1020 Macroeconomics Exam Study Guide
Exam: December 15 , 2011
CHAPTER 20: MEASURING GDP AND ECONOMIC GROWTH
Gross Domestic Product:
Gross domestic product (GDP) – market value of all final goods and services
produced with a country in given time period.
Total production measured by market value of each good.
Only new final goods (bought by final users) measured, not intermediate
goods (bought by firms from firms, used as inputs in production).
GDP measures total production and total income and total expenditure.
Circular Flow of expenditure and income shows four economic sectors (firms,
households, governments, rest of world) operating in factor markets and goods
(and services) markets.
Households sell factor services to firms in return for income – total
household income = aggregate income (Y).
Firms produce goods and services, and sell consumption expenditure
(C) to households.
Firms’ expenditures on investment (I = purchase of new capital +
additions to inventory).
Governments buy goods and services from firms (government
expenditures (G)). Governments also collect taxes and make financial
transfers to households and firms, but these not part of circular flow.
Rest of world buys our exports (X) and sells us imports (M): net exports
Circular flow shows that aggregate income= aggregate production = aggregate
Y= C + I + G + X – M
Capital stock is plant, equipment, buildings, and inventories used to produce
goods and services.
Investment (I) = purchase of new capital.
Depreciation = decrease in value of firm’s capital because of wear and
Gross Investment = net investment + replacing depreciated capital.
Triangle capital stock = net investment = gross investment –
Measuring Canada’s GDP:
Statistics Canada measures GDP two ways on basis of equality:
Income = production = expenditure
Expenditure approach measures C + I + G + X – M
Income approach adds up all incomes paid from firms to households (with
o Net domestic income at factor cost = wages etc. + profits +
interest/investment income + farmers’ income +nonfarm
unincorporated business income. o Net domestic product at market price = net domestic income +
indirect taxes = subsidies.
o GDP = net domestic product + depreciation.
Gap between expenditure and income approach is statistical
discrepancy, which arises due to measurement problems.
GDP increases from production of more goods and services, or from higher
prices for goods and services.
Nominal GDP – value of final goods and services produced in a given
year valued at that year’s prices = sum of expenditure on goods and
Real GDP – value of final goods and services produced in a given year
when valued at prices of reference base year. Real GDP measures
changes in production only.
Real GDP calculated using quantities produced in each year, but valued
with prices from reference base year.
o In reference base year, real GDP = nominal GDP.
o To calculate real GDP in current year, multiply current year quantity
by base year price for each good, and sum resulting values.
The Uses and Limitations of Real GDP:
Real GDP used to compare standards of living over time and across countries.
One method of comparison is real GDP per person (real GDP/population)
– value of goods and services enjoyed by average person.
Canada’s real GDP per person over time shows growth of potential GDP
per person (with slowdown after 1960s) as well as fluctuations of real GDP
around potential GDP.
o Potential GDP – real GDP when labour, capital, land, and
entrepreneurial ability fully employed.
Lower growth rates of real GDP per person after 1970s lead to
accumulated gap in real GDP (Lucas wedge).
Business cycles – fluctuations of pace of expansion of real GDP.
o Each cycle has two turning points (a peak and a trough), and two
phases (recession when real GDP decreases for two or more
quarters, and expansion when real GDP increases.)
International comparisons of real GDP per capita are further flawed by currency
Using market exchange rates, U.S. real GDP per person is 19 times that
Using purchasing power parity or PPP prices (prices prevailing in one
country such as U.S.), U.S. real GDP per person only 8 times China’s.
Real GDP as measure of economic well-being flawed because:
Real GDP does not include factors increasing economic well-being
(household production, underground economic activity, health, life
expectancy, leisure, political freedom, social justice).
Real GDP does not include factors that lower economic well-being
(pollution). The Human Development Index is broader measure of economic well-
being that includes health and education measures, as well as real GDP
CHAPTER 21: MONITORING JOBS AND INFLATION
Employment and Unemployment:
Unemployment rises in recessions and falls in expansions.
Unemployment creates problems from lost production/incomes of
unemployed and damaged job prospects from lost human capital.
