ECON 1010 Notes PDF

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Chapter 5 notes- Adam’s Smith’s Invisible Hand - When an individual makes choices, “.. intends only his own gain, and he is in this... led by an invisible hand to promote an end which was no part of his intention.... By pursuing his own interest he frequently promotes that of the society more effect...

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Chapter 5 notes -

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Adam’s Smith’s Invisible Hand - When an individual makes choices, “…he intends only his own gain, and he is in this... led by an invisible hand to promote an end which was no part of his intention.... By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” Macroeconomics - analyzes the performance of the whole Canadian economy and global economy. the combined outcomes of all individual microeconomic choices Microeconomics - analyzes choices that individuals in households, businesses, and governments make, and how those choices interact in markets Fallacy of composition - what is true for one is not true for all; the whole is greater than the sum of the individual parts - If a farmer has a bumper crop (yields a lot of crops) and sells that crop at world prices, it’s really good. Now if all farmers around the world have a bumper crop, then the increase in supply would cause the world price of that crop to fall Paradox of thrift - attempts to increase saving cause total savings to decrease because of falling employment and incomes The circular-flow model, like all economic models, focuses attention on what’s important for understanding and shows how smart choices by households, businesses, and governments interact in markets. An economic model is a simplified representation of the real world, focusing attention on what’s important for understanding Circular flow model of economic life reduces complexity of the Canadian economy to three sets of players who interact in markets; households, businesses, and governments - In input markets, households are sellers, businesses are buyers - In output markets, households are buyers, businesses are sellers Households supply inputs to businesses (labour or other assets) In exchange, businesses pay the households businesses then take those inputs and use them to produce products of services which they sell in output markets to households Households are able to buy those products and services because of the income that they’ve earned in input markets In the middle of all of this is the government Government is essential for setting the rules of the game. For enforcing laws and contracts, private property Input markets determine incomes Output markets determine the value of all products and services sold Microeconomics focuses on interaction of demand and supply in input markets alone or output markets alone Macroeconomics focuses on connections between input and output markets Money, Banks, and Expectations are part of macro focus on whole economy Governments set rules of the game and can choose to interact in any aspect of the economy, including policy Economic models assume all other things not in the model do not change

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- The mental equivalent of controlled experiments in a laboratory Say’s Law - supply creates its own demand We start off with households supplying inputs to businesses in exchange for money. Businesses produce products and services, which they sell in output markets. households have money to demand those products and services. So there's a circle here that starts with household supplying and why would you sell things? Why would you work unless you wanted to earn money to turn around and buy or demand things?. That's the basic insight of Say's law. If the Invisible Hand works so well, how do we end up with things like the Global Financial Crisis? How do we end up with a Great Depression? We’ll use the circular flow diagram with a twist We start again with households supplying inputs to businesses in exchange for money Businesses take those inputs and they produce products and services to sell to households. But what if households have earned that money, decide to save it instead of spend it? So businesses have produced these products and services, but what happens if households say, well no, we're going to hold on to our money right now. We're going to save instead of spend. So this is the Paradox of thrift outcome. Where if households save and they don't buy, and this impact is big enough that businesses are not selling, they stop production. They lay off workers and income falls, we've got a problem. All of a sudden Supply in input markets is not creating its own demand in output markets.

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This problem has been symbolized here with these brakes in the circular flow. That's somehow the Say's Law story of going around the circle in a smooth, continuous way just doesn't work out.

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The Fundamental Macroeconomic Question “If left alone by government, do the price mechanisms of market economies adjust quickly to maintain steady growth in living standards, full employment, and stable prices?” This is the question, does Adam’ Smith’s Invisible Hand work well? And so markets adjust quickly and produce, constantly circulating money, and output, and products and services, and happy people with increasing standards of living. All employed without inflation are rising prices. Or does something go wrong? “Yes — Markets Self-Adjust” answer is based on Say’s Law (F. Hayek) “No — Markets Fail Often” answer is from J. M. Keynes, founder of macroeconomics in1930s The “Yes” and “No” answers to the question “If left alone, do markets quickly self-adjust?” differ on the fallacy of composition, causes of business cycles, risk of government failure versus market failure, role for government, and political positions. •Like Say (and Hayek) and Keynes, economists and politicians today disagree about the fundamental macroeconomic question Market failure - market outcomes are inefficient or inequitable and fail to serve the public interest

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Government failure - government policy fails to serve the public interest Yes — Left Alone, Markets Self-Adjust — Hands Off camp believes: - Macroeconomic and microeconomic outcomes are the same - External events or government policy cause business cycles - Government failure is more likely than market failure - Government should be hands-off No — Left Alone, Markets Fail Often — Hands On camp believes: - Fallacy of composition — macroeconomic and microeconomic outcomes are different - Markets cause business cycles through connection failures between input and output markets, roles of money, banking, and expectations - Market failure is more likely than government failure - Government should be hands-on political right (conservatives) tend to be in Yes — Markets Self-Adjust camp, so government hands-off political left (liberals/NDP) tend to be in No — Markets Fail Often camp, so government hands-on There are also agreements between camps - Believe some role for government - Markets eventually adjust, but how long do they take?

