• Shuffle
    Toggle On
    Toggle Off
  • Alphabetize
    Toggle On
    Toggle Off
  • Front First
    Toggle On
    Toggle Off
  • Both Sides
    Toggle On
    Toggle Off
  • Read
    Toggle On
    Toggle Off

Card Range To Study



Play button


Play button




Click to flip

Use LEFT and RIGHT arrow keys to navigate between flashcards;

Use UP and DOWN arrow keys to flip the card;

H to show hint;

A reads text to speech;

232 Cards in this Set

  • Front
  • Back

Economics is...

The study of how scarce resources are allocated among alternatives uses to satisfy human wants


Limited in supply

What does the price of resources reflects

Their value/importance and is the mechanism by which they are allocated among economic agents (consumers, firms, resource owners)

Economics is concerned only with....

How much people are willing to pay for what they want

Economists study.....

1. How people make decisions

2. How people interact with each other

3. The forces and trends that affect the economy as a whole

Examples of how people make decisions

How much to work and save, what to buy and how to invest their savings. What resources and technology to use to produce a good, and what to produce.

Examples of how people interact with each other

How prices and quantities of goods are determined

Examples of forces and trends that affect the economy

Business cycles, growth, unemployment, inflation and events in other economies

What are the two subfields of economics?

Microeconomics, and macroeconomics


Studies how households and firms make decisions and interact.

Examples of Microeconomics

1. How market power affects production and price

2. How tariffs affect consumers, producers and society


Studies the overall economy

Macroeconomics examples

1. How a tax cut can stimulate economic growth

2. How increasing the money supply causes inflation

Both are intertwined because....

1. The overall economy is composed of millions of households and firms

2. Any policy to promote economic growth needs to understand how that policy affect individual household and firms

Ten Principles of Economics

1. People face Tradeoffs

2. The cost of something is what you give up to get it

3. Rationale people think at the margin

4. People respond to incentives

5. Trade can make everyone better off

6. Markets are usually a good way to organize economic activity

7. Governments can sometimes improve market outcomes

8. A country's standard of living depends on its ability to produce goods and services

9. Prices rise when the governments prints too much money

10. Society faces a short-run trade off between inflation in opposite directions in the short-run (a few years)

Principle #1 People Face Tradoffs

All decisions involve tradeoffs

Examples of People facing tradeoffs

* Going to a party the night before your midterm leaves less time for studying - this may be career limiting

* Having more money typically means working more, which leaves less time for leisure

What is a common tradeoff in economics

Between efficiency and equity, because these desirable goals often conflict.

Efficiency is...

Getting the most from resources (size of the pie)

Equity is...

Sharing resources fairly within a society (who eats it)

Example of the tradeoff between efficiency and equity

A progressive tax system (like Canada's) reduces the incentive to work

Principle #2 The Cost of Something is What you Give Up to Get it

Making decisions requires comparing the costs and benefits of alternative choices

Opportunity Cost is...

The opportunity cost of any item is whatever must be given up to obtain it. It is the relevant cost for decision making.

Examples of Opportunity cost...

* Going to college for a year is not just the tuition, books, and fees, but also foregone wages

* Seeing a movie is not only the price of admission, but also the value of time spent in the cinema instead of elsewhere

Principle #3 Rationale People Think at the Margin

Rationale People; systematically and purposefully do the best they can to achieve their objectives. They make decisions by evaluating costs and benefits of a marginal changes.

Examples of Rationale people thinking at the margin...

* When a student considers whether to go to college for an additional year, he may compare the fees and foregone wages to the extra income he could earn with the extra year of education

* When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue

Example; If you plan to sell your car, and pay 10,000$ for repairs on the car before selling it, then the transmission dies. You can pay $600 to have it repaired, or sell the car as is. Which is better, scenario 1 in which the value of the car to sell is $6500 if the transmission works, $5700 if it doesnt, and the second option is $6000 if it works, $5500 if it doesn't

Cost of fixing the transmission is $600. For scenario 1, the benefit of fixing the transmission is $800 ($6500-5700). It's worthwhile to fix the transmission, you'll be ahead an extra 200$ after. Scenario 2, the benefit of fixing the transmission is $500 ($6000-5500), paying $600 to fix the transmission is not worthwhile.

Principle #4 People Respond to Incentives

An incentive is something that induces a person to act, as as the prospect of a reward or punishment. Rational people respond to incentives.

Examples of people responding to incentives

* When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs

* When cigarette taxes increase, teen smoking falls

Principle #5 Trade can make Everyone Better Off

Rather than being self-sufficient (do everything themselves), people can specialize in producing one good or service, and exchange it for other goods, to improve their well-being

Countries also benefit from trade and specialization because...

