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Chapter 19-25

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Economics (Arts)
ECON 209
Paul Dickinson

CHAPTER 19: WHAT MACROECONOMICS IS ALL ABOUT 19.1 Key Macroeconomic Variables Output and Income - National Product: most comprehensive measure of a nation’s overall level of economic activity value of its total production of goods and services - Production of output generates income - Aggregating Total Output o Goods are aggregated to measure total output o Add the dollar value to the production of goods o  Sum the values across all the different goods produced in the economy to give us the quantity of total output measured in dollars o Nominal National Income: the value of total output  A change in this measure can be caused by:  Physical quantities  Price on which it is based o 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 (changes only when quantities change) Potential Output and Output Gap - Potential output: level of output we could have in the economy if all the factors of production were fully employed o Symbol of Y* - Actual output o Symbol of Y - Output Gap = Actual GDP – Potential GDP (Y – Y*) o This tells us how much of the resources (GDP) we are not using during a recession since land, labor and capital are sat around idle o Recessionary Gap: when 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 o Inflationary Gap: When Y>Y*, the gap measures the market value of production in excess of what the economy can produce on a sustained basis Employment, Unemployment and the Labor Force - Employment: the number of adult workers - Unemployment: the number of adult workers who are not employed but who are actively searching for a job - Labor force: total number of people who are either employed or unemployed - Unemployment rate: the number of people expressed as a fraction of the labor force o - When the economy is at potential GDP, economists say there is full employment o Two reasons there will still be some unemployment  Frictional Unemployment: Constant turnover of individuals in given jobs and a constant change in job opportunities  Structural Unemployment: Because the economy is constantly adapting to shocks of various kinds, at any moment there will always be some mismatch between the characteristics of the labor force and the characteristics of the available jobs  Cyclical Unemployment: Unemployment that is neither structural or frictional - Why does unemployment matter?  Loss of income which pushes people into poverty  Waste of resources on the economy Productivity: a measure of output per unit of input - Often measured as real GDP per worker or real GDP per hour of work - Increases in productivity are probably the single largest determinant of long-run increases in material living standards o New and better technology o Improvement in skills (e.g. education) - NOTE: A 3% increase in real GDP with a 4% increase in population would be a reduction in the average standard of living - Why does productivity matter? o Productivity growth is the single largest cause of rising material living standards over long periods of time Inflation and the Price Level - Price Level: the average level of all prices in the economy o The Price Level (CPI)  Measure of average price of the goods and services that are bought by the typical household  Basic goods that typical consumer buys  Index number is unit free  Level of this number is absolutely meaningless  But what has meaning is how that level changes over time  Deficiencies of the CPI over long periods  Does not show changes in the quality of output  Needs periodic updating of the base year o New products o Changes in spending patterns (i.e. the ‘weights’) - Inflation: the rate at which the price level is changing - Change in price level x 100 Initial price - Why inflation matters o Inflation reduces the purchasing power of money and the real value of any sum fixed in nominal dollar terms  Purchasing Power: the amount of goods and services that can be purchased with a given amount of money o So inflation:  Hurts people on fixed incomes  Reduces real value of things with fixed price  Creates expectations of further inflation, which affects other behavior (e.g. U.S. house prices and savings rate) - High inflation becomes unstable and therefore unpredictable and that lack of predictability can be a major source of uncertainty in the economy o If an inflation is predicted to occur, nominal wages can be increased leaving wages constant in real terms - Anticipated inflation has less of an effect than unanticipated o Contracts can be adjusted in advance to allow for the effects of anticipated inflation o ‘Indexing’ is a way of automatically adjusting ‘nominal’ values to maintain ‘real’ values Interest Rates: price that is paid to borrow money for a stated period of time – the percentage amount per period - Nominal Interest rate: the rate expressed in money terms - Real Interest rate: the rate expressed in terms of purchasing power o If $1000 is borrowed with a 8% interest rate, but a 8% inflation occurs, the lender/investor will now receive money in which he would be able to purchase the same