Three key performance outcomes of the Canadian economy are GDP, unemployment, and inflation; produced by the choices of five macroeconomic players — consumers, businesses, government, Bank of Canada and the banking system, and the rest of the world. Unemployment tends to be inversely related (when one goes up, the other goes down) to growth in levels of GDP. As GDP goes down, unemployment goes up. When the economy shrinks, employment decreases, and unemployment increases. When unemployment increases, workers have a disadvantage when bargaining for higher wages. Outcomes: Good outcomes are - higher gross domestic product (GDP) - lower unemployment - low and predictable inflation Players: Consumer choices - Spend income or save - Buy Canadian products and services, or imports Business choices

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- Investment spending business purchases of new factories and equipment - Hiring workers or not - Buying inputs domestically or importing - Selling outputs domestically or exporting Government choices - Buying products and services - Fiscal policy - government purchases, taxes / transfers to achieve the macroeconomic outcomes - Bank of Canada and banking system choices - Monetary policy - Bank of Canada changes interest rates and supply of money to achieve the macroeconomic outcomes - Making loans or not Rest of World (R.O.W.) choices - Buying Canadian exports or not, selling imports to Canada or not - Investing money in Canada or not, accepting Canadian investments or not Macroeconomics affects your future - GDP affects living standards, unemployment affects the odds of your finding a job, and inflation can reduce your living standards. Macroeconomics also informs your vote for politicians and policies influencing economic performance, and illuminates the important parts of complex economies. Your personal economic success is affected by: - GDP - higher GDP per person allows higher living standards - Unemployment - affects odds of finding a job - Inflation - reduces living standards if income does not rise as fast as the prices of what you buy - Interest rates, exchange rates, and government taxes and transfer payments Understanding macroeconomics helps you make smart choices and informs your vote for politicians whose economic policies influence economic performance and your economic success Thinking like a macroeconomist means using the circular flow model to focus on connections inside the economy and out to the rest of the world Thinking Like an Economist - “Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions.” - John Maynard Keynes Is Economics a Science? - Science is a systematic enterprise that builds and organizes knowledge in the form of testable explanations and predictions about the universe - Economics uses quantitative expression in mathematics and concise statement of its models in axioms and derived “theorems,” so it looks a lot like the models of science from physics

Chapter 6 notes - GDP Concepts measure the value of all final products and services produced annually in the -

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country Nominal GDP and real GDP - Nominal GDP combines changes in price and quantities, - Real GDP measures only changes in quantities, and real GDP per person is the best measure of material standard of living Nominal GDP - value at current prices of all final products and services produced annually in a country Example of how we might calculate nominal GDP for a given year. - Let's talk about the year 1935. In the equation you see PA 1935 and QA 1935. The superscript, A, represents different products and services produced in that country. So there is product and service A, product and service B, C ect… - P is the price prevailing in 1935 of this particular product A , and Q is the quantity of that product A produced in 1935. So if we multiply the price times the quantity, that gives us the value of product A produced in 1935, in 1935 prices. - We do that for every single product and service in the economy and add them all up and that's what gives us nominal GDP for 1935 - Again we would do the same procedure to find the nominal GDP in 2013

Now if we were to compare the nominal GDP in 1935 and nominal GDP in 2013, two things are changing simultaneously. We've got different prices and different quantities between the two years. This is not good When there are differences in nominal GDP over time, we don't know if they are due to price changes or are those differences due to quantity changes For example if all the increases between 1935 and 2013 and nominal GDP were due to changes in quantity it means the economy in 2013 is producing a lot more stuff which is good from the material standard of living POV. If all the increases in nominal GDP between the two years were due to increased prices with the quantities remaining the same, this is not good. That means there are no more goods and services, products and services, available to satisfy people's wants. GDP includes products and services produced within a country’s borders, regardless the nationality of the business doing the producing GDP is what Economists call a flow variable, which means it's measured per unit of time. For GDP this is per year. It's an annual amount. There are also quarterly GDP statistics , for every three months of the economy's performance, and others such measures. It's a flow per unit of time The contrasting variable is a stock variable, which is something that's measured at a moment in time If we want to isolate the impact of changing quantities in national production, we're going to use a different concept, different from nominal GDP which is called real GDP Real GDP is the value at constant prices of all final products and services produced annually in a country. We're taking the same two years to compare, the superscripts are the same so it's products A or Services A, B, C, D Notice the price that we’re using is 2002. That's called a base year, a particular year we're choosing to do the calculations for all real GDP measurements. Q is a quantity of product A produced in 1935.

