Chapter 20: Measuring GDP and Economic

Growth
Gross Domestic Product (or GDP) is the market value of all final goods and
services produced in a country in a given time period.

This definition has 4 parts:

Market value
Final goods and services
Produced within a country
In a given time period

Market Value
GDP values items at market value - goods and services are valued at their market
prices. Therefore, total production is measure as the summation of each good or
service produced at market price.

Final Goods and Services

GDP is the value of the final goods and services produced

A final good (or service) is an item bought by its final user during a specified
time period
A final good contrasts with an intermediate good, which is an item that is
produced by one firm, bought by another firm, and used as a component of a
final good or service.
o
Excluding the value of intermediate goods and services avoids
counting the same value more than once (double-counting). The final
good already contains the values of the intermediate goods that make the
final good (e.g., a tire for truck, a chip in an iPad)
o
Some goods can be an intermediate group in some situations and a
final good in other situations
o
Some items that people buy are neither final goods nor intermediate
goods and they are not part of GDP.
Examples:

Financial Assets (Stocks, Bonds)

Secondhand Goods (Used cars or existing homes)

Note: A secondhand good was part of the GDP in

the year in which it was produced, but not in the GDP in
following years

Produced Within a Country

GDP measures production within a country - domestic production

In other words, only goods and services that are produced within a country
counts as part of that country's GDP

In a Given Time Period

GDP measures production during a specific time period, normally a year or a quarter
of a year.

Quarter of a Year is called the quarterly GDP data

A full year is called annual GDP data

GDP measures not only the value of total production but also total income and
expenditure

The equality between the value of total production and total income is
important because it shows the direct link between productivity and living
standards
Rising incomes and a rising value of production go together
o
They are two aspects of the same phenomenon: increasing
productivity

GDP and the Circular Flow of Expenditure and Income

GDP measures the value of production, which also equals total expenditure on final
goods and total income.

Households and Firms

Households sell and firms buy the services of labour, capital, and land in
factor markets
o
For these factor services, firms pay income to households:
Wages for labour services

Interest for the use of capital

Rent for the use of land

Entrepreneurship receives profit

Firm's retained earnings - profits that are not distributed to households - are
part of the household sector's income
o
Retained Earnings can be thought of as income that households save
and lend back to firms
Aggregate Income: total income received by households, including retained
earnings
Consumption Expenditures: total payment for consumer goods and
services (goods and services that firms sell and households buy)
o
Examples: Skates, haircut
Investments: The purchase of new plant, equipment, and buildings and the
additions to inventories

Government

Governments buy goods and services from firms

o
Government Expenditure: expenditure of goods and services of the
government
Government finance their expenditure with taxes
o
Taxes are not part of the circular flow of expenditure and income
Government also make financial transfers to households, such as social
security benefits and unemployment benefits, and pay subsidies to firms
o
These financial transfers, like taxes, are not part of the circular flow of
expenditure and income

Rest of the World

Exports: Goods and services sold from the country of origin, to the rest of
the world (X)
Imports: Goods and services bought by the country of origin, from the rest of
the world (M)
Net Exports (NX) = X - M
o
If net exports are positive, the net flow of goods and services is from
the firms of the country of origin (Canada) to the rest of the world
o
If the net exports are negative, the net flow of goods and services is
from the rest of the world to the firms of the country of origin (Canada)

The circular flow shows two ways of measuring GDP.

GDP = Total (Aggregate) Expenditure = Total (Aggregate) Income

Total expenditure on final goods and services equals GDP:

GDP = C + I + G + X M.

Total income equals the total amount paid for the use of factors of production:
wages,
interest, rent, and profit.

Firms pay out all their receipts from the sale of final goods, so income equals
expenditure,

Y = C + I + G + (X M).

Why Domestic and Why Gross?

Domestic

Domestic product is production within a country.

It contrasts with national product, which is the value of goods and services
produced anywhere in the world by the residents of a nation.

Gross

Gross means before deducting the depreciation of capital.

The opposite of gross is net, which means after deducting the depreciation of
capital.

Depreciation is the decrease in the value of a firms capital that results from wear
and
tear and obsolescence.
Gross investment is the total amount spent on purchases of new capital and on
replacing depreciated capital.
Net investment is the increase in the value of the firms capital.
Net investment = Gross investment - Depreciation
Gross investment is one of the expenditures included in the expenditure approach
to
measuring GDP.

So total product is a gross measure.

Gross profit, which is a firms profit before subtracting depreciation, is one of the
incomes included in the income approach to measuring GDP.

So total product is a gross measure.

Measuring Canadian GDP

Statistics Canada uses two approaches to measure GDP:
The expenditure approach
The income approach

The Expenditure Approach

The expenditure approach measures GDP as the sum of consumption expenditure,

investment, government expenditure on goods and services, and net exports.

GDP = C + I + G + (X - M)
The expenditure approach with data (in billions) for 2012:
GDP = $11,007 + $2,032 + $3,055 - $616
= $15,478 billion

The Income Approach

The income approach measures GDP by summing the incomes that firms pay
households for the factors of production they hire wages for labor, interest for
capital,
rent for land, and profit for entrepreneurship.

Incomes in the National Income and Expenditure Accounts are divided into two
broad categories:
1
2

Wages, salaries, and supplementary labour income

a The payment for labour services
b Includes gross wages plus benefits such as pension contributions
Other factor incomes
a Includes corporate profits, interests, farmers' income, and income from
non-farm unincorporated businesses
i
These incomes are a mixture of interest, rent, and profit and include
some labour income from self-employment

Indirect Tax: tax that is paid by consumers when they buy goods and services

Indirect tax makes the market price exceed factor cost

Direct Tax: a tax on income.

Subsidy: payment by the government to a producer

Factor cost exceeds market price

Note: To get from factor cost to market price, we add indirect taxes and subtract
subsidies.

Making this adjustment brings us to Net Domestic Income at Market Prices

Note: To get from net income to gross income, we add depreciation.

Statistical Discrepancy: the gap between the expenditure approach and the income
approach

It is calculated as the GDP expenditure total minus GDP income total

Note: The discrepancy is never large.

Nominal GDP and Real GDP

Nominal GDP is the value of final goods and services produced during a given year
valued at the prices that prevailed in that same year.

Real GDP is the value of final goods and services produced in a given year when
valued at the prices of a reference base year.

Currently, the reference base year is 2007 and we describe real GDP as measured in
2007 dollars.

The Uses of Real GDP

Economists use estimates of real GDP for two main purposes:
1
2

To compare the standard of living

To compare the standard of living across countries

The Standard of Living Over Time

Real GDP per person is Real GDP divided by the population.

By using real GDP, we remove any influence that rising prices and a rising cost of
living might have had on our comparison

Real GDP per person tells us the value of goods and services that the average
person can enjoy

Two features of our expanding living standard:

The growth of potential GDP per person

o
Potential GDP is a "benchmark" for how much goods each individual
can consume.
Fluctuations of real GDP

Potential GDP: The value of real GDP when all the economy's labour, capital, land,
and entrepreneurial ability are fully employed

In other words, it is the maximum level of real GDP that can be produced
while avoiding shortages of labour, capital, land, and entrepreneurial ability
that would bring rising inflation
Ideal scenario: Potential GDP = Real GDP
Potential GDP per person does not grow at a constant pace

What about the Growth Rates (as opposed to the Level) of Real GDP per
Capita?

We calculate the annual percentage change of real GDP per person:

= Growth Rate of Real GDP/Growth Rate of the Population

"Real GDP per person grows only if real GDP grows faster than the population
grows."

Note: The Rule of 70 states that the number of year its takes for the level of a
variable to double is approximately 70 divided by the annual percentage growth
rate of the variable.

"It's ok to be poor, as long as you're growing at an increasing rate, and are able to
catch up"

Productivity Growth Slowdown

The growth rate of real GDP per person slowed after 1970

How Costly was that slowdown?

Lucas Wedge: the dollar value of the accumulated gap between what real GDP
would have been if the 1960s growth rate had persisted and what real GDP turned
out to be.

Business Cycle
Business Cycle: a periodic but irregular up-and-down movement of total
production and other measures of economic activity.

Every Cycle has two phases:

1
2

Expansion
Recession

And two turning points:

1
2

Peak: highest point of the business cycle

Trough: lowest point of the business cycle

Expansion: a period during which GDP increases - from a trough to a peak

Recession: a period which real GDP decreases - its growth rate is negative for at
least two successive quarters

The Standard Living Across Countries

Two problems arise in using real GDP to compare living standards across countries:
1
2

The real GDP of one country must be converted into the same currency units as
the real GDP of the other country
The goods and services in both countries must be valued at the same prices

Purchasing Power Parity (PPP prices): the same prices for both countries (being
assessed)

Limitations of Real GDP

Real GDP measures the value of goods and services that are bought in markets.

Some of the factors that influence the standard of living and that are not of part of
GDP are:

Household Production = "DIY Activities" or Non-market activities

o
The omission of household production from GDP means that GDP
underestimates total production
o
Growth rate of GDP overestimates the growth rate of total production
The reason is that some of the growth rate of market production

(included in GDP) is a replacement for home production. Therefore,

part of the increase in GDP arises from a decrease in home
production
Underground Economic Activity = "Shallow Economic Activity" => Illegal
trades (Black Market)
o
It is economic activity hidden from the view of the government to avoid
taxes and regulations or because the activity is illegal
o
Because it is unreported, it is omitted from GDP
Health and Life Expectancy
Leisure Time = "An economic good that contributes to our well-being and the
standard of living"
o
Other things remaining the same, the more leisure we have, the better
off we are
o
Working time is valued as a part of GDP, but leisure time is not
o
Leisure time must be at least as valuable to individuals as the wage
that is earned for the last hour worked. Otherwise, we would work instead
of taking leisure.
Environmental Quality
o
Economic activity directly influences the quality of the environment
o
Resources used to protect the environment are valued as part of the
GDP
Political Freedom and Social Justice = Human Rights issues

Note: GDP is only a type of measure... There is no perfect measure in the world.

The Bottom Line

Do we get an inaccurate about the level and growth of economic well-being

and the standard of living by looking at the level and growth of real GDP?
The influences omitted from Real GDP are probably large
It is possible to construct border measures that combine the many influences
that contribute to human happiness
Describe all the alternatives, real GDP per person remains the most widely
used indicator of economic well-being

Chapter 21: Monitoring Jobs and Inflation

Employment and Unemployment

Why Unemployment is a Problem

Unemployment results in:

Lost incomes and production

o
The loss of jobs brings a loss of income and lost production.
o
Lost production means lower consumption and a lower investment in
capital, which lowers the living standard in both the present and the future
Lost human capital
o
In Canada, an Employment Insurance exists; however, you must
work around 500 to 700 hours before receiving these benefits (Values and
requirements may vary based on location). Giving a limited time period to
claim these benefits creates an incentive to work harder in finding a job.
Otherwise, individuals may become dependent on the employment
insurance.
Amount received is not very much; a fraction of what was

previously earned.
o
The cost of lost human capital is particularly acute for older workers
o
Governments make strenuous efforts to measure unemployment
accurately and to adopt policies to moderate its level and ease the pain

Labor Force Survey

Statistics Canada conducts a monthly labor force survey to determine the status of
the Canadian labor force

The population is divided into two groups:

1
2

The working-age population - the number of people aged 15 years and older
who are not in jail, hospital, or some other institution
People too young to work (under 15 years of age) or those who live in
institutions

The working-age population is divided into two groups

1
2

People in the labour force

People not in the labour force

The labor force is the sum of employed and unemployed workers.

The employed are either full-time or part-time workers

Part-time workers are either voluntary or involuntary part-time workers.

To be counted as unemployed, a person must be available for work and must be in

one of the following three categories:
1
2
3

Without work but has made specific efforts to find a job within the previous four
weeks
On temporary layoff with an expectation of recall
Has a new job within four weeks

Four Labor Market Indicators

1
2
3
4

The
The
The
The

unemployment rate
involuntary part-time rate
labor force participation rate
employment-to population rate

The unemployment rate is the percentage of the labor force that is unemployed.

Labor Force = Number of people employed + Number of people unemployed

Involuntary Part-Time Rate: the percentage of the people in the labor force who
work part-time but want full-time jobs

Labor Force Participation Rate: the percentage of the working-age population

who are members of the labour force

Employment-to-Population Ratio: the percentage of the working-age

population who have jobs

Other Definitions of Unemployment

The purpose of the unemployment rate is to measure the underutilization of the
labor resources.

Statistics Canada believes that the unemployment rate gives a correct measure.

But the official measure is an imperfect measure because it excludes three types of
underemployed labour:

Discouraged searchers
Long-term future starts
Involuntary part-timers

Discouraged Worker/Searcher: a person who is currently neither working nor

looking for work but has indicated that he or she wants or is available for a job and
has looked for work sometime in the recent past but has stopped looking because of
repeated failure.

The official unemployment measure excludes discouraged searchers because

they haven't made specific efforts to find a job within the past four weeks. In all
other aspects, they are unemployed

Long-term Future Starts: A person with a job to start in more than four weeks is
not counted as part of the labor force.

The economic difference between someone who starts a new job within four
weeks and someone who starts farther in the future is slight and is a potential
source of underestimating the true amount of unemployment

(Involuntary) Part-time Workers: Individuals who would like full-time jobs and
can't find them are not counted as unemployed.

The individuals are part-time workers who would like full-time jobs but can't
find them

Most Costly Unemployment

All unemployment is costly, but the most costly is long-term unemployment that
results from job loss

The unemployment rate does not distinguish among the different lengths of
unemployment spells
If most unemployment is long-term, the situation is worse than if most are
short-term job searchers

Unemployment and Full Employment

Unemployment can be classified into three types:

Frictional unemployment
Structural unemployment
Cyclical unemployment

Frictional Unemployment: unemployment that arises from normal labor market

turnover (i.e., people entering and leaving the labour force and from the creation
and destruction of jobs)

The creation and destruction of jobs requires that unemployed workers

search for new jobs and for business to search for workers
Frictional Unemployment is a permanent and healthy phenomenon in a
dynamic, growing economy

Factors that may influence the size of frictional unemployment:

Increases in the number of people entering and re-entering the labour force
Informational availability
Government/public policies:
o
Increases in unemployment benefits raise frictional unemployment
The more generous the policies are, the longer the frictional

unemployment will last... Non-working individuals (who are eligible

for Employment Benefits) are motivated to continue to rely on the
benefits, thus losing motivation to re-enter the work force.
o
Regulations

Structural Unemployment: unemployment created by changes in technology and

international competition that change the skills needed to perform jobs or the
location of jobs.

