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1 of 28
Chapter 19 What Macroeconomics Is All About
2 of 28
Learning Objectives 1. Explain the meaning and importance of the key macroeconomic variables, including national income, unemployment, inflation, interest rates, exchange rates, and trade flows. 2. View most macroeconomic issues as being about either long-run trends or short-run fluctuations, and see that government policy is relevant for both.
Copyright © 2005 Pearson Education Canada Inc.
3 of 28
19.1 Key Macroeconomic Variables Output and Income The production of output generates income. To measure total output, we add up the values of the many different goods produced. This yields the quantity of total output measured in dollars. The total just described gives the nominal national income. If base-period prices are used, then the measure is of real national income.
Copyright © 2005 Pearson Education Canada Inc.
4 of 28
Real vs. Nominal An example: Nominal Values GDP (bill. of current $'s)
Real Values GDP (bill. of 1992 $'s)
1982
374.9
544.4
1992
691.2
691.2
% change 84.4% 26.9 % % change p.a. 8.4% 2.7% NOTE: about 70% of the increase in nominal GDP was due to price increases and not growth in real output.
5 of 28
National Income: Recent History
Source: Statistics Canada’s CANSIM database, Series V3862685. Current data are available at www.statcan.ca.
Figure (i) shows that GDP has grown steadily since 1962 with only a few interruptions. Figure (ii) shows how the growth rate of GDP fluctuates from year to year. Copyright © 2005 Pearson Education Canada Inc.
6 of 28
As is clear, real GDP fluctuates around a rising trend. The trend shows long-run economic growth. The short-run fluctuations show the business cycle. Potential national income measures what the economy could produce if all resources were employed at their normal levels of utilization. This is often called full-employment income.
To see the most recent values for the macroeconomic variables discussed in this chapter, go to Statistics Canada’s website: www.statcan.ca. Click on “Canadian Statistics” and then “Latest Indicators.”
Copyright © 2005 Pearson Education Canada Inc.
7 of 28
Potential Output and the Output Gap: Potential national output measures what the economy could produce if all resources were employed at their normal levels of utilization. This is often called full-employment output. The output gap measures the difference between potential output and actual output.
Output Gap = Y-Y* APPLYING ECONOMIC CONCEPTS 19-1 The Terminology of Business Cycles
Practice with Study Guide Chapter 19, Exercise 2.
Copyright © 2005 Pearson Education Canada Inc.
8 of 28
Recessionary Gap Real GDP
Recovery
Peak Actual GDP
Recession
Potential GDP Peak Trough
Inflationary Gap Time
When actual income (output) is less than potential income, there is said to be a recessionary gap. When actual income (output) exceeds potential income, there is said to be an inflationary gap. Copyright © 2005 Pearson Education Canada Inc.
9 of 28
Some Recent History on Canadian Output Gaps
Source: Actual GDP: Statistics Canada CANSIM database, series V3862685. Potential output: Bank of Canada Review, Spring 2003.
Since 1965, potential and actual GDP have increased by more than three times. The output gap clearly shows cyclical behaviour. Note: Potential output cannot be directly observed or measured — it must be estimated. Copyright © 2005 Pearson Education Canada Inc.
10 of 28
Employment, Unemployment, and the Labour Force Employment is the number of adult workers (15 and over) who hold jobs. Unemployment is the number of individuals who are not employed but who are actively searching for a job. Even when the economy is at full employment (Y = Y*), some unemployment exists due to frictional and structural causes: • Frictional unemployment is due to the normal turnover of labour (new entrants, re-entrants, quits, fires, etc.). • Structural unemployment occurs because of a mismatch between available workers and jobs. Copyright © 2005 Pearson Education Canada Inc.
11 of 28
The labour force is the total number of people who are either employed or unemployed. The unemployment rate is equal to the number of unemployed people expressed as a percentage of the labour force. Unemployment = Rate
Number of people unemployed Number of people in the labour force
X 100
Practice with Study Guide Chapter 19, Exercise 4.
Copyright © 2005 Pearson Education Canada Inc.
