Economy 102: Introduction to Macroeconomics

Macewan University
Winter Term 2021

Textbook: Principles of Macroeconomics 2e - OpenStax

https://d3bxy9euw4e147.cloudfront.net/oscms-prodcms/media/documents/Macroeconomics2e-OP_
WRQqkIv.pdf

Table of Contents:
Chapter 1: Introduction to Economics

Chapter 6: The Macroeconomic Perspective

Chapter 7: Economic Growth

Chapter 8: Unemployment

Chapter 9: Inflation

Chapter 11: Aggregate Demand and Aggregate Supply Model

Chapter 15: Monetary Policy and Bank Regulation

Chapter 17: Government Budgets and Fiscal Policy

Chapter 21: Globalization and Protectionism

Chapter 1: Introduction to Economics

Economy: the study of how humans make decisions in the face of scarcity

Scarcity: the human want/desire for goods, services, and resources that exceed what is available
-resources such as labor, tools, land and raw material are necessary to produce the G+S we
want but it is in a limited supply.
-ultimate scarce resource is time

Division and Specialization of Labor:

-Dividing complex production processes into smaller, simple tasks to ↑ productivity and ↓ scarcity
-Adam Smith: The Wealth of Nations, 1776

Division of Labor- the way in which different workers divide required tasks to produce a G/S
Specialization- workers/firms focus on simpler tasks within a complex production process
-allows economies to scale (level of production ↑ = lower cost per unit
Trade & Markets- specialization requires trade
- markets allow you to learn a specialized set of skills and you use the pay to buy
G+S
Viewpoints of Economy:

Microeconomics: focuses on actions of the individual within economy, like household, workers,
and business
Macroeconomics: focuses on broad issues like growth, inflation, trade, unemployment, government
and nations/global economy

Monetary Policy: policies that affect bank lending, interest rates and financial capital
markets
-conducted by nation’s central bank
Fiscal Policy: involves government spending and taxes
-conducted by nation’s legislative

Economic Systems and Organization:

Traditional Economy: what you produce is what you consume

-little economic development/prosperity; little efficiency
Command Economy: government owns resources, little private property, no market, education +
(less freedom) health provided by gov.
-little incentives for improvement; communist countries
Market Economy: decentralized decisions, private property, prices determined by markets, private
(more freedom) enterprise
-high inequality; markets undersupply public goods; damage environment;
capitalist countries
Mixed Economy: mix of command and market; most common

Regulations: The Rules of the Game

-there is no absolutely free market because there are always rules

-market-oriented economy = fewer regulations = more freedom
-highly-regulated markets have underground economies (black market) where transactions are
made without gov. approval

The Rise of Globalization:

Gross Domestic Product (GDP): measures the size of total production in an economy
-higher = more exports = more globalization
-exports / GDP = share of county’s total production in an economy

Chapter 6: The Macroeconomic Perspective

Goal - to assess overall economic performance-related in measures such as the value of prediction,
inflation, and unemployment
Measuring the Size of the Economy: GDP

GDP: the value of the production of all final g+s produced within a country in a given year

Can be measured by:

1. The total dollar value of what consumers, gov., and investors purchase in the economy
2. The total dollar value of what the country produces (value measured by market price)

Who buys all of a country's production?

Demand for production can be divided into 4 main parts:

1. Consumer spending (consumption)
2. Business spending (investment)
3. Gov. spending on g+s
4. Spending on net exports

Net Export Component:

-Trade Balance: the gap between exports and imports
-Trade Surplus: when a country’s exports are > the imports
-Trade Deficit: when a country's imports exceed exports

GDP = Consumption + Investment + Gov. + Trade balance

OR
GDP = C + I + G + (X-M)

X= exports
M= imports
Other ways to Measure the Economy:

Gross National Product (GNP):

-includes what is produced domestically, and what is produced by domestic labor and
business abroad in a year

Net National Product (NNP):

-GNP minus the value of depreciation
Depreciation: the process by which capital ages over time and loses its value

Adjusting for Inflation:

