Test

# 1 prep
Fiscal policy: making changes in tax rates and government spending (why there are deficits)
Monetary policy: changing interest rates and changing the amount of money in the economy
Y = C + I + G + NE
Y = total economy
C = consumption
I = investments
G = government spending
NE = net exports
Keynes focused on the short-term: on unemployment and lost production
During the 1970s and 1980s, macroeconomists became more concerned with the long-term:
inflation and economic growth
Every business cycle has 2 phases:
1. Recession: a period during which real GDP decreases for at least 2 successive quarters
2. Expansion: a period during which real GDP increases
And 2 turning points:
1. A peak
2. A trough
Gross domestic product (GDP): market value of all final goods and services produced in a
country in a given time period
GDP is a market value – goods and services are valued at their market prices
GDP is the value of final goods and services produced
Final good: an item bought by its final user during a specified time period
Intermediate good: an item that is produced by one firm, bought by another firm, and used as a
component of a final good or service
Primary good: material in a raw or unprocessed state
GDP measures production within a country and the value of production in a given time period
GDP measures the value of production, which also equals total expenditure on final goods and
total income
The equalitiy of income and output shows the link between productivity and living standards
The circular flow diagram shows the transactions among:
1. Households
2. Firms
 3. Governments
4. The rest of the world
Households sell and firms buy the service of labour, capital, and land in factor markets
Firms sell and households buy consumer goods and services in the goods market. The total
payment for these goods and services is consumption expenditure
When a firm adds unsold output of inventory, we can think of the firm as buying goods from
itself. The purchase of new plant, equipment, and buildings and the additions to inventories are
investment
Governments buy goods and services from firms and their expenditure on goods and services is
called government expenditure
Firms in Canada sell goods and services to the rest of the world – exports – and buy goods and
services from the rest of the world – imports.
The value of exports minus the value of imports is called net exports
GDP can be measured in 2 ways:
1. The expenditure approach: the sum of consumption expenditure (C) investment (I) and
government expenditure on goods and services (X-M)
2. The income approach: summing the incomes that firms pay households for the factors
of production they hire
Investment is financed from 3 sources:
1. Private savings (S)
2. Government budget surplus (T-G)
3. Borrowing from the rest of the world (M-X)
Gross means before accounting for the depreciation of capital. The opposite of gross is net
Flow: a quantity per unit of time
Stock: a quantity that exists at a point in time
Depreciation (Capital consumption): the decrease in the capital stock that results from wear
and tear, and obsolescence
Gross profits and GDP include depreciation
2 adjustments must be made to get GDP:
1. Indirect taxes minus subsidies are added to get from factor cost to market prices
2. Depreciation (or capital consumption) is added to get from net domestic product to
gross domestic product
Real GDP: the value of final goods and services produced in a given year when valued at
constant prices
Calculating real GDP: the first step is to calculate nominal GDP, which is the value of goods and
services produced during a given year valued at the prices that prevailed in that same year
The new method of calculating real GDP, which is called the chain-weighted output index
method, uses the prices of two adjacent years to calculate the real GDP growth rate
This calculation has 4 steps:
1. Value last year’s production and this year’s production at last years prices and then
calculate the growth rate of this number from last year to this year
2. Value last years production and this years production at this years prices and then
calculate the growth rate of this number from last year to this year
3. Calculate the average of the 2 growth rates. This is the growth rate of real GDP from last
year to this year
The average level of prices is called the price level
One measure of the price level is the GDP deflator, which is an average of the prices of the
goods in GDP in the current year expressed as a percentage of the base year prices
Nominal GDP also increases because prices rise
Real GDP is adjusted for inflation whereas nominal is not
We use real GDP to calculate the economic growth rate
The economic growth rate is the % change in the quantity of goods and services produced from
one year to the next
We measure economic growth so we can make:
- Economic welfare comparisons
- International welfare comparisons
- Business cycle forecasts
Economic welfare measures the nations overall state of well-being
Real GDP is not a perfect measure of economic welfare for 7 reasons:
1. Quality improvements tend to be neglected in calculating real GDP so the inflation rate
is overstated and real GDP understated
2. Real GDP does not include household production, that is productive activities done in
and around the house by members of the household
3. Real GDP, as measured, omits the underground economy, which is illegal economic
activity or legal economic activity that goes unreported for tax avoidance reasons
4. Health and life expectancy are not directly included in real GDP
5. Leisure time, a valuable component of an individuals welfare is not included in real GDP
6. Environmental damage is not deducted
7. Political freedom and social justice are not included
Real GDP is used to compare economic welfare in one country with that in another
