Macro 248 Review Q's

What are the distinctions between domestic and national, and gross and net?

"Domestic" means that the production being measured is within a country, no matter by whom; "national" means that the production is produced by residents of a nation anywhere within the world. "Gross" means before subtracting depreciation. "Net" means after subtracting depreciation.

If the expected inflation rate increases by 10 percentage points, how do the short-run Phillips curve and the long-run Phillips curve change?

A 10 percentage point increase in the expected inflation rate shifts the short-run Phillips curve vertically upward by 10 percentage points. (Each point on the new short-run Phillips curve lies 10 percentage points above the point on the old Phillips curve directly below it). A 10 percentage point increase in the expected inflation rate does not change the long-run Phillips curve.

How does the growth rate of real GDP contribute to an improved standard of living?

A benefit of long-term economic growth is the increased consumption of goods and services that is made possible. Growth of real GDP also allows more resources to be devoted to areas such as health care, research, and environmental protection.

How do we tell whether a budget deficit needs discretionary action to remove it?

A budget deficit needs government action to remove it when the deficit is a structural deficit. If the deficit is a structural deficit, then even when the economy is at full employment, the deficit will remain. However, if the deficit is a cyclical deficit, then when the economy returns to full employment, the deficit will disappear.

If autonomous expenditure increases with no change in the price level, what happens to the AE curve and the AD curve? Which curve shifts by an amount that is determined by the multiplier and why?

A change in autonomous expenditure with no change in the price level shifts both the AE curve and the AD curve. The AE curve shifts by an amount equal to the change in autonomous expenditure. The multiplier determines the magnitude of the shift in the AD curve. The AD curve shifts by an amount equal to the change in autonomous expenditure multiplied by the multiplier.

How does a change in the supply of money change the interest rate in the short run?

A change in money supply represents a shift in supply of money curve. For example, a decrease in the supply of money represents a shift in the supply curve to the left, which results in an increase in interest rate.

How do the Bank of Canada's actions change the exchange rate?

A change in the Canadian interest rate changes the Canadian interest rate differential. For example, a rise in the Canadian interest rate, other things remaining the same, means that the Canadian interest rate differential increases. When the Canadian interest rate differential increases, people want to move funds from other countries into Canada to obtain the relatively higher returns on Canadian assets. To move funds into Canada, people buy dollars and sell other currencies, driving the price of the dollar up. A higher dollar means that foreigners must pay more for Canadian-made goods and services, and Canadians pay less for foreign goods and services. So the rise in the interest rate means that exports decrease and imports increase, corresponding to a fall in net exports.

How does a change in the price level influence the AE curve and the AD curve

A change in the price level shifts the AE curve and creates a movement along the AD curve.

What are the tools that a country can use to restrict international trade?

A country can use tariffs; import quotas; other import barriers, such as health, safety, and regulation barriers; and voluntary export restraints to restrict international trade. Export subsidies also decrease other countries' exports and restrict their international trade.

What is a crawling peg and how does it work?

A crawling peg exchange rate policy selects a target path for the exchange rate and then uses direct central bank intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate except that the central bank changes the target value of the exchange rate in accord with its target path.

The price of a PC falls or the price of an MP3 download rises? (Draw the diagrams!)

A fall in the price of a PC decreases the demand for MP3 players because a PC is a substitute for an MP3 player. The demand curve for MP3 players shifts leftward. Supply remains unchanged. The price of an MP3 player falls, and the quantity of MP3 players decreases. A rise in the price of an MP3 download decreases the demand for MP3 players because an MP3 download is a complement of an MP3 player. The demand curve for MP3 players shifts leftward. Supply remains unchanged. The price of an MP3 player falls, and the quantity of MP3 players decreases.

What are the three ingredients of a financial and banking crisis?

A financial crisis has three ingredients: a widespread fall in asset prices, a currency drain, and a run on the banks. When these events occur, banks and other financial institutions face incipient failure, so they drastically decrease their lending activities.

What is a fixed exchange rate and how is its value fixed?

A fixed exchange rate policy is an exchange rate that is pegged at a value decided by the government or central bank. The central bank directly intervenes in the foreign exchange market to block the unregulated forces of supply and demand from changing the exchange rate away from its pegged value. For instance, if a central bank wanted to hold the exchange rate steady in the presence of diminished demand for its currency, the central bank props up demand by buying its currency in the foreign exchange market to keep the exchange rate from falling. If the demand for its currency increases, the central bank increases the supply by selling its currency and keeps the exchange rate from rising.

What is a flexible exchange rate and how does it work?

A flexible exchange rate policy is an exchange rate that is determined by demand and supply with no direct intervention in the foreign exchange market by the central bank. In this arrangement, the forces of supply and demand with no direct central bank intervention are the only factors that influence the exchange rate.

How does a government budget surplus or deficit influence the loanable funds market?

A government budget surplus adds to the supply of loanable funds. A government budget deficit adds to the demand for loanable funds.

How do households make saving decisions?

A household's saving depends on five factors: the real interest rate, the household's disposable income, the household's expected future income, wealth, and default risk. A household increases its saving if the real interest rate increases, its disposable income increases, its expected future income decreases, its wealth decreases, or default risk decreases.

How do economists try to disentangle cause and effect?

A model is a description of some aspect of the economic world. It includes only those features that are necessary to understand the issue under study. An economic model is designed to reflect those aspects of the world that are relevant to the user of the model and ignore the aspects that are irrelevant. A typical model is a GPS map. It reflects only those aspects of the real world that are relevant in assisting the user in reaching his or her destination and avoids using information irrelevant to travel.

What is a model? Can you think of a model that you might use in your everyday life?

A model is a description of some aspect of the economic world. It includes only those features that are necessary to understand the issue under study. An economic model is designed to reflect those aspects of the world that are relevant to the user of the model and ignore the aspects that are irrelevant. A typical model is a GPS map. It reflects only those aspects of the real world that are relevant in assisting the user in reaching his or her destination and avoids using information irrelevant to travel.

Distinguish between comparative advantage and absolute advantage.

A person has a comparative advantage in producing a good when he or she has the lowest opportunity cost of producing it. Comparative advantage is based on the output forgone. A person has an absolute advantage in production when he or she uses the least amount of time or resources to produce one unit of that particular good or service. Absolute advantage is a measure of productivity in using inputs.

What gives a person a comparative advantage?

A person has a comparative advantage in production when he or she gives up the least amount of production of another good or service than anyone else when producing one unit of another good or service. If the person gives up the least amount of other goods and services to produce a particular product, the person has the lowest opportunity cost of producing that product.

Distinguish between a positive statement and a normative statement and provide examples.

A positive statement is a description of how the world is. It is testable. A normative statement is a description of how the world ought to be. It is, by its very nature, not testable, because there is no universally approved criterion by which the statement can be judged. "I will receive an A in this course" is a positive statement made by an economics student—it might not be true, but it is testable. "I will receive a good grade for this course" is a normative statement. Whether someone agrees with it depends on his or her interpretation of what makes for a "good" grade.

Over what range of prices does a shortage arise? What happens to the price when there is a shortage?

A shortage arises at market prices below the equilibrium price. When a shortage occurs, the price rises, which decreases the quantity demanded and increases the quantity supplied. The price will rise until the shortage disappears and the market price is at the new equilibrium.

Over what range of prices does a surplus arise? What happens to the price when there is a surplus?

A surplus arises at market prices above the equilibrium price. When a surplus occurs, the price falls, which decreases the quantity supplied and increases the quantity demanded. The price will fall until the surplus disappears and the market price is at its new equilibrium.

Explain the effects of a tariff on domestic production, the quantity bought, and the price.

A tariff raises the domestic price of the product. The higher price increases domestic production and decreases the domestic quantity purchased.

How does a tax on labour income influence the equilibrium quantity of employment?

A tax on labour income drives a wedge between the after-tax wage rate of workers and the before-tax wage rate paid by firms. The tax on labour income decreases the supply of labour. That is, for each before-tax wage rate, workers provide a lower quantity of labour when faced with a tax that lowers their after-tax wage. The decrease in labour supply raises the before-tax wage rate, even though the after-tax wage rate received by workers falls. The decrease in labour supply also means that the quantity of employment at full employment (i.e., equilibrium employment in the labour market) falls.

Explain the idea of a tradeoff and think of three tradeoffs that you have made today.

A tradeoff is an exchange—giving up one thing to get something else. Three examples of tradeoffs are as follows. (a) When a student sleeps in rather than going to his or her early morning economics class, the student trades off additional sleep for study time. The opportunity cost of the decision is a lower grade on the exam. (b) When a student running late for class parks his or her car illegally, the student trades off saving time for the risk of a ticket. The potential opportunity cost of the decision is the goods and services that cannot be purchased if the student receives an expensive parking ticket. (c) A student trades off higher income by taking a part-time job for less leisure time and study time. The opportunity cost is less leisure and lower grades in classes.

According to RBC theory, how does a fall in productivity growth influence investment demand, the market for loanable funds, the real interest rate, the demand for labour, the supply of labour, employment, and the real wage rate?

According to real business cycle theory, a fall in productivity growth decreases investment demand and the demand for labour. The decrease in investment demand decreases the demand for loanable funds and lowers the real interest rate. Via the intertemporal substitution effect, the lower real interest rate decreases the supply of labour. Because both the demand for labour and the supply of labour decrease, employment decreases. The real wage rate also falls because the decrease in the demand for labour exceeds the decrease in the supply of labour.

How do changes in expectations, fiscal policy and monetary policy, and the world economy change aggregate demand and the aggregate demand curve?

Aggregate demand increases, and the AD curve shifts rightward if expected future income, expected future inflation, or expected future profits increase; government expenditures increase, or taxes are cut; the quantity of money increases, and the interest rate is cut; the foreign exchange rate falls; or foreigners' income increases. The reverse changes decrease aggregate demand and shift the AD curve leftward.

List some examples of the scarcity that you face

An example of scarcity at the economy-wide level would be people with lower incomes being forced to choose between food and gasoline due to high prices for both. An example of scarcity at an individual level would be a person unable to afford life-saving (or life-enhancing) medicine. At a more student-oriented level, examples of scarcity include not enough income to afford both tuition and a nice car and not enough learning capacity to study for both an economics exam and a chemistry exam in one night.

Explain the effects of an import quota on domestic production, consumption, and price.

An import quota raises the domestic price of the product. The higher price increases domestic production and decreases domestic purchases.

What are the effects of an increase in the population on potential GDP, the quantity of labour, the real wage rate, and potential GDP per hour of labour?

An increase in population increases the supply of labour. Employment increases, and the real wage rate falls. The increase in employment creates a movement along the aggregate production function, so potential GDP increases. Because of diminishing returns, real GDP per hour of labour decreases.

Why are consumption taxes relevant for measuring the tax wedge?

An increase in taxes on consumption goods and services is equivalent to a cut in real wage rate. The cut in real wage rate lowers the incentive to labor supply. Thus, taxes on consumption goods and services add to the wedge.

If the natural unemployment rate increases, what happens to the short-run Phillips curve and the long-run Phillips curve?

An increase in the natural unemployment rate shifts both the short-run and long-run Phillips curves rightward by an amount equal to the increase in the natural unemployment rate.

Show the effects of a change in the nominal interest rate and a change in real GDP using the demand for money curve.

An increase in the nominal interest rate decreases the quantity of real money demanded. The slope of the demand for money curve shows how the quantity of real money demanded depends on the nominal interest rate. An increase in the nominal interest rate results in a movement upward along the demand for money curve; a decrease in the nominal interest rate results in a movement downward along the demand for money curve, as illustrated by the arrow in Figure 24.1. A change in real GDP changes the demand for money. An increase in real GDP increases the demand for money and shifts the demand for curve for real money rightward from MD0 to MD1, as shown in Figure 24.2.

More firms produce MP3 players or electronics workers' wages rise? (Draw the diagrams!)

