Review

1
Review

• Key Concepts and Selected Problems

2
Chapter 19 Overview

• Long run growth vs. the Business Cycle
• Potential Output and the Output Gap
• Employment, Unemployment and the Labour Force
• Inflation and the Price Level
• Exchange Rates and Balance of Payments

3
Real GDP fluctuates around a rising trend. The
trend shows long-run economic growth. The
short-run fluctuations show the business cycle.
Potential (full employment) national income
measures what the economy could produce if all
resources were employed at their normal levels of
utilization.
The output gap measures the difference between
potential output and actual output. Output Gap
Y-Y
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Recessionary Gap
Peak
Recovery
Actual GDP
Recession
Real GDP
Potential GDP
Peak
Trough
Inflationary Gap
Time
When actual income (output) is less than
potential income, there is said to be a
recessionary gap.
When actual income (output) exceeds potential
income, there is said to be an inflationary gap.
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Employment is the number of adult workers (15 and
over) who hold jobs.
Unemployment is the number of individuals who are
not employed but who are actively searching for a
job.
The labour force is the total number of people
who are either employed or unemployed.
Number of people unemployed
Unemployment Rate

X 100
Number of people in the labour force
When the economy is at full employment (Y Y),
the unemployment that exists is frictional
and/or structural.
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The unemployment rate that occurs when the
economy is at full employment (YY) is called
the natural rate of unemployment.
During recessions, unemployment rises above its
full-employment level. During booms, unemployment
falls below this level. When unemployment is
greater than the full-employment level, there is
cyclical unemployment.
7

• In a country with a working-age population of 150
  million, 100 million workers are employed and 15
  million workers are unemployed. The size of the
  labour force is
• 150 million
• 100 million
• 115 million
• 15 million

Labour force Employed Unemployed 100 15
115 million

• What is the unemployment rate?
• 15
• 10
• 13
• 66.7

8

• You notice that over the last year the
  unemployment rate has gone from 8.2 percent to
  6.2 percent and growth in real GDP has increased.
  Hence over this year the economy is likely
• in a recession
• at the trough of a business cycle
• in an expansion
• at the peak of a business cycle

9
The price level refers to the average level of
all prices in the economy. Inflation is the rate
at which the price level is changing.
Consumer Price Index (CPI) measures the price
level and is based on the price of a typical
consumption basket. It then expresses that
price as a ratio of the price in some base period.
Inflation erodes the purchasing power of money
and adds to the uncertainty of economic life.
10

• Which of the following is a stock?
• Income
• Depreciation
• Investment
• Capital

• At the end of last year, the CPI equaled 120. At
  the end of this year, the CPI equals 132. What is
  the inflation rate over this year?
• 6
• 10
• 12

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The interest rate is the price of borrowing
funds. The nominal interest rate is the price
expressed in money terms. The real interest rate
is this price expressed in terms of purchasing
power. The burden of borrowing depends on the
real, not the nominal, rate of interest.
Nominal interest rate
Real interest rate
Expected inflation
12
Exercise 19.5
13
The exchange rate is the number of Canadian
dollars required to purchase one unit of foreign
currency. A depreciation of the Canadian dollar
means the exchange rate has increased. An
appreciation of the Canadian dollar means the
exchange rate has decreased.
The balance of payments accounts record all
international payments that are made in the
course of international transactions of goods,
services, and assets.
The trade balance is the difference between the
value of exports and the value of imports.
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Chapter 20 Overview

• Measuring National Income
• The Expenditure Approach
• The Factor Incomes Approach
• Real vs. Nominal GDP
• GDP per capital
• GDP and welfare

15
Gross Domestic Product (GDP) is the total value
added produced in the economy. GDP is a measure
of all final output that is produced in the
economy.
GDP is also equal to the total flow of
expenditure on domestic output. Adding up the
total flow of income generated by domestic
production also gives us GDP.
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The Expenditure Side

