Chapter Summaries

• Chapter 1-Ten Principles of Economics
• Chapter 2-Thinking Like an Economists
• Chapter 3-Interdependence and the Gains from Trade
• Chapter 4-Supply and Demand 1: How Markets Work
• Chapter 5-Measuring a Nation's Income
• Chapter 6-Measuring the Cost of Living
• Chapter 7-Production and Growth
• Chapter 8-Saving, Investment, and the Financial System
• Chapter 9-The Basic Tools of Finance
• Chapter 10-Unemployment and its Natural Rate
• Chapter 11-The Monetary System
• Chapter 12-Money Growth and Inflation
• Chapter 13-Open-Economy Macroeconomics: Basic Concepts
• Chapter 14-A Macroeconomic Theory of the Open Economy
• Chapter 15-Aggregate Demand and Aggregate Supply
• Chapter 16 -The Influence of Monetary and Fiscal Policy on Aggregate Demand
• Chapter 17-The Short-Run Tradeoff Between Inflation and Unemployment
• Chapter 18—Five Debates Over Macroeconomic Policy

Chapter 1-Ten Principles of Economics

• The fundamental lessons about individual decision making are that people face tradeoffs among alternative goals, that the cost of any action is measured in terms of forgone opportunities, that rational people make decisions by comparing marginal costs and marginal benefits, and that people change their behaviour in response to the incentives they face.
• The fundamental lessons about interactions among people are that trade can be mutually beneficial, that markets are usually a good way of coordinating trade among people, and that the government can potentially improve market outcomes if there is some market failure or if the market outcome is inequitable.
• The fundamental lessons about the economy as a whole are that productivity is the ultimate source of living standards, that money growth is the ultimate source of inflation, and that society faces a short-run tradeoff between inflation and unemployment.

Chapter 2-Thinking Like an Economists

• Economists try to address their subject with a scientist’s objectivity. Like all scientists, they make appropriate assumptions and build simplified models in order to understand the world around them. Two simple economic models are the circular-flow diagram and the production possibilities frontier.
• The field of economics is divided into two subfields: microeconomics and macroeconomics. Microeconomists study decision making by households and firms and the interaction among households and firms in the marketplace. Macroeconomists study the forces and trends that affect the economy as a whole.
• A positive statement is an assertion about how the world is. A normative statement is an assertion about how the world ought to be. When economists make normative statements, they are acting more as policy advisers than scientists.
• Economists who advise policymakers offer conflicting advice either because of differences in scientific judgments or because of differences in values. At other times, economists are united in the advice they offer, but policymakers may choose to ignore it.

Chapter 3-Interdependence and the Gains from Trade

• Each person consumes goods and services produced by many other people, both in our country and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services.
• There are two ways to compare the ability of two people in producing a good. The person who can produce the good with the smaller quantity of inputs is said to have an absolute advantage in producing the good. The person who has the smaller opportunity cost of producing the good is said to have a comparative advantage. The gains from trade are based on comparative advantage, not absolute advantage.
• Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage.
• The principle of comparative advantage applies to countries as well as to people. Economists use the principle of comparative advantage to advocate free trade among countries.

Chapter 4-Supply and Demand 1: How Markets Work

• Economists use the model of supply and demand to analyze competitive markets. In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price.
• The demand curve shows how the quantity of a good demanded depends on the price. According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward.
• In addition to price, other determinants of how much consumers want to buy include income, the prices of substitutes and complements, tastes, expectations, and the number of buyers. If one of these factors changes, the demand curve shifts.
• The supply curve shows how the quantity of a good supplied depends on the price. According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward.
• In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers. If one of these factors changes, the supply curve shifts.
• The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied.
• The behaviour of buyers and sellers naturally drives markets toward their equilibrium. When the market price is above the equilibrium price, there is a surplus of the good, which causes the market price to fall. When the market price is below the equilibrium price, there is a shortage, which causes the market price to rise.
• To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the event affects the equilibrium price and quantity. To do this we follow three steps. First, we decide whether the event shifts the supply curve or the demand curve (or both). Second, we decide which direction the curve shifts. Third, we compare the new equilibrium with the initial equilibrium.
• In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources. For every good in the economy, the price ensures that supply and demand are in balance. The equilibrium price then determines how much of the good buyers choose to purchase and how much sellers choose to produce.

