1. Introduction
1. What is Macroeconomics?
a) What is Economics?
Economics is the study of the
An allocation is an answer to the question:
(1) What?
Which goods and services do people demand ⇒
(2) How?
How do firms produce ⇒
(3) For Whom?
Who gets the goods and services? ⇒
ECON 102 Page 1
b) What are Micro- and Macroeconomics?
Microeconomics is the study of how individual decision-makers
(economic agents) such as consumers, workers, or firms allocate
scarce resources as well as their interaction in markets.
Macroeconomics is the study of
Note: Macroeconomics builds upon microeconomics
Microeconomics
Macroeconomics
 Individual income

 Quantity of products a

business produces
 Spending of a household of
company
ECON 102 Page 2

2. The Science of Macroeconomics
a) Positive vs. Normative Analysis
Positive Analysis
Normative Analysis
⇒ positive analysis describes the
⇒ normative analysis describes
world objectively and fact-based.
the world the way it should be.
Positive statements do not have
Normative statements are
to be true, but they do need to
be statements that can be
validated as correct or incorrect
opinion-based, so they cannot
be proved or disproved
Examples:
• We should increase spending on education
• Economic theory clearly tells us that we should increase
spending on education
• There is a significant relationship between a country's
spending on human capital and its economic growth
• If a country spends more on human capital, it causes faster
economic growth
• Because human capital increases economic growth, developing
countries should spend more on human capital
ECON 102 Page 3
b) Economic Models
Economic Models are simplified versions of reality that are used
to analyze real-world situations.
Models…
□
□
□
□

