ECON102 Final EXAM AID

Tutor: Ming Zhou

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Agenda

Chapter 11- Money Growth and InflationChapter 12- Open Economics: Basic ConceptsChapter 14- Aggregate Demand and Aggregate SupplyChapter 15- Monetary and Fiscal Policies

Q&A regarding previous chapters!

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Chapter 11Money Growth and Inflation

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Value of Money

Let P = the price level (CPI or GDP deflator)1/P = the value of $1 in terms of goods

Ex. If the goods basket contains 10 cups of Tim Horton’s– If P = $5, value of $1 is 2 cups of Tim Horton’s– If P = $10, value of $1 is 1 cup of Tim Horton’s

*As prices increase, value of money decreases

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Money Supply and Money Demand

MS is controlled by the Bank of Canada- vertical (unaffected by P)

MD is determined by various factors that affect how much money people want to hold (interest rate, price levels)- downward sloping

Money Equilibrium when MS = MD

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Quantity Theory of Money

• Explains long-run price level and inflation rate

• Quantity of money determines value of money – MS increases creates increase in demand

for g&s– Supply for g&s remains constant, P

increases– Value of money decreases and new

equilibrium is reached6

Classical Dichotomy

• Separation of real and nominal variables

Real variables – measured in terms of output (relative price, real wage)

Nominal variables – measured in terms of $ (nominal price, nominal wage)

Money Neutrality - Monetary shifts affect nominal variables but not real variables

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Velocity of Money

• Average number of transactions a dollar goes through

*Fairly stable in the long run

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Velocity (V) =Nominal GDP (P x Y)

Money Supply (M)

Quantity Equation

M x V = P x Y

• V is assumed to be constant• Change in M does not affect Y (money

neutrality) • P changes in proportion to change in M

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Practice Problem

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One good: Rebecca Black CDs. The economy currently produces 100 CDs. V is constant. In 2011, MS = $100, P = $10/CD.

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a. What is the nominal GDP and velocity in 2011?

For 2012, the BoC increases MS by 100%, to $200.

b. What is the 2012 values of nominal GDP and P?

What is the inflation rate for 2011-2012?

c. Suppose tech. progress causes Y to increase to 150 in 2012. What is the 2011-2012 inflation rate?

Fisher Effect

Nominal IR = Real IR + Inflation Rate

Real IR is unaffected by inflation -> Nominal IR adjusts directly with inflation rate

*Increase in MS leads to increase in Nominal IR

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Inflation Tax

• Inflation caused by the government printing more money (increase in MS)

• Affects the holding of money (nominal IR), not wealth (real IR)

After-tax Real IR = Nominal IR(1 – tax rate) - Inflation

• Higher tax lowers real IR

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Practice Problem

You deposit $100 in the bank for one year.

Case 1: inflation = 0%, nom. interest rate = 10%

Case 2: inflation = 5%, nom. interest rate = 15%

a. How much does the actual value of the deposit grow in each case?

Assume the tax rate is 10%.

b. How much taxes are you paying in each case?

c. Calculate the after-tax real interest rate for both cases.

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Cost of Inflation

1. Inflation fallacy – belief that inflation lowers real income (prices increase, but nominal wage increases as well)

2. Shoeleather cost – cost of using the bank more frequently (time, transaction fee)

3. Menu cost – cost of changing prices (menus, price tags, etc.)

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Cost of Inflation

4. Misallocation of resources from relative-price variability – relative prices vary due to time lag in price changes

5. Confusion & inconvenience – complicates long-term planning due to change in unit of account

6. Tax distortions – paying more taxes at the same real income

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Cost of Inflation

Arbitrary Redistributions of Wealth• Nominal IR is fixed by contractIf actual inflation > estimated inflation:

– Real IR is less, borrowers are better off, lenders are worse off

If actual inflation < estimated inflation:– Real IR is more, borrowers are worse off,

lenders are better off

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Chapter 12

Open Economy Macroeconomics: Basic Concepts

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Flow of Goods & Services

Net Exports (NX) = Exports – Imports Exports – produced domestically, sold

abroadImports – produced abroad, sold

domestically

Trade Deficit - Imports > ExportsTrade Surplus - Exports > ImportsBalanced Trade – Imports = Exports 18

Flow of Financial Capital

Net Capital Outflow (NCO) = Domestic purchase of foreign assets – Foreign purchase of domestic assets

Foreign Direct Investment (capital)Foreign Portfolio Investment (loanable

funds)

Capital Outflow – NCO > 0Capital Inflow – NCO < 0 19

International Flow of G&Sand Capital

S = I + NX since S = Y – C – G

S = I + NCO since NX = NCO

• If S > I, then NCO > 0, the excess loanable funds flow abroad

• When S < I, NCO < 0, some of the country’s investments are financed by foreigners 20