goods and services – borrowers are paying back the same value of money – real interest rate is zero - Real interest rate = nominal rate – inflation rate - The burden of borrowing depends on the real interest rate o Unanticipated inflation hurts the lender and benefits the borrower o As a lender, you care about getting a high interest rate with more purchasing power terms o As a borrower, you would like to pay back as low as possible - a lower interest rate Interest Rates and Credit Flows - Most institutions need credit – some only short term credit but many need both short-term and long-term - Credit necessary for efficient functioning of economy - Financial intermediaries (banks etc) link lenders to borrowers - Interest rate is price of credit, and fluctuations in r tend to have modest effect on D & S of credit - Credit Crunch in 2008 o Lenders not lending even at high interest rates o Unsure which companies were ‘secure’ and which had potential for bankruptcy o High interest rate is no good if not get paid  This interruption in credit flows was a major cause of the recent recession The International Economy - Foreign Exchange: foreign currencies or claims on foreign currencies - Exchange rate: the number of Canadian dollars required to purchase one unit of foreign currency - Depreciation of the Canadian dollar means that it is worth less on the foreign- exchange market o Difference between CAD and foreign currency increases (rise in exchange rate) - Appreciation of the Canadian dollar mean that it is worth more in the foreign- exchange market o Difference between CAD and foreign currency decreases (fall in exchange rate) - The domestic price of Canada’s import rises, and the foreign price of Canada’s exports falls o Canadian Exporters are unhappy when the CAD is high (at par with USD)  If you are producing stuff for export to the rest of the world, when the Canadian dollar is strong, it means that your goods would be expensive in the eyes of foreigners since they will have to buy the expensive CAD o Canadian Importers are unhappy when CAD is weak  If you are producing something but using imported machinery or materials, when the Canadian dollar is weak, those imported materials become very expensive and makes it hard for the importers to bring in these materials o As a consumer, because majority of what we consume comes from imports, we would like the dollar to be strong; however, if you are working, your income might be coming from an export part of the country 19.2 Growth Versus Fluctuations Long-Term Economic Growth - Long-term growth is considerably more important for a society’s living standards from decade to decade than short-term fluctuations - There is considerable debate regarding the ability of government to influence the economy’s long-run growth rate - Sometimes the best policy for the long-term may make things worse in the short- term, and vice versa Recessions and Booms as Self-Fulfilling Prophecies 1. General feeling of pessimism about the future. Consumers expect average incomes to stop growing and firms expect sales to stop growing. 2. Firms cut investment spending: less intermediate capital goods are produced. Some workers are laid off. 3. Laid-off workers but less consumer goods and services. And increased fear of lay-off cause other households to increase saving and reduce spending 4. Firms reduce production of final consumer goods. The cycle continues into recession. Result: the pessimistic expectations of forthcoming recession appear to have been correct. But they were only correct because of how the economy reacted to its own expectations. What Lies Ahead? - To organize our thinking about macroeconomics, we must develop some tools - These will include: o Discussing the measurement of national income o Building a simple model of the economy o Modifying the model to make it more realistic o Using our model to analyze some pertinent economic issues CHAPTER 20: THE MEASUREMENT OF NATIONAL INCOME 20.1 National Output and Value Added - Production occurs in stages – most firms produce output that are other firms’ inputs o Intermediate products: all outputs that are used as inputs by other producers in a further stage of production which are not counted in the overall GDP o The final product: goods that are not used as inputs by other firms but are produced to be sold for consumption, investment, government, or export during the period under consideration – it is the only thing included in GDP to avoid double counting - GDP is the value of final goods and services produced in the domestic economy o Includes additional to inventory (since produced that year) o Includes exports of intermediate goods – they are final sales for the domestic economy o Excludes imported final goods – not produced at home - Problem: Can be hard to distinguish between final good and intermediate goods o The problem of double counting is avoided by measuring total output as the sum of value added  Value Added: the amount of value that firms and workers add to their products over and above the costs of intermediate goods  = Revenue – Cost of Intermediate Goods  = Payments to Factors of Production  Used to avoid double