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McMaster University
James Bruce

Macroeconomics 2X03 9/14/2012 12:46:00 PM INTRODUCTION- The Science of Macroeconomics Definitions  Real GDP: measures the total income of everyone in the economy  Inflation rate: measures how quickly prices are rising  Unemployment rate: measures the fraction of labour force that is out of work  Deflation: falling prices 1.1  Recessions and depressions are associated with unusually high unemployment 1.2 How Economist’s Think Theory as Model Building  Endogenous variables: variables that a model tries to explain  Exogenous variables: model takes as a given  Purpose of a model is to show how the exogenous variables affect the endogenous  Exogenous variables come from outside the model and serve as the model’s input, whereas endogenous variables are determined inside the model and are the model’s output  Changes in aggregate income or in the price of materials affect price and quantity in the market Prices: Flexible vs. Sticky  Market clearing: Price of any good or service is found where the supply and demand curves intersect  Market clearing model assumes that all wages and prices are flexible, but in reality prices and wages are sticky  Over short periods, many prices are fixed at predetermined levels 9/14/2012 12:46:00 PM The Data of Macroeconomics  Gross Domestic Product (GDP) tells us the nation’s total income and the total expenditure on its output of goods and services  CPI measure the level of prices  Unemployment rate tells us the fraction of workers who are unemployed 2.1 Measuring the Value of Economic Activity: GDP  computed every three months  Represents the total dollar value of economic activity in a given time period  Total value of all final goods and services produced within Canada during a particular year or quarter  Total income is earned domestically  Assume that GDP simultaneously measures: o Total output of goods and services o Total income of all individuals o Total expenditure of all individuals  Income must equal expenditure Income, Expenditure, and the Circular Flow  GDP measure the flow of dollars in the economy  To compute GDP we look at either the flow of dollars from firms to households, or the flow of dollars from households to firms Some Rules for Computing GDP Apples vs. Oranges  Combine the value of all goods and services into a single measure  Stock: quantity measured at a given point in time  Flow: quantity measured per unit of time Used Goods  GDP measures the value of currently produced goods and services  When an individual buys a financial asset, this transaction is not counted as part of GDP because a swap of one pre-existing asset (money) for another (the stock or bond) does not involve an productive activity The Treatment of Inventories  Production for inventory increase GDP just as much as production for final sale Intermediate Goods and Value Added  Total value of final goods and services produced  Value added of a firm equals the value of the firm’s output less the value of the intermediate goods that the firm purchases  Sum of all value added must equal the value of all final goods and services Housing Services and Other Imputations  If GDP is to include the value of G&S that can be computable, we estimate: imputed value  Value added in meals at home is left out of GDP  No imputation is made for the value of G&S sold in the underground economy Real GDP vs. Nominal GDP  Value of G&S measured at current prices: nominal GDP  Value of G&S measured using a constant set of prices: real GDP o Because prices are held constant, real GDP varies from year to year only if the quantities produced vary GP Deflator  GDP Deflator= Nominal GDP Real GDP  Reflects what is happening to the overall level of prices in the economy  Allows us to separate nominal GDP into two parts: one part measures real GDP and the other measures prices (the GDP deflector) o Nominal GDP= Real GDP x GDP Deflator  Nominal GDP measure 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 The Components of Expenditure  National accounts identity Y= C + I + G + NX  GDP split into four categories: o Consumption (C)  G&S bought by households  Durable goods, nondurable goods and services o Investment (I)  Goods bought for future use  Business fixed investment, residential construction and inventory investment o Government purchases (G)  G&S bought by federal, provincial and municipal governments o Net exports (NX)  Trade with other countries  Positive when the value of our exports is greater than the value of our imports Several Measures of Income  Interested in personal disposable income because it is the amount households and non-corporate businesses have to spend after satisfying their tax obligations to the government 2.2 Measuring the Cost of Living: The CPI The Price of a Basket of Goods  Most commonly used measure of the level of prices: CPI  This turns prices of many G&S into a single index measuring overall prices  Stats Can weight different items by computing the price of a basket of G&S purchased by a typical consumer The CPI vs. GDP Deflator  GDP Deflator measured the prices of all G&S, CPI measures the prices of only the goods and services bought by consumers  GDP Deflator includes only those goods produced domestically  CPI is computed using a fixed basket of goods where GDP Deflator allows the basket of goods to change over time  PROBLEMS: o Substitution bias o Introduction of new goods o