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ECON 1010 - NOTES Full Notes

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ECON 1010
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Chapter 20 – Measuring GDP and Economic Growth Gross Domestic Product (GDP) – the market value of all final goods and services produced within a country in a given period of time - Market value – it means we count the retail price of a good or service - Final goods and services – it means the end use of product and what final user pays. (not from one firm to another) We look at final goods because it avoids double counting. - Variables can be stock or flow. GDP is a flow variable. Meaning it is some quantity over a period of time - GDP measures the value of production = total expenditure on final goods = total income - Used to measure economic growth, fluctuation and standard living. Used to measure economic well-being - What makes up of GDP? Business sector, consumer sector, government sector, and foreign sector. They all contribute to GDP growth - GDP tells us whether economy is expanding or in a recession. - We measure GDP across the world to compare country’s economics Gross National Product (GNP) – what that is produced in the world by national firms ( like Canadian firms). - To calculate GNP for a country we only calculate what that country’s firms produce regardless of where they are in the world - We take out foreign country’s firms that produce in Canada in GNP - GNP is lesser than GDP in Canada because a lot of foreign firms are in Canada Four main players that do spending: (circular flow diagram shows the transaction among them) - Households - Firms - Governments - The rest of the world Relationship between households and firms : households sell the service and firms buy the service Factors of production: - Labour earns income - Capital earns interest - Land earns rent - Entrepreneurship earns profit 2 types of spending for firms: - Consumption expenditure – if it is slow, economy goes to recession - Investment  Buying stocks is not an investment in economy. It is like lending money to a firm  Buying a house is not considered as expenditure. It is considered as investment We need to subtract imports from expenditures. Capital M stands for it. Symbols: - Personal expenditure: C - Business investment: I (e.g.: buying equipment) - Government expenditure: G Net exports – the value of exports minus the value of imports = X - M GDP = production = expenditure Aggregate Income = the total amount paid for use of factors of production: - Wages - Interest - Rent - Profit Depreciation – the decrease in the value of a firm’s capital that results from wear and tear and obsolescence Gross means before deducting depreciation of capital Net means after deducting the depreciation of capital Gross investment – total amount spend on purchases of new capital and replacing depreciated capital Net investment – increase in the value of the firm’s capital  Net investment = Gross investment – Depreciation Gross profit – a firm’s profit before subtracting depreciation Statistics Canada uses two approaches to measure GDP: - The expenditure approach - The income approach Income = Expenditure  Different approaches, but same numbers GDP = C + I + G + (X-M) Five categories of income according to National Income and Expenditure Accounts: - Wages, salaries, and supplementary labour income - Corporate profits (entreunerships get it) - Interest and miscellaneous investment income - Farmers’ income - Income from non-farm unincorporated businesses The five income components sum to net domestic income at factor cost Two adjustments made to get GDP: - Indirect taxes minus subsidies are added to get from factor cost to market prices - Depreciation is added to get from net domestic product to gross domestic product Two ways to GDP: - Real GDP – value of final goods and services produced in a given year when valued at the prices of a reference base year.  Currently, the reference base year is 2000 and we describe real GDP as measured in 2000 dollars  Used to compare standards of living over time and over countries  Calculated with multiplying today’s quantities by the base year’s prices  The symbol for it is Y - Nominal GDP – value of goods and services produced during a given year valued at the prices that prevailed in that same year Real GPD per person – real GDP divided by the population. It is average person’s income To get from factor cost to market price, we need to add indirect taxes and subtract subsidies which bring to net domestic income at market prices. Potential GDP – value of real GDP when all the economy’s factors of production’s ability are fully employed  Potential GDP grows at a steady pace compared to real GDP when quantities of factors of production and their productivity grow at a steady pace  Recession causes real GDP to fall below the potential GDP  Lucas wedge – is the dollar value of the gap between what real GDP per person could have been if growth rate had persisted and what real GDP per person turned out to be  