Macroeconomics Review

10 Principles of Economics:
1. People face tradeoffs
Give up one thing to gain another
Guns and Butter
2. The cost of something is what you give up to get it
Opportunity cost
i. Whatever must be given up to obtain some item
3. Rational people think at the margin
Marginal changes: small incremental adjustments to a plan of action
A rational decision maker takes an action if and only if the marginal benefit of
the action exceeds the marginal cost
4. People Respond to Incentives
The effects of a goods price on the behaviours of buyers and sellers in a market
is crucial for understanding how the economy allocates scarce resources
5. Trade Can Make Everyone Better Off
By trading with others, people can buy a greater variety of goods and services at
a lower cost
6. Markets are Usually a Good Way to Organize Economic Activity
Market economy: an economy that allocates resources thru decentralized
decisions of many firms and households as they interact in markets for goods
and services
7. Governments Can Sometimes Improve Market Outcomes
2 reasons for a govnt to intervene:
i. To promote efficiency
ii. To promote equity
8. A Countrys Standard of Living Depends on Its Ability to Produce Goods and Services
Productivity: the quantity of goods and services produced from each hour of a
workers time
9. Prices Rise When the Government Prints Too Much Money
In almost all cases of large/persistent inflation, the reason is growth in the
quantity of money
10. Society Faces a Short-Run Tradeoff Between Inflation and Unemployment
Increasing the amount of money in the economy stimulates the overall level of
spending, thus the demands for goods and services.
More hiring means lower unemployment

Economic Models
They omit many details to allow us to see whats truly important
They are built with assumptions
Circular Flow Diagram:
Shows the dollar flow through markets among households and firms
Firms produce goods and services using inputs, such as labour, land, capital,etc.
o Called factors of production
Households own the factors of production and consume all the goods and services that
firms produce
Households and firms interact in 2 types of markets:
o Markets for goods and services (households are buyers, firms are sellers)
Households buy the outputs from the firms
o Markets for the factors of production (households are sellers, firms are buyers)
Households provide the inputs the firms use to produce goods/services
Inner loop represents the flows of inputs and outputs
Outer loop represents the corresponding flow of dollars

PPF (Production Possibilities Frontier) Graphs:
A graph that shows the combinations of output that the economy can possibly produce
given the available factors of production and the available production technology
An outcome is said to be efficient if the economy is getting all it can from the scarce
resources it has available

Positive vs. Normative Analysis:
Positive: claims that attempt to describe the world as it is
o Descriptive and scientific
Normative: claims that attempt to prescribe how the world should be
o Keywords: should, better, good, and improved
Specialization and Trade
Trades offer combinations that would otherwise be unattainable
Absolute Advantage: the comparison among producers of a good according to their
productivity
Means the person with absolute advantage requires less time to produce a unit of a
good
Opportunity Cost: whatever must be given up to obtain some item
To calculate: take the second column and divide it by the first, thats the opportunity
cost for the 1
st
column. For the second column, its just the reciprocal
Basically, for every amount of time you spend on one good, you sacrifice what you could
be spending on another (see defn)
Comparative Advantage: the comparison among producers of a good according to their
opportunity cost
Reflects relative opportunity cost
No one can have comparative advantage in both goods
Specialization is based on comparative advantage. If you specialize in what you have
comparative advantage in, total production in the economy rises.
The Price of Trade:
for both parties to gain from trade, the price at which they trade must lie between the
two opportunity costs
trade makes everyone better off because it allows people to specialize in those activities
in which they have a comparative advantage
the principle of comparative advantage applies to countries as well as to people

