Download CHAPTER 2 Measuring the Performance of the Canadian Economy

CHAPTER 2
MEASURING THE PERFORMANCE OF THE CANADIAN ECONOMY
Chapter Outline:
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Measuring Gross Domestic Product
Measuring Supply: Factor Payments Approach
Measuring Demand: Components of Spending
Allocation of Income and Savings
Real and Nominal GDP and Inflation
Price Indexes and Inflation
Inflation and Real and Nominal Interest Rates
The Unemployed and the Unemployment Rate
Measuring the Unemployment Rate
The Relationship Between Unemployment and GDP: Okun’s Law
Working With Data
Changes from the Previous Edition:
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This chapter has been rewritten so that there is less emphasis on GDP and more emphasis on
measuring data, and how it fits the structure of the Canadian economy.
There is a new section on unemployment and Okun’s Law, so that the chapter now covers GDP,
inflation, nominal and real interest rates and unemployment.
The section on supply side measurement and the production function has been rewritten, with a
new example, which is carried out for the rest of the chapter.
Section 2-2 has been rewritten to incorporate as discussion about savings and investment, the
current account and wealth accumulation. There is a new figure (2-1) which summarizes the
discussion.
The discussion on nominal and real GDP is expanded and clarified, with worked out examples. In
Tables 2-3 and 2-4.
New Box 2-3 on GDP deflator and CPI
New Figure 2-3 Okun’s Law
Learning Objectives:
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Students should be able to understand gross domestic product, and the concepts of measuring this
from a demand or supply perspective.
Students should understand allocation of income beyond the level of simply adding up GDP. In
an economy total savings is composed of private savings plus the government budget deficit,
which is public savings. Total savings must equal investment spending plus the current account
balance. Therefore, savings adds to the stock of wealth of a country by increasing the capital
stock through investment or by increasing the stock of net foreign assets.
Students should understand that the dollar value of gross domestic product can change if the level
of physical production changes or if the price level changes. Therefore inflation could be
measured through changes in the GDP deflator or through changes in the Consumer Price Index.
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Students should understand that the real interest rate is equal to the nominal interest rate minus
the inflation rate
Students understand that the unemployment rate can change if the participation rate change or if
the number of people employed changes.
Students should be introduced to Okun’s Law which shows the relationship between changes in
GDP and the unemployment rate.
Accomplishing These Objectives
Chapter 2 examines the meaning of gross domestic product (GDP), the basic measure of a
nation's economic performance. Explaining GDP in terms of factor payments will help in the study of
aggregate supply and economic growth, while dividing GDP into its four main spending components-consumption (C), investment (I), government purchases (G) and net exports (NX)--will help in the study
of aggregate demand.
On the production side, the factors of production (inputs), such as labour and capital, are
transformed into goods and services (output). To understand this relationship, students will need to
understand the concept of an aggregate production function. This concept will be used throughout the
book.
Students can gain a deep understanding of the working of the economy by understanding the
relationships amongst GDP, savings, investment and wealth. This section allows for a good discussion of
the ambiguities in cause and effect that are often present in macroeconomics, especially when it comes to
the relationship between private domestic saving, investment, the budget surplus, and the trade deficit. An
in-depth discussion of these relationships will, of course, have to be delayed until later. Nonetheless,
students will find it exciting and motivating to see that even the simple equations presented here can be
used to address some rather complex real world problems.
It is particularly important to discuss the following two equations
Y  C + I + G + NX
and
S = I + CA
since they will later also be used as equilibrium conditions. It is important to point out early on the
difference between treating these equations as national income identities, as is done here, and using them,
slightly redefined, as equilibrium conditions in later chapters, especially in Chapter 3.
In Section 2-3 students will learn some valuable lessons concerning the difference between a
situation where the production of real goods and services has increased and a situation where prices have
increased. This will also show students that there is more than one way to measure inflation. Box 2-3
will be helpful in discussing the difference between the consumer price index and the GDP deflator as
measures of price change. The CPI measures the average price increase of a market basket of goods and
services that an average urban household might consume. The GDP-deflator is the most comprehensive
measure and includes all goods and services currently produced.
The distinction between real and nominal interest rates is also very important. Nominal interest
rates represent the actual rate of return on financial instruments as they are stated in the newspapers.
However, a financial investor should be interested much more in the real rate of return, that is, the stated
interest rate adjusted for inflation. Very few financial instruments guarantee a real rate of return.
