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The study of how individual households and firms make decisions, interact with one another in markets
The study of the economy as a whole
Gross Domestic Product (GDP)
What is measures
- Measures total income of everyone in the economy
- Also measures total expenditure on the economy's output of g&s.
- For the economy as a whole, income equals expenditure because every dollar a buyer spend is a dollar of income for the seller
The circular-flow diagram
- A simple depication of the macroeconomy
- Illustrates GDP as spending, revenue, factor payments and income
- It omits: the government (collecting taxes, buying g&s), the financial system (matches savers' supply of funds with borrowers' demand for loans) and the foreign sector (trades g&s financial assets, and currencis with the country's residents)
Factors of production
Are inputs like labour, land, capital, and natural resources
are payments to the factors of production (eg. wages, rent).
Gross Domestic Product (GDP) is...
The market value of all final goods & services produced within a country in a given period of time.
Components of GDP
- Consumption (C)
- Investment (I)
- Government Purchases (G)
- Net Exports (NX)
Consumption (C) is
- Total spending by households on g&s
- Note on housing costs: for renters, consumption includes rent payments; for homeowners, consumption includes the imputed rental value of the house, but not the purchase price of mortgage payments
- Is total spending on goods that will be used in the future to produce more goods.
- Includes spending on: capital goods; structures; inventories
- (Not the purchase of financial assets like stocks and bonds)
Government purchases (G)
- Include spending on goods and services by local, territorial, provincial, and federal governments
- It includes the salaries of government workers and spending on public works
- G excludes transfer payments, such as a Canada pension Plan benefit to an elderly or employment insurance benefits
- They are not purchases of g&s
Net Exports (NX)
- NX=exports - imports
- Exports represent foreign spending on the economy's g&s
- Imports are the portions of C, I and G that are spent on g&s produced abroad
values output using current prices. It is not corrected for inflation
Values outputs using the prices of a base year. Real GDP is corrected for inflation
The GDP deflatore
- The GDP deflatre is a measure fo the overall level of prices.
- GDP deflator = 100 x (nominal GDP)/(real GDP)
- One way to measure the economy's inflation rate is to compute the percentage increase in the GDP deflator from on year to the next
GDP and Economic Well-Being
Real GDP per capita is the main indicator of the average person's standard of living, though it isn't the perfect measure of well-being
GDP does not value
- The quality of the environment
- Leisure time
- Non-market activity, such as the child care a parent provides his or her child at home
- An equitable distribution of income
The Consumer Price Index (CPI)
- Measures the typical consumer's cost of living
- The basis of cost of living adjustments (COLAs) in many contract and in Social Security
Cost of living adjustments
How the CPI is Calculated
- 1. Determine the "basket": statistics Canada surveys consumers to determine what's in the typical consumer's "shopping basket"
- 2. Find the prices: Statistics Canada collects data on the prices of all the goods in the basket.
- 3. Compute the basket's cost: Use the data on prices to compute the total cost on the basket.
- 4. Choose a base year and compute the index: The CPI in any year = 100 X cost of basket in current year/cost of basket in base year.
- 5. Compute the inflation rate: The percentage change in the CPI from the preceding period. Inflation rate = (CPI the year - CPI last year)/CPI last year x 100%
Top four portions of Basket
- Shelter (25.7%)
- Transportation (19.6%)
- Food (16.9%)
- Recreation, education and reading (13%)
3 Bias of CPI
- Commodity substitution
- Introduction of new goods
- Unmeasured Quality change
Commodity Substitution Bias
Problem with CPI
- Over time, some prices rise faster than others.
- Consumers substitute toward goods that become relatively cheaper
- The CPI misses this substitution because it used a fixed basket of goods.
- Thus, the CPI overstates increases in the cost of living
Introduction of New Goods
Problem with CPI
- The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs
- In effect, dollars become more valuable
- The CPI misses this effect because it uses a fixed basket of goods
- Thus, the DPI overstates increases in the cost of living
Unmeasured Quality Change
- Improvements in the quality of goods in the basket increase the value of each dollar
- Statistics Canada tries to account for quality changes but probably misses some, as quality is hard to measure.
- Thus, the CPI overstates increases in the cost of living.