counting  The sum of all values added in an economy is a measure of the economy’s total output (GDP) 20.2 National Income Accounting: The Basics - Three methods for measuring national income (output): o Total value added form domestic product  “GDP by value added” o Total expenditure on domestic output  “GDP on the expenditure side” o Total income from producing domestic products  “GDP on the income side” *Review The Circular Flow of Expenditure and Income - The economy is in equilibrium when the total number of inputs are the same as the total number of outputs GDP from the Expenditure Side - Sum the expenditures needed to purchase the final output produced in any given year - 4 broad expenditure categories: o Consumption expenditure (C ) inaludes expenditure on all goods and services sold to their final users during the year (i.e. present consumption)  Includes imputed rental value for home ownership o Investment expenditure (I ) as expenditure on the production of goods not for present consumption, including:  Change in inventories (measured at market value, not as cost)  Inventories of outputs allow firms to meet orders despite fluctuations in the rate of production  Counts as positive investment since it represents goods produces but not used for current consumption  Decumulation (disinvestment): reduction in the stock of finished goods that are available for sale  Plant and equipment (called fixed investment or capital stock)  Residential investment  New housing construction – treated as investment, not as current consumption  A house being bought from another individual is an asset simply being transferred and is not counted to national income  Gross investment (produced domestically)  Total investment that occurs in the economy  Two types: o Replacement investment: investment required to replace that part of the capital stock lost through the process of depreciation o Net investment (which adds to the capital stock)  = Gross investment – Depreciation  When NI is +, the capital stock is growing  When NI is -, which rarely happens, the capital stock is shrinking o Government purchases (G ) ara the purchases of currently produced goods and services by the government  Excluding transfer payments  Valued at cost in the national accounts rather than at market value  Government spending on most investment goods (e.g. roads that will be used by many generations) is treated same way as spending on (e.g.) civil servants’ pay, cost of commission of inquiry, etc  Only government purchases of currently produced goods and services are included as part of GDP  NOTE: Even if actual output were unchanged, producing more in the private sector and less by government could increase GDP. Why?  Prices are higher under private sector o Net exports (NX ) is the difference between exports and imports: NX = (X – a a a IMa)  Exports are added because they are produced in Canada (even though not consumed by Canadians)  Imports are subtracted because they are not produced in Canada (although are consumed by Canadians)  Imports counted at the value when they enter Canada  NOTE: Spending by foreign visitors to Canada is an export. Canadians’ vacation spending abroad is an import. - Sum all the actual expenditures in these categories and get actual value of GDP o GDP = C + a + a + Na a GDP from the income Side - GDP is also the sum of factor incomes and other claims on the value of output (called non-factor payments) - Factor incomes include: o Wages and salaries o Interest o Business Profits  Dividends and retained earnings o Net domestic income  Excludes the value of output that is used as replacement investment  Income accruing to domestic factors of production  Wages and salaries (before deductions) are income from labor  Business profits are both distributed and undistributed profits - Not-factor payments include: o Indirect taxes and Subsidies  Indirect taxes include sales taxes (GST + PST)  Are the difference between total income valued at factor cost and total income valued at market prices  Why are subsidies subtracted? Example: Firm gets revenues of $10 000 of which $2000 is a government subsidy, so $8000 is the true market value o Depreciation of existing physical capital  Value of capital ‘used up’ producing current output  Is the part of the value of current year’s output ‘paid for’ in previous years (i.e. by previous years’ output)  Measured by the tax system’s Capital Consumption Allowance  Depreciation is not income earned by any factor of production - Total National Income o GDP = Net domestic income + indirect taxes (less subsidies) + depreciation - Some arbitrary decisions have to be made (e.g. additions to inventory valued at market prices rather than at cost) - These can affect the measured level of GDP, but will have little or no relevance when looking at the changes in GDP 20.3 National Income Accounting: Some Extra Issues GDP and GNP - A measure of national output closely related to GDP is Gross National Product (GNP) o GDP is total income produced o GNP is income received by the country’s residents - Some income produced in Canada goes to non-resident, while some Canadian residents earn income from