are your smart choices smart for all? macroeconomics & microeconomics

Are Your Smart Choices Smart for All?

Macroeconomics & Microeconomics

Copyright © 2011 Pearson Canada Inc.Chapter 1 - 2

LEARNING OBJECTIVES

1.1 Explain the differences between microeconomics and macroeconomics

1.2 Describe the hands-off and hands-on views on government policy and connect each to the fundamental macroeconomic question

1.3 Define three key measures of macroeconomic performance, and identify good outcomes for each

continued…


1.4 Identify five groups of macroeconomic players and their choices

1.5 Explain three MAPS for focusing your thinking

like a macroeconomist


RECONCILING MACRO AND MICRO: IS THE WHOLE GREATER THAN

THE SUM OF THE PARTS?

Smart microeconomic choices by individuals may or may not add up to smart macroeconomic

outcomes for the economy as a whole. “If left alone, do markets quickly self-adjust?”


RECONCILING MACRO AND MICRO

• Great Recession (2008 – 2009)

• Great Depression (1929 – 1933) involved financial bubbles that burst, high unemployment, falling living standards, bankruptcies, and government policy mistakes

continued…


• Business cycles ups and downs of overall economic activity

• 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, individual businesses, and governments make, and how those choices interact in markets

continued…


• Fallacy of composition what is true for one is not true for all; whole is greater than the sum of the parts

• Paradox of thrift attempts to increase savings cause aggregate savings to decrease due to falling incomes

continued…


• Fundamental Macroeconomic QuestionIf left alone by government, do the price mechanisms of market economies adjust quickly to maintain steady growth in living standards, full employment, stable prices?

orIf left alone, do markets quickly self-adjust?

• “Yes” Say’s Law “supply creates its own demand”• “No” Keynes rejected Say’s Law


GOVERNMENT HANDS-OFF OR HANDS-ON? ECONOMICS AND POLITICS

The “Yes” and “No” camps disagree on fallacy of composition, causes of business cycles, risk of government failure versus market failure, role for government, and are on different political

sides.


COMPARING CAMPS

• YES — Left Alone, Markets Quickly Self-Adjust– no fallacy of composition so micro = macro– business cycles from external

causes or government policy mistakes– government failure worse than

market failure– hands-off role for government– political right

continued…


• NO — Left Alone, Markets Fail to Self-Adjust– fallacy of composition is real, so micro ≠ macro– business cycles from internal causes —

coordination failures between input & output markets; money, banks, expectations

– market failure worse than government failure

– hands-on role for government– political left


DOES THE ECONOMY MEASURE UP? GDP, UNEMPLOYMENT, INFLATION

The most important outcomes of the Canadian economy are

GDP per person, unemployment, inflation.


MEASURING GDP, UNEMPLOYMENT, INFLATION

• Gross Domestic Product (GDP) value of all final products and services produced annually in a country

• Unemploymentnot employed and actively seeking work

• Inflation rising average prices and falling value of money


CAN’T TELL PLAYERS WITHOUT A SCORECARD: MACROECONOMIC PLAYERS

Five macroeconomic players are consumers, businesses, government, Bank of Canada

and the banking system, and rest of the world. Each group has different choices.


• Consumer choices– spend income or save– buy Canadian products/services or imports

• Business choices– investment spending

business purchases of new factories and equipment — domestically or importing

– hiring workers or not– buying inputs domestically or importing– selling outputs domestically or exporting

CHOICES FOR MACROECONOMIC PLAYERS

continued…


• Government choices– purchases of products/services– taxes and transfer payments– fiscal policy

changes in government purchases, taxes/transfers to achieve macroeconomic outcomes

• Bank of Canada and Banking System choices– monetary policy

Bank of Canada changes interest rates and supply of money to achieve macroeconomic outcomes

– making loans or not

continued…


• Rest of World (R.O.W.) choices– buying Canadian exports,

selling imports to Canada– investing money in Canada or

accepting Canadian investments– demanding Canadian dollars


FOCUSING ON YOUR FUTURE: LIVING STANDARDS, VOTING &

MACROECONOMICS

Macroeconomics affects your future — GDP per person, unemployment, and inflation.