"Market Innovation"
Structural unemployment lasts longer than Frictional unemployment because
workers must retrain and possibly relocate to find a job
A growing/prosperous economy must consider this type of employment.
There is always a chance that the economy may shift due to the continual
growth and development in technology/competition

Structural Unemployment is painful, especially for older workers for whom the
best available option might be to retire early or take lower-skilled, lower-paying
jobs
Examples: Taxis vs. Uber, Retail Book Stores vs. Online Bookstores vs. EReaders, Typewriters vs. Computers

Cyclical Unemployment: the higher than normal unemployment at a business

cycle trough and lower than normal unemployment at a business cycle peak.

Example: worker who is laid off because the economy is in a recession and is
then rehired when the expansion begins experience cyclical unemployment.

"Natural" Unemployment
Natural Unemployment: the unemployment that arises from frictions and
structural change when there is no cyclical unemployment

Natural unemployment is all frictional and structural unemployment

Natural Unemployment Rate: natural unemployment as a percentage of
the labour force

Full Employment: the situation in which the unemployment rate equals the
natural unemployment rate.

When the economy is at full employment, there is no cyclical unemployment

or, equivalently, all unemployment is frictional and structural.

The natural unemployment rate changes over time and is influenced by many
factors.
Key Factors:

The age distribution of the population

o
An economy with a young population has a large number of new job
seekers every year and has a high level of frictional unemployment
o
An economy with an aging population has fewer new job seekers and a
low level of frictional unemployment
The scale of structural change
o
The scale of structural change is sometimes small, but sometimes
there is technological upheaval

The amount of structural unemployment fluctuates with the pace and

volume of technological change and the change driven by fierce
international competition, especially from fast-changing Asian economies
The real wage rate
o
The natural unemployment rate is influenced by the level of the real
wage rate
Nominal: The # of dollars you receive per hour

Real: The # of goods and services that you can really get out

the amount of dollars you earn per hour

o

Note: An individual may be rich in nominal terms, but can be poor in real terms.
Real wage rate that bring unemployment are minimum wage and
efficiency wage
Efficiency Wage: a wage set above the going market wage to enable
firms to attract the most productive workers, get them to work hard,
and discourage them from quitting
Unemployment benefits
o
Unemployment benefits increase the natural unemployment rate by
lowering the opportunity cost of job search
o
Extending unemployment benefits increases the natural
unemployment rate
o

Real GDP and Unemployment Over the Cycle

Potential GDP: the quantity of real GDP produced at full employment

Potential GDP corresponds to the capacity of the economy to produce output

on a sustained basis

Output Gap: the gap between real GDP and potential GDP

Real GDP - Potential GDP = OUTPUT GAP

Note: Over the business cycle, the output gap fluctuates and the
unemployment rate fluctuates around the natural unemployment rate.

Conditions for Output Gap

When the economy is at full employment, the unemployment rate equals

the natural unemployment rate and real GDP equals potential GDP, so the
output gap is zero
When the unemployment rate is less than the natural unemployment rate,
real GDP is greater than potential GDP and the output gap is positive
When the unemployment rate is greater than the natural unemployment
rate, real GDP is less than potential GDP and the output gap is negative

Summary:

Unemployment Rate = Natural

Unemployment Rate

Real GDP = Potential

GDP

Output Gap is
Zero

Unemployment Rate < Natural

Unemployment Rate

Real GDP > Potential

GDP

Output Gap is
Positive

Unemployment Rate > Natural

Unemployment Rate

Real GDP < Potential

GDP

Output Gap is
Negative

(Full Employment)

Price Level, Inflation, Deflation

The price level tells you about the value of the money in your pocket.

We are interested in the price level because we want to:

1
2

Measure the annual percentage change of the price level - inflation rate or the
deflation rate
Distinguish between money values and real values of economic variables

Inflation is a persistent rise in the level of prices

Deflation is a persistent fall in the level of prices

Why Inflation and Deflation Are Problems

Low, steady, and anticipated inflation or deflation is "not" a problem

Unpredictable inflation or period of deflation is a problem because it:

Redistributes income
o
Workers are worse off with an unexpected burst of inflation because
their wages buy less than they bargained for and employers are better off
because their profits rise
o
An unexpected period of deflation has the opposite side effect:
Workers are better off with an unexpected burst of deflation

because their fixed wages buy more than they bargained for and
employers are worse off with lower profits
Redistributes wealth
o
With an unexpected burst of inflation, the money that the borrowers
repay to the lenders buys is less than the money originally loaned
The buyer wins and the lender loses

The interest paid on the loan does not compensate the lender

for the loss in the value of the money loaned

o
With an unexpected burst of deflation, the money that the borrower
repays to the lender buys more than the money originally loaned
The borrower loses and the lender wins

Lowers real GDP and employment

o
Unexpected inflation that raises firms' profits brings a rise in
investment and a boom in production and employment
Real GDP exceeds Potential GDP

Unemployment Rate falls below Natural Unemployment Rate

But the situation is temporary

Profitable investment dries up

Spending falls

Real GDP falls below potential GDP

Unemployment Rate rises

Note: Avoiding these swings in production and jobs means avoiding unexpected
swings in the inflation rate.
o

An unexpected deflation has even greater consequences for real GDP and
jobs.

Businesses and households that are in debt (borrowers) are worse off
and they cut their spending.
A fall in total spending brings a recession and rising unemployment.
Diverts resources from production
o
Unpredictable inflation or deflation turns the economy into a casino
and diverts resources from productive activities to forecasting inflation
It can become more profitable to forecast the inflation rate or

deflation rate correctly than to invent a new product

Professionals (i.e., doctors, accountants, lawyers) stop

specializing and spend more time becoming inflation forecasters and

managing their investments

From a social perspective, the diversion of talent that

results from unpredictable inflation is like throwing scarce
resources onto a pile of garbage

How about Anticipated or Expected Inflation? Any Costs?

Cost of Expected Inflation

Shoe-leather Cost
o
A metaphor
o
Time spent taking trips to the bank
Quite costly; you spend at the same rate as you have in your

wallet. This causes us to visit banks more frequently to take out

money.
o
When the nominal interest rate is high, what would you do?
o
Nominal Interest Rate: The "opportunity cost" of holding cash [in
you wallet]
Menu Cost
o
The cost of "re-printing" your catalogue
o
The change of prices such as that of a menu/flyer
o
The change in prices can cause confusion to consumers
Tax Distortions
o
When individuals are paying taxes when they shouldn't be.... Because
they are neither gaining or losing
o
Tax rates are not adjusted properly for changes in inflation [rates]
Money Illusion
o
A confusion of nominal and real terms (Price Change relative to
increase in wage rates causes the confusion of prices of goods to
increase... Yet, affordability is still the same.)

Any Benefits?

Hyperinflation: an inflation rate of 50 percent a month or higher that grinds the

economy to a halt and causes a society to collapse

It is a situation where the price increases are so out of control that the
concept of inflation is meaningless
Hyperinflation is rare

The Consumer Price Index (CPI)

CPI measures the average of the prices paid by urban consumers for a "fixed"
basket of consumer goods and services.

Reading the CPI Numbers

The CPI is defined to equal 100 in the reference base period

Currently, the reference base period is 2002

That is, for the average of the 12 months of 2002, the CPI equals 100

In June 2014, the CPI was 125.6.

This number tells us that the average of the prices paid by urban consumers
for a fixed basket of goods and services was 25.6 percent higher in June 2014
than it was on average during 2002.

Constructing the CPI

Constructing the CPI involves three stages:

Selecting the CPI basket

Conducting a monthly price survey
Calculating the CPI

The CPI basket is based on a consumer expenditure survey, which is undertaken

infrequently.

The CPI basket today is based on survey data collected in 2011.

Each month, Statistics Canada employees check the prices of the goods and
services in the CPI basket in the major cities.

Calculating the CPI

1
2
3

Find the cost of the CPI basket at base-period prices.

Find the cost of the CPI basket at current-period prices.
Calculate the CPI for the current period

The idea is, CPI tells us the cost of basket in the current period relative to the base
period:

Measuring the Inflation Rate

A major purpose of the CPI is to measure changes in the cost of living and in
the value of money
It is also used to measure inflation

Inflation Rate: the percentage change in the price level from one year to the next.

Formula:

The Biased CPI

The CPI might overstate the true inflation rate for four reasons:

Commodity Substitution Bias

New Goods Bias
Quality Change Bias
Outlet Substitution Bias

Commodity Substitution Bias

The market basket of goods used in calculating the CPI is fixed and does not take
into account consumers substitutions away from goods whose relative prices
increase.

New Goods Bias

New goods that were not available in the base year appear and, they might be more
expensive than the goods they replace.

Quality Change Bias

Quality improvements occur every year. Part of the rise in the price is payment for
improved quality and is not inflation.

The CPI counts all the price rise as inflation and so overstates inflation

Outlet Substitution Bias

As the structure of retailing changes, people switch to buying from cheaper sources,
but the CPI, as measured, does not take account of this outlet substitution.

Note: It is possible to avoid the bias by continually updating the fixed basket of
goods (annually). The restriction to this is the cost involved (expensive.)

The Magnitude of Bias

Estimates say that the CPI overstates the inflation by 0.6 percentage points per
year

Some Consequences of the Bias

Distorts private contracts

Increases government outlays (close to a third of federal government outlays
are linked to the CPI)

A bias of 0.6 percent is small, but over a decade adds up to billions of dollars of
additional expenditure

Alternative Price Indexes

Alternative measures of the price level are:

Chained Price Index For Consumption (CPIC)

o
An index of the prices of all the items included in consumption
expenditure in GDP
o
Is the ratio of nominal consumption expenditure to real consumption
expenditure
o
Because the CPIC uses current-period and previous-period quantities
rather than fixed quantities from an earlier period, it incorporates
substitution effects and new goods and overcomes the sources of bias in
the CPI
GDP Deflator
o
An index of the prices of all the items included in GDP
o
Is the ratio of nominal GDP to real GDP
o
Because real GDP includes consumption expenditure, investment,
government expenditure, and net exports, the GDP deflator is an index of
the prices of all these items

The CPIC equals:

Note: PCE (Personal Consumption Expenditure) Deflator is a broader measure of

the price level than the CPI because it includes all consumption expenditures

The GDP Deflator equals:

Note: GDP Deflator is like the PCE Deflator except it includes the prices of all goods
and services that are counted in GDP

Core Inflation Rate: the CPI inflation rate excluding the volatile elements (of food
and fuel)

The Real Variables in Macroeconomics

We can use the deflator to deflate nominal variables to find their real values

For example,

But this is not the real interest rate! It is different.

Chapter 23: Finance, Saving, and Investment

Financial Markets
Saving is the source of the funds that are used to finance investment

These funds are supplied and demanded in three types of financial markets:

Loan markets
o
Businesses often want short-term finance to buy inventories or to
extend credit to their customers
o
Households often want finance to purchase big ticket items, such as
automobiles or household furnishings, and appliances
They get bank loans in the form of outstanding credit card

balances
o
Households also get finance to buy new homes (Expenditures on new
homes is counted as a part of investment)
These funds are usually obtained as a loan that is secured by a

mortgage - a legal contract that gives ownership of a home to the

lender in the event that the borrower fails to meet the agreed loan
payments (repayment and interest)
Bond markets
o
A bond is a promise to make specified payments on specified dates.
o
Bond Market: where bonds issued by corporations and governments
are traded
o
Term of a Bond
Long (Decades)

Short (just a month or two)

o
Mortgage-Backed Security: entitles its holder to the income from a
package of mortgages
Mortgage lenders create mortgage-backed securities

The holder of a mortgage-backed security is entitled to receive

payments that derive from the payments received by the mortgage

lender from the home buyer-borrower
Stock markets
A stock is a certificate of ownership and claim to the firm's profits
A stock market is a financial market in which shares of stocks of
corporations are traded.

Financial Institutions

They are a borrower in one market and a lender in another. It is a firm that operates
on both sides of the markets for financial capital

Banks
o
Banks accept deposits and use the funds to buy government bonds
and other securities and to make loans
o
14 domestic banks and 33 foreign banks operate in Canada
Trust and Loan Companies
o
Accepts deposits and make personal loans and mortgage loans
o
Also administers estates, trusts, and pension plans
Credit Unions and Caisses Populaires
o
Banks that are owned and controlled by their depositors and borrowers
o
Regulated by provincial rules
o
Operate only inside their own provincial boundaries
o
Large in number, small in size
Pension Funds
o
Receive the pension contributions of firms and workers
o
Pension Contributions that are used to buy diversified portfolios of
bonds and stocks (investments) that they expect to generate an income
that balances risk and return
o
The income is used to pay pension benefits
o
Can be very large and play an active role in the firms whose stock they
hold
Insurance Companies
o
Provide risk-sharing services
o
They enter into agreements with households and firms to provide
compensation in the event of an accident, theft, fire, and a host of other
misfortunes
o
Make payments against claims
o
Receives/Gains premiums from customers
o
Insurance companies use the funds they have received but not paid
out as claims to buy bonds and stocks on which they earn an interest
income

Net Worth (of a Financial Institution) = Market Value of What it has Lent - Market
Value of What is has Borrowed

If net worth is positive (+), the institution is solvent

If net worth is negative (-), the institution is insolvent
o
An insolvent business cannot pay its debts and must go out of business
o
The owners of the insolvent business (usually its stockholders) bear the
loss but the firms and individuals who are owed payments by an insolvent
firm also incur losses

Illiquid: when a firms has made long-term loans with borrowed funds and is faced
with a sudden demand to repay more of what it has borrowed than its available
cash

The Loanable Funds Market

The market for loanable funds is the aggregate of all the individual markets

Funds come from three sources:

1
2
3

Household saving, S
Government budget surplus, (TG)
Borrowing from the rest of the world, (MX)

Net Taxes: the taxes paid to governments minus the cash transfers received from
government (such as social securities and unemployment benefits)
National Saving: the sum of private saving, S, and government saving, (T - G)

The nominal interest rate is the number of dollars that a borrower pays and a
lender receives in interest in a year expressed as a percentage of the number of
dollars borrowed and lent.