Supply and Demand
Markets:
a group of buyers and sellers of a particular good or service
o buyers as a group determine demand
o sellers as a group determine supply
Competitive Market
a market in which there are many buyers and many sellers so that each has a negligible
impact on the market price
assumed to be perfectly competitive
o the goods offered for sale are all the same
o the buyers and sellers are so numerous that no single buyer or seller has any
influence over the market price
a monopoly is when a market only has one seller, and that seller sets the price
Demand
quantity demanded: the amount of a good that buyers are willing and able to purchase
o falls as price rises and rises when price falls
Law of Demand: when the price rises, demand falls. When the prices lowers, demand
rises.
Demand Schedule: a table that shows the relationship between the price of a good and
the quantity demanded
Demand Curve: a graph of the relationship between the price of a good and quantity
demanded
Market Demand: to find market demand, add the x values for individual demand curves
Shifts in the demand curve:
o Any change that increases the quantity demanded, shifts curve to the right and is
called an increase in demand
o Any change that reduces the quantity demanded, shifts curve to the left and is
called a decrease in demand
Variables that can cause a shift in demand:
o Income
Normal good: a good in which increase in income creates increase in
demand
Inferior good: a good for which an increase in income leads to decrease in
demand
o Prices of Related Goods
Substitutes: 2 goods for which an increase in price of one leads to an
increase in demand for the other
Complements: 2 goods for which an increase in the price of one leads to
a decrease in demand for the other
o Tastes
Based on historical and psychological forces
o Expectations
Expectations of the future may affect your demand for a good/service
today
Ex. Expected income increase, expected price decrease, etc.
o Number of Buyers
The more buyers, the more quantity demanded, and vice versa
Supply
Quantity supplied: the amount of good that sellers are willing and able to sell
o Quantity supplied rises as price rises
Law Of Supply: the quantity supplied of a good rises when the price of the good rises
Supply Schedule: a table that shows the relationship between the price of a good and
the quantity supplied
Supply Curve: a graph of the relationship between the price of a good and the quantity
supplied
Market Supply: the sum of all the supplies of all sellers
o Add the x values of individual supply curves
o Shows how the total quantity supplied varies as the price of the good varies
Shifts in the supply curve
o Any change that raises quantity supplied shifts the supply curve to the right, and
is an increase in supply
o Any change that reduces the quantity supplied shifts the supply curve to the left,
and is called a decrease in supply
Variables that cause shifts in supply curves:
o Input prices
The supply of a good is negatively related to the price of inputs used to
make the good
o Technology
Increases in technology reduces the amount of labour necessary,
therefore raising the supply
o Expectations
If prices are expected to rise, some goods may be stored and less sold to
the public at the present
o Number of Sellers
The lower amount of sellers means less supply, and vice versa
Supply and Demand Together
Equilibrium: a situation in which the price has reached the level where quantity supplied
equals the quantity demanded
Equilibrium price: the price that balances the quantity supplied and quantity demanded
Equilibrium quantity: the quantity supplied and the quantity demanded at the
equilibrium price
Surplus: the situation in which quantity supplied is greater than quantity demanded
Shortage: the situation in which quantity demanded is greater than quantity supplied
Law of Supply and Demand: the claim that the price of any good adjusts to bring the
quantity supplied and the quantity demanded for that good into balance
Three steps to analyze changes in equilibrium:
o Decide whether event shifts the supply or demand curve (or both)
o Decide which direction the curve shifts in
o Use the supply/demand diagram to see how shift changes equilibrium price and
quantity
Measuring a Nations Income
To judge a nations overall economy, one looks at the total income that everyone in that
economy is earning
o GDP (Gross Domestic Product)
GDP measures 2 things at once:
o The total income of everyone in the economy
o The total expenditure on the economys output of goods and services
o For an economy as a whole, income must equal expenditure
o A circular flow diagram can be used to illustrate this
GDP:
o The market value of all final goods and services produced within a country in a
given period of time
market value.. means GDP adds together many different kinds of
products into a single measure of the value of economic activity, using
market prices
..of all.. means GDP is comprehensive, including all the items produced
in the economy and sold legally in markets
GDP excludes: most items produced and sold illicitly, such a drugs.
Also excludes items that are produced and consumed at home
(b/c they never enter the market place)
..Final.. means GDP only counts the final goods (i.e the greeting card,
not the greeting card and the paper used to produce the card)
Important exception: when an intermediate good is produced and
put into inventory or storage to be used later
goods and services means GDP includes tangible and intangible
goods and services.
Produced means that GDP includes goods and services that are
being currently produced. Ex: used car sale not included in GDP
Within a country means that GDP measures the value of production
within the confines of a country geographically.
Components of GDP:
Y= C + I + G + NX
Consumption: spending by households on goods and services, with the exceptions of
purchasing new housing
Investments: spending on capital equipment, inventories, and structures, including
household purchases of new housing
Government Purchases: spending on goods and services by local, territorial, and federal
goverments
Net Exports: the value of the Nations exports minus the value of its imports, also called
trade balance
Real vs. Nominal GDP
Nominal GDP: the production of goods and services valued at current prices
o Prices of goods/services change from year to year
Real GDP: the production of goods and services valued at constant prices
o Calculated by choosing a base year price
GDP Deflator
A measure of the price level calculated as the ratio of nominal GDP to real GDP times
100.
1. GDP deflator = Nominal GDP / Real GDP x 100
Inflation Rate
The percentage change in some measure of the price level from one period to the next
1. Inflation Rate in Yr 2= (GDP Deflator Yr 2- GDP Def. Yr 1)/ GDP Def. Yr 1 x 100
Measuring the Cost of Living
Consumer Price Index (CPI)
A measure of the overall cost of the goods and services bought by a typical consumer
How to calculate:
1. Determine the basket
2. Find the prices
3. Compute the baskets cost
4. Choose a base year and compute the index
CPI= Price of basket of goods/services in current year / price of basket in base year x100
Inflation rate of CPI = (CPI in yr 2-CPI in yr 1 )/ CPI in yr 1 x 100
Real and Nominal Interest
Nominal interest: the interest as usually reported without correction for the effects of
inflation
Real interest: the interest rate corrected for the effects of inflation
Real Interest Rate= Nominal Interest rate- Inflation Rate




