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Chapter 4

What Macroeconomics Is All About

4.1 Key Macroeconomic Variables

• National Product and National Income

• The production of output generates income.

• The meaning of aggregation

– This gives nominal national income, which is total national income measured in current dollars.

• Real national income is national income measured in constant (base-period) dollars. It changes only when quantities change.

• One of the most commonly used measures of national income is called gross domestic product (GDP).

• GDP can be measured in real or nominal terms.

• The major movement of real GDP is a positive trend that increased real output by almost four times since 1975. This is referred to as long-term
economic growth.

• Real GDP also shows short-term fluctuations around the trend.

• The Business cycle

– Trough

– Recession

– Recovery

– Peak

• Potential output (Y*)

• The output gap measures the difference between potential output and actual output.

Output Gap = Y − Y*
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• When Y < Y*, the output gap is a recessionary gap.

• When Y > Y*, the output gap is an inflationary gap.

Figure 4-2 Potential GDP and the Output Gap, 1985–2020

Potential and actual GDP both display an upward trend. The output gap measures the difference between an economy’s potential output and its actual
output; the gap is expressed here as a percentage of potential output. Since 1985, potential and actual GDP have almost doubled. The output gap in
part (ii) shows clear fluctuations. Shaded areas show inflationary and recessionary gaps.

Why National Income Matters

• National income is an important measure of economic performance

• Recessions are associated with unemployment and lost output

• Booms can bring inflation

• The long-run trend in real per capita is an important determinant of standard of living.

• Economics grow doesn’t make everyone better off

Employment, Unemployment, and the Labour Force

• Employment

• Unemployment

• Labour force

• Unemployment rate
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• Potential GDP ‒ full employment.

• Even when the economy is at full employment, some unemployment exists because of natural turnover in the labour market (frictional
unemployment) and the mismatch between jobs and workers (structural unemployment).

• When real GDP is less than potential GDP, there is cyclical unemployment.

• Employment has grown roughly in line with the growth in the labour force.

• The data also shows that the short-term fluctuations in the unemployment rate have been substantial.

• The unemployment rate has been as low as 5.7 percent in 2019 and as high as 12 percent during the deep recession of 1982.

• During the COVID-19 pandemic, the unemployment rate increased to a high of 13.7 percent, and then gradually fell throughout 2020.

Why Unemployment Matters

• Enormous social significance

• Loss of income

• Loss of output

• Crime, mental illness, and general social unrest tend to be associated with long-term unemployment.

Productivity

• Productivity is a measure of the amount of output that the economy produces per unit of input.

• Labour productivity is the level of real GDP divided by the level of employment (or total hours worked).

• There has been a significant increase in labour productivity over the past half-century .

• Productivity growth is the single largest cause of rising material living standards over long periods of time.
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Inflation and Price Level

• The price level is the average level of all prices in the economy expressed as an index number.

• Inflation

• The Consumer Price Index (CPI)

• Rate of inflation calculation with CPI data

Why Inflation Matters

• We value money not for itself but for what we can purchase with it.

• The purchasing power of money is the amount of goods and services that can be purchased with a unit of money.

• Inflation reduces the purchasing power of money. It also reduces the real value of any sum fixed in nominal (dollar) terms.

• If households and firms fully anticipate inflation over the coming year, they will be able to adjust many nominal prices and wages to maintain
their real values.

• Unanticipated inflation generally leads to more changes in the real value of prices and wages.

• In reality, inflation is rarely fully anticipated or fully anticipated.

• As a result, some adjustments in wages and prices are made but not all the adjustments that would be required to leave the economy’s allocation of
resources unaffected.

Interest Rates

• The interest rate is the price paid per dollar borrowed per period of time, expressed either as a proportion (e.g., 0.06) or as a percentage (e.g., 6
percent)

• Compare the prime interest rate to the bank rate

• Nominal interest rate vs. real interest rate

• Why do interest rates matter?

– Compare effects on savers to that on borrowers

– Impact on investment plans

• Interest rates and credit flows.

Exchange Rates and Trade Flows

• In June 2021 you could buy 0.68 euros for each dollar that you gave up. Or you could buy 1 euro for 1.47 dollars.

• The exchange rate

• Foreign currency

• The foreign-exchange market

• Appreciation vs. depreciation

Figure 4-7 Canadian–U.S. Dollar Exchange Rate, 1975–2020

• In Canada, the path of the trade-weighted exchange rate is virtually identical to the Canadian–U.S. exchange rate shown in Figure 4-7, reflecting
the very large proportion of total Canadian trade with the United States.

• Two notable periods:

– Depreciation of CDN$ in the late1990s

– Appreciation of CDN$ during the 2002‒2012 period.

• Canada has long been a trading nation

• Compare the history of the relative size of exports to imports

• Net exports are the difference between exports and imports and are often called the trade balance.

• Canada’s exports and imports have increased fairly closely in step with each other over the past 40 years.

• The trade balance has fluctuated mildly over the years, but it has stayed relatively small, as a proportion of total GDP.

Figure 4-8 Canadian Imports, Exports, and Net Exports, 1980–2020

4.2 Growth Versus Fluctuations

• Long-Term Economic Growth

– Long-term trends of rising total output and output per person have meant rising average living standards.

– Long-term growth receives less attention in the media but has more importance for a society’s living standards from generation to generation.

– There is considerable debate regarding the ability of government policy to influence the economy’s long-run rate of growth.

Short-Term Fluctuations

• Short-term fluctuations lead economists to study business cycles.

• Economists debate the effectiveness of monetary and fiscal policy in influencing these fluctuations.

• Some economists argue that despite the power of policy to affect the economy, governments should not attempt to “fine-tune” the economy by
making frequent changes in spending and taxing.