Macroeconomics Review: Chapters 5–8 Study Notes

Macroeconomics: From Micro to Macro

Reconciling Macroeconomics and Microeconomics

Macroeconomics shifts the focus from individual markets to the performance of the entire economy. It examines whether the collective outcome of individual (microeconomic) choices leads to desirable macroeconomic results such as steady growth, full employment, and stable prices.

• Macroeconomics analyzes the performance of the whole economy, considering the combined outcomes of all individual choices.

• Microeconomics studies the choices of individuals, households, and firms, and how these interact in specific markets.

• Fallacy of Composition: What is true for one individual may not be true for the whole economy ("the whole is greater than the sum of its parts").

• Paradox of Thrift: If everyone tries to save more, total savings may fall due to reduced incomes and employment.

• Circular Flow Model: Simplifies the economy to three main players: households, businesses, and governments. It shows how income and spending circulate between input (factor) markets and output (goods/services) markets.

Example: The Global Financial Crisis (2008–2009) and the Great Depression (1929–1933) illustrate how individual financial decisions can aggregate into major macroeconomic downturns.

Market Self-Adjustment vs. Government Intervention

The central macroeconomic debate is whether markets, left alone, can quickly self-adjust to maintain economic stability, or whether government intervention is necessary.

• Say's Law: "Supply creates its own demand"—markets are self-adjusting (hands-off approach).

• Keynesian View: Markets often fail to self-correct quickly; government intervention is needed (hands-on approach).

• Market Failure: When market outcomes are inefficient or inequitable.

• Government Failure: When government policies fail to improve or even worsen economic outcomes.

• Political perspectives often align with these views: conservatives favor hands-off, liberals favor hands-on approaches.

Macroeconomic Outcomes and Players

Three key macroeconomic outcomes are:

• Gross Domestic Product (GDP): Measures total output and income.

• Unemployment: Measures the share of the labor force without jobs.

• Inflation: Measures the rate of increase in average prices.

Five main macroeconomic players:

• Consumers

• Businesses

• Governments

• Bank of Canada and the banking system

• The Rest of the World (R.O.W.)

Example: Consumer choices to spend or save, business decisions to invest or hire, and government fiscal and monetary policies all influence macroeconomic outcomes.

Measuring GDP and Living Standards

Nominal GDP and Real GDP

GDP is a key indicator of economic performance, measuring the value of all final goods and services produced within a country in a given year.

• Nominal GDP: Value at current prices. Changes reflect both price and quantity changes.

• Real GDP: Value at constant prices (base year). Changes reflect only quantity changes.

• Real GDP per Person: Real GDP divided by population; best measure of material standard of living.

Formulas:

• Nominal GDP: $\text{Nominal GDP}_{t} = \sum_{i} P_{i,t} Q_{i,t}$

• Real GDP (using base year prices): $\text{Real GDP}_{t} = \sum_{i} P_{i,\text{base}} Q_{i,t}$

• Real GDP per Person: $\text{Real GDP per Person} = \frac{\text{Real GDP}}{\text{Population}}$

Value Added and the Circular Flow

To avoid double counting, GDP can be measured by value added at each stage of production.

• Value Added: Value of output minus the value of intermediate goods.

• GDP can be calculated as either aggregate spending or aggregate income.

• Circular Flow Equation: $C + I + G + X - IM = Y$

• Where: C = Consumption I = Investment G = Government Spending X = Exports IM = Imports Y = Aggregate Income (GDP)

Injections and Leakages

• Injections: Spending that adds to the circular flow (I, G, X).

• Leakages: Spending that removes from the circular flow (S, T, IM).

• When real GDP is unchanged, total injections equal total leakages.

Limitations of GDP as a Measure of Well-Being

• Excludes non-market production (e.g., household work).

• Does not account for the underground economy.

• Ignores environmental sustainability and resource depletion.

• Does not measure leisure, political freedoms, or social justice.

• Human Development Index (HDI): Combines health, education, and standard of living for a broader measure of well-being.

Potential GDP, Economic Growth, and Business Cycles

Potential GDP

Potential GDP is the level of real GDP when all resources are fully employed. It represents the economy's short-run maximum output.

• Potential GDP per Person: Potential GDP divided by population; indicates maximum possible living standards.

Economic Growth

Economic growth is the increase in the economy's capacity to produce goods and services, shifting the production possibilities frontier (PPF) outward.

• Caused by increases in the quantity and quality of inputs: labor, capital, land/resources, and entrepreneurship.

• Productivity: Real GDP per hour of labor; higher productivity raises living standards.

• Creative Destruction: Innovation improves living standards but can make old industries obsolete.

• Growth Rate Formula: $\text{Growth Rate} = \frac{\text{Real GDP per Person}_{t} - \text{Real GDP per Person}_{t-1}}{\text{Real GDP per Person}_{t-1}} \times 100$

• Rule of 70: Years to double = $\frac{70}{\text{Annual Growth Rate}}$

Business Cycles

Business cycles are short-run fluctuations of real GDP around potential GDP.

• Expansion: Real GDP increases.