Statistics Canada surveys households on their job status.
Working-age population = Number of people 15 years and over.
Labour force = employed + unemployed
Employed = those with full-time and part-time jobs.
Unemployed = without work, actively seeking within last four weeks,
waiting to be called back after layoff, or waiting to start new job within four
Unemployment rate = percentage of labour force unemployed. Increases
in recessions, but no trend recently.
Labour force participation rate = percentage of working-age population
in labour force. Strong upward trend until 1990; decreases in recessions,
increases in expansions.
Employment-to-population ratio = percentage of working-age
population with jobs. Increased from 1960s to 1990 (many new jobs
created); decreases in recessions, increases in expansion.
Unemployment and Full Employment:
Measured unemployment rate excludes some underutilized labour and does not
account for unavoidable natural unemployment.
Marginally attached workers – neither working nor looking for work, but
available and want work.
Discouraged workers – stopped looking for jobs due to repeated job
Every year in Canada, new workers enter labour force and others retire. Many
jobs created and destroyed by expansion and contraction of businesses.
The average net effect is new jobs, but some unemployment is created as
part of the process.
People become unemployed when they are laid off (job losers), voluntarily
quit (job leavers), enter (entrants) or re-enter (re-entrants) labour force to
search for jobs.
People end unemployment when they are hired, recalled, or withdraw from
Primary source of unemployment is job loss, which fluctuates strongly with
Types of unemployment are fictional, structural, cyclical.
Frictional unemployment – normal turnover. Depends on the number of
entrants/re-entrants and job creation/destruction. Structural unemployment – job losses in industries/regions declining
due to technological change or international competition.
o Lasts longer than frictional unemployment, and higher in slow-
growing eastern provinces.
o Structural unemployment also caused by minimum wages and by
firms paying efficiency wages – wages above going market wage
designed to maximize profits by attracting more and more
productive applications, increasing work effort, and decreasing
labour turnover rate (lowering recruiting costs).
Cyclical unemployment – fluctuations in unemployment over business
cycle. Increases in recession, decreases in expansion.
Natural unemployment – only frictional and structural unemployment (no
Natural unemployment rate = natural unemployment as percentage of
Full employment – unemployment rate equals natural unemployment
Economists disagree about size of natural rate and amount it fluctuates.
Actual unemployment rate fluctuates around natural rate, as real GDP fluctuates
around potential GDP over the business cycle.
Output Gap – gap between real GDP and potential GDP.
o When the output gap positive, unemployment rate < the natural
o When the output gap negative, unemployment rate > the natural
The Price Level and Inflation:
Changes in price level (average level of prices) determines value of future
payments (loans, savings).
Inflation rate – percentage change in price level.
o Creates winners/losers by creating unpredictable changes in value
o Leads to resources diverted from productive activities to predicting
Hyperinflation is rapid inflation where money lose its value very quickly.
Consumer Price Index (CPI) measures average of prices paid for fixed basket
of consumer goods and services.
CPI = 100 for reference base period (2002).
CPI basket constructed from monthly surveys of consumers spending
o CPI = Cost of CPI basket at current prices/Cost of CPI basket as
base-period prices X 100.
o Inflation rate = percentage change in CPI.
CPI overstates inflation rate (biased upward) because
o New goods replace old goods.
o Quality improvements create some of price rises. o Consumers change consumption towards cheaper goods not
reflected in fixed-basket price index.
o Consumers substitute toward discount outlets not covered in CPI
Magnitude of CPI bias probably low in Canada, but leads to distorted
contracts, more gov’t outlays, and incorrect wage bargaining.
Alternative price indexes include
GDP deflator ((nominal GDP/real GDP) X 100) which measures all goods
and controls for biases.
Chained price index for consumption ((nominal consumption/real
consumption) X 100) which does not use fixed quantities.
Core inflation rate excludes volatile elements of CPI to reveal underlying trends.
Real Variables (nominal variables divided by GDP deflator) used to see what is
“really” happening to key macroeconomic variables.