12 of 28
Full employment is said to occur when the only existing unemployment is frictional and structural. Unemployment rises and falls as the business cycle ebbs and flows. During recessions, unemployment rises above its fullemployment level. During booms, unemployment falls below this level. When unemployment is greater than the full-employment level, economists say there is cyclical unemployment – this is sometimes called deficient-demand unemployment. The unemployment rate that occurs when the economy is at full employment (Y=Y*) is called the natural rate of unemployment. This is also often called the NAIRU — the Non-Accelerating Inflation Rate of Unemployment.
Copyright © 2005 Pearson Education Canada Inc.
13 of 28
Estimates indicate that the NAIRU rose throughout the 1970s, from around 5.5 percent to a high of 8 percent in the early 1980s, and has now fallen to around 7 percent. Why Does Unemployment Matter? Some unemployment is desirable, as it reflects the time required for workers and firms to “find” each other so that good matches are made. But some unemployment is associated with human hardship, especially for those individuals with skills that are not in high demand by firms.
Copyright © 2005 Pearson Education Canada Inc.
14 of 28
Some Recent History of Canadian Unemployment
Source: Statistics Canada’s CANSIM database. Labour force: Series V2091051. Employment: Series V2091072. Unemployment rate: Series V2091177. Current labour-force statistics are available at www.statcan.ca.
The labour force and employment have grown since 1960, with only a few interruptions. The business cycle is apparent in the fluctuations in the unemployment rate. Copyright © 2005 Pearson Education Canada Inc.
15 of 28
16 of 28
Does the Unemployment Rate Measure Hardship?
17 of 28
Inflation and the Price Level The price level refers to the average level of all prices in the economy. Inflation is the rate at which the price level is changing. The most common measure of the price level is the Consumer Price Index (CPI). The CPI is based on the price of a typical “consumption basket.” It then expresses that price as a ratio of the price in some base period. The CPI for the base period is set to 100.
Copyright © 2005 Pearson Education Canada Inc.
18 of 28
CPI t
PQ ∑ = ∑P Q t
0
0
0
×100
To compute the rate of inflation from any point in your lifetime to today, check out the “inflation calculator” at the Bank of Canada’s website: www.bank-banque-canada.ca.
Practice with Study Guide Chapter 19, Extension Exercise E1.
Copyright © 2005 Pearson Education Canada Inc.
19 of 28
An Example The value of the CPI in January 1995 was 131.9. In January 1996, it was 135.2. The year-over-year inflation rate can be found by dividing the CPI for 1996 by that for 1995, subtracting 1 and multiplying by 100 — it is 2.5 percent. [(135.2 / 131.9) - 1] x 100 = 2.5 That is, the price level increased by 2.5 percent between January 1995 and January 1996 — an inflation rate of 2.5 percent.
APPLYING ECONOMIC CONCEPTS 19-2 How the CPI Is Constructed Copyright © 2005 Pearson Education Canada Inc.
20 of 28
Why Inflation Matters The purchasing power of money is negatively related to the price level. If all financial contracts are written to incorporate a fullyanticipated inflation, then such an inflation will have no real effects. An unanticipated inflation benefits anyone who has an obligation to pay money, and harms anyone who is entitled to receive money. Because it is hard to forecast accurately, inflation adds to the uncertainties of economic life. Highly variable inflation rates cause great uncertainty.
Copyright © 2005 Pearson Education Canada Inc.
21 of 28
Plan for buying a house based on expected inflation of 10% Monthly earnings
Year 1 $5,000
Year 2 ... $5,500
Year 10 $12,969
Mortgage payment (15%)
$3,200
$3,200
$3,200
Other expenditures
$1,800
$2,300
$9,769
Real value of other expend.
$1,800
$2,091
$250,000
$275,000
Value of your house PLAN!
