Macroeconomics

Unit Two

Note: Unit 1 of macro is a review of topics already covered under micro Units 1 and 2.

Unit 2.1 – The Circular Flow and GDP

Gross Domestic Product (GDP) The market value of all final goods and services
produced in an economy in a given period of time. It
includes spending by the four components: C+I+G(X-M).

Market value is how much the time costs.

Final: Bought by the consumer, not the shop that is trying

to sell goods.

All production in Canada counts towards Canada’s

GDP no matter what nationality the company is.

Factors of Production

Factors of Production Factor Payments

Land (natural resources) Rent - payment made or income received in

exchange for natural resources.

Labour (human resources) Wages - payment made or income received

in exchange for labour.

Capital (man-made equipment that will Interest - payment made or income received
produce goods) in exchange for capital (includes dividends or
capital gains earned on stocks and shares of
a company).

Enterprise (entrepreneurs) Profits - the entrepreneur keeps what is left

over after paying rent, wages, and interest.

Capital gains - when your stock/share value goes up.

Simple Circular Flow

The circular flow model demonstrates how money moves through society. In its simplest form,
money flows from producers to households as payments for factors of production, and then it
flows back to producers as payment for goods and services.

In the simple circular flow model, it is assumed that the only economic decision makers are
households (or consumers) and businesses (or firms), and that these two groups are linked

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together through two markets: the resource market and the product market.
Business expenditures on the purchase of resources become factor incomes for households,
which in turn are put toward consumer expenditures on goods and services and become
revenues for businesses.

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Complete Circular Flow Model

The real-world economy is more complicated than this simple model suggests. In the real world,
we have financial markets, a government sector, and trade with other countries. To replicate this
in our model, we need to add some injections and leakages (withdrawals) to our circular flow.

Leakages Payments of income that enter into the circular flow from sources
outside of domestic businesses and households.

Injections Payments of income that enter into the circular flow from sources
outside of domestic businesses and households.

Households own a lot of stuff. They own stuff in their land. Owners and providers of all
resources.

Businesses are the buyers, they buy resources.

Households are the buyers in goods and services.

Businesses are the sellers in goods and services.

Leakages Injections

Savings Investment

Taxes Government Spending

Imports Exports

Savings This is the part of consumer income that is not spent on goods
and services, but instead, is saved. It leaks out of the circular
flow and generally into a financial intermediary (bank).

Investment This is spending by firms on the production of capital goods

(physical capital). It is shown as an injection from financial
intermediaries because it is often funded through borrowing.

Net Taxes Both households and businesses pay taxes to the

(Taxes - Transfer Payments) government. This is a leakage because it is money that is not
spent on goods and service (hoeshols) or resources
(businesses).

Government Spending The government uses its tax revenues to finance government
expenditures on things like healthcare, education, and national

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defense. This money is injected back into the circular flow.

They are getting something in return.

Transfer payments: payments made by the government for

which no goods or services were given in return. Welfare.

Imports These are goods and services produced in other countries and
purchased by domestic buyers. They are shown as a leakage
from households because the money flows out of our
economy.

Exports Goods purchased by foreign countries. Injection cause you

are getting money.

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Macroeconomic Equilibrium

If Leakages > Injections

The size of the circular flow decreases and the economy contracts.

If Leakages = Injections

The macro economy is in a state of equilibrium, and the size of the circular
flow does not change.

If Leakages < Injections

The size of the circular flow increases and the economy expands.

Fill in the missing labels in the complete circular flow diagram below:

Rent, wages, interest, and

Impor Expo

Househol Net Businesse

ds Gov’t Gov’t s (firms)
(consume spendi spendi

Final goods and services

Savings Financial Investme

Note: The circular flow of income shows that in any given time period (say a year), the value of
output produced in an economy is equal to the total income generated in producing that output,
which, if the macro economy is in equilibrium, is equal to the expenditures made to purchase
that output. Therefore, the term national income is sometimes used interchangeably with the
value of aggregate output.

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Practice Questions – Circular Flow of Income:

Use the following to answer questions 1-7:

1. Refer to the model on the previous page to answer this question. What are flows (1) and
(2) respectively?

A) Consumption expenditures and factor payments.

B) Consumption expenditures and goods and services.

C) Factor payments and factors.

D) Factor payments and goods and services.

E) Goods and services and consumption expenditures.

2. Refer to the model above to answer this question. What are flows (3) and (4) respectively?

A) Goods and services and factor payments.

B) Goods and services and factors.

C) Consumption expenditures and goods and services.

D) Goods and services and consumption expenditures.

E) Factor payments and factors.

3. Refer to the model on the previous page to answer this question. What is flow (5)?

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A) Imports. D) Loanable funds.

B) Investment. E) Consumption.

C) Exports.

4. Refer to the model on the previous page to answer this question. What is flow (6)?

A) Exports. B) Investments. C) Savings. D) Factor payments.

5. Refer to the model on the previous page to answer this question. What is box (7)?

A) Exports. D) Savings.

B) Financial intermediaries. (banks) E) Imports.

C) Investments.

6. Refer to the model on the previous page to answer this question. What is
(8)?

A) Investment. B) Savings. C) Imports. D) Financial intermediaries.

7. Refer to the model on the previous page to answer this question. What is flow (9)?

A) Savings. B) Imports. C) Factor services. D) Exports.

Extra Practice Questions – Circular Flow of Income:

1. Which of the following is necessary for national income to be in equilibrium?

A) S + IM + T = I + X + G.

B) S + IM + T = I + XN + G.

C) C + I + G = XN = GNP.

D) C + I + G + X = GDP.

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2. Which of the following is included by Statistics Canada in investment?

A) An increase in business inventories from one year to the next.

B) The purchase of any durable good, such as a car or television.

C) An increase in total saving in the economy.

D) The change in the value of mutual funds from one year to the next.

3. What do leakages from the circular flow diagram lead to?

A) An increase in wealth.

B) An increase in GDP.

C) A decrease in wealth.

D) A decrease in GDP.

E) An addition to loanable funds.

4. Under which circumstance will income in the circular flow diagram expand?

A) If exports increase. Injections

B) If savings expand.

