Microeconomics: how individual households and firms make decisions and how they interact
with one another in markets.
Macroeconomics: studying the economy as a whole. To explain the economic changes that are
affecting households, firms and markets all together.
GDP(Gross Domestic Product): the market value of all final goods and services produced
within a country in a given period of time. It is the most watched economic statistic because it is
thought to be the best single measure of a society’s economic well-being.
• Measures two things:
1) The total income of everyone in the economy
2) The total expenditure on the economy’s output of goods and services.
• For an economy, income must equal expenditure. Every transaction has two parties: a
buyer and a seller.
This diagram explains how income=expenditure. However, in the actual economy households
don’t spend all of their income. They pay some in taxes, save some for the future, etc. Some goods are bought by governments and some are bought by firms planning to use them in the
future. However there is always a buyer+ seller therefore expenditure=income always.
• GDP uses market prices to measure the amount people are willing to pay for different
• GDP includes all items produced in the economy and sold legally in markets. It also
includes the market value for rental housing provided by the economy’s stock of housing.
The rent equals both the expenditure and the landlord’s income. However many people
own the place they live and do not pay rent. The government includes this owner-
occupied housing in GDP by estimating it’s rental value. GDP is based on the assumption
that the owner pays rent to himself, so the rent is included both in his expenditure and his
• Excludes products sold illegally, most items produced and consumed at home because
they never enter the marketplace.
• Iffy situations, for example if Karen paid Doug to mow her lawn that would be a part of
GDP. But if they married and Doug did it for free, Doug’s service wouldn’t be in the
market so GDP would fall.
• GDP only counts Final goods as opposed to intermediate goods. Adding the market
value of the paper to the market value of the card made would be counting the paper
twice. An exception would be when an intermediate good is produced and added to a
firm’s inventory to be used or sold at a later date. Then it is taken to be a final good.
• Is only for goods currently produced, not produced in the past. Meaning if someone
sells an older used car to another person, the value isn’t added to the GDP.
• Within a country means within a geographic region.
• usually GDP is measured in a quarter (three months)
GDP is divided into four components:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
Therefore: Consumption: The spending by households on goods and services.
Investment: the purchase of goods that will be used in the future to produce more goods and
• Capital equipment, inventories and structures.
• Buying a new house is a form of investment, not consumption
• If IBM produces a computer but doesn’t sell it and instead adds it to it’s inventory. IBM
is assumed to have purchased the computer from themselves.
Government Purchases: spending on goods and services by local, territorial, provincial and
• Salaries of government workers, spending on public works.
• Things like pension plan aren’t government purchases but are transfer payment because
they aren’t receiving any service or good for their spending
Net Exports: the purchases of domestically produced goods by foreigners (exports) minus the
domestic purchases of foreign goods (imports). Imports are subtracted from exports.
Real GDP Versus Nominal GDP
If total spending increases either one of these are true:
• The economy is producing larger output of goods and services
• Goods and services are being sold at higher prices.
Real GDP: shows how the economy’s overall production of goods and services changes over
time by evaluating current production using fixed prices at past levels. This means it is not
affected by changes in price. (example on page 107)
Nominal GDP: the production of goods and services valued at current prices.
GDPDeflator: the prices of goods and services but not the quantities produced.
¿ nominalGDP ∗100
GPD Deflator realGDP
• Measures the current level of prices compared to the prices of the base year.
• Has to do with inflation. The inflation rate is calculated as follows: InflationRate∈Year2= GDPDeflator∈year2−GDPDeflator∈Year1 ∗100
Chapter 6- Measuring the Cost of Living
Consumer Price Index: the overall measure of goods and services bought by a typical
Steps to finding the Consumer Price Index:
1) Determine the basket- which prices are most important, weighing which items are
more important than others.
