Econ 291 – Lecture #1

Presented by Joshua F. Boitnott, PhD

Macroeconomic Policy
• Review Syllabus (PDF)
• Suggested Book
• Quizzes will be held Fridays from 11:59
am – 11:59 pm
• All surveys will be anonymous to allow
honest feedback
• Discussions are pass/fail
Macroeconomic Policy
• Macroeconomics is the study of the structure and performance of
national economies and of the policies that governments use to try to
affect economic performance.
• Questions:
‐ What is the goal of macroeconomics?
‐ How is economic policy analyzed?
‐ What are the different approaches to macroeconomics?
Macroeconomic Policy
• A nation’s economic performance depends on
‐ Natural and human resources
‐ Capital stock
‐ Technology
‐ Economic choices made by citizens
‐ Macroeconomic policies of the government
• Main macroeconomic policies:
‐ Fiscal Policy: government spending and taxation.
‐ Monetary Policy: the central bank’s control of short-term interest rates and
the money supply.
Macroeconomic Policy
• When viewing the economy, people often get
focus on business cycles as these have a large
impact on our lives.
- For example, increase in the inflation rate or
unemployment rate.
• However, we care about what is happening on
average in the economy, i.e. the trend the
economy is following.
- In other words, we should care about Long-run
Economic Growth or the sustained upward trend in
the economy’s output over time.
Macroeconomic Policy
• If a country grows at the rate of 𝑔 for a single year, then next year
have 𝑌𝑡+1 = (1 + 𝑔)𝑌𝑡
𝑌𝑡+1 −𝑌𝑡
- Can rearrange this information to calculate the growth rate: 𝑔 =
𝑌𝑡
- For example: If 𝑌𝑡 = 100 and 𝑔 = 2%, then
𝑌𝑡+1 = 1 + .02 100 = 102
- But what happens if the country continues to grow at rate 𝑔 = 2% in the next
year?
𝑌𝑡+2 = 1 + .02 𝑌𝑡+1
𝑌𝑡+2 = 1 + .02 102 = 104.04
Macroeconomic Policy
• Rich nations have experienced extended periods of rapid economic
growth improving average living standards.
• Poor nations either have never experienced these periods of
economic growth or the growth was offset by economic decline.
- For example, total output could be increasing because of increasing
population
• i.e. the number of available workers.
- Economic growth is correlated with increasing average labour productivity:
the amount of output produced per unit of labour input.
• These are impacted by the rates of saving and investment, the rate of technological
change, and rates of change in other factors
Macroeconomic Policy
• People generally are more focused on business cycles: the short-run
contractions and expansions of economic activity.
- The most volatile period in the history of Canadian output was between 1914
and 1945.
- Recession is the downward phase of a business cycle when national output is
falling or growing slowly.
• Hard times for many people
• A major political concern
- Recessions are usually accompanied by high unemployment.
Macroeconomic Policy
• Government cares about
what is happening on
average in the economy
- The Canadian Unemployment
Rate, 1946-2020
- Unemployment always rises
during recessions and usually
(but not always) falls during
periods of economic
expansion.
- But what is unemployment?

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Macroeconomic Policy
• What is unemployment?
- To determine that, we need a couple of other pieces of information such as:
Size of the Labour Force, Unemployment Rate, and Labour Force Participation
Rate:
• Labour Force is the total number of workers, including both the employed and the
unemployed.
Labour Force=Number of Employed + Number of Unemployed
• Unemployment rate is the percentage of the labour force that is unemployed.
Number of Unemployed
Unemployment Rate= × 100
Labour Force
• Labour force participation rate is the percentage of the adult population that is in the
labour force.
Labour Force
Labour Force Participation Rate= × 100
Adult Population

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Macroeconomic Policy

• Example Calculations:
• Calculating the
Unemployment Rate:
1,246.6
× 100 ≈ 6.3%
19, 663.0
• Calculating the Labour
Force Participation Rate:
19,663.0
× 100 ≈ 65.7% Labour and Unemployment:
29,901.7 Exhibit 1 from Exploring Macroeconomics (2019)

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Macroeconomic Policy
• When prices of most goods and services are rising over time it is
inflation.
• When prices are falling it is deflation.
Macroeconomic Policy
• How do we measure inflation and deflation:
(𝑃𝑡+1 − 𝑃𝑡 ) Δ𝑃𝑡+1
𝜋𝑡+1 = =
𝑃𝑡 𝑃𝑡
- Where 𝜋𝑡+1 is the rate of inflation between 𝑡 and 𝑡 + 1,
- 𝑃𝑡 is the price level in period 𝑡,
- 𝑃𝑡+1 is the price level in period 𝑡+1, and
- Δ𝑃𝑡+1 is change in the price level between 𝑡 and 𝑡 + 1
Macroeconomic Policy
• But there is more to the economy than business cycles and economic
growth, for example: Trade
- An economy which has extensive trading and financial relationships with
other national economies is an open economy.
- An economy with no relationships is a closed economy.