Nominal Value: the economic statistics actually announced, not adjusted for inflation
Real Value: an economic statistic after it has been adjusted for inflation
-the real value is more important generally because it allows comparisons over time
GDP Deflator: a price index measuring the average price of all g+s including GDP
 Real GDP = [ Nominal GDP / GDP Deflator ] x 100
-whenever a real statistic is computed, one year (or period) is called a base year (or base period)

Tracking Real GDP over Time:

-gov. reports GDP growth annually
-when analyzing growth in a quarter, the calculated growth in real GDP for the quarter is multiplied
by 4 when it is reported (as if the economy were to grow at the same rate all year)

Recession: a significant decline in GDP

Depression: an especially lengthy and deep decline in output

The Business Cycle:

Peak: the highest point

Trough: the lowest point
Expansion: an ↑
Recession/Contraction: a ↓
One Business Cycle: from one peak to the
next peak

Comparing GDP among Countries:

-to compare the GDP of countries with different currencies, it is necessary to convert to a “common
denominator” using an exchange rate

Exchange Rate: the value or price of 1 currency in terms of another currency

GDP per capita= GDP / population

How Well does GDP Measure the Well-Being of Society:

GDP does not include:

1. Leisure time
2. Actual levels of environmental health
3. Production that is not exchanged in the market (black market)
4. Level of inequalities in society
5. Technology
 Chapter 7: Economic Growth

The Relatively Recent Arrival of Economic Growth:

-GDP only exponentially grew after the Industrial Revolution (1760-1830)

-Britain had a monopoly over much of the industry

Economic Growth depends on many factors:

1. Rule of Law
2. Protection of private property
3. Contractual Rights (agreements)

Labor Productivity & Economic Growth:

-sustainable, long-term economic growth comes from an ↑ in workers’ productivity

Labor Productivity: value that each employed person creates per unit of his/her input (time,
energy)

What Determines how Productive Workers are?

1. Human Capital: the accumulated knowledge, skills and expertise of a worker
2. Tech. Changes: combo of the invention (advances in knowledge) and innovation ( new g+s)
3. Economies of Scale: cost advantage that industries obtain due to size

Sources of Economic Growth: The Aggregate Production Function

Production function: the relationship between input used in production, and the quantity of output
-the microeconomic production function would be a firm’s/industries input and output

Aggregate production function: a production function extended to the whole economy

GDP:
1. Workforce
2. Human capital
3. Physical capital
4. Technology
GDP per capita:
1. Human capital per person
2. Physical capital per person
3. Tech. per person
^aggregate production function with GDP or GDP per capita as its output

Measuring Production:
-productivity growth closely links to the growth of GDP per capita
 -if the percent of the population who hold jobs in an economy ↑, GDP per capita ↑, but the
productivity of workers does not always ↑ as well
-long term, the only way GDP per capita can grow continually is if the production of the average
worker rises, or if capital ↑
-a common measure of US productivity per worker is $ value per hour the worker contributes to the
employer’s output
-excludes gov workers and farmers

The Power of Sustained Economic Growth:

GDP after T years of growth at annual rate of g:

𝑇
Final GDP = initial GDP x [1 + growth rate of GDP (g)]

Example- economy states with GDP at 100 and growth at 3% a year will reach a GDP of 209 after 25 years
25
[100 (1.03) ] = 209

The Rule of 70: GDP doubles in 70 / growth rate of GDP (g) a year if it grows at a rate of g%
Example- if g= 2% in how many years does the GDP double? [70/2 = 35 years]

Components of Economic Growth:

1. Physical Capital: plant and equipment that firms use in production (including
infrastructure)
Infrastructure: a component of physical capital such as roads and rail systems
-↑ in quality and quantity

2. Human Capital

3. Technology: the way in which existing input produces more/higher quality and different
new products

Capital Deepening:
Capital Deepening: when society ↑ levels of capital per person
-can apply to both additional human capital per worker, and to additional physical
capital per worker

-accumulation of capital and economic growth needs to happen at the same time
-to produce more machinery, you need enough to consume and enough to save
-saving allows you to build more capital
 Growth Accounting Studies:

-tech. is the most important contributor to US economic growth

-human and physical capital explain only half or less of economic growth
-however, all 3 factors must be present to succeed