CHAPTER 22: ECONOMIC GROWTH
The Basics of Economic Growth
Economic growth is sustained expansion of production possibilities measured as
the increase in real GDP.
Economic growth rate = annual percentage change in real GDP = Real
GDP this year – Real GDP last year / Real GDP last year X 100
Standard of living depends on real GDP per capital (real
Compounding leads to rapid growth – rule of 70 states that the number of
years it take a variable to double in value = 70/(percentage growth rate).
Economic Growth Trends
Canada’s growth rate was low in 1950s, higher in 1960s, average in 1970s,
slower in 1980s, and average after 1996.
Internationally, between 1960 and now, Canada’s real GDP per person
similar to the US, but Japan and other Asian countries have been catching
up to both countries.
How Potential GDP Grows
Economic growth requires a sustained increase in potential GDP.
More real GDP produced requires less leisure and more time spent
Potential GDP is level of real GDP at full-employment quantity of labour
(with fixed amounts of land, entrepreneurial ability, capital).
Aggregate production function (PF) shows relationship between real
GDP and quantity of labour employed, all other influenced constant.
o Increase in quantity of labour employed creates movement up
Aggregate labour market determines quantity of labour hours employed and real
Demand for labour (LD) – quantity of labour demanded at each real wage
rate = (money of nominal wage rate)/price level. o Firms hire labour as long as marginal product of labour > real wage
o Law of diminishing returns says firms will hire more labour only if
real wage rate falls.
Supply of labour (LS) – quantity of labour supplied at each wage rate.
o Increase in real wage rate increases quantity of labour supplied
because more people work and more people choose to work longer
Real wage rate adjusts to create full-employment labour market
equilibrium where LD=LS, with real GDP=potential GDP.
Potentail GDP increases if labour supply increases or labour productivity
(real GDP per hour of labour) increases.
Labour supply increases if hours per worker increase, or employment-
to-population ratio increases, or working-age population increases.
o Labour supply curve shifts rights, real wage rate decreases,
increasing hiring, causing movement along the PF, increasing
Increase in labour productivity increases demand for labour –
therefore, real wage rate increases, quantity labour supplied increases,
PF shifts upward, and potential GDP increases.
Increases in population lower real GDP per person, but increases in
labour productivity increase it
Why Labour Productivity Grows
Fundamental precondition for labour productivity growth is appropriate incentive
system created by firms, markets, property rights, and money.
Given these preconditions, pace of growth is affected by three things that
increase labour productivity:
Physical capital growth increases capital per worker.
Human capital growth from education and training (including learning by
repetitively doing tasks).
Discovery of new technologies (often embodied in new capital).
Growth accounting calculates how much labour productivity growth is due to
each of its sources.
1 percent increase in capital per hour of labour (with no change in tech)
leads to 0.49 percent increase in labour productivity in Canada.
This rule can explain Canada real GDP growth:
o 1960-73 – high productivity growth due to high tech change and
strong capital accumulation.
o 1973-85 – lower productivity growth due to slowdown in tech
change and lower capital accumulation.
o 1985-1991 – low capital growth and almost no tech change.
o 1992-2002 – roughly zero capital growth and high tech change.
o 2002-2007 – moderate capital growth and tech change.
Growth accounting shows that Asian countries are growing fast because
they are adapting new tech and investing larger percentage of GDP than
Canada. Growth Theories and Policies:
Classical growth theory argues real GDP growth is temporary, because it leads
to population explosions.
Advances in tech increase real GDP per hour of labour.
Since real GDP per hour > subsistence real GDP per hour (minimum
needed to maintain life), population grows, lowering capital per hour of
labour, so output per hour of labour falls back to subsistence.
Neoclassical growth theory says real GDP per person grows due to tech
change including growth in capital per person.
Assumes population growth rate is independent of economic growth.
Driving force of economic growth is tech change, and its interaction with
Ongoing exogenous technological advances increase rate of return on
capital, increasing saving and investment, increasing capital per person,
creating real GDP growth.
As capital per hour of labour increases, rate of return on capital decreases
due to diminishing returns, so capital accumulation and growth end unless
new tech advances occur.
