Econ 102 Summary

4.1 Key Macroeconomic Variables

LO 1

• The value of the total production of goods and services in a country is called its national product. Because production of output generates income in the form of claims on that output, the total is also referred to as national income. One of the most commonly used measures of national income is gross domestic product (GDP).

  • Potential output is the level of output produced when factors of production are fully employed. The output gap is the difference between actual and potential output.

  • The unemployment rate is the percentage of the labour force not employed and actively searching for a job. The unemployment rate fluctuates considerably from year to year. Unemployment imposes serious costs in the form of economic waste and human suffering.

  • Labour productivity is measured as real GDP per employed worker (or per hour of work). It is an important determinant of material living standards.

  • The price level is measured by a price index, which measures the cost of purchasing a set of goods in one year relative to the cost of the same goods in a base year. The inflation rate measures the rate of change of the price level.

  • The interest rate is the price that is paid to borrow money for a stated period and is expressed as a percentage amount per dollar borrowed. The nominal interest r

• The exchange rate is the number of Canadian dollars needed to purchase one unit of foreign currency. A rise in the exchange rate is a depreciation of the Canadian dollar; a fall in the exchange rate is an appreciation of the Canadian dollar.

4.2 Growth Versus Fluctuations

LO 2

• Most macroeconomic variables have both long-run trends and short-run fluctuations. The sources of the two types of movements are different.

  • Important questions for macroeconomics involve the role of policy in influencing long-run growth as well as short-run fluctuations.

5.1 National Output and Value Added

LO 1

• Each firm’s contribution to total output is equal to its value added, which is the value of the firm’s output minus the values of all intermediate goods and services that it uses. The sum of all the values added produced in an economy is the economy’s total output, which is called gross domestic product (GDP).

5.2 National Income Accounting: The Basics

LO 2

• Based on the circular flow of income, there are two commonly used ways to compute national income. One is to add up total expenditure on domestic output. The other is to add up the total income generated by domestic production. By standard accounting conventions, these two aggregations define the same total.

• From the expenditure side of the national accounts,

GDP=Ca+Ia+Ga+(Xa−IMa)

• where Ca comprises consumption expenditures of businesses and households. Ia is investment in inventory accumulation, plant and equipment, and new residential construction. Ga is government purchases of goods and services. (Xa–IMa) represents net exports of goods and services.

• From the income side of the national accounts,

GDP=wages and salaries+interest and profits+depreciation+(indirect taxes−subsidies).

5.3 National Income Accounting: Some Further Issues

LO 3, 4, 5

• Real measures of national income reflect changes in real quanti

6.1 Desired Aggregate Expenditure

LO 1, 2

• Desired aggregate expenditure (AE) is equal to desired consumption plus desired investment plus desired government purchases plus desired net exports. It is the amount that economic agents want to spend on purchasing domestic output.

AE=C+I+G+(X-IM)

• The relationship between disposable income and desired consumption is called the consumption function. The constant term in the consumption function is autonomous expenditure. The part of consumption that responds to income is called induced expenditure.

• A change in disposable income leads to a change in desired consumption and desired saving. The responsiveness of these changes is measured by the marginal propensity to consume (MPC) and the marginal propensity to save (MPS), both of which are positive and sum to 1, indicating that all disposable income is either consumed or saved.

• Changes in wealth, interest rates, or expectations about the future lead to a change in autonomous consumption. As a result, the consumption function shifts.

• Firms’ desired investment depends on real interest rates, changes in sales, and business confidence. In our simplest model of the economy, investment is treated as autonomous with respect to changes in national income.

6.2 Equilibrium National Income

LO 3

• Equiilibrium national income is defined as that level of national income at which desired aggregate expenditure equals actual national income, AE=Y.

• At incomes above equilibrium, desired expenditure is less than national income. In this case, inventories accumulate and firms will eventually reduce output. At incomes below equilibrium, desired expenditure exceeds national income. In this case, inventories are depleted and firms will eventually increase output.

• Equilibrium national income is represented graphically by the point at which the aggregate expenditure (AE) curve cuts the 45° line—that is, where desired aggregate expenditure equals actual national income.