• C Consumption expenditure on final goods
• I Gross Investment Expenditure (inventories,
  plant and equipment, residential housing) Net
  Investment Depreciation.
• G Government Purchases of goods and services
  (does not include transfer payments)
• NX Net Exports Exports Imports
• X Exports purchases of Canadian goods and
  services by foreignors
• IM Imports purchases of foreign produced
  goods by Canadians

GDP C I G NX
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The Income Side

• GDP is the sum of factor incomes and other claims
  on the value of output.
• Net Domestic Income Wages Rent Interest
  Profits

GDP Net Domestic Income (Indirect Taxes
Subsidies) Depreciation
The difference between measured GDP from the
income approach and the expenditure approach is
called the statistical discrepancy.
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GDP vs. GNP
GDP measures the total output produced in Canada
and the total income generated as a result of
that production.
GNP measures the total amount of income received
by Canadian residents, no matter where the income
was generated.
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Real vs. Nominal National Income
Nominal national income is GDP valued at current
prices.
Real national income is GDP that is valued at
constant base-period prices.
GDP at current prices
GDP Deflator
x 100
GDP at base-year prices
Per capita output is the amount of output per
person
20
Limitations of GDP
GDP does not measure everything that contributes
to affects human welfare.

• Excluded
• illegal activities
• the underground economy
• home production
• economic bads

21
Exercise 20.2
Natural Disaster Destruction of the buildings
does not in itself either create or destroy
income, though some of the homes may have been
rental units the flood damage will eliminate some
rental income. Repair and replacement of the
destroyed homes are income creating. To the
extent that they merely shift such things as
lumber and construction labour from one activity
to another, however, they will not change the
measured value of GDP at all.
22
Acid Rain Measured GDP would probably not be
affected at first, although it might fall in
later years as the effects of acid rain on, say,
fish stocks and maple trees, are felt. Clearly,
the true well-being of Canadians is reduced.
Think of pollution and environmental degradation
much like the depreciation of the capital stock.
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Practice Question
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Using the expenditure approach to calculate GDP
Using the factor payments approach to calculate
GPD GDP (Wages and Salaries Business Profits
Interest Income) (Indirect Taxes
Subsidies) Depreciation
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Gross Investment Net Private Investment
Depreciation
Also note that
Gross investment equals national saving and
borrowing from the rest of the world (IM - X).
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Chapters 21-22 Overview

• Simple Macro Model
• Adding Government
• Adding International Trade
• The New Multiplier

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Simple Model
AE C I
C autonomous consumption (MPC x Disposable
Income) C a bYD where YD is disposable income
I investment (autonomous) Autonomous
Expenditure a I Induced Expenditure bYD The
marginal propensity to spend, z MPC
The simple multiplier 1/(1-z)
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Adding Government
G Government Purchases T Net Tax Revenues T
G Government budget balance/Public Saving
Tax Function T tY where t is the tax rate
With taxes, disposable income is less than
national income YD Y T Y tY (1 - t)Y
This changes the consumption function C a
bYD a b(1 t)Y
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Adding International Trade
Imports Function IM mY where m is the marginal
propensity to import.
Net Exports Function NX X IM X - mY
Changes in foreign incomes, the relative prices
of Canadian products and exchange rates will
shift the net exports function.
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AE Function
AE C I G NX
AE C I G (X IM) AE a b(1-t)Y I
G (X mY) AE a I G X b(1-t) mY
Autonomous Expenditure
Induced Expenditure
Marginal Propensity to Spend
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Equilibrium National Income
Y AE
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Suppose there is a change in autonomous
expenditure, A. A a I G X
The resulting change in equilibrium national
income
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Practice Question

AE function AE C I G NX
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AE
AEY
1200
Autonomous Expenditure is 450
450
The slope of the AE function is 0.625 i.e. z
0.625
Y
1200
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At equilibrium national income AEY
We just need to substitute for Y to get
equilibrium consumption, taxes and net exports
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Government expenditure rises from 125 to 200.
AE function shifts up by 75.
1400
1200
New Equilibrium National Income
525
450
1400
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