final review problematic ones Flashcards
1
Q
axes of the net export function
A
Y AXIS: imports and exports
X AXIS: actual national income
2
Q
NX function is drawn holding what constant?
A
- foreign GDP
- domestic and foreign prices
- exchange rate
3
Q
what happens to NX function with an increase in foreign income?
A
increase in foreign income leads to MORE FOREIGN DEMAND for Canadian goods
X increases
NX shifts UPWARDS
4
Q
what happens to NX function with a rise in Canadian prices (holding foreign prices constant)?
A
decreases X
IM function rotates upwards (higher m) as Canadians switch towards foreign goods
NX function shifts DOWN and gets STEEPER
5
Q
what could a rise in Canadian prices relative to foreign prices be caused by?
A
- change in EXCHANGE RATE
- change in PRICE LEVELS
6
Q
what do imports and taxes do to z?
A
they make it smaller
7
Q
what do imports and taxes do to the simple multiplier?
A
also make it smaller
SM = 1/(1-z)
z = MPC (1-t)-m
8
Q
intuition behind idea that imports and taxes make the simple multiplier smaller
A
imports and taxes REDUCES the marginal propensity to spend out of national income
and thus reduces the value of the simple multiplier
9
Q
the higher is m, the ________ is the simple multiplier
A
lower
10
Q
the higher is t, the ______ is the simple multiplier
A
lower
11
Q
simple multiplier with and without government and foreign trade
A
WITH:
SM = change in Y/change in A
SM = 1/(1-z)
SM = 1 / (1-MPC)
WITHOUT:
SM = change in Y/change in A
SM = 1/(1-z)
SM = 1 / ( 1 - (MPC (1-t) - m)
12
Q
fiscal policy
A
use of the government’s spending (G) and tax policies (t)
goal = stabilization
stabilization = policy attempts to stabilize Y at or near Y*
is often clear in which DIRECTION fiscal policy should be adjusted, but less clear how MUCH is necessary
13
Q
fiscal policy - what happens when gov REDUCES t or INCREASES G?
A
AE curve shifts up
multiplier effect in motion
increases equilibrium national income
14
Q
fiscal policy - what happens when gov increases t or decreases G?
A
AE curve goes down
decreases equilibrium national income
15
Q
say government reduces G by $100 million - how much will equilibrium national income fall by?
A
fall by decrease in G ($100 million)
multiplied by the simple multiplier
so if simple multiplier = 1.30, then change in Y is $130 million
essentially, change in Y = change in G times simple multiplier
16
Q
simple macro model = based on 3 central concepts
A
- equilibrium national income
- simple multiplier
- demand-determined output
17
Q
simple multiplier assumption and demand-determined output assumption are closely tied to assumption of what?
A
a constant price level
18
Q
when is the assumption of a constant price level a reasonable assumption?
A
- when output is below potential, firms can increase output without increasing costs
- when firms are price setters, they often respond to shocks by changing output (and only later changing price)
19
Q
what does increasing G do? what about lowering t?
A
increasing G shifts the AE curve upwards
lowering t makes the slope of the AE curve steeper
20
Q
a higher t does what to the AE function? what about a lower t?
A
higher t causes the AE function to become FLATTER
lower t causes the AE function to become STEEPER
21
Q
if the shock affects the slope, can you use the simple multiplier?
A
no
can only use the simple multiplier if the shock affects the constant
22
Q
if exports increase by $1 billion, then how do we calculate the change in equilibrium national income?
A
equilibrium national income will increase by $1 billion times the simple multiplier
23
Q
looking at our AE function, explain why increase in P shifts the AE function down
A
AE = (a + I + G + X) + [b (1 - t) - m] Y
Prices affect a and X
a: increased prices mean less consumption so a falls
X: if prices in our economy increase, our goods become less attractive in the international market, so X falls
24
Q
wealth effect in a nutshell
A
decrease inn consumption because of increase inn prices
25
for any given P, the AD curve shows…
the level of real GDP for which desired AE equals actual GDP
26
2 reasons why the AD curve is negatively sloped
1. a fall in price level leads to rise in private sector wealth - this increases desired consumption and thus leads to an increase in equilibrium GDP
2. a fall in price level (for given exchange rate) leads to a rise in net exports and thus leads to an increase in equilibrium GDP
27
what does the horizontal shift of the AD curve equal?
the simple multiplier times the change in autonomous spending
28
the AS curve relates...
the price level to the quantity of output that firms would like to produce and sell
29
AS curve is drawn for a given...