C) If government spending is reduced.

D) If taxes increase.

E) None of the above.

5. What is the value of production?

A) It always equals total expenditures.

B) At equilibrium, it equals total expenditures.

C) It equals C + I + X.

D) It depends on the rate of savings.

E) It is determined by inventory changes.

Measures of Economic Activity

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Measurement of economic activity involves measuring an economy’s national income, or the

value of total (aggregate) output. The process for doing this is referred to as ‘national income
accounting’. Knowing national income is useful because it allows us to:

1. Assess an economy’s performance over time.

2. Make comparisons between economies

3. Make informed policy decisions to meet economic objectives.

There are three ways to measure the value of aggregate output, all of which give rise to the
same result:

The Expenditure Measures the total amount of spending to buy final goods and
Approach services in a country (usually within one year). Total spending is
broken down into four components: C + I + G + (X-M).

Consumption (C) Investment (I)

All purchases by households on Spending by firms on capital

final goods and services (except goods (i.e buildings, machinery,
housing, which is classified equipment, etc.), or spending on
under investment) new construction (i.e housing
and other buildings). Also
includes changes in value of
inventory.

Government Spending (G) Net Exports (X-IM)

Spending by any level of The value of all exports minus

government within a country on the value of all imports. Imports
resources, including labour must be excluded because they
services. It also includes ‘public do not reflect the value of
investment’, which is usually domestic production.
spending on capital goods like
roads or airports.

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The Income This approach adds up all income earned by the factors of production
Approach within a country over a given period of time (usually a year):

Wages Rent earned by Interest earned Profits earned

earned by land by capital by
labour entrepreneurs-
hip

When these figures are added up, the result is national income.

Note: National income is often used as a measure of economic

activity, but it is not the same as GDP. To calculate GDP using the
income approach, it is necessary to make some adjustments to
national income.

The Value-Added Rather than try to isolate only final goods and services, a more
Approach intuitive way to avoid double counting the value of intermediate goods
in GDP is to look at the value added for each good and service
(intermediate or not) produced at every stage in an economy. Value
added is simply the difference between the cost of inputs to
production and the price of output at any particular stage in the
overall production process.

Unit 2.2 – The Limitations of GDP

GDP vs. GNI or GNP

In theory, the value of output produced in an economy is equal to the total income generated in
producing that output.

However, in the real world, this equality does not always hold true, because sometimes the
output of an economy is produced by factors of production that belong to foreigners.

The value of output produced domestically is all counted in GDP, but some of the income
earned from that production will go to those foreign owners of FOP’s. See how the discrepancy
comes in between GDP and GNI?

Gross Domestic This approach looks at economic output by sector - agriculture,

Product (GDP manufactoring

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Gross National
Income (GNI)

The Limitations of GDP

1. Inaccuracies in data collection

2. Unrecorded or under-recorded economic activity/informal or parallel markets

3. Hidden economy (illegal activity, or legal activity done by illegal workers, or work
done where people want to avoid paying higher taxes)

4. External costs (like pollution or resource depletion are not taken into account)

5. Other quality of life concerns (GDP is not a perfect measure of living standards if it
doesn’t account for things like loss of leisure time)

6. Composition of output (does the economy’s output actually benefit consumers)

Practice Questions – Measuring Economic Activity:

Question One:

Following are national income accounts for a fictional economy (figures in $ billions).

Exports 204
Wages 965
Gross National Product 1586
Investment (net) 130
Consumption 1065
Corporate Profits Taxes 120
Depreciation 85
Indirect Business Taxes 256
Interest 45
Personal Income 1481
Gross Domestic Product 1725
Dividends Paid Out 76
Self-employed Income 60

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Other Income Not Paid Out 12
Transfer Payments 440
Personal Income Taxes 306
Personal Savings 110
Imports 99
Net Corporate Profits 148
Farmers’ Income 46

With this information, use the framework provided to calculate the value of each of the following:

a) Gross Investment _______________

b) Government Spending _______________
c) Net Exports _______________
d) Net Foreign Investment Income _______________
e) Net National Product _______________
f) National Income _______________
g) Gross Corporate Profits _______________
h) Net Domestic Income _______________
i) Undistributed Profits _______________

j) Disposable Income _______________

Question Two:

Following are some of the national income accounts for a fictional economy (figures in $
billions).

Net National Product 339

Farmers’ Income 15
Dividends Paid Out by Corporations 8
Investment (net) 35
Net Domestic Income 283
Disposable Income 260
Net Exports -15
Gross Corporate Profits 45
Investment (gross) 58
Government Spending 74
Interest 37
Government Transfer Payments 126
Gross National Product 362

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Other Income Not Paid Out 4
Self-employed Income 6
Income Taxes of Households 120
Personal Savings 27
Imports 57
Undistributed Corporate Profits 16

With this information, use the framework provided to calculate the value of:

a) Consumption _______________
b) GDP _______________
c) Depreciation _______________
d) Indirect Taxes _______________
e) National Income _______________
f) Wages _______________
g) Corporate Profits Taxes _______________
h) Personal Income _______________
i) Net Corporate Profits _______________
j) Net Foreign Investment Income _______________

Multiple Choice:

1. What is consumption?

A) The amount by which the capital stock is used up each year.

B) The amount by which the stock of consumer durables is used up each year.

C) The expenditure by households on final goods and services.

D) The expenditure by firms on final goods and services.

2. How is the GDP for Canada defined?

A) It is the market value of all final goods and services produced in Canada in a
given year.

B) It is the market value of all goods and services produced by Canadians in a

given year.

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C) It is the market value of all economic resources used in the production of a

year's output.

D) It is the market value of all goods and services, final and intermediate, produced
in Canada in a given year.

3. What does the term final goods and services mean?

A) Those goods and services which are unsold and which are therefore added to
inventories.

B) Those goods and services whose value has been adjusted for changes in the
price level.

C) Those goods and services purchased by the ultimate consumer.

D) The value of all finished products.

E) The value of all goods and services produced minus the value of government
services.

4. What would be the result if intermediate goods and services were included in the
calculation of GDP?

A) The GDP would have to be deflated by the inflation rate.