Nominal Exchange Rate

Nominal Exchange Rate• Rate of trading the currency of one

country for the currency of another

Appreciation – increase in value of currency (can buy more foreign currency)

Depreciation – decrease in value of currency (can buy less foreign currency) 21

Real Exchange Rate

Real Exchange Rate• Rate of trading the g&s of one country

for the g&s of another

Real e =

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Nominal e x Domestic PForeign P*

Purchasing-Power Parity

• Real exchange rate should be 1• Nominal exchange rate adjusts based

on a country’s inflation rate• Law of one price

– A good should be sold at the same price in all markets in order to avoid arbitrage

Nominal e x Domestic P = Foreign P*

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Purchasing-Power Parity

Nominal e =

• Inflation on P* > inflation on P, nominal e increases, dollar appreciates

• Inflation on P > inflation on P*, nominal e decreases, dollar depreciates

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Domestic PForeign P*

Chapter 14Aggregate Demand and Aggregate

Supply

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Economic Fluctuations

1. Irregular and unpredictable due to the business cycle

2. Most macroeconomic variables fluctuate together, except price level (output, income, profit)

3. Unemployment and output are inversely related

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Aggregate Demand

Y = C + I + G + NX

• Represents the total amount of purchases planned by each group of spenders

• Downward sloping shows an inverse relationship between P and Y

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Downward Sloping AD

1. Wealth Effect (P and C)– Purchasing power increases when prices

decrease (consumption will go up)

2. Interest Rate Effect (P and I)– Lower interest rates promote investment

spending

3. Exchange-rate Effect (P and NX)– Lower price levels make Canadian goods

relatively cheaper

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Aggregate Supply

Long-Run AS – Vertical– Affected by factors of production, not P– Y is equal to potential output

Short-Run AS – Upward sloping– Increase in P causes increase in G&S

supplied

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Upward Sloping AS

1. Sticky-Wage Theory– Nominal wages are slow to adjust, which

affects employment and output

2. Sticky-Price Theory– Prices for some goods do not change

immediately, affecting their sales

3. Misperceptions Theory– Firms are unsure whether it is an overall

price level increase, or market-related

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Upward Sloping AS

Short run output is equal to the long run output adjusted for the difference between the actual and expected price levels

*a is a number that represents the output’s sensitivity to price level changes 31

Quantity of output

supplied=

Natural rate of output

+a (Actual price level – Expected price level)

Shifts in AS

• In the long run, expected P = P• Change in factors of production• If expected P changes in the short run

– Increases, then output decreases– Decreases, then output increases

• The greater the difference in price expectation, the greater short run output differs from long run output

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Economic Fluctuations

• Contraction in AD– Leftward shift of AD– Short run recession– No change in output, lower P for long run

• Adverse shift in AS– Leftward shift of AS– Short run stagflation (inflation + recession)– No change in output, higher P for long run

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Chapter 15The Influence of Monetary and Fiscal

Policy on Aggregate Demand

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Theory of Liquidity Preference

r (interest rate), is the opportunity cost of holding money in liquid form– If r increases, then the opportunity cost for

holding money increases, quantity of money demanded decreases (vice versa)

*No inflation in short-run due to sticky prices

At higher P, MD and IR increases, quantity of g&s demanded falls due to lower investment 35

Monetary Policy

Closed Economy – Increase in MS increases AD by decreasing interest rate

Open Economy:Flexible Exchange Rate-Increase in MS eventually decreases

exchange rate and shifts AD right Fixed Exchange Rate-Exchange rate must be held constant by

decreasing MS 36

Fiscal Policy

• Change in government spending/taxation

Expansionary – increase in G and/or decrease in T to shift AD right

Contractionary – decrease in G and/or increase in T to shift AD left

1)Multiplier Effect2)Crowding-Out Effect

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Multiplier Effect

Increase in C caused by an increase in income from G

Marginal Propensity to Consume (MPC)C / Y

Closed-economy Multiplier = 1 / (1-MPC)

Marginal Propensity to Import (MPI)I / Y

Open-economy Multiplier = 1 / (1-MPC+MPI) 38

Crowding-Out Effect

Shift in AD increases the interest rate, which decreases Investment

*Opposite direction of multiplier effect

Y can be greater or less than G depending on the effect of multiplier effect and crowding-out effect

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Open Economy Considerations

*Domestic interest rate = World interest rate due to perfect capital mobility

Flexible Exchange Rate- AD shifts right from government

spending, but shifts left from lower net exports

Fixed Exchange Rate-MS must shifts right to keep exchange

rate constant, cancels crowding out 40

Automatic Stabilizers

1. The Tax System– Less taxes are collected during a recession

and transfer payments increase, C increases

2. Government Spending– Welfare payments, EI benefits, and etc.

naturally increase using recession, G increases

3. Flexible Exchange Rate– When exports go down from one country,

exchange rate goes down, NX increases 41

GOOD LUCK ON YOUR

FINALS! 42