A drop in technology causes a decrease in potential GDP’s growth rate Two features of our expanding living standards: - Growth of potential GDP per person - Fluctuations of real GDP around potential GDP Business cycle – periodic but irregular up-and-down movement of total production and other measures of economic activity. It has two phases: - Expansion – a period during which real GDP increases - Recession – a period during which real GDP decreases (its growth rate is negative) for at least two successive quarters And has two turning points: - Peak - up - Trough - down Chapter 21 – Monitoring Jobs and Inflation Unemployment results in: - Lost production and income - Lost human capital Labour force – sum of employed and unemployed workers  If you don’t have a job and are not looking for one, you are not part of the labour force Four labour market conditions: - Unemployment rate – the percentage of the labour force that is unemployed  = (Number of people unemployed / labour force) * 100 - Involuntary part-time rate – percentage of labour force who work part-time but want full-time jobs - Employment-to-population ratio – percentage of the working-age population who have jobs  = (employment / working-age population) * 100 - Labour force participation rate – the percentage of the working-age population who are members of the labour force  = (labour force / Working-age population) Natural unemployment – unemployment arises from job search activity  There is always someone without a job who is searching for one, so there is always some unemployment  Happens during full employment Three classes of unemployment: - Frictional – arises from normal labour market turnover. The creation and destruction of jobs requires that unemployed workers search for new jobs - Structural – created by changes in technology and foreign competition - Cyclical – the fluctuating unemployment over the business cycle Full employment – occurs when there is no cyclical unemployment, or equivalently, when all unemployment is frictional and structural  Potential GDP is the quantity of real GDP produced at full employment  Potential GDP corresponds to the capacity of economy to produce output  Real GDP minus potential GDP is the output gap Price level – average level of prices and the value of money which is useful to: - Measure the inflation rate - Distinguish between real and nominal values of economic variables Inflation rate – annual percentage change in the price rate  Once it takes hold, it becomes unpredictable and it is a problem because: o It redistributes income and wealth usually between borrowers and lenders o It diverts resources from production  Lenders are hurt by unexpected inflation and buyers gain. If inflation is lower than expected, it is the other way around  = (CPI this year – CPI last year) / CPI last year * 100 Consumer Price Index (CPI) – average price paid by consumers for a fixed basket of goods and services  It is defined to equal 100 for the reference base period. We compare current prices with prices back then, in the basket  = Cost of CPI basket at current-period prices / Cost of CPI basket at base-period prices * 100 Biased CPI - CPI may overstate the inflation rate for four reasons: - New goods bias – new goods that were not available in the base year appear - Quality change bias – quality improvements appear over the year - Commodity substitution bias – market basket of goods is fixed and does not take into account the substitutions - Outlet substitution bias – people switch to buying from cheaper sources Consequences of bias: - Distorts private contracts - Increases government outlays - Biases estimates of real earnings GDP deflator: - = (nominal GDP / Real GDP) * 100 - a broader measure of the price level than the CPI because includes all the items included in GDP Core inflation rate – the CPI inflation rate excluding the volatile elements (food and fuel) - attempts to reveal the underlying inflation trend Chapter 26 – aggregate demand and aggregate supply Quantity of real GDP supplied – total quantity that firms plan to produce during a given period of time Aggregate Supply – the relationship between the quantity of real GDP supplied and the price level 2 time frames associated with different states of the labour market: - long-run aggregate supply (LAS) – relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP  LAS is vertical at potential GDP (LAS curve = potential GDP curve)  If price level and money wage rate change by the same percentage, LAS and potential GDP remain the same - short-run aggregate supply (SAS) – relationship between the quantity of real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant  a rise in the price level with no change in the money wage rate will increase the quantity of real GDP supplied (induces firms to increase production)  SAS is upward sloping Changes in aggregate demand – if an influence in production plans other than the price level changes, including: - Potential GDP - Money wage rate and other factor prices Changes in aggregate supply – when potential GDP increases, both LAS and SAS shift rightward. It happens for 3 reasons: - The full-employment quantity of labour changes - The quantity of capital (physical or human) changes - Technology advances Change in money wage rate shifts the SAS curve leftward and has no effect on LAS Aggregate demand = Y = C+I+G+X-M Buying plans depend on: - The price level - Expectations - Fiscal policy and monetary policy - The world economy Aggregate demand – shows the relationship between the total quantity of real GDP demanded and the price level AD curve slopes downward or upward for two reasons: - Wealth effect  A rise in price level decreases the quantity of real wealth (money, stock, etc.)  