Unmeasured changes in quality 2.3 Measuring Joblessness: The Unemployment Rate  unemployment rate: percentage of those people wanting to work who don’t have jobs  Employed: spent the last week working at a paid job  Unemployed: not employed and waiting to start date of new job, on temp layoff or has been looking for a job  Not in labour force: full time student, retiree, discouraged worker  Labour force= # of Employed + # of Unemployed  Unemployment Rate= # of Unemployed x100 Labour Force  Labour force participation rate: percentage of the adult population that is in the labour force LFPR: Labour force x100 Adult Population Unemployment, GDP, and Okun’s Law  Increases in the unemployment rate should be associated with decreases in real GDP this negative relationship known as Okun’s Law  Implications for unemployment are more dramatic in a recession 12/2/2013 1:14:00 PM CLASSICAL THEORY: THE ECONOMY IN THE LONG RUN National Income: Where it Comes From and Where it Goes  Both households and firms borrow in financial markets to buy investment goods, such as housing and factories  The government receives revenue from taxes, uses it to pay for government purchases and any excess of tax revenue over government spending is called public saving, which can either be positive (budget surplus) or negative (budget deficit) 3.1 What Determines the Total Production of G&S? The Factors of Production  Inputs used to produce G&S o Two most important factors: capital and labour  Capital: is the set of tools that workers use  Labour: the time people spend working The Production Function  Output is a function of the amount of capital and the amount of labour  Constant returns to scale is when there is an increase of an equal percentage in all factors of production causing an equal increase in output by the same percentage zY= F(zK,zL) 3.2 How is National Income Distributed to the Factors of Production?  Factors of production and the production function together determine the total output of G&S, they also determine national income Factor Prices  Distribution of national income is determined by factor prices  Factor prices: the amounts paid to the factors of production- the wage workers earn and the rent the owners of capital collect  Regardless of the factor price, the quantity of factor supplied to the market is the same The Decisions Facing the Competitive Firm  Competitive firm: small relative to the markets in which it trades, so it has little influence on market prices  The firm sells its output at a price P, hires workers at wage W, and rents capital and a rate R (NOTE: firms renting capital we assume that households own the economy’s stock of capital)  Profit is what the owners of the firm keep after paying for the costs of production Profit = Revenue – Labour Costs – Capital Costs = PY – WL – RK = PF(K,L) – WL – RK  Profit depends on the product price P, the factor prices W and R and the factor quantities L and K The Firm’s Demand The Marginal Product of Labour  MPL is the extra amount of output the firm gets from one extra unit from labour  MPL= F(K, L+1) – F(K,L)  MPL is the difference between the amount of output produced with L+1 units of labour and the amount produced with only L units of labour  Diminishing marginal product: holding the amount of capital fixed, the MPL decrease as the amount of labour increases From the Marginal Product of Labour to Labour Demand  Increase in revenue from an additional unit of labour depends on two variables: o The marginal product of labour o The price of the output  Extra revenue: PxMPL  The change in profit from hiring an additional unit of labour is: ΔProfit= ΔRevenue – Δcost = (PxMPL) – W  The competitive firm’s demand for labour is determined by: PxMPL= W  W/P is the real wage: payment to labour measured in units of output rather than in dollars  MPL diminished as the amount of labour increases, this curve slopes downward  MPL schedule is also the firms labour demand curve The Marginal Product of Capital and Capital Demand  Marginal product of capital (MPK) is the amount of extra output the firm gets from an extra unit of capital, holding the amount of labour constant MPK= F(K+1, L) – F(K, L)  The increase in profit from renting an additional machine is the extra revenue from selling the output of that machine minus the machines rental price: ΔProfit= ΔRevenue – Δcost = (PxMPK) – R  Real rental price of capital: rental price measured in units of goods rather than dollars  The firm demands each factor of production until that factor’s marginal product falls to equal its real factor price The Division of National Income  Real wage paid to each worker equals the MPL and the real rental price paid to each owner of capital equals MPK  The income that remains after the firms have paid the factors of production is the economic profit  Economic profit= Y – (MPL x L) – (MPK x K)  Distribution of national income, rearrange to: Y= (MPL x L) + (MPK x K) + Economic Profit  If the production function has constant returns to scale then, F(K, L)= (MPK x K) + (MPL x L)  Constant returns to scale, profit maximization and competition together imply that economic profit is zero  Economic profit and the return to capital are often lumped together  Accounting profit: Accounting profit= Economic Profit + (MPK x K)  Total output is divided between the payments to capital and the payments to labour, depending on their marginal productivities  MPL= (1-α) Y/L  MPK= αY/K  Y/L= average