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Flashcards in Final Exam Deck (282):
1

Which of the following is a generally accepted medium of exchange?
A. a plane ticket
B. federal government bonds
C. fine art
D. currency

D. currency

2

What do economists use the word "money" to refer to?
A. income generated by the production of goods and services
B. those assets regularly used to buy goods and services
C. the value of a person's assets
D. the value of stocks and bonds

B. those assets regularly used to buy goods and services

3

Which of the following is current Canadian currency?
A. fiat money with intrinsic value
B. fiat money with no intrinsic value
C. commodity money with intrinsic value
D. commodity money with no intrinsic value

B. fiat money with no intrinsic value

4

Which of the following is included in M1?
A. government bonds
B. demand deposits
C. savings deposits
D. travellers’ cheques

B. demand deposits

5

How are credit card balances treated in M1 as compared to M2?
A. They are included in M1 but not M2.
B. They are included in M2 but not M1.
C. They are included in M1 and M2.
D. They are included in neither M1 nor M2.

D. They are included in neither M1 nor M2.

6

Which of the following is the fundamental function of credit cards?
A. Credit cards are used for deferring payments.
B. Credit cards are used as store of value.
C. Credit cards are used for increasing the money supply.
D. Credit cards are used as investment assets.

A. Credit cards are used for deferring payments.

7

Given the size of the Canadian money stock, is the amount of currency per person reasonable?
A. Yes, the amount of currency per person is about right.
B. There is no way of determining the amount of currency in circulation.
C. No, there is too little currency per person.
D. No, there is too much currency per person.

D. No, there is too much currency per person.

8

Which of the following agencies is responsible for regulating the money supply in Canada?
A. the Comptroller of the Currency
B. the Bank of Canada
C. the TD Bank
D. the Canadian Payments Association

B. the Bank of Canada

9

For how long is the governor of the Bank of Canada appointed?
A. life
B. a seven-year term
C. a five-year term
D. a two-year term

B. a seven-year term

10

What is the role of the Minister of Finance with respect to the Bank of Canada or the banking system?
A. to control all activities of the Bank of Canada
B. to issue the Governor of Bank of Canada a written directive to resign
C. to issue currency
D. to maintain the stability of the banking system

B. to issue the Governor of Bank of Canada a written directive to resign

11

How do deposits and reserves appear on a bank's T-account?
A. Both deposits and reserves are assets.
B. Both deposits and reserves are liabilities.
C. Deposits are assets and reserves are liabilities.
D. Reserves are assets and deposits are liabilities.

D. Reserves are assets and deposits are liabilities.

12

Suppose a bank has $200 000 in deposits and $180 000 in loans. What is its reserve ratio?
A. 1 percent
B. 5 percent
C. 10 percent
D. 18 percent

C. 10 percent

13

When a bank loans out $1000, what happens to the money supply?
A. It does not change.
B. It decreases.
C. It increases.
D. It has an indeterminate effect on the money supply.

C. It increases.

14

If the reserve ratio is 7 percent and a bank receives a new deposit of $300, which of the following will this bank most likely do?
A. It will increase required reserves by $2100.
B. It will initially see reserves increase by $279.
C. It will be able to make new loans up to a maximum of $279.
D. It will be able to increase its required reserves by $30.

C. It will be able to make new loans up to a maximum of $279.

15

A central bank raised the reserve requirement ratio from 10 percent to 12 percent. Other things the same, how does the money multiplier change?
A. It increases by 1.67.
B. It decreases by 1.67.
C. It increases by about 2.
D. It decreases by 2.

B. It decreases by 1.67.

16

Assets:
Reserves=$100
Loans=$900
Liabilities:
Deposits=$1000

If the Bank of Edmonton has loaned out all the money it wants, given its deposits, what is its reserve ratio?
A. 1 percent
B. 5 percent
C. 10 percent
D. 15 percent

C. 10 percent

17

Assets:
Reserves=$100
Loans=$900
Liabilities:
Deposits=$1000

Assume that the Bank of Edmonton is holding the required percent of deposits as reserves. Also, assume all other banks hold only the required percent of deposits as reserves, and that people hold only deposits and no currency. What is the money multiplier?
A. 1
B. 5
C. 10
D. 15

C. 10

18

Assets:
Reserves=$100
Loans=$900
Liabilities:
Deposits=$1000

Assume that all other banks hold only the required 5 percent of deposits as reserves and people hold only deposits and no currency. If the Bank of Edmonton decides to hold exactly 5 percent reserves, by how much would the economy’s money supply increase?
A. $500
B. $1000
C. $1500
D. $2000

B. $1000

19

If a bank uses $80 of excess reserves to make a new loan when the reserve ratio is 25 percent, what happens to the money supply?
A. The money supply initially decreases by $80.
B. The money supply initially increases by $20.
C. The money supply will eventually increase by more than $20 but less than $80.
D. The money supply will eventually increase by $320.

D. The money supply will eventually increase by $320.

20

In Wellville, the money supply is $80 000 and reserves are $18 000. Assuming that people hold only deposits and no currency, and that banks hold only required reserves, what is the required reserve ratio?
A. 29 percent
B. 22.5 percent
C. 16 percent
D. 4.44 percent

B. 22.5 percent

21

At one time, the country of Freedonia had no banks, but had currency of $40 million. Then a banking system was established with a reserve requirement of one-third. The people of Freedonia now keep half their money in the form of currency and half in the form of bank deposits. If banks do not hold excess reserves, how much currency do the people of Freedonia now hold?
A. $13.33 million
B. $20 million
C. $30 million
D. $36.36 million

C. $30 million

22

Suppose the banking system has $10 million in reserves, the reserve requirement is 20 percent, and there are no excess reserves. The public holds $10 million in cash. Then bankers decide that it is prudent to hold some excess reserves, and so begin to hold 25 percent of deposits in the form of reserves. Other things the same, what will this action cause the money supply to do?
A. to change forms, but not size
B. to fall by $10 million
C. to fall by $5 million
D. to fall by $0.5 million

B. to fall by $10 million

23

Which of the following lists contains only actions that increase the money supply?
A. make open market purchases; raise the reserve requirement ratio
B. make open market purchases; lower the reserve requirement ratio
C. make open market sales; raise the reserve requirement ratio
D. make open market sales; lower the reserve requirement ratio

B. make open market purchases; lower the reserve requirement ratio

24

Which of the following lists ranks the Bank of Canada's monetary policy tools from most to least frequently used?
A. bank rate changes; reserve requirement changes; open market transactions
B. reserve requirement changes; open market transactions; bank rate changes
C. open market transactions; bank rate changes; reserve requirement changes
D. open market transactions; reserve requirement changes; bank rate changes

C. open market transactions; bank rate changes; reserve requirement changes

25

Which of the following is not a tool of monetary policy?
A. open market operations
B. reserve requirements
C. changing the bank rate
D. increasing the deficit

D. increasing the deficit

26

How may the Bank of Canada influence the price level?
A. by conducting open market sales and raising the bank rate
B. by conducting open market sales and lowering the bank rate
C. by conducting open market purchases and raising the bank rate
D. by conducting open market purchases and lowering the bank rate

D. by conducting open market purchases and lowering the bank rate

27

When and where did hyperinflation occur?
A. during 1880–1896 in the United States
B. in post–World War I Germany
C. during the 1970s in Canada
D. during 1930–1933 in the United States

B. in post–World War I Germany

28

Which of the following does the classical theory of inflation try to explain?
A. changes in relative prices in the economy determined by factors other than inflation
B. the effect of inflation on economic growth
C. the short-run determinants of the price level and the inflation rate
D. the long-run determinants of the price level and the inflation rate

D. the long-run determinants of the price level and the inflation rate

29

When the value of money rises, what happens to the number of dollars needed to buy a representative basket of goods?
A. It increases, and so the price level rises.
B. It increases, and so the price level falls.
C. It decreases, and so the price level rises.
D. It decreases, and so the price level falls.

D. It decreases, and so the price level falls.

30

Why is the money supply curve vertical?
A. because the quantity of money supplied increases when the value of money increases
B. because the quantity of money supplied increases when the value of money decreases
C. because the quantity of money supplied increases only if people desire to hold more money
D. because the quantity of money supplied increases only if the central bank increases the money supply

D. because the quantity of money supplied increases only if the central bank increases the money supply

31

How is the supply of money determined?
A. by the price level
B. by the Ministry of Finance
C. by the Bank of Canada
D. by the demand for money

C. by the Bank of Canada

32

When the money market is depicted in a graph with the value of money on the vertical axis, as the price level increases, which of the following happens to the value of money?
A. It increases, so the quantity of money demanded increases.
B. It increases, so the quantity of money demanded decreases.
C. It decreases, so the quantity of money demanded decreases.
D. It decreases, so the quantity of money demanded increases.

D. It decreases, so the quantity of money demanded increases.

33

Which of the following best describes the effects of an open market operation undertaken by the Bank of Canada?
A. If the Bank of Canada purchases bonds in the open market, then the money supply shifts right and the price level increases.
B. If the Bank of Canada sells bonds in the open market, then money supply shifts right and the price level decreases.
C. If the Bank of Canada purchases bonds, then the money supply shifts left and the price level decreases.
D. If the Bank of Canada sells bonds, then the money supply shifts right and the price level decreases.

A. If the Bank of Canada purchases bonds in the open market, then the money supply shifts right and the price level increases.

34

When the money market is depicted in a diagram with the value of money on the vertical axis, in which of the following situations does the value of money increase?
A. if either money demand or money supply shifts right
B. if either money demand or money supply shifts left
C. if money demand shifts right or money supply shifts left
D. if money demand shifts left or money supply shifts right

C. if money demand shifts right or money supply shifts left

35

In the 14th century, the Western African Emperor Kankan Musa travelled to Cairo where he gave away much gold, which was in use as a medium of exchange. Which of the following would we predict this increase in gold would do to the price level and value of gold in Cairo?
A. raise both the price level and the value of gold in Cairo
B. raise the price level, but decrease the value of gold in Cairo
C. lower the price level, but increase the value of gold in Cairo
D. lower both the price level and the value of gold in Cairo

B. raise the price level, but decrease the value of gold in Cairo

36

In the 1970s in response to recessions caused by an increase in the price of oil, the central banks in many countries increased the money supply. How might the central banks have done this?
A. by selling bonds on the open market, which would have raised the value of money
B. by purchasing bonds on the open market, which would have raised the value of money
C. by selling bonds on the open market, which would have raised the value of money
D. by purchasing bonds on the open market, which would have lowered the value of money

D. by purchasing bonds on the open market, which would have lowered the value of money

37

When the money market is depicted in a diagram with the value of money on the vertical axis, which of the following happens if the price level is above the equilibrium level?
A. There is a shortage, so the price level will rise.
B. There is a shortage, so the price level will fall.
C. There is a surplus, so the price level will rise.
D. There is a surplus, so the price level will fall.

