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Final

Macro Exam Notes.pdf

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Department
Economics
Course
ECON 1BB3
Professor
Bridget O' Shaughnessy
Semester
Fall

Description
Chapter 5 February-01-11 10:55 AM Gross Domestic Product(GDP)- the market value of all final goods and servicesproduced within a country in a given period of time - Measures two things at once: total income of everyonein the economyand total expenditure on the economy'soutput of goods and services ○ For the economyas a whole, income must equal expenditure ▪ Can be visualized using circular flow diagram(See Figure 5.1, pg. 99) GDP is the market value - Market prices measure the amount people are willing to pay for different goods or, in essence, the value of these goods Of All - Tries to be comprehensive;all goods/servicesproduced in the economyand sold legally in the markets - Also includes market value of the housing services provided by the economy ○ Governmentestimatesrental value of owner-occupiedhousing ▪ Assumption that owner pays rent to himself(both incomeand expenditure) - Excludes items sold illicitly or at home; underground/informal economy ○ GDP often underestimatestrue amount of productive activitytaking place in the economy Final - Does not measure intermediategoods, only final goods ○ Value of intermediate good is already included in price of final good ○ Avoids counting same item multiple times - Exception arises when an intermediategood is produced and stored, rather than being used(inventoryaccumulation) ○ Intermediategood is taken as "final" for the moment,added to investment ○ When later sold/used, GDP for the later period is reduced accordingly Goods and ServicesProduced - Includes goods/servicescurrentlyproduced - Does not include transactions involving items produced in the past ○ Example: Selling used car to another person Within a Country - Measures value of production within the geographic boundaries of the country ○ Whatever is produced in Canada, regardless of the nationality, is counted towards GDP ○ Foreign Canadian's inputs do not count towards GDP, only GNP In a Given Period of Time - Takes place within a specific interval of time, usually a year or a quarter(3 months) - Flow variable - When governmentreports GDP for a quarter, it presents GDP at an annual rate ○ Figure reported for quarterly GDP is the amount of income/expenditureduring the quarter multiplied by 4 ▪ Helps in comparison with annual figures ○ Figures are usually take seasonal adjustments into account GDP = Y = C+ I + G + NX GDP = Y = Consumption + Investment + Government Purchases + Net Exports Consumption - Spending by households on goods and services ○ Includes durable and nondurable goods - Does NOT include purchases of new housing Investment - Purchase of goods that will be used in the future to produce more goods and services ○ Spending on capital equipment, inventories and structures, including household purchases of new housing ○ Also includes intermediate goods that produced and stored(inventoryaccumulation),rather than being used Government Purchases - Spending on goods and services by bodies of government ○ Includes salaries of government workersand spending on public works ○ Does not include transfer payments such as Canada Pension plan ▪ Although transfer payments alter household income,they do not reflect the economy'sproduction Net Exports - The value of a nation's exports minus the value of its important; also known as trade balance - Purchases of domesticallyproduced goods by foreigners(exports)minus the domesticpurchases of foreign goods(imports)34 - "Net" refers to the fact that imports are subtracted from exports ○ Imports of good/servicesare already included in other componentsof GDP(consumption, investmentor governmentpurchasing) ○ Hence, purchase of goods/servicesfrom abroad does not affect GDP(increases1 of 3 categories but ends up reducing net exports) Canadian GDP in 2005 was around $1.371trillion dollars Real GDP vs. Nominal GDP - If total spending rises from one year to the next, then either ○ The economyis producing a larger output of goods ○ Goods and services are being sold at higher prices - Economistswant to separate these effects and measure the total quantity of goods and services the economyis producing that is not affected by changes in the prices of those goods and services ○ Use a measure called Real GDP ▪ The production of goods and services valued at constant prices ▪ "What would be the value of the goods and services produced this year if we valued these goods and services at the prices from some year in the past?" ▪ By using fixed prices from past levels, real GDP shows how the economy'soverall production of goods/serviceschanges over time ▪ Differentiated from Nominal GDP, or the production of goods and services valued at current prices ▪ See Table 5.3 (pg. 107) for how to calculate ▪ For chosen base year, nominal GDP = real GDP ▪ Nominal GDP uses current prices to place a value on the economy'sproduction of goods and services; Real GDP uses constant base-year prices to place a value on the economy'sproduction of goods and services ▪ Real GDP only affects changes in the amounts being produced □ Not affected by changes in prices □ Thus, a measure of the economy'sproduction of goods and services GDP Deflator GDP Deflator - Nominal GDP reflects both prices of good/servicesand the quantities of good/servicesthe economyis producing - Real GDP reflects only the quantities produced, by keeping prices consistent - GDP Deflator - a measure that reflects the prices of goods and servicesbut not the quantities produced ○ GDP Deflator = Nominal GDP/RealGDP * 100 ▪ Hence, GDP Deflator for base year always equal 100 ○ Measures the change in nominal GDP from the base year that cannot be attributed to the change in real GDP ▪ Nominal GDP(quantityproduced + price) increases, Real GDP(quantityproduced) stays the same, hence GDP deflator(price)must have increased ○ Measures the current level of prices relative to the level of