Predicts growth rates and income levels per person in different countries
should converge, but this convergence doesn’t happen empirically.
New growth theory attempts to overcome this shortcoming by explaining tech
changes as a profit-maximizing choice.
New discoveries sought for (temporary) profits, but once made,
discoveries are copied and benefits are dispersed through economy,
without diminishing returns.
Knowledge is special kind of capital not subject to diminishing returns or
decreasing rate of return.
Inventions increase rate of return to knowledge capital, resulting in
increased capital per person and real GDP growth with no automatic
slowdown because rate of return to capital does not diminish.
Different growth theories lead to four main suggestion for increasing economic
Stimulate saving (and investment in capital) by tax incentives.
Subsidize research and development and new technology.
Encourage international trade.
Improve education quality.
CHAPTER 23: FINANCE, SAVING, AND INVESTMENT
Financial Markets and Financial Institutions
Financial markets channel saving from households to firms, who invest in new
Finance – activity of providing funds for capital expenditures. Money –
used to pay for items and make financial expenditures.
Physical capital is tools, instruments, machines, buildings used to produce
goods and services. Financial capital is funds firms use to buy physical
capital which produces real GDP. Gross investment = amount spent on new capital. Net investment =
value of capital stock = gross investment – depreciation.
Wealth = value of things people own. Wealth = saving (=income – net
taxes – consumption) + capital gains/losses.
Three types of financial markets:
Loan markets involve businesses or households borrowing from banks,
including household mortgages – legal lending contracts giving lender
ownership of house if borrower defaults.
Bond markets involve firms, governments issuing/selling bonds (promise
to make specified payments on specified dates.)
o Bond terms can be months up to decades.
o Mortgage-backed securities are bonds paying income from
package of mortgages.
Firms’ stock shares (certificate of ownership and claim to profits) traded in
Financial markets highly competitive from simultaneous borrowing and lending by
financial institution (firms operating on both sides of financial markets),
including banks, trust and loan companies, credit unions, caisse populaires,
pension funds, insurance companies.
During 2008 financial crisis, pension funds and financial institutions were
hurt as investments in mortgage-backed securities collapsed in value
when U.S. housing market collapsed.
Companies become insolve when net worth (total market value of lending
– total market value of borrowing) is negative.
Companies become illiquid if they are solvent but have insufficient cash to
meet debt payments.
Insolvent companies forced to merge or taken over by government.
Interest rate on asset = interest received/price of asset X 100.
Price of asset and interest rate inversely related.
The Market for Loanable Funds
Market for loanable funds – aggregate of all financial markets.
Adding financial flows from loanable funds to circular flow shows how
investment is financed.
Households’ income spent on consumption or saving or next taxes
(T=taxes – transfer payments received from governments): Y = C + S + T.
Circular flow from Chapter 20 shows: Y = C + I + G + X – M.
Combining above, I financed by private saving (S) + government saving
(T-G) + borrowing from rest of world (M-X):
I = S + (T-G) + (M-X)
If T > G, government can lend some of its surplus.
If foreigners sell Canadians more goods than they buy from us (M > X), we
must borrow from them to finance difference, so foreign savings flows to
Canada for investment purposes.
I financed by national saving (=S + (T-G)) + foreign borrowing.
Nominal interest rate = dollars paid yearly in interest by borrower to lender as
percent of dollars borrowed. Real interest rate – nominal interest rate adjusted for inflation (nominal
interest rate = inflation rate).
Real interest rate is opportunity cost of loanable funds – determined in
market for loanable funds.
Quantity of loanable funds demanded to finance investment, government budget
deficit, international lending.
Higher real interest rate, lower is quantity of loanable funds demanded –
demand for loanable funds (DLF curve) has negative relationship
between real interest rate and quantity demanded.
DLF shifts rightward if expected profit increases.
Quantity of loanable funds supplied from saving, government budget surplus,
Higher real interest rate, higher is quantity of loanable funds supplied –
supply of loanable funds (SLF curve) has positive relationship between
real interest rate and quantity supplied.
SLF curve shifts rightward if disposable income increases, expected future
income falls, wealth falls, or default risk falls.