B. There is a shortage, so the price level will fall.

38

In a graph, on the vertical axis is the Value of Money and horizontal axis is the Quantity of Money. MS1 shifts to the right to become MS2. The equilibrium value of money went fro 2 to 1.

If the money supply is MS2 and the value of money is 2, which of the following relationships holds?
A. The value of money is less than its equilibrium level.
B. The price level is higher than its equilibrium level.
C. Money demand is greater than the money supply.
D. The money supply is greater than money demand.

D. The money supply is greater than money demand.

39

In a graph, on the vertical axis is the Value of Money and horizontal axis is the Quantity of Money. MS1 shifts to the right to become MS2. The equilibrium value of money went fro 2 to 1.

What happens when the money supply curve shifts from MS1 to MS2?
A. The demand for goods and services decreases.
B. The economy's ability to produce goods and services increases.
C. The equilibrium price level increases.
D. The equilibrium value of money increases.

C. The equilibrium price level increases.

40

Which of the following terms refers to economic variables whose values are measured in monetary units?
A. dichotomous variables
B. nominal variables
C. classical variables
D. real variables

B. nominal variables

41

Which of the following does nominal GDP measure?
A. the total quantity of final goods and services produced
B. the dollar value of the economy's output of final goods and services
C. the total income received from producing final goods and services in constant dollars
D. the price level

B. the dollar value of the economy's output of final goods and services

42

Which of the following does real GDP measure?
A. the total quantity of final goods and services produced
B. the dollar value of the economy's output of final goods and services
C. the total income received from producing final goods and services at current prices
D. the change in prices from the base year to current year

A. the total quantity of final goods and services produced

43

What type of variable is the price level?
A. a relative variable
B. an actual variable
C. a real variable
D. a nominal variable

D. a nominal variable

44

What is the price of a Honda Accord divided by the price of a Honda Civic called?
A. a classical variable
B. a dichotomous variable
C. a nominal variable
D. a real variable

D. a real variable

45

An assistant professor of economics gets a $100-a-month raise, but then she figures that with her current monthly salary she can't buy as many goods as she could last year. Which of the following has happened to her real and nominal wage?
A. Her real and nominal wages have risen.
B. Her real and nominal wages have fallen.
C. Her real wage has risen and her nominal wage has fallen.
D. Her real wage has fallen and her nominal wage has risen.

D. Her real wage has fallen and her nominal wage has risen.

46

Which of the following kinds of variables are interest rates adjusted for the effects of inflation?
A. nominal variables
B. real variables
C. classical variables
D. dichotomous variables

B. real variables

47

According to the classical dichotomy, which of the following increases when the money supply increases?
A. the real interest rate
B. real GDP
C. the real wage
D. the price level

D. the price level

48

According to the classical dichotomy, which of the following is NOT influenced by monetary factors?
A. nominal GDP and nominal interest rates
B. real wages and real GDP
C. the price level and nominal GDP
D. the price level and nominal GDP

B. real wages and real GDP

49

How is velocity computed?
A. (PY)/M
B. (PM)/Y
C. (YM)/P
D. (YM)/V

A. (PY)/M

50

Based on the quantity equation, if M = 125, V = 4, and Y = 200, what is P?
A. 0.5
B. 1
C. 1.5
D. 2.5

D. 2.5

51

According to the quantity equation, if Y and M are constant, and V doubles, which of the following will happen to the price level?
A. It will less than double.
B. It will double.
C. It will more than double.
D. It might double, more than double, or less than double; more information is needed.

B. It will double.

52

Assuming that velocity is stable, if real GDP grows by 10 percent this year, and if the money supply does not change this year, how does the price level or nominal GDP change?
A. The price level will not change.
B. Nominal GDP will grow by 10 percent.
C. Nominal GDP will stay the same.
D. The price level will increase by 10 percent.

C. Nominal GDP will stay the same.

53

Velocity in the country of Shem is always stable. In 2009, the money supply was $200 billion and the GDP price deflator was four times as high as it was in the base year. In 2010, the money supply increased to $240 billion, the price level increased by 15 percent, and nominal GDP equalled $1200 billion. By how much did real GDP increase between 2009 and 2010?
A. 20 percent
B. 4.35 percent
C. 2.17 percent
D. There is not enough information to answer the question.

B. 4.35 percent

54

Which of the following best explains why governments may prefer an inflation tax to some other kind of tax?
A. The inflation tax is easier to impose.
B. The inflation tax reduces inflation.
C. The inflation tax falls mainly on high-income individuals.
D. The inflation tax reduces the real cost of government expenditure.

A. The inflation tax is easier to impose.

55

What is the name of the one-for-one adjustment of the nominal interest rate to the inflation rate?
A. the Friedman Effect
B. the Hume Effect
C. the Fisher Effect
D. the Ricardian equivalence effect

C. the Fisher Effect

56

Greta puts money in a savings account at her bank earning 6.5 percent. One year later she takes her money out and notes that while her money was earning interest, prices rose 3.5 percent. Which of the following does Greta now have?
A. 3.5 percent more money with which she can purchase 6.5 percent more goods
B. 6.5 percent more money with which she can purchase 3 percent more goods
C. 6.5 percent more money with which she can purchase 6.5 percent more goods
D. 10 percent more money with which she can purchase 3 percent more goods

B. 6.5 percent more money with which she can purchase 3 percent more goods

57

Which of the following does the shoeleather cost of inflation refer to?
A. the fall in real income associated with inflation
B. the time spent searching for low prices when inflation rises
C. the waste of resources used to maintain lower money holdings
D. the increased cost to the government of printing more money

C. the waste of resources used to maintain lower money holdings

58

Which of the following terms refers to the cost of changing price tags and price listings?
A. inflation-induced tax distortions
B. relative-price variability costs
C. shoeleather costs
D. menu costs

D. menu costs

59

Given a nominal interest rate of 7 percent, in which of the following cases would you earn the lowest after-tax real rate of interest?
A. Inflation is 4 percent, and the tax rate is 25 percent.
B. Inflation is 3 percent, and the tax rate is 20 percent.
C. Inflation is 2 percent, and the tax rate is 15 percent.
D. Inflation is 1 percent, and the tax rate is 10 percent.

A. Inflation is 4 percent, and the tax rate is 25 percent.

60

Under which of the following conditions is wealth distributed from debtors to creditors?
A. When inflation is high, but expected.
B. When inflation is low, but expected.
C. When inflation is unexpectedly high.
D. When inflation is unexpectedly low.

D. When inflation is unexpectedly low.

61

Inflation vs Deflation vs Hyperinflation

Inflation: The increase in the overall level of prices.
Deflation: The decrease in the overall level of prices.
Hyperinflation: An extraordinarily high rate of inflation.

62

Why do economists use the “Classical Theory of Inflation” today?

To explain the long-run determinants of the price level and the inflation rate.

63

Name the determinants of price level and inflation rate in the “Classical Theory of Inflation.”

A) The level of prices and the value of money
B) Money supply, money demand and monetary equilibrium
C) Effects of a monetary injection
D) Classical dichotomy and monetary neutrality
E) Velocity and quantity equation
F) Inflation tax
G) Fisher Effect

64

“Classical Theory of Inflation” - Determinant: The Level of Prices and the Value of Money (Theory of Inflation)

-inflation is more about the value of money than the value of goods
-key point: Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.
-a rise in the price level means a lower value of money because each dollar in your wallet buys a smaller quantity of goods and services
***price level rises = value of money falls (Value of money = 1/P (price of goods)

65

What happens to the value of money when price levels rise?

***price level rises = value of money falls
Value of money = 1/P (price of goods)

66

“Classical Theory of Inflation” - Determinant: Money supply, money demand, and monetary equilibrium (Quantity theory of money)

-value of money is determined by supply and demand for money
-supply of money determined by Bank of Canada
-demand determined by how much wealth people want to hold in liquid form
-in the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply

67

How can the Bank of Canada reduce the money supply?

-increasing overnight rate discourages banks from borrowing from Bank of Canada = reduction in quantity of reserves in banking system = reduces money supply
-Bank of Canada sells bonds in open-market and receives dollars = money supply contracts

68

Which factors influence the quantity of money demanded or the preference for holding wealth in liquid form?

-how much people rely on credit cards
-whether an automated teller machine is easy to find
-depends on the interest rate a person could earn by using the money to buy an interest-bearing bond instead of leaving it in the wallet or a low-interest chequing account
-average level of prices in the economy (money is a medium of exchange to buy goods and services, so the prices of these goods and services is also a factor)

69

What happens to the quantity of money demanded when price levels increase?

-the higher the prices are, the more money the typical transaction requires and the more money people will choose to hold in their wallets and chequing accounts
-the higher the price level, the lower the value of money, the quantity of money demanded increases

70

How is monetary equilibrium maintained if the price level is above equilibrium?

-people will want to hold more money than the Bank of Canada has created, so the price level must fall to balance supply and demand

71

If the value of money (1/P) is on the left vertical axis, the price level (P) is on the right vertical axis (increases from top to bottom) and the quantity of money is on the horizontal axis. How are money supply and money demand shown on the graph?

