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Chapter 6-9

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Bridget O' Shaughnessy

CHAPTER SIX – MEASURING THE COST OF LIVING The Consumer Price Index  Consumer price index (CPI): measure of the overall cost of the goods/services bought by a typical consumer  Monitors changes in cost of living over time  When CPI rises, typical family has to spend more to maintain same standard of living  Inflation: situation where economy’s overall price level is rising  Inflation rate: percentage change in price level from previous period How the Consumer Price Index is Calculated 1. Determine the basket o Determine which prices are most important to typical consumer o If consumer buy more of good than price of that good is more important that good they buy less of 2. Find the prices o Find prices of each good/service in basket for each point in time 3. Compute the basket’s cost o Use prices to calculate cost of basket of goods/services at each time 4. Choose a base year and compute the index o Choose one year to be the base year o All other years compared to this year o CPI = Price of basket of goods & services in current year x (100) Price of basket in base year 5. Compute the inflation rate o Inflation rate: percentage change in CPI from the proceeding period o Inflation rate in year 2 = CPI in year 2 – CPI in year 1 x (100) CPI in year 1  Core inflation: the measure of the underlying trend of inflation  Statistics Canada makes monthly announcement of CPI Problem in Measuring the Cost of Living  Commodity substitution bias: o Prices do not change proportionately o Some prices rise more than others o Consumers buy less of goods whose price has risen and more of goods whose price has fallen o CPI assumes a fixed basket of goods o Ignores possibility of consumer substitution o Overstates increase in cost of living from one year to next  Introduction of new goods: o When new good introduced: consumers have more variety to choose from o Greater variety makes each dollar more evaluable o Need fewer dollars to maintain any given standard of living o CPI does not include new goods (since it is fixed) o Overstates increase in cost of living  Unmeasured quality change: o If quality of good falls, value of dollar falls even if price stays the same o If quality of good rises, value of dollar rises o Overstates if rises, understates if falls  Problems are important because many things are adjusted using CPI (ex. private/public pension problems, personal income tax deductions, government social payments) The GDP Deflator vs. The Consumer Price Index  GDP deflator: ratio of nominal GDP to real GDP  GDP deflator reflects current level of prices relative to level of prices in base year  Use GDP deflator and CPI to see how quickly prices are rising  Two important differences: o (1) GDP deflator reflects prices of all goods/services produced domestically o (1) CPI reflects prices of all goods/services bought by consumers o (2) CPI compares price of fixed basket of goods/services to price of basket in base year o (2) GDP deflator compares price of currently produced goods/services to price of same goods/services in base year o (2) Does not matter if prices changing proportionately Correcting the Economic Variables for the Effects of Inflation Dollar Figures from Different Times  Can compare dollar figure from past to dollar figure from present  Goods/services are more expensive than 50 years ago  How much of rise in price of good is reflection of general fall in value of money (or general rise in prices)  Price index shows size of inflation correction Old price in current dollars = old price x (CPI in current year/CPI in old year)  Can see if price has increased due to inflation or rising prices Indexation  Indexation: the automatic correction of a dollar amount for the effects of inflation by law or contract  Ex. long-term contracts between firms and unions include indexation of wage to CPI  Cost-of-living allowance (COLA): automatically raises the wage when the consumer price index rises Real and Nominal Interest Rates  Interest represents payment in the future for transfer of money in the past  Interest rates always involve comparing amounts of money at different points in time  If prices have risen while money was in bank each dollar buys less than it did  Purchasing power has not risen even though money in bank has (from interest)  Higher rate of inflation means smaller increase in purchasing power  Rate of inflation > rate of interest: purchasing power falls  Deflation: purchasing power rises by more than rate of interest  Nominal interest rate: interest rate reported without correction for inflation  Real interest rate: interest rate corrected for effects of inflation Real interest rate = Nominal interest rate – Inflation rate  Nominal interest rate shows how fast number of dollars in bank account rises over time  Real interest rate shows how fast purchasing power of bank account rises over time  Periods of deflation: real interest rate > nominal interest rate CHAPTER SEVEN – PRODUCTION AND GROWTH Productivity: Its Role and Determinants Why Productivity is so Important  Productivity: the quantity of goods/services produced form each hour of a worker’s time  Productivity is key determinant of living standards  Growth in productivity is key determinant of growth in living standards  GDP measures: o Total income earned by everyone in economy o Total expenditure on economy’s output of goods/services  Possible because economy’s income is economy’s output  Nation enjoys high standard of living if can produce large quantities of goods/services How Productivity is Determined  Physical Capital per Worker: o Physical capital: stock of equipment/structures that are used to produce goods/services o More tools allow more work to be done more quickly and accurately o Capital is an input in production process that used to be an output from the production process  Human Capital per Worker: o Human capital: knowledge and skills that workers acquire through education, training, experience o Human capital is like physical capital o Raises nation’s ability to produce goods/services o Produced factor of production (input was teachers, student time, etc.)  