Chapter 1: Principles of Economics Illustrated by the PPF
January-09-13 2:30 PM
- Scarcity - cannot produce outside the PPF.
- Efficiency - producing on the PPF is more efficient than producing inside the PPF.
C (resources unemployedor unused -> inefficient)
- Trade-offs - more of one good can be produced only if some units of another good are given up
- Opportunity cost - increasingly more of one good requires giving up even more of another good.
- Economic growth - over time, the PPF can shift outward. Chapter 5: Measuring a Nation's Income
January-14-13 2:30 PM
• ×Describes all transactions between households and firms.
Top half of the diagram (marketsfor goods & services)
• Firms and households are brought together to exchange final goods and services.
Bottom half of the diagram (marketsfor factors of production)
• The roles of firms and households are reversed in factor markets.
By convention(by general agreement),spending on new housing is included in the Investment
• Housing provides an on-going service.
• Housing becomespart of the capital stock of the economy.
Real vs Nominal GDP
GDP is calculated, in practice, as:
∑ P i × Q i
i 2011 2011
(above is summationstarting from i to 2011,i is written at the top like an exponent)
If, in the following year, GDP increased, it is possible that either price increased or quantity
increased, or both.
We want to measure changes in production only. We want a figure for GDP that is "adjusted for
Why? So that we can compare GDP figures over time.
The adjusted figure is called real GDP.
The simple calculation:
∑ P i × Q i
i 2011 2011
is called nominal GDP.
Real GDP is output valued at constant (base year) prices.
Example: Assume the base year is 2002.
∑ P i × Q i
i 2002 2011
January 16, 2013
- GDP is the market value of all final goods and services produced within a country in a given period of
- Based on the assumptionsof the Circular Flow Model, GDP measures the value of total output by
i) Total income or
ii) Total expenditure.
- The componentsof GDP are:
Y = C + I + G + NX
- Nominal GDP:uses current year prices and quantities.
- Real GDP: uses constant or base year prices and current year quantities.
CalculatingNominal GDP, Real GDP, and the GDP Deflator
(Refer to slides 27-28)
1. Collect the data on prices and quantities for a year.
2. Calculate the nominal GDP. 2. Calculate the nominal GDP.
3. Calculate real GDP using base year prices.
4. Calculate the GDP deflator.
The GDP Deflator
- The GDP deflator measures the price of output relative to its level in the base year.
- The GDP deflator is a price index which measures the overall price level.
- GDP deflator = Nominal GDP (2011)÷ Real GDP (2011) × 100
= (∑ P2011 × Q2011) ÷ (∑ P2002× Q 2011) × 100
- In these sums, all the quantity terms will be the same (numeratorand denominator)for a given year,
reflecting the effect of relative changes in prices only.
The Basket of Goods and Services
Fig. 6.1 page 124
The #s show the % of expenditure on that categoryof goods and services for the average consumer
in 2005. Chapter 6: Measuring the Cost of Living
January-21-13 2:30 PM
How to Calculate CPI
CPI = Cost of a fixed basket ÷ Cost of a fixed basket in a base year × 100
How to Calculate the Inflation Rate
i) Percentage change in the CPI from one period to the next
ii) Percentage change in the GDP deflator from one period to the next
Problems with the CPI
i) Substitution bias,
ii) Introduction of new goods,
iii) Unmeasured quality changes,
all tend to overstatethe cost of living.
CorrectingEconomic Variables for the Effects of Inflation
Dollar figures from different periods of time.
To inflate past prices to today's prices:
Value in current year $ = Past year nominal value × (CPI in the current year ÷ CPI in the past year)
To deflate today's prices into past year prices:
Value in past year $ = Current year value × (CPI in the past year ÷ CPI in the current year)
Real and Nominal Interest Rates
Example: I lend you $1,000for one year with a nominal interest rate of 15%.
Nominal Interest Rate - the stated or posted cost of borrowing or return to lending
Real Interest Rate - the nominal interest rate adjusted for inflation
Nominal Interest Rate = sum of two components:
i) Compensationto the lender for postponing current consumption, i.e., real interest rate (real
ii) Compensationfor the anticipated or expected inflation, i.e., loss of purchasing power.
Nominal Interest Rate = Real Interest Rate + Expected Inflation
Real IR = Nominal IR - Expected Inflation
Differences Between CPI and GDP Deflator
i) CPI includes imported goods.
ii) GDP deflator includes capital goods.
iii) CPI uses a fixed weight. GDP deflator uses a changing weight.