Macroeconomics also informs your vote for politicians and policies influencing economic performance.


SUCCESS, VOTING, AND MAPS

• Your personal economic success depends on– GDP

higher GDP per person = higher living standards– Unemployment

affects odds of finding jobs– Inflation

reduces living standards if income not rising as fast as prices of what you buy

• Understanding macroeconomics informs your vote for politicians whose economic policy choices influence economic performance and your economic success

continued…


• Thinking like a macroeconomist means focusing on targeted targeted connections in the economy

• 3 MAPS (MAcroeconomic Positioning Systems) for finding targets– MAPS1

focus on the connection between input markets and output markets, for both demand and supply sides

continued…


– MAPS2focus on the connections between Canada and the rest of the world

– MAPS3focus on the connections between money/banks/expectations and the input and output markets of the circular flow


Up Around the Circular Flow GDP, Economic Growth,and Business Cycles


LEARNING OBJECTIVES

2.1 Differentiate nominal GDP, real GDP, and real GDP per person, and how each relates to living standards

2.2 Explain how economic growth occurs and how it is measured

2.3 Describe the language of business cycles, including output gaps as a target for hands-on policymakers

continued…


2.4 Explain how value added and the equality of aggregate spending and aggregate income allow us to measure GDP

2.5 Identify five limitations of real GDP per person as a measure of well-being


HIGHER PRICES, MORE STUFF, OR BOTH? NOMINAL GDP AND REAL GDP

GDP measures value final products/services produced annually;

nominal GDP combines changes in prices & quantities; real GDP measures only changes in quantities;

real GDP per person best measure of material standard of living.


NOMINAL GDP AND REAL GDP

• Nominal GDPvalue at current prices of all final products/services produced annually in a country

• Differences in nominal GDP between years due to either price changes or quantity changes

continued…


• GDP includes products/services produced within a country’s borders, no matter what nationality of business producing

• GDP is a flow amount per unit of time

• Stockfixed amount at a moment in time

continued…


• Real GDPvalue at constant prices of all final products/services produced annually in a country

– real GDP uses constant prices for a single year to value quantities produced in different years

– differences in real GDP between years show only changes in quantities


WHEN MACROECONOMIC DREAMS COME TRUE: POTENTIAL GDP AND ECONOMIC

GROWTH

By increasing quantity and quality of inputs, economic growth increases productivity and potential GDP per

person, raising maximum possible living standards.


POTENTIAL GDP AND ECONOMIC GROWTH

• Potential GDP – real GDP when all inputs fully employed

(labour, capital, land/resources, entrepreneurship)

– short-run goal for ideal economic performance

– outcome if Invisible Hand works perfectly• Potential GDP per person

– potential GDP divided by population – short-run maximum living standards

continued…


• Increases in labour– quantity — population growth,

immigration, and labour force participation rate

– quality — human capital — work experience, on-the-job training, and education

continued…


• Increases in capital– quantity — more factories and equipment– quality — technological change —

innovation, research and development• Increases in land/resources

– quantity — bringing land/resourcesinto circular flow of markets

– quality — usually due to increases in capital used with land

continued…


• Increases in entrepreneurship– quantity and quality interrelated– better management, organization,

and worker/management relations

continued…


• When economic growth progresses smoothly,

stock of inputs serves as a basis for choices; choices then transform the stock of inputs, continuing in an ever-expanding circle

continued…


• Economic growth rateannual percentage change in real GDP per person

• Canada’s average annual economic growth rate, 1926–2008, was 2.1 %

continued…

Real GDP per person growth rate(%)

Real GDP per person this year

Real GDP per person last year

Real GDP per person last yearX 100=

—


• Productivityquantity of real GDP produced by an hour of labour– increases in productivity increase living

standards – more products/services

produced– reducing work time needed

to buy products/services


BOOM AND BUST: BUSINESS CYCLES

Business cycles track real GDP expansion and contraction. Output gaps measure the difference between

real GDP and potential GDP. “Closing the gap” is an important policy target.