6.3 Changes in Equilibrium National Income

LO 4

• Equilibrium national income is increased by a rise in either autonomous consumption or autonomous investment expenditure. Equilibrium national income is reduced by a fall in these desired expenditures.

• The magnitude of the effect on national income of shifts in autonomous expenditure is given by the multiplier. It is defined as ∆Y/∆A, where ∆A is the change in autonomous expenditure.

• The simple multiplier is the multiplier when the price level is assumed to be constant. The simple multiplier = ∆Y/∆A=1/(1-z), where z is the marginal propensity to spend out of national income. The larger is z, the larger is the simple multiplier.

• Expectations play an important role in the determination of national income. Optimism can lead households and firms to increase desired expenditure, which, through the multiplier process, leads to increases in national income. Pessimism can similarly lead to decreases in desired expenditure and national income.

7.1 Introducing Government

LO 1

• Desired government purchases, G, are assumed to be part of autonomous aggregate expenditure. Taxes minus transfer payments are called net taxes and affect aggregate expenditure indirectly through households’ disposable income.

• The budget balance is defined as net tax revenues minus government purchases, (T-G). When (T-G) is positive, there is a budget surplus; when (T-G) is negative, there is a budget deficit.

7.2 Introducing Foreign Trade

LO 2

• Exports are foreign purchases of Canadian goods, and do not depend on Canadian national income. Desired imports are assumed to increase as national income increases. Hence, net exports decrease as national income increases.

  • Changes in international relative prices lead to shifts in the net export function. A depreciation of the Canadian dollar makes Canadian goods cheaper relative to foreign goods. This leads to a rise in exports and a fall in imports, shifting the net export function up. An appreciation of the Canadian dollar has the opposite effect.

7.3 Equilibrium National Income

LO 3

• As in Chapter 6, national income is in equilibrium when desired aggregate expenditure equals actual national income. The equilibrium condition is

Y=AE, where AE=C+I+G+X-IM

• The slope of the AE function in the model with government and foreign trade is z=MPC(1-t)-m, where MPC is the marginal propensity to consume out of disposable income, t is the net tax rate, and m is the marginal propensity to import.

7.4 Changes in Equilibrium National Income

LO 4, 5

• The presence of taxes and net exports reduces the value of the simple multiplier. With taxes and imports, every increase in national income induces less new spending than in a model with no taxes or imports.

  • An increase in government purchases shifts up the AE function and thus increases the equilibrium level of national income. A decrease in the net tax rate makes the AE function rotate upward and increases the equilibrium level of national income.

  • An increase in exports can be caused by an increase in foreign demand for Canadian goods, a fall in the Canadian price level, or a depreciation of the Canadian dollar. An increase in exports shifts the AE function up and increases the equilibrium level of national income.

7.5 Demand-Determined Output

LO 6

• Our simple model of national income determination is constructed for a given price level. That prices are assumed not to change in response to an increase in desired expenditure reflects a related assumption that output is demand determined.

  • Output may be demand determined in two situations: if there are unemployed resources or if firms are price setters.

8.1 The Demand Side of the Economy

LO 1, 2

• The AE curve shows desired aggregate expenditure for each level of GDP at a particular price level. Its intersection with the 45° line determines equilibrium GDP for that price level. Equilibrium GDP thus occurs where desired aggregate expenditure equals actual GDP.

• A change in the price level leads to two effects on aggregate expenditure:

1. By changing wealth it changes desired consumption

2. By changing international relative prices it changes desired net exports

• A rise in the price level shifts the AE curve down and reduces equilibrium GDP; a fall in the price level shifts the AE curve up and increases equilibrium GDP.

  • The AD curve plots the equilibrium level of GDP that corresponds to each possible price level. A change in equilibrium GDP following a change in the price level is shown by a movement along the AD curve.

  • The AD curve shifts horizontally when any element of autonomous expenditure changes, and the simple multiplier measures the size of the shift.

8.2 The Supply Side of the Economy

LO 3

• Any AS curve is drawn for given factor prices and a given state of technology.

  • The AS curve is usually drawn as an upward-sloping curve, reflecting the assumption that firms’ unit costs tend to rise when their output rises.

  • At low levels of output, firms’ excess capacity may result in a horizontal AS curve.

