ECN 204 Chapter 11Marginal Propensity to Consume/Save The marginal propensity to consume, or MPC, is the increase in consumer spending when disposable income rises by $1. The marginal propensity to save, or MPS, is the increase in household savings when disposable income rises by $1. When one earns a dollarthe part of the dollar you spend C/YD MPS = change in savings/YD MPC + MPS = 1

The Multiplier Increase in investment spending = $10 billion + Second-round increase in consumer spending = MPC $10 billion + Third-round increase in consumer spending = MPC2 $10 billion + Fourth-round increase in consumer spending = MPC3 $10 billion Total increase in real GDP = (1 + MPC + MPC2 + MPC3 + . . .) $10 billion The multiplier is the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change.

An autonomous change in aggregate spending is an initial change in the desired level of spending by firms, households, or government at a given level of real GDP.

The change in real GDP equals the multiplier times the autonomous expenditureIndividual Consumption Function An equation showing how an individual households consumer spending varies with the households current disposable income.

Its linear Linear function-upward sloping an increase in disposable income causes an increase in consumption Slope is the MPCAggregate Consumption Function The relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending.Planned Investment Spending The investment spending that businesses plan to undertake during a given period.It depends negatively on: interest rate existing production capacityAnd positively on: Expected future real GDP.

In other wordshow much firms choose to invest Accelerator Principle: A higher rate of growth in real GDP leads to higher planned investment spending.

Inventories Inventories: stocks of goods held for future sales If inventories goes up you sell less, if inventory goes down you sell more Unplanned inventory investment: occurs when actual sales are more or less than businesses expected, leading to unplanned changes in inventories. Actual investment spending: the sum of planned investment spending and unplanned inventory investment Actual Spending Formula:

Income ExpenditureAssumptions underlying the multiplier process: The interest rate is fixed. Taxes, transfers, and government purchases are all zero. Exports and imports are both zero. There is no foreign trade. Price level is fixed, real channels not nominal channelsPlanned Aggregate Expenditure Total amount of money planned to be spent in the economy

Note: the AE slope does not always equal CFIncome Expenditure Equilibrium Incomeexpenditure equilibrium GDP: the level of real GDP at which real GDP equals planned aggregate spending.

New definition of equilibrium Real GDP greater than Y is bigger than Y* the economy is exceeding expectations inventories are reduced, negative increase production Actual GDP falls below the target Y is lower than Y* - inventories are positive and build up reduce production

It tells us when planned aggregate expenditure equals real GDP Planned = Unplanned 45 degree line is the equilibrium line Aggregate expenditure = c + I planned + I unplanned -curve intersects 45 degree line real GDP equilibrium Y = Y*Paradox of Thrift Households and producers cut their spending in anticipation of future tough economic times. These actions depress the economy, leaving households and producers worse off than if they hadnt acted virtuously to prepare for tough times. not everything aggregates well together whats good for one person might not be good for the economy as a whole

ECN 204 Chapter 12 Lecture 7Aggregate Demand Aggregate demand curve: shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world. The curve is downward-sloping because1. Wealth Effect: higher aggregate price level reduces the purchasing power of households wealth and reduces consumer spending. 2. Interest Rate: higher aggregate price level reduces the purchasing power of households money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending. Substitution and wealth effect wealth= Income / price level Interest rateReal balance = money in your wallet / price level Price goes up purchasing power goes down and interest rates goes up They both say different thingsShifts caused by The aggregate demand curve shifts because of: changes in expectations If consumers and firms become more optimistic, aggregate demand increases and vice versa Wealth If the real value of household assets rises, aggregate demand increases and vice versa the stock of physical capital If the existing stock of physical capital is relatively small, aggregate demand increases and vice versa government policies fiscal policy If the government increases spending or cuts taxes, aggregate demand increases and vice versa monetary policy If the central bank increases the quantity of money, aggregate demand increases and vice versa

