econ 1022 Flashcards
Gross Domestic Product (GDP)
The market value of the final goods and services produced within a country in a given time period.
GDP has four parts
Market value
Final goods and services
Produced within a country
In a given time period
Market value
Adding the value of items together at what the market values one unit of a set item.
Final goods
When calculating the GDP we only take the values of the final goods produced.
Final goods
Final goods are goods that are bought by the final user in a specific time period
Intermediate goods are items produced by one firm, bought by another firm, and used as a component to a final good or service
If we added the value of intermediate goods then it would result in double counting
Second-hand goods, financial assets, and stocks and bonds
Produced within a country
Only goods and services produced within that country are a part of its GDP
In a given time period
GDP is normally measured quarterly or yearly
Economy consists of
households, firms, governments, and the rest of the world.
Households sell and firms buy the services of labour, capital, and land in factor markets
A firm’s retained earnings are a part of the household’s income (think of it as income households save and lend back to firms
Households and Factor markets represent
the blue flow, Y, shows total income paid by
firms to households.
Consumption expenditure
The total payment of goods from households to firms.
shown by the red flow labelled C .
Firms buy and sell new capital equipment
(computer systems, airplanes, trucks, assembly line equipment) in the goods market.
Aggregate income =
Aggregate expenditure (Y = C)
Investment
Purchase of new plant, equipment, and buildings, shown by the
red flow labelled I.
Government expenditure
Government expenditure on goods and services, shown as the red flow G.
Government expenditure
Government finances this through taxes, which are not a part of the circular flow diagram
Financial transfers from the government to houses are also not a part of the circular flow
Rest of the World
Firms in Canada sell goods and services to the rest of the world (exports) – and buy goods and services from the rest of the world (imports)
The value of exports (X ) minus the value of imports (M) is
called net exports, the red flow X – M.
net export positive and negative
If net exports are positive, the net flow of goods and
services is from Canadian firms to the rest of the world.
If net exports are negative, the net flow of goods and
services is from the rest of the world to Canadian firms.
Gross Domestic Product
the sum of the red flows equals the blue flow, Y = C + I + G + (X – M)
GDP can be measured in two ways
The total expenditure on goods and services, The total income earned producing goods and services.
The total expenditure on goods and services
This is called aggregate expenditure, which is the sum of all of the red flows in the circular flow diagram (consumption expenditure + investment + government expenditure + net exports)
The total income earned producing goods and services
The total income earned producing goods and services – This is called aggregate income and is equal to the total amount paid for the services of factors of production (wages, interest, rent, profit)
The blue flows in the circular flow diagram demonstrate this
GDP =
C + I + G + X – M.
Gross
Before subtracting the decrepitation of capital.
Net
After subtracting the depreciation of capital.
Depreciation
The decrease in the value of a firm’s capital that results from wear and tear and obsolescence.
Gross Investment
Amount spent buying new capital and replacing depreciated capital.
Net investment
The amount in which the value of capital increases, Gross investment – Depreciation
The Bureau of Economic Analysis uses two approaches to
measure GDP
The expenditure approach
▪The income approach
The Expenditure Approach
The expenditure approach measures GDP as the sum of the red flow: consumption expenditure, investment, government expenditure on goods and services, and net exports.
GDP = C + I + G + (X − M)
The Income Approach
The income approach measures GDP by summing the incomes that firms pay households for the factors of production they hire.
Two broad categories are
1. Wages, salaries, and other labor income
2. Other factor incomes
Measuring Canadian GDP
Payment for labor services (W) includes wages and benefits.
Other factor incomes (OFI) consist of interest, rent, profit, and some self-employment income.
OFI is net income after deducting depreciation; adding depreciation gives the gross measure.
Gross domestic income at factor cost is the sum of W and OFI.
Converting GDP from factor cost to market prices involves adding indirect taxes and subtracting subsidies.
The statistical discrepancy is the gap between expenditure and income approaches in GDP calculation.
Net exports
is the difference between imports and exports
Indirect Tax
Tax paid by consumers when they buy goods and services
Direct Tax
Tax on income
Statistical discrepancy
The gap between the income approach and the expenditure approach (GDPE Total – GDPI Total)
Real GDP
The value of final goods and services produced in a given year when valued at the prices of a reference base year.
The current base year is 2007
Indicates how much production has increased
You can calculate the real GDP by using the prices of the base year for the current year to see the production increase
Nominal GDP
The value of final goods and services produced in a given year when valued at the prices of that year. (More precise name of GDP).
Economists use estimates of real GDP for two purposes:
To compare the standard of living over time
To compare the standard of living across countries
Real GDP per person
The GDP divided by the population.