-money supply curve is vertical because the quantity of money supplied is fixed by the Bank of Canada
-money demand curve is downward sloping because people want to hold a larger quantity of money when each dollar buys less

72

“Classical Theory of Inflation” - Determinant: The Effects of Monetary Injection (Quantity theory of money)

-change in monetary policy
-economy is in equilibrium and then Bank of Canada doubles the supply of money by printing more bills = monetary injection
-supply curve moves from MS1 to MS2 and equilibrium moves from point A to B
-value of money decreases and equilibrium price level increases (increase in money supply makes dollars more plentiful, increases price level and makes each dollar less valuable)

73

Def: Quantity theory of money

A theory asserting that the quantity of money available determines the price level and the growth rate in the quantity of money available determines the inflation rate

74

What happens to an economy who was at equilibrium, but then the Bank of Canada decides to do a monetary injection by increasing the supply of money?

An increase in the supply of money:
-people now have more money in their wallets than they want (money supplied exceeds money demanded) so try to get rid of it by buying goods and services or make loans to others by depositing in the bank
-increases the demand for goods and services, but the economy’s ability to supply goods and services has not changed
-increases the price level (prices of goods and services increases due to increase in demand for them) which increases the quantity of money demanded because people are using more dollars for every transaction
-decreases the value of money

75

“Classical Theory of Inflation” - Determinant: Classical dichotomy and monetary neutrality

-classical dichotomy: the theoretical separation of nominal and real variables
-monetary neutrality: the proposition that changes in the money supply affect nominal variables, but do not affect real variables
-when central bank doubles money supply, all prices double and value of unit of account falls by half ; government reduces length of metre from 100 to 50 cm, all measured distances would double, but the actual distances (real variables) would remain the same
-monetary neutrality does apply in the long run, but maybe not in the short run

76

Nominal vs Real variables in Classical dichotomy

Nominal variable: variables measured in monetary units (Nominal GDP, prices)
Real variable: variables measured in physical units (Real GDP, relative prices, real wage, real interest rate), not influenced by prices, some adjusted for inflation

77

Nominal vs Real GDP

Nominal GDP: measures the dollar value of the economy’s output of goods and services (nominal variable in classical dichotomy)
Real GDP: measures the total quantity of goods and services produced and is not influenced by the current prices of those goods and services (real variable in classical dichotomy)

78

Def: Relative prices

The price of one thing compared to another where the dollar signs cancel out ($/$), making it a real variable since it is now measured in physical units.

79

Def: Real wage

-dollar wage adjusted for inflation
-real variable
-measures the rate at which the economy exchanges goods and services for each unit of labour

80

Def: Real interest rate

-the nominal interest rate adjusted for inflation
-real variable
-measures the rate at which the economy exchanges goods and services produced today for goods and services produced in the future

81

“Classical Theory of Inflation” - Determinant: Velocity and the Quantity Equation

-Velocity of money: the rate at which money changes hands
-V=(P*Y)/M
V=velocity of money
P=price level (GDP deflator)
Y=quantity of output (real GDP)
M=quantity of money
-Quantity Equation: M*V=P*Y which relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services
-velocity of money is relatively stable (so assume constant velocity)

82

According to the quantity equation (M*V=P*Y), what happens to the three variables if the quantity of money increases in the economy?

-the price level (P) must rise
-quantity of output (Y) must rise
-velocity of money (V) must fall

83

Name the 5 steps and key points of the quantity theory of money.

1) The velocity of money is relatively stable over time.
2) Because velocity is stable, when the central bank changes the quantity of money (M), it causes proportionate changes in the nominal value of output (P*Y)
3) The economy’s output of goods and services (Y) is primarily determined by factor supplies (labour, physical capital, human capital, and natural resources) and the available production technology. In particular, because money is neutral, money does not affect output.
4) With output (Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P*Y), these changes are reflected in changes in the price level (P).
5) Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.

84

How is hyperinflation defined and how can it be used in the economy?

-defined as inflation that exceeds 50% per month, so price level increases more than 100-fold over the course of a year
-changes in money supply and price level are so large, but move together
-used to study the effects of money on the economy
-prices rise when the government prints too much money

85

Why do central banks of countries who experienced hyperinflation choose to print so much money that its value is certain to fall rapidly over time?

-governments of these countries use money creation as a way to pay for their spending (build roads, pay salaries, give transfer payments to the poor or elderly)

86

“Classical Theory of Inflation” - Determinant: Inflation Tax

-The revenue the government raises by creating money.
-not like other taxes since no one receives a bill from the government, it’s more subtle
-when the government prints money, the price level rises, and the dollars in your pocket are less valuable
-inflation tax is like a tax on everyone who holds money
-leads to hyperinflation

87

How can hyperinflation end?

-when the government institutes fiscal reforms like cuts in government spending and to eliminate the need for the inflation tax

88

How do you calculate the real interest rate?

Real interest rate = Nominal interest rate - Inflation rate
Nominal interest rate: tells you how fast the dollars in your account will rise over time
Real interest rate: corrects the nominal interest rate for the effect of inflation to tell you how fast the purchasing power of your savings account will rise over time

89

“Classical Theory of Inflation” - Determinant: The Fischer Effect

-when the Bank of Canada increases the rate of money growth, the result is both a higher inflation rate and a higher nominal interest rate
-Fischer effect=one-for-one adjustment of nominal interest rate to inflation rate
-does not hold in the short run (only long run)

90

What is the inflation fallacy?

-what people think: when prices rise, each dollar buys fewer goods and services, so inflation directly lowers living standards
-FALSE!
-inflation does NOT reduce people’s real purchasing power, because when prices rise, buyers pay more but those selling get a bigger income (inflation in income goes hand in hand with inflation in prices = monetary neutrality)
*inflation=tax on holders of money

91

Costs of inflation: Shoeleather costs

-the resources wasted when inflation encourages people to reduce their money holdings
-inflation=tax on holders of money
-taxes are an incentive for people to alter their behaviour to avoid paying it so causes deadweight losses for society as a whole and people waste scarce resources trying to avoid it
-inflation erodes the real value of money in your wallet so to avoid the inflation tax, you hold less money (go to bank more often)
-cost of reducing money holdings=shoeleather cost, where cost of time and convenience is sacrificed
-really affects countries experiencing hyperinflation

92

Costs of inflation: Menu costs

-the costs of changing prices
-typical Canadian firms change prices once a year, but for countries in hyperinflation, prices need to be changed daily to keep up with all other prices in the economy
-menu costs include cost of deciding on prices, cost of printing new catalogues, cost of advertising, cost of dealing with annoyed customers

93

Costs of inflation: Relative price variability and misallocation of resources

-no inflation means constant relative prices
-increase in inflation rate means relative prices start off high, then will be low (higher the inflation=greater the automatic variability)
-colonies rely on relative prices to allocate scarce resources
-consumers decide what to buy by comparing quality and prices of goods and services, but if inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources

94

Costs of inflation: Inflation-induced tax distortions

-lawmakers often fail to take inflation into account in tax laws
-inflation tends to raise the tax burden on income earned from savings
-inflation discourages saving (ex-tax treatment on capital gains, the profits made by selling an asset for more than its purchase price; ex-tax treatment of interest income)
-solution: index the tax system (rewrite tax laws to take into account inflation)

95

Costs of inflation: Confusion and Inconvenience

-Bank of Canada ensures the reliability of a commonly used unit of measurement (dollar), so when it increases the money supply and creates inflation, it erodes the real value of the unit of account
-accountants incorrectly measure firm’s earnings when prices are rising over time (inflation)
-inflation makes investors less able to sort out successful from unsuccessful firms which then impedes financial markets that allocate the economy’s saving to investment

96

Costs of inflation: Arbitrary redistributions of wealth

-unexpected inflation redistributes wealth in a way that has nothing to do with merit or need
-ex) unexpected changes in prices redistribute wealth among debtors and creditors; hyperinflation would enrich the debtors (it diminishes the real value of the debt) but a deflation would enrich the creditor (it increases the real value of the debt)
-since inflation is hard to predict, it puts both creditors and debtors at risk they would both like to avoid
-inflation is volatile and uncertain when the average rate of inflation is high

97

Costs of inflation: inflation is bad, but deflation may be worse

-the Friedman rule: a small and predictable amount of deflation may be desirable since it would lower the nominal interest rate and reduce the cost of holding money, so would require deflation equal to real interest rate
-falling price levels (menu costs)
-deflation comes as a surprise so causes the redistribution of wealth toward creditors and away from debtors (debtors usually poorer so harmful)
-fall in aggregate demand=falling incomes and rising unemployment
-symptom of deeper economic problems

98

What is the viewpoint “monetarism” and why it was not successful?

-central banks should keep the supply of money growing at a slow constant rate = monetary gradualism
-this policy was adopted due to the problem of inflation in order to try and make it fall
-results: at first, inflation stayed high despite the slowdown in money growth, then inflation fell much more quickly than money growth, so this policy was given up

99

The policy of inflation targeting is now being used by many of the world’s central banks. How does this policy work?

-central bank sets a target rate of inflation of 2%
-Bank of Canada adjusts monetary policy by changing the overnight rate of interest to stay at this 2% inflation target
- if there is danger of going over 2% inflation, it raises the overnight rate which reduces the growth rate of money supply and reduces future inflation
-other things equal, an increase in money growth will cause an increase in inflation

100

How does international trade affect the standard of living?
A. It raises the standard of living in all trading countries.
B. It lowers the standard of living in all trading countries.
C. It leaves the standard of living unchanged.
D. It raises the standard of living for importing countries and lowers it for exporting countries.

A. It raises the standard of living in all trading countries.

101

Country A buys $150 of wine from country B, and B buys $30 of wool from A. Which of the following correctly indicates the two countries’ net exports (in the order A, B)?
A. $180 and $0
B. $150 and $30
C. –$120 and $120
D. $120 and –$120

C. –$120 and $120

102

Sonya, a citizen of Denmark, sells Danish boots and shoes in Canada. Which of the following correctly identifies the effects of these sales on net exports?
A. They increase Canadian net exports and have no effect on Danish net exports.
B. They decrease Canadian net exports and have no effect on Danish net exports.
C. They increase Canadian net exports and decrease Danish net exports.
D. They decrease Canadian net exports and increase Danish net exports.

