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1 of 42 Chapter 19 What Macroeconomics Is All About 05/09/07 Copyright © 2008 Pearson Education Canada 2 of 42 In this chapter you will learn 1. the meaning and importance of the key macroeconomic variables, including national income, unemployment, inflation, interest rates, exchange rates, and trade flows. 2. that most macroeconomic issues are about either long-run trends or short-run fluctuations, and that government policy is relevant for both. 05/09/07 Copyright © 2008 Pearson Education Canada 3 of 42 19.1 KEY MACROECONOMIC VARIABLES Output and Income The production of output generates income. To measure total output in dollars, we add up the values of the many different goods produced. This gives nominal national income. With base-period prices, we get real national income. 05/09/07 Copyright © 2008 Pearson Education Canada 4 of 42 Real vs. Nominal: Does it matter? An example: Nominal Values GDP (bill. of current $'s) Real Values GDP (bill. of 1992 $'s) 1982 374.9 544.4 1992 691.2 691.2 % change 84.4% 26.9 % 8.4% 2.7% % change p.a. NOTE: about 70% of the increase in nominal GDP was due to price increases and not growth in real output. 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007 Copyright © 2008 Pearson Education Canada 5 of 42 05/09/07 Copyright © 2008 Pearson Education Canada 6 of 42 Real GDP fluctuates around a rising trend: - the trend shows long-run economic growth - the short-run fluctuations show the business cycle APPLYING ECONOMIC CONCEPTS 19-1 The Terminology of Business Cycles 05/09/07 Copyright © 2008 Pearson Education Canada 7 of 42 Potential output (denoted Y*) is what the economy could produce if all resources were employed at their normal levels of utilization - often called full-employment output The output gap measures the difference between potential output (denoted Y*) and actual output (denoted Y). Output Gap = Y-Y* When Y < Y* , there is a recessionary gap. When Y > Y*, there is an inflationary gap. 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007 Copyright © 2008 Pearson Education Canada 8 of 42 Real GDP Recessionary Gap Peak Actual GDP Potential GDP Peak Trough Inflationary Gap Time NOTE: GDP and Y are the same quantity for the aggregate economy 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007 Copyright © 2008 Pearson Education Canada 9 of 42 05/09/07 Copyright © 2008 Pearson Education Canada 10 of 42 Employment, Unemployment, and the Labour Force Employment: the number of workers (15+) who hold jobs. Unemployment: the number who are not employed but are actively looking for a job. Labour force: the total number of employed + unemployed. The unemployment rate is the number of unemployed expressed as a percentage of the labour force. 05/09/07 Copyright © 2008 Pearson Education Canada 11 of 42 Unemployment = Rate Number of people unemployed Number of people in the labour force Even when Y = Y*, some unemployment exists: • frictional unemployment • structural unemployment 05/09/07 Copyright © 2008 Pearson Education Canada X 100 12 of 42 Employment, Unemployment, the Labour Force Participation Rate and Unemployment Rate: An example - Windsor CMA Second Quarter of 2006 Population (POP): 270,200 (15+) Employment (E): 163,100 Unemployed (UN): 15,300 Labour force (LF): = E + UN = 163,100 + 15,300 = 178,400 Unemployment rate (UR): UN / LF = 15,300 / 178,400 = 8.58% We can also calculate the following variables of interest (not in text) Participation rate (PR): LF / POP = 178,400 / 270,200 = 66.25% Employment rate (ER): E / POP = 163,100 / 270,200 = 60.36% 05/09/07 MFC 41-111 © MFC 41-111 MFC 41-111 MFC41-111MFC2007 Copyright 2008 Pearson Education Canada 13 of 42 05/09/07 Copyright © 2008 Pearson Education Canada 14 of 42 A longer history of labour force and employment growth: What happened after the 1950’s? 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007 Copyright © 2008 Pearson Education Canada 15 of 42 The unemployment rate when Y=Y* is called: - the natural rate of unemployment (or NAIRU) What is the NAIRU? - some estimates suggest that it is now below 7% Why Does Unemployment Matter? Some unemployment is desirable, as it reflects the time required for workers and firms to “find” each other so that good matches are made. But some unemployment is associated with human hardship, especially for those individuals with skills that are not in high demand by firms. 05/09/07 Copyright © 2008 Pearson Education Canada 16 of 42 Does the Unemployment Rate Measure Hardship? Not really. 