labour productivity  Y/K= average capital productivity  The factor shares depend only on the parameter α, not on the amount of capital or labour or on the state of technology as measured by parameter A 3.3 What Determines the Demand for G&S? Consumption  Income that households receive equals the output of the economy Y  Income after the payment of all taxes, Y-T, as disposable income; households divide this income between consumption and saving  Level of consumption depends directly on the level of disposable income C= C(Y-T)  Consumption is a function of disposable income  Marginal propensity to consume (MPC) is the amount by which consumption changes when disposable income increase by one dollar o E.g. if MPC is 0.7 then households spend 70 cents of each additional dollar of disposable income on consumer G&S and save 30 cents Investment  Add to stock of capital  Depends on many things such as the rate of increase in new knowledge, the expectations firms have about the likelihood that households are ready to spend, the level of taxes and the interest rate  If the interest rate rises, fewer investment projects are profitable and the quantity of investment goods demanded falls  The nominal interest rate is the interest rate as usually reported: rate of interest that investors pays to borrow money  Real interest rate: the nominal interest rate corrected for the effects of inflation  Real interest rate measures the true cost of borrowing and determines the quantity of investment Government Purchases  Transfer payments to households (e.g. welfare) are not included in the variable G, though are included in government expenditure  Transfer payments are the opposite of taxes: they increase household’s disposable income  G= T balanced budget, G>T budget deficit, T>G budget surplus: which it can use to repay some of its outstanding debt FYI: The Many Different Interest Rates  Term: interest rate on a loan depend son its terms o Long term loans usually have higher rates  Credit risk: the higher the perceived probability of default, the higher the interest rate  Currency denomination: spread between Canadian and American interest rates widens whenever the Canadian dollar is perceived as “weak” 3.4 What Brings the Supply and Demand for G&S into Equilibrium? Equilibrium in the Market for G&S: The Supply and Demand for the Economy’s Output Y= C(Y-T) + I(r) + G  This equation states that the supply of output equals its demand, which is the sum of consumption, investment and government purchases  At the equilibrium interest rate, the demand for G&S equals the supply Equilibrium in the Financial Markets: The Supply and Demand for Loanable Funds  Y-C-G is the output that remains after the demands of consumers and the government have been satisfied: national saving  Y-T-C is disposable income minus consumption: private saving  T-G is government revenue minus government spending: public saving  “good” is loanable funds and its “price” is the interest rate  Saving is the supply of loanable funds, investment is the demand  Investment depends on the interest rate, the quantity of loanable funds demanded also depends on the interest rate  At the equilibrium interest rate, households’ desire to save balances firms’ desire to invest and the quantity of loans supplied equals the quantity demanded Changes in Saving: The Effects of Fiscal Policy An Increase in Government Purchases  To induce investment to fall, the interest rate must rise o The increase in gov. purchases causes the interest rate to rise and investment to decrease- these gov. purchases are said to crowd out investment  Increase in the government purchases is not accompanied by an increase in taxes, the government finances the additional spending by borrowing – that is by reducing public saving A Decrease in Taxes  Disposable incomes rises by delta T and consumption rises by an amount equal to delta T times the marginal propensity to consume MPC  The higher the MPC, the greater the impact of the tax cut on consumption  Increase in consumption must be met by a decrease in investment  For investment to fall, the interest rate must rise which leads to a reduction in taxes, and like an increase in gov. purchases, this crowds out investment and raises the interest rate Changes in Investment Demand  Technological innovation leads to an increase in investment demand  Government encourages or discourages investment through the tax laws  Because the interest rate is the return to saving, a higher interest rate might reduce consumption and increase saving 3.5 Conclusion/Summary  Competitive, profit-maximizing firms hire labour until the marginal product of labour equals the real wage  Consumption depends positively on disposable income  Investment depends negatively on the real interest rate  Government purchases and taxes are the exogenous variables of fiscal policy  A decrease in national saving, perhaps because of an increase in government purchases or a decrease in taxes, reduces the equilibrium amount of investment and raises the interest rate 9/14/2012 12:46:00 PM Money and Inflation  The overall increase in prices is called inflation  Extraordinarily high inflation: hyperinflation 4.1 What is Money?  