D. They decrease Canadian net exports and increase Danish net exports.

103

Which of the following best defines net capital outflow?
A. It is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreign residents.
B. It is the purchase of foreign assets by domestic residents minus the purchase of foreign goods and services by domestic residents.
C. It is the purchase of domestic assets by foreign residents minus the purchase of domestic goods and services by foreign residents.
D. It is the purchase of domestic assets by foreign residents minus the purchase of foreign assets by domestic residents.

A. It is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreign residents.

104

Which of the following would be Canadian foreign direct investment?
A. A Swedish car manufacturer opens a plant in Sherbrooke, Quebec.
B. A Dutch citizen buys shares of stock in a Canadian company.
C. Tim Hortons, a Canadian company, opens a restaurant in Jamaica.
D. A Canadian citizen buys stock in companies located in Japan.

C. Tim Hortons, a Canadian company, opens a restaurant in Jamaica.

105

Which of the following would be a Canadian foreign portfolio investment?
A. Nortel, a Canadian company, builds a new factory near Rome, Italy.
B. Your economics professor, a Canadian citizen, buys stock in companies located in Eastern European countries.
C. A Dutch hotel chain opens a new hotel in Canada.
D. A citizen of Singapore buys a bond issued by a Canadian corporation.

B. Your economics professor, a Canadian citizen, buys stock in companies located in Eastern European countries.

106

Suppose Connie, a Canadian citizen, buys bonds issued by an automobile manufacturer in Sweden. Which of the following would her expenditure be?
A. Canadian foreign direct investment that would increase Canadian net capital outflow
B. Canadian foreign direct investment that would decrease Canadian net capital outflow
C. Canadian foreign portfolio investment that would increase Canadian net capital outflow
D. Canadian foreign portfolio investment that would decrease Canadian net capital outflow

C. Canadian foreign portfolio investment that would increase Canadian net capital outflow

107

Which of the following shows that any trade transaction must have a financial counterpart?
A. NCO = NX
B. NCO + I = NX
C. NX + NCO = Y
D. Y = NCO – I

A. NCO = NX

108

Suppose Canada sells chocolate to the United States. Which of the following correctly identifies the effects of this transaction?
A. U.S. net exports increase, and U.S. net capital outflow increases.
B. U.S. net exports increase, and U.S. net capital outflow decreases.
C. U.S. net exports decrease, and U.S. net capital outflow increases.
D. U.S. net exports decrease, and U.S. net capital outflow decreases.

D. U.S. net exports decrease, and U.S. net capital outflow decreases.

109

A Canadian firm opens a factory that produces camping equipment in Albania. Which of the following correctly identifies the effects of this transaction?
A. Canadian net capital outflow increases, and Albanian net capital outflow decreases.
B. Canadian net capital outflow decreases, and Albanian net capital outflow increases.
C. Only Canadian net capital outflow increases.
D. Only Albanian net capital outflow increases.

A. Canadian net capital outflow increases, and Albanian net capital outflow decreases.

110

A British pharmacy buys drugs from a Canadian company and pays for them with British pounds. Which of the following correctly identifies the effects of this transaction?
A. It increases British net exports and increases Canadian capital outflow.
B. It increases British net exports and decreases Canadian capital outflow.
C. It decreases British net exports and increases Canadian capital outflow.
D. It decreases British net exports and decreases Canadian capital outflow.

C. It decreases British net exports and increases Canadian capital outflow.

111

Which of the following is the formula for an open economy's GDP?
A. Y = C + I + G
B. Y = C + I + G + T
C. Y = C + I + G + S
D. Y = C + I + G + NX

D. Y = C + I + G + NX

112

Which of the following is the formula for investment in an open economy?
A. I = Y – C
B. I = S
C. I = S – NCO
D. I = S + NX

C. I = S – NCO

113

A country has $80 million of saving and domestic investment of $30 million. What are net exports?
A. –$50 million
B. $50 million
C. $80 million
D. $110 million

B. $50 million

114

The country of Freedonia has a GDP of $4000, consumption of $1800, and government purchases of $500. Which of the following does this situation imply?
A. Investment is equal to –$1700.
B. Investment plus net capital outflow is equal to $1700.
C. Investment plus net exports is equal to $2300.
D. Saving is equal to $2200.

B. Investment plus net capital outflow is equal to $1700.

115

Which of the following does a trade deficit imply?
A. saving is greater than domestic investment and Y > C + I + G
B. saving is greater than domestic investment and Y < C + I + G
C. saving is less than domestic investment and Y > C + I + G
D. saving is less than domestic investment and Y < C + I + G

D. saving is less than domestic investment and Y < C + I + G

116

If a country has business opportunities that become relatively attractive to other countries, which of the following best predicts the effects of this change?
A. Both net exports and net capital outflow increase.
B. Both net exports and net capital outflow decrease.
C. Net exports increase, but net capital outflow decreases.
D. Net exports decrease, but net capital outflow increases.

B. Both net exports and net capital outflow decrease.

117

If the exchange rate is 175 yen = $1, what is the cost of a bottle of rice wine that costs 5250 yen?
A. $28
B. $30
C. $32
D. $34

B. $30

118

Suppose the exchange rate is 5 units of Peruvian currency per dollar, and a hotel room in Lima, Peru, costs 350 units of Peruvian currency. How many dollars do you need to get a room in Lima?
A. $1750
B. $355
C. $70
D. $35

C. $70

119

Exchange rates are 0.98 U.S. dollars per Canadian dollar, 150 yen per Canadian dollar, 0.8 euro per Canadian dollar, and 20 pesos per Canadian dollar. A bottle of beer in New York costs 6 U.S. dollars, 1200 yen in Tokyo, 7 euros in Munich, and 100 pesos in Cancun. Which of the following indicates the most expensive beer?
A. Cancun
B. New York
C. Tokyo
D. Munich

D. Munich

120

The nominal exchange rate is about 2 Aruban florin per dollar. If a basket of goods in Canada costs $40, how many florins must a basket of goods in Aruba cost for purchasing-power parity to hold?
A. 20 florins
B. 40 florins
C. 80 florins
D. 100 florins

C. 80 florins

121

According to the theory of purchasing-power parity, what must the nominal exchange rate between two countries reflect?
A. the different price levels in those countries
B. the different resource endowments in those countries
C. the different income levels in those countries
D. the different standards of living between those countries

A. the different price levels in those countries

122

When a country's central bank decreases the money supply, which of the following best predicts the consequences?
A. Its price level rises, and its currency appreciates relative to other currencies in the world.
B. Its price level falls, and its currency appreciates relative to other currencies in the world.
C. Its price level rises, and its currency depreciates relative to other currencies in the world.
D. Its price level falls, and its currency depreciates relative to other currencies in the world.

B. Its price level falls, and its currency appreciates relative to other currencies in the world.

123

According to purchasing-power parity, if prices in Canada increase by a smaller percentage than prices in Algeria, how does the exchange rate change?
A. The real exchange rate, defined as Algerian goods per unit of Canadian goods, rises.
B. The real exchange rate, defined as Algerian goods per unit of Canadian goods, falls.
C. The nominal exchange rate, defined as Algerian currency per dollar, rises.
D. The nominal exchange rate, defined as Algerian currency per dollar, falls.

C. The nominal exchange rate, defined as Algerian currency per dollar, rises.

124

On behalf of your firm, you make frequent trips to Hong Kong. You notice that you always have to pay more dollars to get enough local currency to get your hair styled than you have to pay to get your hair styled in Canada. Is this consistent with purchasing power parity?
A. No, but it might be explained by limited opportunities for arbitrage across international borders.
B. Yes, if prices in Hong Kong are rising more rapidly than prices in Canada.
C. Yes, if prices in Hong Kong are rising less rapidly than prices in Canada.
D. No, but it can be explained by arbitrage across international borders.

A. No, but it might be explained by limited opportunities for arbitrage across international borders.

125

In the open-economy macroeconomic model, where does the demand for loanable funds come from?
A. domestic investment
B. net exports
C. net capital outflow
D. the sum of net capital outflow and domestic investment

A. domestic investment

126

What does a higher real interest rate lowers the quantity of?
A. national saving
B. net capital outflow
C. loanable funds demanded
D. loanable funds supplied

C. loanable funds demanded

127

What effect does a fall in the real interest rate have on the quantity of loanable funds?
A. It increases the quantity of loanable funds demanded.
B. It decreases the quantity of loanable funds demanded.
C. It increases the quantity of loanable funds supplied.
D. It does not affect the quantity of loanable funds supplied.

A. It increases the quantity of loanable funds demanded.

128

In an open economy, what does net capital outflow equal?
A. imports
B. net exports
C. exports
D. net imports

B. net exports

129

If the world real interest rate exceeds the interest rate that would occur if the Canadian economy were closed, then the Canadian net capital outflow will be which of the following?
A. positive
B. negative
C. decreasing
D. increasing

A. positive

130

Which of the following is consistent with positive net exports?
A. Exports are greater than imports.
B. Net capital outflow is negative.
C. Exports are less than imports.
D. Net capital outflow is zero.

A. Exports are greater than imports.

131

In the market for foreign currency exchange in the open economy macroeconomic model, which of the following does the amount of net capital outflow represent?
A. the quantity of dollars supplied for the purpose of selling assets domestically
B. the quantity of dollars supplied for the purpose of buying assets abroad
C. the quantity of dollars demanded for the purpose of buying Canadian net exports of goods and services
D. the quantity of dollars demanded for the purpose of importing foreign goods and services

B. the quantity of dollars supplied for the purpose of buying assets abroad

132

Which of the following is included in the supply of dollars in the market for foreign-currency exchange in the open-economy macroeconomic model?
A. A retail outlet in Afghanistan wants to buy watches from a Canadian manufacturer.
B. A Canadian bank loans dollars to Blair, a Canadian resident, who wants to purchase a new car made in Canada.
C. A Canadian-based mutual fund wants to purchase stock issued by a Polish company.
D. A Canadian resident imports a car made in Japan.