B) Real GDP would be greater than nominal GDP.

C) The GDP would be overstated.

D) The GDP would be understated.

5. All of the following, except one, are considered investment. Which is the exception?

A) The purchase of a new brewing tank by a brewer.

B) The purchase of government bonds by an investment dealer.

C) The construction by a contractor of an irrigation ditch for a farm.

D) The building of a school.

E) The accumulation of inventories on a retailer's shelf.

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6. Which of the following statements is relevant to the value of Canadian imports?

A) The imports figure is added to exports when calculating GDP because imports
represent spending by Canadians.

B) The imports figure is subtracted from exports when calculating GDP because
imports do not entail spending by Canadians.

C) The imports figure is subtracted from exports when calculating GDP because
imports do not involve production activity in Canada.

D) The imports figure is added when calculating GDP because imports do not
involve production activity in Canada.

E) The imports figure is added when calculating GDP, but subtracted when
calculating GNP.

7. What is the difference between GDP and GNP?

A) GDP includes depreciation, whereas GNP does not.

B) GDP includes net exports, whereas GNP does not.

C) GDP measures production in Canada, whereas GNP measures production by

Canadians.

D) GDP includes imports, whereas GNP does not.

8. What does the concept of net investment refer to?

A) The amount of capital stock used up in producing the current year's GDP.

B) The difference between the book value and the replacement value of all capital
stock.

C) Gross investment less exported capital goods.

D) Total investment less the amount of capital goods used up in producing the
year's output.

E) The amount of depreciation plus the amount of new investment during a given
year.

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9. What is the result if the inventory of goods grows from one year to the next?

A) Gross investment will exceed net investment by the amount of the inventory
increase.

B) The value of the inventory at the end of the current year should be part of the
year's GDP.

C) Inventories are not included in GDP since GDP measures only the value of
goods and services actually sold in a year.

D) It will be necessary to add the additional inventory to obtain this year's GDP.

E) It will be necessary to subtract the additional inventory to obtain this year's

GDP.

10. How could reported GDP remain constant when production has risen?

A) If the price level rises.

B) If the increase in production was in the form of a non-market activity.

C) If underground production fell.

D) If inventories fall.

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Unit 2.3 – Unemployment

Working-age Population In Canada, this is defined as the country’s total population

minus the following groups:

1. Those under 15 years of age;

2. Those living in the three territories or on aboriginal
reserves; and
3. Full-time residents of mental and penal institutions
or hospitals, and those in the armed forces.

Labour Force Members of the working-age population who are working or

actively seeking work. The labour force does not include
retirees, full-time students, stay-at-home parents, those who
are financially independent, etc.

Members of the labour force can either be employed or

unemployed.

Employed People who are in the labour force and hold paid employment (at
least one hour per week)

Unemployed People who are in the labour force, are actively seeking work, but
have less than one hour per week paid employment.

Unemployment Rate Formula Labour Force Participation Rate Formula

No. of people unemployed/total labour force Labour force/working-age population x100.

x100.

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Practice Questions – Unemployment Calculations:

Calculate the 2020 unemployment rate and labour force participation rate for Canada using the
numbers provided in the flowchart on the next page. Show your calculations in the table below.

Unemployment Rate Labour Force Participation Rate

Answer: __________ Answer: __________

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Limitations of the Unemployment Rate

Official unemployment statistics do not account for part-time workers, people who are
overqualified for their jobs, or for discouraged workers. In the table below, please explain what
each of these terms mean, and why the failure to account for them is an issue.

Part-time Employment Underemployment Discouraged Workers

People with part-time Unemployed statistics do not Individuals who want to

employment may struggle to account for people who are work, but are no longer
pay the bills, but the official overqualified for the work actively seeking employment
unemployment rate does they are doing. because they have become
not account for this. They frustrated due to the belief
are simply considered that no opportunity exists.
employed.
As soon as someone stops
actively seeking work, they
are no longer considered
part of the working force and
are not considered
unemployed.

Difficulties in Measuring Unemployment

1 Each country has its own system

· Censuses, surveys, number of people collecting social security or
unemployment insurance, and so on.

2 Hidden unemployment
· Discouraged workers, part-time employment, overqualified workers,
forced early retirement.

3 Work in black markets or informal markets

· Because this work is illegal, many will not admit to it and may appear
as unemployed.

4 Problem with averages

· Statistics often do not take into account regional, ethnic, age, or
gender disparities.

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Natural Rate of Unemployment

This occurs when an economy is at its full employment level of output (i.e. producing
somewhere along its PPC).

In theory, it is the level of unemployment at which the number of people unemployed is equal to
the number of job vacancies waiting to be filled. It just takes time or training to match the
unemployed people to those jobs.

The economy is at full employment when at its natural rate of unemployment. This does not
mean zero unemployment. It just means the economy is experiencing only the healthy kinds of
unemployment.

For most countries, the natural rate of unemployment is somewhere between 2% and 7%
unemployment. Where it lies, to some extent, depends on government policies and the kinds of
social programs available.

Types of Unemployment

Frictional Unemployment Structural Unemployment

Cyclical Unemployment
Included within the Natural Rate of Unemployment
(Also referred to as ‘Voluntary’ or ‘Equilibrium’
unemployment)

Describe the ‘natural’ kinds of unemployment in the spaces provided below.

Frictional Short term unemployment. People have the skills to do the job, but
Unemployment you are taking time to find the right job.

Short-term unemployment where people are between jobs, or

have just left school and are looking for their first job. Often this
involves people taking time to find a job that is the “right fit” for
their skills and training, allowing them to be more productive
contributors to the economy.

Structural There are jobs that are available but you don’t have the skills to do
Unemployment them.

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Exists when there is a permanent fall in the demand for a

particular type of labour. There is a mismatch between the skills of
unemployment workers and the jobs available, and it tends to be
more long term as retraining takes time.

Seasonal unemployment: The job you can work is only available during
certain times of the year (ski teacher, harvester).

