Macro Economics Midterm 1

Front 1

Economics is...

Back 1

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

Front 2

Scarce

Back 2

Limited in supply

Front 3

What does the price of resources reflects

Back 3

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

Front 4

Economics is concerned only with....

Back 4

How much people are willing to pay for what they want

Front 5

Economists study.....

Back 5

1. How people make decisions

2. How people interact with each other

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

Front 6

Examples of how people make decisions

Back 6

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.

Front 7

Examples of how people interact with each other

Back 7

How prices and quantities of goods are determined

Front 8

Examples of forces and trends that affect the economy

Back 8

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

Front 9

What are the two subfields of economics?

Back 9

Microeconomics, and macroeconomics

Front 10

Microeconomics

Back 10

Studies how households and firms make decisions and interact.

Front 11

Examples of Microeconomics

Back 11

1. How market power affects production and price

2. How tariffs affect consumers, producers and society

Front 12

Macroeconomics

Back 12

Studies the overall economy

Front 13

Macroeconomics examples

Back 13

1. How a tax cut can stimulate economic growth

2. How increasing the money supply causes inflation

Front 14

Both are intertwined because....

Back 14

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

Front 15

Ten Principles of Economics

Back 15

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)

Front 16

Principle #1 People Face Tradoffs

Back 16

All decisions involve tradeoffs

Front 17

Examples of People facing tradeoffs

Back 17

* 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

Front 18

What is a common tradeoff in economics

Back 18

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

Front 19

Efficiency is...

Back 19

Getting the most from resources (size of the pie)

Front 20

Equity is...

Back 20

Sharing resources fairly within a society (who eats it)

Front 21

Example of the tradeoff between efficiency and equity

Back 21

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

Front 22

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

Back 22

Making decisions requires comparing the costs and benefits of alternative choices

Front 23

Opportunity Cost is...

Back 23

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

Front 24

Examples of Opportunity cost...

Back 24

* 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

Front 25

Principle #3 Rationale People Think at the Margin

Back 25

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.

Front 26

Examples of Rationale people thinking at the margin...

Back 26

* 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

Front 27

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

Back 27

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.

Front 28

Principle #4 People Respond to Incentives

Back 28

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

Front 29

Examples of people responding to incentives

Back 29

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

* When cigarette taxes increase, teen smoking falls

Front 30

Principle #5 Trade can make Everyone Better Off

Back 30

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

Front 31

Countries also benefit from trade and specialization because...

Back 31

* 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

Front 32

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

Back 32

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

Front 33

Organizing economic activity entails determining...

Back 33

* What goods to sell

* How to produce them

* How much of each to produce

* Who gets them

Front 34

A market economy...

Back 34

* 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)

Front 35

Principle #7 Governments Can Sometimes Improve Market Outcomes

Back 35

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.

Front 36

Causes of Market Failure include...

Back 36

* 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)

Front 37

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

Back 37

Promote efficiency

Front 38

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

Back 38

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

Front 39

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

Back 39

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.

Front 40

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

Back 40

* 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

Front 41

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

Back 41

Less

Front 42

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

Back 42

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.

Front 43

Inflation per year in Canada averaged about;

Back 43

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

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

Front 44

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

Back 44

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

Front 45

Examples of the tradeoff between inflation and unemployment

Back 45

* 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.

Front 46

The Four Principles of How People Make Decisions are;

Back 46

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

Front 47

The Three Principles of How People Interact Are;

Back 47

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.

Front 48

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

Back 48

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.

Front 49

What two roles do Economists play

Back 49

1. Scientists

2. Policy Advisors

Front 50

What do Economists do as Scientists?

Back 50

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

Front 51

What do Economists do as Policy Advisors

Back 51

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.

Front 52

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

Back 52

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

Front 53

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

Back 53

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

Front 54

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

Back 54

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

Front 55

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

Back 55

Normative - another value judgment

Front 56

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?

Back 56

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

Front 57

Why do economists use models to study economic issues?

Back 57

* To draw logical conclusions (deductions)

* To predict real world behavior

Front 58

A model is....

Back 58

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

Front 59

Assumptions...