To restore their real wealth, people increase saving and decrease spending, so AD decreases  A fall in price level, increases quantity of real wealth and quantity of real GDP demanded - Substitution effect  Intertemporal substitution effect o A rise in the price level decreases the real value of money and raises interest rate o When interest rate rises, people borrow and spend less, so quantity of real GDP decreases o A fall in price level, increases the real value of money and lowers the interest rate  International substitution effect o A rise in price level increases the price of domestic goods relative to foreign goods so imports increase and exports decrease which decreases the quantity of real GDP demanded o A fall in price level increases the quantity of real GDP demanded Disposable income – aggregate income - taxes + transfer payments. Fiscal Policy - government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services Monetary Policy – changes in interest rates and the quantity of money in the economy Three main influences on aggregate demand: - Expectations – about future income, future inflation, and future profits o Increase in expected future income increases people’s consumption today n increases AD o A rise in expected inflation rate makes buying goods cheaper today and increases AD o An increase in expected future profit boosts firms’ investment, which increases AD - Fiscal policy and monetary policy: - Fiscal: A tax cut or an increase in transfer payments will increase disposable income which results in consumption expenditure and AD - Monetary: An increase in the quantity of money increases buying power and increases aggregate demand. A cut in interest rates increases expenditure and AD - The world economy – influences AD in two ways:  A fall in foreign exchange rates lowers the price of domestic goods and services relative to foreign goods, which increases exports, decreases imports, and increases AD  An increase in foreign income increases demand for Canadian exports and increases AD An increase in aggregate demand shifts the AD curve rightward and a decrease shifts it leftward Short-run macroeconomic equilibrium – when real GDP demanded equals the quantity of real GDP supplied  If real GDP is below the equilibrium GDP, firms increase prices and production  If real GDP is above the equilibrium GDP, firms decrease prices and production  SAS and AD intersection Long-run macroeconomic equilibrium –real GDP equals to potential GDP and economy is on its LAS  AD and LAS intersection  Happens when money wage rate is adjusted to put SAS through the Long-run equilibrium point Economic growth increases the potential GDP and happens when: - Quantity of labour grows - Capital is accumulated - Technology advances  Economic growth shifts the LAS rightward Inflation – happens when quantity of money grows faster than potential GDP  AD increases by more than long-run aggregate supply  The AD curve shifts rightward faster than the rightward shift of the LAS Business cycle in the AS-AD model occurs when AD and SAS fluctuate, but the money wage rate doesn’t change rapidly enough to keep real GDP at potential GDP - A below full-employment equilibrium is an equilibrium which potential GDP exceeds real GDP  The amount which potential GDP exceeds real GDP is called a recessionary gap - An above full-employment equilibrium is an equilibrium which real GDP exceeds potential GDP  the amount which real GDP exceeds potential GDP is called an inflationary gap - A full-employment equilibrium is an equilibrium in which real GDP equals potential GDP Macroeconomics can be divided into three broad schools of thought: - Classical macroeconomist believe that economy is self-regulating and always at full-employment  New Classical view is that business cycle fluctuations are the efficient responses of well- fluctuating market economy that is bombarded by shocks arising from technological changes - Keynesian macroeconomists believe that left alone, economy would rarely operate at full- employment and we need active help from fiscal and monetary policy to achieve F-E  New Keynesian view holds that money wage rate and prices of goods are sticky - Monetarist is macroeconomist who believes that the economy is self-regulating and that it will normally operate at full employment provided that monetary policy is not erratic and that the pace of money growth