However the Canadian government has issued inflation-indexed government bonds since 1991.
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Suggestions and Pitfalls
Students find the national accounts to be very boring. This is largely an artifact of the manner in
which national accounts material has been presented. Rather than emphasize concepts such as double
counting, with long stories about a farmer taking his wheat to the mill etc., we believe that you should
relate measures of GDP to the supply and demand material introduced in Chapter 1. In addition, students
can be shown how to get the actual data from CANSIM II. Because of the mind numbing amount of data
that can be retrieved on the national accounts, you may want to help students work through the Working
With Data section in this chapter. This will give students more of an understanding of the GDP figures
when they are released, as the press always seems to confuse nominal and real, as well as adjusted and
unadjusted.
You should be careful in discussing Section 2-2, as the equations presented are identities. Theory
will be put into this in later chapters. Most students have no idea what happens to savings, and tying this
to current account and capital accumulation can help explain. Equation (11) is particularly helpful in
generating discussion
S  S P  S G  I  CA
or
S  I  CA  S G
P
which states that the difference between private domestic saving and investment is equal to the difference
between the current account deficit and the government budget deficit. In other words, this equation
implies that an increase in the budget deficit (unless accompanied by an equal increase in private
domestic saving) will lead to the crowding out of investment and/or net exports. This equation can
therefore be used to explain the development of the "twin deficits" in the early 1980s. This is discussed in
detail in Chapter 5.
Students will find a class discussion on the technical aspects of calculating inflation very
rewarding. Each month that the CPI is released it is covered very extensively in the press. Something
that is not well understood by students (or the press for that matter) is the difference between the monthly
inflation rate which is defined as
 tm 
Pt  P t 1
Pt 1
the annualized inflation rate which is defined as
 tm 
Pt  P t 1
*12
Pt 1
and the annual inflation rate, which is defined as
 tm 
Pt  P t 12
Pt 12
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Students should understand that these are all valid measures of inflation. However, we generally think of
inflation in an annual framework.
When discussing real and nominal variables and measurements for inflation, it is important to
discuss the difference between nominal and real interest rates. This is presented in Section 2-4. Notice
that the link between equation (16) and equation (17) is contained in application question (2). This is a
rather difficult question (the answer is below), so you may want to help students with it in class. Working
through this has some payoffs, as the students will understand the difference between nominal and real
variables in general and the nominal and real interest rates in particular.
Solutions to Problems in the Textbook:
Discussion Questions:
1. The article that students are referred to is rather lengthy, and does not really come to any general
conclusions. The paper actually raises more questions than it answers. However, it is important for
students to understand the concepts involved in expanding the current definition of what is contained
in the National Accounts. Many of the issues in this area are still unresolved. Students may want to
discuss these unresolved issues, which are summarized on page xxxix.
2. Rebasing has some effects that students will not have thought of. The basic conclusion of this article
is that rebasing changes the estimates of growth over the period before 1992, so that the 1990-91
recession appears to be slightly worse. The rebasing takes into account the effects of the GST, the
Free Trade agreement and the rapid growth of technology over this period. More generally, you may
want to discuss the chain weighted measures that were introduced in the text.
3. Increases in real GDP do not necessarily mean increases in welfare. For example, if the population of
a country increases by more than real GDP, then the population of the country is on average worse
off. Also some increases in output come from welfare reducing events. For example, increased
pollution may cause more lung cancer, and the treatment of the lung cancer will contribute to GDP.
Similarly, an increase in crime may lead to overtime work for police officers, whose increased salary
will increase GDP. But the welfare of the people in the country may not have increased in either case.
On the other hand, GDP does not always accurately measure quality improvements in goods or
services (faster computers or improved health care) that improve people's welfare.
4. Assume the loan you made yields you an annual nominal return of 7%. If the rate of inflation is 4%,
then your rate of return in real terms is only 3%. If, on the other hand, if inflation rate is 10%, then
you will actually get a negative real rate of return, that is, you will lose 3% of your purchasing power.
One way to protect yourself against such a loss of purchasing power is to adjust the interest rate for
inflation, that is, to index the loan. In other words, you can require that, in addition to the specified
interest rate of the loan of, let’s say, 3%, the borrower also has to pay an inflation premium equal to
the percentage change in the CPI. In this case, a real rate of return of 3% would be guaranteed. You
are better off if you are a borrower with unanticipated inflation.