"All models are wrong, but some are useful"
(George Box, 1976)
Note:
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c) The Scientific Method
(Karl Popper, 1934)
Theory
ECON 102 Page 5
3. The History of Macroeconomics
Market Sceptics
Government Sceptics
1870
Classical Economics
 Inflation & Interest (Wicksel, 1898)
 Quantity Theory (Fisher, 1911)
Irving Fisher
 Founding of NBER (Mitchel, 1920)
 Business Cycles (Kuznets, 1930)
1936
The Keynesian Revolution
 "The General Theory of Employment,
Interest, and Money"
John Maynard Keynes
 Response to Great Depression (1929-1939)
 Effective (Aggregate) Demand
 Consumption, Income, and Multiplier Effects
 Liquidity Preference for Money
 Countercyclical Fiscal Policy
Neoclassical Synthesis
Milton Friedman
 Refinement and mathematical
formulation of Keynes' theories
 IS-LM model (Hicks, 1937)
 "Foundations of Economic Analysis"
(Samuelson, 1947)
 Investment (Tobin, 1966)
 Solow Model (1956)
ECON 102 Page 6
Monetarism
 Restatement of
Quantity Theory
(Friedman, 1958)
 Money Supply
(F./Schwarz, 1963)
1950
1960
 Discovery of the Phillips Curve
 Expectations-
(Phillips, 1958)
adjusted Phillips
Curve
(Phelps, 1968)
New Keynesian Economics
New Classical Economics
 Sticky Wages (Fisher 1977)
 Rational Expectations
 Sticky Prices (Calvo 1983)
Olivier
Blanchard
1970
(Lucas, 1972)
 Coordination Failure
 Policy Ineffectiveness
(Diamond, 1982)
(Sargent, 1975)
 Monopolistic Competition
(Blanchard, Kiyotaki, 1987)
Robert E. Lucas
1980
 Lucas Critique (Lucas, 1976)
 Real Business Cycle Theory
(Kydland, Prescott, 1982)
1990
New Neoclassical Synthesis
 The New Keynesian Model
(Clarida, Gali, Gertler, 1999)
Jordi Gali
⇒ RBC + sticky prices + monopolistic competition
 Great Moderation (until 2008)
2007/
2008
 Financial Frictions (Bernanke, 1998)
Challenge to current paradigm:
 Behavioural Macroeconomics
ECON 102 Page 7
now
a) Classical Economics (Pre-1940)
"Intellectual Witch's Brew: many ingredients, some of them
exotic, many insights, but also a great deal of confusion"
(Olivier Blanchard, 2000)
Prevalent Paradigm:
► Flexible prices
► Quantity theory: Money and Prices are proportional
► Say's Law: Supply creates its own demand
b) The Keynesian Revolution (1936)
The General Theory of Employment, Interest and Money
(John Maynard Keynes, 1936)
"It is a badly written book, poorly organized; […] Flashes of
insight and intuition intersperse tedious algebra. […] its analysis
is found to be obvious and at the same time new. In short, it
(Paul Samuelson, 1946)
is a work of genius."
 General Equilibrium in three
markets: goods, financial and
labour
 In the short run, output is
determined by aggregate demand
 In the long run we are all dead
ECON 102 Page 8
c) The Neoclassical Synthesis (1940-1960)
A refinement, mathematical formulation, and expansion of
Keynes' ideas
► The golden age of macroeconomics
"We are all Keynesians now" (Richard Nixon, 1971)
The US Phillips Curve 1960-1969
Prevalent Paradigm:
► Prices are rigid in the short run
► Recessions are due to shortfalls in demand
► Countercyclical fiscal policy can manage the business cycle
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d) The Monetarist Counter Revolution
► Focus on the money supply
"Inflation is always and everywhere a monetary phenomenon"
(Milton Friedman, 1963)
Friedman predicted the collapse of the Phillips Curve as
people adjust their inflation expectations…
… and that's exactly what happened
Stagflation is a
recession caused by
supply side factors
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e) New Classical Economics (1970-2000)
Lucas Critique: Economic (policy) predictions are invalid if they
don't account for the endogenous change in behaviour
Policy Ineffectiveness: Monetary and fiscal policy are ineffective
people will reflect policy changes in their expectations and adjust
their behaviour accordingly.
Time to Build and Aggregate Fluctuations, Kydland and Precsott, 1982
Prevalent Paradigm:
► People are rational
► Recessions are optimal responses to exogenous changes
► Monetary and fiscal policy are neutral
► Recommendation of rule-based monetary and fiscal Policy
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f) New Keynesian Economics (1970-2000)
► Focus on disequilibrium and Market imperfections
Nominal Rigidity ⇒ Prices adjust slowly
Why are Prices Sticky?, Alan Blinder, 1992
Real Rigidity ⇒ Markets are not perfectly competitive
g) The New Neoclassical Synthesis (2000-now)
Prevalent Paradigm:
► Monetary and fiscal non-neutrality
► Independent and inflation-targeting monetary policy
► Fiscal policy should focus on redistribution
► Countercyclical fiscal policy can manage the business cycle
ECON 102 Page 12
2. Gross Domestic Product
1. Defining the Macroeconomy
a) The Circular Flow Diagram
Goods
Market
Government
Firms
𝐾, 𝐿 → 𝑌
Financial Market
Foreign Markets
Labour Market
𝑊 − 𝑤𝑎𝑔𝑒
𝑟 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝐾 − 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝐿 − 𝑙𝑎𝑏𝑜𝑢𝑟 (ℎ𝑜𝑢𝑟𝑠)
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Households
b) Identities
(1) Government
𝑆 =
⇒
 budget surplus: 𝑆
 budget deficit: 𝑆
(2) Foreign Markets
𝑁𝑋
=
⇒
(3) Firms
𝑌
=
(4) Households
𝑌
=
≡
ECON 102 Page 2
2. Measuring Gross Domestic Product
a) Value Added Approach (Production)
►
𝑌=
ECON 102 Page 3
in Canada:
b) Expenditure Approach (Spending)
►
𝑌=
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in Canada:
c) Income Approach (Factor Payments)
►
𝑌=
ECON 102 Page 5
in Canada:
Example:
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3. GDP and the Standard of Living
a) real GDP per capita
► nominal GDP per person is
.
$ .
.
in Canada (2021): ⎯⎯⎯⎯⎯⎯⎯⎯ = ⎯⎯⎯⎯⎯⎯⎯= 𝐶$65,300
Note:
is this a lot?
⇒
ECON 102 Page 7
%Δ nom. GDP ≈ %Δ real GDP + %Δ prices
Note:
Real GDP lets us compare average income in a country
over time. To compare average income between
countries, we also need to adjust for exchange rates!
b) The Limitations of GDP
(1)
(2)
(3)
(4)
(5)
(6)
ECON 102 Page 8
c) Other Measures of the Standard of Living
►
Real GDP per capita very strongly correlates with many other
measures of the standard of living!
ECON 102 Page 9
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3. Economic Growth
1. Facts of Economic Growth
(1)
ECON 102 Page 1
Country Name
GDP per capita, PPP (constant international $)
Norway
$67,460
United States
$64,623Data from World
$53,970Bank for 2022
Germany
Canada
$48,975
OECD members
$46,208
Korea, Rep.
$45,560
Japan
$41,641
Mexico
$20,255
China
$18,188
World
$17,523
Brazil
$15,093
South Africa
$13,479
Middle income
$12,265
Philippines
$8,582
India
$7,112
Cameroon
$3,724
Haiti
$2,799
Ethiopia
$2,381
Low income
$1,949
Somalia
$1,449
Congo, Dem. Rep.
$1,133
(2)
ECON 102 Page 2
If poorer countries grow faster,
…
(3) Some countries do catch up…
ECON 102 Page 3
(4) …
ECON 102 Page 4
catching/caught up
technological frontier
losing ground
(5) Economic Growth is a recent phenomenon
ECON 102 Page 5
►
This all raises the following questions:
(1)
(2)
(3)
ECON 102 Page 6
2. The Sources of Economic Growth
a) The Production Function
𝐿 − number of total hours of labour provided
𝐾 − amount of physical capital