is kept steady Chapter 27 – Expenditure Multipliers: The Keynesian Model Keynesian model describes the economy in the very short run when prices are fixed. Because each firm’s price is fixed, for the economy as a whole: - The price level is fixed - Aggregate demand determines real GDP There is a two-way link between aggregate expenditure and real GDP:  An increase in real GDP increases aggregate demand and vice versa Disposable income is aggregate income or real GDP minus taxes. (YD = Y-T)  Disposable income is either spent on consumption (C) or saved (S)  It changes when either real GDP or net taxes change Consumption function – the relationship between expenditure and disposable income Saving function – the relationship between saving and disposable income  When consumption exceeds the disposable income we have negative saving (dissaving)  When consumption is less than disposable income there is saving Marginal Propensity to Consume (MPC) – the fraction of a change in disposable income spent on consumption. MPC = ∆C / ∆YD Marginal Propensity to Save (MPS) – the fraction of a change in disposable income that is saved.  MPS = ∆S / ∆YD MPS + MPC always equals to 1 Marginal Propensity to Import – the fraction of an increase in real GDP that is spent on imports Aggregate demand expenditure = planned consumption expenditure + planned investment + planned government expenditure + planned exports – planned imports Planned consumption expenditure and planned imports are influenced by real GDP  When real GDP increases, planned consumption expenditure and planned imports increase Induced expenditure = consumption expenditure – imports (which varies by real GDP) Autonomous expenditure = Investment + Government expenditure + Exports (doesn’t vary by real GDP) Actual aggregate expenditure is always equal to real GDP but aggregate planned expenditure may vary from real GDP because firms may have unplanned changes in inventories Equilibrium expenditure – level of the aggregate expenditure that occurs when aggregate planned expenditure equals to real GDP (when we have no unplanned changes in business)  If aggregate planned demand exceeds real GDP, firms have unplanned decrease in inventories. So firms hire workers and increase production to restore inventories. Real GDP increases  If aggregate planned demand is less than real GDP, there is an unplanned increase in inventories. To reduce inventories firms fire workers and decrease production. Real GDP decreases  If aggregate planned demand equals real GDP, there is no unplanned change in inventories, so firms maintain their current production Multiplier – the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP Increase in investment (or any other components of autonomous expenditure) increases AE and real GDP. (Shifts AE upward)  Increase in real GDP leads to an increase in induced expenditure which leads to a further increase in AE and real GDP. So real GDP increase by more than the initial increase in autonomous expenditure. That’s why multiplier is greater than 1 Size of Multiplier equals to the change in equilibrium expenditure divided by the change in autonomous expenditure. The slope of the AE curve determines the magnitude of the multiplier Multiplier = 1 / (1 – slope of AE curve) = ∆Y / ∆A (∆A = change in autonomous expenditure) When there are no taxes and no imports, the slope of the AE curve equals to the MPC (imports and taxes reduce the size of the multiplier), so: Multiplier = 1 / (1-MPC) = 1 / MPS Turning points in business cycles (peaks and troughs) occur when autonomous expenditure changes Aggregate expenditure curve – the relationship between aggregate planned expenditure and real GDP Aggregate demand curve – the relationship between amount of real GDP demanded and price level  When price level changes, a wealth effect and substitution effect change aggregate planned expenditure and the quantity of real GDP demanded (moves AE curve downward and a movement along the AD curve)  An increase in investment shifts the AE curve upward and AD curve rightward by an amount equal to the change in investment multiplied by the multiplier  If price level rises, AE curve shifts downward Chapter 24 Money – any commodity or token acceptable as a payment and has three functions: - Medium of exchange - Unit of account - Store of value Means of payment – a method of settling a debt Money in US consists of: - Currency – coins and notes held by households - Deposits at banks and other institutions Two official measures of money in Canada: - M1 – currency and chequable deposits of individuals and businesses - M2 – M1 + plus all other deposits  Some savings in M2 are not money, they are liquid assets Liquidity – property of being instantly convertible into a means of payment with little loss of value Deposits are money but cheques are not. Cheque is an instruction to a bank to transfer money Credit cards are not money. They are loans that must be repaid Banking system – consists of private and public institutions that create money and manage nation’s monetary and payments