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ECON 1250 (39)
Chapter 19-20

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ECON 1250

Chapter 19: What Macroeconomics is All About  Macroeconomics is concerned with the behaviour of economic aggregates and averages, such as:  Total output  Total Investment  Total Exports  Price Level  In addition with how they may all be influenced by government policy  When aggregate output rises, the output of many commodities and the incomes of many people rise with it  When the unemployment rate rises, many workers suffer reductions in their incomes  When significant disruptions occur in the credit markets, interest rates rise and borrowers find it more difficult to finance their desired purchases  Marco-economists consider two aspects of the economy:  The short-run behaviour of macroeconomic variables, such as output, employment, and inflation & how government policy can influence these variables  The long-run behaviour of the same variables, especially the long-run path of aggregate output  A full understanding of macroeconomics requires understanding the nature of short-run fluctuations as well as the nature of long-run economic growth 19.1 Key Macroeconomic Variables Output and Income  The most comprehensive measure of a nation's overall level of economic activity is the value of its total production of goods and services, called national product, or sometimes just called output.  One of the most important ideas in economics is that the production of goods and services generates income  The value of national product is by definition equal to the value of national income National Income: Aggregation  To measure national income we add up the values of the many different goods and services that are produced  The sum of all the dollar values of various economic productions give us the quantity of total output, or national income, usually called nominal national income  A change in nominal national income can be caused by a change in either the physical quantities or the prices on which it is based  Real national income: measures the value of individual outputs, not at current prices, but at a set of prices that prevailed in some base period  Nominal national income is often called constant-dollar national income  Real national income is often called constant-dollar national income National Income: Recent History  One of the most commonly used measures of national income is called gross domestic product (GDP)  GDP can be measured in either real or nominal terms; we focus her on real GDP  Periods in which real GDP actually falls are called recessions.  The business cycle refers to this continual ebb and flow of business activity that occurs around the long-term trend Potential Output and the Output Gap  National output (or income) represents what the economy actually produces  An important related concept is the level of output the economy would produce if all resources -land, labour, and capital - were fully employed  This concept is usually called potential output  "Y" is used to denote the economy's actual output  "Y*" is used to denote potential output  The output gap measure the difference between potential output and actual output, and is computed as Y - Y*  When actual output is less than potential output ( Y < Y*), the gap measures the market value of goods and services that are not produced because the economy's resources are not fully employed  When Y is less than Y*, the output gap is called a recessionary gap  When actual output exceeds potential output ( Y > Y*), the gap measures the market value of production in excess of what the economy can produce on a sustained basis  Y can exceed Y* because workers may work longer hours than normal, or factories may operate an extra shift  When Y exceeds Y* there is often upward pressure on prices, and thus we say the output gap is an inflationary gap  Recessions are associated with unemployment and lost output  When actual GDP is below potential GDP, economic waste and human suffering result from the failure to fully employ the economy's resources  When actual GDP exceeds potential GDP, inflationary pressure usually ensues, causing concern for any government committed to keep inflation rate low Employment, Unemployment, and the Labour Force  National income and employment are closely related  If more output is to be produced, either more workers must be used in production or existing workers must produce more  Employment denotes the number of adult workers (Ages 15 and over)  Unemployment denotes the number of adult workers who are not employed but who are actively searching for a job  The labour force is the total number of people who are either employed or unemployed  The unemployment rate is the number of unemployed people expressed as a fraction of the labour force:  Unemployment rate = Number of people unemployed ÷ Number of people in the labour force x 100 percent Frictional, Structural, and Cyclical Unemployment  Frictional Unemployment - Unemployment caused by the normal turnover of labour  EX) New people enter workforce, some people quit their job, others are fired  Structural Unemployment - Mismatch between characteristics of the labour force and the characteristics of the available jobs  EX) Labour does not currently have the skills that are in demand or because labour is not in the part of the country where the demand is located  Cyclical Unemployment - When actual GDP does not equal potential GDP, the economy is not at full employment.  EX) The result of businesses not having enough demand for labor to employ all those who are looking for work  Seasonal Unemployment - Workers that are unemployed due to seasonal variations  EX) Fisherman unemployed in winter, Ski instructor unemployed in the summer Inflation and the Price Level  Inflation means that prices of goods and services are going up, on average Two related but different concepts that are sometimes confused: 1. Price level 2. Rate of inflation  The price level refers to the average level of all prices in the economy and is given by the symbol P.  The second is the rate of inflation, which is the rate at which the price level is rising  Consumer Price Index (CPI) measures the average price of the goods and services that are bought by the typical Canadian household  Since the price level is measured with an index number, its value at any specific time has meaning only when it is compared with its value at some other time  CPI allow us to measure the rate of inflation EX) The value of the CPI in April 2012 was 122.2 and in April 2011 it was 119.8. The rate of inflation during that one-year period, expressed in percentage terms, is equal to the change in the price level divided by the initial price level, times 100: Rate of Inflation = 122.2 - 119.8 119.8 = 0.02 x 100% = 2.0 percent  If the price level doubles, a dollar will buy only half as much, whereas if the price level halves, a dollar will buy twice as much  Inflation reduces the purchasing power of money. It also reduces the real value of any sum fixed in nominal (dollar) terms.  Anticipated inflation has a smaller effect on the economy than unanticipated inflation Interest Rates  The interest rate is the price that is paid to borrow money for a stated period of time  The prime interest rate, the rate that banks charge to their best business customers, is noteworthy because when the prime rate changes, most other rates change in the same direction Interest Rates and Inflation How does inflation affect interest rates? EX) Imagine your friend lends you $100 and that the loan is repayable in one year. The amount you pay her for making this loan, measured in dollar terms, is determined by the nominal interest rate. If you pay her $108 in one year's time, $100 will be repayment of the amount of the loan (which is called the principal) and $8 will be payment of the interest. In this case, the nominal interest rate is 8% per year. How much purchasing power has your friend gained or lost by making this loan?  Depends on the price level during the year  The more the price level rises, the worse off your friend will be and the better the transaction will be for you  This result occurs because the more the price level rises, the less valuable are the dollars you use to repay the loan  The real interest rate measures the return on a loan in terms of purchasing power  The burden of borrowing depends on the real, not the nominal, rate of interest EX) A nominal interest rate of 8 percent combined with a 2 percent rate of inflation (a real rate of 6 percent) is a much greater real burden on borrowers than a nominal rate of 16 percent combined with a 14 percent rate of inflation (a real rate of 2 percent) The International Economy The Exchange Rate Exchange rate: the exchange rate between the Canadian dollar and any foreign currency as the number of Canadian dollars required to purchase one unit of foreign currency Chapter 20: Measurement of National Income 20.1 National Output and Value Added  Production occurs in stages: Some firms produce outputs that are used as inputs by other firms, and these other firms, in turn, produce outputs that are used as inputs by yet other firms.  The error that would arise in estimating the nation's output y adding all sales of all f
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