  • An improvement in technology or a decrease in factor prices shifts the AS curve to the right. This is an increase in aggregate supply.

  • A deterioration in technology or an increase in factor prices shifts the AS curve to the left. This is a decrease in aggregate supply.

8.3 Macroeconomic Equilibrium

LO 4

• Macroeconomic equilibrium refers to equilibrium values of real GDP and the price level, as determined by the intersection of the AD and AS curves. Shifts in the AD and AS curves, called aggregate demand and aggregate supply shocks, change the equilibrium values of real GDP and the price level.

  • When the AS curve is positively sloped, an aggregate demand shock causes the price level and real GDP to move in the same direction. When the AS curve is flat, shifts in the AD curve primarily affect real GDP. When the AS curve is steep, shifts in the AD curve primarily affect the price level.

  • With a positively sloped AS curve, a demand shock leads to a change in the price level. As a result, the multiplier is smaller than the simple multiplier in Chapter 7.

  • An aggregate supply shock moves equilibrium GDP along the AD curve, causing the price level and real GDP to move in opposite directions.

  • Some events are both aggregate supply and aggregate demand shocks. Changes in the world prices of raw materials, for example, shift the AS curve. If the country (like Canada) is also a producer of such raw materials, there will also be a shift in the AD curve. The overall effect then depends on the relative sizes of the separate effects.

9.1 Three Macroeconomic States

LO 1

• The short run in macroeconomics assumes that factor prices are exogenous and technology and factor supplies are constant.

  • During the adjustment process, factor prices respond to output gaps; technology and factor supplies are assumed to be constant.

  • In the long run, factor prices are assumed to have fully adjusted to output gaps; technology and factor supplies are assumed to change.

9.2 The Adjustment Process

LO 2, 3

• Potential output, Y*, is the level of real GDP at which all factors of production are fully employed.

• The output gap is the difference between potential output and the actual level of real GDP, the latter determined by the intersection of the AD and AS curves.

• An inflationary gap means that Y is greater than Y*, and there is excess demand in factor markets. Wages and other factor prices rise, causing firms’ unit costs to rise. The AS curve shifts upward, and the price level rises.

• A recessionary gap means that Y is less than Y*, and there is excess supply in factor markets. Wages and other factor prices fall but perhaps very slowly. As firms’ unit costs fall, the AS curve gradually shifts downward, eventually returning output to potential.

• In our macro model,the level of potential output, Y*, acts as an “anchor” for the economy. Given the short-run equilibrium as determined by the AD and AS curves, wages and other factor prices will adjust, shifting the AS curve, until output returns to Y*.

9.3 Aggregate Demand and Supply Shocks

LO 4

• Beginning from a position of potential output, a positive demand shock creates an inflationary gap, causing wages and other factor prices to rise. Firms’ unit costs rise, shifting the AS curve upward and bringing output back toward Y*.

• Beginning from a position of potential output, a negative demand shock creates a recessionary gap. Because factor prices tend to be sticky downward, the adjustment process tends to be slow, and a recessionary gap tends to persist for some time.

• Aggregate supply shocks, such as those caused by changes in the prices of inputs, lead the AS curve to shift, changing real GDP and the price level. The economy’s adjustment process reverses the shift in AS, eventually bringing the economy back to its initial level of output and prices.

• In the short run, macroeconomic equilibrium is determined by the intersection of the AD and AS curves. In the long run, the economy is in equilibrium only when real GDP is equal to potential output. In the long run, the price level is determined by the intersection of the AD curve and the vertical Y* curve.

• Shocks to the AD or AS curves can change real GDP in the short run. For a shock to have long-run effects, the value of Y* must be altered.

9.4 Fiscal Stabilization Policy

LO 5

• In our macro model, fiscal policy can be used to stabilize output at Y*. To remove a recessionary gap, governments can shift AD to the right by cutting taxes or increasing spending. To remove an inflationary gap, governments can adopt the opposite policies.

• In the short run, increases in desired saving on the part of firms, households, and governments lead to reductions in real GDP. This phenomenon is called the paradox of thrift. In the long run, the paradox of thrift does not apply, and increased saving will lead to increased investment and economic growth.