Example: if the annual interest paid on a $500 loan is $25, the nominal
interest rate is 5 percent per year.

The real interest rate is the nominal interest rate adjusted to remove the effects
of inflation on the buying power of money.

real interest rate ( nominal interest rate -inflation rate )

Example: if the nominal interest rate is 5 percent a year and the inflation rate is 2
percent a year, the real interest rate is 3 percent a year

Note: The real interest rate is the opportunity cost of loanable funds
Note: The real interest paid on borrowed funds is the opportunity cost of
borrowing
Note: The real interest foregone when funds are used either to buy consumption
goods and services or to invest in new capital goods is the opportunity cost of
not saving or lending those funds

The Demand for Loanable Funds

The quantity of loanable funds demanded is the total quantity of funds demanded to
finance investment, the government budget deficit, and international investment or
lending during a given period

The quantity of loanable funds demanded depends on:

1
2

The real interest rate

Expected profit

"Other things remaining the same, the higher the real interest rate, the smaller is
the quantity of loanable funds demanded; and the lower the real interest rate, the
greater the quantity of loanable funds demanded"

The Demand for Loanable Funds Curve

The demand for loanable funds is the relationship between the quantity of
loanable funds demanded and the real interest rate when all other influences
on borrowing plans remain the same.

Business investment is the main item that makes up the demand for loanable
funds.

Changes in the Demand for Loanable Funds

When the expected profit changes, the demand for loanable funds changes
With other things remaining the same, the greater the expected profit from
new capital, the greater is the amount of investment and the greater the
demand for loanable funds (shifts in the curve)

Expected Profits:

Rises during a business cycle expansion

Falls during a recession
Rises when technological changes creates profitable new products
Rises as growing population brings increased demand for goods and services
Fluctuates with contagious swings of optimism and pessimism

The Supply of Loanable Funds

The quantity of loanable funds supplies is the total funds available from private
saving, the government budget surplus, and international borrowing during a given
period.

For now, let us focus on private saving.

How do you decide how much of your income to save and supply in the loanable
funds market?
The quantity of loanable funds supplied depends on
1. The real interest rate (Movement ALONG the Loanable Funds Supplied
Curve)
o

Other things remaining the same, the higher the real interest rate, the
greater is the quantity of loanable funds supplied; and the lower the real
interest rate, the smaller is the quantity of loanable funds supplied

2. Disposable income
o
o
o

Income Earned - Net Taxes

When disposable income increases, other things remaining the same,
consumption expenditures increase but by less than the increase in
income (Some of the increase in income is saved)
The greater a household's disposable income, other things remaining the
same, the greater is its saving

3. Expected future income

o

The higher a household's expected future income, other things remaining

the same, the smaller is its saving today

4. Wealth
o

The higher a household's wealth, other things remaining the same, the
smaller is its savings

5. Default risk
o
o

The risk that a loan will not be repaid

The greater the risk, the higher is the interest rate needed to induce a
person to lend and the smaller is the supply of loanable funds

The Supply of Loanable Funds Curve

The supply of loanable funds is the relationship between the quantity of

loanable funds supplied and the real interest rate when all other
influences on lending plans remain the same.
Saving is the main item that makes up the supply of loanable funds

Changes in the Supply of Loanable Funds

A change in disposable income, expected future income, wealth, or default

risk changes the supply of loanable funds (shift in the curve).
An increase in disposable income, a decrease in expected future income, a
decrease in wealth, or a fall in default risk increases saving and increases the
supply of loanable funds.

Equilibrium in the Loanable Funds Market

The loanable funds market is in equilibrium at the real interest rate at which the
quantity of loanable funds
demanded equals the quantity of loanable funds supplied.

At 7 percent a year, there is a surplus of funds and the real interest rate falls.
At 5 percent a year, there is a shortage of funds and the real interest rate
rises.
Equilibrium occurs at a real interest rate of 6 percent a year.

Changes in Demand

An increase in expected profits increases the demand for funds today.

The real interest rate rises.
Saving and quantity of funds supplied increases.

Changes in Supply

If one of the influences on saving plans changes and saving increases, the
supply of funds increases.
The real interest rate falls.
Investment increases.

Government in the Loanable Funds Market

Government enters the loanable funds market when it has a budget surplus or
deficit.

A government budget surplus increases the supply of funds.

o
Contributes to financing investment
A government budget deficit increases the demand for funds
o
Competes with businesses for funds

Effect of a Government Budget Surplus

A government budget surplus increases the supply of funds.

The real interest rate falls.
Private saving decreases.
Investment increases.

Effect of a Government Budget Deficit

A government budget deficit increases the demand for funds.

The real interest rate rises.
Private saving increases.
Investment decreasesis crowded out

Special Case: The Ricardo-Barro Effect

A budget deficit increases the demand for funds.

Rational taxpayers increase saving, which increases the supply of funds.
Increased private saving finances the deficit.
Crowding-out is avoided.

Chapter 24: What is Money?

Money is any commodity or token that is generally acceptable as a means of
payment.

A means of payment is method of settling a debt

o
When a payment has been made, there is no remaining obligation
between the parties to a transaction

Money has three other functions:

Medium of exchange
Unit of account
Store of value

Medium of Exchange
A medium of exchange is an object that is generally accepted in exchange for
goods and services.

In the absence of money, people would need to exchange goods and services
directly for other goods and services, which is called barter.
o
Barter requires a double coincidence of wants, which is rare, so barter
is costly
A medium of exchange overcomes the needs for a double coincidence of
wants
Money acts as a medium of exchange because people with something to sell
will always accept money in exchange for it.

Commodity Money: money whose value comes from a commodity of which it is

made (Example: Gold, Silver)
Fiat Money: does not have any value, it does not have any inherent or intrinsic
value; it is only used for exchange

Unit of Account
A unit of account is an agreed measure for stating the prices of goods and
services

"Dollars and Cents"

Store of Value
As a store of value, money can be held for a time and later exchanged for goods
and services

If money were not at store of value, it could not serve as a means of payment
The more stable the value of a commodity or token, the better it can act as a
store of value and the more useful it is as money
No store of value has a completely stable value
Inflation lowers the value of money and the values of other commodities and
tokens that are used as money

To make money as useful as possible as a store of value, a low inflation

rate is needed.

Money in Canada Today

Money in Canada consists of:

Currency --> Notes and coins held by households and firms

o
Notes and coins inside banks are not counted as currency because
they are not held by individuals and businesses
o
Currency is convenient for settling small debts and buying low-priced
items
Deposits of individuals and businesses at banks and other depository
institutions
o
Examples: Trust and mortgage companies, credit unions, caisses
populaires
o
Deposits are money because the owners of the deposits can use them
to make payments
o
Deposits owned by the Government of Canada are not counted as
money because they are not held by individuals and businesses

Currency: the notes and coins held by households and firms

Note: Deposits are money because owners of the deposit can use them to make
payments

Official Measures of Money

The two main official measures of money in Canada are M1 and M2.

M1 consists of currency and chequing deposits held by individuals and

businesses
M2 consists of M1 plus all other deposits - non-chequable deposits and fixed
term deposits held by individuals and businesses

Note: M1 is more liquid

Are M1 and M2 Really Money?

All the items in M1 are means of payment. They are money.

Some components of M2 can easily be converted into a means of payment
without loss in value. They are called liquid assets.
Liquidity is the property of being instantly convertible into a means of
payment with little loss of value.
Because the deposits in M2 can be quickly and easily converted into a means
of payment, they are counted as money.

Deposits are Money but Cheques Are Not

In defining money, we include, along with currency, deposits at banks and

other depository institutions.
But we do not count the cheques that people write as money.
A cheque is an instruction to a bank to transfer money.

Credit Cards Are Not Money

Credits cards are not money

A credit card is an ID card that allows an individual to take out a loan at an
instant you buy something
o
A credit card enables the user (or holder) to obtain a loan, but it must
be repaid with money

A depository institution is a firm that takes deposits from households and firms
and makes loans to other households and firms.

Types of Depository Institutions:

Chartered Banks
Credit Unions and Caisses Populaires
Trust and Mortgage Loan Companies

Chartered Banks
A chartered bank is a private firm, chartered under the Bank Act of 1991 to
receive deposits and make loans

By far, chartered banks are the largest institutions in the banking system and
conduct all types of banking and financial business

Credit Unions and Caisses Populaires

A credit union is a cooperative organization that operates under the Cooperative
Credit Association Act of 1991 and that receives deposits from and makes loans to
its members.

A caisse populaire is a similar type of institution that operates in Quebec.

Trust and Mortgage Loan Companies

A trust and mortgage loan company is a privately owned depository institution
that operates under the Trust and Loan Companies Act of 1991

These institutions receive deposits, make loans, and act as a trustee for
pension funds and for estates

What Depository Institutions Do

Depository institutions provide service such as cheque clearing, account
management, credit cards, and Internet banking (all of which provide an income
from service fees)

The goal of any bank is to maximize the wealth of its owners.

To achieve this objective, the interest rate at which it lends exceeds the
interest rate it pays on deposits.

But the banks must balance profit and prudence:

Loans generate profit.

Depositors must be able to obtain their funds when they want them.

A Chartered Bank puts the depositors' funds into four types of assets:

Reservesnotes and coins in its vault or its deposit at the Bank of Canada
o
These funds are used to meet depositors' currency withdrawals and to
make payments to other banks
o
Note: A bank keeps about a half of 1 percent of deposits as reserves
Liquid AssetsCanadian Government Treasury bills and commercial bills
o
These assets are the banks' first line of defence if they need reserves
o
Liquid assets can be sold and instantly converted into reserves with
virtually no risk of loss (earns a low interest rate)
Securitieslongerterm Canadian government bonds and other bonds such
as mortgage-backed securities
o
These assets can be converted into reserves but at prices that
fluctuate
Because the prices fluctuate, these assets are riskier than liquid

assets, but also have a higher interest rate

Loanscommitments of fixed amounts of money for agreed-upon periods of
time
o
Banks make loans to corporations to finance the purchase of capital
o
Riskiest assets of a bank
They cannot be converted into reserves until they are due to be

repaid
Some borrowers default and never repay

o
These assets earn the highest interest rate

Economic Benefits Provided by Depository Institutions

Depository institutions make a profit from the spread between the interest rate they
pay on their deposits and the interest rate they charge on their loans

Deposit Institutions provide four benefits:

Credit Liquidity
o
Created by borrowing short and lending long - taking deposits and
standing ready to repay them on short notice or on demand and making
loan commitments that run for terms of many years
Pool Risk
o
A loan might not be repaid - a default.
Lower the cost of borrowing
Lower the cost of monitoring borrowers
o
By monitoring borrowers, a lender can encourage good decisions that
prevent defaults
This activity is costly.

How Depository Institutions Are Regulated

The goal of financial regulation is to identify, evaluate, and lessen the

consequences of financial risk
Depository institutions engage in risky business.
To make the risk of failure small, depository institutions are required to hold
levels of reserves and owners capital equal to or that surpass the ratios laid
down by regulation.
If a Canadian bank fails, deposits are guaranteed up to $100,000 per
depositor per bank by the Canada Deposit Insurance Corporation.
Provincial government agencies regulate credit unions and caisses populaires

Bank of Canada

Central Bank - the public authority that supervises other banks and financial
institutions, financial markets and the payment system, and conducts
monetary policy
Established in 1935
Management Structure
o
The Bank of Canada is:
Sole issuer of bank notes

The Bank of Canada is the only bank that is permitted to

issue bank notes. The Bank of Canada has a monopoly on this
activity.
Banker to the banks and government

The Bank of Canada has a restricted list of customers

Chartered Banks

Credit Unions

Caisses Populaires

Trust and Mortgage Loan Companies that make up

the banking system

Government of Canada

Central Bank of other countries

The Bank of Canada accepts deposits from depository

institutions that make up the payments system and the
government of Canada.
Lender of last resort

This means that it stands ready to make loans when the

banking system as a whole is short of reserves.

The Bank of Canada's Balance Sheet

The Bank of Canada has two main assets:

1
2

Government Securities
a Treasury Bills bought in the bills market
Loans to Depository Institutions

Its liabilities are:

1

Bank of Canada notes

a Dollar bills that we use in our daily transactions
b Some of the notes are held by individuals and businesses; other are in the
tills and vaults of banks and other depository institutions
Depository Institution Deposits

Monetary Base

The liabilities of the Bank of Canada (plus coins issued by the Canadian Mint)
form the monetary base
The monetary base is the sum of Bank of Canada notes, coins, and depository
institution deposits at the Bank of Canada

The Conduct of Monetary Policy

The Bank of Canada's Policy Tools
To achieve its objectives, the BOC uses two main policy tools:

Open Market Operations

o
Injects money or liquidity into the market
Bank Rate
o
Interest rate that is charged to commercial banks from the Central
Bank
o
Central Bank is the "Last Resort"
Therefore, Commercial Banks try to minimize their loans from

the Central Bank. Rather, they would borrow from other commercial
banks when they are short of funds

An open market operation is the purchase or sale of government securities by

the Bank of Canada from or to a chartered bank or the public.

When the Bank of Canada buys securities, it pays for them with newly
created reserves held by the banks.
When the Bank of Canada sells securities, they are paid for with reserves
held by banks.

So open market operations influence banks reserves.

The Bank of Canada makes short-term loans, typically one-day loans, to major
depository institutions when the banking system is short of reserves.

The interest rate on these loans is bank rate.

o
The interest rate the Bank of Canada charges to commercial banks for
loans
o
The benchmark of other interest rates
Bank rate acts as an anchor for other short-term interest rates and is closely
related to the Banks target for the overnight loans rate.