* They get a better price abroad for goods they produce

* Buy other goods more cheaply from abroad than could be produced at home

* Access a greater variety of goods, including goods they might not be able to get at all

Principle #6 Markets are Usually a Good Way to Organize Economic Activity

A market is a group of buyers and sellers of one good (may be geographically dispersed).

Organizing economic activity entails determining...

* What goods to sell

* How to produce them

* How much of each to produce

* Who gets them

A market economy...

* Allocates resources through the free, decentralized and self-interested decisions of buyers and sellers as they interact in markets to determine market prices.

* Sets market prices that reflect each good's value to buyers and cost of production to sellers

* Often organizes economic activity in a way that maximizes economic well-being (i.e. is efficient)

Principle #7 Governments Can Sometimes Improve Market Outcomes

Key roles for government are to define property rights and to enforce them (with police and the courts). People are less inclined to work, produce, invest, or purchase if the risk is large that their property will be stolen. But markets can sometimes fail to allocate society's resources efficiently.

Causes of Market Failure include...

* Externalities, when the production or consumption of a good affects third parties (e.g, pollution imposes costs on society)

* Market power, small numbers of buyers or sellers have substantial influence on market price (e.g., monopoly is a single seller)

In cases of market failure, public policy may...

Promote efficiency

Government may also alter market outcomes to promote a...

More desirable distribution of resource (equity) - possibly at the expense of efficiency

Principle #8 A Country's Standard of Living Depends on Its Ability to Produce Goods and Services

Living standards vary greatly across countries and over time. Average income in rich countries is more than 10 times average income in poor countries. Canada's standard of living today is 8 times larger than 100 years ago.

Productivity is the most important determinant of living standards because...

* It is the amount of goods produced per hour of a worker's time

* It depends on the equipment, knowledge and skills, natural resources, and technology available to workers

Other factors (e.g., labor unions, foreign competition) have more or less impact on living standards?


Principle #9 Prices Rise When the Government Prints Too Much Money

Inflation is the increase in the general level of prices. In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall. The faster the government creates money, the greater is the inflation rate.

Inflation per year in Canada averaged about;

* 8% per year in the 1970s (overall price level more than doubled)

* 2% per year in the 1990s (overall price level rose by 22%)

Principle #10 Society Faces a Short-Run Tradeoff between Inflation and Unemployment

Many economic policies push unemployment and inflation in opposite directions in the short-run (a few years)

Examples of the tradeoff between inflation and unemployment

* An income tax cut can increase consumer demand and output and reduce unemployment, but will also increase the overall price level

* By reducing interest rates, an increase in the money supply can increase investment and output, and reduce unemployment, but will also increase the overall price level.

The Four Principles of How People Make Decisions are;

1. People Face Tradeoffs

2. The Cost of Something is What You Give Up to Get It

3. Rational People Think At The Margin

4. People Respond to Incentives

The Three Principles of How People Interact Are;

1. Trade Can Make Everyone Better Off

2. Markets Are Usually A Good Way to Organize Economic Activity

3. Governments Can Sometimes Improve Market Outcomes.

The Three Principles of How the Economy as a Whole works are;

1. A country's standard of living depends on its ability to produce goods and services

2. Prices rise when the government prints too much money

3. Society faces a short-run tradeoff between inflation and unemployment.

What two roles do Economists play

1. Scientists

2. Policy Advisors

What do Economists do as Scientists?

Economists make positive statements, which try to describe/explain the world as it is. To do so, they use the scientific method, the dispassionate development and testing of theories about how the world works

What do Economists do as Policy Advisors

Economists make normative statements, which try to prescribe how the world should be, to improve it. The Government of Canada, like other governments, relies on the advice of economists. They are employed in many government agencies and departments, including the Bank of Canada and the Department of Finance.

Between Positive Statements and Normative, which can be confirmed or refuted?

Positive Statements can be confirmed or refuted, Normative Statements cannot.

Is the statement; "Prices rise when the government increases the quantity of money." Positive or Normative and why?

Positive - Described a relationship, could use date to confirm or refute.

Is the statement; "The government should print less money." Positive or Normative and why?

Normative - this is a value judgment, cannot be confirmed or refuted

Is the statement; "A tax cut is needed to stimulate the economy." Positive or Normative and why?

Normative - another value judgment

Is the statement; "An increase in the price of burritos will cause an increase in consumer demand for video rentals." Positive or Normative and why?

Positive - described a relationship. A statement need not be true to be positive.

Why do economists use models to study economic issues?