Real interest rate adjustments achieve equilibrium where quantity loanable funds
demanded = quantity supplied.
Factors shifting DLF rightward lead to new equilibrium with higher real
interest rate, more loanable funds supplied.
Factors shifting SLF rightward lead to new equilibrium with lower real
interest rate, more loanable funds demanded.
Real interest rate has no trend over time.
Starting in 2001, U.S. Federal Reserve (the Fed) provided loanable funds
(increasing SLF), leading to lower interest rates and large increase in house
In 2006, Fed slowed SLF growth, interest rates rose, and many mortgage-
holders defaulted, pushing financial institutions into insolvency.
Government in the Market for Loanable Funds
Government budget surplus increases supply of loanable funds, lowering real
interest rate – investment increases more than private saving decreases.
Budget deficit increases demand for loanable funds, raising real interest
rate – investment decreases (crowing-out) more than private saving
Ricardo-Barro effect states rational taxpayers know increases in budget
deficit (surplus) imply higher (lower) future taxes, so the adjust saving by
equivalent amount – no change in real interest rate.
The Global Loanable Funds Market
Loanable funds market is global – suppliers move to national markets with
higher real interest rates, demanders to markets with lowest real interest rate.
Flows in funds mean there will be one real interest rate globally (for
assets with equal risk).
Riskier assets will pay interest rate = rate on safe loan + risk premium.
Country with higher interest rate than global rate will be a net borrower
globally and have negative net exports as a result. Country with lower interest rate than global rate will be a net lender
globally and have positive net exports as a result.
Changes in demand and supply for small countries like Canada have
no effect on global interest rate. Changes for larger country shift world
DLF or SLF and affect global interest rate.
CHAPTER 24: MONEY, THE PRICE LEVEL, AND INFLATION
What is Money?
Money is something acceptable as a means of payment (method of settling a
debt),and has three functions:
Medium of exchange – accepted in exchange for goods and services.
o Better tan barter (direct exchange of goods for goods) –
guarantees double coincidence of wants.
Unit of account – agreed measure for prices.
Store of value – exchangeable at a later date.
Two official measures of money:
M1: currency outside banks + chequable deposits of individuals and firms.
M2: M1 + all other deposits.
Money is currency (coins + Bank of Canada notes) and deposits (convertible
into currency, used to pay debts).
Cheques are only an instruction to bank.
Credit cards are ID cards for loans, not money.
Currency plus some deposits are means of payments; other deposits are
not, but have liquidity.
The Banking System
Banking systems consists of depository institutions, Bank of Canada, payments
Depository institutions take deposits from households and firms, and
make loans to others.
Chartered banks (chartered under Bank Act), credit unions and caisses
populaires, and trust and mortgage loan companies.
Banks provide services for fees and earn income lending out deposits.
Banks have four assets:
o Reserves (cash + deposits at Bank of Canada), held to meet
demand for currency.
o Liquid assets (government Treasury bills).
o Securities (longer-term government bonds).
o Loans to corporations and households.
Banks make profits by paying depositors low interest rates and lending at
high rates, in return for services of:
o Creating liquidity.
o Pooling risks.
o Lowering cost of borrowing funds.
o Lowering cost of monitoring borrowers.
Bank of Canada is Canada’s central bank (supervises financial institutions,
markets, payments system, and conducts monetary policy). Acts as banker to other banks and government, and as lender of last
resort (makes loans to banking system when there is a reserve shortage).
Bank of Canada is sole issuer of bank notes.
Bank of Canada balance sheet shows assets (government securities and
loans to banks, usually zero) and liabilities (bank notes and deposits of
banks and government.
Monetary base (Bank Of Canada notes/coins + depository institutions’
deposits at the Bank) can be changed using open market operation,
when government securities are bought or sold.
Payments system allows banks to settle inter-bank transactions. Two
Large Value Transfer System (LVTS) is electronic payments system for
chartered banks; Automated Clearing Settlement System (ACSS)
involves smaller payments from LVTS.