• Because government tax-and-transfer programs tend to reduce the size of the multiplier, they act as automatic stabilizers.

• Discretionary fiscal policy is subject to decision lags and execution lags that limit its ability to take effect quickly.

• Fiscal policy has different effects in the short and long run. In the short run, a fiscal expansion created by an increase in government purchases (G) will increase real GDP. In the long run, the effect on potential output depends on which goods are purchased.

• A fiscal expansion created by a reduction in taxes increases real GDP in the short run. In the long run, if the tax reduction leads to more investment and work effort, there will be a positive effect on potential output.

  11.1 The Nature of Money

  LO 1

  • Money is anything that serves as a medium of exchange, a store of value, and a unit of account.

    • Historically, money arose because of the inconvenience of barter, and it developed in stages: from precious metal to metal coinage, to paper money convertible to precious metals, to token coinage and paper money fractionally backed by precious metals, to fiat money, and to deposit money.

  11.2 The Canadian Banking System

  LO 2

  • The banking system in Canada consists of two main elements: the Bank of Canada (the central bank) and the commercial banks.

    • The Bank of Canada is a government-owned corporation that is responsible for the day-to-day conduct of monetary policy. Though the Bank has considerable autonomy in its policy decisions, ultimate responsibility for monetary policy resides with the government.

    • Commercial banks and other financial institutions play a key role as intermediaries in the credit market.

    • Commercial banks are profit-seeking institutions that allow their customers to transfer deposits from one bank to another by means of cheques or electronic transfer. They create deposit money as a by-product of their commercial operations of making loans and other investments.

11.3 Money Creation by the Banking System

LO 3

• Because most customers rarely require more than a fraction of their bank deposits, banks hold only small reserves to back their deposit liabilities. It is this fractional-reserve aspect of the banking system that enables commercial banks to create deposit money.

• When the banking system receives a new cash deposit, it can create new deposits equal to some multiple of this amount. For a target reserve ratio of v and a cash-deposit ratio of c, the total change in deposits following a new cash deposit is

∆ Deposits=New cash depositc+v

11.4 The Money Supply

LO 4

• The money supply—the stock of money in an economy at a specific moment—can be defined in various ways. M2 includes currency plus demand and notice deposits at the chartered banks. M2+ includes M2 plus deposits at non-bank financial institutions and money-market mutual funds.

• Near money includes interest-earning assets that are convertible into money on a dollar-for-dollar basis but that are not currently a medium of exchange. Money substitutes are things such as credit cards that serve as a medium of exchange but are not money.

12.1 Understanding Bonds

LO 1

• The present value of any bond that promises to pay some sequence of payments in the future is negatively related to the market interest rate. A bond’s present value determines its market price. Thus, there is a negative relationship between the market interest rate and the price of a bond.

  • The yield on a bond is the rate of return the bondholder will receive, having bought the bond at its purchase price and then having received the entire stream of future payments the bond offered. For a given stream of future payments, a lower purchase price implies a higher bond yield.

  • An increase in the perceived riskiness of bonds leads to a reduction in bond prices and thus an increase in bond yields.

12.2 The Theory of Money Demand

LO 2

• In our macro model, households and firms are assumed to divide their financial assets between interest-bearing “bonds” and non-interest-bearing “money.” They hold money to facilitate both expected and unexpected transactions.

  • The opportunity cost of holding money is the interest that would have been earned if bonds had been held instead.

  • Households’ and firms’ desired money holdings are assumed to be influenced by changes in three key macroeconomic variables:

• 1.Increases in the interest rate reduce desired money holdings.

• 2. Increases in real GDP increase desired money holdings.

• 3. Increases in the price level increase desired money holdings.

• These relationships are captured in the MD curve, which is drawn as a negative relationship between interest rates (i) and desired money holding (MD). Increases in real GDP (Y) or the price level (P) lead to a rightward shift of this MD curve.

12.3 How Money Affects Aggregate Demand

LO 3, 4

• In the short run, the interest rate is determined by the interaction of money supply and money demand. Monetary equilibrium is established when the interest rate is such that the quantity of money supplied is equal to the quantity of money demanded.

