Principle #10 : Principle #10 : In the short run, In the short run, society faces a trade-off between society faces a trade-off between

inflation and unemploymentinflation and unemployment..

Economic policiesEconomic policies•Budgetary and fiscal policiesBudgetary and fiscal policies•Monetary policiesMonetary policies

What is the role of government when What is the role of government when aggregate expenditures (AD) are either aggregate expenditures (AD) are either too weak or too strongtoo weak or too strong??

Stabilizing the economy in order to Stabilizing the economy in order to reduce GDP growth as close as reduce GDP growth as close as possible to its long-term trend.possible to its long-term trend.

Searching the full-employment Searching the full-employment equilibriumequilibrium

Finding the optimal production level Finding the optimal production level (not inflationary and full employment (not inflationary and full employment level of production)level of production)

What are the two main macroeconomic What are the two main macroeconomic type of policytype of policy??

The budgetary and fiscal policyThe budgetary and fiscal policyExpansionary or restrictiveExpansionary or restrictiveUnder the responsibility of the parliament (federal Under the responsibility of the parliament (federal or provincial)or provincial)Tools: G and taxation and transfer paymentsTools: G and taxation and transfer payments

Monetary policyMonetary policyExpansionary, restrictive, or accommodativeExpansionary, restrictive, or accommodativeUnder the responsibility of the central bank (BoC)Under the responsibility of the central bank (BoC)Tools: Money supply and the bank of Canada Tools: Money supply and the bank of Canada benchmark interest rate (taux directeur, director benchmark interest rate (taux directeur, director rate)rate)

How and in which circumstances do we apply How and in which circumstances do we apply macroeconomic policiesmacroeconomic policies??

Economic Economic SituationSituation

MacroeconomicMacroeconomic

PolicyPolicyToolsTools

Effects on ADEffects on AD

(C, I, G, Xn)(C, I, G, Xn)

Inflationary gapInflationary gap

Inflation > 3%Inflation > 3%

Monetary Monetary and/or and/or BudgetaryBudgetary

RestrictiveRestrictive

MM MM and r and r Or Taxes Or Taxes Or G Or G Or Transferts Or Transferts

Slowdown of Slowdown of growth growth

(( AD) AD)

Recessionary Recessionary gapgap

Inflation < 1%Inflation < 1%

Cyclical Cyclical unemployementunemployement

Monetary Monetary and/or and/or BudgetaryBudgetary

ExpansionnistExpansionnist

MM MM and r and r Or Taxes Or Taxes Or G Or G Or Transferts Or Transferts

Acceleration Acceleration

of growth of growth

(( AD) AD)

Full employementFull employement

Inflation Inflation 2% 2%

Monetary:Monetary:Accommodative

Budgetary : auto. Budgetary : auto. stabilisatorsstabilisators

r low and stabler low and stable

We let the We let the stabilisators do stabilisators do their worktheir work

Long term growthLong term growth

PIB PIB 3% 3%

What are automatic stabilizersWhat are automatic stabilizers??

Automatic stabilizers are a form of Automatic stabilizers are a form of fiscal policyfiscal policy

In a recession or slowdown, state In a recession or slowdown, state spending increases to stabilize spending increases to stabilize aggregate demand.aggregate demand.

What is monetary policyWhat is monetary policy??

It is the set of measures taken by the It is the set of measures taken by the Bank of Canada to influence the Bank of Canada to influence the economy by varying the amount of economy by varying the amount of currency in circulation.currency in circulation.

http://www.banqueducanada.ca/

What are the tools of the Bank of What are the tools of the Bank of Canada?Canada?

The main tools of the Bank of Canada The main tools of the Bank of Canada are the discount rate and the are the discount rate and the overnight rate (taux director).overnight rate (taux director).

They can be used to achieve an They can be used to achieve an expansionary, restrictive or expansionary, restrictive or accommodative monetary policy.accommodative monetary policy.

What is the target for the overnight What is the target for the overnight raterate??

