Chapter 19

What Macroeconomics
Is All About ?
Ratna K. Shrestha

In this chapter you will learn

1.the meaning and importance of the key
macroeconomic variables, including national
income (or Gross Domestic Product, GDP),
unemployment, inflation, interest rates,
exchange rates, and trade flows.
2.. that most macroeconomic issues are about
either long-run trends or short-run
fluctuations, and that government policy is
important for both.

The Last Recession: 2007-2009

In 2007, housing prices in the US fell sharply
and as a result banks who had invested
heavily in mortgage-backed securities were in
trouble (some of them went bankrupt). The
(world) economy entered into a deep
recession.
In 2008, G20 leaders met and discussed the
possible policy intervention to prevent a
repeat of the Great Depression. The leaders
agreed to increase government spending in
infrastructure projects, reduce interest rates
through aggressive central bank actions and
bail out some of the failing financial
institutions and companies.

19.1 Key Macroeconomic

Variables
Output
and Income
The production of output (goods and services)
generates income.
To measure total output in dollars, we add up
the values of the many different goods
produced.
This gives nominal national income, called gross
domestic product (GDP).
When we measure the dollar value of the goods
produced in a given year with respect to some
reference year (base-period prices), we get real
national income.

Growth and Fluctuations

Real GDPreal gross domestic product

is the value of the total production of a nation
from all the sources such as farms, factories,
shops, and offices, in the given time period (say
2014) measured in the prices of a single year
or base year. Currently the base year is 2002.

Economic growth is the expansion of the

economys production possibilitiesan outward
shift of Production Possibility Boundary (PPB).

We measure economic growth by the increase

in real GDP. The increase in real GDP is solely
caused by the expansion in output.
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Growth and Fluctuations in Real GDP,

19652011

(i) The level of real

GDP

(ii)Annual growth rate

of real GDP
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Real GDP fluctuates around a rising trend:

the trend shows long-run economic growth
the short-run fluctuations show the business
cycle-the fluctuations of real GDP around
potential GDP.

APPLYING ECONOMIC CONCEPTS

19-1
The Terminology of Business
Cycles
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 Potential Output or GDP is what the economy

could produce if all resources (such as labour,
capital, land, and entrepreneurial ability) were
employed at their normal levels of utilization often called full-employment output.
The output gap measures the difference
between potential output Y* and actual output
Y.
Output Gap = Y - Y*
When Y < Y* , there is a recessionary gap.
When Y > Y*, there is an inflationary gap.
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Real GDP

Potential GDP

Recessionary Gap
Recovery

Recession

Peak
Actual GDP

Peak
Trough

Inflationary Gap
Time

Potential GDP and the Output Gap, 19852011

(i)

Potential and
actual GDP

(ii) The output gap

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Growth and Fluctuations

A recession is a period during which real GDP
decreases for at least two successive quarters.
When actual real GDP is below potential GDP,
resources are not being fully employed.
An expansion is a period during which real
GDP increases. Expansion, although expands
employment and output, can ensue higher
inflation.
A growth recession occurs when real GDP
growth rate is positive but slows so that real
GDP is below potential GDP.
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Growth and Fluctuations

During the 1960s,
Japans growth rate
was much faster than
the others.
After the 1970s, all
four growth rates were
similar.
Canadas growth rate
has been a bit less
than the U.S. growth
rate.
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Employment, Unemployment, and

the Labor Force
Employment: the number of workers (age 15+)
who hold jobs.
Unemployment: the number who are not
employed but are actively looking for one (within
the previous 4 weeks).
Labour force: the total number of employed +
unemployed.
Unemployment rate: the number of unemployed
expressed as a percentage
of
the
labor force.
Number
of
people
Unemployme=
X
unemployed
nt Rate
Number of people in the
100
labor force
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Jobs and Wages

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When the economy is at potential GDP,

economists say that there is full employment.
Even when Y = Y*, some unemployment,
called natural unemployment, exists:
Frictional Unemployment: caused by normal
turnover of labor (job change, being fired,
etc).
Structural Unemployment: caused by
mismatch between labor (skills) and jobs
available.
When
Y Y*, the economy is not at full
employment. Such unemployment is called
cyclical unemployment.

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Every economy has seasonal variations in

unemployment (ski resort, fishing industry).
However, Stat Canada adjusts unemployment
rate to remove fluctuations caused by seasonal
reasons.

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The unemployment rate when Y=Y* is called

the natural rate of unemployment or NAIRU
What is the NAIRU?
- some estimates suggest that it is now below
7%.
Why Does Unemployment Matter?
Some unemployment is desirable, as it reflects the time required
for workers and firms to find each other so that good matches
are made. But some unemployment is associated with human
hardship, especially for those individuals with skills that are not in
high demand by firms.

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Productivity
Productivity: a measure of output per unit of input
often measured as GDP per worker
or GDP per hour of work
Increases in productivity are probably the single
largest determinant of long-run increases in real
GDP and hence material living standards.
Real GDP is a better measure of living standards,
whereas nominal GDP is not.
Nominal GDP may increase due to increases in
price levels (and not necessarily output levels)

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Real GDP
per worker
is measured
in
thousands
of dollars!