A Healthy Climate for Economic Growth:

-gov. can facilitate capital deepening and tech progress by encouraging,

through low taxes or subsidies (education, health, savings, investment, infrastructure and scientific
research)

Economic Convergence:

Convergence: when poor countries grow faster than rich countries

Arguments Favoring Convergence:

1. Diminishing marginal returns
-describes a situation when an extra unit of capital is less effective when there is
already a large amount of capital in place, but more effective when there is less
capital
2. Importing capital (foreign direct investment)
-when a Canadian company (for example) builds a factory in China, everything
produced in that factory will be part of Chinese GDP, but income goes to the
company
3. Importing knowledge
-many scientific and tech discoveries are produced in rich countries and are publicly
available (internet)

Arguments that Convergence is Neither Inevitable nor Likely:

1. Tech progresses faster in rich countries than poor countries
2. Will tech progress slow down?
3. Success at importing new tech not guaranteed

Chapter 8: Unemployment

How Economists Define and Compute Unemployment Rate:

Employed: number of people currently working for pay

Unemployed: people out of work and looking for jobs
Labor Force: employed + unemployed
Not in the Labor Force: people not working and not looking for jobs
 Adult Population: people 15 and above
Employment rate: employment as a percentage of adult population
Unemployment rate: [unemployed / labor force] x100

Hidden Unemployment:

Hidden unemployment: part-time or temporary workers looking for full-time or permanent work
Underemployed: people who are employed in a job that is below their skill level
Discouraged workers: those who have stopped looking for work due to lack of suitable positions
available (not unemployed, but still not in the labor force)

Participation Rate:

Labor force participation rate: the percentage of adults in an economy who are either employed
or unemployed but looking for work
= [total labor force / total adult population ] x100

Patterns of Unemployment:

-unemployment rates move up and down as the economy moves through the business cycle
-rate usually returns to about 6-8% in Canada

Gender:
-men have a slightly higher unemployment rate than women
Age:
-younger workers have a higher unemployment rate. Rate ↓ with age
Race & Ethnicity:
-rate is lower for white people than for black or hispanic people

What Causes Changes in Unemployment over the Short Run:

Cyclical Unemployment: variation of employment that the economy causes moving though the
business cycle

Sticky Wage Theory: wages are slow to adjust downwards when economic conditions are poor
-if wage is above equilibrium, then the demand for jobs is high. But supply is low.
-results in unemployment

Why Wages may be Sticky Downward:

1. Implicit contract
2. Efficiency selection of wage cuts argument
-productivity will ↑ when employer pays workers above equilibrium
 3. Adverse selection of wage cuts argument
-if everyone’s wages ↓, best workers will leave, so firm must choose which workers
to keep, and which to lay-off
4. Insider-Outsider model
-those already working at firms are the insiders, and new hires/interns are the
outsiders.
-cutting wages will alienate insiders and damage firm’s productivity
5. Relative wage coordination argument
-workers fight against wage cuts and workers compare their wage to their company’s
wages

Rising Wages and Low Unemployment

Sticky -↑ in demand for labor = ↑ in equilibrium quantity of workers hired, and an ↑ in equilibrium
wage
Non sticky -↓ in demand for labor = ↓ in quantity of labor demanded at original wage
-workers want higher wage, but cant find job

What Causes Changes in Unemployment in the Long Run:

Natural Rate of Unemployment: unemployed rate at a constant level

Frictional Unemployment: when workers move between jobs

-↑ efficiency by better matching workers and jobs
Structural Unemployment: occurs because people lack skills that are valued by employers

Full Employment: unemployment = natural rate

Public Policy and the national Rate of Unemployment:

Supply Side Policy: incentives to look for work

-unemployment insurance, welfare benefits, food stamps, gov. medical benefits
-short term and long term benefits
-assistance for job search or retraining

Demand Side Policy: public policies that affect the willingness of firms to hire workers
-gov. rules, social institutions, union workers

Chapter 9: Inflation

Inflation: an ↑ in the level of prices in an entire economy

Basket of goods and services: a “typical” set of consumer purchases

 -The goods and services in a basket of goods fall into eight major categories: food and
beverage, housing, apparel (clothing), transportation, medical care, education and
communication, recreation and other.