prices in the base year ▪ Reflects what's happening to prices Recession is usually defined as two consecutivequarters of falling real GDP Flaws of GDP as a means of measuring standard of living - Does take into account underground/formal economy - Does not measure wide income disparities(90 percent of the wealth in 10 percent of the population in certain countries) - Does not take into account ethical aspects(e.g environment) ○ Production may increase, but at what cost? Chapter 6 February-01-11 9:34 PM Consumer price index (CPI) - a measure of the overall cost of the goods and servicesbought by a typical consumer - Shows the cost of a basket of goods and services relative to the cost of the same basket in the base year - Used to monitorchanges in the cost of living over time - Calculated monthly by Statistics Canada ○ Uses data on the prices of over 600 different goods and services Inflation - describes a situation in which the economy's overall price level is rising - Inflation rate is the percentage change in the price level from the previous period How the Consumer Price Index Is Calculated Determinethe Basket - Determinewhich prices are most importantto the typical consumerand weigh them accordingly in measuring the cost of living Find the Prices - Find price of each of the good and servicesin the basket for each point in time Compute the basket's cost - Use the data on prices to calculate the cost of the basket of goodsand services at different - Isolate price changes from any quantity changes Choose a base year and compute the index - Designate one year as the base year, serves as a benchmark ○ Use quantity/amountin basket from BASE year - Choice of the base year doesn't matter since the index is used to measure changes in the cost of living - CPI = Price of baskets of goods/servicesin one year/Priceof the basket in base year * 100 ○ Hence, index is always 100 in base year Compute the inflation rate - The percentage change in the price index from the preceding period - (CPI in year 2 - CPI in year 1)/CPI in year 1 * 100 Core inflation - the measure of the underlying trend of inflation - Useful in predicting the underlying trend of changes in the CPI Problems in Measuring the Cost of Living - The CPI measures changes in the cost of living ○ In other words, CPI tries to gauge how much incomes must rise in order to maintain a costant standard of living - Substitution bias ○ Consumers substitute towards goods that have become relativelyless expensive ○ If price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitution and, therefore, overstatesthe increase in the cost of living from one year to the next - Introduction of new goods ○ When a new good is introduced, consumershave more variety ○ Greater variety, in turn, makes each dollar more valuable, so consumers need fewer dollars to maintain any given standard of living ○ Because the CPI is based on a fix basket of goods and services, it does not reflect the increase in the value of the dollar that arises from the introduction of new goods - Unmeasured quality change - Unmeasured quality change ○ If the quality of a good deterioratesfrom one year to the next, the value of a dollar falls, even if the price of the good stays the same (and vice versa) ○ Statistics Canada adjusts the price of the good to account for quality changes but changes in quality are hard to measure ▪ Attempting to compute the price of a basket of goods of constant quality GDP Deflator VS. the CPI - GDP deflator is the ratio of nominal GDP to real GDP ○ Reflects the level of prices relative to prices in the base year - Usually similar, but there are two important differences ○ GDP deflator reflects prices of all goods and servicesproduced domesticallywhile CPI reflects the prices of all goods and servicesbought by consumers ▪ Example: Airplane sold by Bombardier increases in price □ Increases GDP deflator, but not CPI -> not in the basket of goods ▪ Example: Volkswagen raises the price of its car □ Increases CPI, but not GDP deflator -> not produced domestically ○ CPI compares the price of a fixed basket of goods/servicesto the price of the basket in the base year; GDP deflator compares the price of currently produced goods and services to the price of the same gods and services in the base year ▪ Thus, the group of goods and servicesused to computethe GDP deflator change over time ▪ Difference not important when all prices are changing proportionatelybut if prices of different goods/servicesare changing by varying amounts, the way we weight various prices matter for the overall inflation rate Dollar Figures from Different Times - Use cross-multiplication - Indexation: automatic correction of a dollar amount for the effects of inflation by law or contract ○ Example: COLA or Cost of Living Allowance, Canada PensionPlan, Old Age Security Benefits Real and Nominal Interest Rates - Real interest Rate = Nominal Interest Rate - Inflation Rate ○ Real interest rate: the interest rate corrected for the effects of inflation ▪ Tells you how fast the purchasing power rises ○ Nominal interest rate: the interest rate as usually reported without a correctionfor the effects of inflation Price indexes allow us to compare dollar figures from different points in time, allowing us to better see how the economyis changing Chapter 7 February-24-11 6:18 PM Productivityis linked to a country's standard of living Productivity- the amount of goods or servicesthat a worker can produce for each hour of work How Productivityis Determined - Physical capital per worker ○ Workers are more productive if they have tools with which to work ○ Stock of equipment/structuresused to produce goods/servicesis known as physical capital, or simply capital ○ While it is a factor of production, it is also a produced factor of production ▪ The equipment that is being used to produce somethinghad to be produced itself first using other capital - Human capital per worker ○ The knowledge and skills that workersacquire through education,training and experience ○ Like physical capital, it is a produced