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Solutions for Frictional and Structural Unemployment

In order to change the natural rate of unemployment in a country, the government needs to
consider the causes of frictional and structural unemployment and deal with those causes
directly. Some potential solutions for natural unemployment are:

1. Reduce unemployment of welfare benefits to encourage workers to spend less

time unemployed.

2. Offer government supported job placement websites or information centers to

help unemployed people find job vacancies.

3. Provide government funding for training programs to help unemployed workers

develop the skills needed by industries in which there are job vacancies.

4. Offer relocation support to help unemployed workers move to areas of the

country in which there are jobs available.

Cyclical There are no jobs for people to work.

Unemployment
Also called demand-deficient unemployment, this is associated
with downsings in the business cycle and is the type of
unemployment that policy makers aim to avoid at all costs.

As economic growth slows, AD falls as there is less C, I, G, and X;

this is likely to lead to a fall in the demand for labour as firms cut
production.

Solutions for Cyclical Unemployment

Cyclical unemployment occurs when there is insufficient demand for goods and services in
the economy, so the way to deal with it is to somehow stimulate demand.

Expansionary The federal government can increase government spending or

reduce taxes.

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Fiscal Policy

Expansionary The Central Bank (Bank of Canada/Federal Reserve) can

Monetary Policy reduce interest rates to encourage spending, or increase the
money supply.

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Consequences of Unemployment

The Consequences of Unemployment can be broken down into three categories as follows:

Costs to the people who are Less income / lower standard of living
unemployed

Long term health / relationship issues

Potential of being deskilled over time

Frustration / loss of self-worth

Costs to society Higher levels of poverty

Crime / drug use / alcoholism

Homelessness

Indebtedness

Neglect of families / children

Costs to the economy as a whole Actual output is less than potential output (operating
inside the PPC curve). This leads to a loss of real GDP
as AD fails.

Government deficit tends to rise - less tax revenue

from income/indirect taxes, and more G spending for
unemployment benefits, welfare, and social programs.

Increasing income and wealth gap between those who

are employed and those who are not

Brain drain may occur where skilled workers leave the

country in search of job opportunities abroad.

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Okun’s Law
The observation that for every 1% of cyclical unemployment, an economy’s GDP is 2.5% below
its potential. (Remember: any unemployment over and above the natural rate must be cyclical.)

Practice Questions – Unemployment:

1. What is the definition of the unemployment rate?

A) The ratio of unemployed to employed workers.

B) The number of employed workers minus the number of workers who are not in the
labour force.

C) The percentage of the labour force which is unemployed.

D) The percentage of the total population which is unemployed.

E) The percentage of the working age population which is unemployed.

2. What is meant by the participation rate?

A) The percentage of the population who are in the labour force.

B) The percentage of the working age population who are in the labour
force.

C) The percentage of the population who are in the working age

population.

D) The percentage of the labour force who are employed.

3. Which of the following is an example of a frictionally unemployed person?

A) A homemaker re-entering the labour force now that her children are older but who
has not yet found employment.

B) A middle-aged man who, having quit his previous job, is searching for something
more satisfying.

C) A contract college instructor who has left her job for a year and is looking for work at
another college.

D) A recent commerce graduate seeking her first job.

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E) All of the above.

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4. Which of the following people would be regarded as unemployed according to our

definition?

A) A steelworker who, laid off a year ago, has given up looking for a job.

B) A homemaker on vacation with the family.

C) A homemaker who does volunteer work with the local library.

D) A homemaker who works 5 hours per week at the minimum wage at the local library.

E) A retired schoolteacher who is seeking a part-time job at the local library.

5. Which of the following people would be regarded as employed according to our

definition?

A) A homemaker who works 14 hours a day taking care of the home and family.

B) A homemaker who does 5 hours of volunteer work each week at the local library.

C) A homemaker who works for 5 hours a week at the minimum wage for the local
convenience store.

D) A steelworker, laid off a year ago, who has given up looking for a job.

E) None of the above.

6. Which of the following is true of frictional unemployment?

A) It is an inevitable part of a market economy.

B) It is a result of the time needed to match people seeking employment with job
vacancies.

C) It often involves people seeking "the right job" rather than "just a job."

D) All of the above.

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7. Assume Brown is temporarily unemployed because she has voluntarily quit her job and
will begin a better job with a new company next week. What is Brown considered to be?

A) Cyclically unemployed.

B) Frictionally unemployed.

C) Not officially included in the labour force.

D) Employed.

E) Structurally unemployed.

8. What is the labour force status of a student who is looking for a job following
graduation from college?

A) She is not officially included in the labour force.

B) She is a part of structural unemployment.

C) She is part of cyclical unemployment.

D) She is part of frictional unemployment.

9. Thompson has lost his job at a Vancouver Island pulp mill which has closed
permanently. He is looking for work, but wants to go to college to study electronics
and eventually find a job in television engineering. At the moment, what can we say
about Thompson's employment status?

A) He is not officially included in the labour force.

B) He is cyclically unemployed.

C) He is structurally unemployed.

D) He is frictionally unemployed.

E) He is employed.

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10 What type of unemployment would result if an entire industry is eliminated because of

new technology?

A) Cyclical unemployment.

B) Frictional unemployment.

C) Structural unemployment.

D) Unemployment would not necessarily change.

11 Which of the following is included in the natural rate of unemployment?

A) Frictional unemployment only.

B) Frictional and structural unemployment.

C) Frictional, structural and cyclical unemployment.

D) None of the above.

12 What is meant by frictional unemployment?

A) Unemployment that is caused by the fact that it takes time for people to find their first job
or to move between jobs.

B) Unemployment which results from structural changes in an economy's industries.

C) Unemployment that occurs as a result of the recessionary phase of the business cycle.

D) Unemployment that occurs because people do not think that there are any jobs available.

13 What is meant by cyclical unemployment?

A) Unemployment that is caused by the fact that it takes time for people to find their first job
or to move between jobs.

B) Unemployment which results from structural changes in an economy's industries.

C) Unemployment that occurs as a result of the recessionary phase of the business cycle.

D) Unemployment that occurs because people do not think that there are any jobs
available.

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14 What is the natural rate of unemployment?

A) The unemployment rate experienced at the depth of a depression.