* To draw logical conclusions (deductions)

* To predict real world behavior

A model is....

A highly simplified representation of a more complicated reality. It captures key features to be investigated, and uses reasonable simplifying assumptions about reality.


Simplify the complexity of the world. It makes the world easier to understand.

The Circular Flow Diagram

A visual model of the economy that shows how dollars flow through markets among households and firms

Two markets

For goods and services, and for factors of production. The resources the economy uses to produce goods and services, this includes land, labor, capital, (machinery and equipment), and natural resources)

Two types of economic agents

1. Households

2. Firms


* Own factors of production and sell/rent them to firms in exchange for income

* Buy and consume goods and services


* Buy/hire factors of productions and use them to produce goods and services

* Sell goods and services.

The Production Possibilities Frontier (PPF)

A graph that shows the maximum combinations of two goods an economy can produce given its available resources and technology

Example of The Production Possibilities Frontier

* Assume the two goods are computers and wheat

* Assume one resource is used to produce each of the two goods (labor [measured in hours])

* Assume the economy has 50,000 labor hours per month available for productions

* Assume producing one computer requires 100 hours of labor.

* Assume producing one ton of wheat requires 10 hours of labor.

Economists often give conflicting policy advice, they disagree

* As human beings

* Are there not many ways to achieve any single goal (e.g., weight loss), and as many opinions as to which is the best way to do so?

Gross Domestic Product (GDP)

Measures both;

1. The total income of everyone in the economy

2. The total expenditure (or spending) on the economy's production of goods and services

For the economy as a whole....

income = expenditure. Because every dollar a buyer spends is a dollar of income for the seller.

What does the Circular Flow Diagram omit?

1. The Government; Collects taxes, buys goods and services

2. The Financial System; Matches savers' supply of funds with borrowers' demand for loans

3. The Foreign Sector; Trades goods and services, financial assets, and currencies with the country's residents.

GDP Defined

The market value of all final goods and services produced within a country in a given period of time.

How are goods valued?

All goods are valued at their market prices and measured in the same units (e.g., dollars in Canada). Things that don't have a market value are excluded (e.g., housework), as are illicit activities.

Final Goods and services...

Are intended for the end user. The value of intermediate goods - goods used in the production of other goods - are already included in the value of final goods.

Are final goods and services be tangible or intangible?

They are both tangible goods (e.g., mountain bikes, beer) and intangible services (e.g., cell phone service, haircuts)

Only newly produced goods

* Not goods produced in the past (e.g., sales of existing houses)

All production that occurs within a country's borders...

Whether done by its own citizens or by foreigners located there. Production by Canadians that takes place in other countries is not included. Usually a year or a quarter (3 months)

The Expenditure Components of GDP

There are four components of spending;

* Consumption (C)

* Investment (I)

* Government Purchases (G)

* Net Exports (NX)

The four Components add up to GDP (Denoted as Y), how?

Y = C + I + G + NX

Consumption (C)

Total Spending by households on goods and services

Goods Include

* Durable goods such as cars and appliances

* Non-Durable goods such as food and clothing

Services Include

Intangible items such as haircuts and health care

Note on housing costs;

* For renters, consumption includes rent payments

* For homeowners, consumption includes the imputed rental value of the house, but not the purchase price or mortgage payments. Expenditures on new housing are treated as investment spending.

Investment (I)

Total spending on goods that will be used in the future to produce more goods

Investment includes spending on;

* Capital equipment (e.g., machines, equipment, tools)

* Structures (factories, office buildings, new houses)

* Inventories (goods produced but not yet sold)

What happens when inventories are sold?

They are recorded as negative inventory investments offset by a positive expenditure

Investment does not mean...

The purchase of financial assets like stocks and bonds. Such investments are rather saving.

Government Purchases (G)

Include spending on goods and services by all levels of government. This is local, territorial, provincial and federal government. Includes both the salaries of government workers and spending on public works.


Transfer payments to persons (e.g., Canada Pension Plan benefits to seniors or Employment Insurance benefits to those who lose their job). Transfer payments are not made in exchange for currently produced goods or services.



Net Exports (NX)

Exports minus imports. Exports represent foreign spending on an economy's goods and services. Imports are those portions of C, I, and G that are spent on goods and services produced abroad.

Imports are subtracted from exports because...

Imports are included elsewhere in GDP. Example; You purchase grub killer made in the US. This increase in consumption expenditures is exactly offset by a decrease in net exports and Canadian GDP is unaffected.

Determine how much GDP and each of its components is affected (if at all); Debbie Spends $200 to buy her husband dinner at the finest restaurant in Ottawa

Consumption and GDP rise by $200

Determine how much GDP and each of its components is affected (if at all); Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China.