factor of production ▪ Requires inputs in the form of teachers, time and libraries - Natural resourcesper worker ○ The inputs into production of goods and services that are provided by nature, such as land, rivers and mineral deposits ○ Two forms: renewable(unlimitedsupply, plant more trees etc) and non-renewable(limited supply) - Technological knowledge ○ The understanding of the best ways to produce goods and services ○ Can be commonknowledge(onceperson uses it, everyonebecomesaware of it), proprietary(onlyknown by the company that discovers it) ○ Technological knowledge refers to society's understanding of how the world works while human capital refers to the resources used to transmit this information to the labour force ▪ Knowledge is the quality of society's textbooks,and human capital is the amount of time the population devotes to reading them Production Function Y = A * f(K, L, H, N) - A=technology,K = physical capital, L = labour, H = human capital, N= natural resources - Used to describe the relationship between the quantity of inputs used in production and the quantity of output from production - Make two assumptions with this production function that will allow us to do certain things: 1. Production function has constant returns to scale. If we double all the inputs, then we get twice as much output. If you multiply inputs by x, then we get x as much inputs. ▪ Allowing x = 1/L, production function can be written in per capita terms. This production function talks about how much output per worker,capital per worker, etc. 2. The original production function was aggregate output. Output in the entire economy depends on how much capital, labour, human capital, natural resources in the entire economy. What can Governmentsdo? - Encourage saving and investment(e.gimpose a consumption tax) ○ Since capital is a produced factor of production, a society can change amount of capital ▪ Raise productivity by increasing current resources in the production of capital ▪ More saving in the economy= more investmentin the economy.Investment = purchases in new capital goods. More investment= morecapital stock in the future purchases in new capital goods. More investment= morecapital stock in the future ○ Diminishing Returns and the Catch Up Effect ▪ As the stock of capital rises, the extra output produced from an additional unit of capital falls ▪ Increase in the saving rate leads to higher growth only for a while □ As higher saving rates allow more capital to be accumulated, the benefits from additional capital become smaller over time, and so growth slows down □ In long run, higher saving rate leads to a higher level of productivity and income but not to higher growth in these variables ▪ Easier for a country to grow fast if it starts out relatively poor □ Catch-up effect: countries that start off poor tend to grow more rapidly than countries that start off rich □ □ A poor country would have low per capita GDP (blue dot) □ Rich country would have high per capita GDP (red dot) What happens if both countries increase output per worker □ We want to increase capita per worker by the same amount for both rich and poor countries. Increase (K/L) -> (K/L)2.There’s a lot of room for improvement for poorer people (i.e. like people with lower marks) and there’s a lot less room for improvementfor people with higher marks - Foreign investmentcan also lead to increased capital ○ Capital investment that is owned and operated by a foreign entity: foreign direct investment ○ Capital investment that is financed with foreign money but operatedby domesticresidents: foreign portfolio investment ○ In both cases, foreign saving is being used to finance localinvestment ▪ Affects GDP and GNP differently(in foreign direct investment,GNP is increased by less than GDP as some money goes to foreign owners) ○ Allowing foreign company to comein an build a factory is good for the economyb/c it increases capital stock. It is not a good thing for poor countries to do b/c profits of the operation will leave the country; it would be better for a domesticcompany to build a factory. BUT if only option is: foreign country invest or nobody else invests, you would rather have the foreign country invest ▪ Able to learn state-of-arttechnology from richer countries - Education ○ Investmentin human capital ▪ Leads to many positive externalities-> new ideas □ Effect of one person's actions on the well-being of a bystander ▪ Brain drain: emigration of most highly educated workers to rich countries - Health and Nutrition ○ Healthier workersare more productive - PropertyRights and Political Stability Propertyrights: the ability of people to exercise authority over the resources they own ○ Propertyrights: the ability of people to exercise authority over the resources they own ○ Political instability leads to doubt about whether property rights will be respected in the future ○ More investment,more capital, improvementsin technology. Peoplewon’t invest in a country if they think someonecan comealong and take profits. - They need a strong legal systemin place and contracts need to be enforced so that people are willing to take risks and invest. ○ Affects technologyand physical capital - Free Trade ○ Can be a substitute for technology ○ Can help with technology (i.e. a lot of growth after WWII in Japan and Korea, they imported goods from the states and learned how to build them, then exportedthem back) ○ Inward(no trade) vs outward(trade)oriented policies - Research and Development ○ Knowledge is a public good ▪ Once one person discoversan idea, everyoneis able to use it ○ Governmentsgive grants to people in universities to fund research and developmentto improveand increase technology ○ Patent system = allows profit from the new invention to go to the researcher/discoverer/inventorgives people incentive for doing research and therefore improvetechnology Chapter 8 February-27-11 6:20 PM Financial System - The group of institutions in the economythat help to match one person's saving with another person's investment - Financial