B) The full-employment unemployment rate.

C) The unemployment caused by frictional unemployment only.

D) The unemployment caused by structural unemployment only.

E) The amount of cyclical unemployment in an economy when frictional and structural

unemployment are both zero.

15 All of the following except one explain why there might be job vacancies even when
unemployment exists. Which is the exception?

A) Because the unemployed do not possess the necessary skills.

B) Because the unemployed do not possess the necessary experience.

C) Because the unemployed are unwilling to work.

D) Because the jobs and the unemployed might not be in the same area.

16 Suppose there are 2 million unemployed workers seeking jobs. After a period of time,
two hundred thousand of them become discouraged over their job prospects and stop
looking for work. What will the effect of this on the unemployment rate?

A) It will increase in the short run but would eventually decline.

B) It will increase.

C) It will fall.

D) It will be unchanged.

E) The question cannot be answered from this information.

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17 Suppose that in a particular economy there are 2 million part-time workers, 10 million
full-time workers, and 4 million unemployed. What is the effect on the unemployment
rate if 2 million of the part-timers become full-time workers?

A) It would decrease.

B) It would increase.

C) It would remain unchanged.

D) The size of the labour force will increase.

E) There will be no immediate change, but in the long run it will decrease.

18 Which of the following is true of official unemployment statistics?

A) They tend to understate the real amount of unemployment because individuals

receiving unemployment benefits are counted as employed.

B) They tend to understate the real amount of unemployment because "discouraged

workers" are not counted as unemployed.

C) They include both frictional and structural unemployment, but not cyclical
unemployment.

D) They tend to overstate the real amount of unemployment because workers who are
involuntarily working part-time are counted as being employed.

E) They tend to understate the real amount of unemployment because many people in
the underground economy declare themselves unemployed whereas they are actually
fully employed.

19 What is a discouraged worker?

A) An individual who wants to work but is no longer seeking employment because of the
conviction that no opportunities exist.

B) An individual who may or may not be employed.

C) An individual who is included in the unemployment statistics.

D) An individual who is not part of the working age population.

E) An individual who is employed but is seeking a different situation.

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Macroeconomics

20 Which of the following statements concerning discouraged workers in the economy is

true?

A) They increase the size of the labour force, but do not affect the unemployment rate.

B) They reduce the size of the labour force, but do not affect the unemployment rate.

C) They may cause the official unemployment rate to understate the real amount of
unemployment.

D) They may cause the official unemployment rate to overstate the real amount of
unemployment.

E) They do not affect the size of the labour force, but do cause the unemployment rate to
be higher than it would otherwise be.

21 What would be the effect of 100 000 discouraged workers entering the labour force?

A) Unemployment rates would remain unchanged, and the size of the labour force would
increase.

B) Both unemployment rates and the size of the labour force would increase.

C) Unemployment rates would increase, and the size of the labour force would remain
unchanged.

D) Both unemployment rates and the size of the labour force would decrease.

22 As far as official statistics are concerned, how are part-time workers categorized?

A) As unemployed, which means that the official unemployment rate tends to overstate
the real level of unemployment.

B) As unemployed, which means that the official unemployment rate tends to understate
the real level of unemployment.

C) As fully employed, which means that the official unemployment rate tends to overstate
the real level of unemployment.

D) As fully employed, which means that the official unemployment rate tends to
understate the real level of unemployment.

E) As fractions of a fully-employed worker.

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Macroeconomics

23. What would be the effect of 50 000 unemployed people becoming discouraged
workers?

A) The unemployment rate would remain unchanged, and the size of the labour force
would decline.

B) Both the unemployment rate and the size of the labour force would decline.

C) The unemployment rate would decline, and the size of the labour force would remain
unchanged.

D) Both the unemployment rate and the size of the labour force size would rise.

E) None of the above.

24. Why might the official unemployment rate be an understatement of actual levels?

A) Because both part-time workers and discouraged workers are included.

B) Because both part-time workers as well as those collecting EI but not actively
seeking work are included.

C) Because people working in the underground economy are not included.

D) Because part-time workers are considered employed, and discouraged workers are
not considered unemployed.

E) Because those not actively seeking work while collecting EI benefits and those in the
underground economy are included.

Use the following to answer question 25:

The following information is from a hypothetical economy (all figures are in millions):

Full-time employed 36

Part-time employed 8

Unemployed 6

Discouraged workers 10

Consumer Price Index 120

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Macroeconomics

25. Refer to the information above to answer this question. What is the current
unemployment rate?

A) 6%.

B) 10%.

C) 12%

D) 13.6%

E) 37.5%.

Unit 2.4 – Price Indices and Inflation

Inflation Sustained increase in the general level of prices for goods and
services in a country, measured as a percentage change. (Year2-
Year1)/Year1x100

Target inflation: 1-3%

Disinflation A decrease in the rate of inflation - a slowdown in the rate of increase

of the general price level of goods and services.

Deflation A decrease in the general price level of goods and services.

Deflation occurs when the inflation rate falls below 0%.

Consumer Price The consumer price index (CPI) measures the change in income a
Index consumer would need in order to maintain the same standard of living
over time under a new set of prices as under the original set of prices.
The CPI measures the cost of a fixed basket of goods and services in
a given year relative to the base year.

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Macroeconomics
Measuring Inflation Using the Consumer Price Index

Step 1:
A representative basket of goods and services is selected that reflects what a typical family of
four in a typical community would purchase on a regular basis. This basket is adjusted
periodically as new products are developed and/or consumer spending patterns change.

Step 2:
The average price of each item in the basket is determined.

Step 3:
Items in the basket are weighted based on frequency of purchase (how many times a typical
family of four would purchase each item in a given year). For example, the basket might include
200 rolls of toilet paper, 25 loaves of bread, and 10 T-shirts.

Step 4:
The cost of the overall basket of goods is calculated. This is the sum of the average price of
each good multiplied by its quantity.

Step 5:
The cost of the basket of goods is compared from one year to the next in order to develop the
consumer price index (CPI).

Step 6:
The percentage change in CPI figures from one year to the next, as well as from the base year
to any given year, is used to calculate inflation.