1. set of factor prices
2. level of technology
30
what happens to slope of AS curve as output rises?
slope increases
when output is low, firms typically have EXCESS CAPACITY so costs don’t rise as fast
but when output is nearer Y*, costs RISE as output rises, so firms need higher prices
31
what causes the AS curve to shift up?
anything that increases firms’ costs
ie. increased factor prices
ie. more expensive technology
32
Keynesian AS curve
extreme version of the AS curve
it’s horizontal over some range of real GDP
range where real GDP is below potential and firms are operating with excess capacity
firms can respond to changes in demand by altering output while keeping prices constant
33
with a horizontal AS curve, what determines the amount of output produced?
the position of the AD curve
it's demand-determined
34
possible causes of demand shocks
1. increase in C
2. increase in I
3. increase in G
4. increase in NX
35
the multiplier in a model where the price level varies - what happens with an increase in P?
AS curve is upward sloping in a model where the price level varies
so increase in AE is subject to increased prices - this will dampen the multiplier effect
so the multiplier effect is smaller than the simple multiplier effect
36
effect of any given shift of the AD curve will depend on...
the slope of the AS curve
1. steeper AS slope means greater price effect and smaller output effect
2. flatter AS slope means smaller price effect and greater output effect
37
possible causes of AS shocks
1. changes in prices of inputs
2. changes in wages
3. changes in technology
38
Asian Crisis and the Canadian Economy
1. 1997 - economies of Malaysia, Indonesia, Thailand, South Korea and Philippines - suffered major RECESSIONS
2. AD: these economies are important users of raw materials and their demand for them declined sharply - LEFTWARD SHIFT OF CAD AD
3. AS: CAD firms use raw materials as inputs. the reduction in prices of raw materials meant a reduction in costs for firms - RIGHTWARD SHIFT OF CAD AS
net effect of these 2 shocks = reduction in CAD AD
(because effect on exports was larger than effect on supply)
39
analyzing 2020 pandemic recession with the AD/AS model
1. economy's ability to combine land, labour and capitol to produce output was severely reduce - LARGE LEFTWARD SHIFT OF AS CURVE
2. both businesses and households reduced their demand - LARGE LEFTWARD SHIFT OF AD CURVE
3. by mid-2021, vaccines allowed returns to work and economies began to recover
4. AS shocks reversed, but LESS THAN EXPECTED
5. once stores, restaurants, airlines and hotels were able to safely conduct business, households and firms returned to normal levels of demand - AD shock quickly reversed
40
effects of 25% increase in US tariffs on Canadian imports
1. AD will fall due to fall in NX
^ exports will decrease due to reduced demand from US
^ imports will also decline due to CAD retaliation, but the reduction will be smaller than the drop in exports
2. AS will shift left
^ higher tariffs increase prices of imported goods
^ increased costs of imported inputs raises production costs for CAD firms
^ their cost-push effect shifts the AS curve to the left, leading to HIGHER PRICES and LOWER OUTPUT
41
why is the multiplier smaller with the AS curve positive?
because with a positive AS curve, producers only produce more output if prices are higher
so the effect on equilibrium will be smaller because it's constrained by higher prices
change in output is smaller
42
short run adjustment of factor prices versus long run
SHORT RUN:
1. factors prices assumed to be constant
2. tech and factor supplies assumed to be constant
ADJUSTMENT:
1. factor prices are flexible
2. tech and factor supplies assumed to be constant
LONG RUN:
1. factor prices have fully adjusted
2. tech and factor supplies are changing
43
what happens to GDP in short run, during adjustment, and in the long run?