5. Clearly the level of GDP would go up, as some items are now being included that were not included
previously. Whether or not the growth rate of GDP would increase, depends on the growth rate of
housework. Students should realize, that the economy is not performing any differently, it is just
being measured differently.
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Application Questions:
2.
Like any nominal variable, the nominal interest rate is expressed in units of currency. We define a
nominal interest rate as:
it 
( Pt B1  Pt B )
Pt B
Where Pt B1 is the nominal price of a bond in period t+1, and Pt B is the nominal price of a bond in period t.
We know that a nominal variable can be converted into a real variable by dividing by price.
Clearly then, the real value of the bond in time t is
Pt B
Pt
Where Pt is the general level of prices at time t. (Think of this as the consumer price index). The real
value of the bond in t 1
Pt B1
Pt 1
We ignore any problem involving expectations of the unknown future price level.
Now, in the same manner that the nominal interest rate is the rate of change in the nominal value
of the bond, the real interest rate is the rate of change in the real value of the bond:
Pt B1 Pt B

Pt 1 Pt
rt 
Pt B
Pt
Although this expression is mathematically correct, it is not very useful, and students probably
have never seen a real interest rate written this way. To put this in a more convenient form, notice that
this equation can be written as
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Pt B1
P
rt  t B1  1
Pt
Pt
Therefore:
Pt B1
P
1  rt  t B1
Pt
Pt
 P B  P
  t 1  tB
 Pt 1  Pt

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
 P B  P 
  t B1  t 
 Pt  Pt 1 
The first term is equal to 1  it and the second term is equal to
P  Pt
1
, Where  t  t 1
, i.e. the
1t
Pt
inflation rate. Upon substitution, you should be able to show that:
rt  it   t
5.a. Since nominal GDP is defined as the market value of all final goods and services currently produced
in this country, we can only measure the value of the final product (bread), and therefore we get $2
million (since 1 million loaves are sold at $2 each).
5.b. An alternative way of measuring total GDP would be to calculate all the value added at each step of
production. The total value of the ingredients used by the bakeries can be calculated as:
1,200,000 pounds of flour ($1 per pound)
= 1,200,000
100,000 pounds of yeast ($1 per pound)
= 100,000
100,000 pounds of sugar ($1 per pound)
= 100,000
100,000 pounds of salt ($1 per pound)
= 100,000
__________________________________________________________
= 1,500,000
Since $2,000,000 worth of bread is sold, the total value added at the bakeries is $500,000.
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Additional Problems
1. Explain the initial effect of the following events on GDP.
a. You sell your used car to a friend.
b. Firms decrease their inventories.
c. The value of your Nortel stock holding decreases.
d. You buy a piece of land with the intention of building a new house.
e. A sports card dealer sells a Bobby Orr rookie card for $100.
f. A German tourist drinks U.S. beer in an Canadian restaurant.
a. GDP will not change, since a used car is not currently produced. (Only if you sell the car through a
dealer will GDP increase by the value of the services rendered.)
b. Inventory changes are part of investment, so investment will decrease. But somebody will have to buy
these inventories, so consumption will increase. If the inventories are sold at a price higher than
invoice, then GDP will increase by the value added.
c. A loss in stock values means a loss in wealth, therefore GDP is not directly affected. Only if your
dividends decrease will your income (and thus GDP) be affected.
d. When you use savings to buy land, a transfer of wealth takes place and GDP is not affected. (Only if a
real estate agent receives a commission will GDP go up by the value of the services rendered.)
e. When the card dealer sells the rookie card, inventory decreases, so investment goes down. Selling the
card to a customer increases consumption. Thus GDP increases only by the value added at the dealer
for his services rendered.
f. GDP will increase by the value added in the Canadian restaurant. If the beer was imported from the
United States for $1.20 and sold (exported) to a German tourist for $3.00, then net exports will
increase by $1.80.
2. How will the following events affect GDP and why?
a. A hurricane destroys part of Edmonton.
b. You sell your old macroeconomics textbook to another student.
c. You sell your holdings of IBM stock.
d. Your local car dealership decides to reduce its inventory by offering price reductions.
e. A retired worker gets an increase in Social Security benefits.
a. When a hurricane destroys property, wealth is affected, not income (or GDP). However, if a
significant amount of the capital stock is destroyed, then less can be produced later, leading to a
decrease in GDP. On the other hand, the rebuilding of destroyed property means that increased
economic activity will take place, leading to an increase in GDP.
b. The sale of your old textbook will not constitute an official market transaction (since you probably
will not report your income to the IRS). In addition, the textbook has already been used and is not
currently produced. Therefore GDP will not be affected.