abroad - GNP = GDP + Net Foreign Factor Payments - Small difference for Canada – outflow but bigger than the inflow - GDP is superior as a measure of domestic economic activity - GNP is superior as a measure of living standards of residents - A more “refined” measure is disposable personal income: o It is the part of national income that is available to households to spend or to save o It equals GNP minus any part not actually paid to households (all taxes, depreciation, retained earnings and interest paid to institutions) plus transfer payments received by household Real and Nominal GDP - Real national income: GDP that is valued at constant base-period prices - GDP Deflator = Nominal GDP / Real GDP x 100 o The GDP deflator is a very comprehensive index of prices because it includes the prices of all goods and services produced in the country (unlike CPI) o The CPI includes the prices of some imported consumption goods, which the GDP deflator excludes o And the deflator prices the current year’s output, not some past year, so no problems with being ‘out of date’ (unlike CPI) - Do the CPI and the GDP deflator move together? o GDP deflator does not change in line with changes in the CPI o Measuring two different things:  CPI: change in average price of consumer goods  GDP deflator: change in the average price of goods produced o Changes in the GDP deflator and CPI similarly reflect over all inflationary trends but changes in relative prices may lead the two price indices to move in different ways Omission from GDP - National income accountants cannot measure economic activity that takes place outside regular, legal markets: o Illegal activities are excluded o Value of leisure  If a person chooses to reduce her time at work from 2400 hours to 2200 hours per year, measured national income will fall by the person’s wage rate time 200 hours  Yet the value of the person of the 200 hours of new leisure enjoyed outside of the marketplace must exceed the lost wages (otherwise she would not have chosen to reduce her work by 200 hours)  Total economic well being has increased even though measured GDP has fallen o The underground economy  Example: people who take cash and do not report it as income so they do not get taxed o Home production (and volunteered activities outside the home)  Includes all the ordinary work that is required to keep a household functioning  Example: the value of a person doing his/her own lawn is omitted from GDP because there is no recorded market transaction o Economic “Bads”  Do not subtract the economic “bads” (Note: spending to clean up pollution increases measured GDP – but in reality are only compensating for an economic ‘bad’) - Do the omissions matter? o Unless the unmeasured economic activity changes rapidly, changes in GDP will do a reasonable job of measuring changes in material living standards o Non-market activities (more prevalent in rural settings?) and economic bads (more prevalent in urban settings) can be a problem when comparing structurally different countries GDP and Living Standards - “Well-being” is a broader concept than material living standards: o Well being consists of more than just income (e.g. environment) o GDP is not a complete measure of economic well-being, let alone the “quality of life” o But income is a very important part of well-being, and GDP is a good measure of income CHAPTER 21: THE SIMPLEST SHORT-RUN MACRO MODEL 21.1 Desired Aggregate Expenditure - The national accounts divide actual GDP into its components: o GDP = C , Iz,aG ,aand NX a - The sum of desired expenditures on domestically produced output is called desired aggregate expenditure o AE = C + I + G + NX - Two types of expenditure: o Autonomous expenditures  Components of aggregate expenditure that do not depend on the level of national income o Induced expenditures  Components of aggregate expenditure that do change systematically in response to the level of national income Where are we going? - Actual may differ from desired because of unplanned factors - When actual differs from desired, economic forces (‘pressure’) will, over time, tend to pull them together - When all adjustments of actual to desired have been made, the economy has an equilibrium at Y = AE (actual equals desired) - If Y = AE with an output gap (YY*), there are still pressures for further change, over time until Y = AE at Y*=Y * (i.e. actual = desired at potential GDP) Important Simplifications - We start by assuming the simplest of all economies – an economy with no government and no trade (i.e. a ‘closed’ economy, with only households and firms) - AE = C + I - We also assume that prices are constant – there is no inflation - In the simplest economy, investment is autonomous Desired Consumption Expenditure - Two possible uses of disposable income: o Consumption (C) o Savings (S): All disposable income that is not spent on consumption  Disposable income: the amount of income households receive after deducting what they pay in taxes and adding what they receive in transfers - In the simplest theory, consumption is determined primarily by current disposable income (Y d - In more advanced theories, individuals are forwards