Two special problems arise in making these comparisons
- Real GDP of one country must be converted into the same currency units as the real
GDP of the other country, so an exchange rate must be used
 - The same prices should be used to value the goods and services in the countries being
compared but often are not
Using the exchange rate to compare GDP in one country with GDP in another is problematic
because prices of particular products in one country may be much less or more than the other
country
Real GDP is used to measure business cycle fluctuations
These fluctuations are probably accurately timed but the changes in real GDP probably
overstate the changes in total production and peoples welfare caused by business cycles
The business cycle is the periodic but irregular up-and-down movement in production and jobs
The population is divided into 2 groups:
1. Working age: 15 and older
2. People too young to work or in institutional care
The working age population is divided into 2 groups:
1. People in the labour force
2. People not in the labour force
The labour force is the sum of employed and unemployed workers
To be considered unemployed, a person must be in one of the following 3 categories:
1. Without work but has made specific efforts to find a job within the previous 4 weeks
2. Waiting to be called back to a job from which he or she has been laid off
3. Waiting to start a new job within 4 weeks
4 labour market indicators:
1. Unemployment rate: the % of the labour force that is unemployed
(# of people unemployed / labour force) X 100
reaches its peak during recessions
2. Involuntary part-time rate
3. Labour force participation rate: the % of the working age population that is in the labour
force
(labour force / working age population) X 100
falls during recessions as discouraged workers – people available and willing to work but
who have not made an effort to find work within the last 4 weeks – leave the labour
force
4. Employment-to-population ratio: the % of working-age people who have jobs
(# of people employed / working-age population) X 100
3 types of people are unemployed:
1. Job losers: workers who have been laid off or fired and are searching for new jobs
2. Job leavers: workers who have voluntarily quit their jobs to look for new ones (smallest
fraction of unemployment)
 3. Entrants and re-entrant: people entering the labour force for the first time or returning
to the labour force and searching for work
People end a spell of unemployment for 2 reasons:
1. Hired or recalled workers gain jobs
2. Discouraged unemployment workers withdraw from the labour force
There are 4 types of unemployment:
1. Frictional: unemployment that arises from normal labour market turnover
2. Structural: unemployment created by changes in technology and foreign competition
that change the match between the skills necessary to perform jobs and the locations of
jobs, and the skills and location of the labour force
3. Seasonal: unemployment that arises because the # of jobs available has decreased
because of the season
4. Cyclical: the fluctuation in unemployment caused by the business cycle
Full employment: occurs when there is no cyclical unemployment or, equivalently, when all
employment is frictional or structural
The unemployment rate at full employment is called the natural rate of unemployment
Potential GDP: the quantity of real GDP produced at full employment. It corresponds to the
capacity of the economy to produce output on a sustained basis; actual GDP fluctuates around
potential GDP with the business cycle
The consumer price index (CPI): measures the average level of the prices of goods and services
consumed by an urban family
The CPI is defined to equal 100 for the reference base period
The value of the CPI for any other period is calculated by taking the ratio of the current cost of a
market basket of goods to the cost of the same market basket of goods in the reference base
period and multiplying by 100
Constructing the CPI involves 3 stages:
- Selecting the CPI basket
- Conducting a monthly price survey
- Using the prices and the basket to calculate the CPI
The CPI basket is based on a consumer expenditure survey
Every month, statistics Canada employees check the prices of the goods and services in the CPI
basket in 64 urban areas
The CPI is calculated using the prices and the contents of the basket
CPI = (cost of basket in current period / cost of basket in base period) X 100
The main purpose of the CPI is to measure inflation
The inflation rate: % change in the price level from one year to the next
Inflation rate = [(CPI this year – CPI last year) / CPI last year] X 100
The CPI may overstate the true inflation for 4 reasons:
1. New goods bias: new goods that were not available in the base year appear and, if they
are more expensive than the goods they replace, the price level may be biased higher.
Similarly, if they are cheaper than the goods they replace, but not yet in the CPI basket,
they bias the CPI upward.
2. Quality change bias: quality improvements generally are neglected, so quality
improvement that lead to price hikes are considered purely inflationary
3. Commodity substitution bias: the market basket of goods used in calculating the CPI is
fixed and does not take into account consumers’ substitutions away from goods whose
relative prices increase
4. Outlet substitution bias: as the structure of retailing changes, people switch to buying
from cheaper sources, but the CPI, as measured, does not take account of this outlet
substitution
The bias of the CPI distorts private contracts increases government outlays (close to a third of
government outlays are linked to the CPI), and biases estimates of real earnings
To reduce the bias in the CPI, statistics Canada undertakes consumer expenditure surveys more
frequently and revises the CPI basket frequently