The stock of liquid financial assets that can be readily used to make transactions The Functions of Money  Store of value o Way to transfer purchasing power from the present to the future  Unit of account o Provides the terms n which prices are quoted and debts are recorded o Unit in which we measure economic transactions  Medium of exchange o What we use to buy G&S o Ease with which an asset can be converted into the medium of exchange and use to buy other things o Economy’s most liquid asset The Types of Money  Money that has no intrinsic value is called fiat money  Established as money by government decree, or fiat  Intrinsic value: commodity money (e.g. gold) How the Quantity of Money is Controlled  Money supply is the quantity of that commodity  Governments control over the money supply is called monetary policy  Attempts to control the supply of money is through open-market operations- the purchase and sale of government bonds o To increase the supply of money Bank of Canada used dollars to buy government bonds from the public o To decrease: sell some of bonds How the Quantity of Money is Measured  Currency is the sum of outstanding paper money and coins  Demand deposits: the funds people hold in their chequing accounts 4.2 The Quantity Theory of Money Transactions and the Quantity Equation  Quantity of money in the economy is closely related to the number of dollars exchanged in transactions  Quantity equation: Money (M) x Velocity (V) = Price (P) x Transactions (T)  T is the number of times a year that G&S are exchanged for money  P is the price of the typical transaction  PT equals the number of dollars exchanged in the year  M is the quantity of money  V is the transaction velocity of money: measures the rate at which money circulates in the economy  If the quantity of money increases and the velocity of money stays unchanged, then either the price or the number of transactions must rise From Transactions to Income  Transactions and output are closely related because the more the economy produces the more goods are bought and sold The Money Demand Function and the Quantity Equation  M/P is the real money balance, which measures the purchasing power of the stock of money  Money demand function is an equation that shows the determinants of the quantity of real money balances people wish to hold (M/P)^d= kY o Where k is a constant that tells us how much money people want to hold for ever dollar of income o Quantity of real money balances demanded is proportional to real income  Higher income also leads to a greater demand for real money balances  When people want to hold a lot of money for each dollar of income (k is large), money changes hands infrequently (V is small)  The money demand parameter k and the velocity of money V are opposite sides of the same coin The Assumption of Constant Velocity  Is velocity if fixed, the quantity of money determines the dollar value of the economy’s output Money, Prices, and Inflation  Factors of production and the production function determine the level of output Y  Money supply determines the nominal value of output PY  The quantity theory implies that the price level is proportional to the money supply  The quantity theory of money states that the central bank, which controls the money supply, has the ultimate control over the rate of inflation  If the central bank keeps the money supply stable, the price level will be stable; if the central bank increases the money supply rapidly, the price level will rise rapidly 4.3 Seignirorage: The Revenue from Printing Money  government can finance its spending in three ways o Raise revenue through taxes o Borrow from the public by selling bonds o Printing the money  Revenue raised by printing money: segniorage  When the government prints money it increase the money supply which causes inflation and imposes an inflation tax  In countries experiencing hyperinflation, seigniorage if often the governments chief source of revenue 4..4 Inflation and Interest Rates Two Interest Rates: Real and Nominal  Nominal interest rate: interest rate that the bank pays  Real interest rate: the increase in your purchasing power  The real interest rate is the difference between nominal interest rate and the rate of inflation  Nominal interest rate can change for two reasons o Because the real interest changes o The inflation rate changes  According to the quantity theory, an increase in the rate of money growth of 1% cause a 1% increase in inflation  According to Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rate  The one-for-one relationship between the inflation rate and the nominal interest rate is called the Fisher effect Two Real interest rates: Ex Ante and Ex Post  Real interest rate that the borrower and lender expect when the loan is made: ex ante real interest rate  Real interest rate that is actually realized: ex post real interest rate  Let π denote actual future inflation and Eπ the expectation of future inflation  The ex ante real interest rate is ι- Eπ and the ex post real interest rate is ι- π ι= r + Eπ o The ex ante real interest rate r is determined by the equilibrium in the market for G&S 4.5 The Nominal Interest Rate and the Demand for Money The Cost of Holding Money  Nominal interest rate is the opportunity cost of holding money: it is what you give up by holding money rather than bonds  Cost of holding money is r- (-Eπ)  Demand for real money balances depends both on the level of income and the nominal interest rate Future Money and Current Prices  M/P= L(r+ Eπ, Y) o The level of real money balance depends on the expected rate of inflation  If the nominal interest rate and the level out of output are held constant, the price level moves