An increase in the number of firms that produce MP3 players increases the supply of MP3 players. The supply curve of MP3 players shifts rightward. Demand remains unchanged. The price of an MP3 player falls, and the quantity of MP3 players increases.A rise in the wages of electronic workers decreases the supply of MP3 players because it increases the cost of producing MP3 players. The supply curve of MP3 players shifts leftward. Demand remains unchanged. The price of an MP3 player rises, and the quantity of MP3 players decreases.

What distinguishes an unemployed person from one who is not in the labour force?

An unemployed person must be available for work and must be in one of three categories: (i) On temporary layoff with an expectation of recall (ii) Without work but has looked for work in the past four weeks (iii) Has a new job to start within four weeks. People in the working-age population who are neither employed nor unemployed are classified as not being in the labour force.

How would you use the Phillips curve to illustrate an unexpected change in inflation?

An unexpected change in inflation results in a movement along the short-run Phillips curve. In particular, an unexpected increase in the inflation rate lowers the unemployment rate, and an unexpected decrease in the inflation rate raises the unemployment rate.

What is arbitrage and what are its effects in the foreign exchange market?

Arbitrage is the practice of seeking to profit by buying in one market and selling for a higher price in another market. Arbitrage has several effects: - Law of one price: At any one time, an exchange rate is the same in all markets. - No round-trip profit: It is impossible to make a profit by using currency A to buy currency B and then selling currency B to buy currency A. It is impossible to make a profit if even longer chains of currency are used. - Interest rate parity: Equal rates of return across currencies, which means that for risk-free transactions, there is no gain from choosing one currency over another. - Purchasing power parity: Equal value of money, which occurs when goods and services cost the same in two countries.

What is the source of the gains from trade?

As long as people have different opportunity costs of producing goods or services, total output is higher with specialization had trade happened than if each individual produced goods and services under self-sufficiency. This increase in output accounts for the gains from trade.

How does the marginal benefit from a good change as the quantity produced of that good increases?

As more of a good is consumed, the marginal benefit received from each unit is smaller than the marginal benefit received from the unit consumed immediately before it, and it is larger than the marginal benefit from the unit consumed immediately after it. This set of results is known as the principle of decreasing marginal benefit and is often assumed by economists to be a common characteristic of an individual's preferences over most goods and services in the economy.

Explain the influences on the pace of labour productivity growth.

At one level, the productivity growth slowdown in Canada was the failure of technology to contribute much to (measured) productivity growth. This answer is relatively shallow. A deeper answer explains why technology's contribution to labour productivity growth collapsed. Technology did not add much to productivity growth because of the energy price shocks. The huge price hikes for energy diverted investment in new technology away from enhancing productivity to replacing capital that was no longer economical and fuel guzzling.

Why is the price at which the quantity demanded equals the quantity supplied the equilibrium price?

At the equilibrium price, the quantity demanded by consumers equals the quantity supplied by producers. At this price, the plans of producers and consumers are coordinated, and there is no influence on the price to move away from equilibrium.

What is the distinction between automatic and discretionary fiscal policy?

Automatic fiscal policy is a fiscal policy action that is triggered by a state of the economy, while discretionary fiscal policy involves action that is initiated by an act of Parliament.

How do depository institutions balance risk and return?

Banks earn a higher return by using the funds they acquire from their deposits to buy higher-yielding, riskier assets, such as loans. But these assets are risky. If the loans fail, a bank might not have sufficient funds to repay its depositors. If the bank undertakes too much risk, its depositors might rush to withdraw their deposits, which would cause the bank to fail. But if the bank forgoes all risky assets, its profit will be much lower. So the bank must balance its search for higher return against the risk earning the return entails.

How do depository institutions create liquidity, pool risks, and lower the cost of borrowing?

Banks earn a higher return by using the funds they acquire from their deposits to buy higher-yielding, riskier assets, such as loans. But these assets are risky. If the loans fail, a bank might not have sufficient funds to repay its depositors. If the bank undertakes too much risk, its depositors might rush to withdraw their deposits, which would cause the bank to fail. But if the bank forgoes all risky assets, its profit will be much lower. So the bank must balance its search for higher return against the risk earning the return entails.

How do banks create money?

Banks within the banking system create money by creating deposits, which are part of the nation's money. Banks create deposits by making loans because part or all of the loans they make will be deposited in another bank. For example, a student given a loan may purchase books at the local bookstore. The bookstore will then deposit the proceeds into its bank as part of the bookstore's chequable account. Thus, the loan has created new deposits at the bookstore's bank.

Describe the gaps between real GDP per person in Canada and in other countries. For which countries is the gap narrowing? For which is it widening? For which is it the same?

Between 1960 and 2010, the gaps between the United States, Canada, and the Europe Big 4 have been almost constant. But starting from a long way below, Japan grew fastest. It caught up to Europe in 1970 and to Canada in 1990. But during the 1990s, Japan's economy stagnated.Real GDP per person in Central and South America was 28 percent of the Canadian level in 1960. It grew more quickly than Canada and reached 30 percent of the Canadian level by 1980, but then growth slowed, and by 2010, real GDP per person was only 23 percent of the Canadian level.In Eastern Europe, real GDP per person has grown more slowly than anywhere except Africa, and it fell from 32 percent of the Canadian level in 1980 to 19 percent in 2003 and then increased again to 22 percent in 2010.Real GDP per person in Africa fell from 10 percent of the Canadian level in 1960 to 5 percent in 2007 and then increased to 6 percent in 2010.

How does the tax wedge influence potential GDP?

By decreasing employment, the tax wedge lowers potential GDP.

Is Canada a net borrower or a net lender? Is it a debtor or a creditor nation?

Canada is a net borrower and debtor nation. Canada's foreign borrowing finances private and public investment, not consumption.

What are the policy actions taken by central banks in response to the financial crisis?

Central banks responded to financial crisis with classic open market operations and by several other unconventional measures. Central banks conducted massive open market operations to provide liquidity to banks. They created an asset-backed commercial paper money market mutual fund liquidity facility to provide liquidity to money market funds. They also created programs that allowed term auction credit and primary dealer and other broker credits to provide liquidity to other financial institutions.

What makes the Canadian dollar exchange rate fluctuate?

Changes in the demand for Canadian dollars and the supply of Canadian dollars lead to fluctuations in the Canadian dollar exchange rate. Because the demand for dollars and the supply of dollars generally change at the same time and in opposite directions, exchange rate fluctuations are frequently large.

How does the natural unemployment rate change and what factors might make it change?

Changes in the natural unemployment rate arise because of changes in frictional and structural unemployment. Any factor that changes frictional unemployment or structural unemployment changes the natural unemployment rate. Factors that influence the natural unemployment rate include the age distribution of the population, the scale of structural change, the real wage rate, and unemployment benefits.

Why are cheques and credit cards not money?

Cheques and credit cards are not money because they are not a means of payment. A cheque is an order to transfer a deposit from one person to another. The deposits are money, but the cheques are not. A credit card is an ID card that lets a person take out a loan the instant he or she buys something. The loan still needs to be repaid with money, so the credit card is not a means of payment—that is, it is not money.

Explain what it means to choose at the margin and illustrate with three choices at the margin that you have made today.

Choosing at the margin means comparing the benefits of a little bit more of something (e.g., an activity) and its cost. Three examples that illustrate "choosing at the margin" are as follows: (a) When a student faces a chemistry final exam and an economics final exam in one day, the student must determine whether spending the last hour studying a little more chemistry or a little more economics will yield a better contribution (marginal benefit) to his or her overall GPA. (b) A university student who is buying a computer must decide whether the marginal benefit of adding 1 GB of additional memory is worth the marginal cost of the additional memory. (c) A student football fan with a choice of a cheap seat in the student bleachers located at the far end of the playing field or a more expensive seat located on the 30-yard-line must determine whether the marginal benefit of watching the game from a better seat is worth the marginal cost of the higher ticket price.

What are the defining features of classical macroeconomics and what policies do classical macroeconomists recommend?

Classical macroeconomists believe that the economy is self-regulating and always at full employment. Classical macroeconomists assert that the proper government policy is to minimize the disincentive effects of taxes on employment, investment, and technological change.

What are the problems that arise when a commodity is used as money?

Commodities are not used as money for several reasons. Many commodities are bulky. And many commodities change in value over time. Using a commodity that changes in value as money would be awkward. Prices would change simply because the commodity's value changed. Additionally, using a commodity as money has a higher opportunity cost than do currency and bank deposits because the commodity has alternative uses that must be foregone.

Which components of aggregate expenditure are influenced by real GDP?

Consumption expenditure and imports are influenced by real GDP. Both increase when real GDP increases.

How does cost-push inflation begin?

Cost-push inflation begins with an increase in the money wage rate or an increase in the money prices of raw materials, which decreases aggregate supply. The decrease in aggregate supply raises the price level and decreases real GDP.

What are the main criticisms of RBC theory and how do its supporters defend it?

Critics of the real business cycle theory level have three criticisms of it: (1) the money wage rate is sticky, (2) the intertemporal substitution effect is small so that the small changes in the real wage rate cannot account for large changes in employment, and (3) measured productivity shocks are likely to be caused by changes in aggregate demand so that business cycle fluctuations cause the measured productivity shocks. Real business cycle supporters respond that (1) the real business cycle theory is consistent with the facts about economic growth, and it explains the facts about business cycles; and (2) real business cycle theory is consistent with a wide range of microeconomic evidence about labour supply, labour demand, investment demand, and the distribution of income between labour and capital.

How does demand-pull inflation begin?

Demand-pull inflation begins with an increase in aggregate demand. The increase in aggregate demand increases real GDP and the price level.

What are depository institutions?

Depository institutions are financial firms that take deposits from households and firms. They then make loans available to other households and firms.

What are the functions of depository institutions?

Depository institutions have four major economic functions: they create liquidity, pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers.

Explain who gains and who loses from an import quota and why the losses exceed the gains.

Domestic consumers lose from the import quota. Domestic producers gain from the import quota. The importers also gain additional profit from the import quota. But the gain to producers plus the importers' profits is less than the loss to consumers, so on net an import quota creates a net social loss. There is a social loss for two reasons: (1) high-cost domestic production expands, so society uses more resources producing some high-cost units of good than it would use if low-cost foreign units were purchased, and (2) the high price leads domestic consumers to decrease their consumption of the good, thereby robbing society of the benefits these units would have produced.

Explain who gains and who loses from a tariff and why the losses exceed the gains.

Domestic consumers lose from the tariff. Domestic producers gain from the tariff. The government also gains revenue from the tariff. But the gain to producers plus the gain in government revenue is less than the loss to consumers, so on net a tariff creates a social loss. There is a social loss for two reasons: (1) high-cost domestic production expands, so society uses more resources producing some high-cost units of good than it would use if low-cost foreign units were purchased, and (2) the high price leads domestic consumers to decrease their consumption of the good, thereby robbing society of the benefits these units would have produced.

How does the unemployment rate fluctuate over the business cycle?

During a recession, the output gap is negative, and the unemployment rate is generally rising. During an expansion, the output gap is positive, and the unemployment rate is generally falling.

What is economic growth and how do we calculate its rate?

Economic growth is the sustained expansion of production possibilities. It is measured by the increase in real GDP over a given time period. The economic growth rate is the annual percentage change in real GDP.

Does economic growth result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply?

Economic growth results from increases in long-run aggregate supply. Economic growth occurs because the quantity of labour increases, capital is accumulated, and there are technological advances over time. All three of these factors increase potential GDP and shift the LAS curve rightward.

How does economic growth influence the production possibilities frontier?

Economic growth shifts the PPF outward. Persistent outward shifts in the PPF—economic growth—are caused by the accumulation of resources, such as more capital equipment, and/or by the development of new technology.

What is the relationship between aggregate planned expenditure and real GDP at equilibrium expenditure?

Equilibrium expenditure occurs when aggregate planned expenditure equals real GDP.

How does equilibrium expenditure come about? What adjusts to achieve equilibrium?

Equilibrium expenditure results from adjustments in real GDP. For instance, if aggregate planned expenditure exceeds real GDP, firms find that their inventories are below their targets. In response, firms increase production to meet their inventory targets. And as production increases, real GDP increases. The increase in real GDP increases aggregate planned expenditure. Eventually, real GDP increases sufficiently so that it equals aggregate planned expenditure, and at that point, equilibrium expenditure occurs.