Chapter 20

Gross Domestic Product

• GDP, or gross domestic product, is the market value of all the final goods and services
produced in a country during a given period
• A final good is an item that is bought by its final user, and it contrasts with an
intermediate good, which is a component of a final good
• GDP is calculated by using either the expenditure or income totals in the circular flow
model
• Aggregate expenditure on goods and services equals aggregate income and GDP

Measuring Canada’s GDP

• Because aggregate expenditure, aggregate income, and the value of aggregate
production are equal, we can measure GDP by using the expenditure approach or the
income approach
• The expenditure approach sums consumption expenditure, investment, government
expenditure on goods and services, and net exports
• The income approach sums wages, interest, rent, and profit (and indirect taxes less
subsidies and depreciation)
• Real GDP is measured using a common set of prices to remove the effects of inflation
from GDP

The uses and limitations of real GDP

• Real GDP is used to compare the standard of living over time and across countries
• Real GDP per person grows and fluctuates around the more smoothly growing potential
GDP
• Incomes would be much higher today if the growth rate of real GDP per person had not
slowed during the 1970s
• International real GDP comparisons use PPP prices
• Real GDP is not a perfect measure of the standard of living because it excludes
household production, the underground economy, health and life expectancy, leisure
time, environmental quality, and political freedom and social justice

Chapter 21

Employment and unemployment

• Unemployment is a serious personal, social, and economic problem because it results in
lost output and income and a loss of human capital
 • The unemployment rate averaged 7.6 percent between 1960 and 2007. In increases in
recessions and decreases in expansions
• The labour force participation rate and the employment-to-population ratio have an
upward trend and fluctuate with the business cycle

Unemployment and full employment

• The unemployment rate is an imperfect measure of the underutilization of labour
resources because it excludes some underutilized labour and some unemployment is
unavoidable
• The unemployment rate underestimates the underutilization of labour resources
because it excludes marginally attached workers and part time workers who want full
time jobs
• Some unemployment is unavoidable because people are constantly entering and leaving
the labour force and losing or quitting jobs; also firms that create jobs are constantly
being born, expanding, contracting, and dying
• Unemployment can be frictional, structural, or cyclical
• When all unemployment is frictional and structural, the unemployment rate equals the
natural unemployment rate, the economy is at full employment, and real GDP equals
potential GDP
• Over the business cycle, real GDP fluctuates around potential GDP and the
unemployment rate fluctuates around the natural unemployment rate

The price level and inflation

• Inflation is a problem because it redistributes income and wealth and diverts resources
from production
• The consumer price index (CPI) is a measure of the average of the prices paid by urban
consumers for a fixed basket of consumer goods and services
• The CPI is defined to equal 100 for a reference base period
• The inflation rate is the percentage change in the SPI from one period to the next
• Changes in the CPI probably overstate the inflation rate because of the bias that arises
from new goods, quality changes, commodity substitution, and outlet substitution
• The bias in the CPI distorts private contracts and increases governments outlays
• Alternative price level measures avoid the bias of the CPI but do not make a large
difference to the measured inflation rate
• Real economic variables are calculated by dividing nominal variables by the price level





