Chapter 19: What Macroeconomics Is All About

Macroeconomics: The study of the determination of economic aggregates, such as total output,
total employment, the price level, and the rate of economic growth, the examination of the
economy as a whole (the big picture)
A full understanding of macroeconomics requires understanding the nature of short-run
fluctuations as well as the nature of long-run economic growth.
Key Macroeconomic Variables
Output and Income
National Product (Output): The value of a nations overall level of economic activity
The production of goods and services generates income
For the nation as a whole, all of the economic value that is produced ultimately belongs
to someone in the form of an income claim on that value
The value of national product = The value of national income
National Income
To measure national income, add up the values of the many different goods and
services that are produced
Nominal National Income
National income measured in current dollars
Number of units of each good produced x Price at which each unit is sold
A change in NNI is caused by a change in either the quantities or prices on which
it is based
Not comparable across various years
Real National Income
National income measured in constant (base-period) dollars
Number of units of each good produced x Base-period price
The sum of quantities valued at prices that prevailed in the base period
Since prices are held constant, changes in RNI from one year to another reflect
changes in only quantity
Comparable across various years
Gross Domestic Product (GDP)
One of the most commonly used measures of national income
The total value of goods and services produced within a country in 1 year
Can be measured in either nominal or real terms
Recession: A fall in the level of real GDP, known as 2 consecutive quarters of negative
GDP (real GDP falls)

Potential Output and the Output Gap

National Output / National Income: What the economy actually produces, Y
Potential Output: The real GDP that the economy could produce if all resources - land,
labor, and capital were fully employed, Y*
The value of potential output must be estimated using statistical techniques, whereas
the value of actual output can be measured directly
Output Gap: The difference between potential output and actual output, Y - Y*
Recessionary Gap: A situation in which actual output is less than potential output, Y < Y*
(Market value of goods and services that are not produced because the economys
resources are not fully employed)
Inflationary Gap: A situation in which actual output exceeds potential output, Y > Y*
(Market value of production in excess of what the economy can produce on a sustained
basis)
Y can exceed Y* because workers may work longer hours or factories may operate an
extra shift, usually causing an upward pressure on price
The Business Cycle
Business Cycle: Fluctuations of national income around its trend value that follow a
more or less wavelike pattern

Income per person (real per capita national income) is essentially equal to our standard of living.
Employment, Unemployment, and the Labor Force
National income and employment are closely related - If more output is to be produced,
more workers must be used in production (+ in employment) or existing workers must
produce more (+ in productivity)
In the short run, changes in output are accomplished by changes in employment
In the long-run, changes in both employment and productivity are significant

 Employment: The number of people 15 years or older who have jobs

Unemployment: The number of people 15 years or older who are not employed and are
actively searching for a job
Labor Force: The number of people employed plus the number of people unemployed
The labor force and employment have grown since 1960 with only a few interruptions
Unemployment Rate: Unemployment expressed as a percentage of the labor force

Frictional, Structural, and Cyclical Unemployment

Frictional Unemployment: Employment that arises from the normal turnover over labor
(new people enter the workforce, some people quit their jobs, some people are fired - it
takes time for these people to find jobs)
Structural Unemployment: Unemployment created by changes in technology and
foreign competition that changes skills needed to perform jobs or the location of jobs
Cyclical Unemployment: Fluctuating unemployment over the business cycle (workers
are laid off, but expect to be hired back when the economy improves)
Full Employment: A situation in which all available labor resources are being used in the
most economically efficient way - No unemployment, Actual GDP = Potential GDP
(Employment is at its natural rate)
Even when the economy is at full employment, some unemployment exists because of
natural turnover in the labor market and mismatch between jobs and workers
Productivity
Canadian real GDP has increased relatively steadily for many years, reflecting steady
growth in the countrys productive capacity
Long-run growth of GDP has had 3 general sources
The level of employment has increased significantly, due to a rising population
and an increase in the proportion of the population that chooses to participate in
the labor force
Canadas stock of physical capital - buildings, factories, and machines used to
produce output has increased more or less steadily over time
Productivity in Canada has increased in almost every year since 1960
Productivity: A measure of the amount of output that the economy produces per unit of
input
Labor Productivity: The amount of real GDP produced per unit of labor employed
The amount of labor employed can be measured either as the total number of
employed workers or by the total number of hours worked (The second measure is
more accurate because the average number of hours worked per employed worker
changes over time)
Productivity growth is the single largest cause of rising material living standards over
long periods of time

Inflation and the Price Level

Inflation: The prices of goods and services are going up, on average
For studying inflation, there are 2 related but different concepts
1) Price Level: The average level of all prices in the economy, expressed as an index
number, P
2) Rate of Inflation: The rate at which the price level is rising
To measure the price level, economic statisticians at Statistics Canada construct a price
index, which averages the prices of various commodities according to how important
they are
Consumer Price Index (CPI): An index of the average prices of goods and services
commonly bought by households
How to calculate CPI

The CPI is not a perfect measure of the cost of living because it does not automatically
account for ongoing quality improvements or for changes in consumers expenditure
patterns
Since the price level is measured with an index number, its value at any specific time has
meaning only when it is compared with its value at some other time
Rate of Inflation: A measure of the annual rate of increase in the price level
To calculate the rate of inflation between any 2 years, calculate the percentage rate
change

The rate of inflation in Canada is currently around 2% per year

Purchasing Power of Money: The amount of goods and services that can be purchased
with a given amount of money
The purchasing power of money is negatively related to the price level - If the price level
doubles, a dollar will only buy half as much
Inflation reduces the purchasing power of money and the real value of any sum fixed in
nominal (dollar) terms
Anticipated inflation has a smaller effect on the economy than unanticipated inflation

Interest Rates
Interest Rate: The price that is paid to borrow money for a stated period of time, which
can be expressed as a percentage amount per year per dollar borrowed
Prime Interest Rate: The rate that banks charge to their best business customers
Bank Rate: The rate that the Bank of Canada charges on short-term loans to commercial
banks (RBC, CIBC)
Types of Interest Rates
1) Nominal Interest Rate: The cost of borrowing in current year dollars
2) Real Interest Rate: The nominal rate of interest adjusted for the change in the
purchasing power of money (RIR = Nominal Interest Rate - Rate of Inflation)
The burden of borrowing depends on the real, not the nominal rate of interest
Banks play a crucial role by intermediating between those households and firms that
have available funds and those who require funds
Exchange Rates
Exchange Rate: The number of units of domestic currency required to purchase 1 unit of
foreign currency
Foreign Exchange: Foreign currencies that are traded on the foreign exchange market
Foreign Exchange Market: The market in which different national currencies are traded
Appreciation: A rise in the exchange rate - It takes more units of domestic currency to
purchase 1 unit of foreign currency
Depreciation: A fall in the exchange rate - It takes fewer units of domestic currency to
purchase 1 unit of foreign currency
Imports and Exports
Imports: Goods and services we bring into our country, M
Exports: Goods and services we give out to other countries, X
Net Exports: The difference between exports and imports, NX (NX = X - M)
If the CAD depreciates, net exports will rise (X +, M -)
If the CAD appreciates, net exports will fall (X -, M +)
Growth Versus Fluctuations
Most macroeconomic variables have both long-run trends and short-run fluctuations, but the
sources of the 2 types of movements are different.
Important questions for macroeconomics involve the role of policy in influencing long-run
growth as well as short-run fluctuations.