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Macroeconomics Exam Review pdf version.pdf

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McMaster University
Bridget O' Shaughnessy

Macroeconomics Exam Review Chapter 5 – Measuring a nations income - Since every transaction has a buyer and a seller , Income = expenditure GDP (Flow variable ) –Market value of all final goods & services produced in a country in a given period of time - Measure of how much stuff we make OR how much output a country is producing - Measured in terms of currency 3 ways to calculate GDP 1) Output (basic prices) Basic prices includes taxes 2) Expenditure (market prices) market prices include sales tax 3) Income (market prices) Y = C + I + G + NX • Gross National Product (GNP): total value of all final goods and services produced by a country’s factors in a given period of time(GDP - income earned by foreigners domestically + income earned by domestic factors abroad) • Net National Product (NNP): GNP – Depreciation (Capital Consumption Allowance) • National Income (NI): NNP – ‘Net’ Indirect Taxes (- tax + subsidise) Real GDP – the production of goods and services valued at constant prices Nominal GDP – The production of goods and services valued at current prices GDP Deflator – a measure of the price level relative to the level of the prices in the base year GDP deflator for the base year always equals zero 𝑛𝑜𝑚𝑖𝑛𝑎𝑙  𝐺𝐷𝑃 𝐺𝐷𝑃  𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 = ×100 𝑅𝑒𝑎𝑙  𝐺𝐷𝑃 GDP increases if output increases CPI - a measure of the overall cost of goods and services bought by a typical consumer 𝐶𝑜𝑠𝑡  𝑜𝑓  𝑏𝑎𝑠𝑘𝑒𝑡   𝑐𝑢𝑟𝑟  𝑦𝑒𝑎𝑟 𝐶𝑃𝐼 = ×100 𝐶𝑜𝑠𝑡  𝑜𝑓  𝑏𝑎𝑠𝑘𝑒𝑡   𝑏𝑎𝑠𝑒  𝑦𝑒𝑎𝑟 𝐺𝐷𝑃  𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟  𝑖𝑛  𝑦𝑒𝑎𝑟  2 − 𝐺𝐷𝑃  𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟  𝑖𝑛  𝑦𝑒𝑎𝑟  1 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛  𝑟𝑎𝑡𝑒  𝑖𝑛  𝑦𝑒𝑎𝑟  2 = ×100 𝐺𝐷𝑃  𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟  𝑖𝑛  𝑦𝑒𝑎𝑟  1 GNP vs GDP GNP - measures the value of all income earned by Canadians regardless of whether it is earned in Canada or another country GDP - measures all income earned in Canada regardless of the nationality of the person who earned it Chapter 6 – Measuring the cost of living Consumer price index (CPI) – a measure of the overall cost of goods and services bought by a typical consumer Steps to calculating inflation using CPI: 1) Fix the basket of goods and services 2) Find the prices of the things in the basket 3) Compare the baskets cost 4) Choose a base year and compute the index (CPI) 𝐶𝑜𝑠𝑡  𝑜𝑓  𝑏𝑎𝑠𝑘𝑒𝑡   𝑐𝑢𝑟𝑟  𝑦𝑒𝑎𝑟 𝐶𝑃𝐼 = ×100 𝐶𝑜𝑠𝑡  𝑜𝑓  𝑏𝑎𝑠𝑘𝑒𝑡   𝑏𝑎𝑠𝑒  𝑦𝑒𝑎𝑟 5) Compute the inflation rate (% change in the index in the preceding year) 𝑃𝑟𝑖𝑐𝑒  𝑖𝑛  𝑐𝑢𝑟𝑟𝑒𝑛𝑡 − 𝑃𝑟𝑖𝑐𝑒  𝑖𝑛  𝑏𝑎𝑠𝑒   𝐶𝑃𝐼 = 𝑃𝑟𝑖𝑐𝑒  𝑖𝑛  𝑏𝑎𝑠𝑒 ×100 Indexing – something is “indexed” when it increases whenever the inflation rate increases Ex: Canada Pension Plan / Old age security Problems with CPI 1) Substitution bias – customers will substitute if prices get too high – CPI overstates inflation 2) Introduction of new goods – The value of the dollar goes up as new goods are introduced and consumers have more choice. CPI is based on a fixed basket of goods and services so does not reflect the increase in the value of the dollar, therefore CPI overstates inflation 3) Unmeasured quality change – some price changes reflect quality improvements; overstates inflation CPI vs GDP deflator 1. CPI- goods and services bought by typical consumers GDP deflator – reflects prices of all goods and services produced domestically 2. CPI – Prices change, quantities stay fixed GDP deflator – quantities change, prices sta cy fixed Nominal Interest Rate: interest rate without correction for inflation – measures the increase in the number of dollars in your bank account Real Interest Rate : interest rate with correction for inflation – measures the increase in the purchasing power of the dollars in your sa vings account Example Using CPI Example: your father was earning $40,000 in 1982. What is this salary worth in 2012 dollars? CPI 1982= 61.8 CPI = 116.3 2012 116.3 ×40,000 = $75,275. 61.8 Chapter 7: Productivity and growth Productivity – the quantity of goods and services that a worker can produce for each hour of work Determinants of productivity: 1. Physical Capital – buildings, trucks etc 2. Technological Knowledge – our knowledge of how to combine inputs in order to produce outputs 3. Human Capital – when people learn from the technological knowledge (ex: understanding how to use accounting software) 4. Natural Resources – renewable, non-renewable Production Function: shows how we combine inputs to produce output Y = A x F (K, L, H, N) Y- output L – Labour A – technology H – Human Capital K – Physical Capital N – Natural resources If a production function exhibits Constant returns to scale , then doubling all inputs leads to a doubling of output Ex: any multiple times all of the inputs at the same time, will give you that number times the output!!! xY = A x F (xK, xL, xH, xN) Y/L = A x F (K/L, 1, H/L, N/L) Diminishing marginal product Product: Output Marginal Product: the extra output produced by increasing an input by 1 unit Diminishing Marginal Product: the extra output produced by adding the 19 thunit of labour (worker) is th smaller then the extra output produced by adding the 18 unit of labour (worker) Catch-Up Effect: poor countries tend to grow faster than rich countries Policies: What can government policy do to raise productivity and living standards? 