Chapter 20: measuring GDP and Economic Growth
To assess the state of the economy and to make big decisions about business contraction or
expansion, firms use forecasts of GDP
Gross domestic product (GDP): the market value of the final goods and services produced
within a country in a given time period. This definition has 4 parts:
1. Market value: the prices at which items are traded in markets
2. Final goods and services: an item that is bought by its final user during a specified time
period
3. Produced within a country: if something is produced in a certain country, it is part of
that country’s GDP
4. In a given time period
Intermediate good or service: an item that is produced by one firm, bought by another firm,
and used as a component of a final good or service
A second hand good was a part of GDP in the year in which it was produced, but not part of
GDP this year
Our standard of living rises when our incomes rise and we can afford more goods and services,
but we must produce more goods and services if we’re able to buy more goods and services
Rising incomes and rising value of production go together. They are two aspects of the same
phenomenon: increasing productivity
There are 4 parts to the circular flow and expenditure and income:
1. Households: sell the services of labour, capital, and land in factor markets. Buy
consumer goods and services
2. Firms: buy the services of labour, capital, and land in factor markets. They pay income to
households such as wages for labour services, interest for the use of capital, and rent for
the use of land. Buy consumer goods and services
3. Governments: buy goods and services from firms
4. The rest of the world
Aggregate income: total income
Retained earnings: profits that are not distributed to households. It is income that households
save and lend back to firms
Consumption expenditure: the total payment of consumer goods and services
Investment: the purchase of new plant, equipment, and buildings and the additions to
inventories
Exports: Canada sells goods and services to the rest of the world
Imports: Canada buys goods and services from the rest of the world
Net exports: the value of exports minus the value of imports
GDP = aggregate income = aggregate expenditure
Depreciation: the decrease in the value of a firms capital that results from wear and tear and
obsolescence
Gross investment: the total amount spent both buying new capital and replacing depreciated
capital
Net investment: the amount by which the value of capital increases (gross investment –
depreciation)
There are 2 approaches available for measuring GDP:
1. The expenditure approach: the sum of consumption expenditure (C), investment (I),
government expenditure on goods and services (G), and net exports of goods and
services (X-M)
2. The income approach: the sum of incomes that firms pay households for the factors of
production they tire (wages for labour, interest for capital, rent for land, profit for
entrepreneurship)
Business investment: expenditure on capital equipment and buildings by firms and the
additions to business inventories
Income can be divided into 5 categories:
1. Wages, salaries, and supplementary labour income: payment for labour services plus
taxes withheld on earnings plus benefits such as pension contributions
2. Corporate profits: the profits of corporations, some of which are paid to households in
the form of dividends and some of which are retained by corporations.
3. Interest and miscellaneous investment income: interest households receive on loans
they make minus the interest households pay on their own borrowing
4. Farmer’s income: mixtures of the top 3. Includes compensation for the owner’s labour,
payment for the use of owner’s capital, and profit.
5. Income from non-farm unincorporated businesses: same as 4
Indirect tax: tax paid by consumers when they buy goods and services
Direct tax: a tax on income
Subsidy: a payment by the government to a producer
Real GDP: the value of final goods and services produced in a given year when valued at the
prices of a reference base year
Nominal GDP: the value of final goods and services produced in a given year valued at the
prices of that year. It is a more precise name for GDP
Economists use estimates of real GDP for 2 main reasons:
1. To compare the standard of living over time
2. To compare the standard of living across countries
Real GDP per capita: real GDP divided by the population. It tells us the value of goods and
services that the average person can enjoy
Potential GDP: when all the economy’s labour, capital, land, and entrepreneurial ability are fully
employed
Business cycle: a periodic but irregular up-and-down movement of total production and other
measures of economic activity
Every cycle has 2 phases:
1. Expansion: a period during which real GDP increases
2. Recession: a period during which real GDP decreases – its growth rate is negative – for
at least 2 successive quarters
And 2 turning points:
1. Peak: real GDP reaches its highest level in an expansion and from which a recession
begins
2. Trough: the bottom of a recession when real GDP reaches a temporary low point from
which the next expansion begins
2 problems arise when comparing real GDP across countries:
1. The real GDP of one country must be converted into the same currency as the other
2. Goods and services of both countries must be valued at the same price
Purchasing power parity (PPP): prices which are the same prices for both countries when
converted at the market exchange rate
Some of the factors that influence the standard of living that are not part of GDP are:
- Household production: making meals, cleaning, etc.
- Underground economic activity: the part of the economy that is purposely hidden from
view of the government to avoid taxes and regulations or because the goods and
services being produced are illegal
- Health and life expectancy
 - Leisure time
- Environmental quality
- Political freedom and social justice
The omission of household production from GDP means that GDP underestimates total
production, and the growth rate of GDP overestimates the growth rate of total production