𝐻 − amount of human capital

𝐴 − level of technology

ECON 102 Page 7
How to increase output:
□ Increase Labour Supply 𝐿

𝑦 − ouput per worker / productivity
𝑘 − capital per worker
ℎ − human capital per worker
𝐴 − total factor productivity
□ Increase capital per worker

□ Increase human capital per worker

□ Increase level of technology

ECON 102 Page 8
b) Malthusian Economic Growth
production increases 𝑌 ↑



An Essay on the Principle of Population (1798)

Notes:
•
•
•
•
ECON 102 Page 9
c) Capital Accumulation
► Neoclassical Growth (Solow, 1956)
(1) Diminishing Returns to Capital
𝑦 = 𝑓(𝑘)
𝑘
For a given amount of labour 𝐿, physical capital 𝐾
(2) Capital Accumulation
The capital stock per person increases with the amount of
investment and decreases with the amount of depreciation
ECON 102 Page 10
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
investment > depreciation =>
investment < depreciation =>
Assumptions:
•
•
⇒ Δ𝑘 =
𝑦
𝑦 = 𝑓(𝑘)
output
𝛿𝑘
depreciation
𝑠𝑦
investment
𝑘∗
•
•
•
ECON 102 Page 11
𝑘
(3) Technological Progress
𝑦 = 𝐴𝑓(𝑘)
ECON 102 Page 12
•
•
d) The Process of Innovation
► New Growth Theory (1990s)
Where does technological progress come from?
□ Investment in research with positive externalities
(1) ideas can be freely shared
► non-rivalry and non-excludability in consumption
(2) ideas do not depreciate
(3) ideas promote other ideas
► positive externality
□ Creative Destruction
 least productive firms go bankrupt
 new firms enter the market
 over time average productivity increases
□ Technology Diffusion/Spillovers
 international trade and direct investment let developing
countries access newer technologies quicker (imitation)
□ Education
 education behaves similarly to capital stock and has
decreasing returns
ECON 102 Page 13
3. Government and Institutions
• Property Rights =>
• Government Stability =>
• Subsidizing Education and Research =>
ECON 102 Page 14
4. Sustainability
a) Limited Economic Resources
𝑌 = 𝐴𝐹(𝐾, 𝐿, 𝑂)
►
►
►
ECON 102 Page 15
b) Environmental Degradation
Problem:
Production processes that use fossil fuels have a
►
Solution:

Distributional Conflict:
It is much easier for advanced countries
to reduce emissions as they have already
gone through the energy-intensive
process of industrialization
Kuznets Curve
ECON 102 Page 16
5. Conclusion
• Countries need strong government institutions to grow
• Countries can grow fast through capital accumulation and
investment in education until they reach the technological
frontier
• At the technological frontier, countries grow at the rate of
technological progress through innovation, research and
development.
• High GDP growth needs to be traded off against other
welfare-improving goals such as inequality or environmental
degradation
ECON 102 Page 17
4. Unemployment
1. Employment and Unemployment
a) Defining the Labour Market
38𝑚
32𝑚
21𝑚
20𝑚
𝑁
=
𝐿=
16.5𝑚
𝐸=
𝐸 =
https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=1410028703
to be considered "unemployed" one must:
(1)
(2)
(3)
ECON 102 Page 1
b) The Unemployment Rate
(1) Unemployment rate over time
𝑢=
►
►
(2) Alternative Measures of Unemployment
ECON 102 Page 2
(3) Unemployment by Individual Characteristics
ECON 102 Page 3
c) The Employment Rate
𝑒=
d) The Participation Rate
𝑝=
►
►
►
ECON 102 Page 4
ECON 102 Page 5
2. The Determinants of Unemployment
a) Defining Unemployment
Unemployment =
𝑢
=
b) Cyclical Unemployment (Short Run)
Boom
Recession
ECON 102 Page 6
labour supply
𝑊
𝑊∗
labour demand
𝐿∗
𝐿
C) The Natural Rate of Unemployment (Long Run)
The Natural Rate of Unemployment is the unemployment that
arises from structural and frictional factors, void of cyclical
components. It is the long-run trend of the unemployment rate.
Note: The natural rate of unemployment is
Natural Unemployment = Frictional Unemployment + Structural Unemployment
ECON 102 Page 7
(1) Frictional Unemployment
► "In-between" jobs unemployment
find job
𝑈
𝐸
lose job
• firms go bankrupt, new firms enter the market
• workers retire, new workers enter the market
 It takes time to find employer-employee matches
□ time and cost of acquiring information
□ skill matching
□ geographical matching
ECON 102 Page 8
(2) Structural Unemployment
labour supply
𝑊
labour demand
𝐿
 A wage higher than the market clearing level creates
○ extensive margin ⇒
○ intensive margin ⇒
□
□
□
□
ECON 102 Page 9
c) Hysteresis
► Interaction between cyclical and natural
unemployment
Long periods of high cyclical unemployment can
□
□
□
ECON 102 Page 10
Special Topic: Tariffs
1. Why free trade?
𝑃
𝑄
•
•
•
2. Import Tariffs
𝑃
𝑄
ECON 102 Page 1
•
•
•

