Chapter 5

Macroeconomics examines if smart microeconomic choices by individuals add up to

smart macroeconomic outcomes for the economy as a whole.
● The Global Financial Crisis of 2008–2009 and the Great Depression of 1929–1933
involved financial bubbles that burst, high unemployment, falling living standards,
bankruptcies, as well as government policy mistakes.
● Macroeconomics analyzes the performance of the whole Canadian economy and
global economy — the combined outcomes of all individual microeconomic choices.
● Microeconomics analyzes choices that individuals in households, businesses, and
governments make, and how those choices interact in markets.
● Fallacy of composition — what is true for one is not true for all; the whole is greater
than the sum of the individual parts.
– Paradox of thrift — attempts to increase saving cause total savings to
decrease because of falling employment and incomes.
● The circular flow model reduces the complexity of the Canadian economy to three
players — households, businesses, and governments.
– Input markets determine incomes.
– Output markets determine the value of all products and services sold.
– Macroeconomics focuses on connections between input and output
markets.
● The fundamental macroeconomic question: “If left alone by government, do the price
mechanisms of market economies adjust quickly to maintain steady growth in living
standards, full employment, and stable prices?”
– “Yes — Markets Self-Adjust” answer is based on Say’s Law — supply
creates its own demand.
– “No — Markets Fail Often” answer is from J. M. Keynes, founder of
macroeconomics in the 1930s.

The “Yes” and “No” answers to the question “If left alone, do markets quickly self-
adjust?” differ on the fallacy of composition, causes of business cycles, risk of
government failure versus market failure, role for government, and political positions.
● Like J. B. Say and J. M. Keynes, economists and politicians today disagree about the
fundamental macroeconomic question.
● Market failure — market outcomes are inefficient or inequitable and fail to serve the
public interest.
● Government failure — government policy fails to serve the public interest.
● “Yes — Left Alone, Markets Self-Adjust — Hands Off” camp believes
– macroeconomic and microeconomic outcomes are the same.
– external events or government policy cause business cycles.
– government failure is more likely than market failure.
– government should be hands-off.
● “No — Left Alone, Markets Fail Often — Hands On” camp believes
– fallacy of composition — macroeconomic and microeconomic outcomes are
different.
 – markets cause business cycles through connection failures between input
and output markets, roles of money, banking, and expectations.
– market failure is more likely than government failure.
– government should be hands-on.
● There are also agreements between camps.
● Politicians on the political right tend to be in “Yes — Markets Self-Adjust” camp, so
government hands-off.
● Politicians on the political left tend to be in “No — Markets Fail Often” camp, so
government hands-on.
● Market failure occurs due to economies of scale and externalities

Three key performance outcomes of the Canadian economy are GDP, unemployment,
and inflation; produced by the choices of five macroeconomic players — consumers,
businesses, government, Bank of Canada and the banking system, and the rest of the
world.
● Good outcomes are higher gross domestic product (GDP), lower unemployment, and
low and predictable inflation.
● Consumer choices:
– spend income or save
– buy Canadian products and services, or imports
● Business choices:
– investment spending — business purchases of new factories and
equipment
– hiring workers or not
– buying inputs domestically or importing
– selling outputs domestically or exporting
● Government choices:
– buying products and services
– fiscal policy — government purchases, taxes/transfers to achieve the
macroeconomic outcomes of steady growth, full employment, and stable
prices
● Bank of Canada and banking system choices:
– making loans or not
– monetary policy — Bank of Canada changes interest rates and the supply
of money to achieve the macroeconomic outcomes of steady growth, full
employment, and stable prices.
● Rest of World (R.O.W.) choices:
– buying Canadian exports or not, selling imports to Canada or not
– investing money in Canada or not, accepting Canadian investments or not

Macroeconomics affects your future — GDP affects living standards, unemployment

affects the odds of your finding a job, and inflation can reduce your living standards.
Macroeconomics also informs your vote for politicians and policies influencing
economic performance, and illuminates the important parts of complex economies.
 ● Your personal economic success is affected by
– GDP — higher GDP per person allows higher living standards
– unemployment — affects odds of finding a job
– inflation — reduces living standards if income does not rise as fast as the
prices of what you buy
– interest rates, exchange rates, and government taxes and transfer
payments
● Understanding macroeconomics helps you make smart choices and informs your
vote for politicians whose economic policies influence economic performance and
therefore your economic success.
● Thinking like a macroeconomist means using the circular flow model to focus on
connections inside the economy and out to the rest of the world.