Chapters 7-11
Financial system: a group of institutions in the economy that help to match one persons saving
with another persons investment
Saving and Investment
Financial Markets direct link between borrowers and savers
Bond market
o Loan
o Large businesses, governments
o Long term, low risk
Stock market
o Ownership
o Profit (dividends) or capital gain
o Risk of capital loss
o The return on stocks is greater than bonds because they are riskier and because
of bankruptcy laws
Financial Intermediaries- indirect link between borrowers and savers
Banks
o Provide loans
o Deposit from savers
Mutual funds actively managed
o People with small amounts of money to buy stocks together
o ETF index fund
National Saving: the total income in the economy that remains after paying for consumption
and government purchases
Private Saving: the income that households have left after paying for its spending
Public Saving: the tax revenue that the government has left after paying for its spending
Budget Surplus: the excess of tax revenue over government spending
Budget Deficit: a shortfall of tax revenue from government spending
Saving=Investment
S=(Y T C) + (T G) Budget Surplus: T>G ; budget deficit G>T
First part: Y= income households receive, T= taxes they pay, C= consumption
Second Part: T= tax revenue government receives, G= money spent on goods and services
Market for Loanable Funds
Saving is the source of supply for the graph
Investment is the source of demand for the graph
Supply:
Positive slope
Comes from people who have extra income they want to save and lend out
Lending can occur directly, like when a household buys a bond from a firm
Occurs indirectly when households make deposits to banks
Demand:
Negative slope
Firms must borrow to invest
Interest rate increases, borrowing becomes more expensive



Unemployment and Its Natural Rate
Adult Population (15 or older) is grouped into 3 categories:
1. Employed
If the person spent some of the previous week working at a paid job
2. Unemployed
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loanable funds
Market for Loanable Funds
Saving
Investment
If the person is on temporary layoff or is looking for a job
3. Not in the labour force
A person who is neither employed nor unemployed
Full-time student, homemaker, retiree
Labour Force: the total number of workers, including both the employed and the unemployed
Non-institutional adults
Includes anyone 15 years or older
People in military arent included
o They cant quit, therefore arent competing in the job market
Unemployment: the percentage of the labour force that is unemployed
**** unemployed not employed
Labour Force Participation Rate: the percentage of the adult population that is in the labour force