Investment rises by $1800, and net exports fall by $1800 (since imports rise by $1800), so GDP is unchanged

Determine how much GDP and each of its components is affected (if at all); Jane spends $1200 on a computer to use in her editing business. She got last year's model on sale for a great price from a local manufacturer

* Current GDP and investment do not change because the computer was built last year

* Investment does not change because, while I increases due to her purchase of the computer, I also decreases due to an equal reduction in inventory investment.

Determine how much GDP and each of its components is affected (if at all); General Motors builds $500 million worth of cars, but consumers only buy $470 million worth of them

Consumption rises by $470 million, inventory investment rises by $30 million, and GDP rises by $500 million.

The two versions of GDP (Inflation can distort economic variables like GDP. One is corrected for inflation; the other is not)

1. Nominal GDP.

2. Real GDP

Nominal GDP

Values output using current prices. It is not corrected for inflation.

Example of Nominal GDP

* Suppose nominal GDP grows both because prices rise and because the economy produces more goods

* The increase will overstate the increase in society's well-being (or income) because part of these increases are due to inflation.

* We need a way to take out the effects of inflation, to see how much people's incomes are growing in terms of purchasing power

Real GDP

Values output using the prices of a base year so prices do not change.

Examples of Real GDP

* It answers the question: "How much would GDP have grown if there had been no inflation?"

* Thus, real GDP is corrected for inflation

GDP Deflator

One measure of the overall level of prices,

Nominal GDP

GDP Deflator = -------------------- x 100

Real GDP

GDP Deflator Cont.

The percentage change in the GDP deflator between any two years is one measure of an economy's inflation rate.

Real GDP per capita

(or real income per capita) is the main indicator of the average person's standard of living. But it is not a perfect measure of well-being

Real GDP per capita does not measure...

Does not measure, for example, the quality of the environment, leisure time, non-market activities (e.g., the care a parent provides his or her child at home) and how equitable is the distribution of income.

GDP Per - capita remains a very useful indicator of well-being

* Having a large GDP enables a country to afford better schools, a cleaner environment, health care, etc.

* Many indicators of the quality of life are positively correlated with GDP

The Consumer Price Index (CPI)

The basis of cost of living adjustments (COLAs) in many private sector contracts, in many government programs such as the Canada Pension Plan and the Old Age Security program, and for various income tax parameters such as the basic personal amount.

The CPP retirement pension

is a monthly benefit designed to replace about 25% of the average person's lifetime pre-retirement employment earnings, up to a maximum amount.

2015 Maximum pensionable earnings amount is...


It is adjusted annually based on....

Increases in the average wage

Maximum retirement pension equals how much per month for 2015?

$1065. It is adjusted annually based on increases in the cost of living as measured by the CPI

Maximum 2015 CPP employee contribution;

* 4.95% x ($53,600 - $3,500) = $2,479.95

* The employer pays an equal amount

* Self-employed persons pay both the employee and employer amounts.

The OAS Program

A non-contributory, residence - based program, financed through general tax revenues, the objective of which is to ensure a minimum income to seniors.

The maximum monthly OAS pension benefit in 2015 is...

$563.74. On a annual basis, the maximum benefit is $6764.88

OAS Pension Benefit is income-tested or not?

It is income-tested. For 2015, higher-income individuals must repay the pension benefit at a rate of 15% of net income for income tax purposes in excess of $72,809. So, individuals with incomes exceeding $117,909 do not receive it.

OAS benefits are adjusted how often?

Quarterly, in January, April, July, and October. To reflect increases in the cost of living as measured by the CPI.

How is CPI Calculated?

1. Determine the "basket"

2. Find the prices

3. Compute the basket's cost

4. Choose a base year (can be any year) and compute the index.

5. Compute the inflation rate - the percentage change in the CPI from a previous period.

The "Basket"

Statistics Canada surveys consumers to determine what a typical consumer buys. Consists of about 600 goods and services (updated every 2 years now)

Find the Prices

Statistics Canada collects data on the prices of all the goods and services in the basket

Compute the basket's cost

The data on prices is used to compute the total cost of the same basket at different times

Choose a base year (can be any year) and compute the index;

CPI = Cost of Basket of Goods in Current Year


Cost of Same Basket in Base Year

x 100

Compute the inflation rate - the percentage change in the CPI from a previous period:

Inflation Rate In Current Year =

CPI in current Year - CPI in Previous Year

----------------------------------------------------------- x 100

CPI in Previous Year

Problems with the CPI

1. Commodity Substitution Bias

2. Introduction of New Goods

3. Unmeasured Quality Change

Commodity Substitution Bias

* Some prices rise faster than others

* Consumers substitute towards goods that become relatively cheaper

* The CPI misses this substitution because it uses a fixed basket of goods - the weighting of each of the 600 basket items does not change

* Thus, the CPI overstates increases in the cost of living.