Find an example of the distinction between microeconomics and macroeconomics in today's headlines.

Examples of headlines that illustrate microeconomic issues include the following: How will a rise in sales taxes change what people buy? What will happen to the number of students attending university if tuition were to increase 55 percent? What will happen to low-skilled workers if the minimum wage is increased? Examples of headlines that illustrate macroeconomic issues include the following: How will Canadian government spending on hospitals influence the national debt? What would happen to total output in the economy if the income tax rates were increased?

Use headlines from the recent news to illustrate the potential for conflict between self-interest and the social interest.

Examples will vary according to the headlines, but one example of an issue concerns import restrictions. Take the ethanol industry, for example. The February 4, 2008, headline from Reuters was "Bush Budget Doesn't Alter Ethanol Import Tariff." When US ethanol producers convinced the government to limit or eliminate imports of ethanol from other nations, such as Brazil, it helped the workers and businesses in the United States ethanol industry earn higher wages and profits, respectively. This outcome served their self-interests. However, it hurt all companies that used ethanol in their products as well as consumers who bought gasoline with ethanol blended in. This decision did not serve the social interest.

How does expected inflation occur?

Expected increases in aggregate demand or expected decreases in aggregate supply create expected inflation because they change the expected price level. For example, in anticipation of an increase in aggregate demand, the money wage rate rises by the same percentage as the price level is expected to rise. With the correct expectation, real GDP remains equal to potential GDP, and unemployment remains at its natural rate.

How have depository institutions made innovations that have influenced the composition of money?

Financial innovation has brought large changes in the composition of money. Expressed as percentage of M2, since 1989, chequable deposits have shrunk from 48 percent to 14 percent. Non-chequable deposits have increased from 22 percent to 32 percent, and fixed term deposits have expanded from 25 percent to 50 percent. The use of currency has decreased from 5 percent to 4 percent.

Why are social institutions such as firms, markets, property rights, and money necessary?

Firms are necessary to allow people to specialize. Without firms, specialization would be limited because a person would need to specialize in the entire production of a product. With firms, people are able to specialize in producing particular bits of a product. In order for a society to enjoy the fruits of specialization and trade, the individuals who comprise that society must voluntarily desire to specialize in the first place. Discovering trade opportunities after a person has specialized in his or her comparative advantage in production is what allows that person to gain from his or her own specialization efforts. Trading opportunities can take place only if a market exists where people observe prices to discover available trade opportunities. Money is necessary to allow low-cost trading in markets. Without money, goods would need to be directly exchanged for other goods, a difficult and unwieldy situation. Finally, people must enjoy social recognition of and government protection of property rights to have confidence that their commitments to trade arrangements will be respected by everyone in the market.

Why might fiscal stimulus crowd out investment?

Fiscal stimulus that is financed by borrowing leads to increase in market interest rates, which crowds out investment.

How do fluctuations in aggregate demand and short-run aggregate supply bring fluctuations in real GDP around potential GDP?

Fluctuations in aggregate demand with no change in short-run aggregate supply bring fluctuations in real GDP around potential GDP. For instance, starting from full employment, a decrease in aggregate demand decreases the price level and real GDP and creates a recessionary gap. In the long run, the money wage rate (and the money prices of other resources) falls so that short-run aggregate supply increases and the economy returns to its full employment equilibrium. Starting from full employment, a decrease in short-run aggregate supply decreases real GDP and raises the price level. The fall in real GDP combined with a rise in the price level is a phenomenon called stagflation.

How do fluctuations in autonomous expenditure influence real GDP?

Fluctuations in autonomous expenditure bring business cycle turning points. When autonomous expenditure changes, the economy moves from one phase of the business cycle to the next. For example, if autonomous expenditure decreases, equilibrium expenditure and real GDP decrease, and as a result, the economy enters the recession phase of the business cycle.

What does the demand curve tell us about the price that consumers are willing to pay?

For any fixed quantity of a good available, the height of the demand curve shows the maximum price that consumers are willing to pay for that quantity of the good. The price on the demand curve at this quantity indicates the marginal benefit to consumers of the last unit consumed at that quantity.

What does the supply curve tell us about the producer's minimum supply price?

For any quantity, the height of the supply curve shows the minimum price that suppliers must receive to produce that quantity of output. As a result, the price is the marginal cost of the last unit produced at this level of output.

Define frictional unemployment, structural unemployment, and cyclical unemployment. Give examples of each type of unemployment.

Frictional unemployment is the unemployment that arises from the "frictions" in the labour market; that is, normal labour market turnover. For example, newly graduated students entering the labour market looking for work are frictionally unemployed. Structural unemployment represents the unemployment created by "structural" changes in the economy. For example, workers are structurally unemployed if they lose their jobs because of changes in technology or the amount of foreign competition and if they have different skills from those required by new jobs or if they live in a region of the country where new jobs are not being created. Finally, cyclical unemployment is the unemployment created by business cycle fluctuations in economic activity (e.g., a worker laid off in 2009 because of the recession).

How has China operated in the foreign exchange market, why, and with what effect?

From 1997 until 2005, the People's Bank of China fixed the foreign exchange value of the Chinese yuan against the US dollar. During this period, the demand for the yuan increased, so the People's Bank of China supplied additional yuan to keep the exchange rate constant. By supplying yuan, the People's Bank acquired large amounts of foreign currency. In addition, by fixing its exchange rate, China essentially pegged its inflation rate to equal the US inflation rate. Since 2005, the yuan has been allowed to appreciate slightly as the People's Bank moved to a crawling peg exchange rate policy. The exchange rate has not been allowed to change much, so over the long run the Chinese inflation rate remains closely tied to US inflation.

What are the gains from specialization and trade?

From society's standpoint, the total output of goods and services available for consumption is greater with specialization and trade. From an individual's perspective, each person who specializes enjoys being able to consume a more complex and larger bundle of goods and services after trading with others who have also specialized than would otherwise be possible under self-sufficiency. These increases are the gains from specialization and trade for society and for individuals.

Why does GDP equal aggregate income and also equal aggregate expenditure?

GDP equals aggregate income because one way to value production is by the cost of the factors of production employed. GDP equals aggregate expenditure because another way to value production is by the price that buyers pay for it in the market.

Define GDP and distinguish between a final good and an intermediate good. Provide examples.

GDP is the market value of all the final goods and services produced within a country in a given time period. A final good or service is an item that is sold to the final user; that is, the final consumer, government, a firm making an investment, or a foreign entity. An intermediate good or service is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. For instance, bread sold to a consumer is a final good, but wheat sold to a baker to make the bread is an intermediate good. Distinguishing between final goods and services and intermediate goods and services is important because only final goods and services are directly included in GDP; intermediate goods must be excluded to avoid double counting them. For example, counting the wheat that went into the bread as well as the bread would count the wheat twice—once as wheat and once as part of the bread.

Why are income taxes on capital income more powerful than those on labour income?

Given positive inflation, what appears to be a moderate tax on interest income dramatically decreases the real after-tax interest rate, which is the interest rate that influences investment and saving plans. In particular, by driving a wedge between the real interest rate that savers receive and firms pay, the tax on interest income decreases the supply of loanable funds, which lowers investment and saving in the economy.

Explain the connection between a government budget deficit and a government debt.

Government debt is the total amount that the government owes. A government budget deficit adds to government debt (and a government budget surplus lowers government debt).

What is the distinction between gross investment and net investment?

Gross investment is the total amount spent on new capital; net investment is the change in the capital stock. Net investment equals gross investment minus depreciation.

Explain why Hong Kong has experienced faster economic growth than Canada.

Hong Kong chose to devote a greater proportion of its available resources to the production of capital than Canada did. This allowed Hong Kong to grow at a faster rate (at least until recently). By forgoing consumption and producing a greater proportion of capital goods over the last few decades, Hong Kong was able to achieve output per person equal to about 88 percent of that in Canada.

If potential GDP increases, what happens to aggregate supply? Does the LAS curve shift or is there a movement along the LAS curve? Does the SAS curve shift or is there a movement along the SAS curve?

If potential GDP increases, both long-run aggregate supply and short-run aggregate supply increase, and the LAS curve and SAS curve shift rightward.

If real GDP and aggregate expenditure are greater than equilibrium expenditure, what happens to firms' inventories? How do firms change their production? And what happens to real GDP?

If real GDP and aggregate expenditure are greater than their equilibrium levels, an unplanned increase in inventories occurs. The unplanned increase in inventories leads firms to decrease production to restore inventories to their planned levels. The decrease in production decreases real GDP.

If real GDP and aggregate expenditure are less than equilibrium expenditure, what happens to firms' inventories? How do firms change their production? And what happens to real GDP?

If real GDP and aggregate expenditure are less than their equilibrium levels, an unplanned decrease in inventories occurs. The unplanned decrease in inventories leads firms to increase production to restore inventories to their planned levels. The increase in production increases real GDP.

What must happen to create a cost-push inflation spiral?

If the Fed responds to each decrease in aggregate supply by increasing the quantity of money, aggregate demand increases, and freewheeling cost-push inflation ensues.

How do real GDP and the price level change if the forecast of inflation is incorrect?

If the actual inflation rate exceeds the forecasted inflation rate, the price level rises by more than expected, and real GDP exceeds potential GDP. If the actual inflation rate falls short of the expected inflation rate, the price level rises by less than expected, and real GDP is less than potential GDP.

How can the federal government use discretionary fiscal policy to stimulate the economy?

If the economy has a recessionary gap, the government can increase its expenditure or lower taxes to increase aggregate demand and move the economy back toward potential GDP.

If the money wage rate rises and potential GDP remains the same, does the LAS curve or the SAS curve shift or is there a movement along the LAS curve or the SAS curve?

If the money wage rate rises and potential GDP remains the same, there is a decrease in short-run aggregate supply and no change in long-run aggregate supply. The SAS curve shifts leftward, and the LAS curve is unchanged.

If the price level and the money wage rate rise by the same percentage, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move?

If the price level and the money wage rate rise by the same percentage, there is no change in the quantity of real GDP supplied, and a movement occurs up along the LAS curve.

If the price level rises and the money wage rate remains constant, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move?

If the price level rises and the money wage rate remains constant, the quantity of real GDP supplied increases, and the economy moves along the SAS curve.

Why does demand not change when the price of a good changes with no change in the other influences on buying plans?

If the price of a good falls, and nothing else changes, then the quantity of the good demanded increases, and there is movement upward along the demand curve, but the demand for the good remains unchanged, and the demand curve does not shift.

What happens to the quantity of cellphones supplied and the supply of cellphones if the price of a cellphone falls?

If the price of cellphones falls and nothing else changes, then the quantity of cellphones supplied will decrease, and there will be a movement downward along the supply curve for cellphones. The supply of cellphones, however, will remain unchanged, and the supply curve does not shift.

What happens if there is a shortage or a surplus of Canadian dollars in the foreign exchange market?

If there is a shortage of Canadian dollars, the quantity of Canadian dollars demanded exceeds the quantity supplied. The foreign exchange rate rises to its equilibrium. If there is a surplus of Canadian dollars, the quantity of Canadian dollars demanded is less than the quantity supplied. The foreign exchange rate falls to its equilibrium.

What, according to neoclassical growth theory, is the fundamental cause of economic growth?

In neoclassical growth theory, growth results from technological advances, which are determined by chance.

How does real GDP change in the long run when autonomous expenditure increases? Does real GDP change by the same amount as the change in aggregate demand? Why or why not?

In the long run, an increase in aggregate expenditure has no effect on real GDP, that is, real GDP does not change. The change in real GDP—zero—is less than the change in aggregate demand. The change in real GDP is nil because, in the long run, the economy returns to its full-employment equilibrium. In the long run, an increase in aggregate expenditure raises the price level but has no effect on real GDP.

How does a change in the supply of money change the interest rate in the long run?