Note: an open market purchase increases bank reserves

Note: an open market sale decreases bank reserves

How (Chartered/Commercial) Banks Create Money

Recall:
Money = Currency + Deposits
M=C+D

Creating Deposits by Making Loans

Banks create deposits when they make loans and the new deposits created are new
money

The quantity of deposits that banks can create is limited by three factors:

The Monetary Base (Controlled by BOC)

"High-powered" money
The size of the monetary base limits the total quantity of money that
the banking system can create
Reason: Banks have a desired level of reserves, households and

firms have a desired holding of currency, and both of these desired

holdings of the monetary base depend on the quantity of deposits.
Desired Reserves (Controlled by Commercial Banks)
Desired Currency Holding (Controlled by individuals)
o
o

The Monetary Base

The monetary base is the sum of BOC notes and coins, and banks' deposits at the
BOC

MB = C + R

Desired Reserves

A bank's actual reserves consists of notes and coins in its vault and its
deposit at the BOC
Different from required reserves, which is the minimum quantity of reserves
that a bank must hold.
The desired reserve ratio is the ratio of the bank's reserves to total
deposits that a bank plans to hold
o
The desired reserve ratio exceeds the required reserve ratio by the
amount that the bank determines to be prudent for its daily business
They can hold more reserves, but not less than the required

reserves.

Desired Currency Holding

People hold some fraction of their money as currency

o
So when the total quantity of money increases, so does the quantity of
currency that people plan to hold
If bank deposits increase, desired currency holding also increases
o
Thus, when banks make loans that increase deposits, some currency
leaves the banks
The leakage of bank reserves into currency is called currency drain
o
The ratio of currency to deposits is the currency drain ratio

The Money Creation Process and the Money Multiplier

The money creation process begins with an increase in the monetary base.

Occurs if the Bank of Canada conducts an open market operation in which it

buys securities from banks and other institutions

Suppose that the BOC conducts an open market operation in which it buys
securities from a bank (say, Premier Bank).

The BOC pays for the securities with newly created bank reserves.
Premier Bank now has more reserves ($100) but the same amount of
deposits, so they have excess reserves.
Instead of keeping the $100 in their vault or deposit at the BOC, suppose that
Premier Bank decided to loan all of it to an individual and the individual in turn
deposit the $100 to Bank A.

Excess reserves = Actual reserves Desired reserves.

*** Assume that the desired reserve ratio is 0.10 and the currency-deposit ratio is 0
***
Bank A will now find itself with a $100 deposit. What to do with it?

$10 of which needs to be kept in reserve and $90 can be loaned out.
Bank A decided to loan the $90 to another individual and the individual in
turn deposit the $90 to Bank B.

Bank B now has a $90 deposit: need to keep $9 in reserve and loan the remaining
$81.

When the banks make loans and create deposits, the extra deposits lower excess
reserves for two reasons:
1
2

The increase in deposits increases desired reserves

A currency drain decreases total reserves

Process of Excess Reserves

1
2
3
4
5
6
7
8

Banks have excess reserves

Banks lend excess reserves
The quantity of money increases
New money is used to make payments
Some of the new money remains on deposit
Some of the new money is a currency drain
Desired reserves increase because deposits have increased
Excess reserves decrease

Note: If the Bank of Canada sells securities in an open market operation, then
banks have negative excess reserves - they are short of reserves

When the banks are short of reserves, loans and deposits decrease and the
"Process of Excess Reserves" (listed above) works in a downward direction until
desired reserves plus desired currency holding has decreased by an amount
equal to the decrease in monetary base

Define:

Money as the sum of currency and chequable deposits: M = C + D

Monetary base as the sum of currency and reserves: MB = C + R

Take the ratio: M/MB = (C + D) / (C + R)

Divide both numerator and denominator of the right-hand side by D:

M/MB = (C/D + 1) / (C/D + R/D)

Where: C/D is the currency-deposit ratio or currency drain ratio
R/D is reserve-deposit ratio or desired reserve ratio

Therefore, M = MB * [ (C/D + 1) / (C/D + R/D) ]

The money multiplier, m is (C/D + 1) / (C/D + R/D).

The money multiplier is the ratio of the change in the quantity of money to the
change in the monetary base.

For example, if the BOC increases the monetary base by $100,000 and the quantity
of money increases by $250,000, the money multiplier is 2.5.

In general, the quantity of money created depends on the desired reserve ratio and
the currency drain ratio.
The smaller these ratios, the larger is the money multiplier.

The Money Market

How much money do people want to hold?

The quantity of money demanded is the inventory of money that people plan
to hold on any given day.
o
Money in our wallets and our deposit accounts in our banks

The Influence of Money Holding

The quantity of money that people plan to hold depends on four main factors:

The Price Level

The Nominal Interest Rate
Real GDP
Financial Innovation

The Price Level

Nominal money is the amount of money measured in dollars.

Real money equals nominal money price level.
o
It is the quantity of money measured in terms of what it will buy
o
The quantity of real money demanded is independent of the price level

The quantity of nominal money demanded is proportional to the price level

a 10 percent rise in the price level increases the quantity of nominal money
demanded by 10 percent.

The Nominal Interest Rate

The nominal interest rate is the opportunity cost of holding wealth in the form of
money

The higher the opportunity cost of holding money, other things remaining the
same, the smaller is the quantity of real money demanded.
The nominal interest rate on other assets minus the nominal interest rate on
money is the opportunity cost of holding money.
o
The interest rate that is earned on currency and chequable deposits is
zero, so the opportunity cost of holding these items is the nominal
interest rate on other assets such as a savings bond or Treasury Bill.
o
By holding money instead, the interest that otherwise would have been
received (from holding currency and chequable deposits) is foregone

Real GDP
An increase in real GDP increases the volume of expenditure, which increases the
quantity of real money that people plan to hold

Financial Innovation
Technological changes and the arrival of new financial products influence the
quantity of money held.

Types of Financial Innovation:

Daily interest chequable deposits

Automatic transfers between chequable and saving deposits
Automatic teller machines
Credit cards and debit cards
Internet banking and bill paying

Note: Financial Innovation that lowers the cost of switching between money and
interest-bearing assets decreases the quantity of real money that people plan to
hold

The Demand or Money

The demand for money is the relationship between the quantity of real money
demanded and the nominal interest rate when all other influences on the amount of
money that people wish to hold remain the same.

A rise in the interest rate brings a decrease in the quantity of real money
demanded
A fall in the interest rate brings an increase in the quantity of real money
demanded

Shifts in the Demand for Money Curve

A decrease in real GDP or a financial innovation decreases the demand for

money and shifts the demand curve leftward.
An increase in real GDP increases the demand for money and shifts the
demand curve rightward.

Money Market Equilibrium

Money market equilibrium occurs when the quantity of money demanded equals the
quantity of money supplied.

Adjustments that occur to bring about money market equilibrium are

fundamentally different in the short run and the long run.

Short-Run Equilibrium
Suppose that the Bank of Canada wants the interest rate to be 5 percent a year.

The Bank adjusts the quantity of money each day so that the quantity of real
money is $800 billion.

If the interest rate exceeds the 5 percent a year,

The quantity of money that people are willing to hold is less than the quantity
supplied.

They try to get rid of their excess money they are holding by buying bonds and
bidding up prices.

This action lowers the interest rate.

If the interest rate is below 5 percent a year,

The quantity of money that people want to hold exceeds the quantity
supplied.

They try to get more money by selling bonds and bid down prices.

This action raises the interest rate.

The Short-Run Effect of a Change in the Quantity of Money

Initially, the interest rate is 5 percent a year.

If the BOC increases the quantity of money, people will be holding more
money than the quantity demanded.
So they buy some bonds.
The increased demand for bonds raises the bond price and lowers the interest
rate.

Initially, the interest rate is 5 percent a year.

If the BOC decreases the quantity of money, people will be holding less money than
the quantity demanded.
So they sell bonds.
The increased supply of bonds lowers the bond price and raises the interest rate.

Long-Run Equilibrium

In the long run, the loanable funds market determines the real interest rate.
The nominal interest rate equals the equilibrium real interest rate plus the
expected inflation rate.
In the long run, real GDP equals potential GDP, so the only variable left to
adjust in the long run is the price level.
The price level adjusts to make the quantity of real money supplied equal to
the quantity demanded.
If in long-run equilibrium, the BOC increases the quantity of money, the price
level changes to move the money market to a new long-run equilibrium.
In the long run, nothing real has changed.
Real GDP, employment, quantity of real money, and the real interest rate are
unchanged.
In the long run, the price level rises by the same percentage as the increase
in the quantity of money.

The Quantity Theory of Money

The quantity theory of money is the proposition that, in the long run, an increase
in the quantity of money brings an equal percentage increase in the price level.

The quantity theory of money is based on the velocity of circulation and the
equation of exchange.
o
The velocity of circulation is the average number of times in a year
a dollar is used to purchase goods and services in GDP.

Denote the velocity of circulation as V, the price level P, real GDP Y, and the
quantity of money M:
V= PY M
The equation of exchange states that MV= PY.
The equation of exchange becomes the quantity theory of money if M does not
influence V or Y.
So in the long run, the change in P is proportional to the change in M.

MV= PY

Expressing the equation of exchange in growth rates:

Money growth rate + growth rate of velocity = Inflation rate + Real GDP
growth
Rearranging:
Inflation rate = Money growth rate + Growth rate of velocity - Real GDP
growth

In the long run, velocity does not change, so

Inflation rate = Money growth rate - Real GDP growth

In the long-run, with the economy at full-employment, real GDP equals potential
GDP, so the real GDP growth rate equals the potential GDP growth rate. Quantity
Theory assumes that the growth rate is zero, so
Inflation Rate = Money Growth Rate

Chapter 25: The Exchange Rate

The Foreign Exchange Market

To buy goods and services produced in another country we need money of

that country
Foreign bank notes, coins, and bank deposits are called foreign currency
The foreign exchange market is the market in which the currency of one
country is exchanged for the currency of another
o
The foreign exchange market is made up of thousands of people importers and exporters, banks, international investors and speculators,
international travellers, and specialist traders called foreign exchange
brokers

Exchange Rates
Foreign exchange rate is the price at which one currency exchanges for another.

Like all prices, an exchange rate is determined in a marketthe foreign

exchange market. With many traders and no restrictions, the foreign exchange
market is a competitive market.
The exchange rate fluctuates, i.e., sometimes it rises and sometimes it falls

We will be consistently using the exchange rate as the units of foreign currency per
one Canadian dollar---for example:

A fall in the value of one currency in terms of another currency is called

currency depreciation.
A rise in value of one currency in terms of another currency is called currency
appreciation.

For example, the dollar appreciates against the yen when the exchange rate
rises from 80 to 90 yen per dollar.

Demand in the Foreign Market

The quantity of Canadian dollars that traders plan to buy in the foreign exchange
market during a given period depends on:
1. The exchange rate
2. World demand for Canadian exports
3. Interest rates in Canada and other countries
4. The expected future exchange rate

The Law of Demand for Foreign Exchange

People buy Canadian dollars so that they can buy Canadian-produced goods and
services or Canadian assets.
Other things remaining the same, the higher the exchange rate, the smaller is the
quantity of Canadian dollars demanded in the foreign exchange market.

The exchange rate influences the quantity of Canadian dollars demanded for two
reasons:

Exports effect
Expected profit effect

Exports Effect

The larger the value of Canadian exports, the greater is the quantity of
Canadian dollars demanded on the foreign exchange market.

The lower the exchange rate, the lower are the prices of Canadian-produced
goods and services to foreigners and the greater is the value of Canadian
Exports, so the greater is the quantity of Canadian dollars demanded

If the exchange rate falls (and other influences remaining the same), the quantity
of Canadian dollars demanded in the foreign exchange market increases.

Example: Mexican Peso P12 = C$1 and 1 bottle of Canadian Maple Syrup = C$2 (or
P24)
Suppose the Canadian Dollar depreciate: P10 = C$1

The price of Canadian Maple Syrup falls from 24 Mexican Pesos to 20 Mexican
Pesos. Mexico would be able purchase Maple Syrup at a lower exchange rate, for a
higher value.

Expected Profit Effect

The larger the expected profit from holding Canadian dollars, the greater is
the quantity of Canadian dollars demanded today.
o
But expected profit depends on the exchange rate.
The lower todays exchange rate, other things remaining the same, the larger
is the expected profit from buying Canadian dollars and the greater is the
quantity of Canadian dollars demanded today.

Demand Curve for Canadian Dollars

Supply in the Foreign Exchange Market

Why do people sell C$ and buy other services?
i
ii
iii

Buy foreign-produced goods and services (Canadian imports)

Buy foreign assets
Hold part of their money in bank deposits denominated in foreign currency

The quantity of Canadian dollars supplied in the foreign exchange market is the
amount that traders plan to sell during a given time period at a given exchange
rate.

This quantity depends on many factors but the main ones are:
1. The exchange rate
2. Canadian demand for imports
3. Interest rates in Canada and other countries
4. The expected future exchange rate

The Law of Supply of Foreign Exchange

Other things remaining the same, the higher the exchange rate, the greater is the
quantity of Canadian dollars supplied in the foreign exchange market.

The exchange rate influences the quantity of Canadian dollars supplied for two
reasons:

Imports effect
Expected profit effect

Imports Effect

The larger the value of Canadian imports, the larger is the quantity of
Canadian dollars supplied on the foreign exchange market.
The higher the exchange rate, the lower are the prices of foreign-produced
goods and services, the greater is the volume of Canadian imports, and so the
greater is the quantity of Canadian dollars supplied in the foreign exchange
market

Expected Profit Effect

For a given expected future Canadian dollar exchange rate, the lower the current
exchange rate, the greater is the expected profit from holding Canadian dollars, and
the smaller is the quantity of Canadian dollars supplied on the foreign exchange
market.

On the other side, the higher the exchange rate today, other things remaining the
same, the larger is the expected profit from selling Canadian dollars today and
holding foreign currencies, so the greater is the quantity of Canadian dollars
supplied in the foreign exchange market.