Introduction of New Goods

* The introduction of new goods increases variety, and allows consumers to find products that more closely meet their needs.

Example; DVDs offer time and cost savings compared with going to a movie theater.

In effect, dollars become more valuable in the sense that less are needed to maintain a given standard of living.

Introduction of New Goods Cont.

* The CPI misses this effect because it uses a fixed basket of goods

* In the Past, new goods were added to the basket only every four years.

* They may now be added to the basket every two years.

* Thus, the CPI overstates increases in the cost of living.

Unmeasured Quality Change

* Improvements in the quality of goods in the basket increase the value of each dollar.

Example; more fuel efficient cars

* Statistics Canada tries to account for quality changes but likely misses some, as quality is difficult to measure

* Thus, the CPI overstates increases in the cost of living.

Consequences of these 3 problems

Each of these 3 problems causes the CPI to overstate cost of living increases. Research by the Bank of Canada suggests the CPI used to overstate the true rate of inflation in Canada by about 0.6 percentage points per year.

Consequences of these 3 problems cont.

The issue is important because private and public pension programs (the OAS program, and the CPP), personal income tax deductions, some government social payments, and many private sector wage settlements are all adjusted upward using the CPI.

The GDP Deflator versus the CPI.

Economists and policymakers monitor both the GDP deflator and the CPI to gauge how quickly prices are rising.

Two important differences that can cause GDP deflator vesus the CPI to diverge

1. Each Measure a different set of goods and services

2. One set of goods and services is fixed; the other, variable

Measures a different set of goods and services

* The GDP deflator reflects the prices of all goods and services produced domestically.

* The CPI reflects the prices of all goods and services bought by a typical consumer.

One set of goods and services fixed and the other variable

* The GDP deflator compares the price of currently produced goods and services to the same goods and services valued at base-year prices; the goods and services change automatically every year.

* The CPI compares the currrent cost of a fixed basket of goods and services to the cost of the same basket in the base year; the goods and services change every two years.

Contrasting the CPI and GDP deflator (Part 1)

Imported Consumer goods;

* Included in CPI

* Excluded from GDP deflator

Contrasting the CPI and GDP deflator (Part 2)

Capital goods;

* Excluded from CPI

* Included in GDP deflator (if produced domestically)

Contrasting the CPI and GDP deflator (Part 3)

The basket;

* CPI uses fixed basket

* GDP deflator uses the basket of currently produced goods and services.

This matters if different prices are changing by different amounts.

In this scenario, what are the effects on the CPI and the GDP deflator; Tim Horton's raises the price of doughnuts

The GDP deflator and the CPI both rise

In this scenario, what are the effects on the CPI and the GDP deflator; Bombardier raises the price of the subway cars it manufactures at its factory near Montreal

The GDP deflator rises; the CPI does not

In this scenario, what are the effects on the CPI and the GDP deflator; Armani raises the price of its Italian - made jeans it sells in Canada.

The GDP deflator does not rise; the CPI does.

Comparing Dollar Figures from Different Times

Inflation makes it hard to compare dollar amount from different times. To determine the inflation, you must use the CPI.

Comparing the Dollar figures Example. Was the 9.5 cents per liter price of gasoline in 1957 high or low compares with the $1.27 per liter price of gasoline in 2012?


Price in Base year's dollars


Price level today/Price level in base year


Price in today's dollars

Outcome of the Gas example;

Since 1.27/I> 78.1 cents/1, the price of gasoline increased by much more than the price of all other CPI goods and services over this 55-year period.


A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or by contract

For example, the increase in the CPI automatically determines;

* The COLA in many multi-year labor contaacts

* Adjustments to CPP and OAS Payments (as we have seen), and to many federal income tax brackets.

Nominal Interest Rate

* The interest rate not corrected for inflation

* The rate of growth in the dollar value of a deposit or debt

The Real Interest Rate

* Corrected for inflation

* The rate of growth in the purchasing power of a deposit or debt

Standards of living

(or income per person)

* At a point in time and are reflected in large differences in the quality of living.

* Over time (growth)


The average quantity of goods and services produced per hour of a worker's time.

Let Y = real GDP = quantity of output produced

Let L = Quantity of labor

Y/L = productivity (output per worker)

What determines productivity and its growth rate?