Chapter 5-Measuring a Nation's Income

• Every transaction has a buyer and a seller, so the total expenditure in the economy must equal the total income in the economy.
• Gross domestic product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. More precisely, GDP is the market value of all final goods and services produced within a country in a given period of time.
• GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports. Consumption includes spending on goods and services by households, with the exception of purchases of new housing. Investment includes spending on new equipment and structures, including households’ purchases of new housing. Government purchases include spending on goods and services by local, provincial, and federal governments. Net exports equal the value of goods and services produced domestically and sold abroad (exports) minus the value of goods and services produced abroad and sold domestically (imports).
• Nominal GDP uses current prices to value the economy’s production of goods and services. Real GDP uses constant base-year prices to value the economy’s production of goods and services. The GDP deflator—calculated from the ratio of nominal to real GDP—measures the level of prices in the economy.
• GDP is a good measure of economic well-being because people prefer higher to lower incomes. But it is not a perfect measure of well-being. For example, GDP excludes the value of leisure and the value of a clean environment.

Chapter 6-Measuring the Cost of Living

• The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the consumer price index measures the inflation rate.
• The consumer price index is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers’ ability to substitute toward goods that become relatively cheaper over time. Second, it does not take into account increases in the purchasing power of the dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the quality of goods and services. Because of these measurement problems, the CPI overstates true inflation.
• Although the GDP deflator also measures the overall level of prices in the economy, it differs from the consumer price index because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect the consumer price index but not the GDP deflator. In addition, while the consumer price index uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.
• Dollar figures from different points in time do not represent a valid comparison of purchasing power. To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated using a price index.
• Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation.
• A correction for inflation is especially important when looking at data on interest rates. The nominal interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate takes into account changes in the value of the dollar over time. The real interest rate equals the nominal interest rate minus the rate of inflation.

Chapter 7-Production and Growth

• Economic prosperity, as measured by GDP per person, varies substantially around the world. The average income in the world’s richest countries is more than ten times that in the world’s poorest countries. Because growth rates of real GDP also vary substantially, the relative positions of countries can change dramatically over time.
• The standard of living in an economy depends on the economy’s ability to produce goods and services. Productivity, in turn, depends on the amounts of physical capital, human capital, natural resources, and technological knowledge available to workers.
• Government policies can try to influence the economy’s growth rate in many ways: by encouraging saving and investment, encouraging investment from abroad, fostering education, maintaining property rights and political stability, allowing free trade, promoting the research and development of new technologies, and controlling population growth.
• The accumulation of capital is subject to diminishing returns: The more capital an economy has, the less additional output the economy gets from an extra unit of capital. Because of diminishing returns, higher saving leads to higher growth for a period of time, but growth eventually slows down as the economy approaches a higher level of capital, productivity, and income. Also because of diminishing returns, the return to capital is especially high in poor countries. Other things equal, these countries can grow faster because of the catch-up effect.

Chapter 8-Saving, Investment, and the Financial System

• The Canadian financial system is made up of many types of financial institutions, such as the bond market, the stock market, banks, and mutual funds. All these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow.
• National income accounting identities reveal some important relationships among macroeconomic variables. In particular, for a closed economy, national saving must equal investment. Financial institutions are the mechanism through which the economy matches one person’s saving with another person’s investment.
• The interest rate is determined by the supply and demand for loanable funds. The supply of loanable funds comes from households who want to save some of their income and lend it out. The demand for loanable funds comes from households and firms who want to borrow for investment. To analyze how any policy or event affects the interest rate, one must consider how it affects the supply and demand for loanable funds.
• National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds available to finance investment. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.

Chapter 9-The Basic Tools of Finance

• Because savings can earn interest, a sum of money today is more valuable than the same sum of money in the future. A person can compare sums from different times using the concept of present value. The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce that future sum.
• Because of diminishing marginal utility, most people are risk averse. Risk-averse people can reduce risk using insurance, through diversification, and by choosing a portfolio with lower risk and lower return.
• The value of an asset, such as a share of stock, equals the present value of the cash flows the owner of the share will receive, including the stream of dividends and the final sale price. According to the efficient markets hypothesis, financial markets process available information rationally, so a stock price always equals the best estimate of the value of the underlying business. Some economists question the efficient markets hypothesis, however, and believe that irrational psychological factors also influence asset prices.