markets: the institutions through which savers can directly provide funds to borrowers ○ Debt finance: sales of bonds to raise money ○ Equity finance: sales of stock to raise money ○ The Bond market ▪ Bond: a certificate of indebtedness □ "I O U" □ Identifies date of maturity(thetime at which loan will be repaid) and rate of interest that will be paid until loan matures □ Buyer gives moneyin exchange for this promise of interest and eventual repayment of the principal(original amount borrowed) □ Buyer can hold bond till maturity or sell it to someoneelse □ Two important characteristics of a bond: Bond's term: length of time until the bond matures ◊ Long term bonds are riskier as they have to wait longer for repayment of principal Thus, pay higher interest rates Credit Risk: the probability that the borrowerwill fail to pay some of the interest or principal ◊ Default: failure to pay ◊ Default on loans by declaring bankruptcy ◊ If probability of default is high, there is a higher interest rate ◊ Affected by level of debt carried by the issuer of the bond, recent changes in the amount of debt carried, and the stability of the issuer's revenue Risk: federal government< provincial government < corporations < financially shaky corporations(issuejunk bonds -> higher interest rate) ○ The Stock Market ▪ Stock represents ownership in a firm and is, therefore,a claim to the profit that the firm makes □ Unlike bonds where issuer of the bond is a creditor of the corporation,not owner ▪ Shareholders benefit from high profits(dividend) whereas bond holders only get interest on their bond ▪ If company runs into financial difficulty,bondholders are paid before stockholders ▪ Compared to bonds, stock offers holder both higher risk and potentiallyhigher return ▪ After corporationissues stock by selling shares to the public, these shares are traded among stockholders on organized stock exchanges □ Corporationitself receives no money when its stock changes hands □ New York Stock Exchange(NYSE), American Stock Exchange, NASDAQ(National Association of Securities Dealers Automated Quotations system),TorontoStock Exchange(TSX), TSX Venture Exchange □ Supply and demand for the stock determine prices Demand, and hence price, of a stock reflects people's perception of the corporation'sfuture profitability corporation'sfuture profitability □ Stock index: computed average of a group of stock prices Dow Jones Industrial Average: 30 major US companies S&P/TSXCompositeIndex: 200 major firms listed on the TSX - Financial Intermediaries:financial institutionsthrough which savers can indirectlyprovide funds to borrowers ○ Banks ▪ Take in deposits from people who want to save and use these to makeloans to people who want to borrow □ Banks pay depositors interest on their deposit and charge borrowersslightly higher interest on their loans to make profit ▪ Also play second role in economyby allowing people to write cheques against their deposit □ Create a special asset(cheque) that people can use as a medium of exchange ○ Mutual fund ▪ Institution that sells shares to the public and uses the proceeds tobuy a portfolioof stocks and bonds ▪ Shareholder of the mutual fund accepts all risk and returns associatedwith stocks and/or bonds 1. Allow people with small amounts of money to diversify □ Don’t put eggs in one basket □ Becomepart owner or creditor of hundreds of major companies □ Company operating the mutual fund charges shareholders a fee, usually 0.5 and 3.0 percent of assets each other 2. Gives ordinary people access to the skills of professionalmoney managers □ Managers have increased know-how □ Economistsare skeptical as index funds, which buy all the stocks in a given index, perform better on average than mutual funds that take advantageof active management Keep costs low by not buying/selling regularly and not having to pay salary of money manager Saving and Investment in the National Income Accounts - National Income Accounting Identity ○ Assume that economyis closed, hence GDP equation becomes Y = C + I + G ○ Y - C - G = I ▪ Total income in the economythat remains after paying for consumption and governmentpurchases, known as saving or national saving, denoted as S ▪ Therefore,S = I, or savings equals investment ○ T = amount that the governmentcollects from households in taxes minus the amount it pays back to households in the form of transfer payments(welfare,employmentinsurance) ▪ S = Y - C - G or S = (Y - T - C) + (T - G) or S = private saving + public saving ▪ Private saving: amount of income that households have after paying their taxes and paying for their consumption ▪ Public saving: the amount of tax revenue that the governmenthas left after paying for its spending □ T > G, then governmenthas budget surplus □ T < G, then governmenthas budget deficit ○ For the economyas a whole, saving = investments ○ As long as income exceeds consumption for a person, they are saving ▪ Even when buying stocks/bonds ○ Investmentonly refers to the purchase of new capital, or equipment/buildings ▪ Sells stock and uses proceeds to build a new factory S = I identity is true for the economy as a whole, not for every individual household/firm ○ S = I identity is true for the economy as a whole, not for every individual household/firm Market for Loanable Funds - Assume one financial market - The market in which those who want to save supply funds and those who want to borrow to invest demand funds - Loanable funds: all incomethat people have chosen to save and lend out, rather than use for their own consumption - Supply of loanable funds comefrom those people who have extra income they want to save and lend out; saving is the source of loanable funds ○ National saving, including both private and public saving - Demand for loanable funds come households and firms who wish to borrow to make investments; investment is the source of demand for loanable funds - Interest rate is the price of the loan ○ Depends on real rather than nominal interest rate - Policy 1: Saving Incentives ○ Lower taxes ▪ Introduce consumptiontaxes(such