$3,766 $648,435 GREAT
22 of 28
What actually happens - unexpectedly 2% inflation NOT SO GREAT OUTCOME! Monthly earnings
Year1 $5,000
Year 2 ... Year 10 $5,100 $6,095
Mortgage payments (15%)
$3,200
$3,200
$3,200
Other expenditures
$1,800
$1,900
$2,895
Real value of other expenditures $1,800
$1,863
$2,375
Value of your house
$255,000
$304,749
$250,000
23 of 28
Plan for investing in a bond based on expected inflation of 2% ($1,000 bond @ 8% for 10 years) end of year payments Year 1 Year 2 ... Year 10 Annual interest earnings $80 $80 $80
Sum $800
Real value of interest earnings $78
$719
Real value of bond
$77
$1,000 $980
$66 $820
Your purchasing power after 10 years of investment $719 + $820 = $1,539 GREAT PLAN!
24 of 28
What actually happens - unexpectedly inflation is10% NOT SO GREAT OUTCOME! Year1 Annual interest earnings $80
Year 2 ... Year 10 Sum $80 $80 $800
Real value of interest earnings $73
$66
$31
Real value of bond
$909
$386
$1,000
Your purchasing power after 10 years of investment $452 + $386 = $838
$492
25 of 28
Some Recent History of Canadian Inflation The trend in the price level has been upward since 1960. This means positive rates of inflation. The rate of inflation has varied from almost 0 to over 12 percent since 1960. Note: As the inflation rate falls, the price level is still rising.
Copyright © 2005 Pearson Education Canada Inc.
26 of 28
27 of 28
Interest Rates The interest rate is the price of borrowing funds. It is expressed as a percentage amount per period per dollar borrowed. The nominal interest rate is the price expressed in money terms. The real interest rate is this price expressed in terms of purchasing power. For example, if the stated nominal interest rate on a loan is 6 percent per year and the inflation rate is 2 percent, the real interest rate is 4 percent. The burden of borrowing depends on the real, not the nominal, rate of interest.
Copyright © 2005 Pearson Education Canada Inc.
28 of 28
Some Recent History of Canadian Interest Rates Inflation over the past 40 years implies that the real interest rate has always been less than the nominal interest rate. Source: Nominal interest rate: 90-day treasury bill rate, Statistics Canada, CANSIM database, Series V122541. Real interest rate base on author’s calculation of CPE inflation, using Series PCPISA from the Bank of Canada.
The real interest rate has usually been below 4% for the past four decades. Through the early 1970s, the real interest rate was negative, indicating that the inflation rate exceeded the nominal interest rate. Copyright © 2005 Pearson Education Canada Inc.
29 of 28
Interest rates vs. the interest rate • There are many different interest rates. Each reflects the cost of borrowing in a particular financial market • There are numerous financial markets (specific set of borrowers and lenders) • Each market is characterize by ‘risk’, ‘liquidity’, ‘term’ of loans, etc. • Each gives rise to a unique rate of interest
30 of 28
Examples of interest rates TD - Canada Trust, Jan. 17, 2005 TD charges Prime 1 year 'open' Mtg 1 year 'fixed' 10 year 'fixed' Unsecured consumer loan Student loans VISA TD pays 1 yr GIC 5 yr GIC Long term G of C bond
4.50% 7.00 4.85 7.50 9.50 4.50 (??) 18.50 2.10 3.00 4.75
31 of 28
The International Economy Foreign exchange refers to foreign currencies or claims on foreign currencies. The foreign-exchange market is where foreign currencies are traded. The exchange rate is the number of Canadian dollars required to purchase one unit of foreign currency — that is, the Canadian-dollar price of foreign currency. A depreciation of the Canadian dollar means the exchange rate has increased, and the Canadian dollar is worth less on the foreign-exchange market. Practice with Study Guide Chapter 19, Exercise 5.
Copyright © 2005 Pearson Education Canada Inc.
32 of 28
Some Recent History of the Canadian Exchange Rate There has been a significant overall depreciation of the Canadian dollar (relative to the US dollar) since 1970. There are also large fluctuations over the course of the business cycle.
Source: Annual average of monthly data, Statistics Canada CANSIM database, Series V37432.
