EC:250 Intermediate Macroeconomics!

1. EC:250Intermediate Macroeconomics! By: David Cade and Luke Sinclair

2. Today’s Schedule • Cover each chapter in detail • We will have examples after each major concept so don’t worry if you don’t get it right away • Question period • Exam study tips • Go over practice questions (if we have time)

3. [Chapters 1 and 2]

4. [Chapters 1 and 2] • Shotgun blast of theory: • What’s the difference? • Macroeconomics • Study of the behaviour and performance of the economy as a whole • Microeconomics • Study of the behaviour and performance of individual parts of the economy • Gross Domestic Product (GDP) • The value of all final goods and services produced within Canadian borders over some period • Basically anything produced in Canada • It is a measure of the aggregate (whole amount of) Output or Income or Spending • Whatever is Produced creates Income which is then Spent. So all 3 show GDP!

5. [shotgun cont…] • Gross National Product (GNP) • The value of all final goods and services produced in Canada or elsewhere by Canadian-owned resources • Inflation Rate • A measure of how fast prices, in general are rising • Exchange rate • The rate at which one country’s currency trades for another • Macroeconomic Models • Simplification of an economy which provides a logical and consistent framework to help understand an economy • 2 types of variables: • Endogenous: Value is determined within the model (the output of the model) • Exogenous: Value is determined outside the model (the input into the model) • 2 type of models: • Classical (freshwater econ): Prices are flexible and study is of the long run effects • Keynesian (saltwater econ): Prices are fixed and study is of the short run effects

6. [Rules for Calculating GDP] • Don’t count inventories • Only count any level increases • Get realistic numbers • Don’t simply compare prices or quantities • Multiply them to get realistic value • Don’t count intermediate goods • Nobody cares if your country is the leading manufacturer of unfinished iPods • If there isn’t a price, use imputed value • Imputed value: Implied value based on the nature of the product • Eg. When calculating income for sailors, a dollar value is imputed for the cost of food and lodging • Don’t include any of these: • Used goods • Home production • Underground economy • Services of durable goods • Environmental effects of production

7. [Real vs. Nominal GDP] • Nominal GDP • ∑ P2008Q2008 • = # of apples in 2008 * cost per apple in 2008 • Real GDP • Set a base year for pricing, pricing is fixed • ∑ P2002Q2008 • = # of apples in 2008 * cost per apple in 2002 • Nominal GDP shows the change in the total value of output produced by a country while real GDP shows the change in volume by fixing the price • GDP Deflator • Price Index that measures the overall price level • Nominal GDP/Real GDP * 100

8. [Example] • Nominal GDP in 2010 • ∑ P2010Q2010 • = (3*600) + (2.5*450) • = $2925 • Real GDP in 2010, base year 2008 • ∑ P2008Q2010 • = (2*600) + (1.5*450) • = $1875 • GDP Deflator • =Nominal GDP/Real GDP = 2925/1875 = 156%

9. [Measuring GDP] • Measuring with Aggregate Expenditure (Y) • Consumption (C): Goods and services purchased by consumers • Investment(I): Goods bought for future use • Government Purchases(G) • Net Exports(NX): Total Exports – Total Imports • Add it all up! • GDP = Y = C + I + G + NX • This is known as the national accounts identity • Measuring with Aggregate Income • Basically calculate the National Income • 3 steps: • Calculate GNP • = GDP – Net Income of Foreigners • Recall: This is because GNP is Canadian only • Calculate NNP (Net national product) • = GNP – Depreciation • Calculate National Income • = NNP – Indirect business taxes (GST, PST)

10. [Chapter 3]

11. [GDP: Supply and Demand] • Short Term GDP • Determined by how much output a country can supply as well as its internal demand for output • Long-term GDP • Determined only by supply. GDP will always adjust to full capacity. • But “What determines supply!?!1!” you may ask… • Capital (K) • You need money and supplies to produce anything obviously • Labour (L) • You need workers to produce the output • So Supply ( ) = F(K,L)

12. [GDP: Supply and Demand • Ok… so what determines demand? • An equation that is the aggregate of all expenditure: • E = MPC(Y - T) + I(r) + G • Break it down: • MPC (Y – T) = Consumption • Consumption is spending so it needs to be added to the equation • Everyone has disposable income (Income – Taxes) • People either spend it or save it hence the marginal propensity to consume • Think of it as the percentage of every dollar that you spend instead of saving • So if you spend 75% of your income the equation would be 0.75(Y-T) Savings MPC = 0.75