  • A change in the money supply (coming from the central bank or the commercial banking system) or in the demand for money (coming from a change in Y or P) will lead to a change in the equilibrium interest rate. This is the first stage of the monetary transmission mechanism.

  • The second stage of the monetary transmission mechanism is that any change in the interest rate leads to a change in desired investment and consumption expenditure. In an open economy with capital mobility, the change in the interest rate leads to capital flows, changes in the exchange rate, and changes in net exports.

  • The third stage of the monetary transmission mechanism is that any change in desired investment, consumption, or net exports leads to a shift in the aggregate demand (AD) curve, and thus to a change in real GDP and the price level.

12.4 The Strength of Monetary Forces

LO 5, 6

• Changes in the money supply have different effects on the economy in the short run and in the long run.

• Money is said to be neutral in the long run if a change in the money supply leads to no changes in the long-run level of real GDP (or other real variables).

• In the long run, after wages and other factor prices have fully adjusted to any output gaps, real GDP returns to potential output, Y*. If Y* is unaffected by the change in the money supply, there will be no long-run effect from the monetary shock.

• There is a strong positive correlation between the rate of money growth and the rate of inflation across countries when viewed over the long run.

• In the short run, the effects of a change in the money supply depend on the shape of the MD and ID curves in our macro model. The steeper the MD curve and the flatter the ID curve, the more effective changes in the money supply will be in causing short-run changes in real GDP.

13.1 How the Bank of Canada Implements Monetary Policy

LO 1

• Monetary policy can be conducted either by targeting the money supply or by targeting the interest rate. But for a given negatively sloped MD curve, both cannot be targeted independently.

• Because of its incomplete control over the money supply, as well as the uncertainty regarding both the slope and the position of the MD curve, the Bank chooses to implement its policy by targeting the interest rate.

• The Bank establishes a target for the overnight interest rate. By offering to lend funds at a rate 25 basis points above this target (the bank rate) and to accept deposits on which it pays interest at 25 basis points below the target, the Bank of Canada can control the actual overnight interest rate.

• Changes in the Bank’s target for the overnight rate lead to changes in the actual overnight rate and also to changes in longer-term interest rates. The various steps in the monetary transmission mechanism then come into play.

• The Bank of Canada conducts an expansionary monetary policy by reducing its target for the overnight interest rate. It conducts a contractionary monetary policy by raising its target for the overnight interest rate.

13.2 Inflation Targeting

LO 2, 3

• High inflation is damaging to economies and costly for individuals and firms.

• Experience with attempts to control inflation has led to the understanding that sustained inflation is ultimately determined by monetary policy.

• For these two reasons, many central banks now focus their attention on maintaining a low and stable rate of inflation.

• The Bank of Canada’s formal inflation target is the rate of CPI inflation. It seeks to keep the annual inflation rate close to 2 percent.

• In the short run, the Bank closely monitors the output gap. By tightening its policy during an inflationary gap and loosening it during a recessionary gap, the Bank can keep the rate of inflation near 2 percent.

• The policy of inflation targeting helps to stabilize the economy. The Bank responds to positive shocks with a contractionary policy and responds to negative shocks with an expansionary policy.

• Two technical issues complicate the conduct of monetary policy:

1. Volatile food and energy prices

2. Changes in the exchange rate

13.3 Long and Variable Lags

LO 4

• The Bank of Canada can change interest rates very quickly. However, it takes time for firms and households to alter their expenditure in response to these changes.

  • Once expenditures change, it takes time for the multiplier process to work its way through the economy, eventually affecting equilibrium national income.

  • Long and variable lags in monetary policy lead many economists to argue that the Bank should not try to “fine-tune” the economy by responding to economic shocks. Instead, it should respond only to shocks that are significant in size and persistent in duration.

13.4 Four Decades of Canadian Monetary Policy

LO 5

• In the early 1980s, the Bank of Canada embarked on a policy of tight money to reduce inflation. This policy contributed to the severity of the recession.

  • A sustained economic recovery occurred from 1983 to 1987. The main challenge for monetary policy during this time was to create sufficient liquidity to accommodate the recovery without triggering a return to the high inflation rates that prevailed at the start of the decade.