BUSINESS CYCLES

• Language of business cyclesfluctuations of real GDP around potential GDP– expansion

period when real GDP increases– peak

highest point of an expansion– contraction

period when real GDP decreases– trough

lowest point of a contraction– recession

2+ successive quarters of real GDP contraction

continued…


Fig. 2.9 Most Recent Complete Canadian Business Cycle


• Output gapsreal GDP minus potential GDP– recessionary gap

real GDP below potential GDP– inflationary gap

real GDP above potential GDP


VALUE ADDED & THE ENLARGED CIRCULAR FLOW

• Value addedvalue of output minus value of intermediate products/services bought from other businesses

• Value added solves problems of double counting, distinguishing final and intermediate products/services– value of final products/services = value added– value of final products/services = inputs’

income– GDP = inputs’ income

continued…


• 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/services– X spending by R.O.W. on Canadian

exports – IM Canadian spending on imports

produced by R.O.W.

continued…


• Aggregate Spending = Aggregate IncomeC + I + G + X − IM = Y


MY GDP IS BIGGER THAN YOURS: WHAT’S WRONG WITH GDP AS A MEASURE OF WELL-

BEING?

Real GDP per person is a limited measure of well-being; excludes nonmarket production, underground economy,

environmental damage, leisure, political freedoms and social justice.


WHAT’S WRONG WITH GDP AS A MEASURE OF WELL-BEING?• Real GDP per person is limited measure of

well-being because it does not include– non-market production

household production that improves quality of life

– underground economy activities that are illegal, or legal but avoid taxes

continued…


– environmental damage costs of environmental damage, resource depletion

– leisure leisure lowers real GDP, but is desirable

– political freedoms and social justice limited freedoms, uneven income distributions

continued…


• Growth rates of real GDP per person still useful for judging economic progress if no significant changes over time in the limitations

• United Nations Human Development Index (HDI) measures quality of life across countries by combining life expectancy, educational achievement, and income– Canada ranked 4th, U.S. 15th in 2006


Costs of (Not) Working and Living

Unemployment and Inflation


LEARNING OBJECTIVES

3.1 Explain what the unemployment rate measures and misses, and identify four types of unemployment

3.2 Define the natural rate of unemployment and explain its connection to recessionary and inflationary output gaps

3.3 Explain how the inflation rate is calculated and what it misses, and describe three problems inflation creates

continued…


3.4 Use the quantity theory of money to explain where inflation comes from

3.5 Describe the Phillips Curve and its connections to demand-pull and cost-push inflations


WHO IS UNEMPLOYED? HEALTHY & UNHEALTHY TYPES OF

UNEMPLOYMENT

Unemployment rate measures percentage of labour force out of work and actively searching for jobs, but misses involuntary part-time and discouraged workers. Four

types of unemployment — frictional, structural, seasonal,

cyclical. Only cyclical is both unhealthy and a problem.

Fig. 3.1 Labour Force Categories for Working-Age Population, May 2009

Employed16 832 200

Unemployed1 548 400Labour Force

18 380 600(employed + unemployed)

Not in Labour Force8 869 400

Working-Age Population 27 250 000

Fig. 3.3 Unemployment & Underutilization of Labour, May 2009

Percentage of Labour Force

Official unemployment rate 8.7Involuntary part-time workers 2.6Discouraged workers 0.2Total Underutilization Rate 11.5

L A B O U R F O R CE C A T E G O R IE S

E M P L O Y E D(1 6 M ILL IO N )

U N E M P L O Y E D(2 M IL L IO N )

L A B O U R F O R C E(1 8 M ILL IO N )