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c. The sale of existing stock holdings is a transfer of wealth and, as such, does not affect GDP. Any fees
that you may have to pay your broker for his or her services, however, constitute payment for services
rendered. GDP will increase by that amount.
d. Inventory changes are counted as part of investment. A reduction in business inventories will lower
the level of investment (I) and thus GDP. However, the sales of the cars count as consumption (C) if
consumers buy them, or investment (I) if firms buy them. Thus the net effect on GDP depends on the
difference between the cost of the cars to the dealership and the sales price of the cars, that is, the
value added.
e. Transfer payments that do not arise from productive activity are not counted in GDP. Thus GDP will
not be affected when Social Security benefits are paid. (Only later, when these payments are spent,
will consumption increase.)
3. If nominal GDP in Germany increased by 2.8% last year, but Canadian GDP increased by
4.2%, can we conclude that the welfare of Canadian citizens increased by more than that of
German citizens? Why or why not?
A country's nominal GDP is not a good measure of the economic welfare of its people, since nominal
GDP can change solely due to inflation. Only if real GDP grows faster than population, will real income
per capita increase. But real GDP per capita still does not take into account changes in income
distribution, changes in environmental quality, or leisure, all of which influence the economic welfare of
the people in a country. Therefore we cannot say whether the welfare of the people in the Canada has
increased more than that of the people in Germany.
4. "Real per capita GDP is a good measure of economic welfare." Comment on this statement.
Real GDP per capita is an imperfect measure of economic welfare as it does not include non-market
activities which affect well being, such as the value of household services, volunteer work, pollution, the
loss of natural wilderness areas resulting from development, and so on. In spite of these limitations,
however, real GDP per capita still does provide some measure of economic welfare.
5. Assume real GDP in 1992 was $7,000 billion, nominal GDP in 1997 was $8,316 billion, and the
GDP-deflator has increased from 100 to 110 from 1992 and 1997. What is the average annual
growth rate of real GDP from 1992 to 1997? Do you think the welfare of all people in Canada
has increased during that time. Why or why not?
RGDP = (NGDP/deflator)*100 = (8.316/110)*100 = 7.56
Growth rate of GDP = (7.56 - 7.0)/7.0 = 0.56/7 = 0.08 = 8%
Thus real GDP has grown 8% in five years, or at an average annual growth rate of 1.6%.
An increase in a country's GDP is not a good measure for an increase in the economic welfare of its
people. For example, nominal GDP can change solely due to inflation, and real GDP has to grow faster
than the population, for real income per capita, and thus living standards, to increase. But real GDP per
capita still does not take into account changes in the income distribution, changes in environmental
quality, or changes in leisure, all of which influence the economic welfare of the people in a country
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6. Explain why indirect taxes are deducted from NDP to calculate national income (Y).
Indirect taxes are not paid to factors of production for the use of their services. Therefore they are not
included in national income, which measures the income of all factors of production.
7. Comment on the following statement:
"Any accumulation of inventories by firms is not included when measuring GDP."
National income accounts do include changes in inventories when measuring investment. Inventories rise
when production exceeds sales, but fall if production falls short of demand. These changes must be
allowed to affect investment. But if investment is affected, so is GDP. Otherwise total economic activity
will be over- or underestimated to the extent that inventory changes are not accounted for.
8. Assume a Hyundai dealership in Calgary bought 30 Hyundais from Korea at a cost of $13,000
per car in September of 2000, and by December 31, 2000 they have sold 20 of these Hyundais at
a price of $16,000 each. The remaining Hyundais were sold in January 2001 at a price of
$14,000 each. How exactly does this affect the GDP in 2000 and 2001, and which categories of
GDP (C, I, G, or NX) are affected?
NX = - (30*13,000) = - 390,000
C = + (20*16,000) = + 320,000
I = + (10*13,000) = + 130,000
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GDP
= + 60,000
2000:
Check: The value added in 1999 is: 20*3,000 = 60,000
C = + (10*14,000) = + 140,000
I = - (10*13,000) = - 130,000
______________________________________
GDP
= + 10,000
2001:
Check: The value added in 2000 is: 10*1,000 = 10,000
9. Comment on the following statement:
"I bought a new home last year. If I sell it today, I will raise the level of economic activity."