Supply Curve for Canadian Dollars

Market Equilibrium

If the exchange rate is too high, a surplus of Canadian dollars drives it down.
If the exchange rate is too low, a shortage of Canadian dollars drives it up.
The market is pulled (quickly) to the equilibrium exchange rate at which there
is neither a shortage nor a surplus.

Exchange Rate Fluctuations

Changes in the Demand for Canadian Dollars
The demand for Canadian dollars in the foreign exchange market changes when
there is a change in:

World demand for Canadian exports

Canadian interest rate relative to the foreign interest rate
The expected future exchange rate

World Demand for Canadian Exports

At a given exchange rate, if world demand for Canadian exports increases, the
demand for Canadian dollars increases and the demand curve for Canadian dollars
shifts rightward.

Canadian Interest Rate Relative to the Foreign Interest Rate

The higher the interest rate that people can make on Canadian assets
compared with foreign assets, the more Canadian assets they buy.
The Canadian interest rate minus the foreign interest rate is called the
Canadian interest rate differential.
If the Canadian Interest Rate rises and the Foreign Interest Rate remains
constant, the Canadian Interest Rate Differential increases
o
If the Canadian interest differential rises, the demand for Canadian
dollars increases and the demand curve for Canadian dollars shifts
rightward.

The Expected Future Exchange Rate

At a given current exchange rate, if the expected future exchange rate for Canadian
dollars rises, the demand for Canadian dollars increases and the demand curve for
dollars shifts rightward.

How the demand curve for Canadian dollars shifts in response to changes in

Canadian exports
The Canadian interest rate differential

The expected future exchange rate

Change in the Supply of Canadian Dollars

A change in any influence on the quantity of Canadian dollars that people plan to
sell, other than the exchange rate, brings a change in the supply of dollars.

These other influences are:

Canadian demand for imports

Canadian interest rates relative to the foreign interest rate
The expected future exchange rate

Canadian Demand for Imports

At a given exchange rate, if the Canadian demand for imports increases, the supply
of Canadian dollars on the foreign exchange market increases and the supply curve
of Canadian dollars shifts rightward.

Canadian Interest Rate Relative to the Foreign Interest Rate

If the Canadian interest differential rises, the supply of Canadian dollars decreases
and the supply curve of Canadian dollars shifts leftward.

With a higher Canadian interest rate differential, people decide to keep more
of their funds in Canadian dollar assets and less in foreign currency assets
o
They buy a smaller quantity of foreign currency and sell a smaller
quantity of Canadian dollars

So a rise in Canadian interest rate, other things remaining the same, decreases the
supply of Canadian dollars in the foreign exchange market.

The Expected Future Exchange Rate

At a given current exchange rate, if the expected future exchange rate for Canadian
dollars rises, the supply of Canadian dollars decreases and the supply curve of
Canadian dollars shifts leftward.

Suppliers of Canadian currency could make a profit if the exchange rate is

high compared to other foreign currencies (a higher value of a foreign currency
per one Canadian dollar). Therefore, if expected future currency rates
decreases, a higher amount of profit would be made with the current
exchange rate; thus, suppliers would increase the supply of Canadian dollars in
the Foreign Exchange Market.

How the supply curve of Canadian dollars shifts in response to changes in

Canadian demand for imports

The Canadian interest rate differential
The expected future exchange rate

Changes in the Exchange Rate

If demand for Canadian dollars increases and supply does not change, the
exchange rate rises.
If demand for Canadian dollars decreases and supply does not change, the
exchange rate falls.
If supply of Canadian dollars increases and demand does not change, the
exchange rate falls.
If supply of Canadian dollars decreases and demand does not change, the
exchange rate rises.

Summary:

A rise in the Canadian Interest Rate Differential or a rise in the Expected

Future Exchange Rate increases demand, decreases supply, and raises the
exchange rate.
A fall in the Canadian Interest Rate Differential or a fall in the Expected
Future Exchange Rate decreases demand, increases supply, and lowers the
exchange rate

Fundamentals, Expectations, and Arbitrage

The exchange rate changes when it is expected to change.

But, what causes this change in expectation?

They are driven by deeper forces

Arbitrage:
The simultaneous purchase and sale of an asset in order to profit from a difference
in the price. It is a trade that profits by exploiting price differences of identical or
similar financial instruments, on different markets or in different forms. Arbitrage
exists as a result of market inefficiencies; it provides a mechanism to ensure prices
do not deviate substantially from fair value for long periods of time.

In simpler terms, it is the practice of seeking to profit by buying in one market

and selling for a higher price in another market.

Arbitrage activities can lead to:

Law of One Price

o
"If an item is traded in more than one place, the price will be the same
in all locations"
No Round-Trip Profit
o
A round trip is using currency A to buy currency B, and then using B to
buy A. A round trip might involve more stages, using B to buy C and then
using C to buy A
o
Arbitrage removes profit from all transactions of this type
Any fleeting profit is taken, and the changes in supply and

demand induce by the momentarily available profit snaps the

exchange rate back to levels that remove the profit.
Interest Rate Parity
Purchasing Power Parity

Interest Rate Parity (IRP)

The rates of returns on two currencies are equal.

For risk-free transactions, there is no gain from choosing one currency over
another

Suppose that bank deposit earns 1% a year in Tokyo and 3% a year in New York.
The return on a currency is the interest rate on that currency plus the expected rate
of appreciation over a given period.

When the rates of returns on two currencies are equal, interest rate parity
prevails.

Interest rate parity means equal interest rates when exchange rate changes are
taken into account.
Market forces achieve interest rate parity very quickly.

The law of one price states that if an item can be traded in more the one place, the
price will be the same in all locations

Purchasing Power Parity (PPP)

One Canadian dollar (or a unit of any currency) can buy the same quantity of
goods and services in any countries.
Equal purchasing power or equal value of money

Conditions:

If most goods and services cost more in one country than another, the
currency of the first country is said to be overvalued
o
A depreciation of the currency would restore PPP
The currency of the country with the lower prices is said to be undervalued
o
An appreciation of that currency would restore the PPP
When goods and services cost the same in two countries, their currencies are
said to be at their PPP levels

Speculation
Speculation is trading on the expectation of making a profit

It contrasts with arbitrage, which is trading on the certainty of making a profit

Most foreign exchange transactions are based on speculation

The Real Exchange Rate

The real exchange rate (RER) is the relative price of Canadian-produced goods and
services to foreign-produced goods and services.

It measures the quantity of real GDP of other countries that a unit of

Canadian real GDP buys.

Example: Suppose a bushel of Canadian wheat sells for $100, and a bushel of
Mexican wheat sells for 500 pesos.

What is the Real Exchange Rate between Canadian and Mexican wheat?

Use the nominal exchange rate to convert the prices into a common currency.
Suppose the exchange rate is 10 pesos per dollar.
The price of Canadian wheat of $100 per bushel is equivalent to 1000 pesos
per bushel.

Therefore,
2 bushel of Mexican wheat per bushel of Canadian wheat (2:1)

The equation that links the nominal exchange rate (E) and real exchange rate (RER)
is

RER= (E x P)/P*
where P is the Canadian price level and P* is the Mexican (or foreign) price level.
If both countries produce identical goods, then the price levels expressed in the
same currency would be the same and RER would equal 1.

The Short Run

In the short run, the equation determines RER.

RER= (E x P)/P*
In the short run, if the nominal exchange rate changes, P and P* do not change and
the change in E brings an equivalent change in RER.

The Long Run

In the long run, RER is determined by the real forces of demand and supply in the
markets for goods and services.
So in the long run, E is determined by RER and the price levels. That is,

E= RER x (P*/P)

A rise in the Japanese price level P* brings an appreciation of the Canadian

dollar in the long run.
A rise in the Canadian price level P brings a depreciation of the Canadian
dollar in the long run.

Exchange Rate Policy

Three possible exchange rate policies are

Flexible exchange rate

Fixed exchange rate
Crawling peg

A flexible exchange rate policy is one that permits the exchange rate to be
determined by demand and supply in the foreign exchange market, with no direct
intervention in the foreign exchange market by the central bank.

A fixed exchange rate policy is one that pegs the exchange rate at a value
decided by the government or central bank and is achieved by direct intervention in
the foreign exchange market to block unregulated forces of demand and supply.

A fixed exchange rate requires active intervention in the foreign exchange market.

How the BOC can intervene in the foreign exchange market to keep the exchange
rate close to a target rate.

Suppose that the target is 100 yen per Canadian dollar.

If the demand for Canadian dollars increases, the BOC sells Canadian dollars
to increase supply.

A crawling peg is an exchange rate that follows a path determined by a decision of

the government or the central bank and is achieved by active intervention in the
market.

China is a country that operates a crawling peg.

A crawling peg works like a fixed exchange rate except that the target value
changes.
The ideal crawling peg sets a target for the exchange rate equal to the
equilibrium exchange rate on average.

The idea behind a crawling peg is to avoid wild swings in the exchange rate that
might happen if expectations became volatile and to avoid the problem of running
out of reserves, which can happen with a fixed exchange rate.

A crawling peg departs from the ideal if, as often happens with a fixed exchange
rate, the target rate departs from the equilibrium exchange rate for too long.

When this occurs, the country either runs out of reserves or piles up reserves

Net Borrower: a country that is borrowing more from the rest of the world than it is
lending to the rest of the world
Net Lender: a country that is lending more to the rest of the world than it is
borrowing from the rest of the world

Debtor Nation: a country that during its entire history has borrowed more from the
rest of the world than it has lent to it

It has a stock of outstanding debt to the rest of the world that exceeds the
stock of its own claims on the rest of the world

Creditor Nation: a country that during its entire history has invested more in the
rest of the world than other countries have invested in it.

Chapter 26: Aggregate Supply and Aggregate

Demand
We look at the demand and supply of all final goods and services in the economy.
The quantity of real GDP supplied is the total quantity that firms plan to produce
during a given period.

This quantity depends on the quantity of labor employed, the quantity of

physical and human capital, and the state of technology.

Aggregate supply is the relationship between the quantity of real GDP

supplied and the price level.
We distinguish two time frames associated with different states of the labor market:

Long-run aggregate supply

Short-run aggregate supply

Long-run aggregate supply is the relationship between the quantity of real GDP
supplied and the price level when the money wage rate changes in step with the
price level to maintain full-employment.
The long-run aggregate supply curve (LAS) is vertical at potential GDP.
Why is real GDP unchanged when all prices change by the same percentage?
Potential GDP is independent of the price level.

Short-run aggregate supply is the relationship between the quantity of real GDP
supplied and the price level when the money wage rate, the prices of other
resources, and potential GDP remain constant.

A rise in the price level with no change in the money wage rate and other
factor prices increases the quantity of real GDP supplied.
The short-run aggregate supply curve (SAS) is upward sloping.

In the short run, the quantity of real GDP supplied increases if the price level rises.

The SAS curve slopes upward.

A rise in the price level with no change in the money wage rate induces firms
to increase production.

With a given money wage rate, the SAS curve cuts the LAS curve at potential GDP.

The price level is 110.

With the given money wage rate, as the price level falls below 110

The quantity of real GDP supplied decreases along the SAS curve.

With the given money wage rate, as the price level rises above 110

The quantity of real GDP supplied increases along the SAS curve.
Real GDP exceeds potential GDP

Changes in Aggregate Supply

Aggregate supply changes if an influence on production plans other than the price
level changes. These influences include:

Changes in potential GDP

Changes in money wage rate (and other factor prices)

Changes in Potential GDP

Potential GDP changes for three reasons:

An increase in the full-employment quantity of labor

An increase in the quantity of capital (physical or human)
Advancement in technology

The Effect of an Increase in Potential GDP

When potential GDP increases, both the LAS and SAS curves shift rightward.

The two curves shift by the same amount ONLY IF the full-employment price
level remains constant, which we will assume to be the case.
The LAS curve shifts rightward and the SAS curve shifts along with the LAS
curve.

Changes in the Money Wage Rate

The effect of a rise in the money wage rate:

Short-run aggregate supply decreases and the SAS curve shifts leftward.
Long-run aggregate supply does not change.

Aggregate Demand
The quantity of real GDP demanded, Y, is the total amount of final goods and
services produced in Canada that people, businesses, governments, and foreigners
plan to buy.
This quantity is the sum of consumption expenditures, C, investment, I, government
expenditure, G, and net exports, XM.
That is,

Y= C+ I+ G+ XM.

Buying plans depend on many factors and some of the main ones are:

The price level

Expectations
Fiscal policy and monetary policy
The world economy

Let us first focus on the relationship between the quantity of real GDP demanded
and the price level, keeping all other influences constant.

Aggregate demand is the relationship between the quantity of real GDP

demanded and the price level.
The aggregate demand curve (AD) plots the quantity of real GDP demanded
against the price level.

The AD curve slopes downward for two reasons:

Wealth Effect
Substitution Effects

Wealth Effect
Real Wealth: the amount of money in the bank, bonds, shares, and other
assets that people own, measured not in dollars but in terms of the goods
and services that the money, bonds, and shares will buy

A rise in the price level, other things remaining the same, decreases the
quantity of real wealth

To restore real wealth, people increase saving and decrease spending.

The quantity of real GDP demanded decreases.

Similarly, a fall in the price level, other things remaining the same,
increases the quantity of real wealth, which increases the quantity of real
GDP demanded.

Substitution Effects

Intertemporal Substitution Effect:

A rise in the price level, other things remaining the same, decreases the real value
of money and raises the interest rate

With a rise in the price value, money can no longer buy the same amount of
goods before the increase. Therefore, real value of money decreases. Since
money cannot buy as many goods as before, individuals are left with borrowing
money from banks. This gives them an opportunity to increase the interest rate
on loans, as the demand to borrow funds has increased.

The idea is, with a smaller amount of real money around, banks and other lenders
can get a higher interest rate on loans.

When the interest rate rises, people borrow and spend less, so the quantity of
real GDP demanded decreases.
This substitution effect involves changing the timing of purchases and is
called an intertemporal substitution effect a substitution across time.

Similarly, a fall in the price level increases the real value of money and lowers the
interest rate.

When the interest rate falls, people borrow and spend more, so the quantity
of real GDP demanded increases.