N O T IN L A B O U R F O R C E(7 M IL L IO N )

W O R K IN G A G E P O P U L A T IO N(2 5 M ILL IO N )

A G E 15 A N D O V E R

O T H E R S(6 M IL L IO N )

P O P U L A T IO N(3 1 M ILL IO N )

Fig. 3.4 Provincial Unemployment Rates, May 2009

Province Unemployment Rate

Newfoundland/Labrador 15.1Prince Edward Island 13.1Nova Scotia 8.9New Brunswick 8.8Quebec 8.7Ontario 9.4Manitoba 4.9Saskatchewan 4.9Alberta 6.6British Columbia 7.6

Fig. 3.5 Varieties of Unemployment

Type of Unemployment

Healthy/Unhealthy

Problem that Needs Addressing?

Cause

Frictional Healthy No Normal, healthy market adjustments of demand and supply

Structural Healthy Yes (worker retraining)

Technological change, international competition, resource depletion

Seasonal Neutral No Weather and seasons

Cyclical Unhealthy

Yes (fiscal or monetary policy)

Business cycles


HOW FULL IS “FULL EMPLOYMENT?” THE NATURAL RATE OF

UNEMPLOYMENT

Natural rate of unemployment at full employment, where only healthy frictional, structural, seasonal

unemployment. Relative to natural rate, unemployment rate is higher in recessionary gap and lower in inflationary

gap.


• Statistics Canada sorts working-age population (age 15 and over) into three categories– employed

working full-time or part-time at paid job– unemployed

not doing paid work and actively searching for job; on temporary layoff; about to start new job

– not in the labour force not employed or unemployed (full-time student, homemaker, retiree)

UNEMPLOYMENT

continued…


• Labour force = employed + unemployed• Unemployment rate

percentage of people in labour force who are unemployed– Unemployment Rate = ×

100UnemployedLabour Force

continued…


• Labour force participation rate– percentage of working-age population in

labour force (employed or unemployed)– Labour Force Participation Rate

= × 100

Labour ForceWorking Age Population

continued…


• Unemployment rate misses– involuntary part-time workers

employed part-time but would rather have full-time job, and can’t find one

– discouraged workerswant to work but have given up actively searching for jobs

• Labour underutilization rateunemployment rate including unemployed, involuntary part-time, discouraged workers

continued…


• Healthy and unhealthy types of unemployment– frictional unemployment

due to normal labour turnover and job search; healthy part of changing economy; not a problem

– structural unemployment due to technology or international competition making workers obsolete; healthy part of changing economy; problem requiring retraining

– seasonal unemploymentdue to seasonal changes in weather; neither healthy nor unhealthy; not a problem

continued…


– cyclical unemploymentdue to fluctuations in economic activity; unhealthy part of changing economy; problem needs addressing


NATURAL RATE OF UNEMPLOYMENT

• Natural rate of unemploymentunemployment rate at full employment; includes frictional, structural, seasonal unemployment– full employment

is not zero percent unemployment but zero percent cyclical unemployment

continued…


• Natural rate of unemployment and potential GDP– when unemployment = natural rate

real GDP = potential GDPfull employment

– when unemployment > natural rate real GDP < potential GDPrecessionary gapcyclical unemployment

– when unemployment < natural rate real GDP > potential GDPinflationary gap

• Economists disagree about the natural rate


PROBLEMS WITH UR FIGURES• MAY OVER OR UNDERESTIMATE

ACTUAL SITUATION BECAUSE1. DOES NOT INCLUDE DISCOURAGED

WORKERS (HIDDEN UNEMPLOYMENT) = PERSON WHO DOES NOT HAVE A JOB, IS AVAILABLE AND WILLING TO WORK BUT HAS NOT MADE ANY EFFORTS TO FIND A JOB WITHIN THE PREVIOUS 4 WEEKS


e.g. DURING RECESSIONS, WHEN PEOPLE STOP LOOKING FOR WORK, HIDDEN UNEMPLOYMENT RISES. BECAUSE THE UR FIGURED IGNORES THIS, IT MAY UNDERESTIMATE UNEMPLOYMENT.