Discouraged Workers: individuals who would like to work but have given up looking for a job
Underemployment:
o Part-time work when they want full time
o Below skill level of worker
There are 3 types of unemployment:
1. Cyclical unemployment: the deviation of unemployment from its natural rate
a. Associated with business cycles
2. Frictional unemployment: unemployment that results because it takes time for workers to
search for the jobs that best suit their tastes and skills
a. Seasonal, search, long-run changes in economy
3. Structural unemployment: unemployment that results because the number of jobs available in
some labour markets in insufficient to provide a job for everyone who wants one
a. Quantity of labour supplied > demanded
Employment Insurance (EI): a government program that partially protects workers incomes when they
become unemployed
The higher and longer EI is paid, the higher the unemployment rates
Unions: a worker association that bargains with employers over wages and working conditions
Like a cartel, a group of sellers acting together in the hope of exerting their joint market power
Collective Bargaining: the process by which unions and firms agree on terms of employment
Efficiency Wages: above-equilibrium wages paid by firms in order to increase productivity
Firms operate more efficiently by increasing worker wages
Why Firms Pay Efficiency Wages:
1. Worker health
2. Worker turnover decreases
3. Worker effort increases, shirking decreases
4. Worker quality
Money and Prices in the Long Run
Money:
an asset regularly used to buy goods and services
has 3 functions:
1. medium of exchange
2. unit of account
3. store of value
liquidity: the ease with which an asset can be converted into the economys medium of
exchange
when prices rise, the value of money falls
Commodity Money: money that takes the form of a commodity with intrinsic value
intrinsic: has value even if it isnt being used for $
Fiat Money: established as money by government decree, with no intrinsic value
The quantity of money circulating an economy is called money stock.
Currency (c): paper bills and coins in the hands of the public
Demand Deposits (d): the balances in bank accounts that depositors can access on demand by writing a
cheque or using a debit card
M=C+D
The Bank of Canada
the central bank in Canada, responsible for controlling the stock of money
Central bank: an institution designed to regulate the quantity of money in the economy
The bank of Canada has four jobs:

1. To issue currency
2. To act as a banker for commercial banks
3. To act as a banker for the Canadian government
4. To control the quantity of money thats available in the economy
Money supply: the quantity of money available in the economy
Monetary policy: the setting of the money supply by policymakers in the central bank
100% Reserve Banking:
Reserves: Deposits that banks have received but have not loaned out
T-account: A chart that shows changes in a banks assets and liabilities (which will perfectly balance)
If banks hold all deposits in reserve, banks do not influence the supply of money
Fractional Reserve Banking:
A banking system in which banks hold only a fraction of deposits as reserves
Reserve ratio: the fraction of deposits that banks hold as reserves
o Determined by a combination of govnt regulation and bank policy
The T-account will have reserves and loans under assets, which will total to the amount of
deposits
When banks hold only a fraction of deposits in reserve, banks create money
The Money Multiplier:
The amount of money the banking system generates with each dollar of reserves
Its the reciprocal of the reserve ratio
Money and Prices in the Long Run
The overall level of prices adjusts to the level at which the demand for money equals the supply

Quantity theory of money: a theory asserting that the quantity of money available determines the price
level and that growth rate in the quantity of money available determines the inflation rate

The Classical Dichotomy and Monetary Neutrality:
All economic values should be divided into 2 groups:
o Nominal variables- variables measured in monetary units
o Real variables- variables measured in physical units
Classical Dichotomy: the theoretical separation of nominal and real variables
Changes in the supply of money affects nominal variables but not real variables
Monetary Neutrality: the proposition that changes in the money do not affect real variables
Velocity and Quantity Equation:
Velocity of money: the rate at which money changes hands
V= (P x Y) / M
o P= price level (GDP deflator) ; Y= quantity of output (real GDP) ; M= Quantity of money
Inflation Tax:
The revenue that the government raises by creating money
There are three ways for government to raise revenue:
o Direct taxes
o Borrowing (which results in future tax)
o Printing money (tax on money)
Hyperinflation: inflation that exceeds 50% per month
Fisher Effect:
Nominal interest rate = real interest rate+ inflation rate
In the long run, a change in money growth does not affect the real interest rate
Fisher Effect: the one for one adjustment of the nominal interest rate to the inflation rate
Costs of inflation:
Shoeleather Costs
Menu costs
Relative price changes
Tax distortions
Confusion and inconvenience