proportionately with the money supply  The general money demand equation implies that the price level depends not just on today’s money supply but also on the money supply expected in the future  The higher nominal interest rate immediately increases the cost of holding money and therefore reduces the demand for real money balances  Higher expected money growth in the future leads to a higher price level today 4.6 The Social Costs of Inflation The Layman’s View and the Classical Response  When inflation slows, firms will increase the prices of their products less each year and, as a result, will give their workers smaller raises  Economic well-being depends on relative prices, not on the overall price level The Costs of Expected Inflation  Inconvenience of reducing money holding is metaphorically called the shoe leather cost of inflation because walking to the bank more often causes one’s shoes to wear out more quickly  High inflation induces firms to change their posted prices more often- menu costs because the higher rate of inflation, the more firms have to print new menus  The higher the rate of inflation, the greater the variability in relative prices  When inflation induces variability in relative prices, it leads to microeconomic inefficiencies in the allocation of resources  Inflation can alter an individuals tax liability, often in ways that lawmakers didn’t intend  One of the central costs of inflation is that it lowers the economy’s accumulation of capital and reduces the standard of living for all future members of future generations  The changing dollar requires that we correct for inflation when comparing dollar figures from different times The Costs of Unexpected Inflation  If inflation turns out to be higher than expected, the debtor wins and the creditor loses because the debtor repays the loan with less valuable dollars  More variable the rate inflation, the greater the uncertainty that both debtors and creditors face  Countries with high average inflation also tend to have inflation rates that change greatly from year to year 4.7 Hyperinflation The Causes of Hyperinflation  Hyperinflations are due to excessive  Begin when the government has inadequate tax revenue to pay for its spending 4.8 Conclusion: the Classical Dichotomy  All variables measured in physical units, such as quantities and relative prices are called real variables  Nominal variables: variables expressed in terms of money  Theoretical separation of real and nominal variables: classical dichotomy  Changes in the money supply do not influence real variables o Irrelevance of money for real variables is called monetary neutrality 9/14/2012 12:46:00 PM The Open Economy 5.1 International Flow of Capital and Goods  key macroeconomic difference between open and closed economies: in open economy a country’s spending in any given year doesn’t need to equal its output of G&S The Role of Net Exports  Divide expenditure on open economy’s output Y into o Cd: consumption of domestic goods and services o Id: investment in domestic G&S o Gd: government purchases of domestic G&S o X: exports of domestic G&S  The sum of domestic spending on foreign goods and services= Cf+If+Gf National Accounts Identity: Y=C+I+G+NX (where NX=X-IM)  If output exceeds domestic spending, we export the difference: net exports are positive  If export falls short of domestic spending, we import the difference: net exports are negative Net Foreign Investment and the Trade Balance  Net exports=trade balance o Tells us how our trade in G&S departs from the benchmark of equal imports and exports  Net capital outflow: the amount that domestic residents are lending abroad minus the amount that foreigners are lending to us  If S-I and NX are positive trade surplus o We are net lenders in the world financial markets; exporting more than importing  S-I and NX negative trade deficit o Borrowers in the world financial markets  If equal exactly 0 balanced trade  International flow of finance capital accumulation and the international flow of G&S are two sides of the same coin  If I>S, the extra investment must be financed by borrowing from abroad 5.2 Saving and Investment in a Small Open Economy Capital Mobility and the World Interest Rate  Perfect capital mobility: residents of the country have full access to the world financial markets  Interest rate in our small open economy, r, must equal the world interest rate r* plus the risk premium,# r=r*+#  The interest rate differential involves many short run variations  Result of the fact that it takes some time for international lenders to react to yield differentials  In the longer run we assume: r=r* o Small open economy takes its interest rate as given by the world real interest rate The Model  The economy’s output Y is fixed by the factors of production Y=F(K,L) where K is constant  Consumption C is positively related to disposable income Y-T C=C(Y-T)  Investment I is negatively related to the real interest rate r I=I(r)  Because saving depends on fiscal policy (lower government purchases G or higher taxes T raise national saving) and investment depends on the world real interest rate r* (high interest rates make some investment projects unprofitable), the trade balance depends on these variables as well  The trade balance is determined by the difference between S and I at r* How Policies Influence the Trade Balance Fiscal Policy at Home  Increase in G reduces national saving because S=Y-C-G  With an