Chapter 6

GDP concepts measure the value of all final products and services produced annually
in a country; nominal GDP combines changes in prices and quantities, real GDP
measure only changes in quantities, and real GDP per person is the best measure of
material standard of living.
● Nominal GDP — value at current prices of all final products and services produced
annually in a country. To calculate nominal GDP:

Differences in nominal GDP between years are due to either price changes or
quantity changes.
● Flow — amount per unit of time.
● GDP includes products and services produced within a country’s borders, no matter
what the nationality of the business doing the producing.
● Real GDP — value at constant prices of all final products and services produced
annually in a country. To calculate real GDP using 2002 constant prices:

Real GDP uses constant prices for a single year to value the quantities of products
and services produced in different years. Differences in real GDP between years
show only changes in quantities.
● Real GDP per person — real GDP divided by population.
 ○ – Real GDP per person is the best measure of material standard of living.

Value added solves the problems of double counting and distinguishing final and
intermediate products and services, and shows how aggregate spending equals
aggregate income in circular flow diagrams.
● Value added — value of output minus the value of intermediate products and
services bought from other businesses.
● Value added solves the problems of double counting and of distinguishing between
final and intermediate products and services.
value of final products and services =value added
value of final products and services (GDP) =input's income
● GDP can be calculated using either half of the circular flow.
– aggregate spending (GDP) =aggregate  income (Y)
– spending on final products and services = payments to input owners

● Flows of spending on the enlarged circular flow:

– C — consumption spending by consumers.
– I — business investment spending on factories and machines made by
businesses.
– G — government spending on products and services.
– X — spending by the rest of the world (R.O.W.) on Canadian exports of
products and services.
– IM — Canadian spending on imports of products and services produced by
the rest of the world.
● Aggregate spending equals aggregate income (Y)
– C+I+G+X−IM=Y
– Only products and services produced in Canada count toward Canadian
GDP. Because some consumption, investment, and government spending is
on imports, imports must be subtracted to accurately measure GDP.
● Figure 6.7 — Enlarged GDP Circular Flow of Income and Spending with Banking
System — will be key for answering all macroeconomic questions.

● Consumer choices:
 – spend or save
– disposable income — aggregate income minus net taxes
– net taxes — taxes minus transfer payments
● Business choices:
– hiring inputs and producing products and services
– investment spending (often financed by borrowing)
● Government choices:
– collect taxes, make transfer payments
– spending on products and services
– policy choices in Chapter 12
● R.O.W. choices:
– buy Canadian exports or products and services from elsewhere
– sell imports to Canada or elsewhere
– invest and borrow money in Canada or elsewhere
● Bank choices:
– take deposits and make loans
By increasing the quantity and quality of inputs, economic growth increases
productivity and potential GDP per person, raising maximum possible living
standards.
● Potential GDP — real GDP when all inputs — labour, capital, land/resources, and
entrepreneurship — are fully employed. Short-run goal for economic performance if
Adam Smith’s invisible hand works perfectly.
● Potential GDP per person — potential GDP divided by the population. Short-run
maximum possible living standards for an economy.
● Economic growth — expansion of economy’s capacity to produce products and
services; increase in potential GDP (per person).
● A macro production possibilities frontier (PPF) shows maximum combinations of
products and services that a country can produce, the output when all inputs —
labour, capital, land/resources, and entrepreneurship — are fully employed.
– On the macro PPF, all inputs are fully employed; economy producing at
potential GDP.
– Inside the macro PPF, some inputs are unemployed; economy producing
below potential GDP.
● Economic growth increases potential GDP (per person) and shifts the macro PPF
outward.
● Economic growth is caused by increases in the quantity or quality of a country’s
inputs, including technological change — labour, capital, land/resources, and
entrepreneurship.
● Increases in labour:
– quantity — from population growth; immigration; increase in labour force
participation rate
– quality — from increases in human capital — increased earning potential
from work experience, on-the-job training, and education
● Increases in capital:
– quantity — from more factories and equipment
 – quality — from technological change — improvements in quality of capital
through innovation, research, and development
● Increases in land and resources:
– quantity — by bringing land and resources not connected to markets into
the circular flow
– quality — increases usually due to increases in capital used with land
● Increases in entrepreneurship:
– quantity and quality interrelated; improvements from better management
techniques, organization, and worker/management relations
● When economic growth progresses smoothly, the stock of inputs serves as a basis
for choices, and choices then transform the stock of inputs, continuing in an ever-
expanding circle.
– stock — fixed amount at a moment in time
● Economic growth rate — annual percentage change in real GDP per person.

