Macroeconomics - Ch 1,2,3, 19 & 20

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Economics

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the science that examines the conditions affecting the production, distribution and consumption of wealth

the study of the use of scarce resources to satisfy unlimited human wants

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Macroeconomics

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the study of the determination of economic aggregates such as total output, employment, and growth

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Positive statement

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matters of fact, tested by scientific evidence and reason

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Normative statement

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value judgments, how something ought to be; not testable

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Resource allocation

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determines the quantities of various goods that are produced

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Resources

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a society’s resources are divided into land, labor, and capital; factors of production

1. Land includes all natural endowments, such as arable land, forests, lakes, oil, and minerals

2. Labor includes all mental and physical human resources, including entrepreneurial capacity and management skills

3. Capital includes all manufactured aids to production, such as tools, machinery, and buildings

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A production possibility boundary

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(PPB) illustrates scarcity, choice, and opportunity cost

Choice implies an opportunity cost – a trade off of opportunity cost is illustrated by the downward slope of the boundary the value of the next best alternative forgone when one chooses alternative

Scarcity is illustrated in the region above the production possibility boundary where combinations are not attainable

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Nature of Markets

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Self-organizing: individual consumers and producers act independently to pursue their own self-interests but the collective outcome is coordinated

Efficiency: sources are organized so as to produce the various goods and services that people want using the least possible amount of resources

Self-interest: individuals acting in rational self-interest determine the supply and demand

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Decision Makers in the economy

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Consumers; Producers; Government

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Product market

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market of economy’s output
what happens?
Households are on the buying side of these markets, purchasing goods and services.
Businesses are on the selling side of these markets, offering products for sale.
Interaction of these buyers and sellers determines the price of each product.
Flow of consumer expenditures constitutes sales receipts for businesses.

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Factor/ resource markets

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markets of capital and labour (input)

What happens?

Households sell resources directly or indirectly (through ownership of corporations).

Businesses buy resources in order to produce goods and services.

Interaction of these sellers and buyers determines the price of each resource, which in turn provides income for the owner of that resource.

Flow of payments from businesses for the resources constitutes business costs and resource owners' incomes.

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Characteristics of production

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Division of labor: the breaking up of a production process into a series of specialized tasks

Specialization is the allocation of different jobs to different people. It is more efficient than self-sufficiency because:

Individual abilities differ—comparative advantage.

Focusing on one activity leads to improvements— learningby doing

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Pure types of economic systems

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Traditional;

Command;

Free-Market

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Exogenous variable

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variable determined by factors outside the theory

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Endogenous variable

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a variable explained by factors in a theory

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Index

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a number is a measure of a variable, conventionally expressed relative to a base period; which is assigned the value of 100

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Quantity demanded

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amount consumers want to buy

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Quantity bought

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or exchanged refers to actual purchases

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Ceteris paribus

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the hypothesis that the price of a product and the quantity demanded are negatively related; the price of the product and the quantity supplied are positively related

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Change in demand

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change in quantity demanded at every price – a shift in the entire curve

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Change in quantity demanded

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movement from one point on the demand curve to another point, either on the same demand curve or another one

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Quantity supplied

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the amount of product a firm desires to sell

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Change in supply

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a change in the quantity supplied at every price – a shift in the entire curve

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Change in quantity supplied

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movement from one point on the supply curve to another point, either on the same supply curve or a new one

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Equilibrium

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at equilibrium price, every buyer finds a seller and every seller finds a buyer—the market “clears”

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The Four Laws of Supply and Demand

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1. an increase in demand causes an increase in both the equilibrium price and quantity

2. a decrease in demand causes a decrease in both the equilibrium price and quantity

3. an increase in supply causes a decrease in equilibrium price and an increase in equilibrium quantity

4. a decrease in supply causes an increase in equilibrium price and decrease in equilibrium quantity

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Absolute price

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the amount of money required to acquire one unit of the product

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Relative price

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price of goods in terms of others

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Nominal national income

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the total income measured in dollars

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Real national income

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national income measured in constant (base-period) dollars. It changes only when quantities change

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Base period price

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the average price for an item in a specified time period used as a base for an index

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Business Cycle

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fluctuations of real national income around its trend value that follow more or less a wave pattern.

