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GDP = National product = national income = output = Y

What is the relationship between output and income?

GDP: the market value of all final goods and services produced within a country in a given year

o The production of output (or goods and services) generates INCOME
- so National Product = National Income

o The VALUE of national product equals national income (the value of income claims generated by the production of output)

*GDP is different from GNP = goods and services produced by Canadians, not necessarily within Canada

GNP: the total amount of income received by Canadian residents
GDP: the value of total output produced in Canada
*GDP can be produced by foreigners who live in Canada (so not limited by Canadians)


Real versus Nominal GDP/national income

How do we calculate real and nominal GDP?

Real = national income measured in CONSTANT (base-period) dollars.
o Considers inflation
o Real national income CHANGES only when QUANTITIES change (increase/decrease in production) and NOT price changes
o Use prices from the base year

Calculating Real GDP:
SUM of Base year prices * current year quantities

Nominal = national income measured in CURRENT dollars
- does not consider inflation

Calculating Nominal GDP:
SUM of current year's prices * current year's quantities


Short-term fluctuations in GDP

Business cycle?

This refers to the Business Cycle
- shows the annual growth rate (% change) of GDP
- consists of a series of peaks and troughs

Phases include:
1) Peak
- highest level of GDP and economic activity
- low unemployment (labour shortages)
- inflation

2) contraction
- decrease in real GDP
- unemployment rate rises
- deflation
*recession = decrease in real GDP for at least 2 consecutive quarters (6 months)

3) trough
- low point in GDP
- sustained and severe recession is called a depression

4) Recovery
- rising GDP


Long-term growth trends

Output gap?

Potential output (Y*): REAL GDP that the economy would PRODUCE if its PRODUCTIVE resources were fully employed --> can go above or below this level

Output gap = Actual GDP - Potential GDP = Y - Y*

Y > Y* = inflationary gap
o Gap measures the market value of goods & services IN EXCESS of what the economy can produce on a sustained basis (workers work longer hours)

" Y < Y* = recessionary gap
o Gap measures the market value of goods & services NOT produced because resources are underemployed



Adult population
Labour Force
Participation Rate
Hidden Unemployment

Limitations to the unemployment rate?

Population: the entire population
Active Adult population: part of the entire population that is ABLE to work (includes both willing and not willing to work)

Labour Force: part of the population that is able and WILLING to work
- labour force = employed + unemployed

Employment: people who are currently employed (15 or older)

Unemployment: people who are currently unemployed but are actively searching for work (15 or older)

U-rate = unemployment rate = # of unemployed/labour force *100
o if given just population, cannot actually find unemployment rate (we need labour force)

Participation rate = labour force/active population *100

Hidden unemployment = people who have given up on the job search and are not included in the unemployment rate (able but NOT willing to work)
--> if you include hidden unemployment, both numerator and denom increase, but more in numerator = RISE in unemployment rate

- does not consider hidden unemployment, underemployment, and natural employment


Types of Unemployment

Even at full employment, unemployment still exists (natural unemployment)

These include:

1) Frictional
- unemployment due to changing jobs (natural turnover of labour)

2) Structural
- unemployment due to changes in the structure of the economy
*full employment includes the above two types of unemployment

3) Seasonal
- unemployment due to changes in seasons

4) Cyclical
- unemployment due to changes in the business cycle



Labour productivity?

Importance of productivity?

Calculate productivity?

Productivity is the amount of OUTPUT per unit of INPUT

Labour Productivity = level of real GDP/# of workers OR
level of real GDP/# of hours worked

Ex: GDP per worker, GDP per hour worked

Productivity is the single largest cause of rising material living standards

GDP/Worker = real GDP/# of people EMPLOYED



Price Level

Inflation rate

CPI method

GDP Deflator method

Inflation is the RATE at which the price level changes (keeping quantities constant)

Price level = the average level of all the prices in an economy (expressed as an index, such as CPI)

CPI: measures cost of consumer baskets
- requires a base year
- CPI = 100 in base year
- Basket Cost = SUM of current year prices* SAME quantities

CPI = [basket cost current year/basket cost BASE year] *100

Inflation Rate = (CPI in current year - CPI in PREVIOUS year)/CPI in previous year *100

GDP deflator = nominal GDP/real GDP *100

Inflation Rate = (GDP deflator current year - GDP deflator previous year)/GDP deflator previous year *100


CPI vs. GDP deflator

CPI uses DIFFERENT prices and SAME quantities to calculate cost of baskets in each year

GDP deflator uses real GDP, which includes base year prices and DIFFERENT quantities

Both GDP deflator and CPI involve dividing an inflated figure by a base year figure
Both GDP deflator and CPI are used to calculate inflation rate using the growth rate formula = (current year - previous year) / previous year *100


Why does inflation matter?