Aggregate Supply Curve Shows the relationship between the aggregate price level and the quantity of aggregate output in the economy. Upward-sloping because nominal wages are sticky in the short run: A higher aggregate price level leads to higher profits and increased aggregate output in the short run. they dont adjust easily Nominal wage: the dollar amount of the wage paid. Sticky Wages: nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labour shortages. Note: In the short run wages are fixedShifts of the Short-Run Aggregate Supply Curve Changes in commodity prices If commodity prices fall, short-run aggregate supply increases and vice versa nominal wages If nominal wages fall, short-run aggregate supply increases and vice versa Productivity If workers become more productive, short-run aggregate supply increases and vice versa . lead to changes in producers profits and shift the short-run aggregate supply curve.

Long-Run Aggregate Supply Curve Shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. RW wont change over time P goes up wages goes upThe AD AS Model Uses the aggregate supply curve and the aggregate demand curve together to analyze economic fluctuations. Short-run macroeconomic equilibrium: when the quantity of aggregate output supplied in the short run is equal to the quantity demanded. Short-run equilibrium aggregate price level: the aggregate price level in the short-run macroeconomic equilibrium. Short-run equilibrium aggregate output: the quantity of aggregate output produced in the short-run macroeconomic equilibrium.Long Run Macroeconomic Equilibrium When the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve. Triple intersection

Gap Recap Recessionary Gap: when aggregate output is below potential output When short run equilibrium is to the left LRE Inflationary Gap: when aggregate output is above potential output When SRE is to the right LRE Output Gap: the percentage difference between actual aggregate output and potential output

SRAS = AD > SRE Actual GDP SRAS=AD=LRAS=LRE Potential GDP Essentially the formulas is (SRAS= AD LRAS) / LRAS Self-Correcting: when shocks to aggregate demand affect aggregate output in the short run, but not the long run. Economy will self-adjust

Recessionary gap E1 to E1 prices fallSRAS goes up from SRAS 1 to SRAS2, move from E2 to E3 Price level going to fallpotential GDP stays same

demand goes up move from AD1 to AD2 At E2 SRAS=AD2 to right of LRAS Prices goes up, inflationary gap cause wages goes up Price goes up, Y stays the same Macro Policy Active stabilization policy: using fiscal or monetary policy to offset shocks.

Policy in the face of supply shocks: There are no easy policies to shift the short-run aggregate supply curve. Policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.

ECN 204 Lecture 8 Chapter 13 & 14 Fiscal PolicyGovernment Budget and Total Spending Fiscal Policy: the use of taxes, government transfers or government purchases of goods and services to shift the aggregated demand curveExpansionary and Contractionary Fiscal Policy

Expansionary fiscal policy-increase in government purchases of goods and services, a reduction in taxes, or an increase in government transfersshifts the aggregate demand curve rightward. Also, it leads to an increase in real GDP It can close the recessionary gap by shifting AD1 to AD2, moving the economy to a new short-run macroeconomic equilibrium, E2, which is also a long-run macroeconomic equilibrium. A contractionary fiscal policyreduced government purchases of goods and services, an increase in taxes, or a reduction in government transfersshifts the aggregate demand curve leftward. Also, it leads to a fall in real GDPLags in Fiscal Policy Realize the recessionary/inflationary gap by collecting and analyzing economic data takes time Government develops a spending plan takes time Implementation of the action plan (spending the money takes time

Fiscal Policy and the Multiplier Theres a multiplier effect with fiscal policy Depends on the type of fiscal policy The multiplier on changes in government purchases, 1/(1 MPC), is larger than the multiplier on changes in taxes or transfers, MPC/(1 MPC), Because part of any change in taxes or transfers is absorbed by savings. How Taxes Affect the Multiplier Taxes and some transfers act as Automatic Stabilizers Reduce the size of the multiplier, reducing size of fluctuations in business cycle Discretionary Fiscal Policy arises from deliberate actions by policy makers rather than from the business cycleBudget Balance