● Rule of 70 — number of years it takes for initial amount to double is roughly 70

divided by annual percentage growth rate.
– Because of compounding, small differences in annual growth rates have
large consequences over time.
● Productivity — measured as quantity of real GDP produced by an hour of labour.
– Increases in productivity increase living standards; more can be produced,
and amount of work time required to buy products and services is reduced.
● Creative destruction — competitive business innovations generate profits for winners,
improving living standards for all, but destroy less productive or less desirable
products and production methods.

Business cycles — fluctuations of real GDP around potential GDP — are periods of
real GDP expansion and contraction. Output gaps measure the difference between
real GDP and potential GDP, and “closing the gap” is an important target for
policymakers.
● Business cycles — up and down fluctuations of real GDP around potential GDP.
● Language of business cycles:
– expansion — period during which real GDP increases
– peak — highest point of an expansion; the turning point beginning a
contraction
– contraction — period during which real GDP decreases
– trough — lowest point of a contraction; the turning point beginning an
expansion
– recession — two or more successive quarters of contraction of real GDP
● Output gap — real GDP minus potential GDP.
 – recessionary gap — real GDP below potential GDP; gap is a negative
number
– inflationary gap — real GDP above potential GDP; gap is a positive number

Real GDP per person is a limited measure of well-being because it excludes non-
market production, underground economy, environmental damage, leisure, and
political freedoms and social justice.
● Real GDP per person is a limited measure of well-being; does not include:
– non-market production — household production is not counted but improves
the quality of life
– underground economy — hides activities that are illegal, or legal but
avoiding taxes (cash payments for services, unreported tips)
– environmental damage — real GDP does not subtract costs of
environmental damage and resource depletion
– leisure — more leisure lowers real GDP, but leisure may be desirable
– political freedoms and social justice — countries with high real GDP per
person can have limited political freedoms, unequal distributions of income
● Growth rates of real GDP per person are still useful for judging economic progress if
there are no significant changes over time in the limitations.
● United Nations Human Development Index (HDI) measures quality of life by
combining life expectancy, educational achievement, and income.

Chapter 7

The unemployment rate measures the percentage of the labour force who are out of
work and actively searching for jobs, but misses involuntary part-time workers and
discouraged workers. There are four types of unemployment — frictional, structural,
seasonal, and cyclical — but only cyclical unemployment is both unhealthy and a
problem.
 ● Statistics Canada places everyone in working-age population (age 15 and over)
into one of three categories:
– Employed — working full-time or part-time at paid job
– Unemployed — not doing paid work and actively searching for job, or
on temporary layoff, or about to start a new job
– Not in the labour force — does not fit into employed or unemployed
categories (full-time student, homemaker, retiree)
● Labour Force = employed + unemployed
● Unemployment Rate
– Percentage of people in labour force who are unemployed

Labour Force Participation Rate

– Percentage of working-age population in the labour force (employed or
unemployed)

● Unem
ploym
ent
rate
misses
– involuntary part-time workers — employed part time, would rather have
full-time job, but can’t find one.
– discouraged workers — want to work but have given up actively
searching for jobs.
● Labour Underutilization Rate — unemployment rate including unemployed,
involuntary part-time workers, discouraged workers.
● Healthy and unhealthy types of unemployment:
– Frictional unemployment — due to normal labour turnover and job
search; healthy part of a changing economy; not a problem.
– Structural unemployment — due to technological change or
international competition making workers’ skills obsolete; there is a
mismatch between the skills workers have and the skills new jobs
require; healthy part of changing economy; problem requiring retraining.
– Seasonal unemployment — due to seasonal changes in weather;
healthy not a problem.
– Cyclical unemployment — due to business cycle fluctuations in
economic activity; unhealthy part of changing economy; problem needs
fixing.

