Chapter 4

4.1 Key Macroeconomic Variables

• how the key macroeconomic variables are measured

• introduce several important macroeconomic variables

Output and Income

• national product or output

  • a nation’s overall level of economic activity is the value of its total production of goods and services

• One of the most important ideas in economics is that the production of goods and services generates income.

• all of the economic value that is produced ultimately belongs to someone in the form of an income claim on that value.

  • For example, if a firm produces ice cream that sells for $100, that $100 becomes income for the firm’s workers, the firm’s suppliers of material inputs, and the firm’s owners. T

  • he value of national product is by definition equal to the value of national income.

• national income to refer to both the value of total output and the value of the income claims generated by the production of that output.

• Nominal National Income

  • Total national income measured in current dollars. Also called current-dollar national income

  • A change in nominal national income can be caused by a change in either the physical quantities or the prices at which they are sold.

  • Nominal national income is often referred to as current-dollar national income. 

• To determine the extent to which any change in national income is due to quantities or to prices, economists calculate real national income.

  • This measures the value of individual outputs, not at current prices, but at a set of prices that prevailed in some base period.

  • Real national income is often called constant-dollar national income

  • Since prices are held constant when computing real national income, changes in real national income from one year to another reflect only changes in quantities.

• gross domestic product (GDP).

  • GDP can be measured in either real or nominal terms; we focus here on real GDP.

• The business cycle refers to this continual ebb and flow of business activity that occurs around the long-term trend. 

• By using a common set of base-period prices, real GDP allows us to compare the quantity of goods and services produced over different years without the distortion of inflation or deflation.

• It helps in understanding the true growth of an economy by focusing on the actual increase in production.

  • For example, a single cycle will usually include an interval of quickly growing output, followed by an interval of slowly growing or even falling output

The Terminology of Business Cycles

• A trough is characterized by unemployed resources and a level of output that is low in relation to the economy’s capacity to produce.

• The process of recovery moves the economy out of a trough.

  • The characteristics of a recovery are many: run-down or obsolete equipment is replaced; employment, income, and consumer spending all begin to rise; and expectations become more favorable.

• Eventually the recovery comes to a peak at the top of the cycle

  • At the peak, existing capacity is used to a high degree; labor shortages may develop, particularly in categories of key skills, and shortages of essential raw materials are likely. As shortages develop, costs begin to rise, but because prices rise also, business remains profitable.

• Peaks are eventually followed by slowdowns in economic activity. Sometimes this is just a slowing of the increase in income, while at other times the slowdown turns into a recession. 

  • A recession, or contraction, is a downturn in economic activity. Common usage defines a recession as a fall in real GDP for two successive quarters.

• As output falls, so do employment and household incomes. 

• These terms are non-technical but descriptive: The entire falling half of the business cycle is often called a slump, and the entire rising half is often called a boom.

Potential Output and the Output Gap

• Potential output is the level of output the economy would produce if all resources—land, labor, and capital—were fully employed

  • The value of potential output must be estimated using statistical techniques, whereas the value of actual output can be measured directly

  • The output gap measures 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 being produced because the economy’s resources are not fully employed potential output.

    • 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.

    • When Y exceeds Y* there is often upward pressure on wages and prices, and thus we say the output gap is an Inflationary gap

• Potential and actual GDP both display an upward trend.

Why National Income Matters

• When actual GDP exceeds potential GDP, inflationary pressure usually ensues, causing concern for any government committed to keeping inflation low.

• When income per person grows, each generation can expect, on average, to be better off than preceding ones.

• the benefits of growth are never shared equally by all members of the population.

• For example, if growth involves significant changes in the structure of the economy, such as a shift away from agriculture and toward manufacturing), or away from manufacturing and toward services, then these changes will reduce some people’s material living standards for extended periods of time.

Employment, Unemployment, and the Labour Force

• Employment denotes the number of adults (defined in Canada as persons aged 15 and over) who have jobs, including those who are self-employed.

• Unemployment denotes the number of adults 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 unemloyment rate is the number of unemployed people expressed as a fraction of the labour force:

Frictional, Structural, and Cyclical Unemployment

• When the economy is at potential GDP, economists say there is full employment.

• For two reasons there will still be some unemployment even when the economy is at potential GDP.

  • frictional unemployment: constant turnover of individuals in given jobs and a constant change in job opportunities. New people enter the workforce; some people quit their jobs; others are fired. It may take some time for these people to find new jobs. 

  • structural unemployment: the economy is constantly adapting to shocks of various kinds, at any moment there will always be some mismatch between the characteristics of the people seeking employment and the characteristics of the available jobs. The mismatch may occur, for example, because labour does not currently have the skills that are in demand or because labour is not in the region of the country where the demand is located. 

    • There is always some frictional unemployment due to natural turnover in the labour market, and some structural unemployment due to mismatch between jobs and workers. As a result, some unemployment exists even when the economy is at “full employment. Full employment is said to occur when the only unemployment is frictional and structural.

  • cyclical unemployment: When actual GDP does not equal potential GDP, the economy is not at full employment. In these situations there is some cyclical unemployment. Cyclical unemployment rises and falls with the ebb and flow of the business cycle.

