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Chapter 19
What Macroeconomics Is
All About
Copyright © 2011 Pearson Canada Inc.
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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 longrun trends or short-run fluctuations, and that government
policy is relevant for both.
Copyright © 2011 Pearson Canada Inc.
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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. But how do we add up steel and haircuts?
This gives nominal national income.
With base-period prices,
we get real national income (denoted Y).
Fixed set of prices? – (prices from some given year, say 2005)
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Output and Income
National output of goods and services during a given period is
measured as gross domestic product - GDP
National income is denoted Y – the total of goods and
services made available to society during a given period
A nation’s income during a given period is exactly equal to
the total of all goods and services it creates during a given
period
Therefore
Y = GDP
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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
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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 output gap measures the difference between potential
output and actual output.
Output Gap = Y-Y*
When Y < Y* , there is a recessionary gap.
When Y > Y*, there is an inflationary gap.
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Real GDP
Recessionary Gap
Peak
Actual GDP
Potential GDP
Peak
Trough
Inflationary Gap
Time
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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 one.
Labour force: the total number of employed + unemployed.
Unemployment rate: the number of unemployed expressed as
a percentage of the labour force.
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Unemployment =
Rate
Number of people unemployed
Number of people in the
labour force
X 100
Even when Y = Y*, some unemployment exists:
• frictional unemployment
• structural unemployment
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Employment, Unemployment, the Labour Force
Participation Rate and Unemployment Rate: An
example - Windsor CMA 2009
Population (POP):
273,300 (15+)
Employment (E):
150,600
Unemployed (UN):
Supplementary slide
24,200
Labour force (LF): = E + UN = 150,600 + 24,200 = 174,800
Unemployment rate (UR): UN / LF = (24,200 / 174,800) x 100 = 13.84%
We can also calculate the following variables of interest (not in text)
Participation rate (PR): LF / POP = (174,800 / 273,300) x 100 = 63.95%
Employment rate (ER): E / POP = (150,600 / 273,300) x 100 = 55.10%
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A longer history of labour force and employment growth:
What happened after the 1950’s?
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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.
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Does the Unemployment Rate Measure Hardship?
Not really.
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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.
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Supplementary slide
Why Productivity Increases Matter
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
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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, work rules, regulations, etc.)
What about how hard people work?
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Real GDP
per worker is
measured in
thousands of
dollars!
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Inflation and the Price Level
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
PQ


PQ
t
0
0
0
100
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*
An Example – How to calculate the rate of inflation
The value of the CPI in January 2009 was 113.0. In January
2008, it was 111.8 (2002 base year)
The year-over-year inflation rate can be found by dividing the
CPI for 2009 by that for 2008, subtracting 1 and multiplying by
100 — it is 1.07 percent.
[(113.0 / 111.8) - 1] x 100 = 1.07%
That is, the price level increased by 1.07 percent between
January 2008 and January 2009 — an inflation rate of 1.07%
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Supplementary slide
The formula for inflation calculations
Inflation is the rate of change in the price level. The rate of inflation is the
percentage change in the price level over any two periods. Consider the price
level in 2006 and 2007 as measured by the CPI:
CPI06 and CPI07
The rate of inflation is given by: The change in the price level divided by the price
level in the initial period multiplied by 100.
[(CPI07 – CPI06) / CPI06] x 100
which is equal to:
[(CPI07 / CPI06) – (CPI06 / CPI06)] x 100
or,
[CPI07 / CPI06 – 1] x 100
Example from the previous slide: [(130.3 / 128.8) - 1] x 100 = 1.2%
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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.
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Why Inflation Matters
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 in the future (debtors) and harms
anyone who is entitled to receive money in the future
(creditors).
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In 1970 could you
have predicted what
inflation would be
during the 1980’s?
In 1980 could you
have predicted what
inflation would be
during the 1990’s?
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Inflation over the longer term
CPI
Rate of inflation
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Interest Rates
The interest rate is the price of “credit”, and the flow of credit
is crucial to firms and households in a modern economy.
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.
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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
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Examples of interest rates
TD - Canada Trust, September 7, 2010
TD charges Prime
1 year 'open' mortgage
1 year 'fixed' mortgage
10 year 'fixed' mortgage
Car loan – 5 year term
VISA unpaid balance
VISA cash advance
2.75%
6.70
3.50
6.50
7.50
19.99
21.50
TD pays 1 yr GIC
5 yr GIC
Long term G of C bond
1.25
2.00
2.95
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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
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Impact of Changes in the exchange rate : an example
Exchange rate 1.17 Cdn $ = 1 US $
P of a Meal in Windsor
P of same meal in Detroit
June 1990
$10.00 Cdn
$ 8.00 US
P of Detroit meal for Windsorite $9.36 in Cdn $’s
(1.17 x $8.00 US = $9.36 Cdn)
Now what if the exchange increases (Canadian dollar depreciates) to
1.65 Cdn $ = 1 US $ as it did by Jan. 2003
P of Detroit meal for Windsorite $13.20 in Cdn $’s
(1.65 x $8.00 US = $13.20 Cdn)
What is your prediction about Windsorites dining out in Detroit?
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From the Detroiter’s perspective
if 1.17 Cdn $ = 1 US $ then
the US exchange rate is 0.85 US $ = 1 Cdn $'s
P of a Meal in Windsor
P of same meal in Detroit
1/1.17 = 0.85
$10.00 Cdn
$ 8.00 US
P of Windsor meal for a Detroiter $8.50 US
(0.85 x $10.00 Cdn = $8.50 US)
Now what if the exchange rate increases (Canadian dollar depreciates) to
1.65 Cdn $ = 1 US $
as it did by Jan. 2003
the US exchange rate is 0.61US $ = 1 Cdn $'s
P of Windsor meal for a Detroiter $6.10 US
(0.61 x $10.00 Cdn = $6.10 US)
What is your prediction about Detroiters eating in Windsor?
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NOTE: as of January 2010 the situation had
reversed (the Canadian dollar has
appreciated)
Exchange rate 1.04 Cdn $ = 1 US $
or 0.96 US $ = 1Cdn $
Why are the Erie Street restaurants, Casino Windsor and the local
manufacturing industry doing so poorly?
Why are you shopping in Detroit again?
Work out the numbers.
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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 35% of GDP — but the trade balance is usually
small.
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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.
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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”.
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What Lies Ahead?
To organize our thinking about macroeconomics, we must
develop some tools. These will include:
• discussing 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
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