C. A Canadian-based mutual fund wants to purchase stock issued by a Polish company.

133

What is the real exchange rate equal to?
A. the relative price of domestic and foreign currency
B. the relative price of domestic and foreign goods
C. the ratio between the domestic and foreign interest rates
D. the nominal exchange rate minus the inflation rate

B. the relative price of domestic and foreign goods

134

What does the identity “net capital outflow = net exports” imply?
A. The supply of dollars equals the demand for dollars in the foreign-currency exchange market.
B. National saving equals domestic investment.
C. The volume of exports equals the volume of imports.
D. National saving is greater than domestic investment.

A. The supply of dollars equals the demand for dollars in the foreign-currency exchange market.

135

Which of the following is consistent with a depreciation of the dollar?
A. Canadian goods become less expensive relative to foreign goods, which makes exports rise and imports fall.
B. Canadian goods become less expensive relative to foreign goods, which makes exports fall and imports rise.
C. Canadian goods become more expensive relative to foreign goods, which makes exports rise and imports fall.
D. Canadian goods become more expensive relative to foreign goods, which makes exports fall and imports rise.

A. Canadian goods become less expensive relative to foreign goods, which makes exports rise and imports fall.

136

In the open-economy macroeconomic model, which of the following is the key determinant of net capital outflow?
A. the nominal exchange rate
B. the nominal interest rate
C. the real exchange rate
D. the real interest rate

D. the real interest rate

137

If Canadian firms decide to invest more domestically at each interest rate, which of the following best describes the results?
A. The real interest rate decreases, the real exchange rate of the dollar depreciates, and Canadian net capital outflow decreases.
B. The real interest rate decreases, the real exchange rate of the dollar appreciates, and Canadian net capital outflow increases.
C. The real interest rate increases, the real exchange rate of the dollar appreciates, and Canadian net capital outflow decreases.
D. The real interest rate increases, the real exchange rate of the dollar depreciates, and Canadian net capital outflow increases.

C. The real interest rate increases, the real exchange rate of the dollar appreciates, and Canadian net capital outflow decreases.

138

How does a change in government budget affect national saving?
A. An increase in budget deficit increases national saving.
B. An increase in budget surplus increases national saving.
C. A decrease in budget surplus increases national saving.
D. A decrease in budget deficit does not affect national saving.

B. An increase in budget surplus increases national saving.

139

The People's Republic of China has had a large trade surplus in recent years. Which of the following is the most likely explanation of this surplus?
A. China has a high rate of inflation, which reduces the value of its currency.
B. China has a large supply of labour, so low wages give it a competitive edge.
C. China has many trade barriers, which restrict the ability of other countries to sell their products in China.
D. China has a large amount of saving relative to domestic investment.

D. China has a large amount of saving relative to domestic investment.

140

Since the mid 1990s, Canadian governments have tried to eliminate budget deficits. Which of the following was expected to happen?
A. This would decrease national savings, appreciate the real exchange rate, and decrease net exports.
B. This would increase national savings, depreciate the real exchange rate, and increase net exports.
C. This would increase national savings, depreciate the real exchange rate, and increase net exports.
D. This would decrease national savings, depreciate the real exchange rate, and decrease net exports.

C. This would increase national savings, depreciate the real exchange rate, and increase net exports.

141

Suppose that Canada imposes an import quota on automobiles. Which of the following describes the most likely effects of this quota?
A. The quota would cause the real exchange rate of Canadian dollars to appreciate, but it would not change the real interest rate in Canada.
B. The quota would cause the real exchange rate of Canadian dollars to appreciate and the real interest rate in Canada to increase.
C. The quota would cause the real exchange rate of Canadian dollars to depreciate and the real interest rate in Canada to decrease.
D. The quota would cause the real exchange rate of Canadian dollars to depreciate, but it would not change the real interest rate in Canada.

A. The quota would cause the real exchange rate of Canadian dollars to appreciate, but it would not change the real interest rate in Canada.

142

What happens to sales and profit during recessions?
A. sales and profits fall
B. sales and profits rise
C. sales rise and profits fall
D. profits fall and sales rise

A. sales and profits fall

143

How does the size of investment as a fraction of GDP compare to its importance in creating economic fluctuations?
A. Investment is a small part of real GDP and it accounts for a small share of the fluctuation in real GDP.
B. Investment is a small part of real GDP, yet it accounts for a large share of the fluctuation in real GDP.
C. Investment is a large part of real GDP and it accounts for a large share of the fluctuation in real GDP.
D. Investment is a large part of real GDP, yet it accounts for a small share of the fluctuation in real GDP.

B. Investment is a small part of real GDP, yet it accounts for a large share of the fluctuation in real GDP.

144

In addition to the price level, which of the following does the aggregate demand and aggregate supply model focus on?
A. real GDP
B. nominal GDP
C. the neutrality of money
D. stock prices

A. real GDP

145

Which of the following best explains the slope of the aggregate demand curve?
A. The aggregate demand curve slopes downward for the same reasons that market demand curves slope downward.
B. The aggregate demand curve is vertical in the long run because people can only consume a certain maximum quantity.
C. The aggregate demand curve is downward sloping because it shows an inverse relation between the price level and the quantity of all goods and services demanded.
D. The aggregate demand curve is downward sloping because the more people wish to consume, the lower is the price.

C. The aggregate demand curve is downward sloping because it shows an inverse relation between the price level and the quantity of all goods and services demanded.

146

Which of the following is NOT included in aggregate demand?
A. purchases of stock and bonds
B. purchases of services such as visits to the doctor
C. purchases of capital goods such as equipment in a factory
D. purchases by foreigners of consumer goods produced in Canada

A. purchases of stock and bonds

147

Which of the following best describes the effects of a fall in the price level?
A. Dollars become more valuable, and interest rates rise.
B. Dollars become more valuable, and interest rates fall.
C. Dollars become less valuable, and interest rates rise.
D. Dollars become less valuable, and interest rates fall.

B. Dollars become more valuable, and interest rates fall.

148

In the aggregate demand and aggregate supply model, when does the aggregate quantity of goods demanded decrease?
A. when real wealth increases
B. when the interest rate falls
C. when the dollar depreciates
D. when stock prices fall

D. when stock prices fall

149

How does the aggregate demand and supply model reflect a decrease in taxes?
A. Consumption increases, so aggregate demand shifts right.
B. Consumption increases, so aggregate supply shifts right.
C. Consumption decreases, so aggregate demand shifts left.
D. Consumption decreases, so aggregate supply shifts left.

A. Consumption increases, so aggregate demand shifts right.

150

Which of the following shifts aggregate demand to the left?
A. an increase in the price level
B. a decrease in the money supply
C. an increase in net exports
D. an investment tax credit

B. a decrease in the money supply

151

When is the aggregate supply curve upward sloping rather than vertical?
A. in the short and the long run
B. in neither the short run nor long run
C. in the long run, but not in the short run
D. in the short run, but not in the long run

D. in the short run, but not in the long run

152


In which of the following situations would the long-run aggregate supply curve shift right?
A. if immigration from abroad decreases
B. if the capital stock decreases
C. if the money supply increases
D. if technology advances

D. if technology advances

153

According to misperceptions theory, if a firm thought that inflation was going to be 5 percent and actual inflation was 6 percent, how the firm may be affected?
A. It may believe that the relative price has increased, so it would increase production.
B. It may believe that the relative price has increased, so it would decrease production.
C. It may believe that the relative price has decreased, so it would increase production.
D. It may believe that the relative price has increased, so it would decrease production.

A. It may believe that the relative price has increased, so it would increase production.

154

According to the sticky wage theory, which of the following is consistent with an unexpected fall in the price level?
A. The real wage rises and employment rises.
B. The real wage rises and employment falls.
C. The real wage falls and employment rises.
D. The real wage falls and employment falls.

B. The real wage rises and employment falls.

155

Which of the following shifts the short-run aggregate supply left?
A. an increase in the price level
B. an increase in the expected price level
C. an increase in the capital stock
D. a decrease in taxes

B. an increase in the expected price level

156

Which of the following could create an increase in the price level and a decrease in real GDP in the short run?
A. an increase in the money supply
B. an increase in government expenditures
C. a fall in stock prices
D. bad weather in farm provinces

D. bad weather in farm provinces

157

Which of the following would cause stagflation?
A. aggregate demand shifts right
B. aggregate demand shifts left
C. aggregate supply shifts right
D. aggregate supply shifts left

D. aggregate supply shifts left

158

Suppose the economy is in long-run equilibrium. Concerns about pollution cause the government to significantly restrict the production of electricity. At the same time, the value of the dollar falls. What would we expect to happen in the short run?
A. Real GDP will rise, and the price level might rise, fall, or stay the same.
B. Real GDP will fall, and the price level might rise, fall, or stay the same.
C. The price level will rise, and real GDP might rise, fall, or stay the same.
D. The price level will fall, and real GDP might rise, fall, or stay the same.

C. The price level will rise, and real GDP might rise, fall, or stay the same.

159

Suppose the economy is in long-run equilibrium. If there is a sharp decline in the stock market combined with a significant increase in immigration of skilled workers, what would we expect to happen?
A. In the short run, real GDP will rise, and the price level might rise, fall, or stay the same. In the long-run, real GDP will rise, and the price level might rise, fall, or stay the same.
B. In the short run, the price level will fall, and real GDP might rise, fall, or stay the same. In the long-run, real GDP and the price level will be unaffected.
C. In the short run, the price level will rise, and real GDP might rise, fall, or stay the same. In the long run, real GDP will rise, and the price level will fall.
D. In the short run, the price level will fall, and real GDP might rise, fall, or stay the same. In the long run, real GDP will rise, and the price level will fall.

D. In the short run, the price level will fall, and real GDP might rise, fall, or stay the same. In the long run, real GDP will rise, and the price level will fall.

160

What are the benefits of international trade?

-raise living standards in all countries (make everyone better off)
-each county can specialize in producing goods and services in which it has comparative advantage
-allows consumption of a great variety of goods and services produced around the world

161

Closed vs Open Ecocomy

Closed economy: an economy that does not interact with other economies in the world
Open economy: an economy that interacts freely with other economies around the world (it buys and sells goods and services in world product markets and it buys and sells capital assets like stocks and bonds in world financial markets)

162

Exports vs Imports

Exports: goods and services produced domestically and sold abroad
Imports: goods and services produced abroad and sold domestically

163

Formula of net exports

Net exports = value of country’s exports - value of country’s imports
*also called trade balance

164

Trade surplus vs trade deficit vs balanced trade

Trade surplus: if net exports are positive, so exports are greater than imports
Trade deficit: if net exports are negative, so imports are greater than exports
Balanced trade: if net exports is 0, so exports and imports are equal

165

Name the factors that might influence a country’s exports, imports and net exports.