2) Find the Prices`
3) Compute the Basket’s Cost- calculate the cost of the basket of goods and services at
4) Choose a base year and compute the index- designate one year as the base year
(Priceof basketof goods∧services∈current year)
CPI= priceof basket∈base year ∗100
5) Compute the Inflation Rate: the percentage change in the price index from the
preceding period. InflationRate∈Year2= CPI∈year2−CPI∈year1 ∗100
Core inflation: thought to be useful in predicting the underlying trend of changes in the
consumer price index.
Problems with the Consumer Price Index
• Commodity substitution bias: when prices change from one year to the next, they don’t
change proportionately. Consumers buy goods more or less based on if the price rises or
falls. The CPI ignores the possibility of consumer substitution and overstates the increase
in the cost of living from one year to the next. The CPI assumes consumers still buy items
that have risen in price.
• Introduction of New Goods: when a new good is introduced, consumers have more
variety from which to choose. Greater variety makes each dollar more valuable so
consumers need fewer dollars to maintain any given standard of living.
• Unmeasured quality change: if the quality of a good changes from one year to the next,
the value of the dollar falls even if the value of the good remains the same. If the quality
raises the dollar raises.
These measurements tend to cause the Canadian CPI to overstate increases in their standard of
living by about 0.6%. This is a problem as OldAge security and the Canada Pension Plan,
personal income tax deductions and some government social payments are all adjusted upwards
using the CPI.Adjustments to wages, pensions and social payments may be larger than necessary
to maintain the purchasing power of these wages and benefits.
The GDP Deflator versus the Consumer Price Index
GDPdeflator: the ratio of nominal GDP to real GDP. It reflects the current level of prices
relative to the level of prices in the base year.
• Economists monitor both the GDP deflator and the CPI to gauge how quickly prices are
Differences between GDPDeflator and CPI:
• GDP deflator reflects the prices of all goods and services produced domestically while
the consumer price index reflects prices of all goods and services bought by consumers.
• The consumer price index compares the price of a fixed basket of goods and services to
the price of the basket in the base year. The GDP deflator compares the price of currently
produced goods and services to the price of the same goods and services in the base year Figure 6.2 page 127
Dollar Figures from Different Times
How much of the rise in the price of a product is simply a reflection of the general rise in prices?
In other words, how much of the rise of the price in gasoline is due to a fall in the value of
money? We would need to inflate the price of the earlier price to the newer price.
Inflate the 1957 price of gas from 9.5 cents/litre to 2009 dollars.
Statistics Canada gives a CPI of 14.8 for 1957 and 114.3 for the year 2009. (The base year is
2002). The overall level of prices rose by a factor of 7.72.
1957 gas price in 2009 dollars=1957 gas price x (CPI in 2009/CPI 1957)
=9.5 cents x (114.3/14.8)
The 1957 price of gasoline is equivalent to a price of 73.4 cents per litre in 2009. Therefore after
adjusting for inflation the 2009 gas price of 95 cents per litre is still considerably higher than 52
Indexed: when a dollar amount is automatically corrected by for inflation by law or contract.
Chapter 7-Production and Growth
The large variations in living standards around the world depends on productivity
-Productivity: the quantity of goods and services a worker can produce for each hour of work
For example in a simple economy (stranded on an island) whatever you produce (fish, cook,
make clothes) the better you live.
GDP measures the total income earned by everyone in the economy and the total expenditure on
the economy’s output of goods and services- they must be equal.
Therefore, the economy’s income must = the economy’s output
How Productivity is Determined
• Physical Capital/Worker: the tools workers have make them more productive.
Equipment and structures that are used to produce goods and services.
• Human Capital: knowledge and skills that workers acquire through education, training
and experience. Teachers, libraries, etc are the inputs. • Natural Resources Per Worker: inputs into production that are provided by nature.
Take 2 forms: renewable and non-renewable. Some countries like SaudiArabia and
Kuwait are rich because they are on top of plenty of Natural Resources.
• Technological Knowledge: the understanding of the best ways to produce goods and
services. Many people used to work on farms but an increase in technology meant more
output, now the labour can be used for other goods and services.