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So we're taking the quantities produced in that year but pricing them at a year that we're going to hold constant which is 2002. This is the same for product B, service C ect. This won't make sense until we see the second equation which is the real GDP in 2013. Same superscripts, products A, B, C and we're holding constant the price at the 2002 level which we've chosen as our base. We're multiplying that times the quantities produced in 2013. This is the year that we’re measuring real GDP for. You do that for every single product and service. So if we are to compare between 1935 and 2013 in real GDP, the only thing that has changed are the quantities because by definition we have held the prices constant

When there is an increase in real GDP, then we know that is due entirely to changes in quantities. Or if there's a decrease in real GDP it is entirely due to a decrease in quantities When we compare real GDP over time, we're looking at changes in quantities

We can see from the graph that the two lines intersect at 2002 because we have chosen 2002 as the base year set of prices that we’re going to hold constant So if for calculating nominal GDP for 2002, that means we use current year prices for 2002, multiplied by current year quantities for 2002. If we do a real GDP calculation for 2002, because that's the year we've chosen to use its price for all other years, the real GDP calculation is the same. So that's the year 2002, where are these two lines intersect After 2002 real GDP is increasing, but nominal GDP is increasing far more than real GDP This graph starts at 2002, where nominal and real GDP are equal We can see the increase in real GDP which is the increase in the actual stuff that the economy has produced The increase in nominal GDP is even higher because not only have quantities increased over time, but prices have increased as well

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By comparing nominal and real GDP, we can sort how much of the increase in nominal GDP is due to increases in quantities which is the amount here (end of real GDP line) and how much is due to increase in prices which is this additional amount here (end of nominal GDP line)

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Real GDP per person - We take real GDP and divided by the population of the country - This gives us the best possible measure of how much stuff there is per person. You can have a really high real GDP, but the population is very large, your real GDP per person might be small. So two countries with equal real GDP may have very different standards of living depending on what is the population, because once you divide real GDP by the population, that tells you the amount of products and services available for each member in that country's population - This is the best possible measure of material standards of living. All GDP Concepts measure the value of final products and services produced annually in a country. Why "final" products and services? Why is that word "final" in here? Final product or service - consumed directly by consumers Intermediate product or service - input bought from other businesses Value added - value of output minus the value of intermediate products and services bought from other businesses Ex. If you as a consumer are going on holiday and you buy an airline ticket, that is classified as a final service because you, the consumer, are the only one who is using the airline ticket. If a salesperson for Ford Motor Company buys an airline ticket to go to on a sales trip, that is actually an intermediate service because that's simply an input into the production and sales of automobiles Value added solves the problems of double counting and of distinguishing between final and intermediate products and services - Value of final products and services = sum of all of the value added - Value of final products and services (GDP) = all of the input’s income Specific example to look at the concept of value added for a very simple economy The figure illustrates the concept of value added and it's crucial importance for avoiding the problem of double counting in the calculation of GDP This economy consists of 3 sectors; a farmer, a miller and a baker. The farmer is going to sell wheat to the miller, who is going to turn it into flour, and the baker is going to turn it into bread to sell it to the final consumer To avoid infinite regress, we're going to assume that the farmer does not buy any inputs from any other businesses in the past. So the farmer has her own seed corn and her own tools She pays herself a wage of $1, pays rent for the land of $2, and produces wheat which sells for $3. That is her value added because she buys nothing from other businesses. The value of her final product and service is $3 The miller is buying that input from the farmer. The miller uses the business to turn it into flour, pays wages of $4, earns profit of $1 (3 + 4 + 1) and produces flour worth $8. The miller's value added is the sum of its final product, which is $8 in value for the flour, minus inputs bought from other businesses, $3 from the farmer. So 8 - 3 is $5 The miller then sells the flour to the baker. That becomes an input to the baker. The baker turns it into bread, and in doing so has to pay out wages of $2 and profits of $2. The bread is the only final product and service in this economy. These are intermediate products and services By adding up the value of all these different products and services, not just the final, we would get $3 for the wheat plus $8 for the flour plus $12 for the bread, or $23. This involves a lot of double-counting because the wheat is counted when making wheat, counted in the inputs of the miller and inputs of the baker. The flour is counted when making flour and counted in the inputs of the baker. So adding up all products and services, not just final products and services, would cause a gross over estimate of GDP.

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Here's the thing that's really effective and useful about the concept of value added. By adding up the value added for the farmer, miller and baker ($3 +$5 +$4 = $12), that is exactly equal to the value of the final products and services, the only final product and service produced in this simple example

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So with the concept of value added, we don't have to decide what’s a final product and what's not. All we have to do is for every sector of the economy, calculate the value added. And that value added is equal to the sum of all inputs - incomes going to inputs. If we add up all those, that gives us another measure for GDP which is equivalent to the value of final products. From this example we can see that the value of the final products and services produced (bread) was equal to the sum of the value added in each of the sectors...