•

Higher prices translate into inflation
Output Prices ↑

Importing Country
Exporting Country
• Inflation
• Inflation
• Output
• Output
►
ECON 102 Page 2
Importing Country
Exporting Country
• Inflation
• Inflation
• Output
• Output
Note:
►
Canada
ECON 102 Page 3
5. Inflation and Money
1. Measuring Inflation
a) Price Indexes
Price of apple
Price of grapes
Price of peach
Cost of market basket
(200 apples, 50 bunches of
grapes, 100 peaches)
Year 1
Year 2
$0.20
0.60
0.25
(200 × $0.20) +
(50 × $0.60) +
(100 × $0.25) =
$95.00
$0.40
1.00
0.45
(200 × $0.40) +
(50 × $1.00) +
(100 × $0.45) =
$175.00
typical purchase: 200 apples, 50 grape bunches, 100 peaches
⇒
□
□
𝐶𝑜𝑠𝑡
𝑃 = ⎯⎯⎯⎯⎯⎯⎯⎯∗ 100
𝐶𝑜𝑠𝑡
𝑃 =
𝑃 =
ECON 102 Page 1
b) The Inflation Rate
►
𝜋 =
π =
c) The Consumer Price Index
The CPI basket:
□
□
ECON 102 Page 2
□ The cost of this basked has steadily been rising

π
𝐶𝑃𝐼 − 𝐶𝑃𝐼
= ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯
𝐶𝑃𝐼
ECON 102 Page 3
Inflation:
Deflation:
Disinflation:
Problems with CPI:




2. Other Measures of Inflation
a) Core Inflation
CPI - trim
CPI - median
https://www.bankofcanada.ca/rates/indicators/key-variables/key-inflation-indicators-and-the-target-range/
ECON 102 Page 4
b) Producer Price Index (PPI)
https://www150.statcan.gc.ca/n1/daily-quotidien/240117/dq240117b-eng.htm?indid=3556-1&indgeo=0
industrial product price index
industrial product price index excluding energy and petroleum
c) GDP Deflator
𝑛𝑜𝑚. 𝐺𝐷𝑃
𝒫 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯∗ 100 =
𝑟𝑒𝑎𝑙 𝐺𝐷𝑃
►
►
►
►
ECON 102 Page 5
ECON 102 Page 6
3. Real and Nominal Variables
a) Real GDP
𝑌
=
𝒲
=
b) Real Wages
- downward nominal wage rigidity -
US data
►
ECON 102 Page 7
c) Real Interest Rate
- Fisher Equation 𝑖
=
d) Real Money Balances
How much does a certain amount of money buy?
 The purchasing power or money
ℳ
=
 Economic decisions are based on real variables
►
Note:
□
□
ECON 102 Page 8
4. The Cost of Inflation
(1) Menu Cost
□ cost of printing a new menu at restaurant
►
(2) Shoe-Leather Cost
□ running to the bank to get cash
►
(3) Distortion of Price Signals
□ identification problem if increase in nominal
price is due to increase in real price or
inflation
►
(4) Unintended Redistribution
□ inflation deflates debt
►
(5) Hyperinflation
□ very high inflation rates are self-reinforcing
►
Note:
ECON 102 Page 9
5. Money
What is money?
Def.: Money
a) Functions of Money
(1)

(2)

(3)

b) Types of Money
a) Commodity Money
►
□
□
□
ECON 102 Page 10
b) Commodity Backed Money
►
□
□
□
Italy:
►
England:
►
c) Fiat Money
►
□
□
□
□
ECON 102 Page 11
d) Cryptocurrency?
□

□
(1)
(2)
(3)
ECON 102 Page 12
6. Financial Markets
1. Loanable Funds
a) Supply of Loanable Funds
𝑆=

