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Chapter 19
What Macroeconomics
Is All About
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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
GDP
(bill. of current $'s)
Real Values
GDP
(bill. of 1992 $'s)
1982
374.9
544.4
1992
691.2
691.2
% change
84.4%
26.9 %
8.4%
2.7%
% change p.a.
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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Real GDP
Recessionary Gap
Peak
Actual GDP
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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Unemployment =
Rate
Number of people unemployed
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%
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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.
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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:
CPIt
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PQ


P Q
t
0
0
0
 100
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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 fullyanticipated 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
have predicted what
inflation would be
In 1980 could you
have predicted what
inflation would be
during the 1980’s?
during the 1990’s?
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Inflation over the longer term
CPI
Rate of inflation
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Your 1980 plan for buying a house based on expected
inflation of 10%
Year 1
Year 2 ...
Monthly earnings
(increases with inflation)
Mortgage payment (15%)
(fixed in nominal terms)
Other expenditures
(increases with inflation)
$5,000
$5,500
$12,969
$3,200
$3,200
$ 3,200
$1,800
$2,300
$ 9,769
Real value of other expend.
$1,800
$2,091
$ 3,766
$275,000
$648,435
Value of your house
(increases with inflation)
$250,000
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
(increases with inflation)
Mortgage payment (15%)
(fixed in nominal terms)
Other expenditures
(increases with inflation)
$5,000
$5,100
$6,095
$3,200
$3,200
$3,200
$1,800
$1,900
$2,895
Real value of other expend.
$1,800
$1,863
$2,375
$250,000
$255,000
$304,749
Value of your house
(increases with inflation)
NOT SO GREAT OUTCOME!
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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
1 year 'open' mortgage
1 year 'fixed' mortgage
10 year 'fixed' mortgage
Unsecured consumer loan
Student loans
VISA
TD pays 1 yr GIC
5 yr GIC
Long term G of C bond
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4.50%
7.00
4.85
7.50
9.50
4.50 (??)
18.50
2.10
3.00
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
P of same meal in Detroit
$10.00 Cdn
$ 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
P of same meal in Detroit
$10.00 Cdn
$ 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 shortterm 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
rate in
productivity
Change in ouput
pph after 40 yrs
(1 working life)
Number of yrs
req'd to double
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 “finetuning.”
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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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