05/09/07 MFCCopyright 41-111 MFC MFC 41-111 MFC41-111MFC2007 © 41-111 2008 Pearson Education Canada 17 of 42 Productivity Productivity: a measure of output per unit of input - often measured as GDP per worker - or GDP per hour of work Increases in productivity are probably the single largest determinant of long-run increases in material living standards. 05/09/07 Copyright © 2008 Pearson Education Canada 18 of 42 Real GDP per worker is measured in thousands of dollars! 05/09/07 Copyright © 2008 Pearson Education Canada 19 of 42 Inflation and the Price Level The price level: the average level of all prices in the economy. Inflation: the rate at which the price level is changing. The CPI is based on the price of a typical “consumption basket,” relative to the price in some base year: CPIt 05/09/07 PQ P Q t 0 0 0 100 Copyright © 2008 Pearson Education Canada 20 of 42 An Example The value of the CPI in January 2006 was 128.8. In January 2007, it was 130.3 (1992 base year) The year-over-year inflation rate can be found by dividing the CPI for 2007 by that for 2006, subtracting 1 and multiplying by 100 — it is 1.2 percent. [(130.3 / 128.8) - 1] x 100 = 1.2% That is, the price level increased by 1.2 percent between January 2006 and January 2007 — an inflation rate of 1.2 percent. 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007 Copyright © 2008 Pearson Education Canada 21 of 42 APPLYING ECONOMIC CONCEPTS 19-2 How the CPI Is Constructed Why Inflation Matters The purchasing power of money is negatively related to the price level. Also, because it is hard to forecast accurately, inflation adds to the uncertainties of economic life. Highly variable inflation rates cause great uncertainty. If all financial contracts are written to incorporate a fullyanticipated inflation, then inflation will have no real effects. An unanticipated inflation benefits anyone who has an obligation to pay money, and harms anyone who is entitled to receive money. 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007 Copyright © 2008 Pearson Education Canada 22 of 42 In 1970 could you have predicted what inflation would be In 1980 could you have predicted what inflation would be during the 1980’s? during the 1990’s? 05/09/07 Copyright © 2008 Pearson Education Canada 23 of 42 Inflation over the longer term CPI Rate of inflation 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111 Copyright © 2008 Pearson Education Canada 24 of 42 Your 1980 plan for buying a house based on expected inflation of 10% Year 1 Year 2 ... Monthly earnings (increases with inflation) Mortgage payment (15%) (fixed in nominal terms) Other expenditures (increases with inflation) $5,000 $5,500 $12,969 $3,200 $3,200 $ 3,200 $1,800 $2,300 $ 9,769 Real value of other expend. $1,800 $2,091 $ 3,766 $275,000 $648,435 Value of your house (increases with inflation) $250,000 GREAT PLAN! 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111 Copyright © 2008 Pearson Education Canada Year 10 25 of 42 What actually happens when inflation turns out to be 2% instead of your predicted 10% Year 1 Year 2 ... Year 10 Monthly earnings (increases with inflation) Mortgage payment (15%) (fixed in nominal terms) Other expenditures (increases with inflation) $5,000 $5,100 $6,095 $3,200 $3,200 $3,200 $1,800 $1,900 $2,895 Real value of other expend. $1,800 $1,863 $2,375 $250,000 $255,000 $304,749 Value of your house (increases with inflation) NOT SO GREAT OUTCOME! 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111 Copyright © 2008 Pearson Education Canada 26 of 42 Interest Rates The interest rate is the price of borrowing funds — the percentage amount per period. Nominal interest rate: the rate expressed in money terms. Real interest rate: the rate expressed in terms of purchasing power. The burden of borrowing depends on the real interest rate. 05/09/07 Copyright © 2008 Pearson Education Canada 27 of 42 Interest rates vs. the interest rate There are many different interest rates. Each reflects the cost of borrowing in a particular financial market There are numerous financial markets (specific set of borrowers and lenders) Each market is characterize by ‘risk’, ‘liquidity’, ‘term’ of loans, etc. Each gives rise to a unique rate of interest 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111 Copyright © 2008 Pearson Education Canada 28 of 42 Examples of interest rates TD - Canada Trust, Jan. 17, 2005 TD charges Prime 1 year 'open' mortgage 1 year 'fixed' mortgage 10 year 'fixed' mortgage Unsecured consumer loan Student loans VISA TD pays 1 yr GIC 5 yr GIC Long term G of C bond 05/09/07 4.50% 7.00 4.85 7.50 9.50 4.50 (??) 