real rate of
real rate of
return of saving:
return of holding
money:
The supply of loanable funds (i.e. saving) is an increasing
function of the interest rate
𝑆 = 𝑆(𝑟)
𝑟
ECON 102 Page 1
b) Demand for Loanable Funds
𝐼
 The interest rate is the opportunity cost of investment
How much are firms going to invest?
𝑟𝑒𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛
𝑜𝑛 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
𝑟
5%
3%
2%
𝑝𝑟𝑜𝑗𝑒𝑐𝑡 1 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 2 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 3 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 4
1
2
3
4
𝐼
The demand for loanable funds (i.e. investment) is a decreasing
function of the interest rate
𝐼 = 𝐼(𝑟)
ECON 102 Page 2
c) Equilibrium in the Loanable Funds Market
Shifts in Investment
□ Demand Expectations
►
Shifts in Saving
□ Income & Uncertainty
►
□ Government Policy
□ Government budget
►
►
□ Technology
□ Demography
►
►
ECON 102 Page 3
2. Investment and Capital Accumulation
□
□
□
□
□
ECON 102 Page 4
𝐼
𝑁𝐼
𝑁𝐼 =
𝐾
𝛿𝐾
𝐾
𝐾
𝐾
=
𝐾
►
►
ECON 102 Page 5
=
=
3. Banking
a) Financial Institutions
A bank is
(1) Depository Institutions in Canada:
1.
►
2.
3.
Banks generate revenues by
(2) Functions of Banks
(1)
►
(2)
►
(3)
►
(4)
►
(5)
►
ECON 102 Page 6
(3) A Bank's Balance Sheet
Assets
Note:
Liabilities
Banks only hold a certain share 𝜃 of their deposits as
reserves. The rest is loaned out.
𝜃 − desired reserve ration
𝑅=
b) Banking Crises
(1) Bank Runs
Assets
Liabilities
𝑅
𝐷
𝑆
𝐸
𝐿
/
ECON 102 Page 7
1.
2.
3.
4.
5.
(2) Contagion
Bank A
Assets
Liabilities
𝑅
𝐷
Assets
Bank B
Liabilities
𝑅
𝐷
𝑆
𝑆
𝐸
𝐿
/
𝐸
𝐿
1. Bank A is low on liquidity
2.
3.
4.
5.
 Banks might engage in 'fire sales'
ECON 102 Page 8
/
Note:
The problem is highly elevated by financial derivatives,
i.e. securities whose value depends on another
security.
Note:
(3) Regulation






ECON 102 Page 9
4. Financial Markets
(1) Loan Market


(2) Bond Market


-
𝑖=
ECON 102 Page 10
(3) Stock Market
 Corporate equity
□
□
Efficient Market Hypothesis: All publicly available information
is reflected in a stock price and it is therefore not possible
to consistently "beat the market", unless…
1. …

2. …

3. …
ECON 102 Page 11
7. International Finance
1. Trade in Canada
□

□

□


ECON 102 Page 1
2. The Balance of Payments
(1)
𝑁𝑋 = 𝐸𝑋 − 𝐼𝑀 = 𝐶𝐴 =
(2) The Current Account is the difference between
domestic production and expenditures on domestic goods
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
(3) The Current Account is the difference between
Investment and Saving
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
𝑌 − 𝐶 − 𝐺 = 𝐼 + 𝑁𝑋
= 𝐼 + 𝑁𝑋
𝑁𝑋 =
𝐼𝑀 > 𝐸𝑋
⇒𝐼>𝑆
𝐼𝑀 < 𝐸𝑋
⇒𝐼<𝑆
United States
Germany
• Trade deficit
• Trade surplus
• Net capital inflows
• Net capital outflow
• Net debtor
ECON 102 Page 2
• Net creditor
Vietnam
Germany
•
•
•
•
•
•
•
•


Note:
ECON 102 Page 3
How about Canada?
Note:
Canada's trade balance is heavily dependent on
ECON 102 Page 4
3. Exchange Rates
a) Nominal Exchange Rate

how many foreign units of currency do
𝑒=
you get for one unit of domestic currency
𝑒↑
𝑒↓
►
►


Nominal Exchange Rate Determination
𝑒
𝑆
𝐷
𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓
𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
Demand
Supply
•
•
•
•
ECON 102 Page 5
b) Real Exchange Rate
how many foreign goods do you get for
𝜀=
one unit of identical domestic good
𝜀=
𝜀=
𝜀=
Net Exports and the Exchange Rate
𝑁𝑋 = 𝑁𝑋 (𝜀 )
𝜀
𝜀
𝜀
𝑁𝑋
𝜀 −Domestic goods are
𝜀 −Domestic goods are
relatively
relatively




ECON 102 Page 6
8. The Business Cycle
1. Trend and Cycle
a) The Output Gap
𝐶𝑎𝑛𝑎𝑑𝑖𝑎𝑛 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑝𝑒𝑟 𝑝𝑒𝑟𝑠𝑜𝑛
potential GDP: 𝑦
actual GDP: 𝑦
►
►
►
Note:
𝑦 =
𝑌
ln ⎯⎯
𝑁
log p r p rson GD
ECON 102 Page 1
y
=
𝑦>0→
𝑦<0→
ECON 102 Page 2
b) Recessions
A recession is a
quarterly frequency:
monthly frequency:
https://www.cdhowe.org/council/business-cycle-council
ECON 102 Page 3
c) Output Gap and Unemployment
ECON 102 Page 4
When the output gap is closed (𝑦 = 0):
⇒
⇒
⇒
□
□
□
When the output gap is not closed:
𝑦>0
𝑦<0
► inflationary gap
► recessionary gap






