CH 19

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Chapter 19
What
Macroeconomics Is
All About
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Learning Objectives
1. Explain the meaning and importance of the key

macroeconomic variables, including national income,
unemployment, inflation, interest rates, exchange rates,
and trade flows.
2. View most macroeconomic issues as being about either

long-run trends or short-run fluctuations, and see that
government policy is relevant for both.
Copyright © 2005 Pearson Education Canada Inc.

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19.1 Key Macroeconomic Variables

Output and Income
The production of output generates income.
To measure total output, we add up the values of the many

different goods produced. This yields the quantity of total
output measured in dollars.
The total just described gives the nominal national income. If

base-period prices are used, then the measure is of real
national income.

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Real vs. Nominal

An example:
Nominal Values Real Values
GDP GDP
(bill. of current $'s) (bill. of 1992 $'s)
1982 374.9 544.4
1992 691.2 691.2
% change 84.4% 26.9 %

% change p.a. 8.4% 2.7%
NOTE: about 70% of the increase in nominal GDP was due to price
increases and not growth in real output.
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National Income: Recent History
Source: Statistics Canada’s CANSIM database, Series V3862685. Current data are available at www.statcan.ca.
Figure (i) shows that GDP has grown steadily since 1962 with only a few
interruptions. Figure (ii) shows how the growth rate of GDP fluctuates from
year to year.
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As is clear, real GDP fluctuates around a rising trend. The

trend shows long-run economic growth. The short-run
fluctuations show the business cycle.
Potential national income measures what the economy could

produce if all resources were employed at their normal levels
of utilization. This is often called full-employment income.
To see the most recent values for the macroeconomic

variables discussed in this chapter, go to Statistics
Canada’s website: www.statcan.ca. Click on “Canadian
Statistics” and then “Latest Indicators.”

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Potential Output and the Output Gap:

Potential national output measures what the economy could
produce if all resources were employed at their normal levels
of utilization. This is often called full-employment output.
The output gap measures the difference between potential
output and actual output.
Output Gap = Y-Y*

APPLYING ECONOMIC CONCEPTS
19-1
The Terminology of Business
Cycles
Practice with Study Guide Chapter 19, Exercise 2.

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Recessionary Gap Peak

Real GDP Recovery Actual GDP
Recession
Potential GDP
Peak
Trough
Inflationary Gap
Time
When actual income (output) is less than potential income,
there is said to be a recessionary gap.
When actual income (output) exceeds potential income, there

is said to be an inflationary gap.

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Some Recent History on Canadian Output Gaps
Source: Actual GDP: Statistics Canada CANSIM database, series V3862685. Potential output: Bank of Canada
Review, Spring 2003.
Since 1965, potential and actual GDP have increased by

more than three times. The output gap clearly shows cyclical
behaviour.
Note: Potential output cannot be directly observed or
measured — it must be estimated.
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Employment, Unemployment, and the

Labour Force
Employment is the number of adult workers (15 and over)
who hold jobs.
Unemployment is the number of individuals who are not
employed but who are actively searching for a job.
Even when the economy is at full employment (Y = Y*), some

unemployment exists due to frictional and structural causes:
• Frictional unemployment is due to the normal

turnover of labour (new entrants, re-entrants, quits,
fires, etc.).
• Structural unemployment occurs because of a
mismatch between available workers and jobs.

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The labour force is the total number of people who are either
employed or unemployed.
The unemployment rate is equal to the number of unemployed

people expressed as a percentage of the labour force.
Number of people unemployed

Unemployment = X 100
Rate Number of people in the
labour force

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Full employment is said to occur when the only existing

unemployment is frictional and structural.
Unemployment rises and falls as the business cycle ebbs and
flows. During recessions, unemployment rises above its full-
employment level. During booms, unemployment falls below
this level.
When unemployment is greater than the full-employment

level, economists say there is cyclical unemployment – this is
sometimes called deficient-demand unemployment.
The unemployment rate that occurs when the economy is at
full employment (Y=Y*) is called the natural rate of
unemployment. This is also often called the NAIRU — the
Non-Accelerating Inflation Rate of Unemployment.

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Estimates indicate that the NAIRU rose throughout the 1970s,

from around 5.5 percent to a high of 8 percent in the early
1980s, and has now fallen to around 7 percent.
Why Does Unemployment Matter?