In the long run, supply and demand in the loanable funds market determines the real interest rate. The nominal interest rate equals the equilibrium real interest rate plus the expected inflation rate. Real GDP equals potential GDP, so the only variable that can adjust in the long run is the price level. In the long run, the price level adjusts so that the money market is in equilibrium.

What determines the real exchange rate and the nominal exchange rate in the long run?

In the long run, the real exchange rate is determined by demand and supply in the markets for goods and services. The real exchange rate is given by the formula RER = (E × P) ÷ P*, where P* is the price level in the foreign country, and P is the price level in Canada. If Japan and Canada produce identical goods, purchasing power parity would make the real exchange rate equal 1. But Canadian real GDP is a different bundle of goods and services from Japanese real GDP, so the real price of Japanese and Canadian real GDP—the real exchange rate—is not 1, and it fluctuates.The forces of demand and supply in the markets for the millions of goods and services that make up real GDP determine the relative prices. So in the long run, demand and supply in the markets for goods and services determine the real exchange rate.The equation for the nominal exchange rate is E = (RER × P*) ÷ P. In the long run, the quantity of money determines the price level. So the nominal exchange rate in the long run is a monetary phenomenon, determined by the quantities of money in two countries.

How does an increase in autonomous expenditure change real GDP in the short run? Does real GDP change by the same amount as the change in aggregate demand? Explain why or why not.

In the short run, an increase in aggregate expenditure increases real GDP. However, the increase in real GDP is less than the increase in aggregate demand because the price level rises. The more the price level rises (the steeper the SAS curve), the smaller the increase in real GDP.

How do taxes and transfer payments programs work as automatic fiscal policy to dampen the business cycle?

Income taxes and needs-tested spending programs both work as automatic stabilizers because they decrease the effect a change in income has on aggregate expenditure. For instance, when income decreases, consumption expenditure and aggregate expenditure decrease. But with the fall in income, income taxes decrease, and needs-tested spending increase so that disposable income does not fall as much as income does. The smaller fall in disposable income means that the fall in consumption expenditure is smaller, so the fall in aggregate expenditure is likewise smaller.

How is economics used as a policy tool?

Individuals, businesses, and governments use economics as a policy tool. Individuals use the economic ideas of marginal benefit and marginal cost when making decisions for such topics as attending college, paying cash or credit for a purchase, and working. Businesses also use the concepts of marginal benefit and marginal cost when making decisions about what to produce, how to produce, and even how many hours to stay open. Finally, governments also use marginal benefit and marginal cost when deciding issues such as the level of property taxes, the amount to fund higher education, or the level of a tariff on imports of Chinese garlic.

Does inflation result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply?

Inflation results from increases in aggregate demand that exceed the increase in long-run aggregate supply. As the aggregate demand curve shifts rightward, the price level rises. Increases in AD that exceed increases in LAS produce inflation.

How might inflation targeting improve U.S. monetary policy?

Inflation targeting might improve US monetary policy in the sense that it helps manage inflation expectations in a more sensible way.

List all the influences on buying plans that change demand, and for each influence, say whether it increases or decreases demand.

Influences that change the demand for a product include the following: The prices of related goods—A rise (fall) in the price of a substitute of a good increases (decreases) the demand for the good. A rise (fall) in the price of a complement of a good decreases (increases) the demand for the good. The expected future price of the good—A rise (fall) in the expected future price of a good increases (decreases) the demand for the good in the current period. Income—For a normal good, an increase (decrease) in income increases (decreases) the demand for the good. For an inferior good, an increase in income decreases (increases) the demand for the good. Expected future income and credit—An increase (decrease) in expected future income or credit might increase (decrease) the demand. The population—An increase (decrease) in population in the market increases (decreases) the demand. People's preferences—If people's preferences for a good rise (fall), the demand increases (decreases).

List all the influences on selling plans, and for each influence, say whether it changes supply.

Influences that change the supply of a good include the following:Prices of factor of production—A rise (fall) in the price of a factor of production increases firms' costs of production and decreases (increases) the supply of the good.Prices of related goods produced—If the price of a substitute in production rises (falls), firms decrease their sales of the original good, and the supply for the original good decreases (increases). A rise (fall) in the price of a complement in production increases (decreases) production of the original good, causing the supply of the original good to increase (decrease).The expected future price of the product—A rise (fall) in the expected future price of the good causes suppliers to reduce (increase) the amount they sell today. This change in expectations decreases (increases) the supply in the current period.The number of sellers—An increase (decrease) in the number of sellers in a market increases (decreases) the quantity of the good available at every price and increases (decreases) the supply.Technology—An advance in technology increases the supply.The state of nature—A good (bad) state of nature, such as good (bad) weather for agricultural products, increases (decreases) the supply.

What is interest rate parity and what happens when this condition doesn't hold?

Interest rate parity, which means equal rates of return across currencies, means that for risk-free transactions, there is no gain from choosing one currency over another. If the rate of return for the Canadian dollar is higher than that for, say, the Japanese yen, people will generally expect the value of the dollar to fall against the yen (that is, the Canadian dollar is expected to depreciate over time). Interest rate parity always prevails.

What are the defining features of Keynesian macroeconomics and what policies do Keynesian macroeconomists recommend?

Keynesian macroeconomists believe that if the economy was left alone, it would rarely operate at full employment. To achieve and maintain full employment, the economy needs active help from fiscal and monetary policy. Aggregate demand fluctuations combined with a very sticky money wage rate are the major sources the business cycle. Keynesian macroeconomists assert that active fiscal and monetary policy, designed to offset fluctuations in aggregate demand, are the proper government policies.

Explain the mainstream theory of the business cycle.

Mainstream business cycle theory attributes business cycles to fluctuations in aggregate demand growth. According to the mainstream view, potential GDP grows steadily, and aggregate demand, while generally growing slightly faster that potential GDP, at times grows more slowly than potential GDP and at other times grows significantly more rapidly than potential GDP. When aggregate demand grows more slowly than potential GDP, the price level falls below its expected level, and the economy slides into a recession so that real GDP is less than potential GDP. When aggregate demand grows more rapidly than potential GDP, the price level rises above its expected level, and the economy moves into a strong expansion accompanied by inflation.

What is marginal cost? How is it measured?

Marginal cost is the opportunity cost of producing one more unit of a good or service. Along a PPF, marginal cost is reflected in the absolute value of the slope of the PPF curve. In particular, the magnitude of the slope of the PPF is the marginal cost of a unit of the good measured along the x-axis.

What are the defining features of monetarist macroeconomics and what policies do monetarist macroeconomists recommend?

Monetarist macroeconomists believe that the economy is self-regulating and will typically operate at full employment if monetary policy is not erratic and the money growth rate is kept steady. The major source of business cycle fluctuations are similar to the Keynesian view that is, changes in aggregate demand combined with a sticky money wage rate. However, according to monetarist macroeconomists, the changes in aggregate demand are the result of fluctuations in the growth rate of money caused by the central bank (e.g., the Bank of Canada in the case of Canada). Monetarists assert that the proper government policies are low taxes, to avoid the disincentive effects stressed by classical macroeconomists, and steady monetary growth.

What makes something money? What functions does money perform? Why do you think packs of chewing gum don't serve as money?

Money is anything that is generally acceptable as a means of payment. Money has three functions: it is a medium of exchange (money is accepted in exchange for goods and services), a unit of account (prices are quoted in terms of money), and a store of value (money can be held and exchanged for goods and services later). Packs of chewing gum do not function as money because they are not particularly good as a store of value—gum deteriorates. Additionally, packs of gum are not generally accepted in exchange for goods and services, so packs of gum are not a medium of exchange.

How does the production possibilities frontier show that every choice involves a tradeoff?

Movement along the PPF frontier illustrates that producing more of one good requires producing less of another good. This observation is the tradeoff that must be made when producing output efficiently.

How are net exports and the government sector balance linked?

Net exports are the value of exports of goods and services minus the value of imports of goods and services. Net exports are equal to the sum of government sector surplus or deficit plus the private sector surplus or deficit.The government sector balance is equal to net taxes minus government expenditure on goods and services. If the government sector balance is negative, then the government sector has a budget deficit. If the government sector budget deficit increases, and the private sector balance, which equals saving minus investment, does not change, the value of net exports becomes more negative.

What is the distinction between nominal GDP and real GDP?

Nominal GDP is the value of final goods and services produced in a given year valued at the prices of that year. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. By comparing the value of production in the two years at the same prices, the change in production is revealed.

What is offshore outsourcing? Who benefits from it and who loses?

Offshore outsourcing occurs when a firm in Canada buys finished goods, components, or services from firms in other countries. Workers who have skills for jobs that have been sent abroad lose from offshore outsourcing. Consumers who consume the goods and services produced abroad and imported into Canada benefit.

What are the flows in the market economy that go from firms to households and the flows from households to firms?

On the real side of the economy, goods and services flow from firms to households. On the monetary side of the economy, payments for factors of production, wages, rent, interest, and profits flow from firms to households. Flowing from households to firms on the monetary side of the economy are the expenditures on goods and services. On the real side, these are the factors of production, labour, land, capital, and entrepreneurship.

What has been the average growth rate of Canadian real GDP per person over the past 86 years? In which periods was growth most rapid and in which periods was it slowest?

Over the past 88 years, Canadian real GDP per person grew at an average rate of 2 percent per year.Real GDP per person decreased during the Great Depression and then grew rapidly during World War II in the 1940s. The 1950s had slow growth, but during the 1960s, the growth rate sped up and averaged 3.3 percent a year. In the 1970s, growth rate slowed to 2.0 percent a year. And in the late 1980s, the growth rate slowed even further to 0.5 percent a year. In the 1990s, the growth rate increased to 1.8 percent a year, but after 1996, it slowed to 0.9 percent a year.

What is PPP and how does it help us to make valid international comparisons of real GDP?

PPP is purchasing power parity. To make the most valid international comparisons of real GDP, we need to value each nation's production using PPP prices rather than by using exchange rates and the prices within each country because relative prices within different countries can vary widely. As a result, if the real GDP of each country is valued using the same PPP prices, then the comparison of real GDP among the countries is more accurate.

Why does unemployment arise and what makes some unemployment unavoidable?

People become unemployed for three reasons: they lose a job, leave a job, and enter or re-enter the labour force. Job losers account for the largest fraction of the unemployed and also are the source of most of the variation. In a dynamic economy, some unemployment is unavoidable. For example, economic growth means that some workers will always be entering the labour force without a job and will therefore be unemployed. Consumers change their demands for various goods, which means that some workers in the newly less-favoured industry will lose jobs and become unemployed. In addition, some workers will leave their current jobs to search for better jobs, and these workers, too, will be unemployed. So some unemployment is unavoidable as the economy churns and reacts to changes.

Why do people specialize and trade?

People can compare consumption possibilities from producing all goods and services through self-sufficiency against specializing in producing only those goods and services that reflect their comparative advantage and trading their output with others who do the same. People can then see that the consumption possibilities from specialization and trade are greater and more complex than under self-sufficiency. Therefore, it is in people's own self-interest to specialize. It was Adam Smith who first pointed out in The Wealth of Nations how individuals voluntarily engage in this socially beneficial and cooperative activity through the pursuit of their own self-interests, rather than for society's best interests.

Explain why choices respond to incentives and think of three incentives to which you have responded today.

People's choices change when their incentives (the marginal benefit and/or marginal cost of the choice) change. So economists predict changes in choices by determining when the marginal benefit and/or marginal cost change and then predicting that people make choices that bring them more marginal benefits and/or fewer marginal costs. Economists emphasize that institutions such as private property protected by a system of laws and markets that enable voluntary exchange affect people's incentives. The goal is to have institutions that channel people's choices so that the choices promote the social interest.

Distinguish between physical capital and financial capital and give two examples of each.

Physical capital includes the actual tools, instruments, machines, buildings, and other items that have been produced in the past and are presently used to produce goods and services. Financial capital includes the funds that businesses use to acquire their physical capital. Examples of physical capital are the pizza ovens owned by Pizza Hut and the buildings in which the Pizza Huts are located. Examples of financial capital are the bonds issued by Pizza Hut to buy pizza ovens and the loans Pizza Hut has made to fund their purchases of new buildings.