-tastes of consumers for domestic and foreign goods
-prices of goods at home and abroad
-exchange rates at which people can use domestic currency to buy foreign currencies
-incomes of consumers at home and abroad
-cost of transporting goods from country to country
-government policies toward international trade

166

Why has international trade increased throughout the years?

-New improvements to transportation of goods around the world (For example, boats can now carry more cargo and planes allow for better air transport)
-Advances in telecommunications allows businesses to reach overseas customers more easily
-Changes in the kinds of goods produced (modern technology allows for lighter products that are less costly and easier to transport)
-Government trade polices (ex-crossing items over US and Canada border without paying import duties, elimination of tariffs, North American Free Trade Agreement, import quotas)

167

Give the formula for net capital outflow.

The purchase of foreign assets by domestic residents - purchase of domestic assets by foreigners

168

What happens to Canadian net capital outflow when:
A) a Canadian buys tock in Telmex, the Mexican phone company
B) a Japanese resident buys a bond issued by the Canadian government

A) raises Canadian net capital outflow
B) reduces Canadian net capital outflow

169

Foreign direct investment vs Foreign portfolio investment

Foreign direct investment: Tim Hortons opens a fast food outlet in Russia (Canadian owner is actively managing the investment)
Foreign portfolio investment: Canadian buys stock in a Russian corporation (Canadian owner has a more passive role)

170

How do foreign direct investment and foreign portfolio investment affect Canadian net capital outflow?

-in both cases, Canadian residents are buying assets located in another country, so both purchases increase Canadian net capital outflow
-net capital outflow is sometimes called net foreign investment

171

When is net capital outflow positive or negative?

Positive: domestic residents are buying more foreign assets than foreigners are buying domestic assets; capital flows out of the country
Negative: domestic residents are buying less foreign assets than foreigners are buying domestic assets; capital flows into the country (capital inflow)

172

Name some variables that influence net capital outflow.

-real interest rates being paid on foreign assets
-real interest rates being paid on domestic assets
-perceived economic and political risks on holding assets abroad (default: not pay interest or principal of the bond when it’s due)
-government policies that affect foreign ownership of domestic assets
*the higher a bond’s real interest rate, the more attractive it is

173

Def: Identity

An equation that must hold because of the way the variables in the equation are defined and measured

174

What is the accounting equation or identity when it comes to net capital outflow and net exports? And why does it hold true?

NCO=NX
*every international transaction is an exchange
-when a seller country transfers a good or service to a buyer country, the buyer country gives up some asset to pay for this good or service
-the value of that asset equals the value of the good or service sold

175

When a country is running a trade surplus, it is selling more goods and services to foreigners than it is buying from them. What happens to NX and NCO? What is it doing with the foreign currency it receives from the net sale of goods and services abroad?

NX>0 and NCO>0 (since NX=NCO)
-with the foreign currency it receives from the net sale of goods and services abroad, it uses it to buy foreign assets
-capital is flowing out of the country

176

When a country is running a trade deficit, it is buying more goods and services from foreigners than it is selling to them. What happens to NX and NCO? How is it financing the net purchase of these goods and services in world markets?

NX<0 and NCO<0 (since NX=NCO)
-to finance the net purchase of these goods and services in world markets, it must be selling assets abroad
-capital is flowing into the country

177

What is the accounting identity for the economy’s domestic gross product (Y)? What about national saving (S)and how it can be applied to this equation?

Y=C+I+G+NX
(Total expenditure on the economy’s output of goods and services is the sum of expenditure on consumption, investment, government purchases and net exports)
S=Y-C-G
Y-C-G=I+NX
S=I+NX
S=I+NCO

178

What does the equation S=I+NCO represent?

Saving=Domestic investment+Net capital investment outflow
-when a Canadian citizen saves a dollar of their income for the future, that dollar can be used to finance accumulation of domestic capital or be used to finance the purchase of capital abroad
-in a closed economy, S=I, but in an economy S=I+NCO (two opportunities for investment)

179

A) When a nation’s saving exceeds its domestic investment, what is net capital outflow?
B) When a nation’s domestic investment exceeds its saving, what is net capital outflow?

A) positive (nation is using some of its saving to buy assets abroad)
B) negative (foreigners are financing some of this investment by purchasing domestic assets)

180

There are three possible outcomes for an open economy when it comes to international flows of goods and capital: trade deficit, balanced trade and trade surplus. Give a summary for each of their effects.

A) Trade Deficit
Exports

181

Def: Nominal exchange rate

-the rate at which a person can trade the currency of one country for the currency of another

182

Appreciation vs Depreciation of the dollar

Appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy (if the exchange rate changes so that a dollar buys more foreign currency)
Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy (if the exchange rate changes so that a dollar buys less foreign currency)

183

What is the exchange rate index and what does it take into account?

-turns the many exchanges rates into a single measure of the international value of the currency
-so appreciation and depreciation refers to an exchange rate index that takes into account many individual exchange rates

184

Def: Real Exchange Rate

-the rate at which a person can trade the goods and services of one country for the goods and services of another
-ex) a case of German beer is twice as expensive as a case of Canadian beer, so the real exchange rate is half of a case of German beer per case of Canadian beer
-expressed as units of foreign item per unit of domestic item (good, not currency)

185

What is the equation to calculate the real exchange rate when calculating for individual items?

Real exchange rate = (Nominal exchange rate*Domestic price)/Foreign price

186

The real exchange rate is a key determinant of what?

Of how much a country exports or imports

187

What is the equation to calculate the overall real exchange rate when calculating for the overall prices (the economy as a whole)? What does it measure?

Real exchange rate = (e*P)/P*
Where, e=nominal exchange rate between the Canadian dollar and foreign currencies, P=price index for a Canadian basket, P*=price index for a foreign basket
-measures the price of a basket of goods and services available domestically relative to a basket of goods and services available abroad

188

A depreciation in Canada’s real exchange rate means what? An appreciation in Canada’s real exchange rate means what?

-A depreciation in Canada’s real exchange rate means that Canadian goods have become cheaper relative to foreign goods, encourages both consumers at home and abroad to buy more Canadian goods and fewer foreign goods, so Canada’s exports rise and Canada’s imports fall, so Canada’s net exports rise.
-An appreciation in Canada’s real exchange rate means that Canadian goods have become more expensive compared to foreign goods, no Canada’s net exports fall.

189

What are the benefits and costs of adopting a common currency (what happened in Europe with the euro)?

Benefits: makes trade easier, each time you wanted to go cross a border you needed to change your money with the exchange rate making it inconvenient and deter you from buying goods and services outside your country
Costs: only one monetary policy so each nation must come to a common agreement on a single policy

190

Def: Purchasing-power parity

-a theory of exchange rate determination (in the long-run) whereby a unit of any given currency should be able to buy the same quantity of goods in all countries

191

What does the “law of one price” explain and how is it a principle that the theory of purchasing-power parity is based on?

-asserts that a good must sell for the same price in all locations, otherwise, opportunities for profit would be left unexploited
-a currency must have the same purchasing power in all countries (purchasing-power parity)
-a Canadian dollar must buy the same quantity of goods in Canada and Japan, and a Japanese yen must buy the same quantity of goods in Japan and Canada

192

Def: arbitrage

The process of taking advantage of differences in prices in different markets.

193

What are the equations that represent the purchasing power of a dollar to be the same in two countries?

1/P =e/P*
(1/P is the purchasing power of 1$ at home and e/P* is the purchasing power for the exchange of the dollar for the foreign currency)
1=eP/P* (real exchange rate)

194

What does the theory of purchasing-power parity imply about the nominal exchange rate between the currencies of two countries?

-The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.
-nominal exchange rates change when price levels change, so also depends on money supply and money demand

195

Does currency appreciate or depreciate relative to other currencies in the world when a central bank decides to increase the money supply?

-causes the price level to rise
-country’s currency depreciates relative to other currencies in the world
-money loses value
-can buy less goods and services
-can buy less of an amount of other currencies

196

Why did the Canadian dollar lose value compared to the German mark and gain value compared to the Italian lira?

Germany pursued a less inflationary monetary policy than Canada (Canadian prices rose and value of the dollar fell) and Italy pursued a more inflationary monetary policy than Canada (Canadian prices fell and value of the dollar rose).

197

Explain what happens (the pattern) during hyperinflation to the price level, money supply and the exchange rate.

-price level increases dramatically
-money supply increases dramatically at the same rate
-exchange rate depreciates dramatically at the same rate
-when things stabilize, everything stabilizes

198

Name two reasons why the theory of purchasing-power parity does not always hold in practice.

1) many goods are not easily tradable
2) even tradable goods are not always perfect substitutes when they are produced in different countries
-for these reasons, real exchange rates fluctuate over time

199

How do economists describe the Canadian economy?

A small open economy with perfect capital mobility

200

Def: Small open economy

-an economy that trades goods and services with other economies and, by itself, has a negligible effect on world prices and interest rates

201

Def: Perfect capital mobility

Full access to world financial markets

202

What is the relationship between the Canadian real interest rate and the world real interest rate with perfect capital mobility?

For a small open economy, r=r^w
( r=Canadian real interest rate and r^w=world real interest rate)
-As long as the Canadian and foreign assets are close substitutes, the difference in interest rates provides an arbitrage opportunity for either borrowers or savers

203

Def: Interest rate parity

A theory of interest rate determination whereby the real interest rate on comparable financial assets should be the same in all economies with full access to world financial markets

204

Name the two reasons why the interest rate parity does not always hold in practice.

1) financial assets carry with them the possibility of default (seller may not repay the buyer), where buyers incur a default risk; the higher the default risk, the higher the interest rate; interest rate differences may persist if the seller of one asset is perceived likely to default more than another
2) financial assets offered for sale in different countries are not necessarily perfect substitutes for one another (tax treatments)

205

Is Canadian net capital outflow positive or negative today?

negative NCO, foreigners purchased more Canadian assets than Canadians purchased foreign assets, so many firms in Canada are owned by foreigners

206

What are the components of the market for loanable funds?