as GST, PST) rather than incometaxes □ Income that is saved is not taxed, so encourages greater saving ○ Increase in the amount that people can contribute to registered retirementsaving plans(RRSP) ▪ By buying an RRSP, people reduce the amount of income that is taxed ○ If a reform of tax laws encouraged greater saving, the result would be lower interest rates and greater investment(supplyshift to the right) - Policy 2: Investment Incentives ○ Introduce investmenttax credit ▪ Tax advantage to any firm building a new factory, buying new equipment ○ If a reform of tax laws encouraged greater investment,the result would be higher interest rates and greater saving - Policy 3: Government Budget Deficits and Surpluses ○ Sum of all budget deficits minus the sum of all budget surpluses is called the government's debt ○ Governmentdeficit leads to reduced national saving, leading to decreased supply(supply shift left, decreased quantity, increased interest rate) ○ Results in crowdingout: a decrease in investment that results from governmentborrowing ▪ When governmentborrows to finance its budget deficit, it crowdsout private borrowerswho are trying to finance investment ○ When the governmentreduces national saving by running a budget deficit, the interest rate rises, and investmentfalls ○ Vicious circle:cycle that results when deficits reduce the supply of loanable funds, increase interest rates, discourage investment,and result in slower economicgrowth; slower growth leads to lower tax revenue and higher spending on income-supportprograms, and the results can be even higher budget deficits ▪ Must raise tax rates and cut spending on governmentprograms ○ Budget surplus, or public saving, contributes to national saving ▪ A budget surplus increases the supply of loanable funds, reduces the interest rate and stimulates investment ○ Virtuous cycle: cycle that results when surpluses increase the supply of loanable funds, reduce interest rates, stimulate investment,and result in faster economicgrowth; faster growth leads to higher tax revenue and lower spending on income-supporting programs, and the result can be even higher budget surpluses Chapter 9 March-04-11 11:01 PM Unemployment Economy'snatural rate of unemployment refers to the amount of unemploymentthat the economy normally experiences - Does not imply that this rate is desirable, constant over time, or unchangeable by economicpolicy - Composedof frictional and structural employment(discussed further down) Cyclical unemploymentrefers to the year-to-yearfluctuations in unemploymentaround its natural rate - Associated with short-run For people who are unemployed,it is bad (i.e. during a recession),but all unemploymentis not necessarily bad for the economyas a whole Identifying Unemployment How is Unemployment Measured? - Measured by Statistics Canada - Monthly survey, known as Labour Force Survey, ○ Produces data on unemployment,length of the average workweekand the duration of unemployment ○ Surveys around 50,000households ○ Separates adults(aged 15 and older) into: i. Employed □ A person is considered employedif he spent some of the previous week working at a paid job ii. Unemployed □ A person is unemployed if he is on temporary layoff or is looking for work, able to work, and unable to find a job iii. Not in the labour force □ A person who fits neither of the first two categories, such as full-time student, homemaker,or retiree is not in the labour force Exception - Not in the adult population = people in some form of institution where they would not be able to find a job even if they wanted to (i.e. people in the armed forces, prison, mental hospital, etc.) ○ Labor force = number of employed + number of unemployed ○ Unemploymentrate = number of unemployed/labourforce * 100 ▪ Percentage of labour force that is unemployed ○ Labour force participation rate(LFPR)= labour force/adultpopulation * 100 ▪ Measures percentage of the total adult population of Canada that is in the labour force ○ Employmentrate = number of employed/adultpopulation x 100 (NOT 100 – unemploymentrate as denominatoris different) Does Unemployment Rate Measure What We Want It To? - Movementsin and out of labour force are common ○ Almost half spells of unemploymentend when then the unemployed person leaves the labour force - UnemploymentRate can be understated(worsethan actually is): ○ Discouraged workers/searchers:people who were looking for a job, but think that prospect of finding a job is so slim that they have exited labour force. of finding a job is so slim that they have exited labour force. ▪ Thus, when Stats Can asks them “are you working?”they say No and when Stats Can asks them “are you looking for a job?” they say No; this meansthey are not included in the unemployed;they would be counted as being not in the labour force. BUT if given an offer days later, they would gladly take the job ▪ Existence of discouraged workersmeans that the problem of unemploymentmay actually be worse than what the figures indicate. ○ Underemploymentcan occur in two ways: 1. Someoneworking part-time, but would really prefer to be working full-time (30+ hours a week = full-time). Someoneworking 32h is considered working full-time, but what if individual would really prefer working 40h/wk. 2. People working below their skill level (i.e. if you have a software engineer who is laid off and that person goes to become a shift manager at McDonalds) ▪ Both #1 and 2, that the calculated unemploymentrate may not be capturing the picture as bad as it really is (reality may be worse). UnemploymentRate can also be overstated: - Due to people lying to Stats Can, saying that they are unemployed(activelylooking), when they are not actively looking for a job ○ Lie to collect employmentinsurance benefits; to collect person needs to be activelylooking ○ Unemploymentrate value may be over-estimatingthe unemploymentproblem - Average spell of unemployment in Canada lasted 15.5weeks Types of Unemployment: 1. Frictional unemployment ○ takes time for workersto search for a job that suits them the