Consumer Price Index: index of variation prices paid by consumers on retail or other goods
CPI: [(Current Expenditure on Basket) / (Base Year Expenditure on Basket)] x100

Inflation Rate: percentage change in CPI between different years

Inflation Rate: [(CPI this year) - (CPI last (base) year) / (CPI last (base) year)] x100

Shortcoming of Using CPI to Measure Cost of Living:

Substitution bias: When consumers replace expensive goods with cheaper goods

Quality/new goods bias: quality of goods in basket improves

-means that the rise in the price of a fixed basket of goods over time tends to overstate the
rise in a consumer’s true cost of living because it does not take into account how
improvements in the quality of existing goods and the invention of new goods improve the
standard of living

Core Inflation Index: excludes volatile categories from the CPI

-Example: food and energy is excluded

Some Other Price Indices:

Producer Price Index (PPI): prices paid for supplies/input
International Price Index: price of goods exported or imported
Employment Cost Index: level of wages paid
GDP Deflator: remember - (C+I+G+net exports)

The Confusion Over Inflation:

-If other economic variables (price, wages, interest rate) does not move together with inflation, or it
adjusts slowly, inflation causes 3 problems…..

1. People with lots of cash will see their wealth ↓ by increasing prices due to inflation
-people who have their wealth in interest earning assets (investments) are not
affected much
-this is how purchasing power is redistributed by inflation
-Fisher’s Formula: real interest rate =[ nominal interest rate - inflation ]

2. Slow adjustments in some prices leads to confusion in people

-people are confused whether changes in price of goods are due to inflation or just
change in price
 3. Long-term planning is made more uncertain by high inflation
-this is because inflation ↓s savings
-Example: retirement planning and mortgage contracts

Indexing:

Indexing: automatic adjustments for inflation of prices, wages or interest rates

Cost of living adjustments (COLAs): contractual provision that wage ↑ to keep up for inflation
Adjustable rate mortgage (ARM): mortgage contract in which interest rates varies with market
-aka variable rate mortgage

Examples of Indexing Arrangement in Government Programs:

1. Tax brackets
2. Social Security benefits ↑ each year with CPI
3. Some government issued bonds

PRACTICE QUESTIONS:

1. A typical consumption basket in Canada can be purchased for the following prices in two
years: in Year 1, the price is $925; in Year 2, the price is $975. Calculate the Consumer Price
Indexes for each year, in two ways: one using Year 1 as the base year, and the other using
Year 2 as the base year. Then, calculate two inflation rates based on the two sets of price
indexes you calculated. Compare the two inflation rates and discuss your result.

Answer:
Base year 1: CPI1 = 100; CPI2 = 975 / 925 x 100 = 105.4; Inflation = (105.4 – 100) / 100 = 5.4%
Base year 2: CPI1 = 925 / 975 *100 = 94.87; CPI2 = 100; Inflation = (100 – 94.87) / 94.87 = 5.4%.
The two inflation rates are virtually the same, which we would expect for small inflation rates like
this. However, for large changes in prices, the two methods (different base years) may be different
because, for instance, the increase from 90 to 100 is greater, in percentage, than the increase from
100 to 110.

2. Anna will retire in 16 years from now. On that occasion, her company will give her a one
time payment of $30,000. If the inflation rate is 2.5% per year, how much that payment will
mean in today’s dollars?

Answer: Y (variable) x (1 + 0.25) ^16 = $30,000 Y = 30000 / (1 + 0.025) ^16 = $20,208

Chapter 11: Aggregate Demand and Aggregate Supply Model

Macroeconomic Perspectives on Demand and Supply:

Say’s Law: “supply creates its own demand”

-focuses on supply side
-long run
Keynes’s Law: “demand creates its own supply”
-focuses on demand side
-short run
Aggregate Supply and Demand Curves:

Aggregate Supply (AS): total quantity produces at a given price

-curve= total quantity produced at all prices
-potential and full employment GDP
Potential GDP: the maximum quantity of output that an economy can produce given its existing
levels of real resources such as labor, physical capital, and technology, in the context of its existing
market and legal institutions.
-Potential GDP is also called full-employment GDP

Aggregate Supply Curve:

-The slope of an AS curve increases from nearly flat at its left (the
Keynesian zone) to nearly vertical at its right (the Neoclassical zone)
- In the Keynesian zone the economy is in recession and
monetary policies mainly affect output but not the inflation rate
-In the Neoclassical zone the capacity of production of the
economy is overloaded and it can hardly increase production even
more. Therefore, an expansionary monetary policy in the
neoclassical zone of the SRAS curve would mainly increase the
price level, not output.

