1. Are Your Smart Choices Smart for All? Macroeconomics & Microeconomics

2. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 2 LEARNING OBJECTIVES 1.1Explain the differences between microeconomics and macroeconomics 1.2Describe the hands-off and hands-on views on government policy and connect each to the fundamental macroeconomic question 1.3Define three key measures of macroeconomic performance, and identify good outcomes for each continued…

3. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 3 1.4Identify five groups of macroeconomic players and their choices 1.5Explain three MAPS for focusing your thinking like a macroeconomist

4. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 4 RECONCILING MACRO AND MICRO: IS THE WHOLE GREATER THAN THE SUM OF THE PARTS? Smart microeconomic choices by individuals may or may not add up to smart macroeconomic outcomes for the economy as a whole. “If left alone, do markets quickly self-adjust?”

5. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 5 RECONCILING MACRO AND MICRO Great Recession (2008 – 2009) Great Depression (1929 – 1933) involved financial bubbles that burst, high unemployment, falling living standards, bankruptcies, and government policy mistakes continued…

6. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 6 Business cycles ups and downs of overall economic activity Macroeconomics analyzes the performance of the whole Canadian economy and global economy — the combined outcomes of all individual microeconomic choices Microeconomics analyzes choices that individuals in households, individual businesses, and governments make, and how those choices interact in markets continued…

7. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 7 Fallacy of composition what is true for one is not true for all; whole is greater than the sum of the parts Paradox of thrift attempts to increase savings cause aggregate savings to decrease due to falling incomes continued…

8. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 8 Fundamental Macroeconomic Question If left alone by government, do the price mechanisms of market economies adjust quickly to maintain steady growth in living standards, full employment, stable prices? or If left alone, do markets quickly self-adjust? “Yes” Say’s Law “supply creates its own demand” “No” Keynes rejected Say’s Law

9. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 9 GOVERNMENT HANDS-OFF OR HANDS-ON? ECONOMICS AND POLITICS The “Yes” and “No” camps disagree on fallacy of composition, causes of business cycles, risk of government failure versus market failure, role for government, and are on different political sides.

10. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 10 The fundamental macroeconomic question: “If left alone by government, do the price mechanisms of market economies adjust quickly to maintain steady growth in living standards, full employment, and stable prices?” – “Yes” answer based on Say’s Law — supply creates its own demand – “No” answer from John Maynard Keynes, founder of macroeconomics in 1930s

11. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 11 COMPARING CAMPS YES — Left Alone, Markets Quickly Self-Adjust – no fallacy of composition so micro = macro – business cycles from external causes or government policy mistakes – government failure worse than market failure – hands-off role for government – political right continued…

12. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 12 NO — Left Alone, Markets Fail to Self-Adjust – fallacy of composition is real, so micro ≠ macro – business cycles from internal causes — coordination failures between input & output markets; money, banks, expectations – market failure worse than government failure – hands-on role for government – political left

13. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 13 Politicians on the right tend to be in “Yes” camp, government as hands-off Politicians on the left tend to be in “No” camp, government as hands-on

14. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 14 DOES THE ECONOMY MEASURE UP? GDP, UNEMPLOYMENT, INFLATION The most important outcomes of the Canadian economy are GDP per person, unemployment, inflation.

15. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 15 MEASURING GDP, UNEMPLOYMENT, INFLATION Gross Domestic Product (GDP) value of all final products and services produced annually in a country Unemployment not employed and actively seeking work Inflation rising average prices and falling value of money

16. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 16 CAN’T TELL PLAYERS WITHOUT A SCORECARD: MACROECONOMIC PLAYERS Five macroeconomic players are consumers, businesses, government, Bank of Canada and the banking system, and rest of the world. Each group has different choices.

17. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 17 Consumer choices – spend income or save – buy Canadian products/services or imports Business choices – investment spending business purchases of new factories and equipment — domestically or importing – hiring workers or not – buying inputs domestically or importing – selling outputs domestically or exporting CHOICES FOR MACROECONOMIC PLAYERS continued…

18. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 18 Government choices – purchases of products/services – taxes and transfer payments – fiscal policy changes in government purchases, taxes/transfers to achieve macroeconomic outcomes Bank of Canada and Banking System choices – monetary policy Bank of Canada changes interest rates and supply of money to achieve macroeconomic outcomes – making loans or not continued…

19. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 19 Rest of World (R.O.W.) choices – buying Canadian exports, selling imports to Canada – investing money in Canada or accepting Canadian investments – demanding Canadian dollars

20. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 20 FOCUSING ON YOUR FUTURE: LIVING STANDARDS, VOTING & MACROECONOMICS Macroeconomics affects your future — GDP per person, unemployment, and inflation. Macroeconomics also informs your vote for politicians and policies influencing economic performance.

21. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 21 SUCCESS, VOTING, AND MAPS Your personal economic success depends on – GDP higher GDP per person = higher living standards – Unemployment affects odds of finding jobs – Inflation reduces living standards if income not rising as fast as prices of what you buy Understanding macroeconomics informs your vote for politicians whose economic policy choices influence economic performance and your economic success continued…

22. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 22 Thinking like a macroeconomist means focusing on targeted targeted connections in the economy 3 MAPS (MAcroeconomic Positioning Systems) for finding targets – MAPS1 focus on the connection between input markets and output markets, for both demand and supply sides continued…

23. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 23 – MAPS2 focus on the connections between Canada and the rest of the world – MAPS3 focus on the connections between money/banks/expectations and the input and output markets of the circular flow

24. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 24 Up Around the Circular Flow GDP, Economic Growth, and Business Cycles

25. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 25 LEARNING OBJECTIVES 2.1Differentiate nominal GDP, real GDP, and real GDP per person, and how each relates to living standards 2.2Explain how economic growth occurs and how it is measured 2.3Describe the language of business cycles, including output gaps as a target for hands-on policymakers continued…

26. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 26 2.4Explain how value added and the equality of aggregate spending and aggregate income allow us to measure GDP 2.5Identify five limitations of real GDP per person as a measure of well-being

27. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 27 HIGHER PRICES, MORE STUFF, OR BOTH? NOMINAL GDP AND REAL GDP GDP measures value final products/services produced annually; nominal GDP combines changes in prices & quantities; real GDP measures only changes in quantities; real GDP per person best measure of material standard of living.

28. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 28 NOMINAL GDP AND REAL GDP Nominal GDP value at current prices of all final products/services produced annually in a country Differences in nominal GDP between years due to either price changes or quantity changes continued…

29. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 29 GDP includes products/services produced within a country’s borders, no matter what nationality of business producing GDP is a flow amount per unit of time Stock fixed amount at a moment in time continued…

30. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 30 Real GDP value at constant prices of all final products/services produced annually in a country – real GDP uses constant prices for a single year to value quantities produced in different years – differences in real GDP between years show only changes in quantities

31. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 31 WHEN MACROECONOMIC DREAMS COME TRUE: POTENTIAL GDP AND ECONOMIC GROWTH By increasing quantity and quality of inputs, economic growth increases productivity and potential GDP per person, raising maximum possible living standards.

32. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 32 POTENTIAL GDP AND ECONOMIC GROWTH Potential GDP – real GDP when all inputs fully employed (labour, capital, land/resources, entrepreneurship) – short-run goal for ideal economic performance – outcome if Invisible Hand works perfectly Potential GDP per person – potential GDP divided by population – short-run maximum living standards continued…

33. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 33 Increases in labour – quantity — population growth, immigration, and labour force participation rate – quality — human capital — work experience, on-the-job training, and education continued…

34. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 34 Increases in capital – quantity — more factories and equipment – quality — technological change — innovation, research and development Increases in land/resources – quantity — bringing land/resources into circular flow of markets – quality — usually due to increases in capital used with land continued…

35. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 35 Increases in entrepreneurship – quantity and quality interrelated – better management, organization, and worker/management relations continued…

36. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 36 When economic growth progresses smoothly, stock of inputs serves as a basis for choices; choices then transform the stock of inputs, continuing in an ever-expanding circle continued…

37. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 37 Economic growth rate annual percentage change in real GDP per person Canada’s average annual economic growth rate, 1926–2008, was 2.1 % continued… Real GDP per person growth rate (%) Real GDP per person this year Real GDP per person last year X 100 = —

38. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 38 Productivity quantity of real GDP produced by an hour of labour – increases in productivity increase living standards – more products/services produced – reducing work time needed to buy products/services

39. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 39 BOOM AND BUST: BUSINESS CYCLES Business cycles track real GDP expansion and contraction. Output gaps measure the difference between real GDP and potential GDP. “Closing the gap” is an important policy target.

40. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 40 BUSINESS CYCLES Language of business cycles fluctuations of real GDP around potential GDP – expansion period when real GDP increases – peak highest point of an expansion – contraction period when real GDP decreases – trough lowest point of a contraction – recession 2+ successive quarters of real GDP contraction continued…

41. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 41 Fig. 2.9 Most Recent Complete Canadian Business Cycle

42. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 42 Output gaps real GDP minus potential GDP – recessionary gap real GDP below potential GDP – inflationary gap real GDP above potential GDP

43. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 43 VALUE ADDED & THE ENLARGED CIRCULAR FLOW Value added value of output minus value of intermediate products/services bought from other businesses Value added solves problems of double counting, distinguishing final and intermediate products/services – value of final products/services = value added – value of final products/services = inputs’ income – GDP = inputs’ income continued…

44. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 44 Flows of spending on the enlarged circular flow – Cconsumption spending by consumers – Ibusiness investment spending on factories and machines made by businesses – Ggovernment spending on products/services – Xspending by R.O.W. on Canadian exports – IM Canadian spending on imports produced by R.O.W. continued…

45. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 45 Aggregate Spending = Aggregate Income C + I + G + X − IM = Y

46. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 46 MY GDP IS BIGGER THAN YOURS: WHAT’S WRONG WITH GDP AS A MEASURE OF WELL-BEING? Real GDP per person is a limited measure of well-being; excludes nonmarket production, underground economy, environmental damage, leisure, political freedoms and social justice.

47. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 47 WHAT’S WRONG WITH GDP AS A MEASURE OF WELL-BEING? Real GDP per person is limited measure of well-being because it does not include – non-market production household production that improves quality of life – underground economy activities that are illegal, or legal but avoid taxes continued…

48. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 48 – environmental damage costs of environmental damage, resource depletion – leisure leisure lowers real GDP, but is desirable – political freedoms and social justice limited freedoms, uneven income distributions continued…

49. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 49 Growth rates of real GDP per person still useful for judging economic progress if no significant changes over time in the limitations United Nations Human Development Index (HDI) measures quality of life across countries by combining life expectancy, educational achievement, and income – Canada ranked 4 th, U.S. 15 th in 2006

50. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 50 Costs of (Not) Working and Living Unemployment and Inflation

51. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 51 LEARNING OBJECTIVES 3.1Explain what the unemployment rate measures and misses, and identify four types of unemployment 3.2Define the natural rate of unemployment and explain its connection to recessionary and inflationary output gaps 3.3Explain how the inflation rate is calculated and what it misses, and describe three problems inflation creates continued…

52. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 52 3.4Use the quantity theory of money to explain where inflation comes from 3.5Describe the Phillips Curve and its connections to demand-pull and cost-push inflations

53. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 53 WHO IS UNEMPLOYED? HEALTHY & UNHEALTHY TYPES OF UNEMPLOYMENT Unemployment rate measures percentage of labour force out of work and actively searching for jobs, but misses involuntary part-time and discouraged workers. Four types of unemployment — frictional, structural, seasonal, cyclical. Only cyclical is both unhealthy and a problem.