2. INCLUDES VOLUNTARY UNEMPLOYMENT: = PEOPLE WHO SAY THEY ARE UNEMPLOYED BUT ARE NOT WILLING OR INTERESTED IN WORKING e.g. welfare recipients


e.g. DURING A BOOM, VOLUNTARY

UNEMPLOYMENT WILL OVERESTIMATE THE UR AND KEEP IT HIGH EVEN THOUGH THERE ARE A LOT OF VACANCIES.


LIGHTENING UP YOUR WALLET: WHAT IS INFLATION?

Inflation hurts those on fixed incomes, creates risk for business investment and can increase

in a vicious cycle of expectations. Inflation rate overstates

cost of living increases, missing switches to cheaper and improved products/services.


INFLATION

• Inflation is persistent rise in average prices and fall in value of money– spend more to get same products/services– your money is worth less

• Consumer Price Index (CPI)measure of average prices of a fixed shopping basket of products and services– CPI = 100 for the base year, currently

2002

continued…


Fig. 3.7 Consumer Price Index Basket

Recreation,education,

reading12.2%Health,

personal care4.7%

Alcoholic beverages, tobacco products3.1%

Food 17%

Transportation 19.9% Shelter 26.6%

Household operations, furnishing and equipment11.1%

Clothing, footwear

5.4%


• Inflation rateannual percentage change in consumer price index

– Inflation

– Core inflation rateinflation rate excluding volatile categories

× 100CPI for previous year

CPI for current year − CPI for previous year

=

continued…


• Inflation is a worry because of falling value of money– inflation reduces purchasing power

of people with fixed (unchanged dollar) income or savings

– nominal interest rateobserved interest rate; dollars per year in interest as percentage of dollars saved

– realized real interest rateis nominal interest rate adjusted for inflation = nominal interest rate − inflation rate

continued…


• Inflation is a worry because – unpredictable prices create risk

and discourage business investment– expectations of inflation can

cause inflation• Predictable inflation rate

between 1 and 3 percent is the Bank of Canada’s aim


VICIOUS CYCLE


• Deflationpersistent fall in average prices and rise in value of money– consumers may postpone purchases,

causing contraction and increasing unemployment

– deflation benefits savers but hurts borrowers

– deflation is worse than low inflation


• CPI fixes quantities in shopping basket to isolate only the impact of changing prices on cost of living– when prices rise, CPI misses switches to

cheaper substitutes and new/improved products

– inflation rate based on CPI overstates increases in cost of living


WHEN TIM HORTONS PAYS $18 PER HOUR: UNEMPLOYMENT AND

INFLATION TRADEOFFS

Phillips Curve shows tradeoff between unemployment and inflation consistent with demand-pull inflation.

Cost-push inflation, changes in expectations and natural rate

of unemployment complicate the original Phillips Curve.


UNEMPLOYMENT – INFLATION TRADEOFFS

• Phillips Curvegraph showing inverse relation between unemployment and inflation

• Demand-pull inflationrising average prices caused by increases in demand explain Phillips Curve’s tradeoff between unemployment and inflation– during expansions, demand is key force

causing shortages and pulling up prices for inputs (wages) and outputs

continued…


Fig. 3.11 Phillips Curve in Canada, 1946 - 1969


• Cost-push inflationrising average prices caused by decreases in supply — does not fit Phillips Curve– caused by supply shocks

events directly affecting business’s costs, prices, and supply. Decrease in supply key force pushing up output prices, while pushing economy into contraction, increasing unemployment.

– can cause stagflation simultaneous recession (unemployment)and inflation

continued…


• Both demand-pull and cost-push inflation require accompanying increase in quantity of money

• Trade-offs between unemployment and inflation of Phillips Curve are complicated due to changes in– expectations– natural rate of unemployment

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