Aggregate Demand (AD): the amount of total spending on domestic goods and services in an economy
-economists call it total planned expenditure
-AD includes all the same things as is included in GDP (C+I+G+net exports)
-as prices ↑, total spending on domestic goods ↓ so therefore GDP ↓

Aggregate Demand Curve:

-The AD curve slopes downward, which is to say that decreases in

the price level of output lead to a higher quantity of goods and
services demanded.
-The AD curve is steep because all the theories behind it (the wealth
effect, the interest rate effect, and the foreign price effect) explain
 only a small part of the negative relationship between the price level and aggregate demand.
-The macroeconomic (aggregate) demand curve is substantially different from a
microeconomic demand curve for a particular product – the reasons for its downward
sloping shape are not as obvious.

Short Run Aggregate Supply (SRAS): input prices do not change

Long Run Aggregate Supply (LRAS): no relationship of price and

GDP in the long run (the same as potential GDP)

Shifts in Aggregate Supply:

What can shift the AS curve?

1. Productivity growth
-shifts the SRAS to the right
-new equilibrium between AS and AD is shifted to the right and down (increasing
GDP and decreasing prices)
2. Long run changes in input prices
-shifts the SRAS to the left
-caused by ↑ in input prices (ex. ↑ in wages or cost of input supplies needed to make
the good)
-new equilibrium shifts left and up (decreasing GDP and increasing prices)
-this is called Stagflation

Shifts in Aggregate Demand:

What can shift the AD curve?

1. Shifts right
-equilibrium shifts right and up (closer to potential GDP)
-can be caused by an ↑ in gov. spending or ↓ in taxes, which ↑ consumer spending
2. Shifts left
-↓ in consumer confidence or business confidence
-equilibrium shifts left and down (further from potential GDP)
-can be caused by ↓ in gov. spending or ↑ taxes which ↓ consumer spending

How Government Policy can Shift the AD curve:

Expansionary Policy:
-shifts right
-↑ in gov. spending and ↓ in taxes
-low unemployment
-shows economic growth
 Contractionary Policy:
-shifts left
-↓ in gov. spending and ↑ in taxes
-high unemployment
-shows a ↓ in economic growth

Identifying Recession and Economic Growth in AD/AS Model:

Recession:
-equilibrium is far from the LRAS/Potential GDP line
-shifting left
Economic Growth:
-equilibrium is close to the LRAS/Potential GDP line
-shifting right
Unemployment:
-High cyclical unemployment=lowest (most left) equilibrium
-Low cyclical unemployment=highest (most right) equilibrium
-Natural rate of unemployment=on LRAS/Potential GDP

*NATURAL RATE OF UNEMPLOYMENT IS THE SAME AS LRAS LINE AND POTENTIAL

GDP LINE ON THE AS/AD MODEL

Chapter 15: Monetary Policy and Bank Regulation

The Federal Reserve Banking System and Central Banks:

Central Bank: controls the interest rate, currency, regulates commercial banks and holds the gov. accounts
-responsible for conducting monetary policy and keeping inflation low and stable
-in Canada, the central bank is called The Bank of Canada
-in America, the central bank is called The Federal Reserve

Stability of Banking System:

What do the Central Banks control, and how do they keep everything stable?