Economic Growth and Public Policy
What can government policy do to raise productivity and living standards?
Saving and Investment
• One way to raise future productivity is to invest more current resources in the production
We face trade offs, devoting fewer resources to producing capital requires
devoting fewer resources to producing goods and services for current
For society to invest more in capital it must consume less and save more of it’s
Diminishing Returns and the Catch-Up Effect
• Diminishing Returns: as the stock of capital rises, the extra output produced from an
additional unit of capital falls. y=output per worker
• An increase in saving rate leads to higher growth only for a while
It is easier for poorer countries to grow faster. Poor countries have low productivity, so increase
in capital can raise productivity substantially which is called the catch up effect
Since capital/worker is already high in rich countries, additional capital investment has a small
effect on productivity.
Investment from Abroad
Investment by foreigners can raise economic growth
• Foreign Direct Investment: capital investment that is owned and operated by a foreign
• Foreign Portfolio Investment: investment financed with foreign money but operated by
Example: a Canadian can buy stock in an Irish company, that company uses the
investment to build a new factory.
Canadian saving is being used to finance Irish Investment. Foreign Investors
expect to earn a profit. If Bombardier opens an assembly plant in Ireland, it
increases Ireland’s productivity and GDP. Some of the income doesn’t apply to
people who do live in Ireland. Therefore the GNP>GDP in this sense. • Foreign Investment leads to poorer countries raising productivity.
• The World Bank and International Monetary Fund lets richer countries give loans to
poorer ones, and gives them advice on how to manage money.
• Raises productivity
• But the opportunity cost means students forgo wages they could have earned
In poorer countries students drop out earlier to help support their families.
• Human capital is good for economic growth because it conveys positive externalities
• Externalities: effect of one person’s actions on the well being of a bystander.
• Brain Drain: most poor countries have their smartest people emigrating.
Health and Nutrition
• Healthier workers are more productive
• Poor countries are poor because their workers are malnourished, but malnourished
because they are poor.
Property Rights and Political Stability
• Policymakers can foster economic growth by protecting property rights and promoting
• Market prices are made to balance supply and demand.
Made by the invisible hand
• Property Rights: the ability for people to exercise authority over the resources they own
Poorer countries lack property rights, and political instability can lead to a threat
of Property rights.
• Inward Oriented Policies: trying to raise productivity by limiting interaction with the
rest of the world. This is for protection from foreign competition.
• Outward Oriented Policies: integrate these countries into the world economy.
Research and Development • Research to improve the ability to produce goods and services.
• Public good: other people can freely use
• Tax breaks are given to firms that engage in Research and Development.
• Alarge population means more workers but less consumers
Doesn’t mean higher standard of living
Thomas Robert Malthus
• An ever increasing population will continually strain society’s resources
• As population grows, each person can use less capital so the GDP per worker lowers.
• If there are more people, there is more knowledge to increase technology and capital
leading to an increased GDP.
Chapter 8- Saving Investment and the Financial System
• Institutions in the economy that help to match one person’s saving with another person’s
• Can be grouped in two categories:
1. Financial Markets
2. Financial Intermediaries
• Institutions through which a person who wants to save can directly supply funds to a
person who wants to borrow.
• Bond Market: a bond is an IOU. It identifies a date of maturity (when it will be resold),
the rate of interest paid: principal. The Bond buyer can keep the bond until maturity or
Perpetuity is a bond that doesn’t expire
Credit Risk is the risk the borrower won’t repay which is called default.
Companies can default on their loan by filing bankruptcy. • Provincial government bond issues are less stable than federal government because their
tax revenues can change quickly.
• Newer companies issue junk bonds because they offer high interest.
• The Stock Market: selling and buying of ownership in a firm and is a claim to the profit
a firm makes
Selling a stock to raise money is called equity finance selling bonds is called
Shareholders enjoy the benefits but bondholders only get the interest.
Stock index is an average of a group of stock prices.
• Financial institutions through which savers can indirectly provide funds to borrowers.