SHORT RUN:
real GDP (Y) is determined by AS and AD intersection
ADJUSTMENT:
factor prices adjust to output gaps, real GDP eventually returns to Y*
LONG RUN:
potential GDP (Y*) grows over long run
44
inflationary output gap formation and closing
1. Y > Y*
2. increased demand for G & S - higher demand for labour
3. wages and unit costs increase
4. prices rise
5. higher prices reduce demand
6. demand falls back down until it reaches AS curve
RESULT IS LOWER OUTPUT AND HIGHER PRICES
45
adjustment asymmetry
inflationary output gaps typically RAISE WAGES QUICKLY
recessionary output gaps often REDUCE WAGES SLOWLY (downward wage stickiness)
46
what curve summarizes the adjustment process after output gaps?
the Phillips Curve
47
Phillips curve was originally drawn as...
negative relationship between UNEMPLOYMENT RATE and RATE OF CHANGE IN NOMINAL WAGES
Y > Y* = excess demand for labour = wages rise
Y < Y* = excess supply of labour = wages fall
Y = Y* = no excess supply or demand = constant wafes
48
now, what's the Phillips curve drawn to show?
negative relationship between INFLATION and UNEMPLOYMENT
when unemployment is low, inflation is high
when unemployment is high, inflation is low
49
why is inflation high when unemployment is low?
because when labour market is TIGHT (low unemployment), workers have more BARGAINING POWER and employers raise wages to attract/retain talent
50
what's slower - recovery from a contractionary or a recessionary AD shock?
recovery from a CONTRACTIONARY AD shock
because of "sticky downward wages"
price level takes longer to fall
51
following either a demand or supply shock, the speed that output returns to Y* depends on...
wage flexibility
flexible wages lead to an adjustment process that quickly pushes economy back to potential output
but if wages are slow to adjust, the economy's adjustment process is sluggish and output gaps persist
52
when is the economy in long run equilibrium?
when factor prices are no longer adjusting to output gaps
Y = Y*
53
vertical line at Y* is sometimes called what?
long run aggregate supply curve
classical aggregate supply curve
54
what's potential output determined by in the long run?
technology, labour, capital, resources...
(not price)
changes in the price level (inflation/deflation) can lead to SHORT TERM ADJUSTMENTS in output but in the long run, prices don't affect the economy's fundamental capacity to produce G & S
55
what does the vertical nature of the LRASC tell us?
that it's independent of price level
56
what determines P in the long run?
AD
57
what's the motivation for fiscal stabilization policy?
to reduce the volatility of aggregate outcomes
58
what are the options when AD or AS shock pushes Y away from Y*?
1. use fiscal stabilization policy
2. wait for recovery of private sector demand (shift in AD curve)
3. wait for economy's adjustment process (shift in AS curve)
59
5 points on Canada's fiscal response to the 2008-2009 recession
1. US housing problem > soon became a global financial crisis
2. sharp decline in the FLOW OF CREDIT > essential input for firms who need credit
3. decline in US economic activity > affected Canada (through REDUCED EXPORTS)
4. coordination among leaders of world's major economies > measures to restore financial and economic activity & FISCAL ACTIONS
5. CANADA: infrastructure spending, targeted income-tax reductions, expansion of the employment insurance program
60
fiscal policy in the great depression
Great Depression - usually dated as beginning with massive stock market crash in 1929 - was one of the MOST DRAMATIC ECONOMIC EVENTS of the 20th century
depth and duration made worse by FUNDAMENTAL MISTAKES in POLICY
1932, CAD prime minister said: “we’re now faced with the most real crisis in the history of Canada. To maintain our credit we must practice the most rigid economy and not spend a single cent.”