1. Encourage Saving (K) • Consume less and save more • Eg. Impose a consumption tax 2. Allow foreign Investment (K) • Some profit from foreign direct investment (FDI) would be brought home and would help boost the economy (this statement is irrelevant) 3. Spend On Education (H) • more educated individuals = more ideas for society • Brain drain problem: emigration of highly educated people to rich countries who can benefit from a higher standard of living 4. Improve property rights and reduce political instability (K,A) 5. Free Trade (A) • Can be a substitute for technology 6. Research and development – R&D (A) • Grants (eg. Funded research at universities) • Patent system (enhances the incentive fo r individuals and firms to engage in research) Chapter 8: Saving, investment and the financial system Financial System: the of institutions in the economy that help to match one person’s saving with another person’s investment - Savers supply their money to the financial system with the expectation that they will get it back with interest at a later date. - Borrowers demand money from the financial system with the knowledge that they will be required to pay it back with interest at a later date. Financial markets: financial institutions through which savers can directly provide funds to borrowers Bond: a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. • Date of maturity – when the bond will be repaid • Principal – the amount loaned • Term – the duration of the bond • Credit Risk – the risk that it will not be paid back • Default – the borrower fails to repay the lender Stock: a claim to partial ownership in a firm Equity Finance: the sale of stock to raise money Debt Finance: the sale of bonds to raise money Financial Intermediaries: Financial institutions through which savers can indirectly provide funds to borrowers. • Banks o Provide loans o Deposits from savers • Mutual Funds o People with small amounts of money to buy stocks together Saving and Investment National income accounting identity: Y = C + I + G • Private saving: income that households have after paying for taxes and consumption Sp= Y – T – C Sp= Private saving Y = GDP (income, output or expenditure) T = taxes C = consumption • Public Saving: the tax revenue that the government has after paying for its spending Sg= T – G Sg= Public Saving T = Taxes G = Government Spending Budget Surplus: T>G Budget Deficit: G quantity of labour demanded 3) Cyclical unemployment • When the economy is in a recession, workers are laid off Natural rate of unemployment (NRU): the rate of unemployment to which the economy tends to return to in the long run. An economy is at its NRU when its cyclical unemployment is at 0 Why is there unemployment? 1) Job search: the process by which workers find appropriate jobs given their tastes and skills, means that there will always be some unemployment 2) Employment Insurance (EI): partially protects workers’ incomes when they become unemployed. Takes away the incentive to sea rch hard for a new job. 3) Minimum wage laws: reduces the quantity of labour demanded and increases quantity of labour supplied. A surplus of labour is created. Not a predominate reason for unemployment because the majority of workers earn well above the min imum wage. These laws are binding for only the least - skilled and least-experienced workers. if the wage is kept above the equilibrium level for any reason, the result is structural unemployment. 4) Worker associations that bargain with employers over wages and working conditions. Unions raise the wage, which causes a drop in labour demanded and an increase in labour supplied. This type of unemployment is structural unemployment. 5) Efficiency wages: above-equilibrium wages paid by firms in order to increase wo rkers productivity. Why pay high wages? Better worker health, lower worker turnover (and lower cost to hire and train new workers), higher worker effort, lowering shirking, better worker quality. Chapter 10: The monetary system • Money – an asset regularly used to buy goods and services • Money has 3 functions: 1. Medium of exchange: an item that buyers give to sellers for purchasing goods and services 2. Unit of account: the common measure of prices in an economy 3. Store of value: an item that people can use to transfer purchasing power from the present to the future *When prices go up, the value of money falls • Liquidity – The ease with which an asset can be converted into the economy’s medium of exchange (how quickly you can turn it to cash) o Money is the most liquid asset • Commodity money: money that takes the form of a commodity with