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ECON 2000
Mokhles Hossain

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ECON2000 Midterm Jessica Gahtan Introduction  Macroeconomics is the study of the economy as a whole  3 variables o Real GDP measures the total income of everyone in the economy (adjusted for the level of prices)  Measure of the standard of living  Grows over time  Not steady growth  Periods when it’s falling: Mild= Recession, Severe= Depression o Inflation Rate measures how quickly prices are rising  Deflation: Periods of falling prices  In recent history, inflation has been the norm o Unemployment rate measures the fraction of the labour f orce that is out of work  Recessions & depressions are usually associated with high levels of unemployment  When total spending is high, unemployment decreases and inflation increases  Unemployment increases when inflation decreases b/c of government policy that decreases total spending  Fiscal policy: Government spending and taxing  Monetary policy: changes in the growth of the nation’s money supply  Models simplify the relationship between endogenous variables (those that the model tries to explain) and exogenous variables (those that the model takes as given) o No universally correct model  A function shows how one variable depends on a set of other variables  Functional notation allows us to express the general idea that variables are related even when we don’t have enough information to indicate the precise numerical relationship  Price flexibility describes the economy in the long run  Price stickiness describes the economy in the short run  Market clearing is the assumption that markets are normally in equilibrium o Continuous market clearing is unrealistic o Market clearing models describe the equilibrium toward which the economy slowly gravitates  Microeconomics is the study of how households and firms make decisions and how these decisions interact in the marketplace o Households and firms optimize (they do the best they can given their objectives and the constraints they face) Data of Macroeconomics  GDP is a nation’s income and total expenditure on its output of g/s  CPI measures level of prices Page 1 of 15 ECON2000 Midterm Jessica Gahtan 2.1 Measuring the Value of Economic Activity: Gross Domestic Product  GDP measures the flow of dollars in this economy o Total income from the production of bread (sum of wages and profit) o Total expenditure on purchases of bread o Total value added of all firms in the econom y  Every dollar spend by someone is a dollar of income for someone else  Gross domestic product (GDP) is the market value of all final goods and services produced within an economy in a given period of time.  To compute the total value of different g/s, the n ational accounts use market prices because these prices reflect how much people are willing to pay for a g/s  The sale of used goods not included because it doesn’t reflect production o Same way that transactions involving financial assets (i.e. buying a bond/stock) are not included in the GDP  Unsold merchandise- two things can happen: o If it spoils/ must be thrown out- no alteration to GDP o If put into inventory to be sold at a later date- counted as the firm buying it now - then counted as a used good in the following period- GDP rises in the year it was produced.  Intermediate goods and value added o Value added of a firm equals the value of the firm’s output less the value of the intermediate goods that the firm purchases o For the economy as a whole, the sum of all the value added must equal the value of all final g/s  Housing services and other imputations o Since some g/s aren’t sold in the marketplace (and thus have no market prices) we need to estimate these values in order to include these values in the GDP  Estimate is called an imputed value o Imputations are important for determining the value of housing - to take into account housing services enjoyed by homeowners, GDP includes the ‘rent’ that these homeowners ‘pay’ to themselves  Imputed rent is included in the homeowner’s expenditure and income o Also use imputations when valuing government services - because they’re not sold in the marketplace, just use the amount paid as wages to value output o Imputation is principle but not always practiced  Value added of home-cooked meal isn’t included • Not included by in ’91 produced estimate that household production in Canada is equal to about 1/of GDP  No imputation for underground economy • Part of economy hidden from government to evade taxes or because the activity is illegal o Since imputations are only estimates , value of many g/s are left out altogether, GDP is an imperfect measure of total economic activity  Imperfections are problematic when comparing standards of living across countries • Size of underground economy , for example, varies between countries Page 2 of 15 ECON2000 Midterm Jessica Gahtan • Yet, as long as the magnitude of these imperfections remains fairly constant over time, GDP is useful for comparing economic activity from year to year  Nominal GDP value of g/s measured at current prices o Could be misleading- because prices could double without the economy becoming any better at satisfying demands  Real GDP value of g/s measured using constant prices; better