Increased gov. spending, increased gov. transfers or lower taxes reduce budget balance for that year Expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger Contractionary fiscal policies smaller gov. spending, smaller gov. transfers or higher taxes increase the budget balance for that year making a budget surplus bigger or a budget deficit smaller Some fluctuations are caused by the business cycle Cyclical Adjustment Budget Balance an estimate of the budget balance if the economy were at potential outputLong Run Implications of Fiscal Policy Persistent budget deficits lead to public debtProblems with Rising Gov. Debt Public debt may crowd out investment spending reduce long run economic growth Rising debt may lead gov. into default( economic and financial turmoil Printing more money causes inflationCHAPTER 14 Money: any asset that can easily be used to purchase goods and services Currency in circulation: money that is held by the public Chequeable deposits: bank deposits on accounts which people can write cheques Money Supply: total value of financial assets in the economy that are considered money Medium of exchange: an asset that individuals acquire for the purpose of trading rather than for their own consumption Store of Value: means of holding purchasing power over time Unit of account: a measure used to set prices and make economic calculations Commodity money: a good used as a medium of exchange that has intrinsic value in other uses Commodity-Backed Money: a medium of change with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods Fiat Money: medium of exchange whose value derives entirely from its official status as a means of payment Monetary aggregate: overall measure of the money supply Near-Moneys: financial assets that cant be directly used as a medium of exchange but can be readily converted into cash or chequeable bank deposits A bank is a financial intermediary that uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers.

Bank reserves: the currency banks hold in their vaults plus their deposits at the Bank of Canada.

A T-account: a tool for analyzing a businesss financial position by showing, in a single table, the businesss assets (on the left) and liabilities (on the right) Summarizes a businesss financial position If assets are more than liabilities the equity is positive and vice versa

Reserve ratio: the fraction of bank deposits that a bank holds as reserves. Reserve requirements: rules set by the central bank that determine the minimum reserve ratio banks.

The desired (or voluntary) reserve ratio: the fraction of deposits that banks want to hold as reserves.Determining the Money SupplyThe effect of before a bank makes a new loan:

The effect of when a bank makes a new loan:

Effect of turning cash into a deposit:

Excess reserves: bank reserves over and above the banks required reserves Ex. Increase in bank deposits from $1,000 in excess reserves = $1,000/rrMoney Multiplier Monetary base: the sum of currency in circulation and bank reserves. Money multiplier: the ratio of the money supply to the monetary base. Central Banks Central bank: an institution that oversees and regulates the banking system and controls the monetary base. Ex. Bank of Canada Banker for commercial banks the BOC will normally act as a lender of last resort for a commercial bank with sound investments that is in urgent need of cash and cannot find a lender. Banker for the federal government the BOC not only manages federal government bank accounts, but it also occasionally lends money to the federal government through buying some of the securities that the government issues. Issues currency ensures the supply of banknotes meets public demand and prevent counterfeiting. Conducts monetary policy controls interest rates, the quantity of money, the exchange rate, or some combination of these actions.

Banks in Canada are not required to hold a fraction of deposits as reserves Overnight Funds Market: a financial market in which banks can borrow funds from banks with excess reserves Overnight rate: the interest rate determined by the overnight funds market Target for the overnight rate: the bank of Canadas official key policy interest rate also known as the discount rate in some countries

Open Market Open Market Operation: is the purchase or sale of assets by a central bank.Bank of Canadas assets and Liabilities:

Deposit switching: the shifting of government deposits between the Bank of Canada and the commercial banks. It is a major tool used by the Bank of Canada in its day-to-day operations. Bank of Canadas policy has been to set a key interest rate rather than set the money supply. The BOC can only influence the money supply, but not control it. It is not clear what the money supply is. Monetary aggregates M1, M2, and M2+ differ not only in their annual growth rates, but may also move in different directions. It is more easily explained to and understood by the public.

