EDIT 12ce Ch19

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Chapter 19
What
Macroeconomics Is
All About
05/09/07
Copyright © 2008 Pearson Education Canada
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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.
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19.1 KEY MACROECONOMIC

VARIABLES
Output and Income
The production of output generates income.
To measure total output in dollars, we add up the values of the

many different goods produced.
This gives nominal national income.
With base-period prices, we get real national income.

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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.
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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
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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
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 a recessionary gap.
When Y > Y*, there is an inflationary gap.

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Recessionary Gap
Real GDP
Peak
Recovery Actual GDP
Recession
Potential GDP
Peak
Trough
Inflationary Gap
Time
NOTE: GDP and Y are the same quantity for the aggregate economy

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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.
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Number of people unemployed

Unemployment = X 100
Rate Number of people in the
labour force
Even when Y = Y*, some unemployment exists:
• frictional unemployment
• structural unemployment
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Employment, Unemployment, the Labour Force

Participation Rate and Unemployment Rate: An
example - Windsor CMA Second Quarter of
2006
Population (POP): 270,200 (15+)
Employment (E): 163,100
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%
We can also calculate the following variables of interest (not in text)
Participation rate (PR): LF / POP = 178,400 / 270,200 = 66.25%
Employment rate (ER): E / POP = 163,100 / 270,200 = 60.36%
05/09/07 MFC 41-111©MFC 41-111 MFC 41-111 MFC41-111MFC2007

Copyright 2008 Pearson Education Canada
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A longer history of labour force and employment growth:

What happened after the 1950’s?

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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.
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Does the Unemployment Rate Measure Hardship?

Not really.
05/09/07 MFCCopyright
41-111 MFC
© 41-111 MFC 41-111
2008 Pearson MFC41-111MFC2007
Education Canada
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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.
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Real GDP
per worker is
measured in
thousands of
dollars!
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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:
CPI t =
∑PQ t 0
×100
∑P Q 0 0
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An Example
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.
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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.
An unanticipated inflation benefits anyone who has an
obligation to pay money, and harms anyone who is entitled to
receive money.
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In 1970 could you In 1980 could you

have predicted what have predicted what
inflation would be inflation would be
during the 1980’s? during the 1990’s?
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Inflation over the longer term
CPI
Rate of inflation
05/09/07 MFC 41-111 MFC Pearson

41-111 MFC 41-111 MFC41-111
Copyright © 2008 Education Canada
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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
Real value of other expend. $1,800 $2,091 $ 3,766
Value of your house $250,000 $275,000 $648,435
GREAT PLAN!
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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

Mortgage payment (15%) $3,200 $3,200 $3,200
(fixed in nominal terms)
Other expenditures $1,800 $1,900 $2,895
Real value of other expend. $1,800 $1,863 $2,375
Value of your house $250,000 $255,000 $304,749
NOT SO GREAT OUTCOME!

41-111 MFC 41-111 MFC41-111
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Interest Rates
The interest rate is the price of borrowing funds — the

percentage amount per period.
Nominal interest rate: the rate expressed in money terms.
Real interest rate: the rate expressed in terms of purchasing

power.
The burden of borrowing depends on the real interest rate.
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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

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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

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The International Economy
Foreign exchange: foreign currencies or claims on foreign

currencies.
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
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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?

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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?

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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!

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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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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.
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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.)

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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

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Short-Term Fluctuations
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.”
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What Lies Ahead?
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
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05/09/07

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1 of 42

In this chapter you will learn

1. the meaning and importance of the key macroeconomic

2. that most macroeconomic issues are about either long-run

19.1 KEY MACROECONOMIC

The production of output generates income.

To measure total output in dollars, we add up the values of the

This gives nominal national income.

With base-period prices, we get real national income.

Real vs. Nominal: Does it matter?

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

Real GDP fluctuates around a rising trend:

APPLYING ECONOMIC CONCEPTS

Potential output (denoted Y*) is what the economy could

Output Gap = Y-Y*

When Y < Y* , there is a recessionary gap.

When Y > Y*, there is an inflationary gap.

05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007

Employment, Unemployment, and the

Employment: the number of workers (15+) who hold jobs.

Unemployment: the number who are not employed but are

Labour force: the total number of employed + unemployed.

The unemployment rate is the number of unemployed

Number of people unemployed

Even when Y = Y*, some unemployment exists:

Employment, Unemployment, the Labour Force

Unemployment rate (UR): UN / LF = 15,300 / 178,400 = 8.58%

We can also calculate the following variables of interest (not in text)

Participation rate (PR): LF / POP = 178,400 / 270,200 = 66.25%

Employment rate (ER): E / POP = 163,100 / 270,200 = 60.36%

05/09/07 MFC 41-111©MFC 41-111 MFC 41-111 MFC41-111MFC2007

A longer history of labour force and employment growth:

05/09/07 MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007

The unemployment rate when Y=Y* is called:

What is the NAIRU?

Why Does Unemployment Matter?

Some unemployment is desirable, as it reflects the time required for

Does the Unemployment Rate Measure Hardship?

Productivity: a measure of output per unit of input

Increases in productivity are probably the single largest

Inflation and the Price Level

Inflation: the rate at which the price level is changing.

The CPI is based on the price of a typical “consumption

The year-over-year inflation rate can be found by dividing the

[(130.3 / 128.8) - 1] x 100 = 1.2%

That is, the price level increased by 1.2 percent between

APPLYING ECONOMIC CONCEPTS

In 1970 could you In 1980 could you

Inflation over the longer term

05/09/07 MFC 41-111 MFC Pearson

Your 1980 plan for buying a house based on expected

Monthly earnings $5,000 $5,500 $12,969

Real value of other expend. $1,800 $2,091 $ 3,766

Value of your house $250,000 $275,000 $648,435

(increases with inflation)

What actually happens when inflation turns out to be 2%

Monthly earnings $5,000 $5,100 $6,095

Real value of other expend. $1,800 $1,863 $2,375

Value of your house $250,000 $255,000 $304,749