systems 3 crucial institutions in financial market: - Depositary institutions – takes money from households and firms and give loans to other households and firms. They divide into:  Chartered banks  Credit unions and caisses populaires  Trust and mortgage loan companies - The bank of Canada – Central bank of Canada. The authority that regulates the nation’s depositary institutions and control the quantity of money. Their assets are government securities and last-resort loans to banks. Bank of Canada is:  Banker to the banks and government  Lender to the last resort – when the banking system is short of reserve, they make loans  Sole issuer of bank notes – the only bank that is permitted to issue bank notes (monopoly) - The payments system – a system through which banks make payments to each other to settle transactions by their customers. It’s owned by the Canadian Payment Association (CPA) and operates two national payment systems:  Large value transfer system  Automated clearing settlement system Goal of every bank is to maximize wealth of owners. To do so they set higher loan interests than deposits. Chartered Banks put their depositor’s funds into four types of assets: - Reserves – notes and coins in its vault or its deposit at bank of Canada - Liquid assets – government of Canada Treasury bills and commercial bills - Securities – longer–term government of Canada bonds and other bonds such as mortgage- backed securities - Loans – commitments of a fixed amount of money agreed-upon periods of time Depositary institutions provide four benefits: - Create liquidity - Pool risk - Lower the cost of borrowing - Lower the cost of monitoring borrowers Banks create deposits when they make loans. The quantity of deposits that bank can create is limited by: - The monetary base – bank of Canada notes outside bank of Canada + banks’ deposits at the bank of Canada + coins held by households, firms, and banks.  to change the monetary base bank of Canada conducts an open market operation - Desired reserve – a fraction of bank’s total deposits held as reserve  the desired reserve ratio is the ratio of reserves to deposits that banks want to hold.  Reserves are not required. Banks are free to determine their level  Excess reserves equal actual reserves minus desired reserves - Desired currency holding – people hold some fraction of their money as currency  when total quantity of money increases, so does the quantity of currency people want to hold  Because desired currency holding increases when deposits increase, currency leaves the banks when they make loans and increase deposits.  leakage of currency is called currency drain and ratio of money to deposits is called currency drain ratio 8 steps in the money creation process: - Banks have excess reserves - Banks lend excess reserves - The quantity of money increases - New money is used to make payments - Some of the new money remains on deposit - Some of the new money is a currency drain - Desired reserves increase because deposits have increased - Excess reserves decrease, but remains positive Money multiplier – the ratio of the change in the quantity of money to the change in the monetary base  when the monetary base increased by $100,000, the quantity of money increased by $250,000, so the money multiplier is 2.5. Influences on money holding: - Price level – a rise in it increases the quantity of nominal money but doesn’t change the quantity of real money people plan to hold  Real money = nominal money / price level  A %10 rise in the price level increases the quantity of nominal money demanded by %10 - Nominal interest rate – opportunity cost of holding wealth in the form of money rather than an interest-bearing asset  A rise in interest rates will decrease the quantity of real money demanded - Real GDP – an increase in real GDP increases the volume of expenditure which increases the quantity of real money that people plan to buy (shifts the demand curve rightward) - Financial innovation – lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold The demand for money – the relationship between the quantity of real money demanded and nominal interest rate, everything else remaining the same. Money market equilibrium – when the quantity of money demanded equals the quantity of money supplied. It is different in short run and long-run: - Short-run – occurs when quantity of money demanded equals the quantity of money supplied - Long-run – demand and supply in the loanable funds market determine the interest rate  Nominal interest rate = the equilibrium real interest + expected inflation rate  Real GDP = Potential GDP. So only price level adjusts in long run to make the quantity of money supplied equal the quantity demanded  Quantity theory of money – When bank of Canada changes nominal quantity of money, price level changes by the same percentage as the change in nominal money (proportional)  Velocity of circulation – average number of times in a year a dollar is used to purchase goods and services in GDP. V = PY
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