ECO 209Y
Macroeconomic Theory
and Policy
Lecture 1:
Introduction
© Gustavo Indart
Slide 1
Branches of Economics

Microeconomics is concerned with the study of the choice
problem faced by the economic agents: households and
firms
 e.g., how the equilibrium price for a particular
commodity is determined

Macroeconomics is concerned with the study of the
economy as a whole
 e.g., how the general level of prices is determined (and
not the price of any particular commodity)
© Gustavo Indart
Slide 2
The Object of Macroeconomics

How the general level of prices is determined?

What determines the percentage of the labour force that is
unemployed?

What determines a country’s level of aggregate output or
GDP?

What determines the level of interest rates?

What determines the foreign exchange rate?

What determines a country’s balance of payments with the
rest of the world?
© Gustavo Indart
Slide 3
The Rate of Inflation
The inflation rate (π) is the percentage increase in the level of
prices during a given period:
π=
P − P-1
P-1
where P is the current price level and P-1 is the price level at
the end of the previous period.
© Gustavo Indart
Slide 4
Canada: Inflation and Deflation
Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics.
© Gustavo Indart
Slide 5
Canada: Inflation and Deflation
January 2004 to September 2014
Annual Change on CPI
© Gustavo Indart
Slide 6
The Rate of Unemployment
The unemployment rate is the fraction of the labour force
that cannot find jobs:
LF − N
u=
LF
where LF is the size of the labour force and N is the number of
employed workers
© Gustavo Indart
Slide 7
Canada: Unemployment Rate
Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics.
© Gustavo Indart
Slide 8
Canada: Unemployment Rate
January 2004 to September 2014
© Gustavo Indart
Slide 9
Aggregate Output (GDP)
Gross Domestic Product (GDP) is the value of all final goods
and services produced in the economy during a given period
of time
 Nominal GDP measures the value of output at the prices
prevailing in the period the output is produced
 Real GDP measures the output at the prices of some base
year
© Gustavo Indart
Slide 10
Canada: Growth in Aggregate Output
Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics.
© Gustavo Indart
Slide 11
Canada: Growth in Aggregate Output
January 2004 to September 2014
Annual Real GDP Growth Rate
© Gustavo Indart
Slide 12
Canada: Growth in Aggregate Output
Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics.
© Gustavo Indart
Slide 13
Canada: Real GDP per Capita
Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics.
© Gustavo Indart
Slide 14
The Rate of Interest

The nominal rate of interest (i) is the actual money
interest charged on a loan

The real rate of interest (r) is the purchasing value
of the interest charged on that loan, that is, the real
interest rate is the nominal rate (i) minus the rate of
inflation (π):
r=i−π
© Gustavo Indart
Slide 15
Canada: Prime Rate of Interest
January 1970 to September 2014
© Gustavo Indart
Slide 16
The Exchange Rate

The exchange rate is the relative value of the currencies of
two countries

We will define the exchange rate (e) to be the value of one
unit of foreign currency measured in Canadian dollars
 The exchange rate for US$ is today approximately e = 1.32
 This means that the value of the Canadian dollar is today
approximately 1/e = 0.76 i.e., Cdn$1 = US$ 0.76

The level of the exchange rate could be set by the Bank of
Canada or be determined by market forces
 Bank of Canada sets the value of e  fixed exchange rate
system
 Market forces determine the value of e  flexible or
floating exchange rate system
 Bank of Canada intervenes in the market to avoid sudden
jumps  managed or dirty floating exchange rate system
© Gustavo Indart
Slide 17
The Exchange Rate between the
Canadian Dollar and the U.S. Dollar
Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics.
© Gustavo Indart
Slide 18
The Exchange Rate between the
Canadian Dollar and the U.S. Dollar
January 2005 to September 2014
© Gustavo Indart
Slide 19
The Balance of Payments

The balance of payments is the record of all transactions of
the economy with the rest of the world

The overall balance of payments is the summation of the
balance in two accounts: the current account and the
capital account
 The current account records all the imports and exports
of goods and services, investment income, and transfer
payments
 The capital account records the capital flows, that is,
investment and borrowing/lending
© Gustavo Indart
Slide 20
Canada’s Balance of Payments, 2010
Receipt
Payment
Balance
547,141
598,005
-50,864
Goods and services
476,086
507,844
-31,757
Investment income
61,794
78,230
-16,436
9,261
11,932
-2,671
156,883
107,176
49,707
Current account
Transfers
Capital account
Statistical discrepancy
© Gustavo Indart
1,157
Slide 21
Canada’s Current Account Balance
as Percent of GDP
January 1980 to September 2013, quarterly
© Gustavo Indart
Slide 22
Economic Policy