best and time for employersto hire the best workers ○ Inevitable because economyis always changing ▪ The precise amount is not inevitable ▪ The more information spreads about job openings and workeravailability, the more rapidly the economycan match workers and firms ▪ Internet, governmentprograms such as government-runemploymentagencies, public training programs can help facilitate job search, leading todecreased frictional unemployment ○ Pros: i. occurs because you have people entering and leaving labour force (i.e. when graduate from university and spend time looking for career job that would match you = unemployed during that period □ this unemploymentis good for the economyb/c it allows firms and workers to make a good match with each other. □ During SovietUnion, they prided themselveson having zero unemploymentin the country – this is b/c gov told people where they were going to work (no matching, no freedomof choice to find a job that is perfect for you). Not good for economy b/c not good matches = not efficient Frictional employment is good for economy b/c gives more efficient outcome and decisions ii. Sectoral shifts in the economy:changes in the compositionof demand among industries or regions □ Canada use to be primarily manufacture based and now most GDP is produced from services sectoral shift; losing manufacturing jobs, gaining service jobs). □ Bad for people who becomeunemployed, but good for the overall economy(i.e. 100 years ago, if people had argued to keep agricultural jobs b/c that is what they are comfortablewith, then would not have progressed). □ Shift in economycan help increase/improvestandard of living. □ Shift in economycan help increase/improvestandard of living. ○ Cons: i. Employmentinsurance benefits can also cause frictional unemployment □ raises the cost of going to work (i.e. get paid if looking for a job) □ bad for the economyb/c more people would want to stay unemployedand collect EI. 2. Structural unemployment ○ quantity of labour supplied > quantity of labour demanded ○ occurs when wage is higher than eqm wage. ○ due to the governmentsetting a legal minimum(price floor), union (negotiation b/w workers and firms), or efficiency wages (firms setting above toattract high-skilled workers) ○ ▪ When go from having no EI to providing EI, the cost of going to work goes up (b/c if don’t go to work, can collect moneyfrom the gov– the opp cost of going to work therefore goes up). ▪ Supply curve shifts to the left. Wage increases (W1 to W2, where W = wage). Number of people working decreases (L1 to L2, where L = labour). ▪ Can be good, but not as many people with jobs ○ Benefit replacementin various countries = how much of your previous income from work do you get paid by the gov (i.e. if unemployed in France, you get paid 75% of your wage @ previous job for almost two years) ▪ Thus, the higher the benefit replacementand benefit duration, the higher the unemploymentrate. The opportunity cost of going to work increases!As compensationincreases, more unemployment. ○ Benefit duration = how long get to collect that benefit for ▪ i.e. in France, you get 75% of the wage of where you were working before for two years. ▪ i.e. Lookat unemploymentrates of countries; there is not a perfect correlation, but unemploymentrate of France, Germany and Spain (where have generous EI programs) is higher than unemploymentrate of UK and US, where unemployment rate not nearly as generous. 3. Cyclical unemployment ○ when the economyis in a recession, workers are laid off unemploymentassociatedwith business cycle (i.e. when economygoesinto recession, ○ unemploymentassociatedwith business cycle (i.e. when economygoesinto recession, unemploymentincreases; when economygoes into boom, unemploymentdecreases). But booms and recession= short run, only deal with long-run for this course Causes of Structural Unemployment 1. Minimum wage is a price floor – legally mandated price floor ○ Illegal to pay someoneor work for someonelower than the minimum. ○ If the minimum wage is above eqm wage, the minimum wage is binding b/c it affects what goes on in the market place. When have a binding price floor, Qs > Qd = excess supply/surplus of labour/unemployment. ○ Unemploymentmeasured by taking the horizontal distance b/w Q of labour supplied and the Q of labour demanded. ○ Minimum Wage: Economic Theory W s L d L ○ If start with binding minimum wage and the minimum wage increases. What happens? Qs increases; Qd decreases = number of people unemployedincreases b/c larger horizontal distance at the new higher minimum wage. ○ argument made by small businesses b/c will say that increasing minimum wage will just increase unemploymentin the economy ○ BUT when look at real world data, don’t actually find a drop in the number of people working when increase minimum wage. This is because…seenext slide. ○ Minimum Wage: Real World W d L s L ○ ○ Vertical labour demand curve. ○ When dealing with minimum wage jobs, usually dealing with low-skilled positions (i.e. running a McDonald’s franchise – will always need a certain amount of workers to run the running a McDonald’s franchise – will always need a certain amount of workers to run the restaurant; someonecooking, handling money,etc. ○ Regardless of how high minimumwage goes, can’t really cut back on the number of employeeswhen get to a certain point) ○ Shown by the graph above. ○ When the minimum wage increases, we technically increase in unemploymentb/c at a higher wage, morepeople want those jobs = the Qs increases BUT the Qd does not decrease (no drop in the number of these jobs even though the wage has gone up). Small business argument is valid to a certain extent– unemploymentincreases only because more low- skilled workers are willing to work and would thereforeincrease the number of people wanting to work à there is NO decrease in the demand for quantity of labour. ○ City with the highest unemployment: Windsor, ON ○ Impact of minimumwage legislation on other labour markets (i.e. if not low-skilled labour – market for lawyers) ▪ Minimum wage compared