The natural rate of unemployment occurs at full employment, when there is only
healthy frictional, structural, and seasonal unemployment. Relative to the natural rate,
the unemployment rate is higher in a recessionary gap and lower in an inflationary
gap.
● Natural Rate of Unemployment — unemployment rate at full employment; includes
frictional, structural, seasonal unemployment.
 – Full employment is not zero percent unemployment but zero percent
cyclical unemployment.
● Relation between natural rate of unemployment and potential GDP:
– When unemployment = natural rate; real GDP = potential GDP; full
employment
– When unemployment > natural rate; real GDP < potential GDP;
recessionary output gap; cyclical unemployment
– When unemployment < natural rate; real GDP > potential GDP; inflationary
output gap

Inflation is measured by changes in the Consumer Price Index, hurts those on fixed
incomes, creates risk for business investment, and, through expectations, can create
a vicious cycle of more inflation. The inflation rate overstates increases in the cost of
living by missing switches to cheaper substitutes and new/improved
products/services.
● Inflation is both a persistent rise in average prices and a fall in the value of money.
When inflation occurs,
– you must spend more to get same products and services as before.
– your money is worth less.
● Consumer Price Index (CPI) — measure of average prices of fixed shopping basket
of products and services.
– CPI = 100 for the base year, currently 2002
● Inflation rate — annual percentage change in consumer price index.

– Core inflation rate — inflation rate excluding volatile categories.

● Inflation is a worry because of the falling value of money.
– Inflation reduces purchasing power of people with fixed (unchanged dollar)
income or savings.
– Nominal interest rate — observed interest rate; equals number of dollars
received per year in interest as percentage of number of dollars saved.
– Realized real interest rate
= nominal interest rate adjusted for effects of inflation
= nominal interest rate – inflation rate.
● Inflation is a worry because unpredictable prices create risk and discourage business
investment.
● Inflation is a worry because expectations of inflation can cause inflation.
● Economists view predictable inflation rates between 1 and 3 percent as acceptable.
● Deflation — persistent fall in average prices and a rise in value of money.
– Falling prices can lead consumers to postpone purchases, causing
economic contraction and increasing unemployment.
– Deflation benefits savers but hurts borrowers.
– Deflation is worse than low inflation.
 ● CPI fixes quantities in the shopping basket to isolate the impact of changing prices
only on cost of living.
– With fixed quantities, when prices rise the CPI misses quantity switches to
cheaper substitutes and new/improved products. Inflation rate based on the
CPI overstates increases in cost of living.

The quantity theory of money explains inflation from an increase in the quantity of
money in an economy, holding constant the velocity of money and the quantity of real
output.
● For any economy with money,
● M×V=P×Q, where
– M represents the quantity of money.
– V represents the velocity of money — number of times a unit of money
changes hands during a year.
– P represents average prices — the consumer price index.
– Q represents the aggregate quantity of real output. Real gdp
– P×Q represents nominal GDP.
● There must be enough money, multiplied by the velocity of money, to allow sales of
all final products and services produced (nominal GDP).
● Quantity theory of money states that an increase in the quantity of money causes an
equal percentage increase in the inflation rate.
– Quantity theory of money takes equation M×V=P×Q, fixes V and fixes Q at
potential GDP.
– Quantity theory of money is behind “printing money causes inflation.”
● Not all inflation is caused by increases in quantity of money. But inflation is always
accompanied by increases in quantity of money.

The Phillips Curve shows an immediate trade-off between unemployment and inflation
consistent with demand-pull stories of inflation. Cost-push inflation (simultaneous
unemployment and inflation) changes in expectations and changes in the natural rate
of unemployment complicate the original Phillips Curve.
● Phillips Curve — graph showing inverse relation between unemployment and
inflation.
● Demand-pull inflation — rising average prices caused by increases in demand —
explains Phillips Curve’s trade-off between unemployment and inflation.
– During expansions, demand is key force causing shortages and pulling up
prices for inputs (like wages) and for outputs.
● Cost-push inflation — rising average prices caused by decreases in supply — does
not fit Phillips Curve.
– Cost-push inflation is caused by supply shocks — events directly affecting
businesses’ costs, prices, and supply. Decrease in supply is key force
pushing up output prices, while pushing the economy into contraction,
increasing unemployment.
– Cost-push inflation can cause stagflation — combination of recession
(higher unemployment) and inflation (higher average prices).
● Both demand-pull and cost-push inflation require an accompanying increase in the
quantity of money.
● Over time, trade-offs between unemployment and inflation of the original Phillips
Curve become complicated due to changes in
– expectations of inflation.
– natural rate of unemployment.