trough is characterized by unemployed resources and a level of output that is low in relation to the economy’s capacity to produce

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Recession

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fall in the level of real GDP;often defined as two consecutive quarters of negative growth in real GDP

the process of recovery moves the economy out of a trough

eventually recovery comes to peak

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Potential output

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is the real GDP that the economy would produce if its productive resources were fully employed – potential GDP

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Output gap

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measures the difference between potential output and actual output; Y -Y* (*potential)

when Y < Y*output gap is called recessionary gap

when Y > Y*output gap is called inflationary gap

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Employment

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the number of persons 15 years age or older who have jobs

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Unemployment

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the number of persons 15 years of age or older who do not have jobs

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Labor force

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the number of persons employed plus the number of person unemployed

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Unemployment rate

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unemployment expressed as a percentage of the labor force

(number of people unemployed/ number of people in labor force) x 100

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Full Employment

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when economy at potential GDP; unemployment still exists because of other factors such as: Frictional unemployment: natural turnover in labor market &

Structural unemployment: mismatch between jobs and workers

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Natural rate of unemployment

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full employment; Y=Y

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Cyclical unemployment

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when real GDP is less than potential GDP

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Productivity

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measure of output produced per unit of input

Often measured as GDP per worker or GDP per hour of work

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Labor productivity

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the level of real GDP divided by the level of employment (hours worked)

Productivity growth causes material living standards to rise

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Price level

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average of all prices in the economy expressed in an index number

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The Consumer Price Index(CPI)

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(Laspeyres Price Index) represents the prices of four hundred commodities that the average consumer would likely purchase each month.

An index of average prices of goods and services commonly bought in household.

A weighted average of price changes, where weight represents how much is spent on a commodity in proportion to total expenditure It measures inflation for consumer goods

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Purchasing power

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the amount of goods and services that can be purchased with a unit of money

Inflation reduces the purchasing power of money. It also reduces the real value of any sum fixed in nominal dollar terms

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Interest Rate

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the price paid per dollar borrowed per period of time, expressed either as a proportion or a percentage

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Nominal interest rate

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the price paid per dollar borrowed per period of time

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Real interest rate

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the nominal interest rate adjusted from the change in purchasing power of money; inflation means real interest rate less than nominal interest rate

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Exchange rate

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the number of units of domestic currency required to purchase one unit of foreign currency

Rise in exchange rate means it takes more Canadian dollars to purchase one unit of foreign currency; depreciation of Canadian dollar Fall in exchange rate means it takes less Canadian dollars to purchase one unit of foreign currency; appreciation of Canadian dollar

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Foreign Currency

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foreign currencies or claim on foreign currencies, such as bank deposits, cheques, promissory notes, that are payable in foreign money

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Foreign-exchangemarket

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market in which different national currencies are traded

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Net exports

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the difference between exports and imports; trade balance

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Double counting

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estimating nation's output by adding all sales of all firms; incorrect calculation

Solution –distinguishing between two types of output

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Intermediate goods

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outputs used as inputs by other producers in further stage of production

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Final goods

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goods that are not used as inputs by other firms but are produced and sold for consumption, investment, government, or export

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Value added

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Value of a firm’s output minus the value of inputs it purchases from other firms:

Value added =sales revenue – cost of intermediate goods

Value added =payments owed to the firm’s factors of production

The sum of all values added in an economy measures total output

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Measuring National Income

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Three methods used to measure national income:

expenditure approach: separating expenditure into categories

income approach:adding up all the incomes that are generated by production

value approach:sum the value that is added at each stage of production

All three measures yield the same total: gross domestic product, the total value of all goods and services produced in the economy during a given period

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Consumption (C)

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household goods and services(excluding residential housing)

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Investment (I)

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inventories, residential construction, plant and equipment

Inventories:stocks of raw materials, good in process, and finished goods held by firms to mitigate the effect of short-term fluctuations in sales or prices

Fixed investment: creating new investment

Gross investment: total investment in economy, which equals net investment plus replacement investment

Net investment: equals gross investment minus depreciation (capital stock depreciates)

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Capital stock

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economy’s total quantity of capital goods