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Inflation and the Price Level

Price level: the average level of all prices in the
economy.
Inflation: the rate at which the price level
increases.
The Consumer Price Index (CPI) is based on the
price of a typical consumption basket, relative
Pt Q0 year (P ):

to the price
in
some
base
CPI
100 o
t

PQ
0

Notice that CPI measures the price of a basket at

the current time relative to the price of the same
basket in base year.
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Consumer Price Index

The price level is the
average level of prices
and is measured by
using a price index.
The consumer price
index, or CPI, measures
the average level of the
prices of goods and
services consumed by
an urban family.

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Consumer Price Index

The CPI is defined to equal 100 for the base
period.
Currently, the base period for the CPI is 2002 (it was
1992 previously until 2008).
The value of 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.
If CPI in 2007 is 125, that means average prices in
2007 for a fixed market basket are 25% higher than
that in 2002 (base year).
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APPLYING ECONOMIC CONCEPTS 19-2

How the CPI Is Constructed
If CPI in 2013 is 110 and that in 2014 is
115, then the annual rate of inflation =
(115 110)/110 = 4.55%.
Why Inflation Matters?
The purchasing power of money is negatively
related to the price level or inflation.
Also, because it is hard to forecast accurately,
inflation adds to the uncertainties of
economic life/decisions.
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The Price Level and the Inflation Rate,

19602012

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Interest Rates
The interest rate is the price you pay for
borrowing money for an specified period of time.
If you borrow $100 with an agreement to repay
$105 next year, then the annual interest rate is
5%. Borrowing and lending and how much
interest you pay or get is crucial to firms and
households in a modern economy.
What are the determinant of interest rates? Why
would a bank lend you at a lower rate than to
your friend?
There are many types of interest rates: One of
the most important is the Prime Rate, the rate
commercial banks (such as TD or RBC) charge to
their best customers. This rate is usually used as

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Interest Rates and Inflation

How does inflation affect interest rates?
Lets say you borrow $100 from your friend
which is repayable in one year at the interest
rate of 8%. Then this 8% is the annual Nominal
Interest Rate (the rate expressed in money
terms).
In the same year if the price level increases by
3%, then the purchasing power of your friend
next year decreases (relative to had the price
level remained the same). In effect, your friend
earns 5% (=8-3%) Real Interest Rate the
interest rate expressed in terms of purchasing
power.
The burden of borrowing depends on the real

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Interest Rates and Credit Flows

A loan represents a flow of credit (between
lenders and borrowers) with interest rate
representing the price of this credit.
Most firms need credit to build a factory or buy
inputs. Similarly households also need credit
from time to time to finance the purchases of
homes, cars etc.
Banks play a crucial role as a intermediary
between those who have savings and those
who need funds. We deposit our savings in a
bank and the bank loans our deposits to others
who need funds.
How does a bank make profits?

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Real and Nominal Interest Rates, 1965

2012

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Why Interest Rates Matter?

Many retirees who rely on their interest
incomes (from their savings and stocks) benefit
from higher real interest rate.
In contrast, borrowers benefit form low interest
rates. If the interest rate is low, are you more
likely to buy a house or a car?
Real interest rate also affect firms decisions to
invest. Lower the real interest rates, more
likely that the firms will invest more.

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The International Economy

Exchange Rate
the number of Canadian dollars required to
purchase one unit of foreign currency (or the
reverse way).
A depreciation of the Canadian dollar means
that it is worth less on the foreign-exchange
market. Recently the value of Canadian dollar
has been declining against the US dollar (CAD
$1 = US $0.86).
When CAD $ gains in value (appreciation),
buying from across the border is cheaper
imports increase. On the other hand when CAD
depreciates, we will export more (as foreigners
will find Canadian goods cheaper).

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CanadianU.S. Dollar Exchange Rate,

19702012

31

Exports and Imports

The difference between Exports (X) and Imports
(IM) is called Trade Balance. When X > IM,
Trade Surplus but when X < IM Trade Deficits.
Both exports and imports are very large in
Canada roughly 35% of GDP but the trade
balance is usually small.
The volume of trade between US, Canada and
Mexico grew quickly in 1990s, particularly after
the signing of NAFTA (North American Free
Trade Agreement) in 1994.
In the wake of recent recession that started in
2007, both export and import sharply declined
again.

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Canadian Imports, Exports, and Net Exports,

19702011

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19.2

Growth Versus Fluctuations

Long-Term Economic Growth

Long-term growth is considerably more
important for a societys living standards from
decade to decade than short-term fluctuations
(often called Business Cycles.)
There is considerable debate regarding the
ability of government to influence the
economys long-run growth rate.
Government (Cabinet and Central Bank) uses
two policy tools (Fiscal and Monetary) to
influence the economys long term economic
growth.
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Short-Term Fluctuations
Economists debate the effectiveness of
monetary and fiscal policy in influencing these
fluctuations.
Monetary policy tools are money supply (or
interest rate change) and exchange rate policy.
They are implemented by the central bank
The Bank of Canada.
Fiscal policy tools are taxes and government
expenditure and are implemented by the
government.
Some economists argue that despite the
power of policy to affect the economy,
governments should not attempt fine-tuning.

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What Lies Ahead?

To organize our thinking about macroeconomics,
we must develop some tools. These include:
discussing measurement of national income
building a simple model of the economy
modifying the model to make it more
realistic
using our model to analyze some pertinent
economic issues

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