• Two of the most important types:
2. Mutual Funds
• Banks: take deposits from people who want to save money and use the deposits to make
loans to people who want to borrow. They pay depositors interest and charge borrowers
slightly higher interest.
• Mutual Funds: an institution that sells shares to the public and uses the proceeds to buy
a selection or portfolio of various types of stocks, bonds or both.
The company operating the mutual fund charges a shareholder’s fee, usually
between 0.5 and 3.0 percent of assets each year.
The people handling the funds buy profitable stocks and sell less profitable.
Index Funds: buy all the stocks in a given stock index. They keep costs low by
buying and selling rarely, and not having to pay the salaries of the professional
Saving and Investment in the National IncomeAccounts
• Identity: an equation that must be true because of the way the variables in the equation
are defined. Important Identites:
GDP: Y=C+I+G+NX…..C=Consumption, I=Investment, G=Government
Purchases, NX=Net exports
Closed Economy: one that doesn’t interact with other economies. Doesn’t engage
in international anything
Open Economies: interact with other economies around the world.
• in a closed economy we may write: Y=C+I+G because there are no exports.
Y-C-G=I is called national saving
Sub “S” for Y-C-G and we get S=I saving equals investment
• Let T= the amount the government collects from households in taxes minus the amount it
pays back in transfer payments.
We can write national savings in two ways:
S=Y-C-G or S=(Y-T-C)+(T-G)
• (Y-T-C) is private savings and (T-G) is public savings.
• Private Saving: amount of income that households have left after paying their taxes and
paying for their consumption. Houses receive income of Y, pay taxes of T and spend C on
• Public Saving: amount of tax revenue the government has left after paying for it’s
spending. Receives T in tax revenue but spends G on goods + services
• There is a Budget Surplus if T exceeds G
• ABudget Deficit is when they are spending more money than the government is
receiving in Tax Revenue. T-G= Negative Number
Market for Loanable Funds
Assume the economy has only one financial market called the market for loanable funds
• Loanable Funds: all income people have chosen to save and lend out. Only one Interest
rate, return to saving and the cost of borrowing.
Supply= people with extra income they want to save and lend out.
Demand=households and firms who wish to borrow to make investments.
The interest rate is the price of a loan. • Low interest rate=less supplied, high interest rate= encourage saving and increase the
quantity of loanable funds supplied and discourage borrowing.
• If higher than the equilibrium, the quantity of loanable funds supplied would be higher
than demanded and interest rates would be driven down.
• Nominal Interest Rate: the interest rate as usually reported. The return to savings and
cost of borrowing.
• Real interest Rate: nominal interest rate corrected for inflation. =Nominal Interest rate-
• People are discouraged to save because the government keeps taxing their incomes. To
solve these economists have tried implementing different things, such as the GST which
is on consumption.
• RRSP’s allow people to save for the future without being taxed.Also TFSA(Tax Free
Savings Accounts) Change in tax laws encouraging saving would shift the supply of loanable funds.
Equilibrium interest rate would fall, the lower interest rate would stimulate investment.
Affects the supply because it affects the amount of quantity of loanable funds supplied.
• investment tax credit: gives a tax advantage to any firm building a new factory or
buying new equipment.
• would affect demand because it is rewarding the firms that borrow and invest in new
capital. Demand would increase because there is more incentive to increase investment
and the quantity of loanable funds would increase. Higher interest rate would stimulate saving and equilibrium interest rate would rise.
Government Budget Deficit and Surpluses
• Government Debt: the sum of all past budget deficits – the sum of all past budget
• It changes the supply of loanable funds because national saving is the supply of loanable
funds. It is composed of public saving and private saving, and the government budget is
public saving. Shifts supply to the left. The fall of investment due to government
borrowing is called crowding out. Chapter 9- Unemployment and It’s Natural Rate
People who would like to work but can’t find jobs don’t contribute production of goods and
services, and GDP is lower.