ECN 204 Lecture 9 Chapter 15 and 16 Non-monetary assets: assets that are not made up of money nor function as money Short-term interest rate: the interest rates on financial assets that mature within six months or less Long term interest rate: interest rates on financial assets that mature a number of years in the future. The motivation is to hold ones money however no interest Hold wealth in the form of money or bonds

Money demand curve: shows the relationship between the interest rate and the (nominal) quantity of money demanded. Downward sloping, negative inverse relationship interest rate goes up quantity of money goes down and vice versa Along the curve shift due to change in interest rate Shifts of Money Demand Curve: Changes in aggregate price level Increase price level creates shift to right and vice versa Changes in real GDP Increase in real GDP creates shift to right and vice versa Changes in credit markets and banking technology Increase credit markets and banking technology creates shift to right and vice versa Changes in institutions

Liquidity preference model of the interest rate: the interest rate is determined by the supply and demand for money. The money supply curve shows how the nominal quantity of money supplied varies with the interest rate. Money supply curve, upward sloping, positive Two assumptions 1: An increasing function of the interest rate 2: The money supply curve is invariant to the interest rate (BOC sets it)

Lower than equilibrium interest rate, money demand is greater than money supply and prices go up Higher than equilibrium interest rate, money demand is lower than money supply and prices fall

Increased money supply which causes excess supply of money which pushes down the prices of money, which pushes down the interest rate

Shrinks the money supply, interest rate goes upMonetary Policy Expansionary monetary policy is monetary policy that increases aggregate demand. To increase the money supply Contractionary monetary policy is monetary policy that reduces aggregate demand. To shrink the money supply

Effects

I (investment spending) and C (Consumer spending) are a function of the interest rate GDP goes down with contractionary and vice versa with expansionary

Monetary Policy in Reality

Inflation Targeting Occurs when the central bank sets an explicit target for the inflation rate and sets monetary policy to hit that target. More or less, a zone rather than targetAdvantages of inflation targeting: Economic uncertainty is reduced because the central banks plan is transparent. The central banks success can be judged by the gap between the actual inflation and the inflation target, making central bankers accountable.Note: One disadvantage of inflation targeting is that its too restrictive when there are other concerns, such as financial system stability, that may require more attention.Zero Bound and QE Zero lower bound for interest rate: interest rates cannot fall below zero, which sets limits to the power of monetary policy. Quantitative Easing (QE): a monetary policy in which a government tries to drive down interest rates, thus exerting an expansionary effect on the economy, by buying longer-term government bonds, instead of the shorter-term bonds it would buy usually. Essentially, flooding money supplyMoney Neutrality Money has inflationary (Price level) effects No change in real GDP Monetary neutrality: changes in the money supply have no real effect on the economy. So, monetary policy is ineffectual in the long run. If it isnt neutral it isnt vertical

Increased money supply MS1 to MS2 , Equilibrium drops, interest rates are lowered , creates demand for money and all this in the long run raise interest rate and alters equilibrium again Money doesnt affect GDPChapter 16Inflation Classical Model of the price level: real quantity of money is always at its long-run equilibrium Aka its neutral Inflation Tax: the reduction in the value of money held by the public caused by inflation Seigniorage: the revenue generated by the governments right to print money Print more money it creates inflation which lowers purchasing power and value of money Nominal because it is the change in M( Money Supply) Real Seigniorage: the real purchasing power that the government takes away from money holders when it generates revenue by printing money, which can be written as rate of growth of the money supply multiplied by real money supply

Output Gap & Unemployment When actual aggregate output is equal to potential output, the actual unemployment rate is equal to the natural rate of unemployment. When the output gap is positive (an inflationary gap), the unemployment rate is below the natural rate. Unemployment is too low When the output gap is negative (a recessionary gap), the unemployment rate is above the natural rate. Unemployment too high Remember: Natural Rate = Long term unemployment

Short Run Phillips Curve: the negative short-run relationship between the unemployment rate and the inflation rate. Downward sloping relationship Short-Run Unemployment low, inflation high and vice versa

NAIRU (Nonaccelerating Inflation Rate of Unemployment): the unemployment rate at which inflation does not change over time. Is there some level of unemployment where inflation is fixed? Long-Run Phillips Curve: shows the relationship between unemployment and inflation after expectations of inflation have had time to adjust to experience. Disinflation: is the process of bringing down inflation that is embedded in expectations.

