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Chapter 25

Economics 102: Chapter 25

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ECON 102
Robert Gateman

ECON 102: Principles of Macroeconomics Chapter 25 25.1 Two Examples of Recent History Inflation and Interest Rates in Canada:  In the 1990's the Bank of Canada (BOC) implemented a controversial policy to reduce the rate of inflation o Governor Thiessen took over from Band governor John crow in 1994 o Thiessen: high inflation erodes the value of money; thus creating high nominal interest rates  Thiessen argued to reduce inflation the BOC had to reduce the growth rate of the money supply o This would tighten up credit markets conditions and push up interest rates  Short-run: to reduce the growth rate of money will make credit scarcer o Greater scarcity of credit causes nominal and real interest rates to rise o Firms will reduce investments in factories, machines, warehouses etc. o Reductions in expenditure lead to a reduction in real GDP o Firms scale back production as real GDP falls, and unemployment rate increases o Economy enters into a recession; AD curve shifts left (reduction in GDP)  Long-run: unemployment and the recession will put downward pressure on wages o Wages start to increase at a slower rate than before, or perhaps even fall o The rate of inflation falls, and the rate of erosion of money's value falls  Nominal interest rates will be lower than before the policy was initiated  In the long run, changes in the money supply have no long-run effect on real variables, but do have an effect on nominal variables o Real variables: GDP, employment and investment o Nominal variables: price level or the rate of inflation  Changes in the money supply do not change the level of potential output Y* Saving and Growth in Japan:  Japanese economic state in the 1990's was blamed for firms and households saving too much o Saving was also linked to Japan's economic success in during WWII  Short-run: uncertainty leads firms to spend less on investment goods, and households on all goods o AD curve shifts left and real GDP falls  Long-run: after wages and factor prices adjust to recessionary gap, greater saving leads to a larger pool of financial capital o Makes firms' investment projects more profitable o Drives down the price of credit, interest rates and makes it more affordable for firms to invest o More investments by firms leads to a higher level of potential output  National income in the short run is largely demand determined o Changes in demand will lead to changes in output in the same direction o An increase in the desire to save leads to a reduction in national income  In the long run, national income is supply determined ECON 102: Principles of Macroeconomics o Sustained increases in output will be possible only if the level of potential output increases o Position of AD curve has not effect on real GDP in the long-run o Increases in potential output require either more factors of production or technology changes 25.2 Accounting for Changes in GDP  Value of Y* is estimates by the amounts of available factors of production, and estimate of these factors' normal rates of utilization and an estimate of each factor's productivity  When studying long-run trend in GDP, economists focus on changes in Y*  When studying short-run fluctuates, economists focus on the change in the output gap GDP Accounting: The Basic Principle  F: the economy's total available factors such as land, labour and capital  o In reality, different factors cannot be added together as they are measured in different units  F: the total amount of all factors of production that the economy currently possess    Changes in GDP can be decomposed into
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