DEFICIT INCREASED BUT NOT CAUSED BY A POLICY DECISION TO REDUCE TAX RATES, INSTEAD CAUSED BY A REAL FALL IN GDP
61
paradox of thrift
1. SHORT RUN: increase in desired saving leads to reduction in GDP
^ shifts AD left and reduces GDP
^ what may be good for an individual in isolation ends up being undesirable for the economy as a whole
2. LONG RUN: doesn't apply
^ in long run, AD doesn't influence level of GDP
^ increase in savings in long run has effect of increasing investment, and therefore increasing potential output
62
discretionary versus automatic fiscal stabilization
DISCRETIONARY:
occurs when gov actively changes G and/or t in an effort to steer real GDP
AUTOMATIC:
occurs because of the design of the tax and transfer system
63
tax and transfer system
(mechanism behind automatic fiscal stabilization)
1. as Y changes, net tax revenue changes
2. the SIZE OF MULTIPLIER is REDUCED (presence of t means a flatter AE)
3. the output response to shocks is dampened
64
algebra behind the fact that the lower the net tax rate (t), the larger the simple multiplier
marginal propensity to spend on national income (z)
z = MPC (1 - t) - m
simple multiplier = 1 / (1 - z)
65
limitations of discretionary fiscal policy
1. impossible to "fine-tune"
2. long lags (decision lag and execution lag)
3. temporary versus permanent changes in policy
66
discretionary fiscal policy temporary versus permanent changes - the more FORWARD LOOKING...
the more forward looking the household, the smaller the effects of what are perceived to be temporary changes in taxes
because people know that if gov reduces taxes, this action will soon have to be financed with increased taxes down the line
67
consequences of fiscal policy that increases G
1. increase in G temporarily increases real GDP
2. adjustment: Y will return to Y* but at higher prices
3. GDP composition will be altered: problem if investment is lower than in new long run equilibrium (crowding out private investment)
4. lower investment = slower rate of accumulation of capital - may reduce growth rate of potential output
68
consequences of fiscal policy that reduces t
1. increase in real GDP
2. adjustment: Y will return to Y* but at higher prices
3. long run effect: lower corporate income tax rates makes investment more profitable to firms
4. increase in investment will tend to increase future growth rate of potential output
APPEARS TO BE NO TRADE-OFF between short and long run!
(but it does mean less gov spending on things like public education, healthcare, national parks etc)
69
what determines the slope of the net export function?
the marginal propensity to import
70
the vertical line in a long run AD and AS model depicts that...
potential real income is compatible with any price level
71
a common measurement of a country's rate of economic growth
chang in output per capita
72
brush up on rule of 72
time to double = 72/annual growth rate
73
what happens to the money supply when the BoC sells gov bonds?
the money supply will decrease
1. central bank sells bonds to banks or the public
2. buyers pay for the bonds with money from their bank accounts
3. that money is transferred to the central bank and is taken out of circulation
4. banks now have less money to lend, so the overall money supply shrinks
74
money supply is said to be an endogenous variable because it's determined by the economic decisions of...
households
firms
commercial banks
central bank
75
suppose a country runs a budget deficit. assume private savings and trade balance are unaffected. how would this affect the equation S + (T - G) = I + (X - IM)?
T < G
T - G is negative
keeping S and (X - IM) fixed as indicated, this implies that there are fewer funds available for private investment
consequently, private investment (I) has to be lower
76
describe the potential implications of running a large budget deficit in the long run
implications of a large budget deficit in long run DEPEND on the REASONS BEHIND THE DEFICIT
if deficit is from INCREASED GOV SPENDING, its impact would VARY based on whether the expenditure is focused on INVESTMENT or CONSUMPTION
if deficit is due to REDUCTION IN TAXES, it may not necessarily have negative implications for the long run
CAREFUL ANALYSIS is REQUIRES to assess the overall economic impact of the deficit
77
suppose that wealth increases by 200 - how does this affect the consumption function and the saving function?
consumption function shifts up in a parallel fashion (an increase of 200 at every level of real national income)
saving function shifts down in a parallel fashion (decrease of 200 at every level of real national income)
78
Suppose a government collects $12.3 billion in various tax revenues, and pays $2.8 billion in debt interest, $9.1 billion in social security benefits, and $0.4 billion in government employee wages. What is the direct contribution to GDP coming from this government’s fiscal actions?
