Western SOS Economics

1022B

About Me…

Richa Parihar

2nd year Honors Specialization in Physiology

Western SOS Economics Course Coordinator and Tutor

rpariha@uwo.ca

Chapter 20Measuring GDP and Economic

Growth

Gross Domestic Product:

• GDP or Gross domestic product is the market value of all the final goods and services produced within a country in a given time period

• A final good (or service) is an item that is bought by its final user during a specified time period

• An intermediate good (or service) is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service

The economy consists of:

o Firms o Households o Governments o Rest of world

Aggregate economic markets are:

o Goods markets (goods and services) o Factor markets (productive resources)

Expenditure approach: Y = C + I + G + NX

Income approach:

o Sums incomes paid by firms to households

o Net domestic income at factor cost + Indirect taxes - Subsidies = Net domestic product at market prices

o Net domestic product at market prices+ depreciation = GDP

Real GDP:

The value of final goods and services produced in a given year when valued at constant prices.

Nominal GDP:

The value of the final goods and services produced in a given year valued at the prices that prevailed in that same year.

When all the economy’s labour, capital, land, and entrepreneurial ability are fully employed, the value of production is called potential GDP.

Real GDP fluctuates around potential GDP

A recession:-A period during which real GDP decreases—the growth rate of real GDP is negative—for at least two successive quarters.

An expansion:A period during which real GDP increases. A peak is an upper turning point where an expansion ends and a recession begins. • A trough is a lower turning point where a recession ends and an expansion begins.

Chapter 21Monitoring Jobs and Inflation

The working-age population :The total number of people aged 15 years and over.

Can be divided into two groups: -In labour force-Not in labour force The labour force:-divides into two groups:

- the employed - the unemployed.

A person is employed if they have either a full-time job or a part-time job.

A person is unemployed if they are in one of the following categories:

- Without work but has made specific efforts to find a job within the previous four weeks

- Waiting to be called back to a job from which he or she has been laid off

- Waiting to start a new job within four weeks

The unemployment rate:The percentage of the people in the labour force who are unemployed.

Unemployment rate = (Number of people unemployed ÷ Labour force) × 100.

Involuntary part-time rate = (Number of involuntary part-time workers ÷ Labour force) X 100.

Labour force participation rate = (Labour force ÷ Working-age population) × 100.

Employment-to-population ratio = (Number of people employed ÷ Working-age population) × 100.

Some Trends:

The unemployment rate increases in recessions and decreases in expansions.

The upward trends in the labour force participation rate and the employment-to-population ratio:

- by the increasing participation of women in the labour market.

A marginally attached worker:

A person who currently is neither working nor looking for work but has indicated that he or she wants and is available for a job and has looked for work sometime in the recent past.

A discouraged worker:

A marginally attached worker who has stopped looking for a job because of repeated failure to find one.

• People become unemployed if they:

o Lose their jobs and search for another job o Leave their jobs and search for another job o Enter or re-enter the labour force to search for a job

• People end a spell of unemployment if they:

o Are hired or recalled o Withdraw from the labour force

• People who are laid off from their jobs, either permanently or temporarily, are called job losers.

• People who voluntarily quit their jobs are called job leavers.

• People who enter or re-enter the labour force are called entrants and re-entrants.

• Frictional unemployment:

The unemployment that arises from normal labour market turnover.

• Structural unemployment:

The unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs.

• Seasonal unemployment

The unemployment that arises because the number of jobs available has decreased because of the season.

• Cyclical unemployment:

The unemployment that fluctuates over the business cycle.

Full employment:occurs when there is no cyclical unemployment or, equivalently, when all the unemployment is frictional, structural, and seasonal.

• The unemployment rate at full employment is called the natural rate of unemployment.

• The quantity of real GDP at full employment is called potential GDP.

•When the unemployment rate is less than the natural rate of unemployment, real GDP is greater than potential GDP.

• And when the unemployment rate is greater than the natural rate of unemployment, real GDP is less than potential GDP.

The Consumer Price Index (CPI) :A measure of the average of the prices paid by urban consumers for a fixed “basket” of consumer goods and services

The CPI calculation has three steps:

o Find the cost of the CPI basket at base period prices

o Find the cost of the CPI basket at current period prices

o Calculate the CPI for the base period and the current period

CPI = (Cost of CPI basket at current period prices ÷ Cost of CPI basket at base period prices) ÷ 100

The inflation rate is the percentage change in the price level from one year to the next.