13. [GDP: Supply and Demand] • I(r) = Investment • Investment is spending on capital investments such as houses or cars • Expensive so it requires borrowing, which has interest • real interest rate (r) = nominal interest rate (i) – inflation (π) • The higher the real interest rate, the higher the cost of borrowing • This is why it is represented by I(r). Investment spending is a function of r. • Here is a fun graph: • G = Government Spending • Determined by the fiscal policy of the government. r I = I(r) S,I Note that investment is inversely related with the interest rate

14. [GDP: Equilibrium] • Equilibrium • Achieved in an economy where supply is equal to demand • So where = C(Y-T) + I(r) + G • The interest rate is the exogenous variable that will adjust in order to ensure equilibrium • In order to understand this we look at how r is determined

15. [GDP: Equilibrium and r] • Interest rates will decrease or increase in order to ensure: supply of loans = the demand for loans • Demand for loans • We already saw this: The Investment line I(r) • Inversely related to the interest rate • Supply of loans (S) • S = Public savings + Private Savings • S = (Disposable income - Taxes - Consumption) + (Taxes - Government spending) • S = (Y-C-T) + (T-G) or, when simplified: • S= Y-C-G

16. [GDP: Equilibrium and r] • When S = I(r) we have financial equilibrium! • When we have financial equilibrium, we also have output market equilibrium • Why? • I(r) = S • I(r) = Y – C(Y-T) – G • Y = C(Y-T) + I(r) + G! r I(r) Equilibrium r1 S = Y - C(Y-T) - G S,I

17. [GDP: Example 1] r I(r) E1 r1 S,I S = Y - C(Y-T) - G We start off with a financial market in equilibrium. This means that the output market is also in equilibrium. Suppose government spending decreases.

18. [GDP: Example 1] r I(r) E1 r1 S1 S,I S2 Demand: A decrease in G has no effect on the investment demand curve. Supply: A decrease in G means there are more unspent tax revenues available for investment. So the supply increases by the amount that G decreases.

19. [GDP: Example 1] r I(r) E1 r1 r2 E2 S1 S,I S2 Supply of loans exceeds the demand. Interest rates fall so as to encourage more investment. I increases with the falling interest rate. This continues until equilibrium where S2 = I(r).

20. [GDP: Example 1] • Looking now at total output: • A decrease in G has no effect on output supply • Recall that it is a function of capital and labour and is always at full capacity • It does not change total expenditure. It does, however, change the composition of that expenditure: • G decreases but r adjusts which in turn increases I(r) • The change in I(r) = the change in G • Thus total output is the same before and after the decrease!

21. [GDP: Example 2] r I(r) E1 r1 S = Y - C - G S,I Back to square one! Suppose, instead, taxes are decreased.

22. [GDP: Example 2] r I(r) E1 r1 S1 S,I S2 Demand: Yet again, no effect on the investment demand curve. Supply: Less taxes means more cash to spend on savings or Bieber concerts. Recall that C = MPC(Y-T) This means more C equal to MPC*(Change in taxes). More spending means less savings. So we see a decrease in supply.

23. [GDP: Example 2] r I(r) E2 r2 E1 r1 S1 S,I S2 If supply can’t keep up with demand the interest rate will increase. This will lower investor demand. Investment decreases until I(r) = S once again. Equilibrium is achieved.

24. [GDP: Example 2] • Looking again at total output: • A decrease in T has no effect on output supply • It changes the composition of Output again: • T decreases which increases consumption by MPC*∆T • r adjusts which causes I(r) to decrease • Thus total output is the same before and after the decrease!

25. [Chapter 5: The Open Market]

26. [GDP: The Open Economy] • Two new flows: • Exports (EX) and Imports (IM) from trade • Half of your consumption is being spent on foreign products so it can’t be counted • But you also must factor in local products that are being exported like maple syrup and lumberjacks • International borrowing and lending • Effect on GDP equation (DON’T MEMORIZE): • Y = (C-Cforeign) + (I-Iforeign) + (G-Gforeign) + Exports • We group all of the foreign spending into one category: Imports • Y = C + I + G + (EX-IM) • National Accounts Identity (MEMORIZE!): • Y = C + I + G + NX • NX = (EX-IM) • So it’s the same identity! All you’re doing is adding in NX.