Okun's Law
ECON 102 Page 5
2. Macroeconomic Data
a) Data Transformations
(1) Removing Trend Growth
•
•
•
○
○
(2) Removing Seasonality
(3) Removing Noise
ECON 102 Page 6
b) Coincident and Leading Indicators
(1) Leading Indicators
Story of a recession
►
►
ECON 102 Page 7
►
►
ECON 102 Page 8
(2) Coincident Indicators
►
►
►
ECON 102 Page 9
►
○
(3) Lagging Indicators
►
►
ECON 102 Page 10
ECON 102 Page 7
9. Aggregate Demand
1. The IS Curve
a) Interest Rate Sensitivity of Demand
► Aggregate Expenditures (Demand) as a function of the
interest rate
𝑌
=
𝐶
+
𝐼
+
.
𝐺
𝑌( 𝑟) = 𝐶 (𝑟) + 𝐼 (𝑟) + 𝐺 (𝑟) + 𝑁𝑋 (𝑟)
𝑟↑
Consumption:
▪
▪
Investment:
▪
▪

Gov. purchases:
▪

Net Exports:
▪
→
ECON 102 Page 1
+
𝑁𝑋
b) Changes in the IS Curve
𝑟
𝑟∗
IS
𝑦
ECON 102 Page 2
𝑦
changes in 𝑟
⇒
changes in 𝐶, 𝐼, 𝐺, 𝑁𝑋 not due to changes in 𝑟
⇒
2. The MP Curve
a) Monetary Policy
The central bank can set a nominal policy rate 𝑖
the money supply in the overnight money market:
𝑖
=
Which implies a (risk free) real interest rate:
𝑟=
ECON 102 Page 3
by fine-tuning
Monetary Policy Rule
𝑟
IS-MP
𝑀𝑃𝑅
𝑟
𝑀𝑃
𝑟∗
𝐼𝑆
π∗
𝜋
𝜋∗ −
𝑟∗ −
Monetary Policy Rule:
Inflation above target (𝜋 > π∗ ) →
Inflation below target (𝜋 < π∗ ) →
ECON 102 Page 4
0
𝑦
b) The Risk Premium
Recall from chapter 6:
𝑖
=
𝑟+𝜋
+
𝜙
Overnight Money Market:
term:
risk:
+
+
𝓉
/
Bond/Consumer Loan Markets:
-
-
-
𝑖
ℓ
𝑟=
=
𝑀𝑃𝑅
𝑟
𝑟
𝑀𝑃
𝑟∗
𝐼𝑆
π∗
𝜋
0
𝑦
There is a gap between the real interest rate in the overnight
money market that the CB can control and the real interest rate
relevant for demand
𝑟−𝑟
≡
𝛾
=
𝜙
ECON 102 Page 5
+
ℓ
+
𝓉
/
Risk Spread
𝛾
=𝑖
.
−𝑖
.
The risk spread is the difference between the interest rate on
corporate bonds (with default risk) and government bonds (assumed
no default risk) with same maturity.
The term spread is the difference between interest rates on 10year and 3-months government bonds.
ECON 102 Page 6
3. The IS-MP Model
a) Demand Shocks
𝑟
𝑀𝑃
𝐼𝑆
𝑦 <𝑦
0
𝑦 >𝑦
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
Notes:
•
•
•
ECON 102 Page 7
𝐼𝑆
b) Financial Shocks
𝑟
𝑀𝑃
𝑀𝑃
𝐼𝑆
𝑦 <𝑦
𝜙
𝑦 >𝑦
−
ℓ
𝓉
0
−
/
−
ECON 102 Page 8
c) Monetary and Fiscal Policy
(1) Fiscal Policy
𝑟
►
𝑀𝑃
𝐼𝑆
𝑦 <𝑦
0
(2) Monetary Policy
𝑟
𝑀𝑃
𝐼𝑆
𝑦 <𝑦
0
ECON 102 Page 9
►
10. Aggregate Supply and Equilibrium
1. The Phillips Curve
a) Price Setting by Firms
Firms set nominal prices
𝑃=
Since production costs are often predetermined,
□
□
Assuming a constant markup, we get the following equation for
inflation (derivation at the end):
Phillips Curve/Aggregate Supply:
𝜋=
π
+𝛼
𝑦
b) Factors that Impact the Phillips Curve
(1) Movements along the Phillips Curve
𝜋 = π + 𝜶(𝒚 − 𝒚 )
𝜋
𝑃𝐶
𝜋∗
0
𝑦
excess supply
𝑦<𝑦
excess demand
𝑦>𝑦
•
•
•
•
•
•
•
•
•
•