measure of economic well-being  The GDP deflator aka the implicit price deflator fo r GDP is Nominal GDP/Real GDP o Describes what’s happening to the overall level of prices o Nominal GDP= Real GDP*GDP Deflator  Nominal GDP measures the current dollar value of the output of the economy. Real GDP measures output valued at constant prices. The GDP deflator measures the price of output relative to its price in the base year Real GDP= Nominal GDP/ GDP Deflator - This takes the inflation out of the Nominal GDP FYI: Stocks and Flows  Stock is a quantity measured at a given point in time  Flow is a quantity measured per unit of time  Stocks and flows are often related  When building theories it’s often useful to determine whether the variables are stocks or flows and whether any relationships link them Stock Flow A person’s wealth His income and expenditure The number of unemployed people The number of people losing their jobs The amount of capital in the economy The amount of investment The government debt The government budget deficit Chain-weighted measures of Real GDP  Base year changes continuously o Average prices in 2008 and 2009 are used to measure real growth from 2009 to 2010 o Various year-to-year growths form a ‘chain’ that an be used to compare the output of g/s between any 2 dates o Ensures that the prices used to co mpute real GDP are never far out of date o Two measures are highly correlated - both methods of computing reflect the same thing: economy-wide changes in the production of g/s Components of Expenditure: 1. Consumption (C) 2. Investment (I) 3. Government Purchases (G) 4. Net Exports (NX) National Accounts Identity : Y=C+I+G+NX Page 3 of 15 ECON2000 Midterm Jessica Gahtan  Consumption: g/s bought by households o 3 categories  Durable goods: Goods that last a long time (cars, TVs)  Nondurable goods: Goods that only last a short time (food, clothing)  Services: work done for consumers by individuals and firms (haircuts)  Investment includes goods bought for future use o 3 categories  Business fixed investment : purchase of new plant and equipment by firms  Residential construction : purchase of new housing by households and landlords  Inventory investment: increase in firms’ inventories of goods (if inventories are falling, inventory investment is negative)  Government Purchases are the g/s bought by federal, municipal and provincial governments o Doesn’t include transfer payment s to individuals  Since they reallocate existing income; not made in exchange for currently produced g/s  Net exports accounts for trade with other countries o Net Exports= our exports less our imports o Can be positive or negative FYI: Two Arithmetic Tricks fo r Working with % Changes 1. The percentage change of a product of two variables is approximately the sum of the % changes in each of the variables 2. The percentage change of a ratio is approximately the change in the numerator minus the percentage change in the denominator FYI: What is investment  Economy’s investment doesn’t include purchases the merely reallocate existing assets among individuals  Investment creates new capital Case Study: GDP and its components  Basically, we earned more from selling to foreigners than we spent on foreign goods o Used up the difference by paying a small part of the annual interest obligation that the average CDN owed on the country’s foreign debt Several Measures of Income Gross National Income= GDP – Net income of forei gners Net National Income= Gross National Income – Depreciation • Depreciation is called the capital consumption allowance in the national accounts Page 4 of 15 ECON2000 Midterm Jessica Gahtan • Indirect business taxes (i.e. Sales tax) place a wedge between the price that consumers pay for a good an the price that firms receive National Income: Measure of how much everyone in the economy has earned National Income= Net National Income – Indirect business taxes National Accounts divide national income into 4 components (depending on the way income is earned) 1. Compensation of employees . Wages and Fringe benefits earned by workers 2. Corporate Profits. The income of corporations after payments to their workers and creditors 3. Non-incorporated business income. The income of non-corporate businesses, such as small farms and law partnerships and the income that landlords receive, including the imputed rent that homeowners ‘pay’ to themselves, less expenses such as depreciation 4. Net interest. The interest domestic businesses pay minus the interest they receive, plus interest earned by foreigners Personal Income= National income – Corporate Profits – Social Insurance Contributions – Net interest + Dividends + Government transfers to individuals + Personal Interest I ncome => Personal Disposable income is the amount households and non-corporate businesses have available after satisfying their tax obligations to the government Personal Disposable income= Personal income – personal tax payments Case Study: Seasonal Adju stment  GDP follows a cyclical cycle o Because of changes in our ability to produce, season tastes  Eliminate the portion of fluctuations due to predictable seasonal changes ( Seasonally adjusted)  Need to look beyond seasonal cycle for the explanation ofor rise in GDP 2.2 Measuring the cost of living: The Consumer