*Physical Capital Per Worker

* Human Capital Per Worker

* Natural Resources Per Worker

* Technological Knowledge

Physical Capital Per Worker (K)

* The stock of machinery, equipment and structures used to produce goods and services.

* K/L = Capital per worker

* Productivity is higher when the average worker has more (physical capital)

Human Capital Per Worker (H)

The knowledge and skills workers acquire through education, training, and experience.

* H/L = human capital per worker

* Productivity is higher when the average worker has more human capital

Natural Resources Per Worker (N)

The inputs into production that nature provides such as minerals and petroleum (non-renewable), forests (renewable)

N/L = Natural resources per worker

* Productivity is higher when the average worker has more natural resources.

Technological Knowledge

* Society's understanding of the best ways to produce goods and services

* Technological progress does not mean only a faster computer, a higher-definition TV, or a smaller cell phone

* It means any advance in knowledge that boosts productivity (allows society to get more output from its resources)

Technological Knowledge vs. Human Capital

* Technological knowledge refers to society's understanding of how best to produce goods and services

* Human capital results from the effort people expend to acquire knowledge.

The Production Function

The relationship between inputs and output. The equation is,

" Y = AF(L, K, H, N)"

F(L, K, H, N) is a function that shows how inputs are combined to produce outputs. Output (or real GDP) depends on labor, capital, etc.

A is the level of technology

The Production Function has the property of...

Constant returns to scale; changing all inputs by the same amount causes output to change by that amount. Doubling all inputs (multiplying each by 2) causes output to double, i.e., 2Y = AF(2L,2K,2H,2N)

The form of the equation for the Production Function...

Show explicitly that productivity (output per worker) depends on;

* The level of technology

* Physical capital per worker

* Human capital per worker

* Natural resources per worker

Importance of Investments

By investing, we can boost productivity (increasing K)

Producing more capital requires what?

Since resources are scarce, it requires us to produce fewer consumption goods.

Reducing Consumption --> Increasing Savings.

Can anyone else help raise savings and investments?

Yes, the government can implement policies to raise this. Then K will rise, causing productivity and living standards to rise. However this faster growth is temporary, due to diminishing returns to capital - as K rises, the extra output from an additional unit of K falls.

Importance of Investment from Abroad

To raise K/L ratio (and hence productivity, wages and living standards), the government can also encourage foreign direct investment, and foreign portfolio investment.

Foreign Direct Investment

A capital investment (e.g., a factory) that is owned and operated by a foreign entity

Foreign Portfolio Investment

A capital investment (e.g., a factory) financed with foreign money (e.g., through a share purchase), but operated by domestic residents

Does the domestic market receive all of the returns from the investment?

Some of the returns of these investments (e.g., profits; dividends) flow back to the foreign countries that supplied the funds. I.e., GNP rises less than GDP

What are the benefits of foreign investment?

Stimulates growth in the economy, and can be beneficial for poorer countries that cannot generate enough saving to fund investment projects themselves. The removal of restrictions on the foreign ownership of domestic capital is a policy that is often advocated by economists.

What is the benefit of Education?

By promoting education, government can increase productivity - making an investment in human capital (H)

What is the opportunity cost associated with education? (Think Principle #2 of Economics; There is an opportunity cost associated with education)

Spending a year in school requires sacrificing a year's wages now to have higher wages later.

True or False; Health care expenditure is another type of investment in Human Capital?

True, because healthier workers are more productive. In countries with significant malnourishment, raising worker's caloric intake raises productivity

Inward-oriented policies

(e.g., tariffs, limits on investment from abroad) aim to raise living standards by avoiding interaction with other countries

Outward-oriented policies

(e.g., the elimination of restriction on trade or foreign investment) promote integration with the world economy

What effects do trade have on technology?

Trade assists in discovering new technologies - it improves productivity and living standards

Technological progress is the main reason why....

living standards rise over the long run

What is a reason that technological progress increases living standards?

One reason is that knowledge is public good. Ideas can be shared freely, increasing the productivity of many.

Policies to promote technological progress include;

* Patent laws

* Tax incentives or direct support for private sector R and D

* Grants for basic research at universities

Population growth may affect living standards in 3 different ways

1. Stretching natural resources

2. Diluting the capital stock

3. Promoting technological progress

Stretching natural resources

200 years ago, Malthus (late 18th century English Minister and scholar) argued that population growth would strain society’s ability to provide for itself

If Malthus was right, living standards would have fallen Instead, they have risen

Malthus failed to account for technological progress and productivity growth

Diluting the capital stock

A bigger population leads to

* Higher L

* Lower K/L

* Lower productivity and living standards

This applies to H as well as K. Fast population growth leads to more children and greater strain on the educational system.