Note: The GDP Deflator is similar to the CPI except that the basket of goods and services
would be larger and would contain items purchased by business, government, and foreign
consumers as well as domestic consumers.

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Macroeconomics
Practice Question – Calculating a Consumer Price Index

The data in the table below shows the total output (a mixture of consumer goods, capital, and
government services), and the prices of each product for the distant country of Vindaloo (all
figures in billions of dollars, and the base year is 2010).

2010 2011 2012

Item Qty Price Nomi- Qty Price Nomi- Price Real Qty Price Nomi- Price Real
s nal s nal s GD s nal s GD
Year GDP Year GDP Year P Year GDP Year P
2010 2011 2010 2012 2010

Pizzas 30 $12 35 $13 40 $14

Movie 20 10 22 11 24 12
Tickets

Farm 3 100 4 95 4 110

Tractor
s

Parking 4 50 4 60 5 70
Meters

Totals

a) Complete the table and answer the following questions to one decimal place.

b) What is the value of nominal GDP in 2010: $__________, 2111 $__________, and
2012: $__________.

c) What is the value of real GDP in 2010: $__________, 2111 $__________, and 2012
$__________.

d) What is the value of the GDP Deflator in: 2010 __________, 2111 __________, and
2012 __________.

e) What is the inflation rate (using the GDP Deflator) in 2111 __________ %, and
2012 __________ %.

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Macroeconomics

f) Suppose that the representative consumer in Vindaloo buys only 5 units of each
consumer good. What is the cost of each consumer bundle in $__________, 2111
$__________, and 2012 $__________. (Note: there are only 2 goods in the consumer
bundle.)

g) Converting the cost of each consumer bundle into a consumer price index, what is
the value of the index in each year using 2010 as the base year?
2010 __________, 2111 __________, and 2012 __________.

h) What is the inflation rate using this consumer price index? 2111 __________ %, and
2012 __________ %.

Producer Price Index The Producer Price Index (PPI) measures the average
change over time in the selling prices received by domestic
producers for their output. In many cases, these products
and services are being sold from one business to another
rather than to the final consumer.

The PPI measures inflation from the perspective of costs to

industry or producers of products. Because it measures price
changes before they reach consumers, it is sometimes seen
as an earlier predictor of inflation than the CPI.
Note: You do not need to know how to calculate the PPI for
the AP course.

Calculating Inflation

Inflation Rate = (price index this year – price index last year) x 100
price index last year

Either the CPI or the GDP Deflator can be used for this calculation.

Real variables, such as real wages or real GDP, are the nominal variables deflated by the
price level (or price index).

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Macroeconomics
Shortcomings of the CPI as a True Measure of Inflation

Substitution Bias The substitution bias is a weakness in the CPI that overstates
inflation because it does not account for the substitution effect,
when consumers choose to substitute one good for another after
its price becomes cheaper than the good they normally buy.

Quality Inflation may be overstated if it does not take into account

improvements in the quality of a good or service.

Average Household Different households may experience inflation differently if their

spending patterns differ from the average household.

Regional and cultural Regional and cultural differences in prices may lead to people
differences experiencing inflation differently.

Changes in basket of Statisticians may be slowing in changing the basket of goods to

goods reflect changes in consumers’ spending habits.

Price volatility of Price of volatility of some goods, like oil or...

some goods

Causes of Inflation

Demand-pull inflation This type of inflation arises when aggregate demand in an

economy increases faster than aggregate supply.

Cost-push inflation This type of inflation is caused by an increase in the prices of

inputs like labour, law materials, oil, etc.

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Macroeconomics
Unit 2.5 – Consequences of Inflation
Nominal Interest Rate = Real Interest Rate + Inflation
Pension- The money earned by old people (retired people)
1. Effect on interest rates (central banks reset)

When inflation rates are increasing, central banks tend to raise interest rates to
combat rising prices. Higher interest rates increase the cost of borrowing.

2. Redistributive effects

When inflation is higher than anticipated

● Borrowers gain and lenders lose
● Businesses gain and workers lose
● People on fixed pensions lose while the organization paying the pension
gains.

3. Loss of purchasing power

As prices rise, what you can buy with a dollar of your income steadily decreases.

4. Erosion of savings (if interest rates are lower than the rate of inflation)

If your savings earn a lower interest rate than the rate of inflation, the real value of
your savings will decline.

5. Damage to export competitiveness

If prices are rising faster in our country than it is in others, our exports will become
less competitive on international markets.

6. Effect on unemployment and growth

The uncertainty created by unanticipated inflation makes businesses hesitant to

invest or hire, which negatively impacts on employment and economic growth.

7. Shoe leather and menu costs

Shoe leather costs come from the idea that, when unanticipated inflation occurs,
consumers put a lot of time and mileage into finding the best prices (thereby wearing
out their shoes). Menu costs have to do with the expense of reprinting menus,
catalogues, or signs.

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Macroeconomics

43
Macroeconomics
Solutions for Inflation

When prices are rising, policy makers want to slow down the economy and discourage
spending. The government can do this through the use of fiscal policy, and the central bank
through the use of monetary policy.

Contractionary Increase taxes to reduce C and I

Fiscal Policy Decrease government spending

Problems:
● Can be a politically unpopular solution
● Can lead to increased gap between the rich and the poor
● There is a time lag for implementation
● Impacts are hard to estimate

Controlled by government

Contractionary Increase interest rate to reduce C and I

Monetary Policy Decrease money supply to lower C

Problems:
● Higher interest rates can be a hard hit on those who have
existing loans
● Changing IR’s affect the exchange rate
Benefits:
● Monetary policy is quick to implement
● Better able to ‘fine tune’ the economy
● Central banks can act independent of government

Controlled by Bank of Canada / Federal Reserve

Central Bank

Deflation

Why is deflation not very common?

1. Wages do not easily fall, and since wages are a big part of production costs,
firms find it hard to lower prices.

2. Firms in oligopoly industries fear price wars if they lower prices.

44
Macroeconomics

3. Firms would have to absorb menu costs if they were to decrease prices.

45
Macroeconomics

Causes of Deflation

‘Good’ deflation “Good” deflation is caused by improvements in the supple

side of the economy (AS) and/or increased productivity (lower
minimum wage, lower oil prices, infrastructure improvements,
lower corporation taxes).