• Unemployment also has seasonal fluctuations. For example, people employed in the fishing industry often are unemployed during the winter, and ski instructors may be unemployed in the summer.

Productivity

• Productivity is a measure of the amount of output that the economy produces per unit of input: Labor productivity which is the amount of real GDP produced per unit of labour employed

  • The amount of labour employed can be measured either as the total number of employed workers or by the total number of hours worked.

• The higher productivity for today’s workers explains why their real incomes (the purchasing power of their earnings) are so much higher than for workers in the past.

Inflation and the Price Level

• Price level: refers to the average level of all prices in the economy and is given by the symbol P

• the rate of inflation: the rate at which the price level is rising.

• price index: averages the prices of various goods and services according to how important they are

  • The best-known price index in Canada is the Consumer Price index (CPI) which measures the average price of the goods and services bought by the typical Canadian household

  • price index is a pure number it does not have any units.

    • the units (dollars) are eliminated because the price index shows the price of a basket of goods at some specific time relative to the price of the same basket of goods in some base period

    • My understanding: Price index is set at 100 + the percentage (index value of 100)

• a price index, such as the CPI, also allows us to measure the rate of inflation

• 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:

• value of the CPI for each year.

  • Survey the consumption behavior of consumers.

  • Calculate the cost of the goods and services purchased by the average consumer in the year in which the original survey was done. Define this as the base period of the index.

  • Calculate the cost of purchasing the same bundle of goods and services in other years.

  • Divide the result of Step 3 (in each year) by the result of Step 2, and multiply by 100.

Why Inflation Matters

• The terms purchasing power of money and real value of money refer to the amount of goods and services that can be purchased with a given amount of money.

Interest Rates

• The interest rate is the price that is paid to borrow money for a stated period of time. Expressed in percentage.

• Interest rates and loans are based on risk

• The real interest rate measures the return on a loan in terms of purchasing power.

Interest Rates and “Credit Flows”

• Credit is essential to the healthy functioning of a modern economy. 

Exchange Rates and Trade Flows

• The exchange rate is the number of Canadian dollars required to purchase one unit of foreign currency

• Depreciation

  • A rise in the exchange rate means that it takes more Canadian dollars to purchase one unit of foreign currency

• Appreciation

  • a fall in the exchange rate means that it takes fewer Canadian dollars to purchase one unit of foreign currency

Long-Term Economic Growth

• Some economists believe that a policy designed to keep inflation low and stable will contribute to the economy’s growth. Some, however, believe there are dangers from having inflation too low—that a moderate inflation rate is more conducive to growth than a very low inflation rate.

Short-Term Fluctuations

•  Most economists agree that the increase in inflation in the 1970s and early 1980s was related to monetary policy, though they also agree that other events were partly responsible

  

Macroeconomics

• Price and Quantity from micro become General Price Level P and National Income/National product Y.

• Major issues:

  • Business cycles: fluctuation of Y in medium term

  • Growth of Y: trend in Y long term

Macro issues (YUPie variables)

• Output and input = Y

  • The value of production belongs to someone

  • By definition, national product = national income

  • Output generates income

• National Income explains the key concepts used to measure a country's economic activity:

  • Final market value: Do not count intermediate goods to avoid double counting. Ex. Do not count the flour, butter, and chocolate that goes into cookies, just the cookies. Also, these goods are final and not for resale.

  • Market value: supply and demand determines the value/worth

  • All of goods and services - The measurement includes everything produced in an economy, covering both tangible goods (e.g., cars, clothes) and intangible services (e.g., education, healthcare).

  • Produced IN the economy - Must be produced in the economy to include in national income

  • During a defined period of time, usually fiscal (12 month period) year - if made in the year, it goes into GDP but if not, it does not go in.

• Monetary and fiscal policy help steer the economy in the right direction

  • Monetary policy: stabilization. Adjusts interest rates and money supply to control inflation, stabilize employment, and promote growth.

  • Fiscal policy: Influence. Uses government spending and taxation to influence the economy.

• Unemployment = U

• Inflation =  P 

  • Inflation is directly related to growth in Y

• YUPie : Primary, Secondary, Tertairy (more of a supporting factor)

  • Y: output. Runs the economy.

  • U: unemployment and P: inflation.  Can provide signals but tends to fluctuate and it is simply a consequence of economic activity.

  • i: interest rates. Interest rates are a tool not a goal and not directly control GDP or Unemployment.

  • E: exchange rates. Affect competitiveness but not directly control GDP or Unemployment.

Circular flow diagram

• Flow of factors

  • K(capital), L(land) , N(labour), T(taxes, leakage), and E(exports, injections)

• Flow of income

  • Money paid in exchange for resources

  • Ex. Wages (for labour), rent (for land)

• Flow of expenditures

  • Money spent by households on goods and services

  • CIGnetX: consumption, investment, government spending, net (X) exports.