Natural Resources per Worker: o Natural resources: inputs into production of goods/services that are provided by nature (ex. land, rivers, mineral deposits) o Two forms: renewable and nonrenewable o Differences in natural resources responsible for differences in standards of living around world o Natural resources not necessary for economy to be highly productive  Technological Knowledge: o Technological knowledge: society’s understanding of the best ways to produce goods/services o Makes labour available to produce other goods/services o Technological knowledge is society’s understanding of how world works o Human capital is resources expended transmitting understanding to labour force Economic Growth and Public Policy The Importance of Saving and Investment  To raise future productivity: invest more current resources in production of capital  Society must sacrifice consumption of goods/services in present to enjoy higher consumption in future  Encouraging saving/investment is one way government can encourage growth and raise economy’s standard of living Diminishing Returns and the Catch-Up Effect  Diminishing returns: the benefit from an extra unit of input declines as quantity of input increases  When workers have large quantity of capital to use in producing goods/services, giving extra unit of capital increases productivity only a little  Increase in saving rate leads to higher growth only for a while  Benefits from capital become smaller over time  Long run: higher saving rate leads to a higher level of productivity and income but not to higher growth in these variables  Easier for country to grow fast if starts out poorer  Catch-up effect: countries that start off poor tend to grow more rapidly than countries that start off rich  Poor countries: smallest amounts of capital investment raise productivity because workers do not have capital already  Rich countries: more capital make less of difference because already have capital Investment from Abroad  Foreign direct investment: capital investment owned and operated by a foreign company  Home country may buy share of ownership in corporation  Foreign portfolio investment: investment financed with foreign money but operated by domestic residents  Home country’s saving is being used to finance foreign country’s investment  GDP: income earned within country by residents and nonresidents  GNP: income earned by residents of country at home and abroad  Plant in foreign country raises income of foreign citizens (GNP) by less than it rises production in foreign country (GDP)  Foreign investment increases economy’s stock of capital leading to higher productivity and higher wages  Governments in less developed countries should encourage investment from abroad Education  Government policy can enhance standard of living by providing good schools and encouraging population to take advantage of them  Economists say education generates positive externalities  Educated person might come up with new ideas that can better everyone  Poor countries face problem of brain drain  Brain drain: emigration of highly educated workers to rich countries where they can enjoy higher standard of living  Countries that educated people leave are poorer than they would be if stayed Health and Nutrition  Healthier workers are more productive  Nation can increase productivity and raise living standards by making right investments in health  People who have bad nutrition cannot work hard  Studies show taller people are more productive (people who are malnourished will not be tall)  Poor countries suffer from malnutrition so hard to raise productivity Population Growth  Stretching Natural Resources o Book: An Essay on the Principle of Population as It Affects the Future Improvement of Society o Said ever-increasing population would strain society’s ability to provide for itself o Power of population is greater than power of earth to produce subsistence for it o Thought eliminating poverty was counterproductive o Poor could have more children putting bigger strain on production capabilities o Was wrong: mankind’s ingenuity has offset effects of larger population o New inventions allow more productivity to sustain more people  Diluting the Capital Stock Free Trade  Inward-oriented policies: policies aimed at raising productivity/living standards in a country by avoiding interaction with rest of world  Poorest countries use these  Domestic firms have protection from foreign competition  Outward-oriented policies: integrate countries into world economy  Economists think this is better for developing countries  Do not have to produce all the goods they consume  Inward-oriented policies cause living standards to fall  Countries surrounded by water find it easier to participate in international trade  Will have higher levels of income Research and Development  Technology has improved production abilities  Has improved living standards  Knowledge is a public good: once person discovers an idea it can be used freely by other people  Government encourages research and development with: o Research grants o Tax breaks to firms that engage in research and development o Patents to person/firm who invents new product Population Growth  Large population means more workers to produce goods/services  Also means more people to consume goods/services  Large population does not necessarily mean high standard of living  Stretching Natural Resources: o Malthus: ever-increasing population would continually strain society’s ability to produce for itself o Mankind was doomed to forever live in poverty o The power of the population is greater than power in the earth to produce subsistence for man o Thought that trying to stop poverty was counterproductive o Helping poor meant they could have more children putting greater strain on production o Reality: technological advances have offset growing population so standard of living is higher not lower  Diluting the Capital Stock: o Population growth means less worker will have less capital o Less capital means lower productivity and lower GDP per worker o Mostly for human capital (ex. hard to educate a large population) o More rapid population growth in poorer countries o Some countries regulate how many children family can have (ex. China can only have one child per family)  Promoting Technological Progress: o More people means more scientists, inventors, engineers to contribute to technological advances o Michael Kremer: world growth rates have increased as world population has o Larger regions experienced more rapid growth (because had more people to discover things) o Need large population for technological advances CHAPTER EIGHT – SAVING, INVESTMENT AND THE FINANCIAL SYSTEM Financial Institutions in the Canadian Economy  Financial system: group of institutions in the economy that help to match one person’s saving with another person’s investment  Financial system moves economy’s scarce resources from savers to borrowers  Savers supply money to financial system expecting to get it back with interest later  Borrowers demand money from financial system knowing they will have to pay it back with interest later  The Office of the Superintendent of Financial Institutions (OSFI): primary regulator of federally regulated banks, insurance companies, pension plans Financial Markets  Financial markets: institutions through which savers can directly provide funds to borrowers  The Bond Market: o Bond: certificate of indebtedness o Has date of maturity (time at which loan will be repaid) and interest rate o Principal: promise of interest and eventual repayment of the amount borrowed o Buyer can hold bond until maturity or sell to someone else before that o Term: length of time until bond matures o Interest rate depends on length of term o Long-term bonds: riskier so pay higher interest rates o Credit risk: probability that borrower will fail to pay some of interest or principal o High risk of default: bond buyers want higher interest rate o Provincial governments are greater credit risk than federal government o Corporate bonds pay higher interest rates than provincial bonds  The Stock Market: o Stock: a claim to partial ownership in a firm (claim to profits that firm makes) o Equity finance: sale of a stock to raise money
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