Some unemployment is desirable, as it reflects the time required for
workers and firms to “find” each other so that good matches are made.
But some unemployment is associated with human hardship, especially
for those individuals with skills that are not in high demand by firms.

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Some Recent History of Canadian Unemployment
Source: Statistics Canada’s CANSIM database. Labour force: Series V2091051. Employment: Series V2091072.
Unemployment rate: Series V2091177. Current labour-force statistics are available at www.statcan.ca.
The labour force and employment have grown since 1960,

with only a few interruptions. The business cycle is apparent
in the fluctuations in the unemployment rate.
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Does the Unemployment Rate Measure

Hardship?
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Inflation and the Price Level

The price level refers to the average level of all prices in the
economy. Inflation is the rate at which the price level is
changing.
The most common measure of the price level is the Consumer

Price Index (CPI). The CPI is based on the price of a typical
“consumption basket.” It then expresses that price as a ratio of
the price in some base period. The CPI for the base period is
set to 100.

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CPI t =
∑PQ t 0
×100
∑P Q 0 0
To compute the rate of inflation from any point in

your lifetime to today, check out the “inflation
calculator” at the Bank of Canada’s website:
www.bank-banque-canada.ca.
Practice with Study Guide Chapter 19,

Extension Exercise E1.

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An Example
The value of the CPI in January 1995 was 131.9. In January
1996, it was 135.2.
The year-over-year inflation rate can be found by dividing the
CPI for 1996 by that for 1995, subtracting 1 and multiplying by
100 — it is 2.5 percent.
[(135.2 / 131.9) - 1] x 100 = 2.5
That is, the price level increased by 2.5 percent between
January 1995 and January 1996 — an inflation rate of 2.5
percent.
APPLYING ECONOMIC CONCEPTS

19-2
How the CPI Is Constructed
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Why Inflation Matters
The purchasing power of money is negatively related to the

price level.
If all financial contracts are written to incorporate a fully-

anticipated inflation, then such an inflation will have no real
effects.
An unanticipated inflation benefits anyone who has an

obligation to pay money, and harms anyone who is entitled to
receive money.
Because it is hard to forecast accurately, inflation adds to the

uncertainties of economic life. Highly variable inflation rates
cause great uncertainty.

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Plan for buying a house based on expected inflation

of 10%
Year 1 Year 2 ... Year 10

Monthly earnings $5,000 $5,500 $12,969
Mortgage payment (15%) $3,200 $3,200 $3,200
Other expenditures $1,800 $2,300 $9,769
Real value of other expend. $1,800 $2,091 $3,766
Value of your house $250,000 $275,000 $648,435

GREAT
PLAN!
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What actually happens - unexpectedly 2% inflation
NOT SO GREAT OUTCOME!

Year1 Year 2 ... Year 10
Monthly earnings $5,000 $5,100 $6,095
Mortgage payments (15%) $3,200 $3,200 $3,200
Other expenditures $1,800 $1,900 $2,895
Real value of other expenditures $1,800 $1,863 $2,375
Value of your house $250,000 $255,000 $304,749

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Plan for investing in a bond based on expected

inflation of 2%
($1,000 bond @ 8% for 10 years) end of year payments

Year 1 Year 2 ... Year 10 Sum
Annual interest earnings $80 $80 $80 $800
Real value of interest earnings $78 $77 $66 $719
Real value of bond $1,000 $980 $820
Your purchasing power after 10 years of investment

$719 + $820 = $1,539 GREAT PLAN!
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What actually happens - unexpectedly inflation

is10%
NOT SO GREAT OUTCOME!
Year1 Year 2 ... Year 10 Sum
Annual interest earnings $80 $80 $80 $800
Real value of interest earnings $73 $66 $31 $492
Real value of bond $1,000 $909 $386
Your purchasing power after 10 years of investment
$452 + $386 = $838

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Some Recent History of Canadian Inflation
The trend in the price

level has been upward
since 1960. This means
positive rates of
inflation. The rate of
inflation has varied from
almost 0 to over 12
percent since 1960.
Note: As the inflation

rate falls, the price level
is still rising.

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Interest Rates
The interest rate is the price of borrowing funds. It is

expressed as a percentage amount per period per dollar
borrowed.
The nominal interest rate is the price expressed in money

terms. The real interest rate is this price expressed in terms of
purchasing power.
For example, if the stated nominal interest rate on a loan is 6

percent per year and the inflation rate is 2 percent, the real
interest rate is 4 percent.
The burden of borrowing depends on the real, not the
nominal, rate of interest.