looking, and so consumption depends more on “lifetime” income – i.e. both current and expected future - Having forwards looking consumer who take expected future income into account has a “smoothing” effect on consumption o Anticipated changed in income have already been accounted for in “lifetime” consumption decisions o So they will cause less change in current consumption than with the simplified Keynesian consumption function o Even unanticipated changes in current income affect consumption mainly via changes in expectations of future income - The consumption function o Relates the total desired consumption expenditures of all households to the several factors that determine it o Factors influencing desired consumption:  Disposable income  Wealth  Interest rates  Expectations about the future o Holding constant other determinants of desired consumption, an increase in disposable income is assumed to lead to an increase in desired consumption o The simple consumption function is written as:  C = a + bYD  a is the autonomous consumption  bY Ds induced consumption o The marginal propensity to consume (MPC) relates the change in desired consumption to the change in disposable income that brought it about  MPC =  The MPC is the slope of the consumption function  Positive slope of the consumption shows that the MPC is positive – increase in income lead to increases in desired consumption expenditure  Constant slope shows that the MPC is the same at any level of disposable income o The average propensity to consume (APC) is equal to total consumption divided by total disposable income  APC = - The saving function o The marginal propensity to save (MPS) relates the change in desired saving to the change in disposable income that brought it about  MPS = o The average propensity to save (APS) is the proportion of disposable income that households want to save  APC = - Since all disposable income is either consumed or saved, we have: o APC + APS = 1 o MPC + MPS = 1 - Shifts in the Consumption Function o If consumption function shifts upward, the saving function must shit downward o Changes in disposable income lead to movements along the consumption function; changes in the other three factors will lead to shifts of the consumption function o What causes a shift in the consumption and saving functions?  Change in Wealth  An increase shifts the consumption function up and the savings function down  No need to save less for the future (e.g. retirement or children’s education), so can increase desired spending on current consumption  Change in Interest rate  Fall in (real) interest rate reduces cost of borrowing, so reduces the cost of higher-priced durable goods  It also reduces the rate of return on savings  Fall in interest rates usually leads to an increase in desired consumption at any level of disposable income; the consumption functions shifts up  A rise in interest rates shifts the consumption function down  Change in expectations  Increased pessimism about future earnings and employment prospects increases desired current saving and reduces desired current consumption Desired Investment Expenditure - Investment expenditure is the most volatile component of GDP: o Changes in investment expenditure are strongly associated with short-run fluctuations - Three important determinants of aggregate investment expenditure are: o Desired Investment and the Real Interest Rate  A rise in the real interest rate reduces the amount of desired investment expenditure  When interest rates are high, it is expensive for firms to borrow funds  The real interest rate is the opportunity cost for:  Investment in new plant and equipment  Investment in inventories o Small dollar value, but important because volatile  Investment in residential construction o Also volatile – e.g. changes in real interest have big effect on demand on housing via the cost of mortgages  The higher the real interest rate, the higher the opportunity cost of investment and thus the lower the amount of desired investment o Desired Investment in Changes in Sales  The higher the level of production and sales, the larger the desired stock of inventories  Changes in the rate of sales cause temporary bouts of investment in inventories  Increase in sales also increases investment in plants and equipment o Desired Investment and Business Confidence  When business confidence improves, firms wants to invest now so as to reap future profits  Business confidence and consumer confidence may feed of one another The Aggregate Expenditure Function - The AE function: o Relates desired aggregate expenditure to the level of actual income o AE = C + I  C: Desired Consumption  I: Desired Investment o Example:  Consumption function is: C = 30 + (0.8)Y  Investment function is: I = 75  The AE function is: C+I = 105+0.8Y - Marginal Propensity to Spend (z): o Measured by the change in national income that brings it about or o Slope of the aggregate expenditure function o The marginal propensity to spend is the amount of extra total expenditure induced when national income rises by $1, whereas the marginal propensity to consume is the amount of extra consumption expenditure induced