unchanged r*, I remains the same  S falls below I and some I must now be financed by borrowing  Tax cut lowers T, raises disposable income (Y-T), stimulates C and reduces national saving  Starting from a balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit Fiscal Policy Abroad  Increase in G purchases reduces world saving and causes the r* to rise  Increase in r* raises the cost of borrowing, reduces I in our small open economy  S now exceeds I and reduction in I also leads to increase in NX which leads to an overall trade surplus at home  Increase in r* due to fiscal expansion abroad leads to a trade surplus Shifts in Investment Demand  Outward shift in the I schedule causes a trade deficit Evaluating Economic Policy  Polices that increase I or decrease S tend to cause a trade deficit and polices that decrease I or increase S tend to cause a trade surplus 5.3 Exchange Rates Nominal and Real Exchange Rates The Nominal Exchange Rate  Relative price of currency of two countries  When people refer to “the exchange rate” between two countries they usually are referring to the nominal exchange The Real Exchange Rate  Relative price of the goods of two countries  Rate at which we can trade goods of one country for the goods of another  Terms of trade  RER= Nominal x Price of domestic good/Price of Foreign Good  If P is domestic price level and P* is foreign, nominal exchange rate e RER= e x (P/P*)  If the RER is high, foreign goods are relatively cheap The RER and the Trade Balance  RER is low: domestic goods relatively cheap and quantity of net exports demanded will be high  RER is high: domestic goods now more expensive relative to foreign goods, domestic buyers now buy more imported good and quantity of net exports demanded will be low NX=NX(RER) The Determinants of the RER  When the RER is lower, domestic goods are less expensive and net exports are greater  Trade balance must equal foreign investment, which in turn equals S-I  S is fixed by the consumption function and fiscal policy, I is fixed by the I function and r*  At the equilibrium RER, the supply of CAD$ available for foreign I balances the demand for dollars by foreigners buying our net exports How Policies Influence RER Fiscal Policy at Home  Government reduces national saving by increasing G purchases  The change in policy shifts the vertical S-I line to the L  Lower supply causes the equilibrium RER to rise and the dollar becomes more valuable  Domestic goods become more expensive which causes exports to fall Fiscal Policy Abroad  Increase in G purchases reduces world saving and increase r*  This reduces domestic I shifts the S-I line to the R, raising the S of CAD$, r falls and the dollar becomes less valuable Shifts in Investment Demand  If investment demand at home increases, increase in investment demanded leads to higher investment  Increase in investment demand causes a trade deficit  Increase in investment demand shifts the vertical S-I line to the L, reducing supply of CAD$ to be invested abroad  When the dollar appreciates, domestic goods become more expensive relative to foreign goods and net exports fall The Effects of Trade Policies  Designed to influence directly the amount of G&S exported or imported  Protecting domestic industries from foreign competition by placing a tax on foreign imports (a tariff) or restricting the amount of G&S that can be imported (a quota)  Protectionist trade policies don’t effect the trade balance  Protectionist polices only lead to an appreciation of the RER  Appreciation offsets the increase in net exports that is directly attributable to the trade restriction  Reduces both the quantity of imports and the quantity of exports The Determinants of the Nominal Exchange Rate  e= RER x (P/P*)  depends on the RER and the price levels in both countries  If P rises, e will fall because the dollar is worth less  P* rises: nominal exchange will increase because the foreign dollar is now worth less, and a domestic dollar will buy more foreign  % Change in e = % Change in RER + % Change in P*- % Change in P  If a country has a high rate of inflation relative to Canada, a Canadian dollar will buy an increasing amount of the foreign currency over time  If a country has a low rate of inflation relative to Canada, a Canadian dollar will buy a decreasing amount of the foreign currency over time The Special Case of Purchasing-Power Parity  Law of one price applied to the international marketplace is called: purchasing power parity o States that: if international arbitrage is possible, then a dollar (or any other currency) must have the same purchasing power in every country  Two important implications: o Changes in S or I don’t influence the real or nominal exchange rate o All changes in the nominal exchange rate result from changes in price levels  The farther the RER drifts from the level predicted by purchasing power parity, the greater the incentive for individuals to engage in international arbitrage of goods 9/14/2012 12:46:00 PM Unemployment  Natural rate of unemployment: average rate of unemployment around which the economy fluctuates 6.1 Job Loss, Job Finding, and the Natural Rate  Every worker is either employed (E) or unemployed (U), the labour force is the sum of both L = E + U  The rate of job separation s and the rate of job finding f determine the rate of unemployment  The number of people finding jobs is fU and the number of people loosing jobs is sE fU= sE  The steady state of