Removes any influences on rising prices and a rising cost of living
Potential GDP
Maximum quantity of GDP that can be produced while avoiding shortages of labour, capital, land, and entrepreneurial ability.
Lucas Wedge
The dollar value of the accumulated gap between what real GDP per person would have been if the growth rate in the 1960’s had persisted.
Business cycle
Fluctuations in the pace and expansion of GDP
The business cycle is not predictable, but it has two phases
Expansion – The real GDP increases, Recession – Period in which real GDP decreases (its growth rate is negative for at least two quaters)
Expansion – The real GDP increases
In the early stages real GDP returns to potential GDP
As the expansion period grows, real GDP eventually exceeds potential GDP
Recession – Period in which real GDP decreases (its growth rate is negative for at least two quaters)
US Bureau of Economic Research – A period of significant decline in total output, income, employment, and trade, usually lasting from six months to a year, and marked contraction of many sectors of the economy
As well as two returning points
Peak – Expansion ends and recession begins (highest level real GDP attains at that time)
Trough – Real GDP reaches a temporary low point which the next expansion begins
Two problems arise when using real GDP to compare living standards across countries:
The real GDP of one country must be converted into the same currency units as the real GDP of the other country – We must compare the purchasing power
The goods and services in both countries must be valued at the same prices
Some of the factors that influence the standard of living and that are not a part of GDP are:
Household production – Things like changing a lightbulb that are not traded in markets (results in GDP overestimating total production)
Underground economic activity – Because this activity is unreported, it it not a part of the GDP calculation (composes about 5-15% of Canada’s GDP 100 billion to 300 billion)
Leisure time – Improvements in leisure and wellbeing are not reflected in the GDP
Environmental quality – Economic activity directly relates to environmental quality – something that many people value
Domestic Product
Production within the country
National Product
The value of goods and services produced anywhere in the world by residents of the nation.
Market price =
Factor costs + Indirect taxes less subsidies
Chained-dollar real GDP
(Three Steps to Calculate)
Value production in the prices of adjacent years
▪ Find the average of two percentage changes
▪ Link (chain) to the reference year
Time-Series
Graph
Time on the x-axis and
▪ The variable in which
we are interested on
the y-axis.
Level of the variable
▪ Change in the variable
▪ The speed of change
in the variable
Cycle
a tendency for a variable to alternate between
upward and downward movements
Unemployment results in
Lost incomes and production – Unemployment benefits create a safety net, but they do not make up for lost wages. Also leads to lower rates of consumption.
Lost human capital – Prolonged unemployment permanently damages this
Population divided into two groups
Working Age Population: Total people aged 15 and older.
Labour Force: Sum of employed and unemployed individuals, including both full-time and part-time workers.
Unemployed: Individuals available for work, falling into categories like on temporary layoff, seeking work, or with a new job to start.
Employed: Divided into full-time, part-time, voluntary part-time (willingly working part-time), and involuntary part-time (seeking full-time but unable to get it).
Not in Labour Force: Includes retirees and those not employed or actively seeking employment.
Others: Individuals under the age of 15.
Statistics Canada’s four indictors of the state of the labor market
The unemployment rate
The involuntary part-time rate
The labour force participation rate
The employment rate
Labor force
Number of people employed+Number of people unemployed
Unemployment rate =
(Number of people unemployed/Labor force) × 100
Involuntary part-time rate =
(Number of involuntary part-time workers/Labour force) × 100
Labour force participation rate
(Labour force/Working-age population) × 100
Employment rate =
(Number of people employed/Working-age population) × 100
The employment rate fluctuates with the business cycle
Falling during a recession and rising during an expansion.
Types of underemployment that Statistics Canada recognizes but does not include in their unemployment calculations
Discouraged searchers – Who wants a job but has stopped searching because of repeated failure to find one
Long-term future starts – Someone who starts a job more than four weeks from the measuring point
Involuntary part-timers – Part-time workers who would like full-time jobs but cannot find them
Statistics Canada recognizes 8 different measures of the unemployment rate, and they have all been tracked since 1996
R1 – Long-term unemployment (narrowest rate and lowest rate)
R2 – Short-term unemployment (second lowest rate and narrow but still double R1)
R3 – Compatible to the official US rate of unemployment (lower than the actual rate)
R4 – The official Canadian unemployment rate
R5 – Adds discouraged searchers (adds very little difference to the rate)
R6 – Adds long-term future starts (goes up significantly)
R7 – Adds involuntary part-timers (also increases)
R8 – Total unemployment rate with everything considered
Frictional unemployment
Unemployment created by people entering and leaving the labor force and the ongoing creation and destruction of jobs.
Structural unemployment
Changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs.