• Note: international trade and borrowing relationships can transmit

business cycles from country to country.
Macroeconomic Policy
• When discussing trade, there are a couple of keep ideas:
- Exports are goods and services produced in domestically and consumed
abroad.
- Imports are goods and services produced abroad and consumed domestically.
- Trade imbalances (trade surplus and deficit) affect output and employment.
- Trade Surplus: exports exceed imports
- Trade Deficit: imports exceed exports
- The trade (im)balance is affected by the exchange rate.
- The Exchange Rate is the amount of domestic currency (i.e. Canadian dollars) that can be
purchased with a unit of foreign currency.
Macroeconomic Policy

• Exports and Imports for Canada

- What determines the trade
balance for a country?
- Are certain types of trade
balances bad for a country?
Macroeconomic Policy
• Macroeconomists ignore distinctions between individual product
markets and focus on national totals.
• The process of summing individual economic variables to obtain
economy wide totals is called aggregation. Aggregate is used in:
- Macroeconomic Forecasting—prediction of future economic trends—has
some success in the short run.
• In the long run too many factors are highly uncertain.
- Macroeconomic Analysis—analyzing and interpreting events as they
happen—helps both private sector and public policymaking.
- Macroeconomic Research—trying to understand the structure of the
economy in general—forms the basis for macroeconomic analysis and
forecasting.
Macroeconomic Policy
• Aggregation also influences:
- Economic Theory: a set of ideas about the economy to be organized in a
logical framework.
- Economic Model: a simplified description of some aspects of the economy.
- In general, the assumption is “the whole is greater than the sum of the parts.”
- Macroeconomists use data to assess the state of the economy, make
forecasts, analyze policy alternatives, and test theories.
• Economics is a social science meaning that it will use the scientific method!
Macroeconomic Policy
• Developing and Testing a Theory:
- State the research question.
- Make provisional assumptions.
- Work out the implications of the theory.
- Conduct an empirical analysis.
- Evaluate the results.
Macroeconomic Policy
• Criteria for Evaluating an Economic Model:
- Are assumptions reasonable?
- Can it be used to study real problems?
- Can it be tested with empirical analysis?
- Are the implications consistent with the data?
Macroeconomic Policy
• The experiments conducted by macroeconomists are called
comparative static experiments.
• Conducting a comparative static experiment involves:
- First, the economic model is assumed to be in equilibrium (quantities
demanded and supplied are equal in all markets).
- Second, we change the value of one variable in the model, a variable whose
value is not affected by changes in other variables in the model (called shocks
by economists).
- Third, we observe how our macroeconomic model responds to the shock.
Macroeconomic Policy
• A positive analysis examines the economic consequences of an
economic policy, but it does not address its desirability.
- In other words, it gives the outcomes that are predicted.
- Economists disagree on positive issues because of different schools of
thought, i.e. assumptions about the world.
• A normative analysis tries to determine whether a certain economic
policy should be used.
- This is a large part of the focus on policy: “Which policy should we adopt?”
- Economists can disagree on normative issues because of differences in values.
Macroeconomic Policy
• The Classical Approach:
- The invisible hand of economics
- General welfare will be maximized if
there are free markets
• If individuals act in their own best interest
- To maintain markets’ equilibrium—the
quantities demanded and supplied are
equal
• Markets must function without
impediments
• Wages and prices should be flexible
- Thus, according to the classical
approach, the government should
have a limited role in the economy.
Macroeconomic Policy
• The Keynesian Approach:
- Keynes (1936) assumed that wages
and prices adjust slowly.
• Thus, markets could be out of equilibrium
for long periods of time and
unemployment can persist.
- Therefore, according to the Keynesian
approach, it may be useful for
governments to take actions to
alleviate unemployment.
- The government can purchase goods
and services, thus increasing the
demand for output and reducing
unemployment.
• Newly generated incomes would be spent
and would raise employment even
further.
Macroeconomic Policy
• Unified Approach to
Macroeconomics:
- Individuals, firms and the government
interact in goods, asset and labour
markets.
- Macroeconomic analysis is based on
the analysis of individual behaviour.
- Keynesian and classical economists
agree that in the long run prices and
wages adjust to equilibrium levels.
• The basic model will be used either with
classical or Keynesian assumptions about
flexibility of wages and prices in the short
run.
Macroeconomic Policy
• The national income accounts is an accounting framework used in
measuring current economic activity.
• There are three approaches to calculate national income.
- The product approach measures the amount of output produced, excluding
output used up in intermediate stages of production.
• Value added = the value of output − the value of inputs purchased from others.