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Some Recent History of

Canadian Interest Rates
Inflation over the past 40

years implies that the real
interest rate has always
been less than the
nominal interest rate.
Source: Nominal interest rate: 90-day treasury
bill rate, Statistics Canada, CANSIM database,
Series V122541. Real interest rate base on
author’s calculation of CPE inflation, using
Series PCPISA from the Bank of Canada.
The real interest rate has usually been below 4% for the past
four decades. Through the early 1970s, the real interest rate
was negative, indicating that the inflation rate exceeded the
nominal interest rate.
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Interest rates vs. the interest rate

• There are many different interest rates. Each
reflects the cost of borrowing in a particular
financial market
• There are numerous financial markets (specific set

of borrowers and lenders)
• Each market is characterize by ‘risk’, ‘liquidity’,

‘term’ of loans, etc.
• Each gives rise to a unique rate of interest

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Examples of interest rates

TD - Canada Trust, Jan. 17, 2005
TD charges Prime 4.50%

1 year 'open' Mtg 7.00
1 year 'fixed' 4.85
10 year 'fixed' 7.50
Unsecured consumer loan 9.50
Student loans 4.50 (??)
VISA 18.50
TD pays 1 yr GIC 2.10
5 yr GIC 3.00
Long term G of C bond 4.75
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The International Economy
Foreign exchange refers to foreign currencies or claims on

foreign currencies. The foreign-exchange market is where
foreign currencies are traded.
The exchange rate is the number of Canadian dollars
required to purchase one unit of foreign currency — that is,
the Canadian-dollar price of foreign currency.
A depreciation of the Canadian dollar means the exchange

rate has increased, and the Canadian dollar is worth less on
the foreign-exchange market.

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Some Recent History of the Canadian Exchange Rate
There has been a

significant overall
depreciation of the
Canadian dollar (relative
to the US dollar) since
1970.
There are also large

fluctuations over the
course of the business
cycle. Source: Annual average of monthly data, Statistics Canada
CANSIM database, Series V37432.
Because the United States is Canada’s largest trading

partner by far, this is the exchange rate that matters most for
Canada.
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Impact of Changes in the exchange rate

An example:
Exchange rate 1 US $ = 1.17 Cdn $'s June 1990
P of a Meal in Windsor $10.00 Cdn

P of same meal in Detroit $8.00 US
P of Detroit meal for Windsorite $9.36
($8.00 US x 1.17 Cdn $ per US $ = $9.36 Cdn)
Now what if the exchange increases to

1 US $ = 1.65 Cdn $'s Jan. 2003
P of Detroit meal for Windsorite $13.20
($8.00 US x 1.65 Cdn $ per US $ = $13.20 Cdn)
What is your prediction about Windsorites dining out in

Detroit?
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Impact of Changes in the exchange rate

Further: Exchange rate 1 US $ = 1.17 Cdn $'s
P of a Meal in Windsor $10.00 Cdn

P of same meal in Detroit $8.00 US
P of Windsor meal for a Detroiter $8.50
($10.00 Cdn x 0.85 US $'s per Cdn $ = $8.50 US)
Recall an exchange rate of 1 US $ = 1.17 Cdn $'s implies an

exchange rate of 1Cdn $ = 0.85 US $'s
Now what if the exchange increases to

1 US $ = 1.65 Cdn $'s Jan. 2003
P of Windsor meal for a Detroiter $6.10
($10.00 Cdn x 0.61 US $'s per Cdn $ = $6.10 US)
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The balance of payments accounts record all international

payments that are made in the course of international
transactions of goods, services, and assets.
One part of the balance of payments is the trade account

— this records the value of all transactions in goods and
services.
The trade balance is the difference between the value of

exports and the value of imports.
For Canada, international trade is very important. Both

exports and imports are very large (roughly 40% of GDP),
but the trade balance is usually very small.

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Although imports
and exports have
increased
dramatically over
the past 40
years, the trade
balance has
remained close
to zero.
Source: Statistics Canada,

CANSIM database. Exports:
Series V499540. Imports: Series
V499557.
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19.2 Growth Versus Fluctuations

Long-Term Economic Growth
Long-term growth is considerably more important for a
society’s living standards from decade to decade than short-
term fluctuations.
There is considerable debate regarding the ability of

government to influence the economy’s long-run growth rate.
Do budget surpluses increase future growth?