Price Index  Increase in the overall level of prices is called inflation  CPI is used to measure the level of prices o StatsCan collects the prices of thousands of g/s o CPI turns the prices of many g/s into a single index measuring the overall level of prices o Stats Can weights different items by computing the price of a based of g/s purchased by a typical consumer  The CPI is the price of this basket of g/s relative to the price of the same basket in some base year o Is the most closely watched index of prices  Also is a producer price index which measures the price of a typical basket of goods bought by firms rather than consumers  Core inflation measures the increase in price of a consumer basket that ex cludes food and energy products- because they exhibit short -run volatility, core inflation is sometimes viewed as better gauge of ongoing inflation trends CPI V. GDP Deflator  GDP Deflator- prices of g/s produced  CPI- prices of g/s bought by consumers  If price of things gov’t / businesses buy increase, it’d only show in the GDPD  Increase in stuff produced abroad and purchased by CDN consumers only affects CPI Page 5 of 15 ECON2000 Midterm Jessica Gahtan  GDP has changing weights making it a paasche index  CPI has fixed weights making it a laspeyres index Case study: Difficulties in Measuring Inflation  Neither method is superior Problems:  Substitution bias  Introduction of new goods- when a new good is introduced, consumers are better off (b/c more to choose from) in effect the intro of new goods increases the real value of the dollar – not reflected in a lower CPI  Unmeasured changes in quality - hard to measure- so CPI rises faster than it should 2.3 Measuring Joblessness: The unemployment rate  The measures the % of those people wanting to work who don’t have j obs  Friction in labour markets: Structural  Cyclical occurs when overall level of economic activity is insufficient to employ all those wanting to work  3 categories: Employed, unemployed & not in the labour force o Employed if he/she spent most of the previo us week at a paid job o Unemployed if not employed waiting for the start of a new job, on a temporary layoff, or has been looking for a job o Student/ Retiree =/= in labour force  Discouraged worker is counted as not being part of the labour force  Labour force = Number of employed+ Number of unemployed  Unemployment Rate = (Number of unemployed/ Labour force)* 100  Labour force participation rate is the % of the adult population that’s in the labour force Labour force participation rate= (Labour force/ Adult popul ation)*100 Case Study: Trends in labour -force participation  Improved birth control, changing political and social attitudes- more women working  Full time students, retirees, stay -at-home fathers mean that less men are working Unemployment GDP and Okun’s Law  Negative relationship between cyclical employment and GDPOkun’s Law  Tells us roughly the amount of growth necessary to keep the growth of the number of jobs in pace with the growing size of the labour force Change in the Unemployment Rate= -0.5 [(% Change in Real GDP) -4] National Income: Where it comes from and Where it goes 3.1 What determines the total production of g/s  GDP depends on factors of production (quantity of inputs) and the production function (economy’s ability to turn inputs into outputs) Factors of Production  Inputs used to produce g/s  Two most important are capital (the set of tools that a worker uses, K) and labour (the time people spend working, L) Page 6 of 15 ECON2000 Midterm Jessica Gahtan  Later we’ll divide capital into physical capital (like machines) and knowledge (aka human capital)  Assume (here) that the two are fixed: K=K L=L o Overbar means that each variable is fixed at some level  Assume that factors of production are fully utilized (even though in real life, some people are unemployed/ factors are usua lly underutilized) Production Function  Y=F (K, L)  Output is a function of the amount of capital and the amount of labour  Constant returns to scale zY=F (zK, zL) The Supply of G/S  Since supplies of capital and labour are fixed, output is also fixed 3.2 How is National Income Distributed to the Factors of Production ?  Neoclassical theory of distribution : prices adjust to balance supply and demand (aka markets for factors of production) and demand for each factor of production depends on the marginal productivity of that factor  Factor Prices are the amounts paid to the factors of production (wage workers earn and the rent the owners of capital collect)  Rental prices is determined by supply and demand for that factor The price paid to any factor of production depends on the supply and demand for that factor’s services. Because we have assumed that supply is fixed, the supply curve is vertical. The demand curve is downward sloping. The intersection of supply and demand determines the equilibrium factor price The Decisions facing the competitive firm  Competitive firm is small relative to the markets in which it trades so it has little influence on market prices o Takes prices of its output and its inputs as give by market conditions o To make its product, firm needs capital and labour  Y= Firm’s output  K= Number of machines used (amount of capital)
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