What determines potential GDP?

Potential GDP is determined from the labour market equilibrium. When the labour market is in equilibrium, there is full employment. The quantity of real GDP produced by the full employment quantity of labour is potential GDP.

What is allocative efficiency and how does it relate to the production possibilities frontier?

Production efficiency occurs when production takes place at a point on the PPF curve. This indicates that all available resources are being used for production, and society cannot produce additional units of one good or service without reducing the output of another good or service. Allocative efficiency, however, requires that the goods and services produced are those that provide the greatest possible benefit. This definition means that the allocative efficient level of output is the point on the PPF (and hence is a production-efficient point) for which the marginal benefit equals the marginal cost.

What is purchasing power parity and what happens when this condition doesn't hold?

Purchasing power parity (PPP) means equal value of money. If most goods and services cost more in one country than another, the currency of the first country is said to be overvalued: a depreciation of the currency would restore PPP. Similarly, the currency of the country with the lower prices is said to be undervalued: an appreciation of that currency would restore PPP.

Explain why real GDP might be an unreliable indicator of the standard of living.

Real GDP is sometimes used to measure the standard of living, but real GDP can be misleading for several reasons. Real GDP does not include household production, productive activities done in and around the house by the homeowner. Because these tasks often are an important component of people's work, this omission creates a major measurement problem. Real GDP omits the underground economy, economic activity that is legal but unreported or that is illegal. In many countries, the underground economy is an important part of economic activity, and its omission creates a serious measurement problem. Real GDP does not include a measurement of people's health and life expectancy, both factors that obviously affect economic well-being. The value of leisure time is not included in real GDP. People value their leisure hours, and an increase in people's leisure that enhances their economic welfare can lower the nation's real GDP and lower the nation's well-being. Environmental damage is excluded from real GDP. So an economy wherein real GDP grows but at the expense of its environment (as was the case with Eastern European countries under communism) falsely appears to offer greater economic welfare than a similar economy that grows slightly more slowly but with less of an environmental cost. Real GDP does not indicate the extent of political freedom and social justice enjoyed by a nation's citizens.

Distinguish between real GDP and potential GDP and describe how each grows over time.

Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. Potential GDP is the amount of real GDP that would be produced when all the economy's labour, capital, land, and entrepreneurial ability are fully employed. So real GDP is the actual amount produced with the actual level of employment of the nation's factors of production, while potential GDP is the amount that would be produced if there were full employment of all factors of production. The growth rates of both potential GDP and real GDP fluctuate over time. But the growth rate of potential GDP is smoother than that of real GDP because its determinants (quantities of factors of production and their productivity) grow at a steady pace. The growth rate of real GDP fluctuates around potential GDP.

According to RBC theory, what is the source of the business cycle? What is the role of fluctuations in the rate of technological change?

Real business cycle (RBC) theory says that economic fluctuations are caused by technological change that makes productivity growth fluctuate. Fluctuations in the rate of technological change are the impulses that create the business cycle.

What conditions must be satisfied if resources are used efficiently?

Resources are used efficiently when more of one good or service cannot be produced without producing less of some of another good or service that is valued more highly. This is known as allocative efficiency, and it occurs when (1) production efficiency is achieved and (2) the marginal benefit received from the last unit produced is equal to the marginal cost of producing the last unit.

Does economic growth overcome scarcity?

Scarcity reflects the inability to satisfy all our wants. Regardless of the amount of economic growth, scarcity will remain present because it will never be possible to satisfy all our wants. For instance, it will never be possible to satisfy all the wants of the several thousand people who all would like to ski the best slopes on Vail with only their family and a few best friends present. So economic growth allows more wants to be satisfied, but it does not eliminate scarcity.

Describe three types of short-run macroeconomic equilibrium.

Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. There are three types of short-run equilibrium: below full-employment equilibrium, where a recessionary gap exists with real GDP less than potential GDP; above full-employment equilibrium, where an inflationary gap exists with real GDP greater than potential GDP; and full-employment equilibrium, where no gap exists and real GDP equals potential GDP.

Compare the growth rates in Hong Kong, Korea, Singapore, Taiwan, China, and Canada. In terms of real GDP per person, how far is China behind these others?

Since 1960, income per person in Hong Kong, Singapore, Korea, Taiwan, and China has grown faster than in Canada. By 2010, real GDP per person in Singapore and Hong Kong had surpassed that of Canada. Real GDP per person in China in 2010 is similar to that of Hong Kong in 1976. China's real GDP per person increased from 3 percent of the Canadian level in 1960 to 15 percent in 2010.

Think of examples of goods whose relative price has risen or fallen by a large amount.

Some examples of items where both the money price and the relative price have risen over time are gasoline, college tuition, and food. Some examples of items where both the money price and the relative price have fallen over time are personal computers, HD televisions, and calculators.

Why does the PPF bow outward and what does that imply about the relationship between opportunity cost and the quantity produced?

Some resources are better suited to produce one type of good or service, like pizza. Other resources are better suited to produce other goods or services, like DVDs. If society allocates resources wisely, it will use each resource to produce the kind of output for which it is best suited. For the PPF, measure pizza production on the x-axis and DVD production on the y-axis. A small increase in pizza output when pizza production is relatively low requires only small increases in the use of those resources still good at making pizza and not good at making DVDs. This yields a small decrease in DVD production for a large increase in pizza production, creating a relatively low opportunity cost reflected in the gentle slope of the PPF curve over this range of output. However, the same small increases in pizza output when pizza production is relatively large will require society to devote to pizza production those resources that are less suited to making pizza and more suited at making DVDs. This reallocation of resources yields a relatively small increase in pizza output for a large decrease in DVD output, creating a relatively high opportunity cost reflected in the steep slope of the PPF curve over this range of output. The opportunity cost of pizza production increases with the quantity of pizza produced as the slope of the PPF curve becomes ever steeper, creating the bowed-out effect (the concavity of the PPF function).

What is stagflation and why does cost-push inflation cause stagflation?

Stagflation occurs when real GDP decreases and the price level rises. Cost-push inflation causes stagflation when aggregate supply decreases because a decrease in aggregate supply raises the price level and decreases real GDP.

Describe the alternative measures of unemployment.

Statistics Canada reports eight alternative measures of the unemployment rate: - R4 is the official rate. - R3 is comparable to the official US rate. - R1 shows long-term unemployment. - R2 shows short-term unemployment. - R5 adds discouraged searchers to R4. - R6 adds long-term future starts to R4. - R7 adds involuntary part-timers to R4. - R8 adds discouraged searchers, long-term future starts, and involuntary part-timers to R4.

How might using the Taylor rule improve the Fed's monetary policy?

Supporters of the Taylor rule argue that it works to limit fluctuations in inflation and output. It helps to reduce the uncertainty in the monetary policy.

What is the key idea of classical growth theory that leads to the dismal outcome?

The "dismal outcome" in classical theory is the conclusion that in the long run, real GDP per person equals the subsistence level. In classical growth theory, an increase in labour productivity leads to higher incomes, which causes population increases that return real GDP per person to the subsistence level because of diminishing returns to labour. In the classical growth theory, an increase in productivity increases the demand for labour. The real wage rate rises, and GDP increases. The increase in the real wage rate means that people's incomes rise, which then creates a population boom. The increase in population increases the supply of labour. Because of diminishing returns to labour, the increase in the supply of labour lowers the real wage rate. As long as the real wage rate remains above the subsistence level, population growth—and, hence, growth in the labour supply—continues. Eventually, the real wage rate falls to equal the subsistence level, at which time the population stops growing. Total GDP is higher than before the increase in productivity, but GDP per person is the same as before and is at the subsistence level.

Summarize the Bank of Canada's monetary policy decision-making process.

The Bank of Canada (along with most other central banks) follows a process that uses a targeting rule. A targeting rule is a decision rule for monetary policy that sets the policy instrument at a level that makes the forecast of the policy target equal to the target. Where the policy target is the inflation rate and the instrument is the overnight rate, the targeting rule sets the overnight rate at a level that makes the forecast of the inflation rate equal to the target for the inflation rate.To implement its targeting rule, the Bank of Canada gathers and processes a large amount of information about the economy, the way it responds to shocks, and the way it responds to policy. It then processes all this data and comes to a judgement about the best level for the overnight rate. The process begins with an exercise that uses a model of the Canadian economy that you can think of as a sophisticated version of the aggregate supply-aggregate demand model (see Chapter 26). The Bank's economists provide the Governor and Governing Council with a baseline forecast that has the overnight loans rate set at a level that hits the inflation target two years in the future. All the available regional, national, and international data on macroeconomic performance, financial markets, and inflation expectations are reviewed, discussed, and weighed in a careful, deliberative process that ends with the Governing Council finding a consensus on the interest rate level to set. After announcing an interest rate decision, the Bank engages in a public communication to explain the reasons for the Bank's decision.

What is the central bank in Canada and what functions does it perform?

The Bank of Canada is Canada's central bank, a public authority that supervises other banks and financial institutions, financial markets, and the payments system and conducts monetary policy. The Bank of Canada is the banker to banks and government, the lender of last resort, and the sole issuer of banknotes.

How do the Bank's actions influence real GDP and how long does it take for real GDP to respond to the Bank's policy changes?

The Bank of Canada's actions affect real GDP by changing expenditure plans. For instance, an expansionary policy by the Bank that lowers the interest rate increases consumption expenditure, investment, and net exports. All three of these changes boost aggregate demand so that real GDP growth increases. Because there are time lags in the process, real GSP initially responds about a year after the policy is initiated.

How do the Bank's actions influence the inflation rate and how long does it take for inflation to respond to the Bank's policy changes?

The Bank of Canada's actions affect the inflation rate and the price level by changing expenditure plans. For instance, an expansionary policy by the Bank that lowers the interest rate increases consumption expenditure, investment, and net exports. All three of these changes boost aggregate demand so that the price level rises and the inflation rate increases. Because there are time lags in the process, the price level initially responds about a year after the policy is initiated.

What are the Bank of Canada's two main policy tools?

The Bank of Canada's two main policy tools are the open market operation and bank rate.

What are the four main ways in which the CPI is an upward-biased measure of the price level?

The CPI is biased upward because of new goods, quality change, commodity substitution, and outlet substitution.

What is the CPI and how is it calculated?

The CPI is the consumer price index. The CPI equals (cost of CPI basket at current prices ÷ cost of CPI basket at base-period prices) × 100.

Does Canada have a stable short-run Phillips curve? Explain why or why not

The Canadian short-run Phillips curve shifts with changes in the expected inflation rate and the natural unemployment rate, so it is not stable.

What is the Laffer curve and why is it unlikely that Canada is on the "wrong" side of it?

The Laffer curve is the relationship between the tax rate and the amount of tax revenue. The amount of tax revenue increases with the tax rate only up to a certain tax rate, after which, further increases in the tax rate cause tax revenue to fall. When tax rates are higher than the tax rate that maximizes tax revenue, a country is said to be on the wrong side of the Laffer curve. It is unlikely that Canada is on the wrong side of the Laffer curve, because even though Canadian tax rates are among the highest in the industrial world, past changes in Canadian tax rates have produced changes in tax revenues in the same direction. This outcome does not occur when an economy is on the "wrong" side of the Laffer curve.

What is the Ricardo-Barro effect and how does it modify the crowding-out effect?

The Ricardo-Barro effect points out that the crowding-out effect is less than predicted by looking only at the effect of a budget deficit on the demand for loanable funds. The Ricardo-Barro effect asserts that as a result of a government budget deficit, households increase their saving to pay the higher taxes that will be needed in the future to repay the debt issued to fund the deficit. The increase in saving increases the supply of loanable funds. This increase in the supply of loanable funds offsets the rise in the real interest rate from the increase in the demand for loanable funds caused by the budget deficit. Because the real interest rate does not rise as much, the decrease in investment (i.e., the amount of crowding out) is less in the presence of the Ricardo-Barro effect.

Use the Rule of 70 to calculate the growth rate that leads to a doubling of real GDP per person in 20 years.