Usually lasts longer than frictional because workers have to retrain or relocate to find a new job
Cyclical unemployment
Faces unemployment due to the business cycle and the changing market conditions.
Natural unemployment
A combination of structural and frictional unemployment.
Full employment occurs when the natural unemployment rate is equal to the unemployment rate
Factors that influence the natural unemployment rate
1)Age Distribution: More young people may lead to higher frictional unemployment; older populations may have lower frictional unemployment.
2)Structural Change: Major technological advancements can increase structural unemployment.
3)Real Wage Rate: High wages set by firms or government may cause unemployment due to an imbalance in job supply and demand.
4)Unemployment Benefits: More benefits can raise the natural unemployment rate by reducing job-seeking incentives.
Potential GDP
Quantity of GDP at full employment.
Real GDP fluctuates around potential GDP in the business cycle
Output gap – The gap between real GDP and potential GDP.
The unemployment rate fluctuates around the natural unemployment rate
When the unemployment rate is below the natural unemployment rate, real GDP exceeds potential GDP and the output gap is positive
When the unemployment rate is above the natural unemployment rate, real GDP is below potential GDP and the output gap is negative
Price level
Inflation
Deflation
Price level – The average level of prices and the value of money.
Inflation – A persistently rising price level.
Deflation – A persistently falling price level.
An unexpected inflation or deflation
Redistributes Incomes: Inflation reduces purchasing power, while deflation increases it. Affects wealth distribution.
Loans Impact: Inflation benefits borrowers, deflation benefits lenders.
Real GDP and Employment: Inflation initially boosts production and employment but leads to a temporary situation followed by a decline. Deflation causes a recession.
Resource Diversion: Forecasting inflation and deflation diverts skilled individuals from essential jobs.
Hyperinflation
When the inflation rate goes above 50 percent
Has occurred in some European and Latin American countries as well as Zimbabwe
Grind society and its economy to a halt
Consumer price index
Measure of the averages prices paid by urban consumers for a fixed basket of consumer goods and services.
Tells you about the value of the money you put in your pocket
Currently the reference base period for the CPI is 2002 (the CPI is equal to 100 in this year)
Calculation for the CPI =
(Cost of CPI basket at current-period prices/Cost of CPI basket at base-period prices) × 100
Selecting the CPI involves 3 stages
Selecting CPI Basket:
Aims to mirror the spending habits of the average urban household.
Ensures relative importance of items aligns with the household budget.
Monthly Price Survey:
Statistics Canada checks basket item values in major cities.
Ensures consistent measurement quantities.
Calculating CPI:
Find the CPI’s cost at base-period prices.
Find the basket’s cost at current-period prices.
Calculate CPI for both the base and current periods.
Calculation for the inflation rate =
(CPI this year-CPI last year/CPI last year) × 100
Main sources of bias in the CPI
New Goods Bias: New technology’s higher cost complicates CPI comparisons across different eras.
Quality Change Bias: Price increases from improved quality are counted as inflation, leading to an overestimation.
Commodity Substitution Bias: CPI may assume consumers buy more expensive items even when they switch to cheaper alternatives.
Outlet Substitution Bias: Increased use of discount stores during price hikes is not considered by the CPI, potentially underestimating cost changes.
Consequences of the bias
Firms who attach the CPI to an increase in wages would end up paying their employees more than the real rate – disadvantaging the company
The government does this with several contracts and when this accumulates this could result in many wages being overvalued
Two alternatives to the CPI
The GDP deflator
The chained price index for consumption
GDP deflator
An index of the prices of all items included in GDP and is the ratio of nominal GDP to real GDP
(Nominal GDP/Real GDP)× 100
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.
(Nominal consumption expenditure/Real consumption expenditure)× 100
Core inflation rate
Excluding Volatile Elements in Inflation Rate:
Initially excluded items like food and fuel due to their volatility.
Now, three measures are used by the bank:
CPI-trim: Excludes the top and bottom 20% extreme price changes.
CPI-median: Measures inflation based on the middle items of the basket.
CPI-common: Uses statistical methods to identify the most common price changes.
Standard of Living and Real GDP per Person:
Standard of living is linked to real GDP per person (real GDP divided by the population).
Sustained growth in real GDP per person can elevate a poor society to wealth.
Rule of 70 is used to calculate the doubling time for any variable, including real GDP per person.
The Rule of 70 states that the doubling time is approximately 70 divided by the annual percentage growth rate of the variable.
Economic growth, growth rate
Economic growth is the expansion of production possibilities.
The growth rate is the annual percentage change of a variable.
Potential GDP
increases if there is an increase in population or an increase in labour
productivity.
Consider an increase in population.
* In the figure, the labour supply curve
shifts rightward from LS0 to LS1, the real
wage decreases and the quantity of
labour employed at full employment
increases.