‘Bad’ deflation “Bad” deflation is caused by changes in the demand side

when a leftward shift in AD decreases in the APL.

But really, no deflation is good for the economy.

Costs and Consequences of Deflation

Some of the costs and consequences of deflation are as follows:

1. Cyclical unemployment (as consumers delay purchases of durables, AD falls

and firms are forced to retrench workers).

2. As AD falls, business confidence suffers and firms are less likely to put $ into
investment,

3. For those who have existing loans, the money they repay will be worth more
than the money they originally borrowed.

4. Savers and people on fixed incomes benefit.

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Macroeconomics
Practice Questions – Inflation:

Use the following to answer questions 1-3:

Assume that goods X, Y, and Z constitute a "market basket" used to compute a

price index and that 2001 is the base year.

Good Quantity in 2001 Price in 2001 Price in 2002

X 10 $8 $7

Y 2 $10 $16

Z 5 $4 $6

1. Refer to the information above to answer this question. What is the price index in 2001?

A) 22.

B) 120.

C) 115.

D) 100.

2. Refer to the information above to answer this question. What is the price index in 2002?

A) 132.

B) 112.

C) 110.

D) 29.

3. Refer to the information above for this question. What is the annual inflation rate in 2002?

A) 0%.

B) 10%.

C) 12%.

D) Cannot be determined from the information.

Use the following to answer questions 4-5:

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Macroeconomics
The following are selected statistics for a given year in a hypothetical
economy:

Nominal GDP $500 billion

Natural rate of unemployment 8%

Actual rate of unemployment 10%

GDP Deflator 115

4. Refer to the information above to answer this question. What is the size of the GDP
gap in percentage terms for this economy?

A) 0%. B) 2%. C) 5%. D) 8%. E) 4 %.

5. Refer to the information on the previous page to answer this question. What is the
amount of the GDP gap?

A) $20 billion. D) $25 billion.

B) $475 billion. E) $525 billion.

C) $435 billion.

Use the following to answer questions 6-8:

Assume an economy is producing only one product and that year 1 is the base
year. Output and price data for a five-year period are as follows:

Years Output Price

1 16 $8

2 20 9

3 25 10

4 30 15

5 33 12

6. Refer to the information above to answer this question. What is the price index for year 3?

A) 51.2.

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Macroeconomics

B) 125.

C) 195.

D) It cannot be determined from the information given.

7. Refer to the information above to answer this question. What is the nominal GDP in year 2?

A) $180.

B) $2250.

C) $2000.

D) $2500.

8. Refer to the information above to answer this question. What is the annual inflation rate in
2002?

A) 0%. B) 10%. C) 12.5%. D) Cannot be determined from the information.

9. What is the difference between nominal income and real income?

A) Nominal income is income earned before taxes, real income is income after
taxes.

B) Nominal income is income earned from all factor services, real income is
income earned from employment only.

C) Nominal income is the amount of income measured in base-year prices, real

income is income measured in current prices.

D) Nominal income is present dollar-value of income, real income is the

purchasing power of income.

10. What is the real rate of interest if the nominal rate of interest is 10% and the rate of
inflation is 4%?

A) 40%. B) 14%. C) 6%. D) 2.5%. E) It cannot be determined.

11. Assume that in 2003, prices increased by 2% over the previous year and the

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Macroeconomics

nominal rate of interest was 8%. In 2004, prices increased by 5%. If the real rate of
interest is to remain at the same level in 2004 as it was in 2003, then what would
the nominal interest rate in 2004 be?

A) 0%. B) 11%. C) 13%. D) 14%. E) 20%.

12. Which of the following people is least likely to be hurt by unanticipated inflation?

A) A retired lawyer who is living off accumulated savings.

B) An owner of a small electronics company.

C) A secretary working in a declining industry.

D) A former office manager living on a pension.

E) A non-unionized berry picker.

13. Why is deflation undesirable?

A) Because it causes a fall in real incomes.

B) Because it causes a fall in tax revenues.

C) Because it causes consumers to overspend.

D) Because it causes consumers to postpone spending.

14. Assume that the Consumer Price Index rises from 80 in one year to 88 in the next
year. What is the rate of inflation?

A) 10%. B) 20%. C) 12%. D) 6%. E) 8%.

15. Assume that between 1993 and 2003 the price level doubled. What is the
approximate average annual rate of inflation over this ten-year period?

A) 10%. B) 7%. C) 5%. D) 2%. E) 1%.

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Macroeconomics

16. What is demand-pull inflation caused by?

A) Excessive wage demands by labour unions which force up costs of

production.

B) High interest rates demanded by lenders.

C) Aggregate expenditures exceeding the economy's capacity to produce.

D) Attempts by firms to obtain increased profits.

E) The increased demand for imported goods.

Unit 2.6 – Real vs. Nominal GDP

We have defined Gross Domestic Product already in our introductory lessons on

macroeconomics. Our next step is to extend this by exploring the difference between nominal
and real GDP.
Gross National Product is everything produced by Canadian companies.
Gross Domestic Product is everything produced on Canadian land, regardless of what country
the company is from.
Definition Formula

Nominal GDP The market value of all final goods and Generally calculated using
services produced in an economy, the expenditure approach
regardless of the nationality of the to measuring economic
producer, over a given period of time activity.
measured in terms of current year
prices.

Real GDP We can see if we are either actually Real GDP = (Nominal
producing more or just inflation is GDP/GDP deflator) x 100
happening.

The market value of all final goods and

services produced in an economy over a
govern period of time, measured in terms
of base year prices. Real GDP removes
the effects of inflation.

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Macroeconomics

Real GDP per With Real GDP per capita, we factor in Per capita real GDP =
capita population growth by looking at the Real GDP/Population
average output of the economy per
person, measured in base year prices.