This statement would be true if a realtor sold your home, as the realtor would have provided a current
service for which she would be paid. Transactions in existing assets such as artwork and residential
housing do not create economic activity in an amount equal to the value of the sale. New home
construction, on the other hand, is included in the calculation of current GDP as it does represent current
economic activity.
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10. True or False? Why?
"The PPI measures the cost of buying a fixed bundle of consumer goods."
False. The Consumer Price Index (CPI) measures the cost of buying a market basket of consumer goods.
The Producer Price Index (PPI) measures the cost of commodities at an early stage of the distribution
system. Changes in the PPI signal a future change in the general price level, as costs are passed on to
consumers.
11. True or false? Why?
"Using the consumer price index or the GDP-deflator to calculate changes in the average price
level should produce identical the inflation rates."
False. The CPI measures the cost of a representative household's consumption bundle whereas the GDPdeflator is a more comprehensive measure of the prices of all goods and services produced in the
economy. Rates of change in these indices vary due to the differences in their construction.
12. Do the CPI and the GDP-deflator always show the same increase in the rate of inflation?
The GDP-deflator measures the average price increase of all final goods and services that are currently
produced. These goods differ from year to year depending on what is produced. The CPI measures only
the average cost increase of a specified market basket of goods and services. The CPI also includes prices
of import goods that the GDP-deflator does not include. Thus, when import prices go up, the CPI will
most likely increase more than the GDP-deflator.
13. Briefly describe the advantages and disadvantages of using the CPI, the IPPI, and the
GDP-deflator as economic indicators.
The consumer price index (CPI) measures the average price increase of a fixed market basket of goods
and services purchased by an average urban wage earner. Not all goods and services are reflected in this
market basket and substitution among these goods is not possible. So the CPI is not a perfect measure for
inflation. However, the CPI is easily available on a monthly basis and is fairly reliable.
The industrial product price index (IPPI) measures the average price increase of a fixed market basket
of intermediate goods up to the retail stage, but it does not include services or interest payments. The PPI
is relatively easily available on a monthly basis and it is used to show future price trends. One has to be
careful to avoid double counting, since the PPI deals with intermediate goods. The PPI does not
necessarily correspond with the CPI, since firms can't always shift higher producer prices onto
consumers.
The GDP-deflator is probably the most useful price index for macroeconomists since it measures the
average price increase of all goods and services currently produced in this country. It does not include
import goods, used goods, or interest payments, and early estimates are often unreliable and have to be
revised repeatedly. However, the GDP-deflator is the most complete of the price indexes.
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14. Assume last year's real GDP was $7,000 billion, this year's nominal GDP is $8,820 billion, and
the GDP-deflator for this year is 120. What was the growth rate of real GDP?
RGDP(1) = [NGDP(1)/GDP-deflator]*100 = [8,820/120]*100 = 7,350
Since RGDP(0) = 7,000 it follows that the growth rate of RGDP is
y = [7,350 - 7,000]/7,000 = 0.05 = 5%.
15. Comment on the following statement:
“A country that spends more than its total national income must have a trade deficit.”
National income is defined as Y = C + I + G + NX. The four main components of aggregate demand are
consumption (C), investment (I), government purchases (G) and net exports (NX). But if the spending on
consumption, investment, and government purchases is greater than national income, it follows that net
exports (NX = X - Q) must be negative, that is, imports (Q) must exceed exports (X), and the country
must have a trade deficit.
16. Calculate the values for government outlays (G), saving (S), and investment (I) from the
following information.
national income
Y = 5,200
budget deficit
BuD = 150
disposable income
YD = 4,400
trade deficit
TD = 110
consumption
C = 4,100
From YD = C + S ==> S = YD - C = 4,400 - 4,100 = 300
From S - I = BuD - TD ==> 300 - I = 150 - 110 ==> I = 260
From Y = C + I + G + NX ==> G = Y - C - I - NX
==>
G = 5,200 - 4,100 - 260 + 110 = 950
17. From the following information (all variables are in billions of dollars) calculate the value of
government spending (G), consumption (C), and investment (I).