-demand for loanable funds comes from domestic investment (I)
-supply of loanable funds comes from national saving (S)

207

Explain what happens when SI.

S=I+NCO
-SI: Canadian savings have been used to purchase foreign assets and NCO is positive

208

Suppose that the Canadian interest rate is 5% and the world interest rate is 8%. Why can’t this situation persist?

-because of full access to world financial markets, Canadian savers would prefer to buy foreign assets that pay the higher interest rate
-savers sell their holdings of Canadian assets and buy foreign assets instead
-Canadian borrowers would have to offer to pay the more attractive world interest rate of 8%

209

In the diagram for the market of loanable funds, why does the demand curve slope downward?

-a higher real interest rate makes borrowing to finance capital projects more costly
-discourages investment
-reduces the quantity of loanable funds demanded

210

In the diagram for the market of loanable funds, why does the supply curve slope upward?

-a high real interest rate encourages people to save
-raises the quantity of loanable funds made available by national saving
-unlike the closed economy where you only take into account the savings of Canadians (real interest rate determined by the intersection of the demand and supply curves for loanable funds), but in a small open economy with perfect capital mobility, the interest rate is equal to the world interest rate and now savings of foreigners are taken into account

211

How is net capital outflow and net exports determined in the market for loanable funds?

-net capital outflow is determined by the difference between the supply of loanable funds due to national saving (S) and demand for loanable funds (I) at the world interest rate
-net exports are determined by the difference between the supply of loanable funds due to national saving (S) and the demand for loanable funds (I) at the world interest rate
-due to NCO=NX

212

Why does the market for foreign currency exchange exist?

-because people want to trade goods, services, and financial assets with people in other countries, but they want to be paid for these things in their own currency
-for a Canadian to purchase a good, service or financial asset from someone in another country, the Canadian must purchase the other country’s currency as well

213

Which identity is useful for describing the market for foreign-currency exchange?

S-I=NX
-states that the imbalance between domestic supply of loanable funds due to national saving (S) and the demand for loanable funds for domestic investment (I) must equal the imbalance between exports and imports
-the difference between S and I (=NCO) represents the quantity of dollars supplied in the market for foreign-currency exchange for the purpose of buying foreign assets
-Japanese want to buy airplane but need Canadian dollars so must demand dollars in the market for foreign-currency exchange

214

What price balances the supply and demand in the market for foreign-currency exchange?

-real exchange rate, is the relative price of domestic and foreign goods
-a key determinant of net exports

215

When Canada’s real exchange rate appreciates, what happens to net exports and to the market for foreign-currency exchange?

-Canadian goods become more expensive relative to foreign goods, making Canadian goods less attractive to consumers both at home and abroad
-exports from Canada fall and imports into Canada rise
-net exports fall
-reduces the quantity of dollars demanded in the market for foreign-currency exchange

216

Why does the demand curve slope downward in the market for foreign-currency exchange?

-a higher real exchange rate makes Canadian goods more expensive
-reduces the quantity of dollars demanded to buy those goods
-demand for dollars comes from net exports

217

Why is the supply curve vertical in the market for foreign-currency exchange?

-quantity of dollars supplied for net capital outflow does not depend on the real exchange rate
-this is due to changes in the exchange rate influence both the cost of buying foreign assets and the benefit of owning them, and these two effects offset each other

218

A) What happens in the market for foreign-currency exchange if the real exchange rate was below the equilibrium level?
B) If the real exchange rate was above the equilibrium level?

A) the quantity of dollars supplies would be less than the demanded, the resulting shortage of dollars would push the value of the dollar upward
B) the quantity of dollars supplied would exceed the quantity demanded, the surplus of dollars would drive the value of the dollar downward

219

The market for foreign-currency exchange’s at the equilibrium real exchange rate means what?

-the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports

220

A) When a Canadian resident imports a car made in Japan, this transaction does what to the quantity of dollars demanded or supplied?
B) When a Japanese citizen buys a Canadian Government bond, this transaction does what to the quantity of dollars demanded or supplied?

A) decrease in quantity of dollars demanded (because net exports fall) rather than an increase in the quantity of dollars supplied
B) decrease in the quantity of dollars supplied (because net capital outflow falls) rather than an increase in the quantity of dollars demanded

221

Which variable links the market for loanable funds and the market for foreign-currency exchange? What is the key determinant for this variable?

A) Net capital outflow
B) world interest rate

222

Is net capital outflow positive or negative when:
A) the world interest rate is higher than the interest rate that equates the demand for loanable funds to the supply of loanable funds coming form savings
B) the world interest rate is lower than the interest rate that equates the demand for loanable funds to the supply of loanable funds coming form savings

A) net capital outflow is positive and is equal to the difference between national saving and the domestic demand for loanable funds
B) net capital outflow is negative and is equal to the difference between national saving and the domestic demand for loanable funds

223

Because national saving in the market for loanable funds is more than sufficient to provide loanable funds for domestic investment, the excess is used to ______.

Buy foreign assets, this is net capital outflow.
NCO=S-I

224

What does the net capital outflow in the Market for Loanable Funds represent in the Market for Foreign-Currency Exchange?

It represents the supply of dollars (S-I); the vertical line

225

Name what each market allows us to determine.
A) The Market for Loanable Funds
B) The Market for Foreign-Currency Exchange

A) national saving, domestic investment, net capital outflow (NCO=S-I)
B) real exchange rate (price of domestic goods and services relative to foreign goods and services)

226

Why is the Canadian economy affected by the changes in interest rates in the United States?

Because the United States is the largest economy in the world, so movements in the US interest rates are responsible in large part for movements in the world interest rate.

227

An increase in the world interest rate would affect the Market for Loanable Funds and the Market for Foreign-Currency Exchange how?

Market for Loanable Funds: causes net capital outflow to increase
Market for Foreign-Currency Exchange: increase in supply of dollars to be exchanged into foreign currency and causes the real exchange rate to depreciate (so there’s a shift to the right in the supply of dollars)
*a depreciation in the real exchange rate makes Canadian goods less expensive so people switch to this less expensive product, meaning Canada’s exports rise and imports fall = net exports rise

*Conclusion: In a small open economy with perfect capital mobility, an increase in the world interest rate crowds out domestic investment, causes the dollar to depreciate, and causes net exports to rise

228

An increase in the government budget deficit would affect the Market for Loanable Funds and the Market for Foreign-Currency Exchange how?

Loanable Funds: reduces national saving (shifts supply of loanable funds from national saving curve to the left), reduces net capital outflow
Foreign-Currency Exchange: reduces supply of dollars (shifts supply of dollars curve to the left), causes real exchange rate to appreciate
*dollar becomes more valuable relative to foreign currencies, so Canadian goods become more expensive and people buy foreign goods instead, exports fall and imports rise, net exports fall

*Conclusion: In a small open economy with perfect capital mobility, an increase in government budget deficits causes the dollar to appreciate and causes net exports to fall

229

A decrease in the government budget deficit would affect the Market for Loanable Funds and the Market for Foreign-Currency Exchange how?

In a small open economy with perfect capital mobility, a decrease in budget deficit causes the dollar to depreciate and causes net exports to rise.

230

Def: Trade policy

A government policy that directly influences the quantity of goods and services that a country imports or exports.
Ex) tariff or import quota

231

Def: Tariff

A tax on goods produced abroad and sold domestically (tax on imported goods)

232

Def: Import quota

A limit on the quantity of a good that is produced abroad and sold domestically

233

What are the effects of an import quota on the Market for Loanable Funds and the Market for Foreign-Currency Exchange?

Market for Foreign-Currency Exchange: increases demand for dollars (shifts supply of dollars curve to the right), causes the real exchange rate to appreciate
Market for Loanable Funds: net capital outflow and net exports remain the same
*the appreciation in the real exchange rate encourages imports and discourages exports which offset the direct increase in net exports due to quota

*Conclusion: Trade policies do not affect the trade balance

234

Why do most economists oppose trade policies?

-free trade allows economies to specialize doing what they do best, making residents of all countries better off
-trade restrictions interfere with these gains from trade and reduce the overall economic well-being

235

Def: Capital flight

A large and sudden reduction in the demand for assets located in a country
*tends to increase interest rates and cause the currency to depreciate

236

Explain what is the open economy trilemma?

-in most nations, economic policy makers would like to achieve these three goals:
1) make the country’s economy open to international flows of capital
2) use monetary policy as a tool to help stabilize the economy
3) maintain stability in the currency exchange rate
-BUT you can’t get all three! Can only choose two of the three!

237

Def: Recession

A period of declining real incomes and rising unemployment (real GDP falls)
-recessions are two or more quarters of negative real GDP growth

238

Def: Depression

A severe recession

239

Name three facts about economic short-run fluctuations.

1) are irregular and unpredictable
2) most macroeconomic quantities fluctuate together
3) as output falls, unemployment rises

240

Def: Business cycle

-another name for short-run fluctuations in the economy
-economic fluctuations correspond to changes in business conditions
-misleading because it suggests that economic fluctuations follow a regular, predictable pattern which it is NOT predictable
-when real GDP grows rapidly, business is good, customers are plentiful and profits are growing = economic expansion
-when real GDP falls during recession, businesses have trouble, firms experience declining sales and dwindling profits= economic contraction

241

What does real GDP measure?

-the value of all final goods and services produced within a given period of time
-measures the total income (adjusted for inflation) of everyone in the economy

242

Which macroeconomic quantities fluctuate together in the economy, especially evident during recessions?

(recessions are two or more quarters of negative real GDP growth)
-real GDP declines
-investment spending declines
-unemployment rises

243

Which variable causes the biggest decline in GDP during recessions but only accounts for a small portion of GDP?

-investment spending accounts for only 1/5 of GDP but it represented 80% of the declines in GDP during Canada’s last three recessions
-much of the decline is attributable to reductions in spending on new factories, housing and inventories

244

What is the natural unemployment rate in Canada?