• Natural rate of unemployment: normal amount of unemployment an economy
• Cyclical Unemployment: year to year fluctuations in unemployment.
How is unemployment measured?
3) Not in the labour force
=sum of employed and unemployed
=number of employed +number of unemployed
¿numberof unemployed ∗100
Unemployment rate labour force Labour force participation: measures the percentage of the total adult population of Canada that
is in the labour force.
labour force ∗100
Labour force participation rate= adult population
• The economy returns to the natural rate of unemployment in the long run
Estimate for Canada is 6% to 8%.
• The difference between the observed unemployment rate and the natural unemployment
rate is the cyclical unemployment rate.
• Frictional unemployment: the unemployment that results from the process of matching
workers and jobs.
• Structural unemployment: quantity of labour supplied exceeds quantity demanded.
Occurs when wages are set above the level of equilibrium.
Government programs try to facilitate job search in many different ways. Employment agencies,
public training programs, etc.
• Employment insurance: providing income for the unemployed. Some believe that this
may increase the unemployment rate to be higher than normal. May increase the amount
of frictional unemployment without intending on doing so. In places with low
unemployment rates, more hours of work are needed to be eligible for EI.
• When a minimum-wage law forces the wage to remain above the level that balances
supply and demand (equilibrium), it raises the quantity of labour supplied and reduces the
quantity of labour demanded compared to equilibrium level. Because there are more
workers willing to work than there are jobs. • Union: a worker association that bargains with employers over wages and working
High union wages reduce the quantity of labour demanded and cause some
workers to be unemployed and reduce the wages in the rest of the economy.
• Efficiency wages: theory that firms operate more efficiently when wages are above the
Health: better paid workers eat more nutritious and are more healthier and
Firms can reduce turnovers (workers leaving) by paying them high wages.
Working effort: people work harder when paid more.
Worker Quality: higher wages attract more experienced workers.
Chapter 10- The Monetary System
• Double Coincidence of Wants: the unlikely occurrence that two people have
goods/services each other wants. • Money: set of assets people use to buy goods and services
The Functions of Money
1) Medium of Exchange: an item that buyers give to sellers when they purchase goods and
2) Unit ofAccount: standard monetary unit of measurement ($)
3) Store of Value: item people can use to transfer purchasing power from the present to the
future. You can hold the money and become a buyer of another good or service at another
time.Arecognized form of exchange.
4) Liquidity: the ease that an asset can be changed into a medium of exchange (money).
Stocks and bonds can be sold easily with small cost so they are relatively liquid. Selling a
house requires more time and effort so this is less liquid.
The Kinds of Money
• Commodity money: when money has value if it weren’t used as money. Example: gold
is used as currency, also to make jewellery.
• Fiat Money: established as money by the government. (Canadian dollars)
The Bank of Canada measures the money stock defined as M1+ and M2.
The Bank of Canada
• Central Bank: an institution designed to control the quantity of money in the economy.
Owned by the government and hand over profits to the government. Primary
responsibility is to act in national interest.
• Commercial Bank: owned by their shareholders. Primary responsibility is to maximize
the profits they earn on behalf of their shareholders.
Bank of Canada Jobs:
1) Issue Currency
2) Act as a banker to commercial banks
3) Act as a banker to the Canadian government
4) Control the quantity of money made available to the economy (money supply).
Decisions concerning the money supply constitute monetary policy. Commercial Banks and The Money Supply
• Reserves: deposits that banks have received but haven’t lent out.
Each deposit in the bank reduces currency and raises demand deposits by exactly
the same amount, leaving the money supply unchanged.
• If the flow of new deposits is roughly the same as the flow of withdrawals, the bank only
needs to keep a fraction of it’s deposits in reserve. They adopt a system called fractional-
• Reserve Ratio: fraction of total deposits that a bank holds. If you have a 10% reserve
ratio and you hold $100 in demand deposits, you need $10 in reserves and can loan $90.