Back 59

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

Front 60

The Circular Flow Diagram

Back 60

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

Front 61

Two markets

Back 61

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)

Front 62

Two types of economic agents

Back 62

1. Households

2. Firms

Front 63

Households

Back 63

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

* Buy and consume goods and services

Front 64

Firms

Back 64

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

* Sell goods and services.

Front 65

The Production Possibilities Frontier (PPF)

Back 65

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

Front 66

Example of The Production Possibilities Frontier

Back 66

* 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.

Front 67

Economists often give conflicting policy advice, they disagree

Back 67

* 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?

Front 68

Gross Domestic Product (GDP)

Back 68

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

Front 69

For the economy as a whole....

Back 69

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

Front 70

What does the Circular Flow Diagram omit?

Back 70

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.

Front 71

GDP Defined

Back 71

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

Front 72

How are goods valued?

Back 72

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.

Front 73

Final Goods and services...

Back 73

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.

Front 74

Are final goods and services be tangible or intangible?

Back 74

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

Front 75

Only newly produced goods

Back 75

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

Front 76

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

Back 76

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)

Front 77

The Expenditure Components of GDP

Back 77

There are four components of spending;

* Consumption (C)

* Investment (I)

* Government Purchases (G)

* Net Exports (NX)

Front 78

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

Back 78

Y = C + I + G + NX

Front 79

Consumption (C)

Back 79

Total Spending by households on goods and services

Front 80

Goods Include

Back 80

* Durable goods such as cars and appliances

* Non-Durable goods such as food and clothing

Front 81

Services Include

Back 81

Intangible items such as haircuts and health care

Front 82

Note on housing costs;

Back 82

* 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.

Front 83

Investment (I)

Back 83

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

Front 84

Investment includes spending on;

Back 84

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

* Structures (factories, office buildings, new houses)

* Inventories (goods produced but not yet sold)

Front 85

What happens when inventories are sold?

Back 85

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

Front 86

Investment does not mean...

Back 86

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

Front 87

Government Purchases (G)

Back 87

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.

Front 88

Excludes...

Back 88

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.

Front 89

Note: GOVERNMENT IS NOT A PERSON

Back 89

Note: GOVERNMENT IS NOT A PERSON

Front 90

Net Exports (NX)

Back 90

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.

Front 91

Imports are subtracted from exports because...

Back 91

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.

Front 92

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

Back 92

Consumption and GDP rise by $200

Front 93

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.

Back 93

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

Front 94

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

Back 94

* 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.

Front 95

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

Back 95

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

Front 96

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

Back 96

1. Nominal GDP.

2. Real GDP

Front 97

Nominal GDP

Back 97

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

Front 98

Example of Nominal GDP

Back 98

* 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

Front 99

Real GDP

Back 99

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

Front 100

Examples of Real GDP

Back 100

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

* Thus, real GDP is corrected for inflation

Front 101

GDP Deflator

Back 101

One measure of the overall level of prices,

Nominal GDP

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

Real GDP

Front 102

GDP Deflator Cont.

Back 102

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

Front 103

Real GDP per capita

Back 103

(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

Front 104

Real GDP per capita does not measure...

Back 104

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.

Front 105

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

Back 105

* 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

Front 106

The Consumer Price Index (CPI)

Back 106

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.

Front 107

The CPP retirement pension

Back 107

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

Front 108

2015 Maximum pensionable earnings amount is...

Back 108

$53,600

Front 109

It is adjusted annually based on....

Back 109

Increases in the average wage

Front 110

Maximum retirement pension equals how much per month for 2015?

Back 110

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

Front 111

Maximum 2015 CPP employee contribution;

Back 111

* 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.

Front 112

The OAS Program

Back 112

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

Front 113

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

Back 113

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

Front 114

OAS Pension Benefit is income-tested or not?

Back 114

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.

Front 115

OAS benefits are adjusted how often?

Back 115

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

Front 116

How is CPI Calculated?

Back 116

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.

Front 117

The "Basket"

Back 117

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

Front 118

Find the Prices

Back 118

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

Front 119

Compute the basket's cost

Back 119

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

Front 120

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

Back 120

CPI = Cost of Basket of Goods in Current Year

-----------------------------------------------------------

Cost of Same Basket in Base Year

x 100

Front 121

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

Back 121

Inflation Rate In Current Year =

CPI in current Year - CPI in Previous Year

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

CPI in Previous Year

Front 122

Problems with the CPI

Back 122

1. Commodity Substitution Bias

2. Introduction of New Goods

3. Unmeasured Quality Change

Front 123

Commodity Substitution Bias

Back 123

* 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.