27. [GDP: Open economy with S] • Recall that S = Y-C-G • In an open economy Y – C – G = I + NX • So S = I + NX or NX = S – I • This makes sense because: • If S > I: Any savings that a country has that isn’t spent on domestic investment will logically be spent overseas • If S < I: Part of the investment spending must be funded by foreign investors, as the domestic savings is lacking

28. [GDP: Open economy and r*] • Main difference is in the real interest rate • Recall that in a closed economy it is determined at the level that equates savings and investment • In an open economy it is determined by the world interest rate (r*) r = r* + θ where θ is the risk premium • For simplification purposes Canada’s risk premium is assumed as 0 • The interest rate is fixed, and does not adjust in order to match supply of investment and its demand r r* I(r) I(r*) E1 E1 r1 r*1 S = Y - C - G S = NX + I S,I S,I Fixed! Closed Economy Open Economy

29. [GDP: Twin Deficits] Suppose the economy begins in equilibrium where S = NX+I Government spending (G) increases with no change in taxes. This creates a budget deficit (T – G) < 0 This budget deficit causes the domestic supply of loans to decrease so the S curve shifts left. This means demand for loans outstrips supply. Foreign investors supply the difference so imports (IM) increases causing net exports (NX) to decrease. This results NX < 0 which means there is a trade deficit as well as a budget deficit. r* r* I(r*) I(r*) E1 r*world r*world NX = S – I S S,I S,I Before After 29

30. [Chapter 4: Money and Inflation]

31. [The Price Level: Measurement] P = The average price of final goods and services purchased or produced within a period of time Two main price indexes: • CPI overstates inflation (by ignoring substitution away from goods and services whose relative price has risen) • \ • GDP Deflator understates inflation (by ignoring loss in welfare resulting from substitution away from goods and services whose relative price has risen CPI2007 = ∑ P2007 * Q2002 ∑ P2002 * Q2002 GDP Deflator2007 = ∑ P2007 * Q2007 ∑ P2002 * Q2007

32. [Inflation] Inflation = Rate of change of a price index Note: (can be rate of change of either GDP Deflator or CPI) Example: 2005 CPI = 112.4 2004 CPI = 110.1 2000 Base CPI = 100.0 Man trying to buy a loaf of bread in Zimbabwe Rate of Inflation= (112.4- 110.1) * 100 = 2.09% 110.1

33. [Money, Money, Money!] Money is a stock of assets directly used in transactions Functions of money: • Medium of exchange Use to buy stuff • Unit of account Used for prices and debts • Store of value Transfer your purchasing power to the future! Types of money: • Fiat No intrinsic value (just paper) • Commodity Has intrinsic value (such as gold since it is shiny) Money is neutral (does not affect anything) The Money Supply determines the price level

34. Control and the Quantity Theory of Money The Bank of Canada controls the money supply through open market operations Bank of Canada buys government bonds Bank of Canada sells government bonds Quantity Theory of Money • Quantity Equation: M * V = P * Y • Where: • Y = The volume of output per period • P = Price of a typical unity or GDP Deflator • M = The size of the money stock • V = Velocity of circulation of money (how many times the entire M is used in a specific period) • Money Stock

35. QTM Continued QTM as a Theory of Nominal GDP • Assume that: M = M and V = V • Since Nominal GDP = M * V and Nominal GDP = P * V Therefore: P * Y = M * V QTM as a theory of Price Level • Assume that: M = M and V = V and Y = Y Therefore: P = M * V Y This can be re-written as: %∆M + %∆V - %∆Y

36. [Inflation and Nominal Interest Rates] i = nominal interest rate r = real interest rate π = actual inflation rate Real Interest Rate= Example: • Lend $1250 dollars for a year at an interest rate of 6%. After the year is done you realize that your real return was only 4.15%. How much did prices rise over that year? Fisher Effect: Nominal interest rate = Real interest rate + Expected inflation rate (1+r) = (1+i) (1+ π )

37. [Welfare Costs of Inflation] The following are welfare costs related to HIGH inflation: • Shoeleather cost  More frequent trips to the bank • Menu cost Costs of frequently changing prices • Non-indexed tax systems: (inflation lowers the after tax return on savings) • r = i(1-t) – π • An indexed tax system would fix this where: r = (i–π)(1-t) Other Inflation Related Dangers: • Unexpected inflation Creditors lose and debtors gain (makes it difficult for pension funds / mortgages) • Variability of inflation Higher uncertainty and risk = Less investment • Low Inflation Difficult to reduce real wages as most workers resist nominal wage decreases (aka pay cuts) • Deflation Households may delay purchases

38. [Chapter 5: Exchange Rates]

39. [Super Fun Definition Bonanza] • e : the nominal exchange rate • The cost in the nominal (monetary) terms of the target country to buy one unit of your currency • I.e. The cost in American dollars to buy one Canadian dollar = e • Spot rate: Exchange rate at that time • Forward rate: Rate if exchanged later • Foreign Exchange Market: Electronic market that links all banks around the world through which currencies are exchanged