• Inflation rate = [(CPI this year – CPI last year) ÷ CPI last year] × 100

The main sources of bias in the CPI are:

o New goods bias o Quality change bias o Commodity substitution bias o Outlet substitution bias

Alternative Price Indexes:

• The GDP deflator :An index of the prices of all the items included in GDP and is the ratio of nominal GDP to real GDP.

• The chained price index for consumption:An index of the prices of all the items included in consumption expenditure in GDP and is the ratio of nominal consumption expenditure to real consumption expenditure.

Chapter 22Economic Growth

The economic growth rate:The annual percentage change of real GDP.

- The standard of living depends on real GDP per person, which is real GDP divided by the population.

Rule of 70:

The Rule of 70 states that the number of years it takes for the level of any variable to double is approximately 70 divided by the annual percentage growth rate of the variable.

• Potential GDP increases if there is an increase in population or an increase in labour productivity

• An increase in population increases the supply of labour.

With an increase in population, potential GDP per hour of work decreases.

Labour productivity:

The quantity of real GDP produced by an hour of labour, calculated by dividing real GDP by aggregate labour hours.

Labour productivity increases if there is: o An increase in physical capital o An increase in human capital o An advance in technology

The law of diminishing returns:

As the quantity of one input increases with the quantities of all other inputs remaining the same, output increases but by ever smaller increments.

if a given number of hours of labour use more capital (with the same technology)

the additional output that results from the additional capital gets smaller as the amount of capital increases

One-third rule:

- With no change in technology, a 1 percent increase in capital per hour of labour brings a one-third of 1 percent increase in real GDP per hour of labour.

Classical growth theory:

Real GDP growth is temporary and that when real GDP per person rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level

A technological advance occurs, and wage rates increase

increases population

A growing population means that labour hours grow, so capital per hour of labour falls

real GDP per hour of labour falls and keeps falling as long as the population grows back to subsistence level

Neoclassical growth theory:

Real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labour grow.

It implies that growth rates and income levels per person around the globe will converge.

New growth theory:

Real GDP per person grows because of the choices people make in the pursuit of profit and that growth can persist indefinitely.

• The theory begins with two facts about market economies:

- Discoveries result from choices. - Discoveries bring profit and competition destroys profit.

Want a higher standard of living

Incentives to make the innovations

Gives new and better techniques and new and better products

new firms and new and better jobs

Higher standard of living

Chapter 23Finance, Saving, and

Investment

Physical capital:

The tools, instruments, machines, buildings, and other items that have been produced in the past and that are used today to produce goods and services

The funds that firms use to buy physical capital are called financial capital.

A financial institution is a firm that operates on both sides of the market for financial capital

Y = C + S + T (households use their income to: buy consumption goods, save, and pay taxes)

Y = C + I + G + NX

Which gives: S + T = I + G + NX

I = S + T - G - NX

-S is household (private) saving - T - G is government saving (or dissaving) - (-) NX is foreign saving

- The sum of private saving (S) and government saving (NT – G) is called national saving.

I = S + T - G - NX

The nominal interest rate:

The number of dollars that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed or lent.

The real interest rate The nominal interest rate adjusted to remove the effects of inflation on the buying power of money.

It is equal to:

The nominal interest rate minus the inflation rate.

The quantity of loanable funds demanded:

The total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given period.

Other things remaining the same:- the higher the real interest rate the smaller is the quantity of loanable funds demanded

The quantity of loanable funds supplied:

The total funds available from private saving, a government budget surplus, and international borrowing during a given period.

Other things remaining the same:

the higher the real interest rate the greater is the quantity of loanable funds supplie

Government Budget Surplus:

• Is added to private saving (PSLF) to determine tsupply of loanable funds (SLF)

• Lowers the real interest rate and increases the quantity of loanable funds

Government Budget Deficit:

• Is added to private demand for loanable funds (PDLF) to determine the demand for loanable funds (DLF)

• It raises the real interest rate, increases the quantity of loanable funds and decreases investment.