Because the United States is Canada’s largest trading partner by far, this is the exchange rate that matters most for Canada. Copyright © 2005 Pearson Education Canada Inc.
33 of 28
Impact of Changes in the exchange rate An example: Exchange rate 1 US $ = 1.17 Cdn $'s June 1990 P of a Meal in Windsor $10.00 Cdn P of same meal in Detroit $8.00 US P of Detroit meal for Windsorite $9.36 ($8.00 US x 1.17 Cdn $ per US $ = $9.36 Cdn) Now what if the exchange increases to 1 US $ = 1.65 Cdn $'s Jan. 2003 P of Detroit meal for Windsorite $13.20 ($8.00 US x 1.65 Cdn $ per US $ = $13.20 Cdn) What is your prediction about Windsorites dining out in Detroit?
34 of 28
Impact of Changes in the exchange rate Further: Exchange rate 1 US $ = 1.17 Cdn $'s P of a Meal in Windsor $10.00 Cdn P of same meal in Detroit $8.00 US P of Windsor meal for a Detroiter $8.50 ($10.00 Cdn x 0.85 US $'s per Cdn $ = $8.50 US) Recall an exchange rate of 1 US $ = 1.17 Cdn $'s implies an exchange rate of 1Cdn $ = 0.85 US $'s Now what if the exchange increases to 1 US $ = 1.65 Cdn $'s Jan. 2003 P of Windsor meal for a Detroiter $6.10 ($10.00 Cdn x 0.61 US $'s per Cdn $ = $6.10 US)
35 of 28
The balance of payments accounts record all international payments that are made in the course of international transactions of goods, services, and assets. One part of the balance of payments is the trade account — this records the value of all transactions in goods and services. The trade balance is the difference between the value of exports and the value of imports. For Canada, international trade is very important. Both exports and imports are very large (roughly 40% of GDP), but the trade balance is usually very small. Copyright © 2005 Pearson Education Canada Inc.
36 of 28
Although imports and exports have increased dramatically over the past 40 years, the trade balance has remained close to zero.
Source: Statistics Canada, CANSIM database. Exports: Series V499540. Imports: Series V499557. Copyright © 2005 Pearson Education Canada Inc.
37 of 28
19.2 Growth Versus Fluctuations Long-Term Economic Growth Long-term growth is considerably more important for a society’s living standards from decade to decade than shortterm fluctuations. There is considerable debate regarding the ability of government to influence the economy’s long-run growth rate. Do budget surpluses increase future growth? Some economists argue that when governments spend less than they raise in tax revenue, the reduced need for borrowing drives down interest rates and stimulates investment, which increases future growth. Is this belief justified?
Copyright © 2005 Pearson Education Canada Inc.
38 of 28
Long-term growth and increases in productivity • We will see that one of the most important determinants of long-term growth is increased productivity • One measure of productivity is output per person hour • Output per person hour is determined by many factors (capital, technology, regulations, etc.)
39 of 28
Why Productivity Growth Matters Annual growth rate in productivity 1.0% 1.5% 2.0% 2.5% 3.0%
Change in ouput pph after 40 yrs (1 working life) 49% 81% 121% 168% 226%
Number of yrs req'd to double output pph 70 yrs 47 yrs 35 yrs 28 yrs 23 yrs
40 of 28
Short-Term Fluctuations The economy’s short-term fluctuations in output and unemployment are often called business cycles. Monetary policy is important for understanding business cycles. When the Bank of Canada implemented an inflationreduction policy in the early 1990s, is it a coincidence that a recession followed? Many economists argue that fiscal policy can also be used to mitigate short-term fluctuations by changing the government’s spending and/or taxation behaviour. Other economists say that governments should not attempt to “fine-tune” the economy.
Copyright © 2005 Pearson Education Canada Inc.
41 of 28
What Lies Ahead In order to organize our thinking about the questions raised in this chapter, we must develop some tools. These will include: • discussing measurement of national income, • building a simple model of the economy to highlight some key macroeconomic relationships, • modifying the model to make it increasingly complex and realistic, and • using our model to analyze some pertinent economic issues.