CPI is used for:
i) COLAs for labour contracts.
ii) Indexation of governmentprograms.
iii) Correcting economicvariables for the effects of inflation. Chapter 7: Production and Growth
January-21-13 2:30 PM
We have talked about how to measure prices and quantities.
Now, we want to focus on the long run issues of economicgrowth and productivity,i.e., the forces that
determine prices and quantities.
Importance of productivity - output/worker/hour
Productiveprocess requires inputs - factors of production.
i) Physical capital
ii) Human capital
iii) Natural resources
iv) Technological knowledge
The relationship between inputs and outputs is summarized by the production function:
FYI: The Production Function
- Economistsoften use a production function to describe the relationship between the quantity of inputs
used in production and the quantity of output from production.
Simple production function
Y = F(K, L)
GDP = Function (Capital, Labour)
Assume: some level of technology exists.
• Physical capital
• Human capital
• Natural resources
Equally important are public policies pursued by the government.
Constant Returns to Scale (CRS)
By changing all inputs, we can change output by the same amount.
2Y = F(2K, 2L)
1/3Y = F(1/3K, 1/3L)
By increasing K, while holding L fixed, the contribution to output (Y) gets smaller and smaller.
Property Rights and PoliticalStability
• Property designates ownership. Ownership allows the owner to use or not use the property as he sees
fit, to exclude others from using it, or to transfer ownership.
• Strong, clear property rights require enforcing contracts, fostering political stability.
• Prices are an incentive. Why create something in demand if you cannot reap the rewards?
• No foreign investmentwithout strong property rights.
An increase in population will increase the labour force and GDP, but NOT productivity.
If population grows faster than GDP, then GDP per person will be reduced. If population grows faster than GDP, then GDP per person will be reduced.
The relationship between inputs and output is summarized by the production function:
Y = F(K, L)
• Assume technological knowledge exists.
• Assume this production function has the property of constant returns to scale.
Meaning: If you change ALL inputs by any positive constant, then output will change by the same
Let z > 0, then
zY = F(zK, zL)
e.g. Double inputs implies double output.
2Y = F(2K, 2L)
e.g. Halve inputs implies halve output.
1/2Y = F(1/2K, 1/2 L)
Let z = 1/L
Then, Y/L = F(K/L, L/L)
Rename: y = f(k)
Meaning: productivityor output/worker(y) depends on capital/worker(k)
What can the government do to enhance productivity?
1. Encourage saving and investment.
Q: Will saving moreincrease productivity and our standard of living?
A: Due to diminishing returns, more saving and more investmentin capital goods increases economic
growth only for awhile.
To demonstrate the idea of diminishing returns:
As we add more and more capital to the productive process, holding constant all other determinants
of output, then output increases (Y↑) at a diminished relative to increasing only one input.
Y = F(K, L
1 5 6 K
2. Investment from abroad.
4. Property rights and politicalstability.
5. Free trade.
6. Research and development.
Issues around population growth.
Issues around natural resources. Chapter 8: Saving, Investment, and the Financial System
January-28-13 2:30 PM
The Financial Market
1. There is only one financial market.
2. All investmentspending (I) is financed by new borrowing.
3. Any governmentbudget deficit is financed by new governmentborrowing.
4. All private savings are used to make new loans to firms or the government.
LF - loanable funds supply comesfrom savings decisions
LF - loanable funds demand comes from borrowing decisions
Note: We do not wish to consider consumer or household debt.
Since LF = S and LF = I, then in equilibrium, LF = LF is equivalent to S = I
Effects of ↓ Taxes on Savings
Figure 8-2 page 178
• ↓ tax on interest income will ↑ supply of LF (shift right)
• In the long run, as ↓ IR, the quantity of LF demanded will increase (↑I) along the LF curve.
Effect of Favourable Tax Treatmenton Investment Borrowing Decisions
Figure 8-3 page 180
• Impose a favourable tax treatmentfor investmentspending.
• ↑ the demand for LF (shift right)
• In the long run, ↑ IR will ↑ the quantity of LF supplied along the LF curve.
Financial system (split into 2 groups):
1. Financial markets(direct)
2. Financial intermediaries(indirect)
Y = C + I + G (National Accounting Identity (Closed economy))
S = Y - C - G (National saving)
Y - T - C = private saving
T - G = public saving
S = (Y - T - C) + (T - G) (National saving)
S = I (Long run, closed economy,equilibrium condition)
The Market for Loanable Funds
Real IR S
Equilibrium real IR
Equilibrium Quantity of LF
Quantity of LF Quantity of LF
LFS comes from saving decisions
LFD comesfrom investment decisions.