-banking services to commercial banks

-lender of last resort (liquid fund)
-emergency loans
-resolution authority
-research
-banking policy (develop and implement)

How a Central Bank Executes Monetary Policy:

 Money Supply: all the money in an economy
Monetary Policy: policies that control money supply
Tools in Monetary Policy:
- Open-market operations
- Monetary policy interest rate
- Quantitative easing

High interest = contractionary policy (↓ money supply)

Low interest = expansionary policy (↑ money supply)

Monetary Policy and Economic Outcomes:

-monetary policy should be countercyclical

-bank of canada loosens MP in a recession, and tightens it when inflation threatens
-too loose MP can cause inflation
-too tight MP can cause recession
-recessions are identified on a graph by ↑ unemployment (unemployment ↑ when interest rate ↓)

Expansionary MP: Interest rate ↓, Investment and Consumption ↑, Prices and real GDP ↑ (shift right)
Contractionary MP: Interest rate ↑, Investment and Consumption ↓, Prices and real GDP ↓ (shift left)

Pitfalls for Monetary Policy:

The Quantity Equation of Money -

[Money supply] x [Velocity of money] = [Price level (GDP deflator)] x [Real GDP]
MV = PY
*Price level multiplied by real GDP is the same as the nominal GDP

-Banks have a minimum level of reserved, but there is no rule against holding additional excess
reserves
-Velocity of money is the speed with which money that circulates through the economy decreases as
money lays unused in bank deposits and reserves
-Velocity = Nominal GDP / Money supply

Unemployment and Inflation:

Inflation Targeting: central bank focusing on low, stable inflation

-no consensus about inflation targeting

-in a neoclassical view, MP affects only price level, not the level of output
-price levels adjust quickly so economy always remains at full employment
-for example, expansionary policy causes AD to shift right, but prices ↑ quickly (no deviation from
full employment supply curve)

PRACTICE QUESTIONS:

1. Contrast the actions a central bank would take to increase the quantity of money in the
economy with the actions it would take to produce the opposite effect.
Answer: A central bank that wants to increase the quantity of money in the economy can buy bonds
in an open market operation, lower the monetary policy rate, or engage in quantitative easing.
Conversely, a central bank that wants to reduce the quantity of money in the economy can sell
bonds in an open market operation, raise the monetary policy rate, or reverse its past practices of
quantitative easing.

2. Contrast the actions a central bank should take when an economy is in recession with
production substantially below potential GDP and those needed when an economy is
producing in overdrive above potential GDP.
Answer: When the economy is in a demand-driven recession the central bank should raise the
supply of money by reducing interest rates, engaging in open market operations, or even in
quantitative easing if the recession is deeper. When the economy is producing above the potential
GDP, in the inflationary zone, the central bank should reduce the supply of money. Expansionary
monetary policy is effective in increasing output in the Keynesian zone of the SRAS curve;
contractionary monetary policy is effective in reducing inflation in the neoclassical zone.

3. Discuss the reserve requirements method of conducting monetary policy, including a

description of this method, the types of adjustments banks are likely to be required to make
and the effects on the economy that are likely to result.
Answer: A reserve deposit is the amount, as a proportion of its deposits, that a bank is legally
required to deposit with the central bank. In Canada there is no reserve requirement, although banks
may decide by themselves how much reserves to maintain as a precautionary measure. In countries
where there is such a requirement, reserve deposits give the central bank an additional monetary
policy tool. If a bank finds that it is not holding enough in reserves to meet the reserve
requirements, it needs to borrow at least for the short term from the central bank. If the central bank
raises the discount (monetary policy) rate, then banks will hold a higher level of reserves to reduce
the chance of needing to borrow at that higher interest rate. Higher reserves reduce the amount
available for loans, and therefore the money supply in the economy.

Chapter 17: Government Budgets and Fiscal Policy

Fiscal Policy: a change in government spending or taxation with the purpose of stimulating the
economy
-Bank of Canada regulates monetary policy, and the government regulates fiscal policy
Government and Federal Spending:

Government Budget-
G= Gov. Spending T= Tax Revenue

Budget Deficit = G - T, when G is > T

Budget Surplus = T - G, when T is > G
Balanced Budget = G=T

Major Federal Spending Categories include:

1. National defense
2. Social security
3. Health programs
4. Interest payment

Taxes Collected by the Federal Government:

1. Individual income tax
-personal income tax is the largest single source of federal government revenue, but
it still represents < half of federal tax revenue
2. Payroll tax
-captured in social insurance and retirement receipts, which provides funds for Social
Security and Medicare.
3. Progressive tax
-Income tax is progressive, meaning the tax rates ↑ as a household’s income ↑
4. Regressive tax
-people with higher income pay less taxes than those with lower income
5. Proportional tax
-flat % of income earned
6. Corporate income tax
-tax on corporate profits
7. Excise tax
-tax on specific goods, like gas and alcohol
8. Estate and gift tax
-tax on assets passed down

Marginal Tax Rate: tax paid on an additional dollar of income, or tax % on the last dollar earned
-ranged from 15% - 33%

State and Local Taxes:

1. Property tax
2. Revenue passed along from the federal gov.
3. Personal and corporate income tax
4. A variety of fees and charges
Using Fiscal Policy to Fight Recession, Unemployment, and Inflation:

Expansionary FP: ↑ AD by ↑ gov. Spending or cutting taxes

Contractionary FP: ↓ AD by ↓ gov. Spending or increasing taxes (reducing inflation)
[AD = aggregate demand]

Categories of Fiscal Policy:

1. Discretionary/Intentional FP:
- Happens when gov passes new laws that explicitly changes overall tax or spending
levels with the intent of influencing the level of overall activity
2. Automatic Stabilizers:
- Taxes and spending rules that have the effect of slowing down the tate of ↓ in AD
when the economy slows down, and restraining AD when economy speeds up
- Example: unemployment insurance, food stamps

Practical Problems with Discretionary Fiscal Policy:

Crowding Out: expansionary FP ↑ interest rate, ↓ private investment and consumption

-happens when gov borrowing and spending results in an ↑ in interest rate, which
reduces business investment and household consumption

-when gov borrows $, it shifts demand right

-equilibrium shifts right and up
Interest rates increase not only for gov but also private
investors and consumers too
 Time Lags:
Recognition lag: time it takes to determine that a recession has occurred
Legislative lag: time it takes to get FP bill passed
Implementation: time it takes for the funds related to FP to be dispersed to the agencies to
implement programs

PRACTICE QUESTIONS:

1. Briefly explain the purpose served by payroll taxes and how they are collected. Describe any
comment that economists point out about payroll taxes.
Answer: Payroll taxes are technically collected half from employee paychecks and half from
employers. However, as economists object, the employer’s half of the taxes are probably passed
along to the employees in the form of lower wages.

2. Identify and briefly describe all the sources of federal taxes.

Answer: The primary sources of federal taxes are individual income taxes and the payroll taxes.
Corporate income taxes, excise taxes, and other taxes provide smaller shares of revenue. In Canada,
the federal government collects income taxes, sales taxes such as the Goods and Services Tax
(GST) or Harmonized Sales Tax (HST), customs duties or tariffs on certain imported and exported
products, and contributions to social security plans such as Employment Insurance and Canada
Pension Plan.
*Note: progressive, regressive, proportional and marginal taxes are not sources of federal taxes

3. Identify and briefly describe some practical difficulties of discretionary fiscal policy.
Answer: Fiscal policy is either automatic, such as unemployment benefits, or discretionary.
Discretionary fiscal policy faces some practical difficulties: first, expansionary fiscal policy can
raise interest rates, which tends to reduce the expansionary impact of the policy by lowering private
investment; second, there are long time lags in enacting fiscal policies and waiting for them to take
effect; finally, it may be hard to persuade politicians of the merits of fiscal policies, and political
negotiations take time.

Chapter 21: Globalization and Protectionism

Protectionism - An Indirect Subsidy from Consumers to Producers:

Protectionism: policy of protecting domestic industries against foreign competition by means of

tariffs, quotas, or other restrictions on imports and foreign competitors

Tariffs: taxes or duties that are levied on imported goods

-aim is to ↑ prices of imported goods to at least the level of the current domestic price, or
to ↑ revenue for government
Imported quotas: numeral limits on quantity of product a country can import
 Non-Tariff barriers: ways a nation can draw up rules, regulations, inspections, and paperwork to
make it costly or difficult to import products

*look at graph in textbook

International Trade and Its Effects on jobs, wages and working conditions:

-in theory, imports might injure workers (fewer jobs, lower wages, poor working conditions)
-protectionism can save jobs in a specific industry, but it costs jobs in other unprotected industries
-if consumers are paying higher prices to a protected industry, they have less money to spend on
other industries
-because trade ↑ the amount an economy can produce by letting firms and workers specialize, trade
will cause the average level of wages to ↑
-barriers to trade = ↓ in average wages

Agreements in Support of Restricting Imports:

1. Infant industries
- small domestic industries need to be temporarily protected for the business/industry
to have a chance to grow
2. Anti-dumping
- Dumping = foreign companies sell under the fair price
- While the intention of anti-dumping duties is to save domestic jobs, these tariffs can
also lead to higher prices for domestic consumers.
- In the long-term, anti-dumping duties can reduce the international competition of
domestic companies producing similar goods.
- Anti-dumping laws block imports that are sold below the cost of production by
imposing tariffs that ↑ the price of these imports to reflect their cost of production
- -dumping is not allowed under the rules of the World Trade Organization (WTO)
3. Environmental Protection
- The race to the bottom scenario of global environmental degradation runs like this:
Profit-seeking multinational companies shift their production from countries with
strong environmental standards to countries with weak standards, thus reducing their
costs and increasing their profits.
4. Unsafe Consumer Products
- Consumers are advocating for regulation of goods, however WTO allows countries
to set their own policies regarding unsafe products
5. National Interest
- Some argue that a nation should not depend too heavily on other countries for
supplies of certain key products (such as oil, or for special materials or technologies)
that might have national security applications

How Governments Enact Trade Policy:

 1. General agreements on tariffs and trade (GATT)
- Nations can come together to negotiate reduction in tariffs and other barriers to trade
2. Free trade Agreement
- Free trade agreement (no tariffs or quotas)
3. Common Market
- Agreement to allow free trade in goods and services, labor, financial capital, while
having a common trade
4. Economic Union
- Economic agreement between countries to allow free trade between members, a
common external trade policy, and coordinate monetary and fiscal policy

PRACTICE QUESTIONS:

1. Define protectionism as a policy and describe what a country stands to lose when it enacts
such a policy.
Answer: Protectionism imposes tariffs or other trade barriers on imported goods to raise the price,
to the benefit of domestic producers. Consequently, the domestic consumers or firms using
imported intermediate products pay higher prices. Foreign producers lose; foreign consumers may
gain from lower prices. Overall, countries that allow free trade gain from comparative advantage
efficiencies, from learning new technologies and product design from foreign producers, and from
the economies of scale brought about by specialization, even though some people working in
import-competing industries may temporarily lose.

2. In the national interest argument, it is sometimes argued that a nation should not depend too
heavily on other countries for supplies of certain key products. This argument has been
made for commodities that are important to the U.S. economy, like oil. Discuss some
arguments economists may raise against this.
Answer: National security is sometimes used as an argument for limiting imports and supporting
domestic production. However, invoking this motive to increase trade barriers hurts consumers and
the overall economy. Instead, governments could find other solutions if they are truly concerned
about national security. For example, if the United States needs to be protected from a possible cut
from foreign oil, they could build up strategic stocks from import and save the U.S. domestic oil
resources, they could increase the tax on the use of oil, they could encourage the development of
alternative sources of energy, and they could diversify the foreign sources from which to import oil.
In general, economists are skeptical about the validity of the national security argument for trade
protectionism.

3. What are the effects of a tariff, and who benefits and who loses when tariffs are imposed?
What are the effects of a quota, and who benefits and who loses when quotas are imposed?
Answer: A tariff, which is a per-unit tax on an imported good, raises the domestic price of the
good. The higher price benefits domestic producers and the tariff revenue benefits the government
at the expense of domestic consumers. A quota, which is a limit on the quantity imported, also
raises the domestic price by making the good less abundant. The higher price benefits domestic
producers and the foreign producers who can sell the good at a higher price, again at the expense of
the domestic consumer. Overall, economists calculate that the gains from tariff revenue and higher
profits to domestic producers fall short of the loss in consumer surplus; therefore, economists rarely
recommend tariffs or quotas.