• Banks have a legal requirement of reserves called a reserve requirement so they don’t
• When banks make loans, the money supply increases. When a bank holds only a fraction
of deposits in reserve, banks create money. The borrowers are taking on debts, so the
loans don’t make them any richer.At the end of this process of money creation the
economy is more liquid because there is more medium of exchange but the economy is
no wealthier than before.
• The amount of money the banking system generates with each dollar of reserves is called
the money multiplier. (Page 230 and 231 read this and understand it)
• The higher the reserve ratio, the less of each deposit banks loan out and the smaller the
Changing the Overnight Rate
• Bank Rate: rate of interest central banks charge commercial banks for these loans
• Overnight rate: rate of interest on very short-term loans between commercial banks.
Will always be around a quarter of a percent below the bank rate.
Ahigher overnight rate discourages banks from borrowing reserves from the
Bank of Canada Chapter 11- Money Growth and Inflation
Prices rise when the government prints too much money.
The Level of Prices and the Value of Money
• Money used to buy something can become less valuable.
• Inflation concerns the value of the economy’s medium of exchange
• If P is the price of a good, the amount that can be bought withP$1 is
Money Supply, Money Demand and Monetary Equilibrium
Supply and demand for money determines the price of money
• The demand of money depends on liquidity preference, how much money people want to
How much money they hold depends on prices
In the long run, the overall level of prices adjusts to the level at which the demand for money
equals the supply People want to hold a larger quantity of money when each dollar buys less.
• When the value of money is high, the price level is low
When the value of money is low, people demand a larger quantity of it to buy
goods and services
• Equilibrium of money supply and money demand determines the value of money and the
The Effects of a Monetary Injection • Value of money decreases and the equilibrium price level increases
• Each dollar is less valuable when there is an increase in money supply
• Quantity Theory of Money: quantity of money available in the economy determines the
value of money and growth in quantity is the cause of inflation
The Classical Dichotomy and Monetary Neutrality
All Economic variables should be divided into two groups
1) Nominal Variables: variables measured in monetary units
2) Real Variables: variables measured in physical units. (Real wage and real interest rate)
The separation of these groups is called classical dichotomy
Relative Prices: measuring the value of something with the quantity of another.
Changes in the supply of money affect nominal variables but not real variables.
• Monetary Neutrality: irrelevance of monetary changes for real variables in the long run.
Real variables are things such as production, employment, real wages, etc. Velocity and the Quantity Equation
• Velocity of Money: speed the typical dollar travels from wallet to wallet
Divide the nominal value of output (nominal GDP is P*Y) by the quantity of
money. If P is the price level (GDP deflator), Y is the quantity of output (Real
GDP), M is the quantity of money, velocity is:
V= (P∗Y )
Can also be written:
M∗V =P∗Y which is called the quantity equation
Relates the quantity of money(M) to the nominal value of output (P*Y)
The quantity equation shows that increasing the money supply should only be
because of price level rising, the quantity of output rising or the velocity of money
Since Y is determined by factory supplies and technology, when the central bank
alters the money supply (M), the changes are reflected in changes in the price.
Therefore when the Central Bank increases the money supply, the result is a high
rate of inflation.
The Inflation Tax
Governments print money to fund different projects if they don’t have enough tax revenue.
• When the government raises revenue by printing money, it is said to levy an inflation tax.
Inflation tax: when the government prints money, the price level rises and the
dollars in your pocket are less valuable. Inflation tax is like a tax on everyone who
The Fisher Effect
Real Interest Rate=Nominal Interest Rate−Inflation Rate
Nominal Interest Rate=Real Interest Rate+InflationRate • Fisher Effect: When the Bank of Canada increases the rate of money growth, the result
is both a higher inflation rate and a higher nominal Interest rate.
The Inflation Fallacy
• People aren’t losing money with inflation, as incomes inflate as well.
• Shoeleather cost: the cost of reducing your money holdings. (Called shoeleather because
it erodes your shoes walking to the bank so often)
• you can avoid inflation tax by going to the bank more often, holding less money on you.