Copyright © 2005 Pearson Education Canada Inc.
42 of 28
Chapter 19 What Macroeconomics Is All About
2 of 28
Learning Objectives 1. Explain the meaning and importance of the key macroeconomic variables, including national income, unemployment, inflation, interest rates, exchange rates, and trade flows. 2. View most macroeconomic issues as being about either long-run trends or short-run fluctuations, and see that government policy is relevant for both.
Copyright © 2005 Pearson Education Canada Inc.
3 of 28
19.1 Key Macroeconomic Variables Output and Income The production of output generates income. To measure total output, we add up the values of the many different goods produced. This yields the quantity of total output measured in dollars. The total just described gives the nominal national income. If base-period prices are used, then the measure is of real national income.
Copyright © 2005 Pearson Education Canada Inc.
4 of 28
Real vs. Nominal An example: Nominal Values GDP (bill. of current $'s)
Real Values GDP (bill. of 1992 $'s)
1982
374.9
544.4
1992
691.2
691.2
% change 84.4% 26.9 % % change p.a. 8.4% 2.7% NOTE: about 70% of the increase in nominal GDP was due to price increases and not growth in real output.
5 of 28
National Income: Recent History
Source: Statistics Canada’s CANSIM database, Series V3862685. Current data are available at www.statcan.ca.
Figure (i) shows that GDP has grown steadily since 1962 with only a few interruptions. Figure (ii) shows how the growth rate of GDP fluctuates from year to year. Copyright © 2005 Pearson Education Canada Inc.
6 of 28
As is clear, real GDP fluctuates around a rising trend. The trend shows long-run economic growth. The short-run fluctuations show the business cycle. Potential national income measures what the economy could produce if all resources were employed at their normal levels of utilization. This is often called full-employment income.
To see the most recent values for the macroeconomic variables discussed in this chapter, go to Statistics Canada’s website: www.statcan.ca. Click on “Canadian Statistics” and then “Latest Indicators.”
Copyright © 2005 Pearson Education Canada Inc.
7 of 28
Potential Output and the Output Gap: Potential national output measures what the economy could produce if all resources were employed at their normal levels of utilization. This is often called full-employment output. The output gap measures the difference between potential output and actual output.
Output Gap = Y-Y* APPLYING ECONOMIC CONCEPTS 19-1 The Terminology of Business Cycles
Practice with Study Guide Chapter 19, Exercise 2.
Copyright © 2005 Pearson Education Canada Inc.
8 of 28
Recessionary Gap Real GDP
Recovery
Peak Actual GDP
Recession
Potential GDP Peak Trough
Inflationary Gap Time
When actual income (output) is less than potential income, there is said to be a recessionary gap. When actual income (output) exceeds potential income, there is said to be an inflationary gap. Copyright © 2005 Pearson Education Canada Inc.
9 of 28
Some Recent History on Canadian Output Gaps
Source: Actual GDP: Statistics Canada CANSIM database, series V3862685. Potential output: Bank of Canada Review, Spring 2003.
Since 1965, potential and actual GDP have increased by more than three times. The output gap clearly shows cyclical behaviour. Note: Potential output cannot be directly observed or measured — it must be estimated. Copyright © 2005 Pearson Education Canada Inc.
10 of 28
Employment, Unemployment, and the Labour Force Employment is the number of adult workers (15 and over) who hold jobs. Unemployment is the number of individuals who are not employed but who are actively searching for a job. Even when the economy is at full employment (Y = Y*), some unemployment exists due to frictional and structural causes: • Frictional unemployment is due to the normal turnover of labour (new entrants, re-entrants, quits, fires, etc.). • Structural unemployment occurs because of a mismatch between available workers and jobs. Copyright © 2005 Pearson Education Canada Inc.
11 of 28
The labour force is the total number of people who are either employed or unemployed. The unemployment rate is equal to the number of unemployed people expressed as a percentage of the labour force. Unemployment = Rate
Number of people unemployed Number of people in the labour force
X 100
Practice with Study Guide Chapter 19, Exercise 4.