Problems with the CPI
- The CPI probably overstates inflation by about 0.6% points per year, according to research by the Bank of Canada
- The issue is important because private and public pension programs, personal income tax deductions, some government social payments, and many private sector wage settlements are all adjusted upward using the CPI
- The bias in the CPI suggests that adjustments to wages, pensions, and social payments that are based on the CPI may be larger than necessary to maintain the purchasing power of these wages and benefits.
The GDP Deflator vs. the CPI
- Economist and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. Usually, these two statistics tell a similar story.
- Yet there are two important differences that can cause them to diverge:
- 1. The GDP deflator reflects the prices of all goods and services produced domestically, where as the CPI reflects the prices of all goods and services bought by consumers
- 2. The CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year. The GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.
Comparing Variables for inflation
- Inflation makes it harder to compare dollar amounts from different times
- Was the 1957 price of 9.5 cents per liter high or low compared with the 209 price of gas (95 cents/liter)?
- To compare we need to inflate the old price to turn the old dollar into a new dollar. A price index shows us the size of this inflation correction
- Amount in today's $ = Amount in year T $ x price level today/price level in year T
- Researchers, business analysts and policymakers often use this technique to convert a time series of current-dollar (nominal) figures into constant-dollar (real) figures
- They can then see how a variable has changed over time after correcting for inflation
- Correcting Variables for inflation:
- A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract.
- For example, the increase in the CPI automatically determines: The COLA in many multi-year labour contracts; the adjustments to Canada pension plan and Old Age Security Payments, and federal income tax brackets.
Real vs. Nominal Interest Rates
- The nominal interest rate: The interest rate not corrected for inflation; the rate of growth in the dollar value of a deposit or debt
- The real interest rate: corrected for inflation; the rate of growth in the purchasing power of a deposit or debt.
- Real interest rate = (nominal interest rate) - (inflation rate)
Income and Growth around the world
- Fact 1: There are vast differences in living standards around the world.
- Fact 2: There is also great variation in growth rates across countries.
Questions that arise from the difference in incomes and growth around the world
- Why are some countries richer than others?
- Why do some countries grow quickly while others seem stuck in a poverty trap?
- What policies may help raise growth rates and long-run living standards?
A country's standard of living depends on it ability to produce g&s.
- This ability depends on productivity, the average quantity of g&s produced from each hour of a worker's time.
- Y = real GDP = quantity of output produced
- L = quantity of labour
- Y/L = productivity (output per worker)
Why Productivity is SO important
- When a nation's workers are very productive, real GDP is large and incomes are high.
- When productivity grows rapidly, so do living standards.
Physical Capital per worker
- The stock of equipment and structures used to produe g&s is called [physical} capital, denoted K.
- K/L = capital per worker
- Productivity is higher when the average worker has more capital (machines, equipment, etc.)
- Thus, and increase in K/L causes an increase in Y/L
Human Capital per worker
- Human capital (H): the knowledge and skills workers acquire through education, training and experience
- H/L = the average worker's human capital
- Productivity is higher when the average worker has more human capital (education, skills, etc.)
- Thus, an increase in H/L causes an increase in Y/L
Natural Resources per worker
- Natural resources (N): the inputs into production that nature provides (land, mineral deposits)
- Other things equal, more N allows a country to produce more Y.
- In per-worker terms, an increase in N/L causes an increase in Y/L
- Some countries are rich because of abundant natural resources, but some countries are able to be rich without a large amount of N (such as Japan)
- Technological knowledge: society's understanding of the best ways to produce g&s.
- Technological progress does not only mean a faster computer, a higher-definition TV, or a smaller cell phone
- It means any advance in knowledge that boosts productivity (allows society to get more output from its resources)
- Eg. Henry Fords assembly line
Tech. Knowledge vs. Human Capital
- Technological knowledge refers to society's understanding of how to produce g&s.
- Human capital results from the effort people expend to acquire this knowledge.
- Both are important for productivity
The Production Function
- The production function in a graph or equation showing the relation between output and inputs:
- Y = A F(L, K, H, N)
- F( ) - a function that shows how inputs are combined to produce output
- "A" - the level of technology
- "A" multiplies the function F( ), so improvements in technology (increases in "A") allow more output (Y) to be produced from any given combination of inputs
- This has the property constant returns to scale: changing all inputs by the same percentage causes output to change by that percentage.