Chapter 21: Monitoring jobs and inflation
Unemployment is a serious personal and social economic problem for 2 main reasons. It results
in:
- Lost production and incomes
- Lost human capital
Labour force survey: 54,000 households are asked a series of questions about the age and job
market status of the members of each household
The population divides into 2 broad groups:
1. The working-age population: total number of people age 15 and older
2. Others who are too young to work or who live in institutions and are unable to work
The working-age population is divided into 2 groups:
1. Those in the labour force
2. Those not in the labour force
Labour force: the sum of the employed and unemployed
Employed people are either full-time or part-time workers; and part-time workers either want
part time work (voluntary part-time) or want full-time work (involuntary part-time)
To be counted as unemployed, a person must be available for work and must be in one of the
following 3 categories:
1. Without work but has made specific efforts to find a job within the previous four weeks
2. Laid of from work and waiting to be called back to work
3. Waiting to start a new job within four weeks
Statistics Canada calculates 4 indicators of the state of the labour market:
1. The unemployment rate: the % of the people in the labour force who are unemployed
2. The involuntary part-time rate: part time workers who want full time work
3. The labour force participation rate: the % of the working-age population who are
members of the labour force
 4. The employment-to-population ratio: the % of people of working age who have jobs
Unemployment rate = # of people unemployed / labour force X 100
Involuntary part-time rate = # involuntary part-time workers / labour force X 100
Labour force = # people employed X # people unemployed
Labour force participation rate = labour force / working-age population X 100
Employment-to-population ratio = # people employed / working-age population X 100
The employment-to-population ratio fluctuates with the business cycle: it falls in a recession
and rises in an expansion
The unemployment rate is an imperfect measure for 2 reasons:
- It excludes some underutilized labour
- Some unemployment is unavoidable
2 types of underutilized labour that are excluded are:
1. Marginally attached workers: a person who currently is neither working not looking for
work but has indicated that he or she wants and is available for a job and has looked for
a job sometime in the recent past
Discouraged worker: a marginally attached worker who has stopped looking for a job
because of repeated failure to find one
2. Part-time workers who want full-time jobs
People become unemployed if they:
1. Lose their jobs and search for another job ( job losers)
2. Leave their jobs and search for another job ( job leavers)
3. Enter or reenter the labour force to search for a job ( entrants and reentrants)
People end a spell of unemployment if they:
1. Are hired or recalled
2. Withdraw from the labour force
Frictional unemployment: the unemployment that arises from normal labour turnover – from
people entering and leaving the labour force and from the ongoing creating and distruction of
jobs
Structural unemployment: the unemployment that arises when changes in technology or
international competition change the skills needed to perform jobs or change the locations of
jobs (usually lasts longer than frictional unemployment)
Efficiency wage: a wage set above the going market wage, and it creates unemployment just
like the minimum wage does
A firm might choose to pay an efficiency wage for 4 reasons:
1. It enables the firm to face a steady stream of available new workers
2. It attracts the most productive workers
3. The fear of losing a well-paid job stimulates greater work effort
4. Workers are less likely to quit their jobs, so the firm faces a lower rate of labour
turnover and lower recruiting and training costs
Cyclical unemployment: the higher-than-normal unemployment that arises at a business cycle
trough and the unusually low unemployment that exists at a business cycle peak
Full employment: a situation in which the unemployment rate equals the natural
unemployment rate
Natural unemployment: unemployment that results from natural physical constraints on the
ease with which the labour market can match workers with jobs
Potential GDP: the quantity of real GDP at full employment
Output gap: the gap between real GDP and potential GDP
When the economy is at full employment, the unemployment rate equals the natural
unemployment rate and real GDP equals potential GDP so the output gap is zero
When the unemployment is less than the natural employment rate, real GDP is greater than
potential GDP and the output gap is positive
When the unemployment rate is greater than the natural employment rate, real GDP is less
than potential GDP and the output gap is negative
Price level: the average level of prices
We are interested in price level for 2 main reasons:
1. We want to measure the inflation rate: the annual percentage change of the price level
2. We want to distinguish between the money values and real values of economic
variables
Inflation is a problem because, once it takes hold, its rate is unpredictable
Unpredictable inflation brings serious social and personal problems because it:
- Redistributes income and wealth
- Diverts resources from production
Hyperinflation: an inflation rate so rapid that workers are paid twice a day because money loses
its value so quickly
Consumer price index (CPI): a measure of the average of the prices paid by urban consumers for
a fixed basket of consumer goods and services
The CPI is defined to equal 100 for a period called the reference base period
Constructing the CPI is a huge operation that involved 3 stages:
1. Selecting the CPI basket (contains goods and services. More weight is put on things that
are more important like food and shelter)
2. Conducting the monthly price survey
3. Calculating the CPI
To calculate the CPI, we
1. Find the cost of the CPI basket at base-period prices
2. Find the cost of the CPI basket at current-period prices
3. Calculate the CPI for the base period and the current period
CPI = cost of CPI basket @ current-period prices/ cost @ base-period prices X 100
Inflation rate = CPI this year – CPI last year/ CPI last year X 100
The main sources of bias in the CPI are:
1. New goods bias: comparing objects now with objects in the past creates a bias because
the items now are better
2. Quality change bias: inflation is overstated because it doesn’t take into account that
prices sometimes rise because the quality is better
3. Commodity substitution bias: changes in relative prices lead consumers to change the
items they buy
4. Outlet substitution bias: people will use discount stores when prices rise
2 alternatives to CPI:
- GDP deflator: an index of the prices of all the items included in GDP and is the ratio of
nominal GDP to real GDP
- Chained price index for consumption (CPIC): an index of the prices of all the items
included in consumption expenditure in GDP and is the ratio of nominal consumption
expenditure to real consumption expenditure
Core inflation rate: the inflation rate excluding volatile elements, attempts to do just that and
reveal the underlying inflation trend