Chapter 10-Unemployment and its Natural Rate

• The unemployment rate is the percentage of those who would like to work but do not have jobs. Statistics Canada calculates this statistic monthly based on a survey of thousands of households.
• The unemployment rate is an imperfect measure of joblessness. Some people who call themselves unemployed may actually not want to work, and some people who would like to work have left the labour force after an unsuccessful search.
• In the Canadian economy, most people who become unemployed find work within a fairly short period of time. The fraction of those who find themselves unemployed for periods longer than six months is relatively small. Public policy solutions to the unemployment problem should be directed toward providing help to those experiencing long bouts of unemployment.
• One reason for unemployment is the time it takes for workers to search for jobs that best suit their tastes and skills. Employment Insurance is a government policy that, while protecting workers’ incomes, increases the amount of frictional unemployment.
• A second reason why our economy always has some unemployment is minimum-wage laws. By raising the wage of unskilled and inexperienced workers above the equilibrium level, minimum-wage laws raise the quantity of labour supplied and reduce the quantity demanded. The resulting surplus of labour represents unemployment.

Chapter 11-The Monetary System

• The term money refers to assets that people regularly use to buy goods and services.
• Money serves three functions. As a medium of exchange, it provides the item used to make transactions. As a unit of account, it provides the way in which prices and other economic values are recorded. As a store of value, it provides a way of transferring purchasing power from the present to the future.
• Commodity money, such as gold, is money that has intrinsic value: It would be valued even if it were not used as money. Fiat money, such as paper dollars, is money without intrinsic value: It would be worthless if it were not used as money.
• In the Canadian economy, money takes the form of currency and various types of bank deposits, such as chequing accounts.
  The Bank of Canada, Canada’s central bank, is responsible for controlling the supply of money in Canada. The governor and senior deputy governor of the Bank of Canada are appointed for seven-year terms, and the other directors are appointed for three-year terms. All these appointments are made by the Canadian government, which owns the Bank of Canada.
• The Bank of Canada controls the supply of money primarily through changes in the overnight rate. Lowering the overnight rate increases the money supply, and raising the overnight rate reduces the money supply. The Bank of Canada also controls the money supply through open-market operations. The purchase of government bonds increases the money supply, and the sale of government bonds reduces the money supply.
• When banks loan out some of their deposits, they increase the quantity of money in the economy. Because of this role of banks in determining the money supply, the Bank of Canada’s control of the money supply is imperfect.

Chapter 12-Money Growth and Inflation

• The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation.
• The principle of monetary neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. Most economists believe that monetary neutrality approximately describes the behaviour of the economy in the long run.
• A government can pay for some of its spending simply by printing money. When countries rely heavily on this “inflation tax,” the result is hyperinflation.
• One application of the principle of monetary neutrality is the Fisher effect. According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, so that the real interest rate remains the same.
• Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy, however, because inflation also raises nominal incomes.
• Economists have identified six costs of inflation: shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to nonindexation of the tax code, confusion and inconvenience resulting from a changing unit of account, and arbitrary redistributions of wealth between debtors and creditors. Many of these costs are large during hyperinflation, but the size of these costs for moderate inflation is less clear.

Chapter 13-Open-Economy Macroeconomics: Basic Concepts

• Net exports are the value of domestic goods and services sold abroad minus the value of foreign goods and services sold domestically. Net capital outflow is the acquisition of foreign assets by domestic residents minus the acquisition of domestic assets by foreigners. Because every international transaction involves an exchange of an asset for a good or service, an economy’s net capital outflow always equals its net exports.
• An economy’s saving can be used either to finance investment at home or to buy assets abroad. Thus, national saving equals domestic investment plus net capital outflow.
• The nominal exchange rate is the relative price of the currency of two countries, and the real exchange rate is the relative price of the goods and services of two countries. When the nominal exchange rate changes so that each dollar buys more foreign currency, the dollar is said to appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken.
• According to the theory of purchasing-power parity, a dollar (or a unit of any other currency) should be able to buy the same quantity of goods in all countries. This theory implies that the nominal exchange rate between the currencies of two countries should reflect the price levels in those countries. As a result, countries with relatively high inflation should have depreciating currencies, and countries with relatively low inflation should have appreciating currencies.
• Most economists prefer to use a model that describes Canada as a small open economy with perfect capital mobility. In such economies, interest rate parity is expected to hold. Interest rate parity is a theory that predicts interest rates in Canada will equal those in the rest of the world. Due to differences in tax rates and concerns about default risk, interest rates in Canada are not expected to exactly equal those in the rest of the world, but we do expect Canadian interest rates to rise and fall with increases and decreases in world interest rates.