The Rule of 70 states that the number of years it takes for the level of any variable to double is approximately equal to 70 divided by the growth rate. If the level of real GDP doubles in 20 years, the rule of 70 gives 20 = 70 ÷ (growth rate), so the growth rate equals 70 ÷ 20, which is 3.5 percent per year.

What does the aggregate demand curve show? What factors change and what factors remain the same when there is a movement along the aggregate demand curve?

The aggregate demand curve shows the relationship between the quantity of real GDP demanded and the price level when other influences on expenditure plans remain the same. When there is movement along the aggregate demand curve, the price level changes, and other factors (such as expectations, fiscal and monetary policy, and the world economy) remain the same.

Why does the aggregate demand curve slope downward?

The aggregate demand curve slopes downward because of the wealth effect and two substitution effects. First, a rise in the price level decreases real wealth, which brings an increase in saving and a decrease in spending—the wealth effect. Second, a rise in the price level raises the interest rate, which decreases borrowing and spending—an intertemporal substitution effect, as people decrease current spending in favour of future spending—and increases the price of domestic goods and services relative to foreign goods and services, which decreases exports and increases imports—an international substitution effect.

What is the aggregate production function?

The aggregate production function is the relationship that tells us how real GDP changes as the quantity of labour changes, when all other influences on production remain the same.

What are the infant industry and dumping arguments for protection? Are they correct?

The attempt to stimulate the growth of new industries is the infant industry argument for protection, which states that it is necessary to protect a new industry from import competition to facilitate the growth of that industry, making it competitive in the world markets. This argument is based on the concept of dynamic competitive advantage (which was introduced in Chapter 2). Learning-by-doing is a powerful engine of productivity growth. However, the learning-by-doing argument for protection works only if the benefits also spill over into other industries and other parts of the economy. This is rarely the case, as the entrepreneurs of infant industries and their financial supporters take this risk into account, and all returns usually accrue only to them, not to other industries. And it is more efficient to subsidize the infant industry needing protection than it is to protect it by restricting trade.The dumping argument for protection states that a foreign firm is selling its exports at a lower price than its cost of production. Foreign firms trying to monopolize the international market may use this practice. Once the competition is gone, the foreign firm will raise prices and reap profits. This argument fails for several reasons. First, it is virtually impossible to detect the occurrence of dumping, since it is impossible to verify a firm's production costs. The test most commonly used is if the export price is lower than the import price. This test examines only the supply side of the two markets and ignores the demand side. If the domestic market is inelastic and the export market is elastic (which is almost always the case), then it is natural for a firm to price the domestic goods higher than the exports. Second, it is difficult to see how a global firm could have a monopoly for the goods or services it exports. There are too many foreign suppliers (and potential suppliers), making global competition too extensive for a monopoly to exist in the global market. And, even if there is global monopoly, it is more efficient to regulate it than to impose trade restrictions on its products.

Describe the trends and fluctuations in the Canadian unemployment rate since 1960.

The average unemployment rate between 1980 and 2014 was 7.6 percent. The unemployment rate increases in a recession, peaks after the recession ends, and decreases in an expansion. The unemployment rate was unusually high following the recessions of 1982 and 1991. The unemployment rate following the recession of 2008-2009 was less severe than the unemployment rates following the two earlier recessions.

What is a business cycle and what are its phases and turning points?

The business cycle is a periodic but irregular up-and-down movement of total production and other measures of economic activity. A business cycle has two phases: recession and expansion. The turning points are the peak and the trough. A business cycle runs from a trough to an expansion to a peak to a recession to a trough and then back to an expansion.

How does the production possibilities frontier illustrate production efficiency?

The combinations of outputs that lie on the PPF curve illustrate the concept of production efficiency. These points are the maximum production points possible and are attained only by producing the goods and services at the lowest possible cost. Any point inside the frontier reflects production where one or both outputs may be increased without decreasing the other output level. Clearly, such points cannot be production efficient.

How does the core inflation rate differ from the overall CPI inflation rate?

The core inflation rate excludes the eight most volatile elements components of the overall CPI inflation rate. Although the Bank watches the core inflation rate closely, it must take into account the possibility that the eight volatile elements that it excludes have a different trend inflation rate from the remaining items. As it turns out, between 1995 and 2000, the core and overall CPI trends were the same. But since 2000, the core rate has run at about 0.5 percent a year below the overall CPI inflation rate.

What is the crowding-out effect and how does it work?

The crowding-out effect refers to the decrease in investment that occurs when the government budget deficit increases. An increase in the government budget deficit increases the demand for loanable funds. As a result, the real interest rate rises. The rise in the real interest rate decreases—or "crowds out"—investment.

What are the transactions that the balance of payments accounts record?

The current account records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest paid abroad, and net transfers (such as foreign aid payments).The capital account records foreign investment in Canada minus Canadian investment abroad. Any statistical discrepancy is also recorded in the capital account.The official settlements account records the change in Canadian official reserves.

What are the influences on the demand for Canadian dollars in the foreign exchange market?

The demand for Canadian dollars depends on four main factors: the exchange rate, the world demand for Canadian exports, the interest rate in Canada and other countries, and the expected future exchange rate.

What determines the demand for labour, the supply of labour, and labour market equilibrium?

The demand for labour depends on the real wage rate. A fall in the real wage rate increases the quantity of labour demanded because of diminishing returns. The demand for labour also depends on productivity. If productivity increases, the demand for labour increases.The supply of labour also depends on the real wage rate. An increase in the real wage rate increases the quantity of labour supplied because more people enter the labour force, and the hours supplied per person increases.The real wage adjusts so that the labour market is in equilibrium. If the real wage rate is above (below) its equilibrium, there is a surplus (shortage) of labour that then causes the real wage rate to fall (rise). For example, if the real wage rate is above the equilibrium level, there is a surplus of labour, so the real wage rate falls until it reaches its equilibrium. The equilibrium quantity of employment is the full employment quantity of labour.

What determines the demand for loanable funds and what makes it change?

The demand for loanable funds depends on the real interest rate and expected profit. If the real interest rate falls and nothing else changes, the quantity of loanable funds demanded increases. Conversely, if the real interest rate rises and everything else remains the same, the quantity of loanable funds demanded decreases. Movements along the loanable funds demand curve illustrate these events. If the expected profit increases and nothing else changes, the demand for loanable funds increases, and the demand for loanable funds curve shifts rightward. If the expected profit decreases and everything else remains the same, the demand for loanable funds decreases, and the demand for loanable funds curve shifts leftward.

How do we calculate the effects of real GDP on consumption expenditure and imports by using the marginal propensity to consume and the marginal propensity to import?

The effects of real GDP on consumption expenditure and imports are determined respectively by the marginal propensity to consume and the marginal propensity to import. In particular, the effect of a change in real GDP on consumption expenditure equals the marginal propensity to consume multiplied by the change in disposable income. Similarly, the effect of a change in real GDP on imports equals the marginal propensity to import multiplied by the change in real GDP.

What is the equation of exchange?

The equation of exchange is the formula that MV = PY, where M is the quantity of money, V is the velocity of circulation, P is the price level, and Y is real GDP. The equation of exchange is always true by definition because the velocity of circulation is defined as PY/M.

How is the equilibrium exchange rate determined?

The equilibrium exchange rate is the exchange rate at which the quantity of Canadian dollars demanded equals the quantity of Canadian dollars supplied. At the equilibrium exchange rate, there is neither a shortage nor a surplus of Canadian dollars.

What is the equilibrium price of a good or service?

The equilibrium price is the price at which the quantity demanded by the buyers is equal to the quantity supplied by the sellers.

Why is the equilibrium price the best deal available for both buyers and sellers?

The equilibrium price reflects that the highest price consumers are willing to pay for that amount of the good or service, and it is just equal to the minimum price that suppliers would require for delivering it. Demanders would prefer to pay a lower price, but suppliers are unwilling to supply that quantity at a lower price. Suppliers would prefer a higher price, but demanders are unwilling to pay a higher price for that quantity. So neither demanders nor suppliers can do business at a better price.

What is the expenditure approach to measuring GDP?

The expenditure approach measures GDP by focusing on aggregate expenditures. Data are collected on the different components of aggregate expenditure and then summed. Specifically, the Bureau of Economic Analysis collects data on consumption expenditure (C), investment (I), government expenditure on goods and services (G), and net exports (NX). These expenditures are valued at the prices paid for the goods and services, called the market price. GDP is then calculated as C + I + G + NX.

What are the four special forms of the mainstream theory of the business cycle and how do they differ?

The four versions of the mainstream theory are the Keynesian cycle theory, the monetarist cycle theory, the new classical cycle theory, and the new Keynesian cycle theory. These theories differ according to the factors they believe are the most responsible for causing fluctuations in the growth of aggregate demand.Keynesian cycle theory asserts that fluctuations in aggregate demand growth are the result of fluctuations in investment driven by fluctuations in business confidence. The monetarist cycle theory says that fluctuations in both investment and consumption expenditure lead to fluctuations in aggregate demand growth and that the basic source of the fluctuations in investment and consumption expenditure is fluctuations in the growth rate of the quantity of money. New classical cycle theory claims that the money wage rate and the position of the short-run aggregate supply curve are determined by the rational expectation of the price level, which in turn is determined by potential GDP and the expected aggregate demand. As a result, only unexpected changes in aggregate demand growth lead to business cycles. Finally, new Keynesian cycle theory says that money wage rates and the position of the short-run aggregate supply are determined by rational expectations of the price level from the past. As a result, both expected and unexpected fluctuations in aggregate demand growth lead to business cycles.

What are the preconditions for labour productivity growth?

The fundamental preconditions for labour productivity growth are firms, markets, property rights, and money. These fundamental preconditions create an incentive system that can lead to labour productivity growth. Once these preconditions are in place, the sources of labour productivity growth are physical capital growth, human capital growth, and advances in technology. All of these activities enable an economy to grow, and they all increase labour productivity. They all also interact: human capital creates new technologies, which are then embodied in both new human capital and new physical capital.

Describe the situation in the market for a good or service that Canada exports.

The goods and services Canada exports are those in which Canada has a lower opportunity cost of production relative to other countries. In those markets, the Canadian no-trade price is lower than the world price. With trade, the quantity produced in Canada exceeds the quantity consumed, and the excess is exported.

Describe the situation in the market for a good or service that Canada imports.

The goods and services Canada imports are those in which Canada has a higher opportunity cost of production relative to other countries. In those markets, the Canadian no-trade price is higher than the world price. With trade, the quantity produced in Canada is less than the quantity consumed and the difference is imported.

Under what circumstances does the government have a budget surplus?

The government has a budget surplus when total revenues exceed total outlays.

What is the relationship between the growth rate of real GDP and the growth rate of real GDP per person?

The growth rate of real GDP tells how rapidly the total economy is expanding, while the growth rate of real GDP per person tells how the standard of living is changing. The growth rate of real GDP per person approximately equals the growth rate of real GDP minus the population growth rate.

What is the income approach to measuring GDP?

The income approach measures GDP by focusing on aggregate income. This approach sums all the incomes paid to households by firms for the factors of production they hire. Income is divided into five categories by the National Income and Product Accounts: compensation of employees, net interest, rental income, corporate profits, and proprietors' income. The sum of these income components does not quite equal GDP, because it values the output at factor cost rather than the market price and omits depreciation. So further adjustments must be made to calculate GDP: indirect taxes and depreciation must be added, and subsidies must be subtracted.

What are the effects of an increase in labour productivity on potential GDP, the quantity of labour, the real wage rate, and potential GDP per hour of labour?

The increase in labour productivity shifts the aggregate production function curve upward. It also increases the demand for labour, and the demand for labour curve shifts rightward. The increase in the demand for labour raises the real wage rate and increases employment. The increase in employment as well as the upward shift of the aggregate production function increase potential GDP. Real GDP per hour of labour increases.

How do we calculate the inflation rate and what is its relationship with the CPI?

The inflation rate is the percentage change in a price index from one year to the next. The rate of change of the CPI is often used as a measure of inflation as faced by consumers.