When LF = LF , then S = I
(based on the assumptions of the model).
How does the model work?
1. Policies aimed at savers shift the LF curve.
2. Policies aimed at borrowers shift the LF curve.
3. Governmentborrowing to finance a budget deficit has the effect of reducing LF . The resulting increase
in the interest rate leads to "crowding out" of investmentspending.
Private saving Public saving
S = (Y - T - C) + (T - G)
(fewer funds in financial market)
Effect of Government Budget Deficits
Figure 8-4 page 181
• Public dissaving (T < G) causes a ↓ in national saving.
• ↓ supply of LF (shift left) means fewer LF for the private sector.
• In the long run, ↑ IR leads to a ↓ quantity of LF demanded along the demand curve.
• This is called "crowding out." Chapter 9: Unemployment and Its Natural Rate
January-30-13 2:30 PM
The Labour Force survey deliberately excludes individuals in all of the following categories:
1. Persons younger than 15 years old,
2. Persons residing in the Yukon, Northwest Territories,Nunavut, and Aboriginal settlements,
3. Full-time membersof the armed forces,
4. Inmates in institutions.
Categorize the adult population.
Define the Labour Force.
Measuring unemployment - Labour Force Survey
U = # unemployed ÷ Labour force × 100
Labour Force Participation Rate
LFPR = Labour force ÷ Adult population × 100
Unemployment: Evidence for Canada
People who becomeunemployed are typically unemployed for a short period of time.
However,they are joining a pool of long-term unemployed people.
i) Industries - the increase or decrease in demand for labour which produces certain goods/services
ii) Regions - increases in the demand for labour in one region and decreases in the demand for labour in
other regions of the economy
Unions and CollectiveBargaining
Insiders - those people who hold (high-paying) union jobs
Outsiders - those people who wish to hold, but do not have (high-paying) union jobs
• Outsiders bear part of the cost of high-paying jobs because if the union wage were lower, they might be
W1 unemployment union wage
W2 lower wage
When unions increase the wage in one part of the economy,what happens to outsiders?
W S W S1
W1 A S2
D D W1
UNION SECTOR NON-UNION SECTOR
i) Remain unemployed, or
ii) Take other non-union jobs.
Non-union sector: greater supply which in turn pushes down the wage (no incentive to pay high wages
since so many people applying)
The increase in the supply of labour in other parts of the economyputs downward pressure on wages.
Problems: discouraged searchers
Duration of Unemployment
Why Does Unemployment Persist?
Define: natural rate of unemployment
Sources of Unemployment
1. Cyclical Unemployment – related to the state of the economy
2. Job search causes frictional unemployment.Sectoral shifts cause frictional unemployment.
3. Quantity of labour supplied > quantity of labour demanded causes structural unemployment.
Governmentcan help reduce unemployment
Government contributes to unemployment
Minimum wage laws
Unions: insiders and outsiders
Theory of EfficiencyWages Chapter 10: The Monetary System
February-06-13 2:30 PM
Medium of Exchange
Eliminates the need for a double coincidence of wants
Separates sellers from buyers
Unit of Account
The values of goods and services are denominated in dollars and cents
Able to compare products – get a lot of informationthat way
Store of Value
Allows us to hold part of our wealth in a convenient form
Allows us to postpone purchases or otherwise plan transactions to suit ourselves
Would have value even if it were not used as money
The gov’t and the central bank regulate the fiat money system
However,the monetarysystem is really a social system
If we do not accept it, even gov’t decree will not make it so
Canadian dollar will be worth the same as a gum wrapper on the ground
Two Measures of the Money Stock for the Canadian Economy
Money consists of coins, bank notes and chequable deposits
M1 = currency (bank notes + coins) outside the banks + demand deposits located in chartered banks
Demand Deposits:funds in accounts that can be removedw/o notice and usually pay little or no interest
Examples:current accounts, personal chequable accounts (very liquid)
M2 = M1 + personal savings deposits + non-personal notice deposits located in chartered banks
Savings Deposits: bank deposits that typically earn a rate of return and require a stipulated amount of
notice to be withdrawn, though rarely enforced (24 hr. waiting period)
Notice Deposits: deposits which have a notice requirement in the contractual agreement with the client,
although banks almost never enforce this clause
Term Deposits:bank deposits paying a market rate of return which are deposited for a fixed term and
thus have limited liquidity (very long waiting periods – cannot spend until term has expired)
A written order from the Minister of Finance to the Governor of the Bank of Canada instructing him to
change monetary policy (way to settle disputes)
1. NO directive has ever been issued
2. A directive must be issued publicly
NOTE: for this discussion, the money supply = currency+ deposits (this is a simplifying assumption)
• What is it?