Chapter 14-A Macroeconomic Theory of the Open Economy

• Most economists prefer to use a model that describes Canada as a small open economy with perfect capital mobility. This means that borrowers must pay, and lenders demand that they receive, the world interest rate. In the analysis of the macroeconomics of such an economy, two markets are central—the market for loanable funds and the market for foreign-currency exchange. In the market for loanable funds, the world interest rate determines the quantity of loanable funds demanded for domestic investment and the quantity of loanable funds made available from national saving. The difference between the quantity of loanable funds demanded and the quantity of loanable funds supplied at the world interest rate is net capital outflow. In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (from net capital outflow) and the demand for dollars (from net exports). Because net capital outflow is determined in the market for loanable funds and provides the supply of dollars for foreign-currency exchange, it is the variable that connects these two markets.
• An increase in a government budget deficit reduces the supply of loanable funds available from national saving. This reduces net capital outflow and in turn reduces the supply of dollars in the market for foreign-currency exchange. The fall in the supply of dollars causes the real exchange rate to appreciate and therefore causes net exports to fall. A decrease in a government deficit, or an increase in a government surplus, increases the supply of loanable funds and increases net capital outflow. The increase in the supply of dollars in the market for foreign-currency exchange causes the real exchange rate to depreciate and net exports to rise.
• Although restrictive trade policies, such as tariffs or quotas on imports, are sometimes advocated as a way to alter the trade balance, they do not necessarily have that effect. A trade restriction increases net exports for a given exchange rate and, therefore, increases the demand for dollars in the market for foreign-currency exchange. As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods. This appreciation offsets the initial impact of the trade restriction on net exports.
• When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound. In particular, political instability can lead to capital flight, which tends to increase interest rates and cause the currency to depreciate.

Chapter 15-Aggregate Demand and Aggregate Supply

• All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.
• Economists analyze short-run economic fluctuations using the model of aggregate demand and aggregate supply. According to this model, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.
• The aggregate-demand curve slopes downward for three reasons. First, a lower price level raises the real value of households’ money holdings, which stimulates consumer spending. Second, a lower price level reduces the quantity of money households demand; as households try to convert money into interest-bearing assets, interest rates fall, which stimulates investment spending. Third, a lower price level reduces the real exchange rate. This depreciation makes Canadian produced goods and services cheaper relative to foreign-produced goods and services, and in this way stimulates net exports.
• Any event or policy that raises consumption, investment, government purchases, or net exports at a given price level increases aggregate demand. Any event or policy that reduces consumption, investment, government purchases, or net exports at a given price level decreases aggregate demand.
• The long-run aggregate-supply curve is vertical. In the long run, the quantity of goods and services supplied depends on the economy’s labour, capital, natural resources, and technology, but not on the overall level of prices.
• Three theories have been proposed to explain the upward slope of the short-run aggregate-supply curve. According to the sticky-wage theory, an unexpected fall in the price level temporarily raises real wages, which induces firms to reduce employment and production. According to the sticky-price theory, an unexpected fall in the price level leaves some firms with prices that are temporarily too high, which reduces their sales and causes them to cut back production. According to the misperceptions theory, an unexpected fall in the price level leads suppliers to mistakenly believe that their relative prices have fallen, which induces them to reduce production. All three theories imply that output deviates from its natural rate when the price level deviates from the price level that people expected.
• Events that alter the economy’s ability to produce output, such as changes in labour, capital, natural resources, or technology, shift the short-run aggregate-supply curve (and may shift the long-run aggregate-supply curve as well). In addition, the position of the short-run aggregate-supply curve depends on the expected price level.
• One possible cause of economic fluctuations is a shift in aggregate demand. When the aggregate-demand curve shifts to the left, for instance, output and prices fall in the short run. Over time, as a change in the expected price level causes wages, prices, and perceptions to adjust, the short-run aggregate-supply curve shifts to the right, and the economy returns to its natural rate of output at a new, lower price level.
• A second possible cause of economic fluctuations is a shift in aggregate supply. When the aggregate-supply curve shifts to the left, the short-run effect is falling output and rising prices—a combination called stagflation. Over time, as wages, prices, and perceptions adjust, the price level falls back to its original level, and output recovers.