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Depreciation

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amount by which capital stock is depleted through production process

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Government (G)

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includes roads, airports or any other goods or services that the government provides (expenditure)

Government purchases: all government expenditure on currently produced goods and services, excluding government transfer payments Transfer payments: payments to an individual or institution not made in exchange for a good or service

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Net exports (NX)

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exports minus imports

Imports:the value of all domestically produced goods and services purchased from firms,households, or governments in other countries

Exports:the value of all goods and services sold to firms, households, and governments in other countries

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Expenditure approach

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Add up all expenditure categories - consumption, investment, government and net exports -- to calculate Gross Domestic Product, to measure national income and economic activity

GDP= Ca + Ia + Ga + NXa

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Income Approach

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Gross Domestic Product calculation involves adding all of the factor incomes and other claims on the value of output, accounting for all value i.e. add all the factor payments that are generated by the process of production to calculate by the income approach

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Factor incomes

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Factor Incomes include three main components: Wages /salaries: labor’s claim against the final output; paid to labor

Interest: earned by deposits at financial intermediaries and other assets that earn interest Profit: dividends and retained earnings of corporations and profits from small businesses

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Non-factor Payments

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Indirect taxes: taxes on production and the sale of goods and services; government’s claim to the value of final output

Subsidies: payments from the government to firms, which act like negative taxes

Depreciation: value attached to depletion of existing capital stock;

Rent: payments for services of land and other factors that are rented

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Gross Domestic Product (GDP)

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Nominal Gross Domestic Product (GDP): total GDP valued at current prices

Real GDP:GDP valued at base-period prices

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GDP Deflator

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If nominal and real GDP change by different amounts over a given time period, then prices must have changed over that period

GDP deflator does not necessarily change in line with CPI. They measure different things: CPI measures change in average price of consumer goods; GDP deflator reflects change of average price of goods produced in Canada

GDP deflator is an index number calculated by dividing nominal GDP by real GDP, then multiplying by 100 (nominal GDP/ real GDP) X 100

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The current approach to measuring GDP is useful because

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It would be difficult to correct the major omissions. The level of GDP may be inaccurate but the change in GDP is a good indication of the changes in economic activity. To design policies to control inflation it is necessary to know the flow of money payments made to produce and purchase Canadian output. Modified measures that included non-market activities would distort these figures and likely lead to policy errors.

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Opportunity Cost

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The cost of any good, service, or activity is the value of what must be given up to obtain it

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Full production

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resources are employed to provide maximum satisfaction of our economic wants.

Underemployment occurs if this is not so.

Implies two kinds of efficiency:

Allocative efficiency: resources are used for producing the combination of goods and services most wanted by society

Productive efficiency: least costly production techniques are used to produce wanted goods and services

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Marginalism

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a theory of economics that attempts to explain the discrepancy in the value of goods and services by reference to their secondary, or marginal, utility

Marginal utility: additional satisfaction of consumer gains but consuming one more unit of product

Marginal benefit: what people are willing to give up to attain one more unit of good

Marginal cost: the value of what people are willing to give up to attain one more unit of good

Additional units should be produced so long as marginal benefit exceeds marginal cost

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Three schools of thought

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monetarism; classical; keynesian

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Monetary vs fiscal policy

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Monetary policy involves changing the interest rate and influencing the money supply.

Fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy

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Transaction costs

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cost incurred in making an economic exchange of some sort, or in other words the cost of participating in a market

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public vs private goods

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private goods: excludable, rivalrous

public enterprise goods: excludable, non-rivalrous

common goods: non-excludable, rivalrous

public goods: non-excludable, non-rivalrous

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core sphere

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consists of households, families, and community groups that organize the many important economic activities central to sustaining human life

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Four essential economic activities

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production, distribution, consumption, & resource maintenance

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Five types of capital

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natural; human; social; manufactured; financial

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Forms of economic distribution

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exchange & transfer:

exchange two-way distribution, trading between two partners;

transfer one-way distribution, giving without anything expected in return

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Normal good

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any good in which the demand increases when income increases

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Inferior good

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demand decreases when income increases

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superior goods

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make up a larger portion when income rises

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Price elasticity

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a measure used to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price, ceteris paribus