What makes an exchange rate hard to predict?

The influences of expectations and the constant arrival of news about the influences on supply and demand make day-to-day and week-to-week changes in the exchange rate impossible to predict.

What is the key proposition of new growth theory that makes economic growth persist?

The key proposition that makes growth persist indefinitely in the new growth theory is the assumption that the returns to knowledge and human capital do not diminish. As a result, increases in knowledge do not cause diminishing returns, and the incentive to innovate remains high. As people accumulate more knowledge, the incentive to innovate does not fall, so people continue to innovate new and better ways to produce new and better products. This innovation means that economic growth persists indefinitely.

Describe the trends and fluctuations in the Canadian employment-to-population ratio and labour force participation rate since 1960.

The labour force participation rate and the employment-to-population ratio show an upward trend before 1990 and then flatten off. The employment-to-population ratio fluctuates with the business cycle: it falls in a recession and rises in an expansion. The labour force participation rate has milder business cycle swings that reflect movements into and out of the labour force.

What is the law of demand and how do we illustrate it?

The law of demand states, "Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded." The law of demand is illustrated by a downward-sloping demand curve drawn with the quantity demanded on the horizontal axis and the price on the vertical axis. The slope is negative to show that the higher the price of a good, the lower is the quantity demanded and the lower the price of a good, the higher is the quantity demanded.

What is the law of supply and how do we illustrate it?

The law of supply states that "other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied." The law of supply is illustrated by an upward-sloping supply curve drawn with the quantity supplied on the horizontal axis and the price on the vertical axis. The slope is positive to show that the higher the price of a good, the greater is the quantity supplied, and the lower the price of a good, the smaller is the quantity supplied.

Does the quantity theory correctly predict the effects of money growth on inflation?

The long-run historical and international evidence on the relationship between money growth and the inflation rate support the quantity theory. The data suggest a marked tendency for nations with high money growth rates to have high inflation rates. Thus, the long-run cause of inflation is growth in the quantity of money.

What are the main components of money in Canada today?

The main components of money in Canada today are currency and deposits at banks and other depository institutions.

What are the main functions of markets?

The main function of a market is to enable buyers and sellers to get information and to do business with each other. Markets have evolved because they facilitate trade; that is, they facilitate the ability of buyers and sellers to trade with each other.

What are the main items of government revenues and outlays?

The main items of government revenues are personal income taxes, corporate income taxes, indirect and other taxes, and investment income. The main items of government outlays are transfer payments, expenditure on goods and services, and debt interest.

What are the three main types of markets for financial capital?

The main types of markets for financial capital are the loan markets, the bond markets, and the stock markets.

What is marginal benefit? How is it measured?

The marginal benefit of a good or service is the benefit received from the last unit consumed. It is measured by what an individual is willing to give up (or pay) for that last unit.

Define and explain how we calculate the marginal propensity to consume and the marginal propensity to save.

The marginal propensity to consume is the proportion of an increase in disposable income that is consumed. In terms of a formula, the marginal propensity to consume, or MPC, equals ∆C/∆YD where ∆ means "change in." The marginal propensity to save is the proportion of an increase in disposable income that is saved. In terms of a formula, the marginal propensity to save, or MPS, equals ∆S/∆YD which equals (1 − ∆C/∆YD). The sum of the MPC and the MPS is 1.0.

How do the marginal propensity to consume, the marginal propensity to import, and the income tax rate influence the multiplier?

The marginal propensity to consume, the marginal propensity to import, and the income tax rate all influence the magnitude of the multiplier. The multiplier is smaller when the marginal propensity to consume is smaller, when the marginal propensity to import is larger, and when the income tax rate is larger.

What is the loanable funds market?

The market for loanable funds is the market in which households, firms, governments, banks, and other financial institutions borrow and lend. It is the aggregate of all the individual financial markets and includes loan markets, bond markets, and stock markets. The real interest rate is determined in this market.

How does an open market operation change the monetary base?

The monetary base is the sum of Bank of Canada notes, coins, and depository institution deposits at the Bank of Canada. Depository institution deposits at the Bank of Canada are bank reserves. When the Bank of Canada conducts an open market operation, it buys securities and pays for them with newly created reserves, or it sells securities and is paid with reserves held by banks. In both cases, the monetary base changes.

What is the monetary base and how does it relate to the Bank of Canada's balance sheet?

The monetary base is the sum of Bank of Canada notes, coins, and depository institution deposits at the Bank of Canada. The Bank of Canada's liabilities together with coins issued by the Royal Canadian Mint make up the monetary base.

How is money market equilibrium determined in the short run?

The money market equilibrium occurs when the quantity of money demanded equals the quantity supplied. In the short run, demand for money curve is determined by real GDP, while the supply of money curve is determined by the Bank of Canada.

What is the distinction between a money price and a relative price?

The money price of a good is the dollar amount that must be paid for it. The relative price of a good is its money price expressed as a ratio to the money price of another good. Thus, the relative price is the amount of the other good that must be forgone to purchase a unit of the first good.

What is the multiplier? What does it determine? Why does it matter?

The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure and real GDP. A change in autonomous expenditure changes real GDP by an amount determined by the multiplier. The multiplier matters because it tells us how much a change in autonomous expenditure changes equilibrium expenditure and real GDP.

What is the natural unemployment rate?

The natural rate of unemployment is the unemployment rate when no cyclical unemployment exists; that is, when all unemployment is frictional or structural, the unemployment rate equals the natural rate of unemployment. Full employment occurs when there is no cyclical unemployment and the unemployment rate equals the natural rate of unemployment.

How does the production possibilities frontier illustrate opportunity cost?

The negative slope of the production possibility curve illustrates the concept of opportunity cost. Moving along the production possibility frontier, producing additional units of a good requires that the output of another good must fall. This sacrifice is the opportunity cost of producing more of the first good.

Why is the net gain from international trade positive?

The net gain from international trade is positive. In the case of imports, the consumer gains what the producer loses and then gains even more on the cheaper imports. In the case of exports, the producer gains what the consumer loses and then gains even more on the items it exports.

What is the Bank of Canada's monetary policy objective?

The objective of monetary policy as set out in the preamble to the Bank of Canada Act of 1935 is to "regulate credit and currency in the best interests of the economic life of the nation...and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action..." These words have come to mean that the Bank's job is to control the quantity of money and interest rates in order to avoid inflation and, when possible, prevent excessive swings in real GDP growth and unemployment. This emphasis on inflation has been made concrete by an agreement between the Bank of Canada and the Government of Canada.

What are the official measures of money? Are all the measures really money?

The official measures of money are M1 (the sum of currency outside banks, personal chequable deposits, and non-personal chequable deposits) and M2 (the sum of M1, personal non-chequable deposits, non-personal non-chequable deposits, and fixed term deposits). All of the components of M1 are truly money because all the components serve as a means of payment. Some of the components of M2 are not truly money because they are not a means of payment (e.g., funds savings deposits are not a means of payment). But all of these "nonmoney" assets are liquid assets and are very quickly converted into a means of payment. So the items in M2 are counted as money.

What is the Bank of Canada's record in achieving its inflation-control target?

The overall CPI inflation rate has only rarely gone outside the target range. The inflation rate has been both above target and below target on occasion, so there is no bias or tendency for inflation to be persistently above or below target. The Bank of Canada has done a remarkable job of holding inflation to its 2 percent target, with only small and temporary deviations from that goal.

How is the overnight rate determined in the market for bank reserves?

The overnight rate is determined by equilibrium in the market for reserves. The overnight rate is the rate that sets the quantity of reserves demanded equal to the quantity of reserves supplied.

What is the price level?

The price level is the average level of prices.

Define the quantity demanded of a good or service.

The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price.

What limits the quantity of money that the banking system can create?

The quantity of money that the banking system can create is limited by the monetary base, desired reserves, and desired currency holdings.

What are the main influences on the quantity of real money that people and businesses plan to hold?

The quantity of real money demanded depends on four factors: the price level, the nominal interest rate, real GDP, and financial innovation. An increase in the price level increases the nominal demand for money, but the quantity of real money demanded is independent of the price level. An increase in the nominal interest rate decreases the quantity of real money demanded because the nominal interest rate is the opportunity cost of holding money. An increase in real GDP increases the demand for real money because more real GDP implies more transactions and an increase in the demand for money to finance the transactions. And financial innovations that make it less costly to get by with less money on hand decrease the demand for money.

Define the quantity supplied of a good or service.

The quantity supplied of a good or service is the amount of the good or service that firms plan to sell in a given period of time at a specified price.

What is the quantity theory of money?

The quantity theory of money is the proposition that in the long run, an increase in the quantity of money creates an equal percentage increase in the price level.

What determines the real exchange rate and the nominal exchange rate in the short run?

The real exchange between Canada and Japan, RER, equals (E × P) ÷ P* where P is the Canadian price level, P* is the Japanese price level, and E is the nominal exchange rate in yen per dollar. In the short run, changes in the nominal exchange rate bring an equal change in the real exchange rate, because the price levels in Japan and Canada do not adjust instantly to a change in the nominal exchange rate. In the short run, the nominal Canadian exchange rate is determined in the foreign exchange market as the exchange rate that sets the quantity of Canadian dollars demanded equal to the quantity of Canadian dollars supplied.

How do changes in the demand for and supply of loanable funds change the real interest rate and quantity of loanable funds?

The real interest rate is determined by the supply of loanable funds and the demand for loanable funds. The equilibrium real interest rate is the real interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Changes in the demand for or supply of loanable funds change the equilibrium real interest rate and equilibrium quantity of loanable funds. If the demand for loanable funds increases (decreases), the real interest rate rises (falls), and the quantity of loanable funds increases (decreases). If the supply of loanable funds increases (decreases), the real interest rate falls (rises), and the quantity of loanable funds increases (decreases).

Why is the real interest rate the opportunity cost of loanable funds?

The real interest rate is the opportunity cost of loanable funds, because the real interest rate measures what is forgone by using the funds. If the funds are loaned, then the real interest rate is received. If the funds are borrowed, then the real interest is paid for the funds. The real interest rate forgone when funds are used either to buy consumption goods and services or to invest in new capital goods is the opportunity cost of not saving or not lending those funds.

Why was the U.S. recovery from the 2008-2009 recession so slow?

The reason is not clear, but critics of the Fed argue that the Fed itself contributed to the problem more than to the solution. Investment has not rebounded. The problem is that the extreme uncertainty about the future is keeping business investment low. Critics emphasize the need for greater clarity about monetary policy strategy.

Explain why a relative price is an opportunity cost.

The relative price of a good is the opportunity cost of buying that good because it shows how much of the next best alternative good must be forgone to buy a unit of the first good.

Why is opportunity cost a ratio?

The slope of the PPF is a ratio that expresses the quantity of lost production of the good on the y-axis when increasing the production of the good on the x-axis. The steeper the slope, the greater the ratio, and the greater is the opportunity cost of increasing the output of the good measured along the horizontal axis.

What are the influences on the supply of Canadian dollars in the foreign exchange market?

The supply of Canadian dollars depends on four main factors: the exchange rate, the Canadian demand for imports, the interest rate in Canada and other countries, and the expected future exchange rate.

What determines the supply of loanable funds and what makes it change?

The supply of loanable funds depends on the real interest rate, disposable income, expected future income, wealth, and default risk. An increase in the real interest rate increases the quantity of loanable funds supplied; a decrease in the real interest rate decreases the quantity of loanable funds supplied. An increase in disposable income increases the supply of loanable funds; a decrease in disposable income decreases the supply of loanable funds. An increase in wealth decreases the supply of loanable funds; a decrease in wealth increases the supply of loanable funds. An increase in expected future income decreases the supply of loanable funds; a decrease in expected future income increases the supply of loanable funds. Finally, an increase in default risk decreases the supply of loanable funds; a decrease in default risk increases the supply of loanable funds.

What are the alternative measures of the price level and how do they address the problem of bias in the CPI?