International Substitution Effect:

A rise in the price level, other things remaining the same, increases the price of
domestic goods relative to foreign goods.

The change in relative prices encourages people to spend less on Canadianmade items and more on foreign-made items

o
o

Hence, exports will decrease, and imports will increase

Therefore, quantity of real GDP demanded decreases

Similarly, a fall in the price level, other things remaining the same, increases
the quantity of real GDP demanded.

Changes in Aggregate Demand

A change in any influence on buying plans other than the price level changes
aggregate demand.

The main influences on aggregate demand are:

Expectations
Fiscal policy and monetary policy
The world economy

Expectations
Expectations about future income, future inflation, and future profits change
aggregate demand.
Increases in expected future income increase peoples consumption today and
increases aggregate demand.
A rise in the expected inflation rate makes buying goods cheaper today and
increases aggregate demand.
An increase in expected future profits boosts firms investment, which increases
aggregate demand.

Fiscal Policy and Monetary Policy

Fiscal policy is the governments attempt to influence the economy by setting and
changing taxes, making transfer payments, and purchasing goods and services
(government spending)
A tax cut or an increase in transfer payments increases households disposable
income (aggregate income minus taxes plus transfer payments).

The greater () is disposable income, the greater is the quantity of

consumption goods and services that households plan to buy and the greater
is the aggregate demand
As government expenditure on goods and services increases (), aggregate
demand increases

Monetary policy is the central banks attempt to influence the economy by

changing the interest rate and adjusting the quantity of money.
With an increase in the quantity of money (), it increases aggregate demand
through channels:

Lowers interest rates

Makes it easier to get a loan

With lower interest rates (), businesses plan greater investment in new capital and
households plan greater expenditure on new homes, on home improvements, on
automobiles, and a host of other consumer durable goods

Note: a decrease in the quantity of money has the opposite effects and lowers
aggregate demand

The World Economy

The world economy influences aggregate demand in two ways:

Exchange Rate
o
The amount of a foreign currency that you can buy with a Canadian
dollar
o
Other things remaining the same, a rise in the exchange rate
decreases aggregate demand

A higher exchange rate means that we are able to purchase

goods from foreign markets at a cheaper price, thus reducing the
purchases of Canadian-made goods and more of Foreign-made goods
o
Therefore, a fall in the exchange rate increases aggregate demand

A decrease in exchange rate causes foreign goods to be more

expensive. Therefore, we decide to reduce the consumption/purchase
of foreign goods and increase consumption of Canadian goods
Foreign Income
o
An increase in foreign income increases Canadian exports and
increases Canadian aggregate demand

An increase in foreign income allows other countries to increase

their consumption of Canadian goods, thus increasing the aggregate
demand for Canadian goods.

Changes in Aggregate Demand

When the aggregate demand increases, the AD curve shifts rightward

When the aggregate demand decreases, the AD curve shifts leftward

Explaining Macroeconomic Trends and Fluctuations

Short-run Macroeconomic Equilibrium occurs when the quantity of real GDP
demanded equals the quantity of real GDP supplied at the point of intersection of
the AD curve and the SAS curve.

Long-run Macroeconomic Equilibrium occurs when real GDP equals potential

GDPwhen the economy is on its LAS curve.

Long-run equilibrium occurs at the intersection of the AD and LAS curves

The adjustment to long-run equilibrium:

Initially, the economy is at Below-Full Employment Equilibrium.

o
This output gap is called a Recessionary Gap
In the long run, the money wage falls until the SAS curve passes through the
long-run equilibrium point.

When the economy is initially at an Above-Full Employment Equilibrium:

The output gap is called an Inflationary Gap

In the long run, the money wage rises until the SAS curve passes through the
long-run equilibrium point.

Economic Growth and Inflation in the AS-AD Model

Because the quantity of labor grows, capital is accumulated, and technology
advances, potential GDP increases.

The LAS curve shifts rightward.

If the quantity of money grows faster than potential GDP, aggregate demand
increases by more than long-run aggregate supply.

The AD curve shifts rightward faster than the rightward shift of the LAS
curve.

The Business Cycle in the AS-AD Model

The business cycle occurs because aggregate demand and the short-run aggregate
supply fluctuate, but the money wage does not change rapidly enough to keep real
GDP at potential GDP.

An above full-employment equilibrium is an equilibrium in which real GDP

exceeds potential GDP.
A full-employment equilibrium is an equilibrium in which real GDP equals
potential GDP.
A below full-employment equilibrium is an equilibrium in which potential
GDP exceeds real GDP.

Above Full-Employment Equilibrium

The amount by which potential GDP exceeds real GDP is called an inflationary gap
(output gap which is the gap between real GDP and potential GDP, is positive).

Below Full-Employment Equilibrium

The amount by which real GDP is less than potential GDP is called a recessionary
gap.

Fluctuations in Aggregate Demand

The effects of an increase in aggregate demand:

An increase in aggregate demand shifts the AD curve rightward.

Firms increase production and the price level rises in the short run.
At the short-run equilibrium, real GDP increases
The money wage rate begins to rise and short-run aggregate supply begins to
decrease
The price level continues to rise until the inflationary gap is eliminated, and
the SAS and AD curves intersect the LAS curve (Long-term)

Fluctuations in Aggregate Supply

The effects of a rise in the price of oil:

The SAS curve shifts leftward.

Real GDP decreases and the price level rises.

The economy experiences stagflation (a combination of inflation and

recession)
o
As a result of a decrease in real GDP, the economy experiences a
recession
o
Because the price level increases, the economy experiences inflation

Macroeconomic Schools of Thought

Classical
Keynesian
Monetarist

The Classical View

A Classical macroeconomist believes that the economy is self-regulating and
always at full employment.

The term classical derives from the name of the founding school of
economics that includes Adam Smith, David Ricardo, and John Stuart Mill.
A new classical view is that business cycle fluctuations are the efficient
responses of a well-functioning market economy that is bombarded by shocks
that arise from the uneven pace of technological change.

The Keynesian View

A Keynesian macroeconomist believes that left alone, the economy would rarely

operate at full employment and that to achieve and maintain full employment,
active help from fiscal policy and monetary policy is required.

The term Keynesian derives from the name of one of the twentieth
centurys most famous economists, John Maynard Keynes.
A new Keynesian view holds that not only is the money wage rate sticky but
also are the prices of goods.

The Monetarist View

A Monetarist is a macroeconomist who believes that the economy is selfregulating and that it will normally operate at full employment, provided that
monetary policy is not erratic (unpredictable) and that the pace of money growth is
kept steady.

The term monetarist was coined by an outstanding twentieth-century

economist, Karl Brunner, to describe his own views and those of Milton
Friedman.

Chapter 27: Expenditure Multiplier

The Keynesian model describes the economy in the very short run when prices are
fixed.
Because each firms price is fixed, for the economy as a whole:
1
2

The price level is fixed.

Aggregate demand determines real GDP.

Aggregate Planned Expenditure is equal to the sum of the planned levels of

consumption expenditure, investment, government expenditure on goods and
service, and exports minus imports

The components of aggregate expenditure sum to real GDP.

That is,

Y= C+ I+ G+ XM.

Two components of aggregate expenditure, consumption and imports, are

also influenced by real GDP.
So there is a two-way link between aggregate expenditure and real GDP.

Two-Way Link Between Aggregate Expenditure and Real GDP

Other things remaining the same,

An increase in real GDP increases aggregate expenditure.

An increase in aggregate expenditure increases real GDP.

Disposable income (YD) is aggregate income or real GDP, Y, minus net taxes, T.
That is,

YD= YT

Disposable income changes when either real GDP changes or net taxes
change.
Disposable income, YD, is either spent on goods and services, C, or
saved, S.

YD= C+ S

Consumption
Consumption expenditure is influenced by many factors but the most direct one is
disposable income.

The relationship between consumption expenditure and disposable income,

other things remaining the same, is the consumption function.

Let us write the consumption function as:

= () + = () + ()
where () denotes the autonomous consumption
MPC is the marginal propensity to consume

The marginal propensity to consume (MPC) is the fraction of a change in

disposable income spent on consumption.

That is,

MPC=

Aggregate Expenditure and Aggregate Demand

The aggregate expenditure curve is the relationship between aggregate planned
expenditure and the real GDP, with all other influences on aggregate planned
expenditure remaining the same

The aggregate demand curve is the relationship between the quantity of real
GDP demanded and the price level, with all other influences on aggregate demand
remaining the same

Deriving the Aggregate Demand Curve

When the price level changes, a wealth effect and substitution effects change
aggregate planned expenditure and change the quantity of real GDP demanded

Suppose:

C = 0 + 0.7 (Y T)
T=0
I = 100
G= 200
X=0
M= 0 + 0.2 (Y T)

Find the AE.

AE = C + I + G + X - M = 300 + 0.5(Y - T)
Find the equilibrium Y.
Y = AE
Suppose G increases by 50. Find the new equilibrium Y.

AE = 350 + 0.5(Y - T)
AE = Y
*Find New Y

What is the size of the multiplier?

1/1 - Slope of Aggregate Demand Curve

Chapter 28: Inflation, Job, and the Business

Cycle
The Business Cycle
Mainstream Business Cycle Theory
The mainstream business cycle theory is that potential GDP grows at a steady rate
while aggregate demand grows at a fluctuating rate

Because the money wage is sticky, if aggregate demand grows faster than
potential GDP, real GDP moves above potential GDP and an inflationary gap
emerges
If aggregate demand grows slower than potential GDP, real GDP moves below
potential GDP and a recessionary gap emerges

Note: If aggregate demand decreases, real GDP also decreases in a recession

Special Forms of Mainstream Business Cycle Theory

Keynesian Cycle Theory

Fluctuations in investment drive by fluctuations in business confidence

- summarized by the phrase "Animal Spirits" - are the main source of
fluctuations in aggregate demand
Monetarist Cycle Theory
o
Fluctuations in both investment and consumption expenditure, driven
by fluctuations in the growth rate of the quantity of money, are the main
source of fluctuations in aggregate demand
o

Note: Both the Keynesian and Monetarist Cycle Theories simply assume that money
wage is rigid and don't explain the rigidity.

New Classical Cycle Theory

o
The rational expectation of the price level, which is determined by
potential GDP and expected aggregate demand, determines the money
wage rate and the position of the SAS curve.
In this theory, only unexpected fluctuations in aggregate

demand bring fluctuations in real GDP around potential GDP

New Keynesian Cycle Theory
o
Today's money wage rates were negotiated at many past dates, which
means that past rational expectations of the current price level influence
the money wage rate and the position of the SAS curve
In this theory, both unexpected and currently expected

fluctuations in aggregate demand bring fluctuations in real GDP

around potential GDP

Real Business Cycle Theory

Real Business Theory regards random fluctuations in productivity as the main
source of economic fluctuations

These productivity fluctuations are assumed to result mainly from

fluctuations in the pace of technological change, but they might also have
other sources , such as international disturbances, climate fluctuations, or
natural disasters

The RBC Impulse

The impulse in the RBC theory is the growth rate of productivity that results from
technological change

RBC theorists believe this impulse to be generated mainly by the process of

research and development that leads to the creation and use of new
technologies

The pace of technological change and productivity growth is not constant

o
Sometimes productivity growth speeds up, sometimes, it slows, and
occasionally it even falls - labour and capital become less productive, on
average

A period of rapid productivity growth brings a business cycle expansion

A slowdown or fall in productivity triggers a recession.

All technological change eventually increases productivity

o
If, initially, technological change makes a sufficient amount of existing
capital - especially human capital - obsolete, productivity can temporarily
fall.
The results in more jobs being destroyed than created and more

businesses fail than start up.

The RBC Mechanism

Two effects follow from a change in productivity that sparks an expansion or a
contraction:

Investment Demand Changes

The Demand for Labour Changes

Effects and Consequences during a Recession (The opposite occurs in an

expansion)
Technological change makes some existing capital obsolete and temporarily
decreases productivity.

Firms expect future profits to fall and see their labour productivity falling
With lower profit expectations, they cut back their purchases of new capital,
and with lower labour productivity, they plan to lay off some workers

Therefore, the initial effect of a temporary fall in productivity is a decrease in

investment demand and a decrease in the demand for labour

According to the RBC theory, people decide when to work by doing a cost-benefit
calculation

They compare the return from working in the current period with the
expected return from working in a later period
Workers work fewer hours, sometimes zero hours, when the real wage rate is
temporarily low, and they work more hours when the real wage rate is
temporarily high
When-to-work decision depends on the real interest rate
o
If Real Interest Rate > Real Wage Rate, then working longer hours now
and shorter hours a year from now would result in getting a higher wage
rate (difference of Real Interest Rate and Real Wage Rate)
o
If Real Interest Rate < Real Wage Rate, then working few hours now
and more hours a year from now creates a higher wage rate
Note: The lower the real interest rate, other things remaining the same, the
smaller is the supply of labour today

Real things, not nominal or monetary things, cause the business cycle

If the quantity of money changes, aggregate demand changes

o
But with no real change - with no change in the use of resources or in
potential GDP - the change in the quantity of money only changes the
price level

Cycles and Growth

Economic growth arises from the upward trend in productivity growth, and
according to RBC theory , the most positive but occasionally negative higher
frequency shocks to productivity bring the business cycle

Criticisms and Defences of RBC Theory

Three Main Criticisms of RBC Theory:
1
2
3

The money wage is sticky, and to assume otherwise is at odds with a clear fact
Intertemporal substitution is too weak a force to account for large fluctuations
in labour supply and employment with small real wage rate changes
Productivity shocks are as likely to be caused by changes in aggregate demand
as by technological change

Defences for RBC Theory

If aggregate demand fluctuations cause the fluctuations in productivity, then

the traditional aggregate demand theories are needed to explain them
o
Fluctuations in productivity do not cause the business cycle but are
caused by it

Inflation Cycles
In the long run, inflation occurs if the quantity of money grows faster than
potential GDP.
In the short run, many factors can start an inflation, and real GDP and the price
level interact.