What is wrong with CPI?

o Want to keep it at 2%

Inflation reduces the purchasing power of money

Purchasing power of money = amount of goods and services that can be purchased with a unit of money
- with inflation, people can buy LESS goods & services with the same unit of money

CPI uses a FIXED basket of consumer goods, which may not accurately reflect the goods purchased by consumers overtime as variety changes
- changes in price may also be due to changes in quality, not just inflation


Interest rates

How does inflation affect interest rates?

Nominal and real interest rates?

Interest rates are the cost of borrowing
- higher interest rates make it more expensive to borrow money, leading to decreased spending and increased saving
- interest rates can be + or -
- real interest rate can be smaller or greate rthan nominal interest rate

Inflation affects interest rates by changing the purchasing power of the lender
o The more the price level RISES, the WORSE of the LENDER (the less valuable the dollars used to repay the loan)
Ex: with inflation, $108 received back can buy you the same quantity of goods and services as original $100 lended
- the higher inflation, the better off the person paying back!

Nominal interest rate = price paid per dollar borrowed per period of time

Real interest rate = nominal rate of interest ADJUSTED for the CHANGE in the purchasing power of money (i.e. inflation)

Real interest rate = nominal interest rate - rate of inflation

Inflation means that nominal interest rate is greater than real interest rate


Exchange rate



Foreign Exchange Market

Trade Balance

Trade Surplus

The exchange rate is the # of units of domestic currency used to purchase 1 unit of foreign currency
Ex: 1.22 CAD = 1 USD

Depreciation: when the CAD decreases in value
- costs MORE CAD to buy 1 USD (ex: 1.50 CAD for 1 USD)
- also called RISE in exchange rate

Appreciation: when CAD increases in value
- costs LESS CAD to buy 1 USD (ex: 1 CAD for 1 USD)
- also called FALL in exchange rate
(fall in the Canadian-dollar price of foreign currency)
---> CAD more valuable and requires less CAD to buy foreign currency

Foreign-exchange market = market in which different national currencies are TRADED

Trade BALANCE = net exports = exports - imports

Trade Surplus = Exports > Imports (good for the economy)


Measuring National Output/Income/GDP/Y

1) Value Added Approach

Value Added Approach
- we want to avoid double counting because outputs are typically inputs to other goods

A) add up only the value of FINAL Goods

B) add up value added at each stage
Value-added = sales revenue - cost of intermediate goods
o Ex: sold for $2400 and cost the firm $1600 --> value added = $800

Value added is also = Payments owed to the firm's factors of production (i.e. workers)


Measuring National Output/Income/GDP/Y

2) Expenditure Approach

Gross investment, net investment

2) Expenditure Approach
GDP = Y = Ca + Ia + Ga + NXa --> the KEY IS ACTUAL, not desired amounts!
- GDP is equal to the total expenditure on DOMESTICALLY produced output

Ca = actual consumption by households

Ia = actual investment (not present for consumption)
Investments includes:
- inventories
- plant & equipment (capital goods)
- residential housing (new construction, not sale)

Gross investment = total investment that occurs in an economy
o Replacement investment and net investment
Net investment = Gross investment - Depreciation where a positive net investment = growing capital stock

Ga = actual government purchases (not transfer payments)

NXa = actual net exports
Exports - Imports


Measuring National Output/Income/GDP/Y

2) Income Approach

production of output GENERATES income, so the values measured from both expenditure and income approach should be equal

GDP = factor incomes + net indirect taxes + depreciation

Factor Incomes = wages & salaries + interest + business profits

Net Indirect taxes: indirect taxes - subsidies


Criticisms of GDP

GDP does not capture many economic activities, including:

o Illegal Activities - gambling, drug trade

o The Underground Economy - legal transactions that are not reported for tax purposes

o "Home Product" (no prices or no recorded market transaction, renovations, leisure, volunteering) --> changes in well-being not captured

o Economic "Bads" - pollution

Therefore GDP is not an accurate reflection of overall well being and quality of life

Other indicators include:
happiness index


Inflation rate versus Average Inflation rate per year over this period

Inflation rate = [(P2 - P1)/P1] * 100

Average Inflation rate = [(P2 - P1)/P1] * (100/2)


Suppose a large number of previously working fathers quit their jobs and become stay at home dads, what will happen to the a) size of the labour force and b) unemployment rate?

Key to remember: fathers were WORKING before (employed!)

- quit jobs and not actively looking for work
- not part of labour force (those who are employed and unemployed but looking for jobs)
- therefore size of labour force decreases

b) u rate = unemployed/labour rate
- denominator is getting smaller
- the # of unemployed people REMAINS THE SAME (fathers were working, so # of employed people decrease)
- U rate increases


Which of the following groups would benefit most in real terms from a period of HIGH INFLATION

homeowners who had long-term fixed rate mortages

- pay back money that has less purchasing power


One person claims that there are more people working now then when he took office. Another person says that the unemployment rate is higher now.

What scenario must happen for both of them to be right?

Labour force increased faster than number of employed people