to what lawyers make is lower than the equilibrium and is therefore not binding and does not affect equilibrium. It is illegal to pay a lawyer less than $8/hr, but lawyers cost $400 000. This means that lawyerswon’t become unemployed as a result of the minimum wage legislation. Minimum wage: market for lawyers W Ls ▪ 400 000 Ld Wmin L ○ Minimum wage has to be above eqm to be binding. Canada min wage > US min wage. ○ Not a predominant reason for unemployment as most works in the economy earn wages well above the legal minimum ▪ Minimum wage laws are binding most often for the least skilled and least experienced members of the labour force 2. Unions ○ Union is a group of workers who band togetherand try to bargain for higher wages from the firm ○ Have power using the threat to strike. ○ If workersstrike, firm makes no product and therefore no profits ▪ CollectiveBargaining: the process by which unions and firms agree on terms of employment ▪ Cause conflict between insiders, who benefit from high union wages, and outsiders, who do not get the union jobs due to higher wages ▪ Workers in unions reap the benefit of collectivebargaining, while workers not unions bear some of the cost ○ Example: ▪ Consider a small town that has one factory and many small businesses. Why would you expect the wage to be the same in both industries? □ What would happen if the wage wasn’t the same in both industries? Smaller □ What would happen if the wage wasn’t the same in both industries? Smaller industry -> factory -> people switch from factoryto industry, but eventually…industrywage is driven down and factory wage is driven up. Factory Small businesses W Ls W Ls ○ Ld Ld L L ○ In both graphs, the wage is the same. ○ If wage was higher in one sector, more workers would enter that sectorand drive the wage down and drive the wage in the other sector up. This explains why the wages start out the same (W1). ○ Suppose workers in the factory unionize. What happens? Factory Small businesses W L W Ls ▪ Ld Ld L L ○ If the workers convince the firm to pay them a higher wage, the wage is above eqm in the factory. Qs > Qd; when most union contracts are written, there is a provision in the contract to protect jobs, but if you think about what the firm does over time,they would probably try not to hire more workers as they increase output and have workers just produce more stuff. At some point, the firm will cutback on workers. ○ In the factory sector, there is unemployment.Some of these workerswill go look for jobs in the other sector (small businesses). This causes the Ls curve to shift out to the right ○ New union wage is always higher than non-union wage. ▪ Unions cause unemployment (some may go back to school, sithome, etc.) □ Unemployed people will leave sector and enter a new one, leading to increased labour supply which , in turn, reduces wages in industries that are not unionized 3. Efficiency Wages ○ Firms may operate more efficiently if firms offer a higher than equilibrium wage ▪ Worker Health – only true in poor countries; their eqm wages are so low that it doesn’t provide a healthy diet for workers. If you increase their pay, they can actually afford to eat enough calories to be productive workers. □ Not the case in developed countries. ▪ Worker Turnover – will decrease – fewer people leaving; it costs money to hire and train new employees.Profitability may increase. train new employees.Profitability may increase. ▪ Worker Effort – workerswill work harder b/c don’t want to get fired. If get fired, they will earn a lower wage at a competing firm. ▪ Worker Quality – may increase as well ○ When workers are looking for a job, they have a reservation wage: the minimum wage they are willing to accept in order to take a position ○ Depends on things only the workerknows (i.e. how hard working they are, how intelligent they are) ▪ Someonewho is a hard worker and very smart is likely to have a higher reservation wage than someonewho is lazy and not so smart ○ If the firm offers a wage that is higher than the high quality worker’sreservation wage then both workers will apply for the job. The firm stands a chance of getting the high quality worker. ▪ If the wage that the firm is offering is only higher than the lowquality worker’swage, then only the low quality worker applies for the job. ○ This idea of efficiency wages was first introduced by Henry Ford when he started offering $5/day to work in his factory. Henry Ford is known for introducing the assembly line method of production. There is a reason why efficiency wages were first introduced to an assembly line setting. ○ Prior the introduction of an assembly line, you would have one group of workersbuilding a car in one corner of the factory from start to finish and another group building another car. If one memberwas sick, then the rest of the group members could work on building the car OR it was only the production of one car put in jeopardy. When there is an assembly line, however,you have the car moving along and if first workerin the assembly line is sick, then the entire assembly line is stopped. Henry Ford figured that if he paid them higher than eqm wage (he paid them double the going rate), then his workers would work harder, wouldn’t quit as much, wouldn’t be sick as often. This made his profits increase. - Summary ○ All three cases (minimum wage, union, efficiency wage) are about the same ○ Wage is higher than eqm, which results in a surplus of workers, resulting in unemployment. Difference is what the driving force is behind each of these three causes of structural unemployment. ▪ Minimum wage = governmentthat is causing the wage to be higher than eqm ▪ Union = workersare causing higher wage ▪ Efficiency wages = firm causing higher wage ○ Same diagram and same result, but with different people causing structural unemployment W Ls Weff ○ L d L Chapter 10 March-06-11 1:14 PM Money Money is an asset that is regularly used to buy goods and services - financial assets: money,stocks and bonds, savings account - physical assets: diamonds, house, gold, baseball