$0.4 billion
79
“High mortgage rates discourage new house purchases.” Assuming that housing construction falls when house sales fall… what happens to AE graph?
The purchase of new houses is the residential component of investment.
The investment function shifts down, assuming that housing construction falls when house sales fall.
This shifts the AE function down and reduces the equilibrium level of national income.
80
effect on GDP - a tax rebate of $5 billion will add directly to what? what effect will this have?
will ADD DIRECTLY to DISPOSABLE INCOME
so the initial direct increase in aggregate demand will be $5 billion TIMES THE MPC
81
Can you offer one reason why the minister of finance might choose to emphasize increases in government spending rather than tax reductions in a federal budget in an effort to increase national income?
The eventual effect on national income (after the multiplier effect) will be smaller after a tax reduction than in the case of the increase in spending
This basic logic partly explains why the federal government emphasized increases in spending rather than tax reductions
82
t0 versus t1, and the equation that relates them
t0: the level of net tax revenues that would exist if national income were 0
t1: the net tax rate
T = t0 + t1 (Y)
83
m0 versus m1 and the equation that relates them
m0 = autonomous level of import
m1 = marginal propensity to import
84
what would a decrease in demand for Canada’s exports do to the AS curve?
cause a movement DOWNWARD and to the LEFT along the AS curve
exports are part of AGGREGATE DEMAND, so a decrease in export demand would decrease AD
this decrease in demand would typically lead to LOWER OUTPUT and LOWER PRICES in the short run
but WOULD NOT DIRECTLY SHIFT the AS CURVE
instead, the economy would experience MOVEMENT ALONG THE AS CURVE, because decrease in demand leads to reduction in output and employment at the existing price level
85
law of diminishing returns
exemplified by the AS curve’s increasing slope as output increases
law of diminishing returns to the variable factor (usually labour) means that increases in output may only be possible by driving up unit production costs, thus requiring a rise in prices
86
the larger the value of the simple multiplier, the ________ the AD curve
FLATTER
larger value of z = steeper aggregate expenditure line
for given change in price, the change in real GDP is larger when the multiplier is larger
the larger horizontal movement (GDP change) for a given vertical movement (price change) means the curve is flatter
LARGER MULTIPLIER > AD IS MORE RESPONSIVE TO PRICE CHANGES > FLATTER AD CURVE
87
the ________ the multiplier, the smaller the size of the shift in the AD curve for any given change in autonomous expenditure
smaller
88
a flatter AD curve means that GDP will be MORE or LESS responsive to changes in price?
MORE
(so flatter AD curve = steeper z)
89
long run: changes in what determine changes in Y?
changes in Y* (potential output)
factor prices have adjusted and technology has changed
90
what causes stagflation?
contractionary AS shock
ie. increase in price of oil
AS shifts up, GDP decreases and prices rise
recessionary gap opens up
91
business cycle dynamics in closing inflationary gaps
1. when Y > Y, shortages eventually arise and restrict further expansion
2. revision of firms expectations - they reduce their desired investment
3. there's a reduction in consumer confidence and a reduction in desired consumption
(real GDP moves back to Y)
92
business cycle dynamics in closing recessionary gaps
1. when Y < Y*, consumer durable goods (cars, appliances, electronics) become obsolete
2. normal replacement expenditures and firm's replacement investments recover
3. there's a revival of favourable expectations
(real GDP rises back towards Y*)
93
what curve does the economy's adjustment process concern?
the AS curve
ie. with shortages, the AS curve will shift up
ie. with surpluses, the AS curve will shift down
94
why doesn't the paradox of thrift apply in the long run?
because AD has no effect on the level of GDP in the long run
an increase in savings caused by thriftiness in the long run will actually boost investment and potentially increase GDP
95
we can change T to...
keep output closer to potential
when we increase T, the slope of the AE curve (z) becomes flatter
automatically makes the economy more stable
96
fiscal stabilization policy: an increase in G
1. increase in G temporarily increases real GDP
2. adjustment: Y will return to Y* but at higher prices
3. GDP composition will be altered (recall: Y = C + I + G + NX)
^ higher G and lower private investment
4. slower rate of accumulation of capital
(this may reduce rate of growth of potential output)
97
increase in G can crowd out what?