54. Fig. 3.1 Labour Force Categories for Working-Age Population, May 2009 Employed 16 832 200 Unemployed 1 548 400 Labour Force 18 380 600 (employed + unemployed) Not in Labour Force 8 869 400 Working-Age Population 27 250 000

55. Fig. 3.3 Unemployment & Underutilization of Labour, May 2009 Percentage of Labour Force Official unemployment rate 8.7 Involuntary part-time workers2.6 Discouraged workers0.2 Total Underutilization Rate11.5

57. Fig. 3.4P rovincial Unemployment Rates, May 2009 ProvinceUnemployment Rate Newfoundland/Labrador 15.1 Prince Edward Island13.1 Nova Scotia8.9 New Brunswick8.8 Quebec 8.7 Ontario9.4 Manitoba4.9 Saskatchewan4.9 Alberta6.6 British Columbia7.6

58. Fig. 3.5 Varieties of Unemployment Type of Unemployment Healthy/ Unhealthy Problem that Needs Addressing? Cause FrictionalHealthyNo Normal, healthy market adjustments of demand and supply StructuralHealthy Yes (worker retraining) Technological change, international competition, resource depletion SeasonalNeutralNoWeather and seasons CyclicalUnhealthyYes (fiscal or monetary policy) Business cycles

59. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 59 HOW FULL IS “FULL EMPLOYMENT?” THE NATURAL RATE OF UNEMPLOYMENT Natural rate of unemployment at full employment, where only healthy frictional, structural, seasonal unemployment. Relative to natural rate, unemployment rate is higher in recessionary gap and lower in inflationary gap.

60. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 60 Statistics Canada sorts working-age population (age 15 and over) into three categories – employed working full-time or part-time at paid job – unemployed not doing paid work and actively searching for job; on temporary layoff; about to start new job – not in the labour force not employed or unemployed (full-time student, homemaker, retiree) UNEMPLOYMENT continued…

61. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 61 Labour force = employed + unemployed Unemployment rate percentage of people in labour force who are unemployed – Unemployment Rate = × 100 Unemployed Labour Force continued…

62. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 62 Labour force participation rate – percentage of working-age population in labour force (employed or unemployed) – Labour Force Participation Rate = × 100 Labour Force Working Age Population continued…

63. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 63 Unemployment rate misses – involuntary part-time workers employed part-time but would rather have full-time job, and can’t find one – discouraged workers want to work but have given up actively searching for jobs Labour underutilization rate unemployment rate including unemployed, involuntary part-time, discouraged workers continued…

64. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 64 Healthy and unhealthy types of unemployment – frictional unemployment due to normal labour turnover and job search; healthy part of changing economy; not a problem – structural unemployment due to technology or international competition making workers obsolete; healthy part of changing economy; problem requiring retraining – seasonal unemployment due to seasonal changes in weather; neither healthy nor unhealthy; not a problem continued…

65. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 65 – cyclical unemployment due to fluctuations in economic activity; unhealthy part of changing economy; problem needs addressing

66. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 66 NATURAL RATE OF UNEMPLOYMENT Natural rate of unemployment unemployment rate at full employment; includes frictional, structural, seasonal unemployment – full employment is not zero percent unemployment but zero percent cyclical unemployment continued…

67. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 67 Natural rate of unemployment and potential GDP – when unemployment = natural rate real GDP = potential GDP full employment – when unemployment > natural rate real GDP < potential GDP recessionary gap cyclical unemployment – when unemployment potential GDP inflationary gap Economists disagree about the natural rate

68. Copyright © 2011 Pearson Canada Inc.Chapter 3 - 68 PROBLEMS WITH UR FIGURES MAY OVER OR UNDERESTIMATE ACTUAL SITUATION BECAUSE 1.DOES NOT INCLUDE DISCOURAGED WORKERS (HIDDEN UNEMPLOYMENT) = PERSON WHO DOES NOT HAVE A JOB, IS AVAILABLE AND WILLING TO WORK BUT HAS NOT MADE ANY EFFORTS TO FIND A JOB WITHIN THE PREVIOUS 4 WEEKS

69. Copyright © 2011 Pearson Canada Inc.Chapter 3 - 69 e.g. DURING RECESSIONS, WHEN PEOPLE STOP LOOKING FOR WORK, HIDDEN UNEMPLOYMENT RISES. BECAUSE THE UR FIGURED IGNORES THIS, IT MAY UNDERESTIMATE UNEMPLOYMENT.