Population Increase and Potential GDP per Hour
An increase in population leads to a decrease in potential GDP per hour of work.
Initially, with potential GDP at $1,400 billion and 20 billion labor hours, potential GDP per hour was $70.
With a population increase, potential GDP rises to $1,750 billion and labor hours to 30 billion, resulting in potential GDP per hour decreasing to $58.33.
Diminishing returns contribute to the decline in potential GDP per hour.
Labor productivity is the quantity of real GDP produced per hour of labor, calculated by dividing real GDP by aggregate labor hours.
Labour productivity increases if there is:
An increase in physical capital
o An increase in human capital
o An advance in technology
Consider an increase in population.
* In the figure, the labour supply curve
shifts rightward from LS0 to LS1, the real
wage decreases and the quantity of
labour employed at full employment
increases.
Growth Theories
The task of growth theory is to explain the trends in economic growth.
* The three growth theories we study are:
o Classical growth theory
o Neoclassical growth theory
o New growth theory
Classical growth theory
Views real GDP growth as temporary; population explosion occurs when it exceeds subsistence, bringing it back.
Technological Advance and Population Growth:
Technological advance raises wage rates.
Higher earnings lead to more children and longer life, causing population growth.
Decline in Real GDP per Hour of Labor:
Growing population increases labor hours, causing a fall in capital per hour of labor.
Real GDP per hour keeps falling as long as population and capital per hour of labor decline.
Process ends when real GDP per hour returns to subsistence.
Neoclassical Growth Theory:
Proposes that real GDP per person grows due to technological change inducing saving and investment, causing capital per hour of labor to grow.
Implies global convergence in growth rates and income levels per person.
Dismal Conclusion of Classical Growth Theory:
Pessimistic outcome results from the assumption that a population explosion occurs if real GDP per hour exceeds subsistence.
New Growth Theory
Holds that real GDP per person grows through profit-driven choices, persisting indefinitely.
Key factors include discoveries as public capital goods, and knowledge as non-diminishing capital.
People’s pursuit of profit incentives leads to innovations, creating new firms, better jobs, and a higher standard of living.
Growth process continues as people seek an even higher standard of living.
Key Canadian Financial Institutions
Banks, trust and loan companies, credit unions and caisses populaires, pension funds, and insurance companies play crucial roles.
Physical Capital and Financial Capital:
Physical capital includes tools, machines, buildings, etc., used for production.
Financial capital refers to funds firms use to buy physical capital.
Saving and Investment
Saving is the source of funds for investment, crucial for economic growth.
Three Types of Markets
Funds for investment are supplied and demanded in loan markets, bond markets, and stock markets.
Financial Assets
Stocks, bonds, short-term securities, and loans are termed financial assets.
Inverse Relationship
Interest rates and financial asset prices have an inversely related relationship.
How investment is financed:
Y = C + S + T (households use their income to buy consumption goods, save, and pay
taxes)
o Y = C + I + G + NX
o So, S + T = I + G + NX
o And, I = S + T – G – NX
o S is household (private) saving
o T – G is government saving (or dissaving)
o –NX is foreign saving
o The sum of private saving (S) and government saving (T – G) is called national saving.
The nominal interest rate
is 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
is the nominal interest rate adjusted to remove the effects of inflation on
the buying power of money. The real interest rate is approximately equal to the nominal
interest rate minus the inflation rate.
* The real interest rate is the opportunity cost of loanable funds.
Demand for Loanable Funds, Supply of Loanable Funds
Demand for Loanable Funds:
Represents funds needed for investment, government deficit, and international transactions.
Inverse relationship: Higher real interest rate decreases demand; lower interest rate increases demand.
Expected profit growth during expansion shifts the demand curve rightward.
Supply of Loanable Funds:
Represents funds available from private saving, government surplus, and international borrowing.
Inverse relationship: Higher real interest rate increases supply; lower interest rate decreases supply.
Supply of Loanable Funds, Supply increases and the curve shifts rightward when
Supply of Loanable Funds:
Inverse relationship: Higher real interest rate increases quantity supplied; lower interest rate decreases supply.
Factors Influencing Supply:
Supply increases and the curve shifts rightward when:
Household disposable income increases.
Expected future income decreases.
Wealth decreases.
Default risk decreases.
Government Budget Deficit and Loanable Funds
Government budget deficit is added to private demand for loanable funds to determine total demand.
Resulting deficit raises real interest rate, increases loanable funds quantity, but decreases investment.
crowding-out effect.
The tendency for a government budget deficit to raise the interest rate and decrease
investment
the Ricardo-Barro effect
that neither a government budget
surplus nor a government budget deficit have any effect on the real interest rate or investment.