  • In 1988, when inflation was between 4 and 5 percent, the Bank of Canada announced that monetary policy would henceforth be guided by the long-term goal of “price stability.” By 1992, the Bank’s tight money policy had reduced inflation to below 2 percent.

  • Controversy concerned two issues. First, was the cost in terms of lost output and heavy unemployment worth the benefits of lower inflation? Second, could the low inflation rate be sustained?

  • This controversy was partly responsible for the 1994 change in the Bank of Canada’s governor, from John Crow to Gordon Thiessen. Despite this administrative change, the stated policy of price stability continued. By 2000, the rate of inflation had been around 2 percent for about seven years.

  • Following the stock-market declines in 2000–2001 and the terrorist attacks in the United States in September 2001, the Bank of Canada and the U.S. Federal Reserve dramatically reduced their policy interest rates in an attempt to prevent a recession.

  • In the 2002–2005 period, the main challenges for the Bank involved determining the relative strength of the two different forces leading to a substantial appreciation of the Canadian dollar. By summer of 2006, the Bank had increased its target for the overnight interest rate by two percentage points, to a level still below its previous peak in the summer of 2000.

    14.1 Adding Inflation to the Model

    LO 1, 2

    • Inflation is generally accompanied by growth in wages and other factor prices such that the AS curve is shifting upward. Factors that influence wages can be divided into two main components: output gaps and expectations.

    1. Inflationary output gaps tend to cause wages to rise; recessionary output gaps tend to cause wages to fall, but only slowly.

    2. Expectations of inflation tend to cause wage increases equal to the expected price-level increases. Expectations can be backward-looking, forward-looking, or some combination of the two.

    • With a constant rate of inflation and no supply shocks, expected inflation will eventually come to equal actual inflation. There is no output-gap effect on inflation in this scenario.

    • With real GDP equal to Y*, a constant inflation can occur with the AD and AS curves shifting upward at the same rate.

    14.2 Shocks and Policy Responses

    LO 3, 4

    • The initial effects of a single positive demand shock are a rise in the price level and a rise in real GDP. If the shock is unvalidated, output tends to return to its potential level while the price level rises further (as the AS curve shifts upward). Monetary validation allows demand inflation to proceed without reducing the inflationary gap (AD curve continues to shift upward).

    • The initial effects of a single negative supply shock are a rise in the price level and a fall in real GDP. If inflation is unvalidated, output will slowly move back to its potential level as the price level slowly falls to its pre-shock level (AS curve slowly shifts down). Monetary validation allows supply inflation to continue in spite of a persistent recessionary gap (AD curve shifts up with monetary validation).

    • If the Bank of Canada tries to keep real GDP constant at some level above Y*, the actual inflation rate will eventually accelerate.

    • Aggregate demand and supply shocks have temporary effects on inflation. But sustained inflation is caused by sustained monetary expansion.

      14.3 Reducing Inflation

      LO 5, 6

      • The process of ending a sustained inflation can be divided into three phases.

      1. Phase 1 consists of ending monetary validation and allowing the upward shift in the AS curve to remove any inflationary gap that does exist.

      2. In Phase 2, a recessionary gap develops as expectations of further inflation cause the AS curve to continue to shift upward even after the inflationary gap is removed.

      3. In Phase 3, the economy returns to potential output, sometimes aided by a one-time monetary expansion that raises the AD curve to the level consistent with potential output.

      • The cost of disinflation is the recession that is created in the process. The sacrifice ratio is a measure of this cost and is calculated as the cumulative loss in real GDP (expressed as a percentage of Y*) divided by the reduction in inflation.

  15.1 Employment and Unemployment

  LO 1

  • Canadian employment and the labour force increased steadily throughout the twentieth century. The unemployment rate fluctuates significantly over the course of the business cycle.

  • Looking only at the level of employment or unemployment obscures considerable activity in the labour market as individuals flow from unemployment to employment or from employment to unemployment. Such gross flows reflect the turnover that is a normal part of any labour market.

  • There are three types of unemployment: cyclical unemployment, which is associated with output gaps; frictional unemployment, which is a result of normal labour-market turnover; and structural unemployment, which is caused by the need to reallocate resources among occupations, regions, and industries as the structure of demand and supply changes.