40. [Defs: Flexible Rates] • Flexible exchange rate: Country allows for the international market to determine exchange rate • Pure: Central bank does absolutely nothing to control the exchange rate • Dirty float (managed exchange rate): Only some control. The principal is it is flexible. • Appreciation: An increase in the value of the currency • Depreciation: A decrease in the value of the currency

41. [Example!] • Let’s take a currency: Euro (€) • Very strong currency. • Many people are exchanging their currency for the Euro and its reserves are decreasing. • Demand is increasing while supply remains the same. • Naturally the exchange rate appreciates • In essence: The cost in a foreign currency (let’s say Indian Rupees) to buy one Euro is more. e e e increases e1 e1 D1 D1 S S e2 € €

42. [Defs: Fixed Rates] • Fixed exchange rates: The exchange rate is fixed in order to avoid the instability of flexible exchange rates • Revaluation: An increase in the value of currency • Devaluation: A decrease in the value of currency • Foreign Currency Reserve: A stock of assets held by a bank in a foreign country’s currency €

43. [Example! Continued] • Lets assume the European Union wants to keep an attractive exchange rate with India. • They want to maintain the previous exchange rate. So they want the € pegged at a fixed rate. The EU will simply increase the supply of € by printing more of them. • The exchange rate stays constant e e e1 D2 e D1 S S1 D1 € € S2

44. [Defs: Real Exchange Rate] • Real exchange rate • Denoted as ε • The relative price of goods in the two countries used • Equation: ε = eP/P* • e = Nominal exchange rate in Canada (Cost in US$ to buy one Canadian dollar • P= price level of a good in Canada in Canadian dollars • eP = Price level of a good in Canada in US dollars • P* = price level of a good in the US in US dollars • The higher the real exchange rate the more expensive is a good in Canada as compared to the US

45. [Purchasing Power Parity] • Method of predicting future exchange rates • PPP Approach Fast Facts • Only long run predictions • Two-types Absolute and Relative • Basic idea behind PPP approach: Law of one price • The Law of one Price argues that goods should cost the same in every country

46. [PPP: Law of One Price] • Argues that eP = P* • Suppose eP > P* • The cost of an item in Canada, translated to American dollars (eP) is more than the cost of the item in the United States (P*). • That item is therefore exported to the US much less • They can get it much cheaper by buying it domestically. • The result is an excess supply so logically the price in Canada (P) is lowered. • This in turn decreases eP • At the same time, US purchases of the US-made product will increase, also leading to an increase in P* • Over time, eP decreases while P* increases until eP=P* • This process is called arbitrage

47. [PPP: Absolute PPP] • Basically argues that law of one price holds for the aggregate of all products between two countries • So ε = 1 for the average price of all goods • In essence, the average price of goods in one country is equal to the average price of goods in the other country after being adjusted to account for the exchange rate • This can’t happen if: • The good is untradeable • Services, advertising, housing etc. • Most goods are not tradable • There are massive transportation costs • There are obstacles to trade (quotas, tariffs, regulations etc.) • Because of these, ABS PPP often doesn’t hold 

48. [PPP: Relative PPP] • This is used to compensate for the shortcomings of ABS PPP • Basically argues that instead of ε equalling 1 for the aggregate of all products, it is instead equal to a ratio • Quick Example to illustrate: • P = $100 P* = $95 e = 0.9 • ε = 0.9*100/95 = 0.947 • The Canadian price inflates to $110 while US price inflates to $100 • What is the new exchange rate if relative PPP holds? • The price ratio of 0.947 must hold • So 0.947 = e110/100 • e = 0.861 Alternate Formula

49. [Interest Rate Parity Approach] • Interest Rate Parity explains exchange rates in the short term • Basic Idea: • Investors will reallocate their assets across countries until the expected rate of return is the same • They will either buy a bond in Canada, or, if there are better interest rates elsewhere, they can exchange to that country’s currency and buy bonds there

50. [Interest Rate Parity Approach] • Strict Formula: • Left side: The amount that would be received in one year if a dollar was invested in local bonds • Top right: The amount that would be received in one year if a dollar was exchanged to a foreign currency (e) and then invested in that country’s bonds (foreign interest rate = i*) • Bottom right: The exchange rate between the two countries one year from now • The interest rate parity approach states that these will always be equal to each other • If one changes, then it will sort itself out by process of arbitrage