card - Better than barter as it does not require double coincidence of wants ○ The unlikely occurrence that two people each have a good or servicethat the other wants - Not the same as wealth How can we tell an asset qualifies as worth money? - Medium of exchange – people generally willing to accept it in exchange for goods and services;an item that buyers give to sellers for purchasing goods and services - Unit of account – what mostprices are measured in; in Canada, prices are set in Can dollars; thus, the unit of account is the Canadian dollar - Store of value – an asset is a store of value ○ it retains its value and over a period of time, the asset can be sold ○ an item that people can use to transfer purchasing power fromthe present to the future ○ money is not the only store of value as person can transfer purchasing power from the present to future by holding other assets ▪ Wealth: the total of all stores of value, including both moneyand nonmonetaryassets Credit card and debit card both measure in dollars (both fulfill #2). #1 and #3 fulfilled by debit card, NOT credit card. When use debit card to buy something, you are exchanging moneyfor a G/S. When use credit card to buy something, you haven’t actually paid for it yet; there hasn’t been an exchange. It has been deferred – let someoneelse pay the store keeper and later, you will pay that personback. Debit card is an asset/money. Liquidity: the ease with which an asset can be convertedinto the economy’smedium of exchange - money is the most liquid asset available ○ Currency > stocks > fine art ▪ Currency is a medium of exchange. Why are stocks more liquid than fine arts? Bigger market, morepeople willing to buy and sell; can call broker fine and sell. Fine arts only in a special auction; not that many people can buy, therefore not as liquid. - money is the not the perfect store of value - when prices rise, the value of money falls, meaning when goods and services becomemore expensive, each dollar you have can buy less ○ If you have $10 in wallet, but the next day prices double. $10 would only buy ½ as much as before -> this means that the value of money has decreased as prices increase; purchasing power has decreased Commodityvs. Fiat Money - Commoditymoney: moneythat takes the form of a commoditywith intrinsic value (eg. gold, cigarettes) ○ Has value other than the fact that it is used as money ○ Precious metals have intrinsic value b/c can used to make jewellery/useit to make other goods. ▪ Have uses other than the fact that it can be used as money. ○ Prisoners use cigarettes as commoditymoney(can smokeit or trade it). ▪ Easy to get (not illegal to have on you) and easy to count ▪ Easy to get (not illegal to have on you) and easy to count - Barter economy(chicken for vegetables). Reason why have moneyso we don’t have to barter. Money is convenient. Does not require double coincidence of wants - Fiat money: established as moneyby governmentdecree, with no intrinsic value ○ Governmentsays this bill is legal tender, meaning that people have toaccept it in exchange for G/S. This isn’t what gives fiat money its value! What gives fiat money its value is that businesses are willingto accept in exchange for G/S. ▪ Even though governmentsays that people have to accept a certain currency, it does not mean that the moneyhas value □ Example: Zimbabwe:they now print currency/bills in billions of dollars – it’s not worth the paper it’s printed on; can’t do anything with fiat moneyother than use it as money. Money in the Canadian Economy M1 = Currency + Demand deposits + travellers cheques + other chequable deposits M2 = M1 + moneymarket account + savings account + sometimesdeposits - Currency:the most widely accepted medium of exchange in the economy,which includes the paper bills and coins in the handsof the public ○ It does NOT include the currency in the bank vault. - Demand deposits (D) : the balances in bank accounts that depositors can access on demand by writing a cheque or using a debit card larger componentof money in Canada ○ You write a cheque -> person takes it to their bank -> money transferred immediately(no 24h/3 day waiting period to get access to your deposits) - The amount of currency in Canada per person is $1500-1600 ○ But we don’t carry this amount, so who is carrying all the currency? ▪ Criminals because crime is a cash business. ▪ In order to be untraceable, your drug dealer doesn’t accept cheques or credit cards ○ US average is even higher ▪ Crime but also: □ US is considered a safe asset in the world hence people from different countries convert moneyinto US currency Gold System - When economyuses gold as money(oruses paper money that is convertibleinto gold on demand), it said to be operating under a gold standard ○ Not a lot of countries in the metallic standard anymore (transactions via gold, silver, etc.) ▪ The last time used was before WWII. - The international financial system established for a duration after WWII was called the Bretton Woods system ○ NOT a gold standard ○ Key currency system(key currency being US dollars) – most countries in the world, fixed exchange rate with respect to the US dollars. - At the same time, US gov agreed to buy/sell gold in an unlimited quantity at a price of $35/ounce. BUT the amount of gold in the US had nothing to do with the money supply in the US. In order to print currency, the central bank has to take in gold. - Bretton Woods systemofficially ended in 1970s and the dollar became fully 'fiat currency,' backed by nothing but the promise of the federal government ○ No countries are on the gold standard, after having been replaced with the fiat currency How do banks create money? How do banks create money? - Create money only in fractional reserve banking system ○ a banking systemin which a bank holds only a fraction of deposits as reserves(depositsthat banks have received but have not loaned out) ▪ hence, use deposits to create money ▪ As opposed to 100 percent reserve banking -> purpose was to onl
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