Front 124

Introduction of New Goods

Back 124

* 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.

Front 125

Introduction of New Goods Cont.

Back 125

* 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.

Front 126

Unmeasured Quality Change

Back 126

* 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.

Front 127

Consequences of these 3 problems

Back 127

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.

Front 128

Consequences of these 3 problems cont.

Back 128

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.

Front 129

The GDP Deflator versus the CPI.

Back 129

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

Front 130

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

Back 130

1. Each Measure a different set of goods and services

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

Front 131

Measures a different set of goods and services

Back 131

* 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.

Front 132

One set of goods and services fixed and the other variable

Back 132

* 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.

Front 133

Contrasting the CPI and GDP deflator (Part 1)

Back 133

Imported Consumer goods;

* Included in CPI

* Excluded from GDP deflator

Front 134

Contrasting the CPI and GDP deflator (Part 2)

Back 134

Capital goods;

* Excluded from CPI

* Included in GDP deflator (if produced domestically)

Front 135

Contrasting the CPI and GDP deflator (Part 3)

Back 135

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.

Front 136

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

Back 136

The GDP deflator and the CPI both rise

Front 137

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

Back 137

The GDP deflator rises; the CPI does not

Front 138

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.

Back 138

The GDP deflator does not rise; the CPI does.

Front 139

Comparing Dollar Figures from Different Times

Back 139

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

Front 140

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?

Back 140

Equation;

Price in Base year's dollars

x

Price level today/Price level in base year

=

Price in today's dollars

Front 141

Outcome of the Gas example;

Back 141

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.

Front 142

Indexation

Back 142

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.

Front 143

Nominal Interest Rate

Back 143

* The interest rate not corrected for inflation

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

Front 144

The Real Interest Rate

Back 144

* Corrected for inflation

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

Front 145

Standards of living

Back 145

(or income per person)

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

* Over time (growth)

Front 146

Productivity

Back 146

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)

Front 147

What determines productivity and its growth rate?

Back 147

*Physical Capital Per Worker

* Human Capital Per Worker

* Natural Resources Per Worker

* Technological Knowledge

Front 148

Physical Capital Per Worker (K)

Back 148

* 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)

Front 149

Human Capital Per Worker (H)

Back 149

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

Front 150

Natural Resources Per Worker (N)

Back 150

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.

Front 151

Technological Knowledge

Back 151

* 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)

Front 152

Technological Knowledge vs. Human Capital

Back 152

* 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.

Front 153

The Production Function

Back 153

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

Front 154

The Production Function has the property of...

Back 154

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)

Front 155

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

Back 155

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

Front 156

Importance of Investments

Back 156

By investing, we can boost productivity (increasing K)

Front 157

Producing more capital requires what?

Back 157

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

Reducing Consumption --> Increasing Savings.

Front 158

Can anyone else help raise savings and investments?

Back 158

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.

Front 159

Importance of Investment from Abroad

Back 159

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

Front 160

Foreign Direct Investment

Back 160

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

Front 161

Foreign Portfolio Investment

Back 161

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

Front 162

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

Back 162

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

Front 163

What are the benefits of foreign investment?

Back 163

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.

Front 164

What is the benefit of Education?

Back 164

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

Front 165

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

Back 165

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

Front 166

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

Back 166

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

Front 167

Inward-oriented policies

Back 167

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

Front 168

Outward-oriented policies

Back 168

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

Front 169

What effects do trade have on technology?

Back 169

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

Front 170

Technological progress is the main reason why....

Back 170

living standards rise over the long run

Front 171

What is a reason that technological progress increases living standards?

Back 171

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

Front 172

Policies to promote technological progress include;

Back 172

* Patent laws

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

* Grants for basic research at universities

Front 173

Population growth may affect living standards in 3 different ways

Back 173

1. Stretching natural resources

2. Diluting the capital stock

3. Promoting technological progress

Front 174

Stretching natural resources

Back 174

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

Front 175

Diluting the capital stock

Back 175

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.

