1. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 1 Chapter 19 What Macroeconomics Is All About

2. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 2 In this chapter you will learn 1. the meaning and importance of the key macroeconomic variables, including national income, unemployment, inflation, interest rates, exchange rates, and trade flows. 2. that most macroeconomic issues are about either long-run trends or short-run fluctuations, and that government policy is relevant for both.

3. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 3 Output and Income This gives nominal national income. With base-period prices, we get real national income. The production of output generates income. To measure total output in dollars, we add up the values of the many different goods produced. 19.1 KEY MACROECONOMIC VARIABLES

4. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 4 Real vs. Nominal: Does it matter? An example: Nominal Values Real Values GDP GDP (bill. of current $'s) (bill. of 1992 $'s) 1982 374.9 544.4 1992 691.2 691.2 % change 84.4% 26.9 % % change p.a. 8.4% 2.7% NOTE: about 70% of the increase in nominal GDP was due to price increases and not growth in real output. MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007

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6. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 6 Real GDP fluctuates around a rising trend: - the trend shows long-run economic growth - the short-run fluctuations show the business cycle APPLYING ECONOMIC CONCEPTS 19-1 The Terminology of Business Cycles

7. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 7 The output gap measures the difference between potential output (denoted Y*) and actual output (denoted Y). Output Gap = Y-Y* When Y > Y*, there is an inflationary gap. When Y < Y*, there is a recessionary gap. Potential output (denoted Y*) is what the economy could produce if all resources were employed at their normal levels of utilization - often called full-employment output MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007

8. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 8 Trough Recession Recovery Peak Potential GDP Time Recessionary Gap Inflationary Gap Peak Actual GDP Real GDP NOTE: GDP and Y are the same quantity for the aggregate economy MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007

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10. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 10 Employment, Unemployment, and the Labour Force Employment: the number of workers (15+) who hold jobs. Unemployment: the number who are not employed but are actively looking for a job. Labour force: the total number of employed + unemployed. The unemployment rate is the number of unemployed expressed as a percentage of the labour force.

11. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 11 Unemployment Rate = Number of people unemployed Number of people in the labour force X 100 frictional unemployment Even when Y = Y*, some unemployment exists: structural unemployment

12. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 12 Employment, Unemployment, the Labour Force Participation Rate and Unemployment Rate: An example - Windsor CMA Second Quarter of 2006 Population (POP): 270,200 (15+) Unemployed (UN): 15,300 Labour force (LF): = E + UN = 163,100 + 15,300 = 178,400 Unemployment rate (UR): UN / LF = 15,300 / 178,400 = 8.58% Employment (E): 163,100 Employment rate (ER): E / POP = 163,100 / 270,200 = 60.36% We can also calculate the following variables of interest (not in text) Participation rate (PR): LF / POP = 178,400 / 270,200 = 66.25% MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007

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14. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 14 A longer history of labour force and employment growth: What happened after the 1950’s? MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007

15. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 15 The unemployment rate when Y=Y* is called: - the natural rate of unemployment (or NAIRU) What is the NAIRU? - some estimates suggest that it is now below 7% Why Does Unemployment Matter? Some unemployment is desirable, as it reflects the time required for workers and firms to “find” each other so that good matches are made. But some unemployment is associated with human hardship, especially for those individuals with skills that are not in high demand by firms.

16. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 16 Does the Unemployment Rate Measure Hardship? Not really. MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007

17. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 17 Productivity Productivity: a measure of output per unit of input - often measured as GDP per worker - or GDP per hour of work Increases in productivity are probably the single largest determinant of long-run increases in material living standards.

18. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 18 Real GDP per worker is measured in thousands of dollars!

19. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 19 Inflation and the Price Level The price level: the average level of all prices in the economy. Inflation: the rate at which the price level is changing. The CPI is based on the price of a typical “consumption basket,” relative to the price in some base year:

20. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 20 An Example MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007 The value of the CPI in January 2006 was 128.8. In January 2007, it was 130.3 (1992 base year) The year-over-year inflation rate can be found by dividing the CPI for 2007 by that for 2006, subtracting 1 and multiplying by 100 — it is 1.2 percent. [(130.3 / 128.8) - 1] x 100 = 1.2% That is, the price level increased by 1.2 percent between January 2006 and January 2007 — an inflation rate of 1.2 percent.

21. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 21 APPLYING ECONOMIC CONCEPTS 19-2 How the CPI Is Constructed Why Inflation Matters The purchasing power of money is negatively related to the price level. Also, because it is hard to forecast accurately, inflation adds to the uncertainties of economic life. Highly variable inflation rates cause great uncertainty. If all financial contracts are written to incorporate a fully- anticipated inflation, then inflation will have no real effects. MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007 An unanticipated inflation benefits anyone who has an obligation to pay money, and harms anyone who is entitled to receive money.

22. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 22 In 1970 could you have predicted what inflation would be during the 1980’s? In 1980 could you have predicted what inflation would be during the 1990’s?

23. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 23 Inflation over the longer term CPI Rate of inflation MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111

24. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 24 Your 1980 plan for buying a house based on expected inflation of 10% Year 1 Year 2... Year 10 Monthly earnings $5,000 $5,500 $12,969 (increases with inflation) Mortgage payment (15%) $3,200 $3,200 $ 3,200 (fixed in nominal terms) Other expenditures $1,800 $2,300 $ 9,769 (increases with inflation) Real value of other expend. $1,800 $2,091 $ 3,766 Value of your house $250,000 $275,000 $648,435 (increases with inflation) GREAT PLAN! MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111

25. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 25 What actually happens when inflation turns out to be 2% instead of your predicted 10% Year 1 Year 2... Year 10 Monthly earnings $5,000 $5,100 $6,095 (increases with inflation) Mortgage payment (15%) $3,200 $3,200 $3,200 (fixed in nominal terms) Other expenditures $1,800 $1,900 $2,895 (increases with inflation) Real value of other expend. $1,800 $1,863 $2,375 Value of your house $250,000 $255,000 $304,749 (increases with inflation) NOT SO GREAT OUTCOME! MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111

26. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 26 Interest Rates The interest rate is the price of borrowing funds — the percentage amount per period. The burden of borrowing depends on the real interest rate. Nominal interest rate: the rate expressed in money terms. Real interest rate: the rate expressed in terms of purchasing power.

27. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 27 Interest rates vs. the interest rate There are many different interest rates. Each reflects the cost of borrowing in a particular financial market There are numerous financial markets (specific set of borrowers and lenders) Each market is characterize by ‘risk’, ‘liquidity’, ‘term’ of loans, etc. Each gives rise to a unique rate of interest MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111

28. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 28 Examples of interest rates TD - Canada Trust, Jan. 17, 2005 TD charges Prime 4.50% 1 year 'open' mortgage 7.00 1 year 'fixed' mortgage 4.85 10 year 'fixed' mortgage 7.50 Unsecured consumer loan 9.50 Student loans 4.50 (??) VISA 18.50 TD pays 1 yr GIC 2.10 5 yr GIC 3.00 Long term G of C bond 4.75 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111

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30. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 30 The International Economy Exchange rate: the number of Canadian dollars required to purchase one unit of foreign currency. A depreciation of the Canadian dollar means that it is worth less on the foreign-exchange market  a rise in the exchange rate Foreign exchange: foreign currencies or claims on foreign currencies.

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32. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 32 Impact of Changes in the exchange rate : an example Exchange rate 1 US $ = 1.17 Cdn $'s June 1990 P of a Meal in Windsor $10.00 Cdn P of same meal in Detroit $ 8.00 US P of Detroit meal for Windsorite $9.36 in Cdn $’s ($8.00 US x 1.17 = $9.36 Cdn) Now what if the exchange increases (Canadian dollar depreciates) to 1 US $ = 1.65 Cdn $'s as it did by Jan. 2003 P of Detroit meal for Windsorite $13.20 in Cdn $’s ($8.00 US x 1.65 = $13.20 Cdn) What is your prediction about Windsorites dining out in Detroit? MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111

33. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 33 From the Detroiter’s perspective Exchange rate 1 US $ = 1.17 Cdn $'s P of a Meal in Windsor $10.00 Cdn P of same meal in Detroit $ 8.00 US P of Windsor meal for a Detroiter $8.50 US ($10.00 Cdn x 0.85 = $8.50 US) Recall an exchange rate of 1 US $ = 1.17 Cdn $'s implies an exchange rate of 1Cdn $ = 0.85 US $'s Now what if the exchange rate increases (Canadain dollar depreciates) to 1 US $ = 1.65 Cdn $'s as it did by Jan. 2003 P of Windsor meal for a Detroiter $6.10 US ($10.00 Cdn x 0.61 = $6.10 US) What is your prediction about Detroiters eating in Windsor? MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111

34. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 34 NOTE: as of January 2007 the situation has reversed (the Canadian dollar has appreciated) Exchange rate 1 US $ = 1.18 Cdn $'s or 1Cdn $ = 0.85 US $'s The situation has reverted to what it was in June 1990. Why are the Erie Street restaurants, Casino Windsor and the local manufacturing industry doing so poorly? Work out the numbers. Why are you shopping in Detroit again! MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111

35. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 35 The balance of payments accounts record all payments made in international transactions — goods, services, and assets. - trade balance - current account balance - capital account balance For Canada, exports and imports are both very large — roughly 40% of GDP — but the trade balance is usually small.

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37. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 37 19.2 GROWTH VERSUS FLUCTUATIONS Long-Term Economic Growth Long-term growth is considerably more important for a society’s living standards from decade to decade than short- term fluctuations. There is considerable debate regarding the ability of government to influence the economy’s long-run growth rate.

38. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 38 Long-term growth and increases in productivity We will see that one of the most important determinants of long-term growth is increased productivity One measure of productivity is output per person hour Output per person hour is determined by many factors (capital, technology, regulations, etc.) MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111

39. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 39 Why Productivity Growth Matters Annual growth Change in ouput Number of yrs rate in pph after 40 yrs req'd to double productivity (1 working life) output pph 1.0% 49% 70 yrs 1.5% 81% 47 yrs 2.0% 121% 35 yrs 2.5% 168% 28 yrs 3.0% 226% 23 yrs MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111

40. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 40 Short-term fluctuations are often called business cycles. Economists debate the effectiveness of monetary and fiscal policy in influencing these fluctuations. Some economists argue that despite the power of policy to affect the economy, governments should not attempt “fine- tuning.” Short-Term Fluctuations

41. of 42 Copyright © 2008 Pearson Education Canada 05/09/07 41 To organize our thinking about macroeconomics, we must develop some tools. These will include: discussing the measurement of national income building a simple model of the economy modifying the model to make it more realistic using our model to analyze some pertinent economic issues What Lies Ahead?

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