Copyright © 2005 Pearson Education Canada Inc.
12 of 28
Full employment is said to occur when the only existing unemployment is frictional and structural. Unemployment rises and falls as the business cycle ebbs and flows. During recessions, unemployment rises above its fullemployment level. During booms, unemployment falls below this level. When unemployment is greater than the full-employment level, economists say there is cyclical unemployment – this is sometimes called deficient-demand unemployment. The unemployment rate that occurs when the economy is at full employment (Y=Y*) is called the natural rate of unemployment. This is also often called the NAIRU — the Non-Accelerating Inflation Rate of Unemployment.
Copyright © 2005 Pearson Education Canada Inc.
13 of 28
Estimates indicate that the NAIRU rose throughout the 1970s, from around 5.5 percent to a high of 8 percent in the early 1980s, and has now fallen to around 7 percent. Why Does Unemployment Matter? Some unemployment is desirable, as it reflects the time required for workers and firms to “find” each other so that good matches are made. But some unemployment is associated with human hardship, especially for those individuals with skills that are not in high demand by firms.
Copyright © 2005 Pearson Education Canada Inc.
14 of 28
Some Recent History of Canadian Unemployment
Source: Statistics Canada’s CANSIM database. Labour force: Series V2091051. Employment: Series V2091072. Unemployment rate: Series V2091177. Current labour-force statistics are available at www.statcan.ca.
The labour force and employment have grown since 1960, with only a few interruptions. The business cycle is apparent in the fluctuations in the unemployment rate. Copyright © 2005 Pearson Education Canada Inc.
15 of 28
16 of 28
Does the Unemployment Rate Measure Hardship?
17 of 28
Inflation and the Price Level The price level refers to the average level of all prices in the economy. Inflation is the rate at which the price level is changing. The most common measure of the price level is the Consumer Price Index (CPI). The CPI is based on the price of a typical “consumption basket.” It then expresses that price as a ratio of the price in some base period. The CPI for the base period is set to 100.
Copyright © 2005 Pearson Education Canada Inc.
18 of 28
CPI t
PQ ∑ = ∑P Q t
0
0
0
×100
To compute the rate of inflation from any point in your lifetime to today, check out the “inflation calculator” at the Bank of Canada’s website: www.bank-banque-canada.ca.
Practice with Study Guide Chapter 19, Extension Exercise E1.
Copyright © 2005 Pearson Education Canada Inc.
19 of 28
An Example The value of the CPI in January 1995 was 131.9. In January 1996, it was 135.2. The year-over-year inflation rate can be found by dividing the CPI for 1996 by that for 1995, subtracting 1 and multiplying by 100 — it is 2.5 percent. [(135.2 / 131.9) - 1] x 100 = 2.5 That is, the price level increased by 2.5 percent between January 1995 and January 1996 — an inflation rate of 2.5 percent.
APPLYING ECONOMIC CONCEPTS 19-2 How the CPI Is Constructed Copyright © 2005 Pearson Education Canada Inc.
20 of 28
Why Inflation Matters The purchasing power of money is negatively related to the price level. If all financial contracts are written to incorporate a fullyanticipated inflation, then such an inflation will have no real effects. An unanticipated inflation benefits anyone who has an obligation to pay money, and harms anyone who is entitled to receive money. Because it is hard to forecast accurately, inflation adds to the uncertainties of economic life. Highly variable inflation rates cause great uncertainty.
Copyright © 2005 Pearson Education Canada Inc.
21 of 28
Plan for buying a house based on expected inflation of 10% Monthly earnings
Year 1 $5,000
Year 2 ... $5,500
Year 10 $12,969
Mortgage payment (15%)
$3,200
$3,200
$3,200
Other expenditures
$1,800
$2,300
$9,769
Real value of other expend.
$1,800
$2,091
$250,000
$275,000
Value of your house PLAN!