Front 176

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

Back 176

* China's one child per family laws

* Contraception education and availability

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

Front 177

Promoting technological progress

Back 177

More people leads to;

* More scientists, inventors, engineers

* More frequent discoveries

* Faster technological progress and economic growth

Front 178

Evidence of population growth being connected to technological progress;

Back 178

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

Front 179

List the determinants of productivity

Back 179

* K/L, physical capital per worker

* H/L, human capital per worker

* N/L, natural resources per worker

* A, technological knowledge

Front 180

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

Back 180

* 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

Front 181

What are downsides of population growth?

Back 181

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

Front 182

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

Back 182

* Hybrid cars use less gas

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

Front 183

What happens as resources become more scarce?

Back 183

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

Front 184

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?

Back 184

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

Front 185

The financial system

Back 185

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

Front 186

Financial markets

Back 186

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

* The Bond Market

* The Stock Market

Front 187

The Bond Market (Debt finance)

Back 187

* 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)

Front 188

The Stock Market (Equity Finance or Shares)

Back 188

* 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

Front 189

Financial Intermediaries

Back 189

Institutions through which savers can indirectly provide funds to borrowers

Front 190

Examples of Financial Intermediaries

Back 190

1. Banks and Trust Companies

2. Mutual Funds

Front 191

Banks and Trust Companies

Back 191

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

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

Front 192

Mutual Funds

Back 192

* 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.

Front 193

Three Different Kinds of Saving

Back 193

1. Private Saving

2. Public Saving

3. National Saving

Front 194

Private Saving

Back 194

* 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

Front 195

Public Saving

Back 195

* Tax revenue (total minus transfers) minus government spending

= T-G

Front 196

National Saving

Back 196

* 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

Front 197

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

Back 197

Y = C+I+G

In a closed economy, Saving = Investment

Front 198

Budget Surplus

Back 198

An excess of tax revenue over government spending.

= T-G

= Public Saving

Front 199

Budget Deficit

Back 199

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

Front 200

For budget surplus / public saving

Back 200

If T>G -> Budget surplus/public saving

Front 201

For Budget deficit

Back 201

If T<G -> budget deficit

Front 202

For Balanced Budget

Back 202

If T=G -> balanced budget

Front 203

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.

Back 203

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

Front 204

Answer to the above question;

Back 204

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

Front 205

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

Back 205

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

Front 206

Private Saving

Back 206

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

Front 207

Examples of what households do with private saving;

Back 207

* 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

Front 208

Investment

Back 208

The purchase of new capital

Front 209

Examples of (physical investment)

Back 209

* 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

Front 210

In economics investment is NOT...

Back 210

the purchase of stocks and bonds

Front 211

What do financial markets help allocate?

Back 211

The economy's scare resources to their most efficient uses

Front 212

What governs financial markets?

Back 212

Financial markets are governed by the forces of supply and demand

Front 213

Financial markets also link the present to the future by;

Back 213

* 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

Front 214

A supply-demand model of the financial system

Back 214

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

* Investment is the demand for funds for private investment

Front 215

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

Back 215

* The financial system coordinates savings and investment

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

Front 216

Assume only one financial market...

Back 216

* 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

Front 217

The supply of loanable funds comes from saving:

Back 217

* 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

Front 218

The demand for loanable funds comes from private investment;

Back 218

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

* Households borrow the funds they need to purchase new houses

Front 219

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

Back 219

extremely rapid

Front 220

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

Back 220

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

Front 221

The rise in the interest rate would make borrowing what?

Back 221

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

Front 222

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

Back 222

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

Front 223

The fall in the rate would make borrowing...

Back 223

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.

Front 224

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

Back 224

* Greater reliance on sales taxes instead of income taxes

* Income tax incentives for both saving and investment

Front 225

Greater reliance on sales taxes instead of income taxes

Back 225

* Sales taxes tax only consumption; not saving

Front 226

Income tax incentives for both saving and investment

Back 226

* Savings incentives include; TFSAs, RRSPs, RESPs

* Income tax greatly reduces the return to saving

Front 227

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

Back 227

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

Front 228

Analysis shows the by reducing national saving....

Back 228

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

Front 229

Government debt is the...

Back 229

Sum of all past budget deficits and surpluses

Front 230

Crowding out

Back 230

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.

Front 231

Vicious circle

Back 231

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

Front 232

Virtuous circle

Back 232

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.