  • Together, frictional and structural unemployment make up the NAIRU. The actual unemployment rate is equal to the NAIRU when real GDP is equal to Y*

    15.2 Unemployment Fluctuations

    LO 2

    • Market-clearing theories assume labour markets clear continuously with perfectly flexible wages and prices. Such theories can explain cyclical variations in employment but predict no involuntary unemployment.

      • Empirical evidence suggests that wages are relatively stable over the business cycle, in contrast to what is predicted by market-clearing theories of the labour market.

      • Non-market-clearing theories of the labour market provide an explanation for involuntary unemployment based on wage stickiness; real wages do not adjust frequently in response to all shocks to labour demand and supply.

      • To explain wage stickiness, non-market-clearing theories have focused on:

    1. the nature of long-term employment relationships

    2. the costs of changing wages and prices

    3. efficiency wages

    4. union bargaining

15.3 What Determines the NAIRU?

LO 3, 4

• The NAIRU will always be positive because it takes time for labour to move between jobs both in normal turnover (frictional unemployment) and in response to changes in the structure of the demand for labour (structural unemployment).

  • Some unemployment is socially and economically desirable. Searching for appropriate job matches allows workers to make the best use of their skills.

  • Anything that increases the rate of turnover in the labour market, or the pace of structural change in the economy, will likely increase the NAIRU.

  • Employment insurance also increases the NAIRU by encouraging workers to spend longer searching for an appropriate job. Policies that mandate job security increase the costs to firms of laying off workers. This makes them reluctant to hire workers in the first place and may increase the NAIRU.

15.4 Reducing Unemployment

LO 5

• Cyclical unemployment can be reduced by using monetary or fiscal policies to close recessionary gaps.

  • Frictional and structural unemployment can be reduced by making it easier to move between jobs and by raising the cost of staying unemployed (e.g., by reducing employment-insurance benefits).

  • In a growing, changing economy populated by people who want to change jobs for many reasons, it is neither possible nor desirable to reduce unemployment to zero.

  • Policies that assist workers in retraining and in moving between jobs, regions, or industries may be the most effective way to deal with the various shocks that buffet the economy.

17.1 The Gains from Trade

LO 1, 2

• Country A has an absolute advantage over Country B in the production of a specific product when the absolute cost of the product is less in Country A than in Country B.

  • Country A has a comparative advantage over Country B in the production of a specific good if the forgone output of other goods is less in Country A than in Country B.

  • Comparative advantage occurs whenever countries have different opportunity costs of producing particular goods. World production of all products can be increased if each country transfers resources into the production of the products for which it has a comparative advantage.

  • International trade allows all countries to obtain the goods for which they do not have a comparative advantage at a lower opportunity cost than if they were to produce all products for themselves; specialization and trade therefore allow all countries to have more of all products than if they tried to be self-sufficient.

  • A nation that engages in trade and specialization may also realize the benefits of economies of large-scale production and of learning by doing.

  • Traditional theories regarded comparative advantage as largely determined by natural resource endowments that are difficult to change. Economists now know that some comparative advantages can be acquired and consequently can be changed. Public policies may, in this view, influence a country’s role in world production and trade.

17.2 The Determination of Trade Patterns

LO 3, 4

• The law of one price says that the national prices of tradable goods (net of taxes and tariffs) must differ by no more than the costs of transporting these goods between countries. After accounting for these transport costs, there is a single world price.

  • Countries will export a good when the world price exceeds the price that would exist in the country if there were no trade. The low no-trade price reflects a low opportunity cost and thus a comparative advantage in that good. Thus, countries export goods for which they have a comparative advantage.

  • Countries will import a good when the world price is less than the price that would exist in the country if there were no trade. The high no-trade price reflects a high opportunity cost and thus a comparative disadvantage in that good. Thus, countries import goods for which they have a comparative disadvantage.

  • The terms of trade refer to the ratio of the prices of exports to the prices of imports. The terms of trade determine the quantity of imports that can be obtained per unit of exports.

  • An improvement in the terms of trade—a rise in export prices relative to import prices—is beneficial for a country because it expands its consumption possibilities.