To combat diluting capital stock, developing countries use policies to control population growth such as...

* China's one child per family laws

* Contraception education and availability

* Promoting female literacy to raise the opportunity cost of having babies

Promoting technological progress

More people leads to;

* More scientists, inventors, engineers

* More frequent discoveries

* Faster technological progress and economic growth

Evidence of population growth being connected to technological progress;

Michael Kremer (US Economist, Harvard): Over the course of human history;

* Economic growth rates increased as the world's population increased

* More populated regions grew faster than less populated ones

List the determinants of productivity

* K/L, physical capital per worker

* H/L, human capital per worker

* N/L, natural resources per worker

* A, technological knowledge

What policies may governments use to raise living standards by increasing one of the determinants of productivity?

* Encourage saving and investment, to raise K/L

* Encourage investment from abroad, to raise K/L

* Provide public education, to raise H/L

* Patent laws or grants, to raise A

* Control population growth, to raise K/L and H/L

* Tax incentives to encourage exploration, to raise N/L

What are downsides of population growth?

Some argue that population growth is depleting the Earth's non-renewable resources, and thus will limit growth in living standards

Technological progress often finds ways to avoid these limits, such as

* Hybrid cars use less gas

* Better insulation in homes reduces the energy required to heat or cool them

What happens as resources become more scarce?

Its market price rises, which increases the incentives to conserve it and develop alternatives.

Since the prices of most natural resources (in real terms) are stable or falling, what is happening to our ability to conserve and our supply of these resources?

Our ability to conserve natural resources is growing more rapidly than supplies of resources are dwindling.

The financial system

The group of institutions that help match the saving of one person with the investment of another

Financial markets

Are institutions through which savers can provide funds directly to borrowers such as;

* The Bond Market

* The Stock Market

The Bond Market (Debt finance)

* A bond is a certificate of indebtedness; the buyer lends money in return for interest payments over some period of time (the term of the bond) and the future repayment of the money borrowed (the principal amount of the loan)

* The interest rate is higher, the higher is the borrowers credit risk (the likelihood that the borrower will default - fail to repay some or all of the loan)

The Stock Market (Equity Finance or Shares)

* A Stock is a claim to partial ownership of a firm and its profits

* Compared to bonds, stocks offer higher risk and higher return in the form of dividends and capital gains

* Stock prices reflect expected profitability -> stock indexes are watched closely as indicators of future economic conditions

Financial Intermediaries

Institutions through which savers can indirectly provide funds to borrowers

Examples of Financial Intermediaries

1. Banks and Trust Companies

2. Mutual Funds

Banks and Trust Companies

* Pay depositors interest and charge borrowers higher interest on loans (to maximize profits)

* Also act as a medium of exchange (cheque writing facilitates transactions)

Mutual Funds

* Sell shares in the fund to the public and use the proceeds to buy portfolios of stocks and bonds of other companies

* Provide asset diversification and access to professional money managers for "smaller investors" for a fee.

Three Different Kinds of Saving

1. Private Saving

2. Public Saving

3. National Saving

Private Saving

* The portion of households' income that is not used for consumption or paying taxes

= Y-C-T or (Y-T) - C

Where Y-T is disposable income

Public Saving

* Tax revenue (total minus transfers) minus government spending

= T-G

National Saving

* Private Saving + Public Saving

= (Y-C-T) + (T-G)

= Y-C-G

The portion of national income that is not used for consumption or government purchases

The national income accounting identity for a closed economy is...

Y = C+I+G

In a closed economy, Saving = Investment

Budget Surplus

An excess of tax revenue over government spending.

= T-G

= Public Saving

Budget Deficit

A shortfall of tax revenue from government spending

= G-T

= -(T-G) = - (Public saving).

Since a budget deficit is simply a negative budget surplus, we will use only the latter notation in what follows, i.e., T-G

For budget surplus / public saving

If T>G -> Budget surplus/public saving

For Budget deficit

If T<G -> budget deficit

For Balanced Budget

If T=G -> balanced budget

Suppose GDP equals $10 million, consumption equals $6.5 million, the government spends $2 million and has a budget deficit of $300 thousand. Find public saving, taxes, private saving, national saving, and investment.

Step 1; What information do we have?