The textbook discusses two alternative price level measures to the CPI. The first alternative price level is the GDP deflator. The GDP deflator is an index of the prices of all the items included in GDP and is the ratio of nominal GDP to real GDP. To calculate the GDP deflator, divide nominal GDP by real GDP, and multiply by 100. Because real GDP includes consumption expenditure, investment, government expenditure, and net exports, the GDP deflator is an index of the prices of all these items. Real GDP is calculated using the chained-dollar method, which means that the weights attached to each item in the GDP deflator are the components of GDP in both the current year and the preceding year. Because it uses current period and previous period quantities rather than fixed quantities from an earlier period, a chained-dollar price index incorporates substitution effects and new goods and overcomes the sources of bias in the CPI.The second alternative price level is the chained price index for consumption (CPIC). The CPIC is 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. Because the CPIC uses both current-year and preceding-year quantities, rather than fixed quantities from an earlier period, it incorporates substitution effects and new goods and overcomes the biases in the CPI.

How is real GDP calculated?

The traditional method of calculating real GDP is to value each year's GDP at the constant prices of a fixed base year.

What are the two broad sources of potential GDP growth?

The two broad sources of growth in potential GDP are growth of the supply of labour and growth of labour productivity.

What generates economic growth?

The two key factors that generate economic growth are technological change and capital accumulation. Technological change allows an economy to produce more with the same amount of limited resources, but in a new way that increases output. Capital accumulation, including human capital, means that an economy actually has increased its available resources for production.

What are the two parts of the inflation-control target?

The two parts of the inflation-control target state that (1) the inflation-control target range will be 1-3 percent a year, and (2) policy will aim at keeping the trend of inflation at the 2 percent target midpoint.

How does the production possibilities frontier illustrate scarcity?

The unattainable combinations of production that lie beyond the PPF curve illustrate the concept of scarcity. There simply are not enough resources to produce any of these combinations of outputs. Additionally, moving along the PPF to increase the production of one good requires that the production of another good be reduced, and this also illustrates scarcity.

What problems arise from the CPI bias?

The upward bias in the CPI distorts private contracts and government outlays that include formulas based on CPI change as a measure of inflation. If the intent is to maintain the real value of a payment, indexing payments to the CPI will, in fact, increase the real value of payments over time if the CPI has an upward bias. In one year, the effect of the bias may not be much, but it will accumulate over time. Close to one-third of federal government outlays are indexed to the CPI.

How is the velocity of circulation calculated?

The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. The velocity of circulation equals (nominal) GDP divided by the quantity of money.

Can protection save jobs and the environment and prevent workers in developing countries from being exploited?

There are many myths about trade restrictions. The problem mentions three of them, all false reasons often offered as reasons to restrict international trade. These arguments are as follows: - Trade restrictions save domestic jobs. This argument ignores the fact that, under free trade, consumers in the importing country will have greater disposable income, and citizens in the exporting countries will have greater incomes. This means total demand for the goods and services that are exported by our domestic industry increases, increasing the number of jobs created in the domestic industries under free trade. - Trade restrictions penalize lax environmental standards. Not all developing countries have lax environmental standards. Also, a clean environment is a normal good. Countries that are relatively poor and have lax pollution standards do not care as much about the environment, because imposing clean air, water, and land standards has a high opportunity cost because it will slow economic development. The best way to encourage environmental quality is not to restrict economic development but to encourage rapid economic growth, which will more quickly increase citizen demand for a cleaner environment in those developing countries. - Trade restrictions prevent rich countries from exploiting poorer countries. Importing goods made in countries with low wage levels increases the demand for labor in those countries, increasing the number of jobs available and raising wages over time. The more free trade that occurs with these countries, the more quickly the wages will rise and the working conditions will increase in quality and safety.

What are the main reasons fro imposing a tariff?

There are two main reasons for imposing tariffs on imports: (1) the government receives tariff revenues from imports, which can be useful when revenues from income taxes and sales taxes are less effective ways of gaining government revenue, and (2) rent seeking by individuals in industries that would be hurt by foreign competition can influence the government to impose tariffs.

Explain the connection between the price of a financial asset and its interest rate.

There is an inverse relationship between the price of a financial asset and its interest rate. When the price of a financial asset rises, its interest rate falls. Similarly, when the interest rate on an asset falls, the price of the asset rises.

find some examples of scarcity in today's headlines

This was a headline in the National Post in July 2008: "Last-Frontier Forest Is at Risk From Boom." The story discussed how the "global resource boom is threatening one of the world's last tropical-forest frontiers: the Merauke region of Indonesia's remote Papua province." The story pointed out the scarcity of tropical rainforests as well as the scarcity of mineral reserves and how the two are colliding.

A bank manager tells you that she doesn't create money. She just lends the money that people deposit. Explain why she's wrong.

Though the manager does not see the entire process, the loans the manager makes nonetheless create more deposits and more money. Point out to the manager that when she makes a loan, the deposits at her bank do not change. And when the loan is spent, the recipient selling the goods or services that have been purchased will deposit part or all of the proceeds in his or her bank. When the recipient makes this deposit, the total amount of the nation's deposits increase, and, because deposits are part of the nation's money, the quantity of money also increases. However, actions of other economic agents also affect the creation of money. For example, if people decide to hold less currency and more deposits, the immediate effect on the quantity of money is nil. But over time, the quantity of money increases because banks gain more (excess) reserves, which are then loaned and then deposited, thereby creating additional deposits and increasing the quantity of money.

What makes the demand for Canadian dollars change?

Three factors change the demand for Canadian dollars: the world demand for Canadian exports, the interest rate in Canada and other countries, and the expected future exchange rate. If world demand for Canadian exports increases, the demand for Canadian dollars increases. If the interest rate in Canada rises relative to interest rates in other countries, the demand for Canadian dollars increases. And if the expected future exchange rate rises, the demand for Canadian dollars increases.

What makes the supply of Canadian dollars change?

Three factors change the supply of Canadian dollars: Canadian demand for imports, the interest rate in Canada and other countries, and the expected future exchange rate. If Canadian demand for imports increases, the supply of Canadian dollars increases. If the interest rate in Canada falls relative to interest rates in other countries, the supply of Canadian dollars increases. And if the expected future exchange rate falls, the supply of Canadian dollars increases.

How do firms make investment decisions?

To determine the quantity of investment, firms compare the expected profit rate from an investment with the real interest rate. The expected profit from an investment is the benefit from the investment. The real interest rate is the opportunity cost of investment. If the expected profit from an investment exceeds the cost of the real interest rate, then firms make the investment. If the expected profit from an investment is less than the cost of the real interest rate, then firms do not make the investment.

What adjustments must be made to total income to make it equal GDP?

Total income is net domestic product at factor cost. To convert it to GDP at market prices, we must add the depreciation of capital and add indirect taxes minus subsidies.

Why don't the winners from free trade win the political argument?

Trade restrictions are enacted despite the inherent inefficiency because of the political actions of rent-seeking groups, which fear that foreign competition might have a negative impact on their industry, firm, or jobs. The anti-trade groups are easily organized and have much to gain from trade restrictions, whereas the vast millions of consumers, who would win from free trade, are difficult to organize, because each individual has only a small amount of loss when trade restrictions are imposed. Hence, the winners from trade restrictions frequently out lobby the winners from free trade.

Describe the broad facts about what, how, and for whom goods and services are produced.

What gets produced today is significantly different than what was produced in the past. Today the economy produces more services (such as medical operations, teaching, and hair-styling) than goods (such as pizza, automobiles, and computers). Businesses determine how the factors of production (land, labour, capital, and entrepreneurship) are combined to make the goods and services we consume. Land includes all natural resources, both renewable natural resources, like wood, and nonrenewable natural resources, like natural gas. The quality of labour depends on human capital. Human capital obtained through schooling has increased over the years, with far more people completing high school and attending college and university than in past years. Finally, income distribution among a country's citizens determines whom goods and services are to be produced for. This distribution in Canada is not equal: the 20 percent of people with the lowest incomes earn about 5 percent of the nation's total income, while the 20 percent of people with the highest incomes earn about 44 percent of total income. On average, men earn more than women, and university graduates earn more than high-school graduates.

How is the gain from exports distributed between consumers and domestic producers?

When a good is exported, the price paid by the consumer rises, and the quantity consumed decreases. The consumer loses. When a good is exported, the price received by domestic producers rises, and the quantity produced increases. The producer gains.

How is the gain from imports distributed between consumers and domestic producers?

When a good is imported, the price paid by the consumer falls, and the quantity consumed increases. The consumer gains. When a good is imported, the price received by domestic producers falls, and the quantity produced decreases. The producer loses.

What is the opportunity cost of economic growth?

When a society devotes more of its scarce resources to research and development of new technologies or devotes additional resources to produce more capital equipment, it leads to increased consumption opportunities in future periods at the cost of less consumption today. The loss of consumption today is the opportunity cost borne by society for creating economic growth.

What happens when the Bank of Canada buys securities in the open market?

When the Bank of Canada buys government securities in the open market, it pays for its purchases by increasing banks' reserves. As a result, the quantity of reserves increases. When the Bank of Canada sells government securities in the open market, it receives payment in the form of banks' reserves. As a result, the quantity of reserves decreases.

Describe the channels by which monetary policy ripples through the economy and explain how each channel operates.

When the Bank of Canada lowers the overnight rate, other short-term interest rates also fall. As a result, the exchange rate falls because investors decrease their demand for Canadian dollars, since the interest yield on dollars is lower. When the Bank of Canada lowers the overnight rate, it does so by buying securities in the open market. Bank reserves increase so that banks have excess reserves. Because banks have excess reserves, they loan the excess. Loans increase, and a multiple expansion of the quantity of money results. The supply of loanable funds increases so that the long-term real interest rate falls, and consumption and investment increase. Net exports increase because of the lower exchange rate. All three of these changes increase aggregate demand, so real GDP growth and the inflation rate both increase.

What must happen to create a demand-pull inflation spiral?

When the economy is at an above full-employment equilibrium, the money wage rate rises, which decreases the short-run aggregate supply. The decrease in the short-run aggregate supply decreases real GDP and raises the price level. If nothing else changes, the price level eventually stops rising. To create a demand-pull inflation spiral, aggregate demand must persistently increase, and the only way in which aggregate demand can persistently increase is if the quantity of money persistently increases.

What is the Bank of Canada's monetary policy instrument?

While the Bank of Canada could use the quantity of money, the exchange rate, or a short-term interest rate, it chooses to use a short-term interest rate (in particular, the overnight rate). The overnight rate is the interest rate on overnight loans of reserves that members of the Large Value Transfer System (LVTS) make to each other.

Do interest rates fluctuate in response to the Bank of Canada's actions?

Yes, interest rates fluctuate in response to the Bank of Canada's actions. Indeed, the first effect of a change in monetary policy is a change in the overnight rate.

What is the operating band?

he operating band is the target overnight rate plus or minus 0.25 percentage points. It is a band that is 0.5 percentage points wide. The Bank of Canada creates the operating band by setting two other interest rates: bank rate and the interest rate on reserves.Bank rate is the interest rate that the Bank of Canada charges Large Value Transfer System (LVTS) banks on loans. If a bank is short of reserves, it can always obtain reserves from the Bank of Canada, but it must pay bank rate on the amount of borrowed reserves.The Bank of Canada sets bank rate at the target overnight rate plus 0.25 percentage points. Because the Bank of Canada is willing to lend funds to banks at this interest rate, bank rate acts as a cap on the overnight loans rate. If a bank can borrow from the Bank of Canada at bank rate, it will not borrow from another bank unless the interest rate is lower than or equal to bank rate.The Bank of Canada pays banks interest on their reserves at the Bank of Canada. The Bank calls these reserves "settlement balances," and the interest rate that they earn is the settlement balances rate. The Bank of Canada sets the settlement balances rate at the target overnight rate minus 0.25 percentage points, which also equals the low end of the Bank's target range for the overnight rate. If banks can earn the settlement balances rate from the Bank of Canada, they will not make overnight loans to other banks unless they earn a higher interest rate than what the Bank of Canada is paying. The operating band keeps the overnight rate to within 0.25 percentage points of its target.