Chapter 16 -The Influence of Monetary and Fiscal Policy on Aggregate Demand

• In developing a theory of short-run economic fluctuations, Keynes proposed the theory of liquidity preference to explain the determinants of the interest rate. According to this theory, the interest rate adjusts to balance the supply and demand for money.
• An increase in the price level raises money demand and increases the interest rate that brings the money market into equilibrium. Because the interest rate represents the cost of borrowing, a higher interest rate reduces investment and, thereby, the quantity of goods and services demanded. In a small open economy, an increase in the price level also increases the real exchange rate. An increase in the real exchange rate makes Canadian-produced goods and services more expensive relative to foreign-produced goods and services. As a result, Canada’s net exports fall, reducing the quantity demanded of Canadian goods and services. The downward-sloping aggregate-demand curve expresses these negative relationships between the price level and the quantity demanded.
• Policymakers can influence aggregate demand with monetary policy. An increase in the money supply reduces the equilibrium interest rate for any given price level. Because a lower interest rate stimulates investment spending, the aggregate-demand curve shifts to the right. In a small open economy, the lower interest rate also means a fall in the exchange rate. Because a lower exchange rate increases the quantity demanded of Canadian-produced goods and services, a monetary injection in a small open

Chapter 17-The Short-Run Tradeoff Between Inflation and Unemployment

• The Phillips curve describes a negative relationship between inflation and unemployment. By expanding aggregate demand, policymakers can choose a point on the Phillips curve with higher inflation and lower unemployment. By contracting aggregate demand, policymakers can choose a point on the Phillips curve with lower inflation and higher unemployment.
• The tradeoff between inflation and unemployment described by the Phillips curve holds only in the short run. In the long run, expected inflation adjusts to changes in actual inflation, and the short-run Phillips curve shifts. As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.
• The short-run Phillips curve also shifts because of shocks to aggregate supply. An adverse supply shock, such as the increase in world oil prices during the 1970s, gives policymakers a less favourable tradeoff between inflation and unemployment. That is, after an adverse supply shock, policymakers have to accept a higher rate of inflation for any given rate of unemployment, or a higher rate of unemployment for any given rate of inflation.
• When the Bank of Canada contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve, which results in temporarily high unemployment. The cost of disinflation depends on how quickly expectations of inflation fall. Some economists argue that a credible commitment to low inflation can reduce the cost of disinflation by inducing a quick adjustment of expectations. To this point, there has been little empirical evidence to support the theoretical possibility of costless disinflation.

Chapter 18—Five Debates Over Macroeconomic Policy

• Advocates of active monetary and fiscal policy view the economy as inherently unstable and believe that policy can manage aggregate demand to offset the inherent instability. Critics of active monetary and fiscal policy emphasize that policy affects the economy with a lag and that our ability to forecast future economic conditions is poor. As a result, attempts to stabilize the economy can end up being destabilizing.
• Advocates of an independent central bank argue that such independence guards against politicians using monetary policy in an attempt to influence voters. They also assert that a lower rate of inflation and a more favourable short-run tradeoff between inflation and unemployment is possible when the central bank is independent of political influence. Critics of central bank independence argue that because monetary policy has large and lasting influences on aggregate demand, and hence on output and employment, citizens should have a say on the conduct of monetary policy, just as they do on the conduct of fiscal policy.
• Advocates of a zero-inflation target emphasize that inflation has many costs and few if any benefits. Moreover, the cost of eliminating inflation—depressed output and employment—is only temporary. Even this cost can be reduced if the central bank announces a credible plan to reduce inflation, thereby directly lowering expectations of inflation. Critics of a zero-inflation target claim that moderate inflation imposes only small costs on society, whereas the recession necessary to reduce inflation is quite costly.
• Advocates of reducing government debt argue that debt imposes a burden on future generations by raising their taxes and lowering their incomes. Critics of reducing the government debt argue that the debt is only one small piece of fiscal policy. Single-minded concern about the debt can obscure the many ways in which the government’s tax and spending decisions affect different generations.
• Advocates of tax incentives for saving point out that our society discourages saving in many ways, such as by heavily taxing the income from capital and by reducing benefits for those who have accumulated wealth. They endorse reforming the tax laws to encourage saving, perhaps by switching from an income tax to a consumption tax. Critics of tax incentives for saving argue that many proposed changes to stimulate saving would primarily benefit the wealthy, who do not need a tax break. They also argue that such changes might have only a small effect on private saving. Raising public saving by increasing the government’s budget surplus would provide a more direct and equitable way to increase national saving.