Policy makers use mainly two types of policies to affect the
economy: fiscal and monetary policies

The government (Parliament) controls fiscal policy, while
the Bank of Canada controls monetary policy
 The instruments of fiscal policy are tax rates and
government spending
 The main instruments of monetary policy are changes in
either the stock of money or the bank rate
© Gustavo Indart
Slide 23
Leading Schools of Thought

There is a widespread belief that the government can and
should take actions to influence key economic variables such
as inflation and unemployment
 Economists don’t agree, however, on what measures will
achieve the desired results
 The reason for this disagreement is that we don’t have any
particularly compelling theory

There are different schools of thought and the most
important ones are the Monetarist, the Keynesian, the New
Classical, and the New Keynesian
© Gustavo Indart
Slide 24
The Monetarist School

Governments should have policies towards a limited number
of macroeconomic variables (e.g., growth of money supply,
government expenditure, taxes, and/or the government
deficit)

Governments should adopt fixed rules for the behaviour of
these variables (e.g., a fixed rate of growth of money supply
or balanced budget over a period of four or five years)

Policy changes should be announced as far ahead as possible
to enable people to take account of them in planning their
own economic affairs
© Gustavo Indart
Slide 25
The Keynesian School

They advocate more detailed intervention to “fine tune”
the economy in the neighbourhood of full employment and
low inflation
 Government intervention should be counter-cyclical

Policy changes should not be pre-announced in order to
deter speculation
© Gustavo Indart
Slide 26
The New Classical School

The New Classical or Rational Expectations school assumes
that markets are continuously in equilibrium (particularly the
labour market)

They also assume that expectations are formed “rationally”,
that is, taking into account all the economically relevant
information
 For this reason, expected government intervention cannot
affect the real variables in the economy
© Gustavo Indart
Slide 27
The New Keynesian School

The New Keynesians assumes that wages are not fully
flexible as to always equate the demand and supply of
labour

They assume that wages are fixed during a period of time
due to institutional constraints (e.g., minimum wage
legislation or labour contracts)
 Due to these rigidities in the labour market, government
intervention can most effectively affect the economic
variables
© Gustavo Indart
Slide 28
Macroeconomic Models

Economists use models to help explain real world phenomena

Economic models represent simplifications of the real world
 They take into account only some “endogenous” and
“exogenous” variables
 They also make assumptions about the behaviour of
economic agents

If some determining variables are left out or some
behavioural assumptions are at odds with reality, then the
model represents a distortion and not a simplification of the
real world

Different models help to explain the behaviour of the
economy at different times and situations
© Gustavo Indart
Slide 29
Aggregate Demand

The level of aggregate demand is the real value of the total
demand for domestically produced goods and services

The aggregate demand curve (AD) shows the negative
relationship between the price level and the real value of the
quantity demanded of domestically produced goods and
services

At each price level, the AD curve shows the value of output at
which both the goods markets and the money markets are
simultaneously in equilibrium (we’ll see this in more detail
later on)
© Gustavo Indart
Slide 30
Aggregate Supply

The level of aggregate supply is the real value of the output
the economy can produce given the resources and technology
available

The aggregate supply curve (AS) shows the relationship
between the price level and the real value of the quantity
supplied of goods and services and its slope depends on
whether we are referring to the short run, medium run, or
long run

The short run, medium run, and long run do not refer
necessarily to different time-periods
 They refer rather to different situations the economy goes
through over time
© Gustavo Indart
Slide 31
Aggregate Supply (continued)

In the short run the level of output can vary without affecting
the price level
 The economy is producing at less than full capacity and
unemployment is high
 The AS curve is horizontal, and the aggregate demand
determines the level of output

In the medium run there is little or no excess capacity and
unemployment is low, thus the AS curve has a positive slope
© Gustavo Indart
Slide 32
Aggregate Supply (continued)

In the long run the level of output is determined by the
productive capacity, and thus it is fixed at this maximum
level
 Therefore, in the long run the aggregate supply curve is
vertical at this maximum level of output
 Changes in demand can only affect the price level but
not the level of output

In the very long run the productive capacity of the economy
increases and thus the vertical AS curve shifts to the right
© Gustavo Indart
Slide 33
The AS Curve
AS
P
Medium-run
Long-run
Short-run
Yfe
© Gustavo Indart
Y
Slide 34