Y = A F(L, K, H, N)
- If we multiply each input by 1/L, then output is multiplied by 1/L:
- Y/L = A F(1, K/L, H/L, N/L)
- This equation shows that productivity (output per worker) depends on:
- The level of technology (A)
- Physical capital per worker
- Human capital per worker
- Natural resources per worker
Saving and Investment on Productivity
- We can boost productivity by increasing K, which requires investment
- Since resources are scarce, producing more capital requires producing fewer consumption goods.
- Reducing consumption = increasing saving. This extra saving funds the production of investment good
- Hence, a tradeoff between current and future consumption
Diminishing Returns and the Catch-Up Effect
- The govt can implement policies that raise saving and investment
- Then K will rise, causing productivity and living standards to rise.
- But this faster growth is temporary, due to diminishing returns to capital: as K rises, the extra output from an additional unit of K falls.
Investment from Abroad
- To raise K/L and hence productivity, wages and living standards, the govt can also encourage: foreign direct investment; a capital investment (eg factory) that is owned & operated by a foreign entity) or foreign portfolio investment: a capital investment financed with foreign money but operated by domestic residents
- Some of the returns from these investments flow back to the foreign countries that supplied the funds
- Especially beneficial in poor countries that cannot generate enough saving to fund investment projects themselves
- Also helps poor countries learn state-of-the-art technologies developed in other countries
- Govt can increase productivity by promoting education-investment in human capital (H): public schools, subsidized loans for college
- Education has significant effects: in Canada, each year of schooling raises a worker's wage by 10%
- But investing in H also involved a tradeoff (opportunity cost)
Health and Nutrition
- Health care expenditure is a type of investment in human capital - healthier workers are more productive
- In countries with significant malnourishment, raising worker's caloric intake raises productivity
Property Rights and Political Stability
- The price system allocates resources to their most efficient uses, but this requires respect for property rights, the ability of people to exercise authority over the resources they own.
- In many poor countries, the justice system doesn't work very well: Contracts not enforced; fraud, corruption often go unpunished; in some, firms must bride govt officials for permits
- Political instability (eg. frequent coups) creates uncertainty over whether property rights will be protected in the future
- When people fear their capital may be stolen by criminals there is less investment, including from abroad and the economy functions less effiecitly
- Economic stability, efficiency and healthy growth require law enforcement, effective courts, a stable constitution, and honest govt officials.
- Inward oriented policies: (tariffs, limits on investment from abroad) aim to raise living standards by avoiding interaction with other countries
- Outward-oriented policies (the elimination of restrictions on trade or foreign investment) promote integration with the world economy
- Trade has similar effects as discovering new technologies - it improves productivity and living standards
- Countries with inward-oriented policies have generally failed to create growth
- Countries with outward-oriented policies have often succeeded.
Research and Development
- Technological progress is the main reason why living standards rise over the long run
- One good reason is that knowledge is a public good; ideas can be shared freely, increasing the productivity of many.
- Policies to promote tech. progress: Patent laws; tax incentives or direct support for private sector R&D; grants for basic research at universities
Population Growth may affect living standards in 3 different ways:
- 1. stretching natural resources (Malthus argue the pop. growth would strain society's ability to provide for itself, he failed to accounted for technological progress and productivity growth)
- 2. Diluting the capital stock (bigger population = higher L = lower K/L = lower productivity & living standards) (this applies to H as well as K)(countries with fast pop. growth tend to have lower educational attainment) This is combated with policy to control pop. growth: China's one child per family laws, contraception education & availability, promote female literacy to raise opportunity cost of having babies.
- 3. Promoting tech. progress (more people = more scientists, inventors, engineers = more frequent discoveries = faster tech. progress & economic growth)
Are natural resources a limit to growth
- Some argue that pop. growth is depleting the Earth's non-renewable resources, and thus will limit growth in living standards
- But tech. progress often yields ways to avoid these limits: hybrid cars use less gas; better insulation in homes reduces the energy required to heat or cool them
- As a resource becomes scarcer, its market price rises, which increases the incentive to conserve it and develop alternatives
In the long run, what determines living standards?