To study these interactions, we distinguish between two sources of inflation:

Demand-pull inflation
Cost-push inflation

Demand-Pull Inflation
An inflation that starts because aggregate demand increases is called demand-pull
inflation.

Demand-pull inflation can begin with any factor that increases aggregate
demand.
Examples are a cut in the interest rate, an increase in the quantity of money,
an increase in government expenditures, a tax cut, an increase in exports, or
an increase in investment stimulated by an increase in expected future profits

Initial Effect of an Increase in Aggregate Demand

Starting from full employment, an increase in aggregate demand shifts the AD curve
rightward.

The price level rises, real GDP increases, and an inflationary gap arises.
The rising price level is the first step in the demand-pull inflation.

There is an increase in aggregate demand

There is an increase in the quantity supplied

Money Wage Rate Response

The money wage rate rises and the SAS curve shifts leftward.
The price level rises and real GDP decreases back to potential GDP.

A demand-pull inflation spiral

Aggregate demand keeps increasing and the process just described repeats
indefinitely.

Although any of several factors can increase aggregate demand to start a demandpull inflation, only an ongoing increase in the quantity of money can sustain it.
A demand-pull inflation occurred in Canada in the 1960s.

Cost-Push Inflation
An inflation that starts with an increase in costs is called cost-push inflation.

There are two main sources of increased costs:

1. An increase in the money wage rate
2. An increase in the money price of raw materials, such as oil

Initial Effect of a Decrease in Aggregate Supply

A rise in the price of oil decreases short-run aggregate supply and shifts the SAS
curve leftward.
Real GDP decreases and the price level rises.

Aggregate Demand Response

The initial increase in costs creates a one-time rise in the price level, not
inflation.
o
Note: A supply shock on its own cannot cause inflation
To create inflation, aggregate demand must increase.
That is, the BOC must increase the quantity of money persistently.

Response of Aggregate Demand.

The Bank of Canada stimulates aggregate demand to counter the higher
unemployment.
Real GDP increases and the price level rises again.

A Cost-Push Inflation Process

If the oil producers raise the price of oil to try to keep its relative price higher,
and the Bank of Canada responds by increasing the quantity of money,
a process of cost-push inflation continues.

The combination of a rising price level and a decreasing real GDP is called
stagflation.

Cost-push inflation occurred in Canada during the 1970s when the Bank
responded to the OPEC oil price rise by increasing the quantity of money.

Expected Inflation
If inflation is expected, the fluctuations in real GDP that accompany demand-pull
and cost-push inflation don't occur.

Instead, inflation proceeds as it does in the long run, with real GDP equal to
potential GDP and unemployment rate at its natural rate

Aggregate demand increases, but the increase is expected, so its effect on the price
level is expected.

Note: The cause of the inflation is the result of expecting inflation, which caused
the money wage rate and the price level to increase.

The money wage rate rises in line with the expected rise in the price level.

The price level rises as expected and real GDP remains at potential GDP.

The process repeats

Forecasting Inflation
To expect inflation, people must forecast it.

Expectations formation:

The best forecast available is one that is based on all the relevant information
and is called a rational expectation.
o
A rational expectation is not necessarily correct, but it is the best
available.
Adaptive Expectation

Inflation and the Business Cycle

When the inflation forecast is correct, the economy operates at full employment.

If aggregate demand grows faster than expected, real GDP moves above
potential GDP, the inflation rate exceeds its expected rate, and the economy
behaves like it does in a demand-pull inflation.
If aggregate demand grows more slowly than expected, real GDP falls below
potential GDP, the inflation rate slows, and the economy behaves like it does in
a cost-push inflation.

Mainstream Business Cycle Theory

Because potential GDP grows at a steady pace while aggregate demand grows at a
fluctuating rate, real GDP fluctuates around potential GDP. Initially, the economy is
at full employment at point A. Potential GDP increases and the LAS curve shifts
rightward

During an expansion, aggregate demand increases and usually by more than

potential GDP.

The AD curve shifts to AD1.

Assume that during this expansion the price level is expected to rise to 110 and that
the money wage rate was set on that expectation.

The SAS shifts to SAS1.

The economy remains at full employment at point B.
The price level rises as expected from 100 to 110.

But if aggregate demand increases more slowly than potential GDP, the AD curve
shifts to AD2.

The economy moves to point C.

Real GDP growth is slower; inflation is less than expected.

But if aggregate demand increases more quickly than potential GDP, the AD curve
shifts to AD3.

The economy moves to point D.

Real GDP growth is faster; inflation is higher than expected.

Economic growth, inflation, and the business cycle arise from the relentless
increases in potential GDP, faster (on average) increases in aggregate demand, and
fluctuations in the pace of aggregate demand growth.

Deflation
An economy experiences deflation when it has a persistently falling price level

During a period of deflation, inflation rate is negative

What Causes Deflation?

A one-time fall in the price level is NOT deflation

Deflation is a persistent and ongoing falling price level

A Persistently Falling Price Level

The price level falls persistently if aggregate demand increases at a persistently
slower rate than aggregate supply

The trend rate of increase in aggregate supply is determined by the forces

that make potential GDP grow
o
These forces are the growth rates of the labour force and capital
stock and the growth rate of productivity that result from
technological change
Forces that drive aggregate demand include the quantity of money
o
The quantity can grow as quickly or as slowly as the central bank
chooses

The Quantity Theory of Money and Deflation

The foundation of the quantity theory is the equation of exchange, which states:

The quantity theory adds to the equation of exchange two propositions:

1
2

The trend rate of change in the velocity of circulation does not depend on the
money growth rate and is determined by decisions about the quantity of
money to hold and to spend
The trend growth rate of real GDP equals the growth rate of potential GDP and,
again, is independent of the money growth rate

Consequences of Deflation
The effects of deflation (like those of inflation) depend on whether it is anticipated
or unanticipated

Because inflation is normal and deflation is rare, it is usually unanticipated

Note: Unanticipated Deflation redistributes income and wealth, lowers real GDP and
employment, and diverts resources from production

How Can Deflation Be Ended?

Deflation can be ended by removing its cause: The quantity of money is growing
too slowly

If the central bank ensures that the quantity of money grows at the target
inflation rate plus the growth rate of potential GDP minus the growth rate of
the velocity of circulation, then, on average, the inflation rate will turn out to
be close to target.

The Phillips Curve

The Phillips Curve is a relationship between inflation and unemployment.

The Short-Run Phillips Curve

The Short-Run Phillips Curve is the relationship between inflation and
unemployment, when:
1
2

The expected inflation rate is held constant

The natural unemployment rate is held constant

The Long-Run Phillips Curve

The Long-Run Phillips Curve is the relationship between inflation and
unemployment when the actual inflation rate equals the expected inflation rate

The long run Phillips curve is vertical at the natural unemployment rate
because, in the long run, any expected inflation rate is possible

Change in Expected Inflation

A change in the expected inflation shifts the short-run Phillips curve, but it
does not shift the long-run Phillips Curve
Another source of a shift in the Phillips curve is a change in the natural
unemployment rate.

Change in Natural Unemployment Rate

A change in the natural unemployment rate shifts both the short-run and
long-run Phillips curves

Chapter 29: Fiscal Policy

The Federal Budget

Federal Budget: the annual statement of the outlays and revenues of the
Government of Canada, together with the laws and regulations that approve and
support those outlays and revenues.

Initial purpose (before WWII) was to finance the business of government

Second purpose (late 1940s) is to pursue the government's fiscal policy
o
Fiscal Policy: the use of the federal budget to achieve
macroeconomic objectives such as full employment, sustained long-term
economic growth, and price level stability

Three Components:

Revenues
o
Personal Income Taxes
Taxes paid by individuals on their incomes

o
Corporate Income Taxes
Taxes paid by companies on their profits

o
Indirect and Other Taxes
Includes Harmonized Sales Taxes (HST) and taxes on the sale of

gasoline, alcoholic drinks, and a few other items

o
Investment Income
Income from government enterprises and investments

Outlays
o
Transfer Payments
Payments to individuals, businesses, other levels of government,

and the rest of the world

Includes unemployment cheques and welfare payments to

individuals, farm subsidies, grants to provincial and local

governments, aid to developing countries, and dues to international
organizations such as the United Nations
o
Expenditures on Goods and Services
Government's expenditure on final goods and services

Includes the expenditure on national defence, computers for the

Canadian Revenue Agency (CRA), government cars, and highways

o
Debt Interest
Interest on the government debt

Budget Balance
o
Budget Balance = Revenues - Outlays

If revenues exceed outlays, the government has a budget

surplus
If outlays exceed revenues, the government has a budget
deficit
If revenues equal outlays, the government has a budget
balance

Provincial Budget: an annual statement of the revenues and outlays of a

provincial government, together with the laws and regulations that approve or
support those revenues or outlays

Government Budget: the total amount of government borrowing, which equals

the sum of past deficits minus the sum of past surpluses

When the government budget is in deficit, government debt increases

When the government budget is in surplus, government debt decreases

Supply-Side Effects of Fiscal Policy

Full Employment and Potential GDP
Recall (Chapter 22):

At full employment, the real wage rate adjusts to make the quantity of labour
demanded equal to the quantity of labour supplied
Potential GDP is the real GDP that the full-employment quantity of labour
produces

Income Tax and the Labour Market

Labour Market

An income tax weakens the incentive to work and decreases the supply of
labour.
The supply of labour decreases because the tax decreases the after-tax wage
rate.
The quantity of labour employed decreases

Hence, full employment and potential GDP also decrease.

As a result, Aggregate Supply also decreases.

Tax Wedge: the gap created between the before-tax and after-tax wage rates

To find New Before-Tax and After-Tax Wage Rates

1
2
2

Shift the Supply Curve left by adding the income tax at each point of the
curve
Find the new Full Employment point by finding where the LS + Tax and the
LD curve intersect (New Equilibrium point)
a This Equals the new Before-Tax Wage Rate
Find the new Full-Employment Quantity of Labour and the Real Wage
Rate at that quantity on the initial Supply Curve
a This is the new After-Tax Wage Rate

Note: A tax cut would increase the supply of labour, increase equilibrium
employment, and increase potential GDP

Taxes on Expenditure

Taxes on consumption expenditure add to the tax wedge.

The reason is that a tax on consumption raises the prices paid for
consumption goods and services and is equivalent to a cut in the real wage
rate.
Note that the incentive to supply labour depends on the goods and services
that an hour of labour can buy.
o
The higher the taxes on goods and services and the lower the aftertax wage rate, the less is the incentive to supply labour

If the income tax rate is 25 percent and the tax rate on consumption
expenditure is 10 percent, a dollar earned buys only 65 cents worth of goods
and services.
o
The tax wedge is 35 percent.

Tax Wedge = Income Tax Rate + Tax Rate on

Consumption Expenditure
Buying Power of a Dollar (in terms of Goods and
Services) = 1 - Tax Wedge

Taxes and the Incentive to Save and Invest

A tax on interest income weakens the incentive to save and drives a wedge
between the after-tax interest rate earned by savers and the interest rate paid
by firms.
o
Tax on interest (capital) income lowers the quantity of saving and
investment and slows the growth rate of GDP.
o
The true tax rate on interest income is much higher than that on labour
income because of the way in which inflation and taxes on interest
income interact.

Effect of Tax Rate on Real Interest Rate

Note that the interest rate that influences investment and saving plans is the
real after-tax interest rate.

Real After-Tax Interest Rate = Real Before-Tax Interest Rate Income Tax Rate
= Nominal (Before Tax Interest Rate) Inflation Rate Income Tax Rate

But the taxes are based on nominal interest rate, not on real interest rate.
So the higher the inflation rate, the higher is the true tax rate on interest
income.

Example:

Suppose the real interest rate is 4% a year and the tax rate is 40%.

If there is no inflation, then the nominal interest rate = real interest

rate. The tax on 4% interest is 1.6% (40% of 4%), so the real after-tax interest
rate is 4-1.6=2.4%.
o
Tax = Real Interest Rate Tax Rate

-----------------------------------------------------------

Now, suppose inflation rate is 6% a year and the nominal interest rate is
10%.
o
Nominal Interest Rate = Real Interest Rate + Inflation
The tax on 10% interest is 4% (40% of 10%), so the real after-tax interest rate
is 4%-4%=0%.
The true tax rate in this case is not 40% but 100%.
o
True Tax Rate = (Tax Real Interest Rate) 100

____________________________________
Now, suppose inflation rate is 10% a year and the nominal interest rate is 14%.
The tax on 14% interest is 5.6% (40% of 14%), so the real after-tax interest rate is
4%- 5.6%=-1.6%
The true tax rate in this case is not 40% but 140% (5.6% = 140% x 4%)

Taxes on Interest Income and the Effects on Saving and

Investment
A tax on interest income weakens the incentive to save decreases the supply of
loanable funds.

Equilibrium quantity of loanable funds decreases

Investment and saving decrease.

To find New Before-Tax and After-Tax Interest Rates

1
2
2

Shift the Supply Curve left by adding the income tax at each point of the
curve
Find the new Full Employment point by finding where the SLF + Tax and the
DLF curve intersect (New Equilibrium point)
a This Equals the new Before-Tax Interest Rate
Find the new Full-Employment Quantity of Loanable Funds and the Real
Interest Rate at that quantity on the initial Supply Curve
a This is the new After-Tax Interest Rate

Tax Revenues and the Laffer Curve

Note: An interesting consequence of the effect of taxes on employment and saving
is that a higher tax rate does not always bring greater tax revenue

A higher tax rate brings in more revenue per dollar earned, but at the cost of
decreasing the number of dollars earned

The relationship between the tax rate and the amount of tax revenue collected is
called the Laffer curve

Tax Revenue = Tax Rate x Income

For Tax Rates below T*, an increase in the tax rate increases tax revenue
o
In other words, any point on the left side of the Laffer curve shows an
increasing tax revenue.
At T*, tax revenue is maximized
A Tax Rate increase above T* decreases tax revenue
o
In other words, if we are on the right side of the Laffer curve, it is
better to reduce taxes in order to generate higher tax revenue.