6-7%
-it never approaches zero, instead it fluctuates around its natural rate

245

How is unemployment affected by recessions?

-when real GDP declines, firms choose to produce a smaller quantity of goods and services so they lay off workers, increasing the rate of unemployment

246

What do most economists say about the classical theory in the short-run and the long-run?

Most economists believe that classical theory describes the world in the long-run, but not in the short-run. In the short-run, real and nominal variables are highly intertwined, and changes in the money supply can temporarily push real GDP away from its long-run trend.

247

What do we mean by a “social recession”?

The daily lives of individuals, their families and whole communities are torn by financial loss, unemployment, fear and declining physical and mental health during economic recessions.

248

Def: Model of Aggregate Demand and Aggregate Supply

The model that most economists use to explain short-run fluctuations in economic activity around its long-run trend

249

The Model of Aggregate Demand and Aggregate Supply focuses on the behaviour of which two variables?

-real GDP, a real variable
-overall price level (measured by the CPI or GDP deflator), a nominal variable

250

Def: Aggregate demand curve

A curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level

251

Def: Aggregate Supply Curve

A curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

252

Why is the Aggregate Demand Curve downward sloping (Summary)?

-a fall in the price level increases the quantity of goods and services demanded
1) consumers are wealthier, which stimulates the demand for consumption goods
2) interest rates fall, which stimulates the demand for investment goods
3) the exchange rate depreciates, which stimulates the demand for net exports
*assume “other things equal” which means money supply is fixed (amount of money in economy is fixed)

253

Why the Aggregate Demand Curve slopes downward: The Wealth Effect

-nominal value of the dollar is fixed (always 1$) but real value of money is not fixed
-when the price level falls, the value of money rises, which increases your real wealth and your ability to buy goods and services so want to spend more, which also means a larger quantity of goods and services demanded

254

Why the Aggregate Demand Curve slopes downward: The Interest Rate Effect

-a lower price level means less money people need to hold to buy goods and services so try to reduce their holdings of money by lending some out, which reduces interest rates on bonds and loans, encourages greater spending on investment goods and finally increases the quantity of goods and services demanded

255

Why the Aggregate Demand Curve slopes downward: The Real Exchange Rate Effect

-for a given nominal exchange rate, a lower price level causes the real exchange rate to depreciate, making Canadian produced goods and services cheaper relative to foreign produced goods and services, which stimulates Canadian net exports and increases the quantity of goods and services demanded

256

Why might the aggregate-demand curve shift: Changes in consumption

-an event that makes consumers spend more at a given price level (tax cut, stock market boom) shifts the aggregate demand curve to the right
-an event that makes consumers spend less at a given price level (tax hike, stock market decline) shifts the aggregate demand curve to the left

257

Why might the aggregate-demand curve shift: Changes in investment

-an event that makes firms invest more at a given price level (optimism about the future, fall in interest rates due to an increase in money supply) shifts the aggregate demand curve to the right
-an event that makes firms invest less at a given price level (pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the aggregate demand curve to the left

258

Why might the aggregate-demand curve shift: Government purchases

-an increase in government purchases of goods and services (greater spending on defence or highway construction) shifts the aggregate demand curve to the right
-a decrease in government purchases of goods and services (a cutback in defence or highway spending) shifts the aggregate demand curve to the left

259

Why might the aggregate-demand curve shift: Net exports

-an event that raises spending on net exports at a given price level (a boom experienced by a major trading partner, an exchange rate depreciation) shifts the aggregate demand curve to the right
-an event that reduces spending on net exports at a given price level (a recession experienced by a major trading partner, an exchange rate appreciation) shifts the aggregate demand curve to the left

260

What is the difference between the aggregate supply curve in the long-run and the short-run?

In the long run, the aggregate supply curve is vertical, whereas in the short run, the aggregate supply curve is upward sloping.

261

Why is the aggregate supply curve vertical in the long run?

-in the long run, an economy’s production of goods and services (its real GDP) depends on its supplies of labour, capital, and natural resources and on the available technology used to turn these factors of production into goods and services
-because price level does not affect these long run determinants, the supply curve is vertical
-a graphical representation of the classical dichotomy and monetary neutrality
-implies that the quantity of output (real variable) does not depend on level of prices (nominal variable)

262

How does a change in price level affect the long-run aggregate supply curve?

Does not affect the quantity of goods and services supplied in the long run.

263

Natural level of output / potential output / full-employment output

The production of goods and services that an economy achieves in the long run when unemployment is at its normal rate.

264

Why might the aggregate supply curve shift: Changes in labour

-an increase in the quantity of labour available (perhaps due to a fall in natural rate of unemployment) shifts the aggregate-supply curve to the right
-a decrease in the quantity of labour available (perhaps due to a rise in the natural rate of unemployment) shifts the aggregate-supply curve to the left

265

Why might the aggregate supply curve shift: Changes in capital

-an increase in physical or human capital shifts the aggregate supply curve to the right
-a decrease in physical or human capital shifts the aggregate supply curve to the left

266

Why might the aggregate supply curve shift: Changes in natural resources

-an increase in the availability of natural resources shifts the aggregate supply curve to the right
-a decrease in the availability of natural resources shifts the aggregate supply curve to the left

267

Why might the aggregate supply curve shift: Changes in technology

-an advance in technological knowledge shifts the aggregate supply curve to the right
-a decrease in available technology (perhaps due to government regulation) shifts the aggregate supply curve to the left

268

What do short-run fluctuations represent?

Short-run fluctuations in output and the price level should be viewed as deviations from the continuing long-run trends.

269

Explain what happens when the long-run growth and inflation in the model of aggregate demand and aggregate supply?

-in the long run, technological progress shifts the long-run aggregate supply to the right
-growth in money supply (done by the Central Bank) shifts the aggregate demand to the right
-this leads to growth in output
-an ongoing inflation of price levels

270

Why is the aggregate supply curve sloping upward in the short run?

-an increase in the overall price level tends to raise the quantity of goods and services supplied
-a decrease in the price level tends to reduce the quantity of goods and services supplied
*the quantity of output supplied deviates from its long run or “natural” level when the actual price level deviates from the price level that people expected to prevail (when price level rises above the expected level, output rises above its natural level and when the price level falls below the expected level, output falls below its natural level)
*the three theories will not persist forever!

271

Theories for upward slope of the short-run aggregate supply curve: The Sticky Wage Theory

-because nominal wages are slow to adjust to changing economic conditions (wages are sticky in the short run)
-nominal wages are based on expected prices and do not respond immediately when the actual price level turns out to be different from what was expected
-firms have an incentive to produce less than the natural level of output when the price level turns out to be lower than expected and to produce more when the price level turns out to be higher than expected

272

Theories for upward slope of the short-run aggregate supply curve: The Sticky-Price Theory

-emphasizes that the prices of some goods and services also adjust sluggishly in response to changing economic conditions
-slow adjustment of prices occurs in part due to costs to adjusting prices (menu costs)
-an unexpected fall in price level leaves some firms with higher than desired prices which depress sales and induce firms to reduce the quantity of goods and services they produce

273

Theories for upward slope of the short-run aggregate supply curve: The Misperceptions Theory

-changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output
-a lower price level causes misperceptions about relative prices and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied

274

What is the formula for the quantity of output supplied?

Quantity of output supplied = natural level of output + a (actual price level-expected price level) SHORT RUN
Where a is a number that determines how much output responds to unexpected changes in the price level

Quantity of output supplied = Natural level of output LONG RUN

275

Why the Short-Run Aggregate-Supply Curve Might shift: Changes in the Expected Price Level

**all the same reasons in the long-run except for an additional reason:
-a decrease in the expected price level shifts the short-run aggregate-supply curve to the right
-an increase in the expected price level shifts the short-run aggregate-supply curve to the left (wages are higher, costs increase and firms supply a smaller quantity of goods and services at any given price level)

276

How does a wave of pessimism affect the economy?

-affects spending plans so affects the aggregate-demand curve
-households and firms want to buy a smaller quantity of goods and services for any given price level, reduces aggregate demand so shifts to the left
-causes output to fall in the short-run and price level to fall = recession
-firms respond to lower sales and production by reducing employment (rising unemployment) and falling incomes
-expected price level falls which alters wages, prices and perceptions
-firms begin to bargain for lower nominal wages, which encourages firms to hire more workers an expand production
-over time, the short-run aggregate supply curve shifts to the right
-now in the long run, price level falls and output returns to its natural level
*the long-run effect of a shift in aggregate demand is a nominal change (price level is lower) but not a real change (output is the same)

277

What are the three important lessons of shifts in aggregate demand?

1) in the short-run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services
2) in the long-run, shifts in aggregate demand affect the overall price level but do not affect output
3) policymakers who influence aggregate demand can potentially mitigate the severity of economic fluctuations

278

How does an increase in production costs affect the economy?

-production costs affect the firms that supply goods and services so does changes to the aggregate-supply curve
-higher production costs make selling goods and services less profitable, firms now supply a smaller quantity of output for any given price level
-short-run aggregate supply curve shifts to the left
-causes output to fall
-price level rises
*economy experiences both stagnation (falling output) and inflation (rising prices) =stagflation
-firms raise their expectations of the price level and set higher nominal wages, so costs rise again and short-run aggregate supply curve shift further to the left (stagflation even worse) =wage-price spiral
-low level of output and employment will put downward pressure on worker’s wages due to less bargaining power when unemployment is high
-nominal wages fall, producing goods and services become more profitable and the short-run aggregate supply curve shifts to the right
-price level falls and quantity of output approaches its natural level (in the long run)

279

Def: stagflation

A period of falling output and rising prices

280

What does it mean when policymakers accommodate the shift in aggregate supply curve?

-accepts a permanently higher level of prices to maintain a higher level of output and employment

281

What are the two important lessons about the shifts in aggregate supply?

1) shifts in aggregate supply can cause stagflation-a combination of recession (falling output) and inflation (rising prices)
2) Policymakers who can influence aggregate demand can potentially mitigate the adverse impact on output, but only at the cost of exacerbating the problem of inflation

282

Def: Cartel

A group of sellers that attempts to thwart competition and reduce production in order to raise prices