unemployment (U/L) depends on the rates of job separation and job finding  Any policy aimed at lowering the natural rate of U must either reduce the rate of job separation or increase the rate of job finding  Any policy that affects the rate of job separation or job finding also changes the rate of U  Two underlying reasons for U: o job search o wage rigidity 6.2 Job Search and Frictional Unemployment  frictional unemployment: U caused by the time it takes workers to search for a job  Sectorial shift: change in the composition of demand among industries or regions  As long as S and D for labour among firms is changing, frictional U is unavoidable  Government programs inadvertently increase the amount of frictional U o E.g. employment insurance (EI): U workers can collect fraction of their wages for a certain period after losing their jobs o By softening the economic hardship of U, EI increases the amount of frictional U and raises the natural rate  Workers now less pressed to search for new E and more likely to turn now less attractive job offers 6.3 Real-Wage Rigidity and Structural U  Wage rigidity: failure of wages to adjust to level at which labour supply equals labour demand  Reduces the rate of job finding and raises the level of U  U resulting from wage rigidity and job rationing is called structural U o Fundamental mismatch between the number of people who want to work and the number of jobs available o Arises because firms fail to reduce wages despite an excess supply of labour Minimum-Wage Laws  Government causes wage rigidity when it prevents wages from falling to equilibrium levels Union and Collective bargaining  Another cause for wage rigidity: monopoly power of unions  Wages of unionized workers are determined by the bargaining between union leaders and firm management  Result is a reduction in the number of workers hired, a lower rate of job finding and an increase in structural U  Conflict between different groups of workers (insiders and outsiders) o Workers already employed by a firm, the insiders try to keep their firm’s wages high Efficiency Wages  High wages make workers more productive  Maintains a healthy work force, reduces labour turnover  The more a firm pays its workers, the greater their incentive to stay with the firm  Decreasing the time and money spent hiring and training new workers  Average quality of a firm’s work force depends on the wage it pays its employees  Improves worker effort  Reduce the problem of moral hazard by paying a high wage o The higher the wage, the greater the cost to the worker of getting fired 6.4 Labour Market Experience: Canada The Duration of U  Incidence is the likelihood that an individual suffers an U spell, and duration is the average length of that spell  Long term U is more likely to be structural U representing a mismatch between the number of jobs available and the number of people who want to work  If the goal is to lower substantially the natural rate of U, policies must aim at the long term U because these people account for a large number of U Variation in the U Rate Across Age Groups and Regions  Younger workers have only recently entered the labour market and they are often uncertain about their career plans  Can hurt the welfare of those same individuals in the long run if unemployment insurance is not reformed Trends in U  Demographics o Because younger workers have higher U rates, this influx of baby boomers into the labour forces increased the average level of U  Sectorial Shifts o Greater the number of sectorial reallocation, the greater the rate of job separation and the higher the level of frictional U  Productivity o Lower productivity means reduced labour D and lower real wages o When productivity changes, workers may only gradually alter the real wages they ask from their employers, making real wages sluggish in response to labour D o D for unskilled workers has fallen relative to the D for skilled workers, probably due to changes in technology  Discouraged workers: want a job, but after an unsuccessful search, have given up looking o Considered out of the labour force 9/14/2012 12:46:00 PM Economic Growth I: Capital Accumulation and Population Growth 7.1 The Accumulation of Capital The Supply and Demand for Goods  Considering the supply and demand for goods we can determine how much output is produced at any given time The Supply of Goods and the Production Function  Based on the production function output depends on the capital stock and the labour force Y= F(K,L)  Production function has constant returns to scale  Allow us to analyze all quantities in the economy relative to the size of the labour force  Size of the economy- doesn’t affect the relationship between output per worker and capital per worker  y=Y/L output per worker  k= K/L  capital per worker  Production function can then be rewritten as: y= f(k) o The slope of this shows how much extra output a worker produces when given an extra unit of capital o As the amount of capital increases, the production function becomes flatter- indicating that the production function exhibits diminishing marginal product The Demand for Goods and the Consumption Function  Output per worker y is divided between consumption per worker c and investment per worker i y= c + i o This is the per worker version of the national accounts  The model assumes that each year people save a fraction s of their income and cons
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