Note:
Movements along the PC are
(2) Shifts of the Philips Curve
𝜋 = 𝝅𝒆 + 𝛼(𝑦 − 𝑦 )
𝜋
𝑃𝐶
𝜋∗
0
𝑦
higher than expected inflation
π < π∗
•
lower than expected inflation
𝜋 > π∗
•
○
○
○
○
○
•
○
•
○
•
•
○
Note 1: Phillips Curve in the Book
𝜋 = 𝜋 + 𝛼(𝑦 − 𝑦 )
𝜋−𝜋
if 𝑦 = 𝑦 (𝑦 = 0) then
When the output gap is closed the best expectation for inflation
is
Note 2: The Classic Phillips Curve
Phillips Curve
𝜋 = 𝜋 + 𝛼𝑦
Okun's Rule of Thumb
𝑦 = −𝛾(𝑢 − 𝑢 )
𝜋 = 𝜋 − 𝛽(𝑢 − 𝑢 )
𝛽=
α
𝛾
2. The IS-MP-PC Model
a) Interaction of Demand and Supply
𝑟
IS-MP

𝑟∗
𝑀𝑃


𝐼𝑆
𝜋
𝑦

𝑃𝐶

PC

π∗

0
𝑦

b) Macroeconomic Shocks
(1) Financial Shocks
(2) Spending/Demand Shocks
(3) Supply Shocks
3. The AS-AD Model
a) Endogenous monetary policy
𝑟=𝑟
+𝛾
𝑟
Monetary Policy Rule
𝑀𝑃𝑅
𝑟
IS-MP
𝑀𝑃
∗
𝐼𝑆
π∗
𝜋
𝑦
AS-AD
𝐴𝑆/𝑃𝐶
0
𝐴𝐷
𝑦
𝜋
𝜋
π∗
45°
𝜋
Notes:
•
•
•
b) Demand Shocks
𝑟
Monetary Policy Rule
𝑀𝑃𝑅
𝑟
IS-MP
𝑟∗
𝑀𝑃
𝐼𝑆
π∗
𝜋
𝑦
AS-AD
𝐴𝑆/𝑃𝐶
0
𝐴𝐷
𝑦
𝜋
𝜋
π∗
45°
𝜋

c) Supply Shocks
𝐴𝑆/𝑃𝐶
𝜋
π∗
𝐴𝐷
0
►

𝑦
Appendix: Derivation of the Aggregate Supply Function
𝑃 = 𝑃 ∗ 𝜇 ∗ 𝑀𝐶
𝑃 = 𝑃 ∗ 𝜇 ∗ 𝑀𝐶
take logs:
𝑝 = 𝑝 + 𝜇 + 𝑚𝑐
same true for previous period:
so:
π =𝑝 −𝑝
𝑝
= π + 𝑚𝑐 − 𝑚𝑐
=𝑝
+ 𝜇 + 𝑚𝑐
= π + Δ𝑚𝑐
the change in marginal cost is proportional to the output gap.
Δ𝑚𝑐 = 𝛼𝑦
This is more complicated to show, but it basically comes from
wage pressures in the labour market. Wages increase faster when
unemployment is low and slower/stagnate when unemployment is
high
𝜋 = π + 𝛼𝑦
11. Monetary Policy
1. The Bank of Canada
a) Core Functions
(1)
(2)

(3)

(4)

Note:
(5)

Bank of Canada (relative) independence:
•
•
ECON 102 Page 1
b) The Monetary Policy Framework
Objective:
Policy:


𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑡𝑎𝑟𝑔𝑒𝑡𝑖𝑛𝑔
Policy Instrument: Overnight money market interest rate
ECON 102 Page 2
2. The Conduct of Monetary Policy
a) The Overnight Money Market
□ 16 participating banks in Lynx (high-value payment system)
□ Multilateral netting at end of day
►
►
□
supply
𝑖
𝑖
∗
demand
𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠
ECON 102 Page 3
b) Setting the Policy Rate
(1) Cut off demand with deposit and bank rate
□

□

□

𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑟𝑎𝑡𝑒
ECON 102 Page 4
(2) Fine tune supply with open-market operations
□
𝑠𝑢𝑝𝑝𝑙𝑦 𝑠𝑒𝑡 𝑏𝑦 𝐶𝐵
□
Repo:
(1)
(2)
(3)
ECON 102 Page 5
Reverse Repo: CB sells bond, buys it back tomorrow
(1)
(2)
(3)
Note:
c) Propagation of short-term to long-term interest rates
Option 1: 2-year term
Option 2: 2 times 1-year term
(1 + 𝑖 )𝐵
Both should yield the same return, but option 1 is riskier:
!
(1 + 𝑖 ) =
□ Expectations theory of interest rates:
!
(1 + 𝑖 ) = (1 − 𝑖 ) 1 + 𝑖
!
(1 + 𝑖 ) =
1+𝑖
1+𝑖