$3,766 $648,435 GREAT
22 of 28
What actually happens - unexpectedly 2% inflation NOT SO GREAT OUTCOME! Monthly earnings
Year1 $5,000
Year 2 ... Year 10 $5,100 $6,095
Mortgage payments (15%)
$3,200
$3,200
$3,200
Other expenditures
$1,800
$1,900
$2,895
Real value of other expenditures $1,800
$1,863
$2,375
Value of your house
$255,000
$304,749
$250,000
23 of 28
Plan for investing in a bond based on expected inflation of 2% ($1,000 bond @ 8% for 10 years) end of year payments Year 1 Year 2 ... Year 10 Annual interest earnings $80 $80 $80
Sum $800
Real value of interest earnings $78
$719
Real value of bond
$77
$1,000 $980
$66 $820
Your purchasing power after 10 years of investment $719 + $820 = $1,539 GREAT PLAN!
24 of 28
What actually happens - unexpectedly inflation is10% NOT SO GREAT OUTCOME! Year1 Annual interest earnings $80
Year 2 ... Year 10 Sum $80 $80 $800
Real value of interest earnings $73
$66
$31
Real value of bond
$909
$386
$1,000
Your purchasing power after 10 years of investment $452 + $386 = $838
$492
25 of 28
Some Recent History of Canadian Inflation The trend in the price level has been upward since 1960. This means positive rates of inflation. The rate of inflation has varied from almost 0 to over 12 percent since 1960. Note: As the inflation rate falls, the price level is still rising.
Copyright © 2005 Pearson Education Canada Inc.
26 of 28
27 of 28
Interest Rates The interest rate is the price of borrowing funds. It is expressed as a percentage amount per period per dollar borrowed. The nominal interest rate is the price expressed in money terms. The real interest rate is this price expressed in terms of purchasing power. For example, if the stated nominal interest rate on a loan is 6 percent per year and the inflation rate is 2 percent, the real interest rate is 4 percent. The burden of borrowing depends on the real, not the nominal, rate of interest.
Copyright © 2005 Pearson Education Canada Inc.
28 of 28
Some Recent History of Canadian Interest Rates Inflation over the past 40 years implies that the real interest rate has always been less than the nominal interest rate. Source: Nominal interest rate: 90-day treasury bill rate, Statistics Canada, CANSIM database, Series V122541. Real interest rate base on author’s calculation of CPE inflation, using Series PCPISA from the Bank of Canada.
The real interest rate has usually been below 4% for the past four decades. Through the early 1970s, the real interest rate was negative, indicating that the inflation rate exceeded the nominal interest rate. Copyright © 2005 Pearson Education Canada Inc.
29 of 28
Interest rates vs. the interest rate • There are many different interest rates. Each reflects the cost of borrowing in a particular financial market • There are numerous financial markets (specific set of borrowers and lenders) • Each market is characterize by ‘risk’, ‘liquidity’, ‘term’ of loans, etc. • Each gives rise to a unique rate of interest
30 of 28
Examples of interest rates TD - Canada Trust, Jan. 17, 2005 TD charges Prime 1 year 'open' Mtg 1 year 'fixed' 10 year 'fixed' Unsecured consumer loan Student loans VISA TD pays 1 yr GIC 5 yr GIC Long term G of C bond
4.50% 7.00 4.85 7.50 9.50 4.50 (??) 18.50 2.10 3.00 4.75
31 of 28
The International Economy Foreign exchange refers to foreign currencies or claims on foreign currencies. The foreign-exchange market is where foreign currencies are traded. The exchange rate is the number of Canadian dollars required to purchase one unit of foreign currency — that is, the Canadian-dollar price of foreign currency. A depreciation of the Canadian dollar means the exchange rate has increased, and the Canadian dollar is worth less on the foreign-exchange market. Practice with Study Guide Chapter 19, Exercise 5.
Copyright © 2005 Pearson Education Canada Inc.
32 of 28
Some Recent History of the Canadian Exchange Rate There has been a significant overall depreciation of the Canadian dollar (relative to the US dollar) since 1970. There are also large fluctuations over the course of the business cycle.
Source: Annual average of monthly data, Statistics Canada CANSIM database, Series V37432.