• Peak: Highest point before contraction.

• Contraction: Real GDP decreases.

• Trough: Lowest point before expansion.

• Recession: Two or more consecutive quarters of declining real GDP.

• Output Gap: $\text{Output Gap} = \text{Real GDP} - \text{Potential GDP}$ - Recessionary Gap: Real GDP < Potential GDP (unemployment above natural rate). - Inflationary Gap: Real GDP > Potential GDP (unemployment below natural rate).

Economic Shocks

• Shocks: Unexpected events affecting the economy.

• External Shocks: New technologies, resource discoveries, natural disasters, wars, global price changes.

• Internal Shocks: Changes in expectations, financial market disruptions.

• Shocks can be positive (expansion) or negative (recession).

• Recessions often begin with reduced business investment, leading to a chain reaction of lower spending and higher unemployment.

Example: The COVID-19 pandemic caused a sharp recession due to government-mandated shutdowns, followed by rapid recovery as restrictions eased.

Unemployment and Inflation

Calculating the Unemployment Rate

The unemployment rate measures the percentage of the labor force that is out of work and actively seeking employment.

• Labor Force: Employed + Unemployed (actively seeking work).

• Unemployment Rate: $\text{Unemployment Rate} = \frac{\text{Unemployed}}{\text{Labor Force}} \times 100$

• Labor Force Participation Rate: $\text{Labor Force Participation Rate} = \frac{\text{Labor Force}}{\text{Working-Age Population}} \times 100$

• Limitations: Does not count involuntary part-time workers or discouraged workers (those who have stopped looking for work).

• Labor Underutilization Rate: Includes unemployed, involuntary part-time, and discouraged workers.

Types of Unemployment

• Frictional Unemployment: Short-term, due to normal job search and turnover; healthy.

• Structural Unemployment: Mismatch between workers' skills and job requirements; healthy but may require retraining.

• Seasonal Unemployment: Due to seasonal changes in demand or weather; healthy.

• Cyclical Unemployment: Due to business cycle downturns; unhealthy and a policy concern.

• Natural Rate of Unemployment: The sum of frictional, structural, and seasonal unemployment; occurs at full employment (cyclical unemployment = 0).

Relationship to Output Gaps:

• Unemployment = Natural Rate: Real GDP = Potential GDP (full employment).

• Unemployment > Natural Rate: Real GDP < Potential GDP (recessionary gap).

• Unemployment < Natural Rate: Real GDP > Potential GDP (inflationary gap).

Inflation

Inflation is a persistent rise in the average price level, reducing the purchasing power of money.

• Consumer Price Index (CPI): Measures average prices of a fixed basket of goods and services.

• Inflation Rate: $\text{Inflation Rate} = \frac{\text{CPI}_{\text{current}} - \text{CPI}_{\text{previous}}}{\text{CPI}_{\text{previous}}} \times 100$

• Core Inflation Rate: Excludes volatile items for a clearer trend.

• Limitations: CPI may overstate inflation by not accounting for substitution or new products.

• Nominal Interest Rate: Stated rate, not adjusted for inflation.

• Real Interest Rate: $\text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate}$

• Inflation hurts savers and those on fixed incomes, benefits borrowers, and creates uncertainty for investment.

• Disinflation: A decrease in the inflation rate.

• Deflation: A persistent fall in average prices; can lead to economic contraction.

The Quantity Theory of Money

This theory links the money supply to the price level and output in the economy.

• Equation of Exchange: $M \times V = P \times Q$ - M: Money supply - V: Velocity of money (number of times money changes hands) - P: Price level (CPI) - Q: Real output (real GDP)

• If V and Q are constant, increases in M lead to proportional increases in P (inflation).

• "Printing money causes inflation" is based on this theory.

Unemployment and Inflation Trade-Offs: The Phillips Curve

The Phillips Curve illustrates the short-run inverse relationship between unemployment and inflation.

• Demand-Pull Inflation: Caused by increased demand; explains the trade-off (lower unemployment, higher inflation).

• Cost-Push Inflation: Caused by supply shocks (e.g., rising input costs); can lead to stagflation (high unemployment and inflation).

• Over time, expectations and changes in the natural rate of unemployment can "flatten" the Phillips Curve, weakening the trade-off.

Summary Table: Types of Unemployment

Type	Cause	Healthy/Unhealthy	Policy Concern?
Frictional	Normal job search/turnover	Healthy	No
Structural	Skill mismatch/tech change	Healthy (needs retraining)	Somewhat
Seasonal	Seasonal demand/weather	Healthy	No
Cyclical	Business cycle downturns	Unhealthy	Yes

Summary Table: GDP Calculation Approaches

Approach	Description	Formula
Expenditure	Sum of spending on final goods/services	$C + I + G + X - IM$
Income	Sum of incomes earned by input owners	Wages + Rent + Interest + Profits
Value Added	Sum of value added at each production stage	Output - Intermediate Inputs

Additional info: These notes synthesize and expand upon the provided review content, adding definitions, formulas, and structured tables for clarity and exam preparation.