Economic Growth is defined as an increase in an economy’s capacity to produce goods and

services measured in terms of the percentage change in the real GDP per capita.
Definition Formula

Green GDP Green GDP accounts for the Green GDP = GDP -
environmental costs incurred from the environmental cost of
production of goods and services: production.

● Costs of damage caused by

pollution
● Costs of waste disposal
● Costs of clearing up
environmental damage

Green GDP will obviously be lower than

that calculated in the ways described so
far.

Practice Questions – Nominal GDP vs. Real GDP:

Use the following to answer questions 1-4:

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Macroeconomics

Below is some hypothetical data for the economy of Claymor:

2000 2001 2002

Nominal GDP ($ billions) 500 522 550

GDP Deflator 125 127 129

Population (in millions) 29 29.5 29.6

1. Refer to the data above to answer this question. What is the value of real GDP in 2000?

A) $13,793.

B) $17,240.

C) $400 billion.

D) $500 billion.

E) $625 billion.

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Macroeconomics

2. Refer to the data above to answer this question. What is the value of real GDP per
capita in 2000?

A) $13,793.

B) $17,240.

C) $400 billion.

D) $500 billion.

E) $625 billion

3. Refer to the data above for this question. What is the value of real GDP per capita in 2001?

A) $13,933.

B) $17,695.

C) $22,473.

D) $139,330.

E) $176,950.

4. Refer to the data on the previous page to answer this question. What is the growth
rate of real GDP per capita between 2000 and 2001?

A) – 1.0%.

B) + 1.0%.

C) + 1.7%.

D) + 2.8%.

E) + 4.4%.

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Macroeconomics
Use the following to answer question 5-6:

Year Nominal GDP Real GDP

(in $ billions) (in $ billions)

1999 $600 $600

2000 648 629

2001 701 658

2002 755 699

5. Refer to the information above to answer this question. What is the value of the
GDP deflator in 1999?

A) 0 B) 100.0

C) 104.8 D) 108.0

E) Cannot be determined from the information.

6. Refer to the information above to answer this question. What is the value of the
GDP deflator in 2001?

A) 93.9 B) 100.0

C) 104.6 D) 106.5

E) 108.2

7. If the real GDP per capita in 2001 is $32 000 and in 2002 it is $33 600, what is the
economic growth rate?

A) 4.8%

B) 5.0%

C) $1600

D) –4.8%

E) Cannot be determined without knowledge of the population size.

Unit 2.7 – Business Cycles

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Macroeconomics
Explaining the Business Cycle

Business cycles are fluctuations in aggregate output (measured by real GDP per capita)
and employment because of changes in aggregate supply and/or aggregate demand.

Phases of the Business Cycle

Recession Expansion

A period in which the economy is The phase of the business cycle where
producing below potential and has had real GDP per capita grows for two or
two consecutive quarters of negative more consecutive quarters, moving the
economic growth (falling real GDP per economy from a trough toward a peak.
capita).

Falling aggregate demand (as consumption This is typically accompanied by a rise in

and investment decrease) leads to higher employment and consumer confidence.
unemployment as firms lay off workers.
People spend even less as unemployment Expansion is also referred to as an
increases (which can lead to disinflation). economic recovery.

Turning Points of a Business Cycle

Trough Peak

This is where the economy hits a low point This is when economic growth is when an
in its contraction and economic growth economy hits its maximum rate. It is
begins to recover. generally characterized by increasing
employment and upward pressure on prices.
This is the turning point in a business cycle
between a recession and an expansion. This is the turning point in a business cycle
between an expansion and a recession.

Output Gaps

Actual Output Potential Output

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Macroeconomics

This is the real-life level of output that is The level of output an economy can achieve
currently being produced in an economy. It when it is producing at full employment (i.e.
could be below potential, at potential, or unemployment is at its natural rate). This is
temporarily beyond potential output. equivalent to being on the PPC line, and is
the highest level of output that can be
sustained over the long term.

What is the output gap?

Negative Output Gap Positive Output Gap

This is the difference between actual output This is the difference between actual output
and potential output when the economy is and potential output when the economy is
producing less than potential output. producing more than potential output.
Unemployment would be greater than its Unemployment would be below its natural
natural rate, meaning there would be some rate, and the economy would be operating
cyclical unemployment, and the economy outside of its PPC.
would be operating inside its PPC.

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Macroeconomics
Graphing the Business Cycle

Following is a business cycle diagram showing multiple recessionary and expansionary phases
and their corresponding trough and peak turning points.
Note: There is a long-term upward trend in the business cycle. (i.e. Each peak is a bit higher
than the previous peak.)

Practice Questions – Business Cycle

1. What is the business cycle?

A) The expansionary and contractionary phases in the growth rate of real GDP.

B) The expansionary and contractionary phases in the rate of

unemployment.

C) The continuous rise in GDP that Canada has experienced throughout the
Twentieth Century.

D) The rise and fall in the rate of inflation.

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Macroeconomics

2. What does it mean to say that the economy is in a contractionary phase of the
business cycle?

A) That real GDP per capita is declining.

B) That the rate of growth of real GDP per capita is falling.

C) That real GDP per capita is increasing

D) That the rate of growth of real GDP per capita is positive.

E) That inflation is declining.

3. All of the following, except one, refer to the total amount of production when all of
an economy's resources are being fully utilized. Which is the exception?

A) Equilibrium GDP. C) Potential GDP.

B) Full-employment GDP. D) Economic capacity.

Use the following to answer question 4:

4. Which of the following movements best illustrates an increase in potential GDP?

A) From PP1 to PP2. B) From A to B. C) From A to C. D) From B to C.

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Macroeconomics

5. All of the following, except one, are possible causes of the business cycle. Which is
the exception?

A) An increase in the economic growth rate.

B) A change in government spending.

C) A change in interest rates.

D) A change in the foreign demand for Canadian products.

E) A significant technological breakthrough.

6. Which of the following is true with regards to the business cycle?

A) It is in contraction when the economy reaches full employment.

B) It is a particular pattern of fluctuation in GDP.

C) It is in expansion when cyclical unemployment is rising.

D) It is in contraction when cyclical unemployment is rising.

E) It peaks when frictional unemployment exceeds structural unemployment.

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