Because the United States is Canada’s largest trading partner by far, this is the exchange rate that matters most for Canada. Copyright © 2005 Pearson Education Canada Inc.
33 of 28
Impact of Changes in the exchange rate An example: Exchange rate 1 US $ = 1.17 Cdn $'s June 1990 P of a Meal in Windsor $10.00 Cdn P of same meal in Detroit $8.00 US P of Detroit meal for Windsorite $9.36 ($8.00 US x 1.17 Cdn $ per US $ = $9.36 Cdn) Now what if the exchange increases to 1 US $ = 1.65 Cdn $'s Jan. 2003 P of Detroit meal for Windsorite $13.20 ($8.00 US x 1.65 Cdn $ per US $ = $13.20 Cdn) What is your prediction about Windsorites dining out in Detroit?
34 of 28
Impact of Changes in the exchange rate Further: Exchange rate 1 US $ = 1.17 Cdn $'s P of a Meal in Windsor $10.00 Cdn P of same meal in Detroit $8.00 US P of Windsor meal for a Detroiter $8.50 ($10.00 Cdn x 0.85 US $'s per Cdn $ = $8.50 US) Recall an exchange rate of 1 US $ = 1.17 Cdn $'s implies an exchange rate of 1Cdn $ = 0.85 US $'s Now what if the exchange increases to 1 US $ = 1.65 Cdn $'s Jan. 2003 P of Windsor meal for a Detroiter $6.10 ($10.00 Cdn x 0.61 US $'s per Cdn $ = $6.10 US)
35 of 28
The balance of payments accounts record all international payments that are made in the course of international transactions of goods, services, and assets. One part of the balance of payments is the trade account — this records the value of all transactions in goods and services. The trade balance is the difference between the value of exports and the value of imports. For Canada, international trade is very important. Both exports and imports are very large (roughly 40% of GDP), but the trade balance is usually very small. Copyright © 2005 Pearson Education Canada Inc.
36 of 28
Although imports and exports have increased dramatically over the past 40 years, the trade balance has remained close to zero.
Source: Statistics Canada, CANSIM database. Exports: Series V499540. Imports: Series V499557. Copyright © 2005 Pearson Education Canada Inc.
37 of 28
19.2 Growth Versus Fluctuations Long-Term Economic Growth Long-term growth is considerably more important for a society’s living standards from decade to decade than shortterm fluctuations. There is considerable debate regarding the ability of government to influence the economy’s long-run growth rate. Do budget surpluses increase future growth? Some economists argue that when governments spend less than they raise in tax revenue, the reduced need for borrowing drives down interest rates and stimulates investment, which increases future growth. Is this belief justified?
Copyright © 2005 Pearson Education Canada Inc.
38 of 28
Long-term growth and increases in productivity • We will see that one of the most important determinants of long-term growth is increased productivity • One measure of productivity is output per person hour • Output per person hour is determined by many factors (capital, technology, regulations, etc.)
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Why Productivity Growth Matters Annual growth rate in productivity 1.0% 1.5% 2.0% 2.5% 3.0%
Change in ouput pph after 40 yrs (1 working life) 49% 81% 121% 168% 226%
Number of yrs req'd to double output pph 70 yrs 47 yrs 35 yrs 28 yrs 23 yrs
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Short-Term Fluctuations The economy’s short-term fluctuations in output and unemployment are often called business cycles. Monetary policy is important for understanding business cycles. When the Bank of Canada implemented an inflationreduction policy in the early 1990s, is it a coincidence that a recession followed? Many economists argue that fiscal policy can also be used to mitigate short-term fluctuations by changing the government’s spending and/or taxation behaviour. Other economists say that governments should not attempt to “fine-tune” the economy.
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What Lies Ahead In order to organize our thinking about the questions raised in this chapter, we must develop some tools. These will include: • discussing measurement of national income, • building a simple model of the economy to highlight some key macroeconomic relationships, • modifying the model to make it increasingly complex and realistic, and • using our model to analyze some pertinent economic issues.
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