Given: Y= $10M, C=$6.5M, G=$2M, T-G= -$0.3M

Identity S = (Y-C-T)+(T-G) = I

Answer to the above question;

Public Saving = Budget deficit = T-G = -$0.3M

Taxes = T=G - 0.3 = 2.0 - 0.3 = $1.7M

Private Saving = Y-C-T = 10.0 - 6.5 - 1.7 = $1.8M

National Saving = Y-C-G = 10 - 6.5 - 2.0 = $1.5M

Investment = National saving = $1.5M

If there is a tax cut, and T falls to $1.5M. What happens to public savings?

Initial public savings = T-g = 1.7-2 = -$0.3M

New public saving = T-G = 1.5 -2 = -$0.5M

Change in public savings = -0.5 - (-0.3) = -$0.2M = tax cut

Since public saving = the budget deficit, the budget deficit increases by $200k and public saving falls by $200k

Private Saving

The income remaining after households pay their taxes and pay for consumption.

Examples of what households do with private saving;

* Buy corporate bonds or equities

* Purchase a certificate of deposit at the bank

* Buy shares of a mutual fund

* Let interest accumulate in saving or chequing accounts


The purchase of new capital

Examples of (physical investment)

* Dofasco spends $250 million to produce a new line of steel products in Hamilton

* You buy $5000 worth of computer equipment for your business

* Your parents spend $400,000 to have a new house built

In economics investment is NOT...

the purchase of stocks and bonds

What do financial markets help allocate?

The economy's scare resources to their most efficient uses

What governs financial markets?

Financial markets are governed by the forces of supply and demand

Financial markets also link the present to the future by;

* They enable savers to convert current income into future purchasing power

* They enable borrowers to acquire capital to produce goods and services in the future

A supply-demand model of the financial system

* Saving is the supply of funds, both public and private

* Investment is the demand for funds for private investment

How does the supply-demand model of the financial system work;

* The financial system coordinates savings and investment

* Government policies and other factors affect saving, investment, the interest rate

Assume only one financial market...

* All savers deposit their saving in this market

* All borrowers take out loans from this market

* There is one interest rate, which is both the return to saving and the cost of borrowing

* The interest rate is the real interest rate

The supply of loanable funds comes from saving:

* Households with extra income can loan it out and earn interest

* Public saving

- If positive (budget surplus), adds to national saving and the supply of loanable funds

- If negative (budget deficit), it reduces national saving and the supply of loanable funds

The demand for loanable funds comes from private investment;

* Firms borrow the funds they need to pay for new equipment, factories, etc.

* Households borrow the funds they need to purchase new houses

In the real world, financial market adjustment is...

extremely rapid

If the interest rate were lower than the equilibrium level, the demands for loanable funds would...

exceed its supply (shortage of funds), causing the interest rate to rise.

The rise in the interest rate would make borrowing what?

More costly, and would reduce the quantity of funds demanded. It would also encourage households to save more, which would increase the quantity of funds supplied. This process would occur until equilibrium was achieved

If the interest rate were higher than the equilibrium level, there would be...

A surplus of funds, causing the interest rate to fall to restore equilibrium

The fall in the rate would make borrowing...

Less costly and would increase the quantity of funds demanded. The fall in the interest rate would also encourage households to save less, which would decrease the quantity of funds supplied. This process would occur until equilibrium was achieved.

Policies that affect savings (both private and public), and investments

* Greater reliance on sales taxes instead of income taxes

* Income tax incentives for both saving and investment

Greater reliance on sales taxes instead of income taxes

* Sales taxes tax only consumption; not saving

Income tax incentives for both saving and investment

* Savings incentives include; TFSAs, RRSPs, RESPs

* Income tax greatly reduces the return to saving

There are 3 steps to keep in mind when analyzing the effects of any policy

1. Decide whether the policy shifts the supply curve, the demand curve, or both

2. Decide in which direction the curve shifts

3. Use the supply-demand diagram to determine how the shift changes the interest rate (the price of loans) and the quantity of loans in equilibrium

Analysis shows the by reducing national saving....

A budget deficit reduces investment, which we have seen is important for the long-run standard of living. This is one reason why many economists believe budget deficits are generally undesirable

Government debt is the...

Sum of all past budget deficits and surpluses

Crowding out

The decrease in private investment that results from government borrowing. Because investment is important for long-run economic growth, government budget deficits reduce the economy's growth rate.

Vicious circle

The cycle that results when deficits reduce the supply of loanable funds, increase interest rates, discourage investment, and result in slower economic growth. Slower growth leads to lower tax revenue and higher spending on income support programs, and the result can be even higher budget deficits

Virtuous circle

The cycle that results when surpluses increase the supply of loanable funds, reduce interest rates, stimulate investment, and result in faster economic growth. Faster growth leads to higher tax revenue and lower spending on income-support programs, and the result can be even higher budget surpluses.