Long run Phillips curve is invariant, an unemployment rate at which inflation is stable

The natural rate of unemployment is the portion of the unemployment rate unaffected by the swings of the business cycle. The NAIRU is another name for the natural rate. Natural Rate is the long term target rate

ECN 204 Lecture 10 Chapter 18 & 19Chapter 18Classical Macroeconomics: believes monetary policy only affects the aggregate price level, not aggregate output. Changes in M change P but not Y (GDP) Classical believes short run was not important Also believes prices are flexible, making supply curves vertical The change in M = the change in P Growth rates The change in growth rate of money supply = change in price but no change in GDP Increase in money supply causes inflationKeynesian EconomicsKeynes brought a new economic theoryHe believed: Wages are not flexible, there is stickiness, rigidness in the economy Wages and prices do not adjust easily Explained with unions and how price dont change every day therefore W/P cant be fixed As a result, SRAS is upward sloping not vertical In the long run, we are all deadMonetarism: believes that GDP will grow if money supply grows steadily In other words, money matters Believes the solution is to inject money in the economyDiscretionary Monetary Policy: when the central bank changes interest rates or money supply based on their assessment of the state of the economy Basically, when they have to make a change Monetary policy rule decides the central banks actions Velocity of money equation: M x V = P x Y Where V = velocity Classical believes: PY determines MV Keynes believes: MV determines PY When V is stable. M = PY (aka Nominal GDP)

Fiscal Policy with a fixed money supply

In this casePrice levels increased so Consumption goes down, investments goes down but interest increases Crowing out effect that even though fiscal policy can increase GDP, there may not actually be an increase If AD only falls a little thats complete crowding out Fiscal policy becomes less effective when the money supply is held fixedInflation & Natural Rate of unemployment When actual inflation = expected inflation Growth will be constant Long run believes everything will fix itselfNew Classical Macroeconomics The new classical macroeconomics approach says: Money doesnt matter, fiscal policy doesnt matter only thing that matters is the business cycleonly can use policy to control it with a target range ( Prevent from getting too high or low)Rational Expectations Says: you need forward looking expectations, use systematic forecasting, believes the economy is stableReal Business Cycles Real business cycle theory says the market is fundamentally flawed, wages are sticky and prices are stickyDebate Over fiscal policy: monetary policy doesnt work when interest rates are close to 0 It doesnt matter how you finance debt, it is bad Over monetary policy: if you like monetary policy you believe wages and prices are sticky If the interest rate is near zero there is no monetary policy

Chapter 19Exchange Rates Currencies are traded in the foreign exchange market Aka wherever you can buy foreign currency When currency becomes stronger, more valuable it appreciates. Vice versa it will depreciateEquilibrium Exchange Rate The exchange rate at which the quantity of a currency demanded in the foreign exchange market is equal to the quantity supplied The equilibrium price at which currency is exchanged Excess demand pushes the demand curve, leads to an appreciation for the Canadian dollar Thus, Canadian dollars are more valuable Real Exchange RatesMexican pesos per Canadian dollar this would be nominal exchange rateREAL exchange rate is Mexican pesos per Canadian dollar X (Price of Canadian / Price of Mexican)Purchasing Power Parity If you hold the price level constant then this price should be constant worldwide In reality, doesnt workExchange Rate Policy A country has the right to fix the exchange against some other currency Floating exchange rate, is letting the market forces be flexible with the exchange rate If you have a flexible exchange rate, then you only have monetary policy and lose mobility of controlling it If an exchange rate isnt fixed it would adjust back to equilibriumDilemmas Money only goes so far theres only so many things that the policy can do, it cant be controlled all at once in the market A country can set whatever rate it wants Monetary policy under floating exchange rates If you expand the money supply, you decrease the interest rate, deprecate the value of the Canadian dollar, a lot more would be exported, the dollar is worth less than prior to Decreasing the exchange rate Aggregate demand would go up