It is the midpoint of a range of 50 basis pointsIt is the midpoint of a range of 50 basis points (0,5%)(0,5%)

The top of the range is the official discount rate The top of the range is the official discount rate (taux d’escompte): the rate charged for loans to (taux d’escompte): the rate charged for loans to banksbanks

The low end is the rate paid to bank in excess The low end is the rate paid to bank in excess (taux créditeur)(taux créditeur)

This is what sends the signal for the fluctuations This is what sends the signal for the fluctuations in interest rates to chartered banks.in interest rates to chartered banks.

50 points

de base

Discount Rate: BoC loans rate on its advances to members of the monetary system (eg private banks)

Creditor rate

Taux de rémunération des excédents

Overnight rate (Taux directeur): median range)

1,25

1,0

0,75

The effects of lowering the The effects of lowering the overnight rateovernight rate

P. 312

The effects of increasing the The effects of increasing the overnight rateovernight rate

P. 314

2. The monetary market

Money represent Money represent all payment mediums that are all payment mediums that are accepted. It serves as a medium of exchange, a valuation accepted. It serves as a medium of exchange, a valuation unit and a reserve of wealth.unit and a reserve of wealth.

The monetary market or money market: The monetary market or money market: is the market is the market where short term financial assets (up to one year) are where short term financial assets (up to one year) are exchanged. Money is the most liquid asset. With the exchanged. Money is the most liquid asset. With the floating exchange regime money can be bought and sold floating exchange regime money can be bought and sold for other currencies. for other currencies.

In the short run, the interest rate make the In the short run, the interest rate make the monetary monetary market clear, supply=demandmarket clear, supply=demand. r represents the gains of . r represents the gains of financial assets in %.financial assets in %.

Money supply The money supply is equal to the total amount of The money supply is equal to the total amount of

cash that individuals and companies have outside cash that individuals and companies have outside banks and their deposits in checking accounts and banks and their deposits in checking accounts and personal current accounts (demand deposits of the personal current accounts (demand deposits of the public).public).

The Bank of Canada "control" the money supply The Bank of Canada "control" the money supply indirectly. Influencing credit conditions through the indirectly. Influencing credit conditions through the discount rate (Bank Rate) and the target overnight discount rate (Bank Rate) and the target overnight rate, the central bank encourages commercial rate, the central bank encourages commercial banks to increase or decrease the volume of loans.banks to increase or decrease the volume of loans.

The money supply is an exogenous variable.The money supply is an exogenous variable.

Money supplyMS

Q

r

Money demand

The aggregate money demand (MD) is the sum of all The aggregate money demand (MD) is the sum of all individual demands for money. It depens onindividual demands for money. It depens on::

Interest rates: Interest rates: a higher interest rate increases the a higher interest rate increases the opportunity cost of holding money and reduces the opportunity cost of holding money and reduces the amount demanded.amount demanded.

Price level: Price level: if prices increase, we must hold more if prices increase, we must hold more money to buy more goods and servicesmoney to buy more goods and services

Real GDP Real GDP when aggregate spending increases, the when aggregate spending increases, the quantity of money demanded in the economy quantity of money demanded in the economy increasesincreases..

MD curve

MD

Q

r

Monetary market equilibrium

If the interest rate (7%) is higher than the equilibrium If the interest rate (7%) is higher than the equilibrium level, the agents hold more money than desired:level, the agents hold more money than desired:

They buy securitiesThey buy securities The price of securities increases and their rates The price of securities increases and their rates

decreasesdecreases We therefore have a lower interest rateWe therefore have a lower interest rate It then evolves towards the equilibrium interest rate It then evolves towards the equilibrium interest rate

(5%)(5%)

Monetary market Goods and servicesmarket

Slope of the AD

P

Real GDP

AD

P1

r

Q

MS

MD1

r1

MD2

r2

P2

Illustration of an expansionary Illustration of an expansionary monetary policymonetary policy

Crowding out effect• Definition. : additional shift of the AD

from the effect of fiscal policy on interest rates

G AD

MD r AD

• The crowding out effect reduces the effect of fiscal policy on the AD

Monetary market Goods and services

Crowding out effect

P

PIB réel

AD1

r

Q

MS

MD1

r1

MD2

r2

AD3

AD2