Some economists argue that when governments spend less than they
raise in tax revenue, the reduced need for borrowing drives down interest
rates and stimulates investment, which increases future growth. Is this
belief justified?

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Long-term growth and increases in

productivity
• We will see that one of the most important
determinants of long-term growth is increased
productivity
• One measure of productivity is output per person

hour
• Output per person hour is determined by many

factors (capital, technology, regulations, etc.)
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Why Productivity Growth Matters
Annual growth Change in ouput Number of yrs

rate in pph after 40 yrs req'd to double
productivity (1 working life) output pph
1.0% 49% 70 yrs
1.5% 81% 47 yrs
2.0% 121% 35 yrs
2.5% 168% 28 yrs
3.0% 226% 23 yrs
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Short-Term Fluctuations
The economy’s short-term fluctuations in output and
unemployment are often called business cycles.
Monetary policy is important for understanding business
cycles. When the Bank of Canada implemented an inflation-
reduction policy in the early 1990s, is it a coincidence that a
recession followed?
Many economists argue that fiscal policy can also be used to
mitigate short-term fluctuations by changing the government’s
spending and/or taxation behaviour.
Other economists say that governments should not attempt to
“fine-tune” the economy.

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What Lies Ahead

In order to organize our thinking about the questions raised in
this chapter, we must develop some tools. These will include:
• discussing measurement of national income,
• building a simple model of the economy to highlight some
key macroeconomic relationships,
• modifying the model to make it increasingly complex and
realistic, and
• using our model to analyze some pertinent economic issues.

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1 of 28

1. Explain the meaning and importance of the key

2. View most macroeconomic issues as being about either

Copyright © 2005 Pearson Education Canada Inc.

19.1 Key Macroeconomic Variables

To measure total output, we add up the values of the many

The total just described gives the nominal national income. If

Copyright © 2005 Pearson Education Canada Inc.

Real vs. Nominal

1982 374.9 544.4

1992 691.2 691.2

% change 84.4% 26.9 %

National Income: Recent History

As is clear, real GDP fluctuates around a rising trend. The

Potential national income measures what the economy could

To see the most recent values for the macroeconomic

Copyright © 2005 Pearson Education Canada Inc.

Potential Output and the Output Gap:

Output Gap = Y-Y*

Copyright © 2005 Pearson Education Canada Inc.

Recessionary Gap Peak

When actual income (output) exceeds potential income, there

Copyright © 2005 Pearson Education Canada Inc.

Some Recent History on Canadian Output Gaps

Since 1965, potential and actual GDP have increased by

Employment, Unemployment, and the

Even when the economy is at full employment (Y = Y*), some

• Frictional unemployment is due to the normal

Copyright © 2005 Pearson Education Canada Inc.

The unemployment rate is equal to the number of unemployed

Number of people unemployed

Practice with Study Guide Chapter 19, Exercise 4.

Copyright © 2005 Pearson Education Canada Inc.

Full employment is said to occur when the only existing

When unemployment is greater than the full-employment

Copyright © 2005 Pearson Education Canada Inc.

Estimates indicate that the NAIRU rose throughout the 1970s,

Why Does Unemployment Matter?

Copyright © 2005 Pearson Education Canada Inc.

Some Recent History of Canadian Unemployment

The labour force and employment have grown since 1960,

Does the Unemployment Rate Measure

Inflation and the Price Level

The most common measure of the price level is the Consumer

Copyright © 2005 Pearson Education Canada Inc.

To compute the rate of inflation from any point in

Practice with Study Guide Chapter 19,

Copyright © 2005 Pearson Education Canada Inc.

APPLYING ECONOMIC CONCEPTS

Why Inflation Matters

The purchasing power of money is negatively related to the

If all financial contracts are written to incorporate a fully-

An unanticipated inflation benefits anyone who has an

Because it is hard to forecast accurately, inflation adds to the

Copyright © 2005 Pearson Education Canada Inc.

Plan for buying a house based on expected inflation

Year 1 Year 2 ... Year 10

Mortgage payment (15%) $3,200 $3,200 $3,200

Other expenditures $1,800 $2,300 $9,769