70. Copyright © 2011 Pearson Canada Inc.Chapter 3 - 70 2.INCLUDES VOLUNTARY UNEMPLOYMENT: = PEOPLE WHO SAY THEY ARE UNEMPLOYED BUT ARE NOT WILLING OR INTERESTED IN WORKING e.g. welfare recipients

71. Copyright © 2011 Pearson Canada Inc.Chapter 3 - 71 e.g. DURING A BOOM, VOLUNTARY UNEMPLOYMENT WILL OVERESTIMATE THE UR AND KEEP IT HIGH EVEN THOUGH THERE ARE A LOT OF VACANCIES.

72. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 72 LIGHTENING UP YOUR WALLET: WHAT IS INFLATION? Inflation hurts those on fixed incomes, creates risk for business investment and can increase in a vicious cycle of expectations. Inflation rate overstates cost of living increases, missing switches to cheaper and improved products/services.

73. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 73 INFLATION Inflation is persistent rise in average prices and fall in value of money – spend more to get same products/services – your money is worth less Consumer Price Index (CPI) measure of average prices of a fixed shopping basket of products and services – CPI = 100 for the base year, currently 2002 continued…

74. Copyright © 2011 Pearson Canada Inc.Chapter 3 - 74 Fig. 3.7 Consumer Price Index Basket Recreation, education, reading 12.2% Health, personal care 4.7% Alcoholic beverages, tobacco products 3.1% Food 17% Transportation 19.9% Shelter 26.6% Household operations, furnishing and equipment 11.1% Clothing, footwear 5.4%

75. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 75 Inflation rate annual percentage change in consumer price index – Inflation – Core inflation rate inflation rate excluding volatile categories × 100 CPI for previous year CPI for current year − CPI for previous year = continued…

76. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 76 Inflation is a worry because of falling value of money – inflation reduces purchasing power of people with fixed (unchanged dollar) income or savings – nominal interest rate observed interest rate; dollars per year in interest as percentage of dollars saved – realized real interest rate is nominal interest rate adjusted for inflation = nominal interest rate − inflation rate continued…

77. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 77 Inflation is a worry because – unpredictable prices create risk and discourage business investment – expectations of inflation can cause inflation Predictable inflation rate between 1 and 3 percent is the Bank of Canada’s aim

78. Copyright © 2011 Pearson Canada Inc.Chapter 3 - 78 VICIOUS CYCLE

79. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 79 Deflation persistent fall in average prices and rise in value of money – consumers may postpone purchases, causing contraction and increasing unemployment – deflation benefits savers but hurts borrowers – deflation is worse than low inflation

80. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 80 CPI fixes quantities in shopping basket to isolate only the impact of changing prices on cost of living – when prices rise, CPI misses switches to cheaper substitutes and new/improved products – inflation rate based on CPI overstates increases in cost of living

81. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 81 WHEN TIM HORTONS PAYS $18 PER HOUR: UNEMPLOYMENT AND INFLATION TRADEOFFS Phillips Curve shows tradeoff between unemployment and inflation consistent with demand-pull inflation. Cost-push inflation, changes in expectations and natural rate of unemployment complicate the original Phillips Curve.

82. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 82 UNEMPLOYMENT – INFLATION TRADEOFFS Phillips Curve graph showing inverse relation between unemployment and inflation Demand-pull inflation rising average prices caused by increases in demand explain Phillips Curve’s tradeoff between unemployment and inflation – during expansions, demand is key force causing shortages and pulling up prices for inputs (wages) and outputs continued…

83. Copyright © 2011 Pearson Canada Inc.Chapter 3 - 83 Fig. 3.11 Phillips Curve in Canada, 1946 - 1969

84. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 84 Cost-push inflation rising average prices caused by decreases in supply — does not fit Phillips Curve – caused by supply shocks events directly affecting business’s costs, prices, and supply. Decrease in supply key force pushing up output prices, while pushing economy into contraction, increasing unemployment. – can cause stagflation simultaneous recession (unemployment) and inflation continued…

85. Copyright © 2011 Pearson Canada Inc.Chapter 1 - 85 Both demand-pull and cost-push inflation require accompanying increase in quantity of money Trade-offs between unemployment and inflation of Phillips Curve are complicated due to changes in – expectations – natural rate of unemployment