- The income approach measures the incomes received by the producers of
output.
- The expenditure approach measures the amount of spending by the ultimate
purchasers of output.
Macroeconomic Policy
• An example economy:
AppleInc Transactions
Wages paid to AppleInc employees $15,000
Taxes paid to government $5,000
Revenues received from the sale of $35,000
Apples sold to public $10,000
Apples sold to JuiceInc $25,000
JuiceInc Transactions
Wages paid to JuiceInc employees $10,000
Taxes paid to government $2,000
Apples purchased from AppleInc $25,000
Revenues received from the sales $40,000
Macroeconomic Policy
• Product Approach:
AppleInc value added 35,000
JuiceInc value added +15,000
Total Production 50,000
Macroeconomic Policy
• Income Approach:
Wages income 25,000
Taxes paid to government 7,000
Profits +18,000
Total Income 50,000
Macroeconomic Policy
• Expenditure Approach:
Expenditures on apples 10,000
Expenditures on apple juice +40,000
Total Expenditures 50,000
Macroeconomic Policy
• The market value of a good (product) and the spending on a good
(expenditure) are always the same.
• The seller’s receipts (expenditure) are equal to the total income
generated by the economic activity (income).
• Fundamental identity of national income accounting:
Total Production = Total Expenditure = Total Income
Macroeconomic Policy
• A nation’s gross domestic product (GDP) is the market value of final
goods and services newly produced within a nation during a fixed
period of time.
• Using market values allows adding the production of different goods
and services
• Problems with the market values:
- Some goods are not sold in markets.
- The underground economy – illegal activities and legal activities hidden from
the government.
- Lack of market values to use when calculating the government’s contribution
to the GDP.
Macroeconomic Policy
• Correlation Between GDP and other measures.
Macroeconomic Policy
• Correlation Between GDP and other measures.
Macroeconomic Policy
• Correlation Between GDP and other measures.
Macroeconomic Policy
• GDP includes only goods and services newly produced within the
current period. It is a sum of value added – value of an output minus
value of its inputs.
• GDP includes only final goods – not intermediate goods, the end
products.
- Intermediate goods are those used up in the production of other goods in the
same time period.
- Capital goods and inventory investment are final goods.
Macroeconomic Policy
• Gross national product (GNP) is the market value of final goods newly
produced by domestic factors of production (capital, labour) during
the current period.
• Examples of GDP versus GNP:
1. Canadian-owned capital and labour used abroad produce output and
income.
• This is included in Canadian GNP, not GDP.
2. Foreign-owned capital and labour used in Canada produce output and
income.
• This is included in Canadian GDP, not GNP.
Macroeconomic Policy
• Relationship between GDP and GNP:
𝐺𝐷𝑃 + 𝑁𝐹𝑃 = 𝐺𝑁𝑃
• Net factor payments from abroad (NFP) is
- Income paid to domestic factors of production by the rest of the world
- Minus income paid to foreign factors of production by the domestic economy
• In 2015 Canadian GDP was $1,983 billion and Canadian GNP was
$1,956 billion, a difference of just over 1%.
Macroeconomic Policy
• The Expenditure Approach to Measuring GDP:
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
- Where:
- Y = GDP
- C = consumption
- I = investment
- G = government purchases of goods and services
- NX = net exports of goods and services (exports minus imports)
Macroeconomic Policy
• Wealth is the difference between assets and liabilities.
‐ Wealth is a stock variable—a variable that is measured at a point in time.
‐ National wealth is the wealth of an entire nation.
• Saving is current income minus spending on current needs.
‐ Saving is a flow variable—a variable that is measured per unit of time.
‐ Public Saving is saving the government does with a budget deficit being the
excess of government spending over tax collection.
‐ Private Saving is saving made by the consumers.
Macroeconomic Policy
• Saving Relationship:
S = Y + NFP − C − G
= (C + I + G + NX ) + NFP − C − G
= I + ( NX + NFP )
= I + CA
‐ Where 𝐶𝐴 is current account balance – payments received from abroad for
exports minus payments made to foreigners for imports, NFP included.
Macroeconomic Policy
• Government Income and Saving:
Net Government Income = 𝑇 − 𝑇𝑅 − 𝐼𝑁𝑇
‐ Where 𝑇𝑅 = transfers received from the government, 𝐼𝑁𝑇 = interest
payments on the government’s debt, and 𝑇 = taxes
Government Saving = 𝑇 − 𝐺 − 𝑇𝑅 − 𝐼𝑁𝑇
‐ The government budget surplus (government saving) is a positive difference
between government revenue (𝑇) and government expenditure (𝐺 + 𝑇𝑅 +
𝐼𝑁𝑇).
‐ The government budget deficit (government saving) is a negative difference
between 𝑇 and (𝐺 + 𝑇𝑅 + 𝐼𝑁𝑇).
Macroeconomic Policy
• Private income:
‐ Private disposable income (PDI) is the amount of income the private sector
has available to spend after paying taxes and receiving government transfers.
Private Disposable Income
= 𝑌 + 𝑁𝐹𝑃 − 𝑇 + 𝑇𝑅 + 𝐼𝑁𝑇
‐ Where 𝑌 = gross domestic product (GDP), 𝑁𝐹𝑃 = net factor payments from
abroad, 𝑇𝑅 = transfers received from the government, 𝐼𝑁𝑇 = interest
payments on the government’s debt, and 𝑇 = taxes
Macroeconomic Policy
• Private Saving:
Spvt = Y − 𝐶 + 𝑁𝐹𝑃 − 𝑇 + 𝑇𝑅 + 𝐼𝑁𝑇
‐ Private saving is disposable income less whatever is consumed, or