ECON 102 Page 6
1+𝑖
+𝛾
…+ 𝛾
ECON 102 Page 7
3. Monetary Policy Transmission
a) Conventional Monetary Policy
□ Transmission Channels
(1)

(2)

(3)


(4)

ECON 102 Page 8
□ The Taylor Rule
𝑟
+𝛾
𝑀𝑃𝑅
𝛾
𝑟∗
π∗
𝑖
=
𝑟∗
+
(
𝜋
𝜋
)
ECON 102 Page 9
+ 𝜙 (π − π∗ ) + ϕ (𝑦 − 𝑦)
b) Non-Conventional Monetary Policy
□ The Liquidity Trap
IS-MP
𝑟
𝑀𝑃
𝐼𝑆
𝑦
0
►
Solution:


𝑟
(1) Negative Interest Rates
IS-MP
•
𝑀𝑃
𝐼𝑆
0
𝑦
ECON 102 Page 10
(2) Quantitative Easing
►

ECON 102 Page 11
(3) Forward Guidance
►
(1 + 𝑖
) = (1 − 𝑖
) 1+𝑖

Note:
ECON 102 Page 12
1+𝑖
1+𝑖
…+𝛾
12. Fiscal Policy
1. The Government Budget
𝑆 =
𝑇
−
.
𝐺
𝐺=
𝐷 = −𝑆
a) Government Revenues
(1) Federal Government Revenues
ECON 102 Page 1
Income Taxes are…
►
□

► Marginal
□

𝐹𝑒𝑑𝑒𝑟𝑎𝑙 𝑡𝑎𝑥 𝑏𝑟𝑎𝑐𝑘𝑒𝑡𝑠 2022
►
□



ECON 102 Page 2
Payroll taxes…
□
○
○
Corporate taxes…
□
○
Federal Revenues and Expenditures 2019/2020
ECON 102 Page 3
(2) Provincial Revenues
Provinces levy top-ups on:
• income tax
• corporate tax
• sales tax (GST)
Note:
One quarter of provincial
revenue is transfers from the
federal government
Provincial Revenues and Expenditures 2019/2020
ECON 102 Page 4
(3) Municipal Revenues
Main sources of revenue for municipalities are…



ECON 102 Page 5
b) Government Expenditures
(1) Federal Spending
ECON 102 Page 6
Major Federal Spending Programs:
•
•
•
•
(2) Provincial Spending
Major Provincial Spending Programs in Alberta:
•
•
•
○
○
○
○
ECON 102 Page 7
(3) Municipal Spending
Major Municipal Spending Programs in Edmonton:
•
•
•
•
ECON 102 Page 8
c) The Size of Government


revenues
Anglo-Saxon countries → low redistribution
Continental European countries → high redistribution
Canada → in between
►
►
ECON 102 Page 9
2. Fiscal Policy
a) Aggregate Demand
𝑌 = 𝐶 (𝑌 − 𝑻, 𝑟) + 𝐼(𝑟) + 𝑮 + 𝑁𝑋(𝜀)
IS-MP
Expansionary Fiscal Policy
Contractionary Fiscal Policy
𝑟
𝑟
𝑟∗
𝑀𝑃
𝑟∗
𝑀𝑃
𝐼𝑆
𝐼𝑆
𝑦
0
0
 increase government
 decrease government
 cut taxes 𝑇
 raise taxes 𝑇
►
►
spending 𝐺

ECON 102 Page 10
spending 𝐺
𝑦
b) Discretionary Fiscal Policy
The government can use discretionary spending programs and
changes to tax rates to manage the business cycle.
Examples:
•
•
Problems
(1) Crowding Out of Investment
 Increasing the deficit will lower total saving in the
economy
𝑆 ↓= 𝑆 + 𝑆 ↓
𝑟
𝑆
𝐼
loanable funds
 The increase in interest rates will lower investment
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
ECON 102 Page 11
(2) Policy and Time Lags
 Political Process
○
 Implementation
○

b) Automatic Stabilization and Cyclical Deficits
► tax revenue is a function of income (personal income tax,
corporate income tax, value added tax)
𝑇=
where 𝑡 is the average tax rate
ECON 102 Page 12
► many government expenditures automatically increase during
economic downturns (unemployment benefits, income support)
𝐺=
𝑔 −
𝑔 𝑌−
𝑆 =𝑇−𝐺 =
𝑆 =
𝑆
𝑌
−𝑔


ECON 102 Page 13
𝑌
ECON 102 Page 14
3. Government Deficit and Debt
𝐵
=𝐵
+ 𝐷
.
a) Structural Deficits
Structural Surplus
Structural Deficit
𝑆
𝑆
Y
Y
𝑌
Should the government run budget deficits even when the
output gap is closed?
ECON 102 Page 15
𝑌
Worst Case:

□
□

ECON 102 Page 16
b) Debt Sustainability
Debt to GDP ratio = ⎯



Problem:
ECON 102 Page 17