Macro Final Exam
Study Guide

Scarcity & Opportunity Cost

Scarcity — unlimited wants vs. limited resources → forces choices.

Opportunity cost — the value of the next best alternative forgone. Every decision has one.

Production Possibilities Frontier (PPF)

Shows the maximum combination of two goods an economy can produce.

• On the curve = efficient
• Inside = inefficient (unused resources)
• Outside = unattainable without growth

Bowed-out shape reflects increasing opportunity costs.

Expenditure Approach

• C — Consumption (household spending)
• I — Investment (business spending on capital)
• G — Government spending
• NX — Net Exports (Exports − Imports)

Income Approach

Sum of all incomes earned in production:

• Wages & salaries
• Rent
• Interest
• Profits

Both approaches give the same GDP total.

Nominal vs. Real GDP

GDP Limitations

GDP does not capture:

• Underground / informal economy
• Non-market activity (household work, volunteering)
• Leisure time
• Environmental quality
• Income distribution / inequality

Measuring Inflation

Types of Inflation

Demand-pull: Excess aggregate demand — "too much money chasing too few goods."

Cost-push: Rising input costs shift SRAS left (e.g., oil shocks, wage increases).

Key Formulas

Labour Force = Employed + Unemployed

Natural Rate of Unemployment

No cyclical unemployment. The economy is at "full employment" at this rate.

Potential GDP is the output level when unemployment equals the natural rate.

Recession

Commonly defined as two or more consecutive quarters of declining real GDP.

Output Gap

Recessionary gap: Actual < Potential (unemployment above natural rate)

Inflationary gap: Actual > Potential (unemployment below natural rate)

Aggregate Demand (AD)

Slopes downward — higher price level → lower real GDP demanded.

Why AD slopes down:

1. Wealth effect — higher prices reduce real savings → less C
2. Interest-rate effect — higher prices → more money demand → higher rates → less I
3. Exchange-rate effect — higher prices → goods costlier abroad → fewer exports

AD Shifters

Anything that changes C, I, G, or NX at every price level:

• Consumer confidence / wealth
• Interest rates / monetary policy
• Government spending & taxes
• Foreign income, exchange rates
• Expectations about the future

Short-Run Aggregate Supply (SRAS)

Slopes upward — higher price level → firms produce more (sticky wages/prices).

Shifters:

• Input prices (oil, wages)
• Productivity changes
• Supply shocks
• Business taxes / regulations
• Expected future prices

Long-Run Aggregate Supply (LRAS)

Vertical at potential GDP (Y_f).

In the long run, output is determined by resources and technology, not the price level.

Shifts with:

• Labour force changes
• Capital stock
• Technology
• Natural resources
• Institutional quality

Short-Run Phillips Curve (SRPC)

Inverse relationship between inflation and unemployment.

• Expansionary policy → lower unemployment, higher inflation
• Contractionary policy → higher unemployment, lower inflation

Shifts when expected inflation changes or supply shocks occur.

Long-Run Phillips Curve (LRPC)

Vertical at the natural rate of unemployment.

In the long run, there is no trade-off between inflation and unemployment.

If inflation expectations rise → SRPC shifts up.

The Multiplier Effect

An initial change in spending creates a chain of additional spending.

Tax multiplier is smaller because some of a tax cut is saved, not spent.

Automatic Stabilizers

Built-in mechanisms that cushion the business cycle without new legislation:

• Progressive income taxes — revenue falls automatically in recession
• Employment Insurance (EI) — payments rise automatically in recession

These partially offset GDP declines without any government action.

Functions of Money

Fiat money (Canadian dollar) — value from government decree, not intrinsic value.

Money Supply

Fractional Reserve Banking

Banks hold a fraction of deposits as reserves and lend the rest.

Actual multiplier is smaller due to excess reserves and currency drain.

The Bank of Canada

Canada's central bank — responsible for monetary policy.

• Primary objective: Low, stable, predictable inflation
• Inflation target: 2% (within 1–3% band)
• Key tool: Setting the overnight rate

The Money Market

• Money demand (M_d) — slopes down: lower interest rates → people hold more money
• Money supply (M_s) — vertical, set by the Bank of Canada
• Equilibrium determines the nominal interest rate

Limitations

• Time lags — recognition, decision, and implementation delays
• Liquidity trap — near-zero rates make further easing ineffective
• Expectations — if people expect inflation to persist, policy less effective

Components

Key Shifts

• Gov't deficit → demand shifts right → higher real rate → crowding out
• ↑ Private saving → supply shifts right → lower real rate → more investment

Drivers of Long-Run Growth

1. Physical capital — machines, infrastructure
2. Human capital — education, skills, health
3. Technological progress — innovation
4. Institutional quality — rule of law, property rights

The Rule of 70

Balance of Payments

Current Account + Capital Account ≈ 0

Trade surplus: Exports > Imports   |   Trade deficit: Imports > Exports

Exchange Rates

Nominal: Price of one currency in terms of another.

Real: Adjusts for price differences → relative purchasing power.

Exchange Rate Determinants

• Interest rate differentials
• Inflation differentials
• Income growth
• Speculation
• Central bank intervention

Regimes & Monetary Policy Link

Flexible (floating) — market-determined. Canada uses this.

Fixed (pegged) — government maintains a set rate.