intrinsic value (eg. gold, cigarettes) • Fiat money: established as money by government decree, with no intrinsic value (eg. Canadian dollars) Money in the Canadian economy: • M = C + D • Currency (C): The paper bills and coins in the hands of the public • Demand deposits (D): The balances in bank accounts that depositors can access on demand by writing a cheque or using a debit card The legal tender requirement means that: a) People are more likely to accept the dollar as a medium of exchange b) The government must hold enough gold to return all currency c) People may not make trades with anything else d) All of the above are correct How do banks create money? • Fractional-reserve banking: a banking system in which a bank holds only a fraction of deposits as reserves • Reserve Ratio – The fraction of total deposits that a bank holds as reserve *Money allows us to take advantage of specia lization and trade* • Money Multiplier: The amount of deposits the banking system generates with each dollar of reserves 1 𝑚𝑜𝑛𝑒𝑦  𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑟𝑒𝑠𝑒𝑟𝑣𝑒  𝑟𝑎𝑡𝑖𝑜 Suppose the reserve ratio is 5%. If $100 is deposited into the banking system, what happens to total deposits? ▯ 𝑚𝑜𝑛𝑒𝑦  𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = = 20 ▯.▯▯ D increase by 2000 The Bank of Canada • Established in 1935 • Bank of Canada is Canada’s central bank • The Bank of Canada has four main areas of responsibility: 1. Monetary Policy – controls the money supply 2. Currency – designs, produces, and issues currency 3. Financial System – facilitates cheque-clearing and acts as a “lender of last resort” 4. Funds Management – acts as a banker for the Canadian government Bank of Canada’s Tools of Monetary Control The Bank of Canada controls the money supply by: 1. Open-market operations – buying and selling government bonds 2. Changing the overnight rate – the interest rate on very short-term loans between commercial banks. The government can change the bank rate, which equally changes the overnight rate 3. Foreign exchange market operations – the purchase or sale of foreign money by the Bank of Canada 4. Sterilization – the process of offsetting foreign exchange market operations wi th the open-market operations, so that the effect on the money supply is cancelled out Prime rate = interest rate that banks charge their best customers when they come in for a loan Bank Runs and The Money Supply Run on the bank – when everyone wants t o take out their money at the same time • Depositors believe that a bank might go bankrupt • Problem for banks using the fractional -reserve banking system • Canada Deposit Insurance Corporation ($60,000) Chapter 11: Money growth and inflation Inflation: the increase in the overall level of prices • Price of a good – reflects value • Money – value falls as the price level rises • Demand for money – from households – as prices rise we need more money to buy the same goods • Why do we want money? We want to buy stuff with it. • Savings is a flow variable. • Add savings from previous savings and we have WEALTH, which is a stock variable. • The demand for money curve has a negative slope Nominal variables: variables measured in monetary units Real variables: variables measured in physical units Quantity Theory of Money • The quantity of money available determines the price level • The growth rate in quantity of money available determines the inflation rate Classical Dichotomy : The separation of real and nominal variables Monetary Neutrality : Changes in M affect nominal variables, but not real variables Velocity: The rate at which money changes hands Example: Produce 2000 cups of hot chocolate / week • $2 per cup o How many times must each dollar circulate through the economy for all the hot chocolate to be purchased?  Total spending = 4000  Money supply = 500  Velocity = 8 Quantity Equation • Y is also known as the quantity of output! • There are 3 ways for a government to raise revenue: 1. Direct taxes 2. Borrowing – future tax 3. Printing money – tax on money • Hyperinflation is inflation that exceeds 50% per month Ex: a large cup of coffee at Tim Hortons costs $1.39 in first month and after 12 months was $181.35 Inflation tax: the revenue the government raises by creating money Fisher Effect • Nominal interest rate = real interest rate + inflation rate • In the long run, a change in money growth does not affect the real interest rate • Fisher effect: the one-for-one adjustment of the nominal interest rate to the inflation rate Ex: 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. Costs of Inflation • Shoeleather costs – the resources wasted when inflation encourages people to reduce their money holdings • Menu costs – the cost of frequent price changes Ex: reprinting price lists, catalogues due to high inflation and increasprices • Relative price changes – gradual price changes, timing of when firms make their price changes. Consumer decisions become distorted • Tax distortions – lawmakers fail to take into ac
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