national income Y = 6,000
tax revenues
TA = 1,500
saving
S = 1,000
transfer payments TR = 700
net exports
NX = - 120
budget deficit
BuD = 230
From YD = Y - TA + TR ==> YD = 6,000 - 1,500 + 700 ==> YD = 5,200
From YD = C + S ==> C = YD - S = 5,200 - 1,000 = 4,200
From S - I = BuD - TD ==> 1,000 - I = 230 - 120 ==> I = 890
From Y = C + I + G + NX ==> G = Y - C - I - NX
==>
G = 6,000 - 4,200 - 890 + 120 = 1,030
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Check: BuS = TA - TR - G ==> -230 = 1,500 - 700 - G ==> G = 1,030
18. From the information below, calculate the level of investment (I), consumption (C), and
national income (Y).
government spending G = 1,200
budget surplus BuS = 60
disposable income
YD = 4,500
net exports
NX = -110
saving
S = 500
From YD = C + S ==> C = YD - S = 4,500 - 500 = 4,000
From S - I = BuD - TD ==> 500 - I = - 60 - 110 ==> I = 670
From Y = C + I + G + NX ==> Y = 4,000 + 1,200 + 670 - 110 = 5,760
19. Assume the government cuts its purchases by $60 billion. As a result, the budget deficit is
reduced by $20 billion, savings increases by $10 billion, disposable personal income decreases
by $15 billion and the trade deficit is reduced by $5 billion. By how much have investment (I),
consumption(C), and national income (Y) changed?
From S - I = (G + TR - TA) + NX ==>
I = S - (G + TR - TA) - NX ==> I = S - BD - NX
==> I = 10 - (-20) - 5 = + 25
From YD = C + S ==> C = YD - S = - 15 - 10 = - 25
From Y = C + I + G + NX ==> Y = C + I + G + NX
==> Y = - 25 + 25 - 60 + 5 = - 55.
20. Will an increase in the federal budget surplus necessarily lead to a decrease in the foreign trade
deficit? Why or why not?
The equation I - S = BS - NX states that the difference between investment and private domestic saving is
equal to the difference between the budget surplus and the trade surplus. If the budget surplus increases
(or the budget deficit decreases), then U.S. interest rates are likely to decrease. This will cause an outflow
of funds, depreciating the value of the U.S. dollar and making the U.S. more competitive on world
markets. Therefore we will see an increase in the trade surplus (or a decrease in the trade deficit).
However, this does not necessarily always happen, since the other two variables in this equation, that is,
investment and saving, may also change. For example, if there is a significant increase in investment
spending due to the lower interest rates, then we may not see a change in the trade surplus.
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21. "High budget deficits ultimately lead to foreign trade deficits." Comment on this statement.
From S + TA - TR = I + G + NX ==> S - I = - (TA - G - TR) - (-NX) = BuD - TD,
that is, the difference between saving and investment is equal to the difference between the budget deficit
and the trade deficit. Throughout the late 1970’s and the 1980's the size of the budget deficit increased
sharply. Saving remained low and thus interest rates increased. However, an increase in the budget
deficit, does not necessarily increase the trade deficit, since the other two variables in this equation, i.e.,
investment and saving may also be affected. As long as we can finance the increase in the budget deficit
domestically, no trade deficit has to result. Instead saving may increase or investment may be crowded
out.
22. Assume you are a banker and you’d like a 4% real rate of return on your loans. If you expect
that the inflation rate is likely to average about 6% over the next thirty years, what would be
the most likely mortgage interest rate that you would charge your customers for a thirty year
fixed rated mortgage? How would your answer change if you expected a 4% average inflation
rate over the length of the mortgage? Explain your answers.
The Fisher equation states that the nominal interest rate is the expected real rate of interest (r e) plus the
expected rate of inflation (e), or
i = re + e.
In other words, if you expected an inflation rate of 6%, you would charge your customers a 10%
mortgage interest rate since
i = 4% + 6% = 10%.
But if you expected only a 4% inflation rate, you would charge your customers a mortgage interest rare of
i = 4% + 4% = 8%.
23. Assume a government bond pays you a fixed interest rate of 5.5% per year and the average
annual rate of inflation is 4.2%. What is your real rate of return? How would this real rate of
return change if inflation increased to 6.8%?
The real interest rate is defined as the nominal interest rate minus the inflation rate, that is,
r=i-
Therefore your real rate of return is
r = 5.5% - 4.2% = 1.3%
if the inflation rate is 4.2%. But if the inflation rate increases to 6.8%, then your real rate of return will be
negative, that is,
r = 5.5% - 6.8% = - 1.3%.
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