Keep your wealth in interest- bearing savings account and less in your wallet.
Inflation-Induced Tax Distortions
Taxes distort incentives
• Capital Gains: the profits made by selling an asset for more than it’s purchase price. You
have to include this on your income and be taxed. Inflation could have been greater, and
you could have been taxed on a greater gain. Inflation exaggerates the size of capital
gains and inadvertently increases the tax burden on this type of income.
Chapter 12- Open-Economy Macroeconomics: Basic Concepts
• Netexports=(Valueof Exports)−(Valueof Imports)
Also called the trade balance
NetCapitalFlow=(purchaseof foreignassetsbydomesticresidents)−(the purchaseof domestic assetsbyforeigners)
• Net Capital Outflow must be equal to Net Exports
• When NX>0, there is a trade surplus. Is it selling more goods and services to foreigners
than it is buying from them. However the foreign currency it is using is buying foreign
assets, and NCO>0 too. • When a nation has a trade deficit, capital is flowing out of the country NX<0, but the
foreigners must be buying our domestic assets, so capital is flowing into the country.
• National Saving is written as(Y−C−G)=I+NX ,S=I but because net exports (NX)
also equals (NCO), we can write the equation
Country with a Trade Surplus
Income (Y=C+I+G+NX) must be greater than domestic spending (C+I+G), but if Y is
greater than C+I+G than Y-C-G must be greater than I. (S=Y-C-G) must be greater than
investment. Net capital outflow must be greater than zero.
Country with a Trade Deficit
Income (Y=C+I+G+NX) must be less than domestic spending (C+I+G), meaning (Y-C-
G) is less than I. Net Capital Outflow is negative.
Nominal Exchange Rate
• The rate at which a person can trade the currency of one country for the currency of
• Appreciation: the dollar buys more foreign currency
• Depreciation: the dollar buys less foreign currency.
Real Exchange Rate
• The rate at which a person can trade the goods and services of one country for the goods
and services of another.
Express it as units of a foreign item per units of domestic items.
ForeignPrice • Macroeconomists use CPI and prices of foreign baskets to measure an economy as a
whole. Canadian basket (P), price index for a foreign basket (P*) and the nominal
exchange rate between the Canadian dollar and foreign currencies (e)
Measures the price of a basket of goods and services available domestically
relative to a basket of goods and services available abroad.
Acheaper domestic real exchange rate means consumers will buy more from us,
but a more expensive one means we will buy from others and other wont buy
• Aunit of any given currency should be able to buy the same quantity of goods in all
• If one good is cheaper in another country, people will buy it and sell it to other countries,
driving up the price in the once cheap country, and lowering it in the other. Bringing it to
• For the purchasing power of a dollar to be the same in two countries, it must be the case
that 1 = e rearranged to 1= eP
P ¿ ¿
The left-hand side of this equation is a constant, and the right side is the real
exchange rate. Thus if the purchasing power of the dollar is always the same at
home and abroad, then the real exchange rate cannot change.
Nominal Exchange rate: ¿ , the nominal exchange rate must be equal to the
different price levels in those countries.
When a country prints money, the value of it’s currency depreciates.
Perfect Capital Mobility • Meaning we have full access to international markets, and our market is available
• Real Interest rate, must equal the world Real Interest rate.=r
If higher, Canadians would prefer to buy internationally instead of
domestically, and vice-versa.
• The theory that Canadian interest rates should be equal to the rest of the world’s is
interest rate parity.
Chapter 13-AMacroeconomic Theory of the Open Economy
• When a country is buying foreign assets, their savings are going abroad to purchase
• To understand the forces in an open economy, we look at the market for loanable funds
and the market for foreign-currency exchange
The Market for Loanable Funds
• If a nation’s savings exceed its amount to purchase domestic capital, the amount left over
can be used to purchase foreign assets (NCO Positive). (S>I)
• If national saving is insufficient to purchase domestic capital, the shortfall can be met by
the savings of foreigners (NCO is negative). (S