Fiscal Stimulus
A fiscal stimulus is the use of fiscal policy to increase production and employment.
Fiscal stimulus can be either

Automatic
Discretionary

Automatic fiscal policy is a fiscal policy action triggered by the state of the
economy with no government action.
Discretionary fiscal policy is a policy action that is initiated by an act of
Parliament

Requires change in a spending program or in a tax law

Automatic Fiscal Stimulus

Two items in the government budget change automatically in response to the state
of the economy.

Tax revenues
Transfer payments

Lets look at how tax revenues automatically responds to the state of the economy.

Tax Revenue = Tax rate x Income

Tax revenue depends on tax rates and incomes.

Parliament sets the tax rates that people must pay.
Let us suppose that the tax rate is constant that is, flat tax rate.
o
When the economy is booming (expansion), the tax automatically
adjusts upwards and prevents the real GDP from moving too far off from
potential GDP
o
When the economy is in a recession, the taxes automatically adjusts
downwards so that individuals pay less taxes with a lower amount of
income

Structural Surplus or Deficit: the budget balance that would occur if the
economy were at full employment
Cyclical Surplus or Deficit: the actual surplus or deficit minus the structural
surplus or deficit

Discretionary Fiscal Stimulus

Most discretionary fiscal stimulus focuses on its effects on aggregate

demand.
Changes in government expenditure and taxes change aggregate demand
and have multiplier effects.

Two main fiscal multipliers are:

Government expenditure multiplier

Tax multiplier

The government expenditure multiplier is the quantitative effect of a change in

government expenditure on real GDP.

Because government expenditure is a component of aggregate expenditure,

an increase in government expenditure increases real GDP.
When real GDP increases, incomes rise and consumption expenditure
increases.
o
Aggregate demand increases.
o
If this were the only consequence of increased government
expenditure, the government expenditure multiplier would be greater
than 1
An increase in government expenditure increases government borrowing (or
decreases government lending if there is a budget surplus) and raises the real
interest rate
o
With a higher cost of borrowing, investment decreases, which partly
offsets the increase in government spending
o
If this were the only consequence of increased government
expenditure, the multiplied would be less than 1

Y=C+I+G+X-M
I = Ia
G = Ga
X = Xa
M = Ma
T = Ta = 0
C = Ca + MPC (Y - T)

The tax multiplier is the quantitative effect of a change in taxes on real GDP.

The demand-side effects of a tax cut are likely to be smaller than an

equivalent increase in government expenditure.

Time Lags
The use of discretionary fiscal policy is also seriously hampered by three time lags:

Recognition lagthe time it takes to figure out that fiscal policy action is
needed.
Law-making lagthe time it takes Parliament to pass the laws needed to
change taxes or spending.
Impact lagthe time it takes from passing a tax or spending change to its
effect on real GDP being felt.

Chapter 30: Monetary Policy

Origins: in 1934, the Parliament passed the Bank of Canada Act, and the Bank of
Canada started operations in 1935

Monetary Policy Objectives

The objective of monetary policy as set out in the preamble to the Bank of Canada
Act of 1935 is essentially to:

Control the quantity of money and interest rates in order to avoid inflation
When possible, prevent excessive swings in real GDP growth and
unemployment.

The emphasis on inflation has been made concrete by an agreement between the
Bank and the government.

Joint Statement of the Government of Canada and the Bank of

Canada
The agreement of 2011:
1
2
3

The target is the 12-month rate of change in the CPI.

The inflation target is the 2 percent midpoint of the 1 to 3 percent inflationcontrol range.
The agreement will run until December 31, 2016.

Such a monetary policy strategy is called inflation rate targeting (a monetary

strategy in which the central bank commits to an explicit inflation target and to
explaining how its actions will achieve that target).

But the Bank pays close attention to core inflation, which it calls its
operational guide.
The Bank believes that core inflation is a better measure of the underlying
inflation trend and better predicts future CPI inflation.

Actual Inflation
The figure shows the Banks inflation target.

The actual CPI inflation rate has only rarely gone outside the target range.
It shows no bias (fluctuations are neither persistently above or below target).

The figure shows the trend inflation rate of 2 percent a year, at the midpoint of the
target range.
The Bank has done a good job of holding CPI inflation to its target, with only small
and temporary deviations.

Rationale for an Inflation-Control Target

Two main benefits from adopting an inflation-control target:
1
2

Fewer surprises and mistakes on the part of savers and investors.

Anchors expectations about future inflation.
a Firmly held (and correct) inflation expectations also help to make better
economic decisions, which in turn help to achieve a more efficient
allocation of resources and more stable economic growth

Controversy About the Inflation-Control Target

Critics of inflation targeting fear that:
1
2

By focusing on inflation, the Bank might permit the unemployment rate to rise
or real GDP growth to slow.
The Bank might permit the value of the dollar rise on the foreign exchange
market and make exports suffer.

Supporters of inflation targeting respond:

1
2

Keeping inflation low and stable is the best way to achieve full employment
and sustained economic growth.
The Banks record is good. The last time the Bank created a recession was at
the beginning of the 1990s when it was faced with double-digit inflation.

Responsibility for Monetary Policy

The Bank of Canadas Governing Council is responsible for the conduct of

monetary policy.
The Governor and the Minister of Finance must consult regularly.
If the Governor and the Minister disagree in a profound way, the Minister may
direct the Bank in writing to follow a specified course and the Bank would be
obliged to accept the directive.
o
Governor would most likely resign in such a situation

The Conduct of Monetary Policy

How does the Bank of Canada conduct monetary policy?

1
2
3

What is the Bank of Canadas monetary policy instrument?

How does the Bank of Canada make its policy decision?
How does the Bank of Canada implement its policy?

The Monetary Policy Instrument

The monetary policy instrument is a variable that the Bank of Canada can
directly control or closely target.

The Bank of Canada has three possible instruments:

1
2
3

The quantity of money (the monetary base)

The price of Canadian money on the foreign exchange market (the exchange
rate)
The opportunity cost of holding money (the short-term interest rate)

The Bank of Canada can set any one of these three variables, but it cannot set all
three.

The values of two of them are the consequence of the value at which the
third one is set.
If the Bank decreased the quantity of money, both the interest rate and the
exchange rate would rise.
If the Bank raised the interest rate, the quantity of money would decrease
and the exchange rate would rise.
If the Bank lowered the exchange rate, the quantity of money would
increase and the interest rate would fall.

The Overnight Loans Rate

The Bank of Canadas choice of policy instrument (which is the same choice
as that made by most other major central banks) is a short-term interest rate.
Given this choice, the Bank permits the exchange rate and the quantity of
money to find their own equilibrium values.
The specific interest rate that the Bank of Canada targets is the overnight
loans rate, which is the interest rate on overnight loans that chartered banks
make to each other.

The Overnight Loans Rate

When the Bank wants to slow inflation, it raises the overnight loans rate.
When inflation is low and the Bank wants to avoid recession, it lowers the
overnight loans rate

Although the Bank of Canada can change the overnight loans rate by any
(reasonable) amount that it chooses, it normally changes the rate by only a quarter
of a percentage point.

Having decided the appropriate level for the overnight loans rate, how does the
Bank get the overnight loans rate to move to the target level?
The answer is by using open market operations to adjust the quantity of monetary
base.

The Banks Interest Rate Decision

To make its interest rate decision, the Bank of Canada gathers a large amount
of data about the economy, the way it responds to shocks, and the way it
responds to policy.
The Bank must then process all this data and come to a judgement about the
best level for the policy instrument.
After announcing an interest rate decision, the Bank engages in a public
communication to explain the reasons for its decision.

Hitting the Overnight Loans Rate Target

Once an interest rate decision is made, the Bank of Canada achieves its target by
using two tools:

Operating band
Open market operations

Operating Band
The operating band is the target overnight loans rate plus or minus 0.25
percentage points. So the operating band is 0.5 percentage points wide.
The Bank creates the operating band by setting:
1

Bank Rate, the interest rate that the Bank charges big banks on loans, is set
at the target overnight loans rate plus 0.25 percentage points.
a If a bank is short of reserves, it can always obtain resources from the Bank
of Canada, but the bank must pay bank rate on the amount of borrowed
reserves
b Bank rate acts as a cap on the overnight loans rate
c If a bank can borrow from the Bank of Canada at bank rate, it will not
borrow from another bank unless the interest rate is lower than or equal to
bank rate
Settlement Balances Rate, the interest rate the Bank pays on reserves, is
set at the target overnight loans rate minus 0.25 percentage point.
a Banks won't make overnight loans to other banks unless they earn a
higher interest rate than what the Bank is paying
b Alternative of lending in the overnight market is to hold reserves
c Alternative of borrowing in the overnight market is to hold smaller
reserves

Conditions:

If the overnight rate equals bank rate, banks are indifferent between
borrowing reserves and lending reserves
If the overnight rate equals the settlement balances rate, banks are
indifferent between holding reserves and lending reserves
If the overnight loans rate is above target, the Bank buys securities to
increase reserves, which increases the supply of overnight funds and lowers
the overnight rate
If the overnight loans rate is below target, the Bank sells securities to
decrease reserves, which decreases the supply of overnight funds and
raises the overnight rate
If the overnight rate is at the target level, the Bank neither buys nor sells

Monetary Policy Transmission

The Bank of Canadas goal is to keep the inflation rate as close as possible to
2 percent a year.
When the Bank uses its policy tools to move the overnight loans rate closer to
its desired level, a series of events occur.
Were now going to trace the events that follow a change in the overnight
loans rate and see how those events lead to the ultimate policy goal keeping
inflation on target.

Quick Overview
When the Bank of Canada lowers the overnight loans rate:
1
2
3
4
5
6
7

The Bank buys securities in an open market operation.

Other short-term interest rates and the exchange rate fall.
The quantity of money and the supply of loanable funds increase.
The long-term real interest rate falls.
Consumption expenditure, investment, and net exports increase.
Aggregate demand increases.
Real GDP growth and the inflation rate increase.
When the Bank of Canada raises the overnight loans rate, the ripple
effects go in the opposite direction.

Figure 30.4 provides a schematic summary of these ripple effects, which stretch out
over a period of between one and two years

Interest Rate Changes

Figure 30.5 shows the fluctuations in three interest rates:

The short-term bill rate

The long-term bond rate
The overnight loans rate

Short-term rates move closely together and follow the overnight loans rate.

If the interest rate of Treasury Bills is higher than the overnight loans rate,
the quantity of overnight loans supplied decreases and the demand for
Treasury Bills increases
o
The price of Treasury Bills rises and the interest rate falls
If the interest rate on Treasury Bills is lower than the overnight loans rate,
the quantity of overnight loans supplied increases and the demand for
Treasury Bills decreases
o
The price of Treasury Bills falls and interest rate rises

Long-term rates move in the same direction as the overnight loans rate but are only
loosely connected to the overnight loans rate

Exchange Rate Fluctuations

The exchange rate responds to changes in the interest rate in Canada relative
to the interest rates in other countriesthe Canadian interest rate differential.
But other factors are also at work, which make the exchange rate hard to
predict.
When the Bank of Canada raises the overnight loans rate, the Canadian
interest rate differential rises, and other things remaining the same, the
Canadian dollar appreciates
When the Bank of Canada lowers the overnight loans rate, the Canadian
interest rate differential falls and, other things remaining the same, the
Canadian dollar depreciates

Money and Bank Loans

When the Bank increases the overnight loans rate, the quantity of money
and the quantity of bank loans decrease
o
A rise in the overnight loans rate decreases reserves and decreases the
quantity of deposits and bank loans created
When the Bank lowers the overnight loans rate, the quantity of money and
the quantity of bank loans increase.
o
A fall in the overnight loans rate increases reserves and increases the
quantity of deposits and bank loans created

Note: These changes occur because of two reasons:

1
2

The quantity of deposits and loans created by the banking system changes
The quantity of money demanded changes

Consumption and investment plans change.

o
With more money and easier access to loans, consumers and firms
spend more
o
With less money and loans harder to get, consumers and firms spend
less

Long-Term Real Interest Rate

Equilibrium in the market for loanable funds determines the long-term real
interest rate, which equals the nominal interest rate minus the expected
inflation rate.
The long-term real interest rate influences expenditure plans.
A fall in the overnight loans rate that increases the supply of bank loans
increases the supply of loanable funds and lowers the equilibrium real
interest rate
A rise in the overnight loans rate that decreases the supply of bank loans
decreases the supply of loanable funds and raises the equilibrium real
interest rate

Expenditure Plans
The ripple effects that follow a change in the overnight rate change three
components of aggregate expenditure:

Consumption expenditure
o
Other things remaining the same, the lower the real interest rate, the
greater is the amount of consumption expenditure and the smaller is the
amount of spending
Investment
o
Other things remaining the same, the lower the real interest rate, the
greater is the amount of investment
Net exports
o
Other things remaining the same, the lower the interest rate, the
lower is the exchange rate and the greater is the exports and the
smaller are imports

A change in the overnight loans rate changes in aggregate expenditure plans, which
in turn changes aggregate demand, real GDP, and the price level.
So the Bank influences the inflation rate and output gap

The Bank of Canada Fights Recession

If inflation is low and the output gap is negative, the Bank lowers the overnight
rate target. An increase in the monetary base increases the supply of money.

The short-term interest rate falls and the quantity of money demanded
increases
The increase in the supply of money increases the supply of (real) loanable
funds.

The long-term real interest rate falls.

o
Investment increases
o
Aggregate Planned Expenditure increases
o
Net Exports increase

The fall in the real interest rate increases aggregate planned expenditure. The
multiplier increases aggregate demand.

Real GDP increases and closes the recessionary gap.

The Bank of Canada Fights Inflation

If inflation is too high and the output gap is positive, the Bank of Canada raises the
overnight loans rate target. A decrease in the monetary base decreases the supply
of money.

The short-term interest rate rises and the quantity of money demanded
decreases.
The decrease in the supply of money decreases the supply of (real) loanable
funds.
The long-term real interest rate rises.
o
Investment decreases
o
Aggregate Planned Expenditure decreases
o
Net Exports decrease

The rise in real interest rate decreases aggregate planned expenditure. The
multiplier decreases aggregate demand.

Real GDP decreases and closes the inflationary gap.