Definitions of the money supply
• M2 Bank of Canada
• Most important function: control of the money supply
The Money Multiplier
Money multiplier= 1 ÷ Reserve ratio
Assume R = 10%
Money multiplier = 1 ÷ .10 = 10
From our example:
$100 × 10 = $1,000.00$1,000
Assume R = 20%
Money multiplier = 1 ÷ .20 = 5
$100 × 5 = $500
The Bank of Canada's Tools of Monetary Control
Money held by the Bank of Canada is NOT included in the money supply.
Foreign Exchange Market Operations
(and an e.g. of sterilization)
BoC sells $US and buys $CDN Use these $CDN to buy bonds
IR IR S1 S2
IR2 B IR1 A
A IR2 B
*upward pressure on the domesticIR *sterilize the effects of the FMOs
- Solution only works in the short-run
- Simplifying assumption -> why the supply curves are vertical
Foreign Exchange Market Operations and Sterilization
If the Bank of Canada wants to sell foreign currency for any reason, but does not want the money supply
to fall, it uses the Canadian currency obtained in the exchange to buy governmentbonds (open market
This process of offsetting a foreign exchange market operation with an open market operation is called
The Bank of Canada's Tools of Monetary Control: The Overnight Rate
1.25% UPPER BOUND = Bank Rate (banks can borrow from BoC at this rate)
1% midpoint (Target for the overnight rate) .5% wide
(banks can borrow from each other at this rate) 1/4%
1% midpoint (Target for the overnight rate) .5% wide
(banks can borrow from each other at this rate)
LOWER BOUND - Rate paid on positive
Negative balance Positivebalance
Changing the Overnight Rate Affects the Money Supply
An increase in the overnight rate reduces the amount of money available for loans and, therefore,
reduces the money supply.
A decrease in the overnight rate increases the amount of money available for loans and, therefore,
increases the money supply.
Changing Reserve Requirements
- Some central banks around the world (but not the Bank of Canada) also influence the money supply
with reserve requirements, which are regulations on the minimum amount of reserves that banks must
hold against deposits.
- Canada's official reserve ratio = 0% (but in practice never 0%)
- Since 1994, the Bank of Canada has phased out reserve requirements altogether.
The Influence of the Financial Sector
• Financial institutions can influence the size of the money supply
• Reserve ratio (R) = Reserves ÷ Deposits
• Money multiplier= 1 ÷ R
• The money multiplier tells us how much "new money"can be created from a new deposit and a reserve
• In a fractional reserve banking system (R < 100%),financial institutions have the opportunity to increase
the money supply by creating new demand deposits.
• Amount of money generated by the banking system = Deposit × Multiplier
Monetary Policy Instruments of the Bank of Canada
1. Open market operations
• BoC BUYS governmentbonds/securitiesfrom the public to INCREASE the moneysupply.
• BoC SELLS governmentbonds/securities to the public to DECREASEthe money supply.
2. Foreign exchange market operations
• BoC BUYS foreign currency and SELLS $CAD to INCREASE the money supply.
• BoC SELLS foreign currency and BUYS $CAD to DECREASE the money supply.
• Sterilization- reversing the effects of a foreign exchange market operation by using an open market
3. Changing the overnight rate
• INCREASINGthe overnight rate DECREASES the money supply.
• DECREASINGthe overnight rate INCREASESthe money supply.
The BoC controls the money supply but cannot control it precisely because of the influence of
individual's saving decisions and banks' lending decisions. Chapter 11: Money Growth and Inflation
February-13-13 2:30 PM
The Money Market
(in the long run)
Fig. 11.1 page 245
Supply curve - vertical
Meaning: the quantity of money is fixed by the Bank of Canada and is assumed to be unaffected by the
Demand curve - downward sloping
Meaning: when the value of money is low, which corresponds to high prices, people want to hold a
• The opposite is true.
An Increase in the Money Supply - The Adjustment from Point A to Point B (Slide 17 & 18)
1. The money marketbegins in equilibrium at point A.
2. There is a monetaryinjection which creates an excess supply of money immediately.
3. Now, people have more money than they need at this price level.
4. They may buy goods and services with their excess holdings of money or make deposits in banks.
5. The demand for goods and services increases causing the prices of goods and services to rise.
6. The overall price level for goods and services adjusts to bring money supply and mo