‐ Alternatively, this relationship suggest private saving is utilized for Investment,

Government Deficits, and Current Account Balance
Macroeconomic Policy
• As part of class focus will be inflation, we will again look at GDP:
‐ Nominal GDP (or current-dollar GDP) is the dollar value of an economy’s final
output at current market prices.
‐ Real GDP (or constant-dollar GDP) is the physical volume of an economy’s
final output using the prices of a base year.
‐ A price index is a measure of the average level of prices for some specified set
of goods and services.
• In essence, this is a tool to estimate the relationship between real and nominal GDP or
convert nominal GDP to real GPD
Macroeconomic Policy
• The GDP Deflator is a price index that measures the overall level of
prices of goods and services included in GDP.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 = × 100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
‐ The measurement of real GDP and the GDP deflator depends on a choice of a
base year.
• The consumer price index (CPI) measures the price of consumer
goods.
‐ The CPI is calculated for a fixed consumer “basket.”
‐ The basket should be occasionally updated or chain-weighted indexes should
be used.
Macroeconomic Policy
• The rate of inflation is the percentage rate of increase in a price index
(the CPI, for example) per a period of time.
‐ The Bank of Canada’s goal is to target
CPI inflation at 2%
‐ Could measure inflation using the
GDP Deflator, but government is
more concerned about what is
impact on consumers (voters)
‐ Other places use different price
index to measure inflation, such as
CPE in US.
Macroeconomic Policy
• An interest rate is a rate of return promised by a borrower to a lender.
‐ We talk about “the” interest rate. Although there are numerous interest rates
because they move up and down together.
‐ The real interest rate is the rate at which the real value of an asset increases
over time.
‐ The nominal interest rate (i) is the rate at which the nominal value of an asset
increases over time.
Real Interest Rate = 𝑖 − 𝜋
‐ Where 𝑖 = nominal interest rate and 𝜋 = inflation rate
Macroeconomic Policy
• The expected real interest rate (𝑟) is the rate at which the real value of
an asset is expected to increase over time.
𝑟 = 𝑖 − 𝜋𝑒
‐ Where 𝜋 𝑒 = an expected inflation rate
‐ Note: Bank of Canada can only set a nominal interest rate and not the real
interest rate!
‐ By targeting a particular rate of inflation, goal is to impact 𝜋 𝑒