular Flow of Expenditure and Income
45
b) GDP -Expenditure Side
Consider adding up the expenditures needed
to purchase the final output produced in any
given year.
There are four broad expenditure categories:
 consumption
 investment
 government purchases
 net exports
GDP  C  I  G  ( X  IM )
GDP -Expenditure Side
Consumption expenditure (C) includes
household expenditure on all final goods
during the year
Haircuts, Xbox’s, chicken, legal advice, etc.
Investment expenditure (I) is expenditure
on the production of goods not for present
consumption, including:
inventories
plant and equipment (capital stock)
residential housing
Government purchases (G) is the purchase of
currently produced goods and services by
government
excluding transfer payments (unemployment
insurance, Canada Pension Plan, etc.)
Net exports (X – IM) is the difference
between exports and imports
Exports are purchases of Canadian-produced
goods and services by foreigners. We
subtract imports because they are not
produced in Canada.
Table 20-1
GDP from the
Expenditure
Side, 2011
49
Chapter 20, Slide
c) GDP from the Income Side
GDP is also the sum of factor incomes and
other claims on the value of output.
1) Factor incomes:
wages
net domestic income
rent, interest, and profits
2) Non-factor payments:
indirect taxes (ie GST; income collected but not
received)
Subsidies (ie: furnace subsidy; negative tax)
50
depreciation
of existing physical capital
GDP from the income side is therefore equal to:
GDP = Net domestic income +
Indirect taxes (less subsidies) +
Depreciation
Table 20-2
GDP from the
Income Side, 2011
20.c GDP Issues
1) GDP and GNP
A measure of national output closely related to
GDP is Gross National Product (GNP).
GDP measures production in Canada (even if
some of the profits leave the country)
Measure of domestic production
GNP measures income of Canadians (even if
they earn income outside of Canada)
Measure of domestic income
GNP is typically 3%-4% less than GDP
20.c GDP Issues
2) Disposable Personal Income
A more important measure for households is
disposable personal income – the part of
GNP that households can spend or save
It equals GNP minus:
any part not actually paid to households
 Taxes, depreciation, retained earnings, and interest paid
to institutions
plus transfer payments received by households
 Child Tax Credit, Unemployment Insurance, GST rebate,
etc.
3) The Problem with Nominal GDP
Assume: prices quadruple (x4)
production is cut in half (x 1/2)
Nominal GDP (year 1) = 1 X 1 = 1
Nominal GDP (year 2) = 0.5 X 4 = 2
although production has been devastated,
GDP reflects extreme growth
Real GDP
-Base year value of all goods currently
produced:
∑ quantities X prices
base year
-doesn’t change when prices change
-changes when quantities change
The Solution of Real GDP
Assume: prices quadruple (x4)
production is cut in half (x 1/2)
Real GDP (year 1) = 1 X 1 = 1
Real GDP (year 2) = 0.5 X 1 = 0.5
-real GDP accurately reflects the economy
GDP – Converting Between Real and
Nominal
Nominal GDP
GDP Deflator 
x 100
Real GDP
Nominal GDP
Real GDP 
x 100
GDP Deflator
Table 20-3
Nominal and Real
GDP in Canada
Note that the CPI
and GDP deflator
follow different
things:
CPI : price of goods
bought by
Canadians
GDP Deflator : price of
goods produced in
Canada
4) Omissions from the GDP
National income accountants cannot
measure economic activity
that takes place outside of regular, legal
markets:
illegal activities
Leisure (people work less because they derive a
benefit from it)
the underground economy (unreported income,
trading, etc)
home production (ie: stay at home parents)
economic "bads“ (ie: pollution)
Do These Issues Matter?
The current calculations is used because:
It would be difficult to correct the major
omissions.
The level of GDP may be inaccurate but the
change in GDP is a good indication of the
changes in economic activity.
To design policies to control inflation it is
necessary to know the ACTUAL, LEGAL flow of
money payments made to produce and purchase
Canadian output.
GDP and Living Standards
"Well-being" is a broader concept than
material living standards:
GDP is not a complete measure of economic
well-being
 Equity, environment, freedom of religion/expression,
unemployment, weather, etc are all factors
but income is a very important part of well-being
and GDP is a good measure of income.
Topic 6 Summary
 Macroeconomics is the the study of how the broad
economy behaves
 Long-Run output examines economic growth
 Short-Run output gives us the business cycle
 The government’s control over each is debatable
 Key Macroeconomic Variables include
unemployment, productivity, inflation, interest
rates, exports and imports
 The difference between real and nominal variables
is key to macroeconomics
63
Topic 6 Summary
 Only final goods should be considered when
calculating a country’s production
 Thus every stage of production adds a “value
added”
 GDP can be calculated from its Expenditure or
Income side
 GDP is production inside Canada; whereas GNP is
income made by Canadians
 GDP issues include GNP, disposable income,
nominal GDP problems, and GDP omissions
64
Topic 6 Summary
 Despite GDP difficulties, GDP is still useful in
analyzing the economy and making decisions
 Factors other than GDP influence quality of life
 But GDP is still a good measure
 You should buy that DVD player before it goes up
in price
65