• Flow of outputs

  • Production of goods and services by businesses

  • Total value of GDP

• GDP ( Y )

  • W (wages and salaries) + R (economic rent) + I (interest) + P (profits)

  • Flow of income

  • Return to factors of production

• GDP ( E )

  • C (consumption) + I (investment) + G (gov't expenditures) + NetX

  • Flow of expenditures

  • Return to flow of output

• Y =

  • National income

  • National expenditure

  • National output

  • National production

  • GDP

Real vs Nominal Values

• Nominal: Actual, current, money, change in P and/or change in Q

• Real: Constant dollar, only change in Q, holding P constant to base year values

  • Real = nominal/price (purchasing power, how much you can actually buy with your money)

  • Y is always real unless stated otherwise

Output gaps

• Potential income = income = income at full employment

• Maximum real output if all inputs are used at their normal utilization rate

• Output gap:

  • Actual output - potential output

    • Recessionary gap: Actual output - potential output = Negative (economy is at less than its potential

    • Inflationary gap: Actual output - potential output = Positive (economy at more than potential)

• Business Cycle

  • There are slumps and booms, more commonly known as contraction, expansion, peaks, and troughs.

  • Recession: 2 quarters of negative growth

  • Depression: persistent low growth, high unemployment.

• Unemployment: U

  • National income Y and unemployment U are related

    • As Y increases, either U falls in the short run or productivity rises in the long run.

  • Labour force: number of workers, 15 and over who are willing and able to work, who are both unemployed and employed

  • Employment: number of workers, 15 and over who have ANY job.

    • Employment rate: employment/working age population, includes discouraged workers. (calculating in the POPULATION, employment to population.)

  • Unemployment (U): number of workers, 15 and over, willing and able to work but have no job

    • Unemployment rate: unemployment/labour force (calculating in the LABOUR FOURCE)

• Types of unemployment

  • Frictional: unemployment that is unavoidable

  • Structural: mismatch unemployment

  • Cyclical unemployment: recessionary unemployment

  • Full employment: level of employment to produce at potential, only frictional and structural U

  • NAIRU: Non-Accelerating Inflation Rate of Unemployment: lowest level of unemployment that does not cause inflation to rise. Its the natural rate of unemployment

  • Seasonally adjusted unemployment rate: remove the seasonal fluctuations

Productivity

• Productivity: Real output per unit of input (all 5 inputs)

• Labour productivity: real output per unit of labour input, measured as either per worker or per hour worked.

Inflation

• Price level (P): the average prices of all prices in the economy (consumer price index)

• CPI: an index of the weighted average price of all goods and services as a representative basket of goods.

  • Is a cost of living index not an inflation index

  • Adjusts for quality changes over time

  • Adjust for consumption pattern changes

• How to construct an index

  • Determine the goods in the index

  • Determine base year: price in the base year * quantity in the base year

  • Find current year: Price in the current year * quantity in the Base year

  • Index: Ration Current year value / Base year value

    • If index = 120, prices have risen 20%

  • Inflation = P Up (PUP)

  • Inflation rate = % change in P

  • Purchasing power = number of goods that can be purchased per dollar

• Inflation matters because:

  • it diminishes the purchasing power of money

  • Also reduces the real value of any fixed asset

  • Distorts the price signal and market mechanism

• Only unanticipated inflation seems to have effects macro.

• How to construct an index

  • Determine the goods in the index

  • Determine base year: price base year * quantity base year

  • Find current year: Price current year * Quantity Base year

  • Index: Ration Current year / Base year

Interest rates (i)

• Interest rate is the cost of borrowing money

• The average (mean) of all the interest rates = The mean of all i-rates

  • Prime rate: the charted bank charges their best most preferred customers, typically lower

  • Bank rate: rate bank of Canada charges charted bank

  • Nominal interest rate: current cost of borrowing

  • Real rate of interest: nominal i-rate corrected for changes in purchasing power

    • Real i-rate = nominal i-rate - inflation rate

    • Real cost of borrowing depends on the real interest rate

• Why interest rates matter

  • Credit is necessary for an economy

  • Interest rates affect borrowers and lenders

  • i-rates affect the cost of investment = engine of growth

• Exchange rates = e

  • Foreign exchange: actual foreign currency

  • Foreign exchange market: market for foreign exchange

• External value (ev): price of domestic currency

• Exchange rate (e or ER): Price of foreign currency

• Appreciation: rise in ev, fall in the exchange rate

• Depreciation: fall in ev, rise in the exchange rate 

The balance of payments

• BOP: summary of record of country's transaction with the rest of the world. Is the full economic relationhip with the world, inluding trade + investment, always balances out

• BOT: (X-M)=netX=NX , can have a surplus or deficit

Growth and fluctuation

• Long term economic growth

  • Growth is the trend in national income in long run

  • Measured as total output or output per capita, shows how much overall economic production is growing

  • Output per person is a proxy for standard of living ?

  • How can affect growth fiscal and monetary Policy ?

• Short term business cycles

  • Business cycles are the cycles of Y in the short run

  • The study of business cycles is simplified by assuming growth is constant (study of change in y around Y* in the short run)

  • Study of economuc growth ignores these fluctuations (study of Y* in the long run)

  • How does G policy affect business cycle?