when households’ disposable income rises by $1 21.2 Equilibrium National Income - Desired aggregate expenditure > Actual output: o Lines or waiting lists of unsatisfied customers will appear o This will put pressure on firms to increase output o The final response is a rise in national income (rise in output = rise in GDP) - Desired aggregate expenditure < Actual output o There is pressure for output to fall since people are desiring less goods o Results in a fall of national income - Desired aggregate expenditure = Actual output (Equilibrium) o Purchasers can fulfill their spending plans without causing inventories to change o There is no incentive for firms to alter output o Output and income will remain steady o The equilibrium condition is: Y = AE  (graph) 21.3 Changes in Equilibrium National Income Shifts of the AE function - Caused from the shift of the consumption function or investment function - Causes the equilibrium to increase or decrease - Two types of shifts can occur with the AE function:  The AE function can shift parallel to itself  A rise of desired aggregate expenditure causes the curve to shift up, a fall causes the curve to shift down  The slope of the AE function can change  If there is a change in the marginal propensity to spend  Increase in MPS causes the AE curve to steepen and increase equilibrium  Decrease in MPS causes the AE curve to flatten and decrease equilibrium The Multiplier - The multiplier is a measure of the size of the change in equilibrium national income that results from a change in autonomous expenditure - In our simplest of macro models, the multiplier exceeds one - Simple multiplier: measures the change in equilibrium national income that occurs in response to a change in autonomous expenditure when the price level is constant o The size of the Simple Multiplier  Depends on the slope of the AE function (the MPS)  Larger MPS, larger simple multiplier  =  Finding the Simple Multiplier (Check book and Written notes) Economic Fluctuations as Self-Fulfilling Prophecies - Households and firms base their desired investment and consumption partly on their expectations of the future: o Changes in expectations can lead to real changes in the current state of the economy - Example 1: o Firms feel optimistic about the future o This increases heir desired investment, shifting up the AE curve o This increases Y (by a multiple), “justifying” the initial optimism - Example 2: o Firms feel pessimistic o This reduces their desired investment, shifting the AE curve down by o This decreases Y (by a multiple), “justifying” the initial pessimism - Example 3: o Households feel pessimistic about the future o This increase their desired saving, shifting the AE curve down by o This decreases Y (by a multiple), “justifying” the initial pessimism CHAPTER 22: ADDING GOVERNMENT AND TRADE TO THE SIMPLE MICRO MODEL 22.1 Introduction Government Government Purchases - Government purchases of goods and services (G) are part of desired aggregate expenditures o Not including transfer payments o Including all levels of government – federal, provincial, territorial and municipal Net Tax Revenues - Net Taxes (T) are total tax revenue received by the government minus total transfer payments made by the government o Net tax revenue is positive since transfer payments are less than total tax revenue - We assume net tax revenues are given by: o T = tY  t: net tax rate o T enters the AE function indirectly via the consumption function:  C = a + bYD= a + b (Y-T) The Budget Balance - The budget balance is the difference between total government revenue and total government expenditure (T – G) o If G < T: A budget surplus (‘public saving’ > 0)  Uses the excess revenue to buy outstanding government debt o If G > T: A budget deficit (‘public saving’ < 0)  Must borrow thus adding to government debt Provincial and Municipal Governments - When measuring the overall contribution of government to desired aggregate expenditure, all levels of government must be included: 22.2 Introduction to Foreign Trade Net Exports - We make two central assumptions: o Canada’s exports are autonomous with respect to Canadian GDP o Canada’s imports rise as Canadian GDP rises  IM = mY  m: marginal prosperity to import  The amount that desired imports rise when national income rises by $1 o Thus, net exports are given by:  NX = X – mY o Certeris peribus, changes in domestic GDP lead to changes in net exports:  As Y rises, NX falls (as imports rise)  As Y falls, NX rises (as imports fall) o Net Export Function: negative relationship between Y and NX Shifts in the Net Export Function - Anything affecting exports will shift the NX function parallel to itself (up or down depending on increase or decrease) - Anything affecting the proportion of income that consumers want to spend on imports will change the slope of the NX function - Factors that lead to change: o An increase in foreign income leads to more foreign demand for Canadian goods  Increases X and shifts NX function upward o A rise in local prices relative to international ones (holding foreign prices constant) causes both IM and
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