How Banks Create Money
Banks create money (deposits) when lend out excess reserves (reserves =
notes/coins + deposits at Bank of Canada).
Quantity of deposits that can be created limited by monetary base, level of
desired reserves, and desired currency holding.
People desire to hold some money as currency – currency drain ratio =
If bank gets new deposit, creates excess reserves (actual reserves –
o Reserve ratio – reserves/total deposits.
o Desired reserve ratio – ratio of reserves to total deposits banks
wish to hold.
Banks loan out excess reserves.
o Borrower spends loan (and keeps some as currency), recipient of
spent money deposits it at her bank.
o New bank has more reserves, some desired, but some are excess
reserves, leading to further steps in deposit multiplier process.
Total triangle quantity of money = increase in currency + increase in
Money multiplier = (triangle quantity of money)/(triangle monetary base).
The Market for Money
People choose money holdings based on price level, nominal interest rate, real
GDP, financial innovation.
People hold money for its buying power.
o Increase in price level (P) causes equal increase in nominal money
demanded (M), so no change in real money demanded (M/P).
Interest rate = opportunity cost of holding money.
o Higher interest rate decreases quantity of real money demanded.
o Demand for money is relationship between quantity of real money
demanded and interest rate, holding constant other factors.
Increase in real GDP shifts MD curve rightward. Financial innovation has ambiguous effect on MD curve – decreases
demand for currency and some deposits, increases demand for other
Money market equilibrium occurs when quantity of money demanded equals
quantity of money supplied.
Short-run equilibrium determined by quantity of money supplied
(determined by actions of banks and Bank of Canada).
Bank of Canada adjusts quantity of money to hit its target.
o Changes in interest rate create equilibrium in money market.
o If interest rate above equilibrium, people have excess money
o Therefore, they buy financial assets, increasing price of financial
assets, and decreasing interest rates toward equilibrium.
In long run, supply and demand in loanable funds market determine real
interest rate, nominal interest rate = real interest rate + expected inflation
The Quantity Theory of Money
Quantity theory of money predicts increase in quantity of money leads to equal
percentage increase in price level.
Quantity theory starts with velocity of circulation (V=PY/M), which leads
to equation of exchange (MV=PY).
o Assumes velocity unaffected by triangle M.
o Then, % triangle P= % triangle M - % triangle Y.
Historical evidence suggests money growth rate correlated with inflation
rate, but greater than inflation rate.
Mathematical Note: The Money Multiplier
Deriving the money multiplier starts with definitions:
Desired currency holding = a X Deposits.
Desired reserves = b X Deposits.
A = currency drain ratio; b = desired reserve ratio.
Next, MB = desired currency holding + desired reserves
= (a + b) X deposits
Triangle MB = (A + B) X triangle deposits.
M = deposits + desired currency holding.
= (1 + A) X deposits.
Triangle M = (1 + A) X deposits.
Money Multiplier = triangle M/triangle B = (1+A)/(A+B)
Larger desired reserve ratio (b) means smaller multiplier.
Larger currency drain ratio (a) means smaller money multiplier.
CHAPTER 25: THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS
Currencies and Exchange Rates
To buy foreign goods/assets, Canadians need foreign currency (foreign notes,
coins, bank deposits); to buy Canadian goods/assets, foreigners need Canadian
dollars. Foreigners and Canadians exchange dollars for foreign currency in the
foreign exchange market.
Exchange rat = price at which one currency exchanges for another –
nominal exchange rate (E) = foreign currency per Canadian dollar.
Currency depreciation (appreciation) is decrease (increase) in value of
Canadian dollar in terms of another currency.
Real exchange rate (RER) is relative price of Canadian-produced goods
and services versus foreign produced – RER = E X (P/P*) where P/P* =
Canadian/foreign price level.
Canadian-dollar effective exchange rate index (CERI) – average
exchange rates of Canadian dollars versus 6 currencies, weighted by
o Since 1998, nominal exchange rate fluctuated strongly versus U.S.
dollar and yen, steady versus euro.
o CERI shows appreciation between 2002 and 2007, and
depreciation since then.
The Foreign Exchange Ma