18.50 2.10 3.00 4.75 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111 Copyright © 2008 Pearson Education Canada 29 of 42 05/09/07 Copyright © 2008 Pearson Education Canada 30 of 42 The International Economy Foreign exchange: foreign currencies or claims on foreign currencies. Exchange rate: the number of Canadian dollars required to purchase one unit of foreign currency. A depreciation of the Canadian dollar means that it is worth less on the foreign-exchange market a rise in the exchange rate 05/09/07 Copyright © 2008 Pearson Education Canada 31 of 42 05/09/07 Copyright © 2008 Pearson Education Canada 32 of 42 Impact of Changes in the exchange rate : an example Exchange rate 1 US $ = 1.17 Cdn $'s June 1990 P of a Meal in Windsor P of same meal in Detroit $10.00 Cdn $ 8.00 US P of Detroit meal for Windsorite $9.36 in Cdn $’s ($8.00 US x 1.17 = $9.36 Cdn) Now what if the exchange increases (Canadian dollar depreciates) to 1 US $ = 1.65 Cdn $'s as it did by Jan. 2003 P of Detroit meal for Windsorite $13.20 in Cdn $’s ($8.00 US x 1.65 = $13.20 Cdn) What is your prediction about Windsorites dining out in Detroit? 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111 Copyright © 2008 Pearson Education Canada 33 of 42 From the Detroiter’s perspective Exchange rate 1 US $ = 1.17 Cdn $'s P of a Meal in Windsor P of same meal in Detroit $10.00 Cdn $ 8.00 US P of Windsor meal for a Detroiter $8.50 US ($10.00 Cdn x 0.85 = $8.50 US) Recall an exchange rate of 1 US $ = 1.17 Cdn $'s implies an exchange rate of 1Cdn $ = 0.85 US $'s Now what if the exchange rate increases (Canadain dollar depreciates) to 1 US $ = 1.65 Cdn $'s as it did by Jan. 2003 P of Windsor meal for a Detroiter $6.10 US ($10.00 Cdn x 0.61 = $6.10 US) What is your prediction about Detroiters eating in Windsor? 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111 Copyright © 2008 Pearson Education Canada 34 of 42 NOTE: as of January 2007 the situation has reversed (the Canadian dollar has appreciated) Exchange rate 1 US $ = 1.18 Cdn $'s or 1Cdn $ = 0.85 US $'s The situation has reverted to what it was in June 1990. Why are the Erie Street restaurants, Casino Windsor and the local manufacturing industry doing so poorly? Work out the numbers. Why are you shopping in Detroit again! 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111 Copyright © 2008 Pearson Education Canada 35 of 42 The balance of payments accounts record all payments made in international transactions — goods, services, and assets. - trade balance - current account balance - capital account balance For Canada, exports and imports are both very large — roughly 40% of GDP — but the trade balance is usually small. 05/09/07 Copyright © 2008 Pearson Education Canada 36 of 42 05/09/07 Copyright © 2008 Pearson Education Canada 37 of 42 19.2 GROWTH VERSUS FLUCTUATIONS Long-Term Economic Growth Long-term growth is considerably more important for a society’s living standards from decade to decade than shortterm fluctuations. There is considerable debate regarding the ability of government to influence the economy’s long-run growth rate. 05/09/07 Copyright © 2008 Pearson Education Canada 38 of 42 Long-term growth and increases in productivity We will see that one of the most important determinants of long-term growth is increased productivity One measure of productivity is output per person hour Output per person hour is determined by many factors (capital, technology, regulations, etc.) 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111 Copyright © 2008 Pearson Education Canada 39 of 42 Why Productivity Growth Matters Annual growth rate in productivity Change in ouput pph after 40 yrs (1 working life) Number of yrs req'd to double output pph 1.0% 49% 70 yrs 1.5% 81% 47 yrs 2.0% 121% 35 yrs 2.5% 168% 28 yrs 3.0% 226% 23 yrs 05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111 Copyright © 2008 Pearson Education Canada 40 of 42 Short-Term Fluctuations Short-term fluctuations are often called business cycles. Economists debate the effectiveness of monetary and fiscal policy in influencing these fluctuations. Some economists argue that despite the power of policy to affect the economy, governments should not attempt “finetuning.” 05/09/07 Copyright © 2008 Pearson Education Canada 41 of 42 What Lies Ahead? To organize our thinking about macroeconomics, we must develop some tools. These will include: • discussing the measurement of national income • building a simple model of the economy • modifying the model to make it more realistic • using our model to analyze some pertinent economic issues 05/09/07 Copyright © 2008 Pearson Education Canada 42 of 42 05/09/07 Copyright © 2008 Pearson Education Canada