What affects the next generation's living standards?
Polices that affect the determinants of productivity: One such policy is saving and investment
The group of institutions that help match the saving of one person with the investment of another
Institutions through which savers can directly provide funds to borrowers. Examples: the Bond Market (a bond is a certificate of indebtedness); the stock market (a stock is a claim to partial ownership in a firm)
Institutions through which savers can indirectly provide funds to borrowers. Examples; banks; mutual funds - institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds
Institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds
Saving and Investment in the National Income Accounts
- Recall that GDP is both total income in an economy and total expenditure on the economy's output of goods and services:
- Y = C + I + G + NX
- In a closed economy: Y = C + I + G
- The portion of households' income that is not used for consumption or paying taxes
- = Y - T - C
- Tax revenue less government spending
- = T - G
- Private saving + public saving
- = (Y - T - C) + (T - G)
- = Y - C - G
- =the portion of national income that is not used for consumption or government purchases
= investment (only) in a closed economy
- An excess of tax revenue over govt spending
- = T - G
- = public saving
A shortfall of tax revenue from govt spending
- = G - T
- = - (public saving)
- is the income remaining after households pay their taxes and pay for consumption
- Examples of what they do with savings: Buy corporate bonds or equities; purchase a certificate of deposit at the bank; buy shares of a mutual fund; let accumulate in saving or checking accounts
- The purchase of new capital
- Examples: building a new R&D center: buy $5000 worth of computer equipment for your business; or spending $300,000 to have a new house built
Remember, in economics, investment is NOT
the purchase of stocks and bonds!
The market for loanable funds
- A supply-demand model of the financial system
- Helps us understand: how the financial system coordinates saving & investment; how govt policies and other factors affect saving, investment, the interest rate
- Assume: only one financial market: all savers deposit their saving in this market; all borrowers take out loans from this market; there is one interest rate, which s both the return to saving and the cost of borrowing.
- The supply of loanable funds comes from saving: household with extra income can loan it out and earn interest; public saving, if positive, adds to national saving and the supply of loanable funds; if negative it reduces national saving and the supply of loanable funds.
- The demand for loanable funds comes from investment: firms borrow the funds they need to pay or new equipment, factories, etc; households borrow the funds they need to purchase new houses.
Policy 1: Saving Incentives
- Tax incentives for saving increase the supply of loanable funds
- which reduces the equilibrium interest rate and increases the equilibrium quantity of loanable funds
Policy 2: investment incentives
- An investment tax credit increases the demand for loanable funds
- which raises the equilibrium interest rate and increases the equilibrium quantity of loanable funds.
Policy 3: Govt Budget Deficits
- A budget deficit reduces national saving and the supply of loanable funds
- which increases the equilibrium interest rate and decreases the equilibrium quantity of loanable funds
The sum of all past budget deficits and surpluses.
Government budget deficits and surpluses
- Many of the most pressing policy issues that have arisen over the past 30 years in Canada have either directly or indirectly results from large government budget deficits and the debt that accumulated as a result of these deficits
- Much public debate over past 25 years as centered on the effects of these deficits, both on the allocation of the economy's scarce resource and on long-term economic growth
- Crowding out is a large problem because investment is important for long-run economic growth.
- A decrease in investment that results from government borrowing
- Because investment is important for long-run economic growth, government budget deficits reduce the economy's growth rate
Cycle that results when deficits reduce the supply of loanable funds, increase interest rates, discourage investment, and result in slower economic growth; slower growth leads to lower tax revenue and higher spending on income support programs, and the result can be even higher budget deficits
A cycle that results when surpluses increase the supply of loanable funds, reduce interest rates, stimulate investment, and result in faster economic growth; faster growth leads to higher tax revenue and lower spending on income-support programs, and the result can be even higher budget surpluses
Accumulation of Government Debt in Canada
- Budget deficits became a chronic problem in Canada only in the mid-1970s.
- Because GDP is rough measure of the government's ability to raise tax revenue, a declining debt-to-GDP ratio indicates that the economy is, in some sense, living within its means