• The tendency for a government budget deficit to raise the interest rate and decrease investment is called the crowding-out effect.

• The Ricardo-Barro effect:

Neither a government budget surplus nor a government budget deficit have any effect on the real interest rate or investment.

Chapter 24Money, the Price Level

and Inflation

Money:Any commodity or token that is generally acceptable as the means of payment. • A means of payment is a method of settling a debt.

• Money performs three other functions: - Medium of exchange - Unit of account - Store of value

• A medium of exchange:Any object that is generally acceptable in exchange for goods and services.

• A unit of account:An agreed measure for stating the prices of goods and services.

• A store of value:Any commodity or token that can be held and exchanged later for goods and services.

• Money in Canada today consists of currency and deposits at banks and other financial institutions

• The two main measures of money are called:

o M1 o M2

M1:

•Consists of currency held outside the banks and chequable deposits of individuals and businesses

• does NOT include currency held by banks

• does NOT include currency and bank deposits owned by the government of Canada.

M2:Consists of M1 plus all other deposits.

A depository institution:

A private firm that takes deposits from households and firms and make loans to other households and firms.

-To provide security for its depositors:- a bank divides its funds into reserves

- which are currency in a bank’s vault plus its deposit at the Bank of Canada and loans.

A bank has four types of assets: -overnight loans- liquid assets- investment securities- loans.

Banks provide four services for which people are willing to pay:

- create liquidity- minimize the cost of borrowing- minimize the cost of monitoring borrowers- pool risk.

The Bank of Canada:

Makes loans to banks and serves as the lender of last resort, which means that it stands ready to make loans when the banking system as a whole is short of reserves.

The payments system:The system through which banks make payments to each other to settle transactions.

The Large Value Transfer System (LVTS):An electronic payments system that enables financial institutions and their customers to make large payments instantly and with the sure knowledge that the payment has been made.

The Automated Clearing Settlement System (ACSS):The system through which all payments not processed by the LVTS are handled.

• The fraction of a bank’s total deposits that are held in reserves is called the reserve ratio.

• The desired reserve ratio is the ratio of reserves to deposits that banks wish to hold.

- A bank’s desired reserves are equal to its deposits multiplied by the desired reserve ratio.

• Actual reserves minus desired reserves are excess reserves.

• When a bank has excess reserves it makes loans. • We call the leakage of currency from the banking system the currency drain, and we call the ratio of currency do deposits the currency drain ratio.

There are nine steps in the sequence of money creation:

1. Banks have excess reserves. 2. Banks lend excess reserves. 3. The quantity of money increases. 4. New money is used to make payments. 5. Some of the new money remains on deposit. 6. Some of the new money is a currency drain. 7. Desired reserves increase because deposits have increased. 8. Excess reserves decrease, but remain positive.

• The monetary base:

The sum of Bank of Canada notes outside the Bank of Canada, banks’ deposits at the Bank of Canada, and coins held by households, firms, and banks.

• The money multiplier:

The ratio of the change in the quantity of money to the change in monetary base

• The quantity of money that people choose to hold depends on four main factors:

o The price level o The nominal interest rate o Real GDP o Financial innovation

The quantity of money:Measured in dollars is nominal money.

The quantity of nominal money that people plan to hold is proportional to the price level.

• The higher the interest rate: the greater the opportunity cost of holding money the smaller is the quantity of money that people plan to hold

• The quantity of money measured in constant dollars is called real money

• Real money = Nominal money / price level.

NOTE: The quantity of real money held is independent of the price level.

The demand for money curve:

The relationship between the quantity of real money demanded and the interest rate when all other influences on the amount of money that people wish to hold remain the same.

• The interest rate :

The amount received by a lender and paid by a borrower expressed as a percentage of the amount of the loan.

NOTE: The interest rate on a bond varies inversely with the price of the bond.

• When the interest rate is high:

people try to economize on holding moneyput more of their wealth into bonds.

• When the interest rate is low:

people hold more money put less of their wealth into bonds.

The quantity of money demanded varies inversely with the interest rate.

• The quantity of real money supplied:

Depends on the price level and the quantity of nominal money that the Bank of Canada enables the banks to create.

• For a given price level, the Bank of Canada can determine the quantity of nominal money.