PRIVATE INVESTMENT
^ risk of fiscal stabilization policy that increases G
increased gov spending means the supply of funds will decrease
means we have less savings in the economy
lower NS means a HIGHER INTEREST RATE
some firms will decide not to borrow and invest because of the higher interest rate
SO INCREASE IN G CAN CROWD OUT PRIVATE INVESTMENT
98
small differences in income growth rates make…
enormous differences in levels of income over a few decades
ie. income is 100 in year 0
^ at growth rate of 3% per year, it’ll be 134 in 10 years, 438 after 50 years, 1922 after 100 years
^ big differences in income levels between 2% and 3% growth rates
99
rule of 72
time to double = 72 / interest rate (%)
100
economic growth that raises average income tends to change the whole society's...
consumption patterns
1. shifts away from tangible goods and TOWARDS SERVICES
2. economic growth also provides HIGHER INCOMES that call for demands for CLEANER ENVIRONMENT
101
addressing poverty and income inequality
1. in recent years, majority of aggregate income growth in many countries (including Canada) has been ACCRUING TO THE TOP EARNERS in the income distribution
2. while average per capita income has been rising, there's also been a RISE IN INCOME INEQUALITY
3. poverty and income inequality are important challenges for public policy
102
2 costs of economic growth
1. FORGONE CONSUMPTION
^ economic growth (which promises more G & S in the future) is achieved by consuming fewer goods today
2. SOCIAL COSTS
^ some worker's skills become obsolete
103
4 major determinants of growth
1. growth in LABOUR FORCE
2. growth in PHYSICAL CAPITAL
3. growth in HUMAN CAPITAL
4. TECHNOLOGICAL IMPROVEMENT
104
in short run, real GDP does what to determine equilibrium?
it adjusts until S = I
recall:
Y = C + I
Y - C = I
S = I
105
national savings in the long run
private savings + public savings
(Y* - T - C) + (T - G)
Y* - C - G
106
economy's market for financial capital is made up of...
1. national savings supply curve
2. investment demand curve
107
aggregate production function
GDP = F^T (L, K, H)
F^T = indicates the function depends on the state of technology
L = labour
K = physical capital
H = human capital
108
2 key assumptions in the aggregate production function
1. displays diminishing marginal returns when any one of the factors is increased on its own
2. displays constant returns to scale when all factors are increased tgt
109
how do banks create more money?
by issuing more PROMISES TO PAY (deposits) than they have in cash reserves
110
3 main characteristics of the central bank
1. acts as a bank to the banking system (banker for commercial banks)
2. usually government-owned (acts as fiscal agent of the gov)
3. the sole money-issuing authority (regulates money supply)
111
joint responsibility system
BoC has considerable autonomy
but is formally accountable to the Minister or Finance and Parliament
112
commercial bank
privately-owned, profit-seeking institution
provides variety of financial services
important financial intermediaries - crucial for smooth operation of credit markets
113
when we say that commercial banks are financial intermediaries, what do we mean?
they provide credit and accept deposits
(crucial for the smooth operation of credit markets)
114
balance sheet of commercial banks
ASSETS:
1. reserves (R)
2. gov securities (G)
3. loans (L)
LIABILITIES:
1. deposits (D)
115
why are deposits liabilities for commercial banks?
because they're something the CBs must respond to
must RESPOND to the demand for a deposit with a WITHDRAWAL
116
balance sheet of central bank
ASSETS:
1. government securities (G)
LIABILITIES:
1. C (notes in circulation)
2. R/D (reserves - deposits from commercial banks)
117
target reserve ratio
fraction of deposits the bank wants to hold as reserves
(either in VAULT CASH or in DEPOSITS with central bank)
^ below this is risky, above this is unnecessary
118
March 2019 - Canadian banking system held what fraction of their deposits as reserves?
less than 1%
119
excess reserves are central in what process?
money creation process
120
what's a new deposit?
deposit of cash that's NEW to banking system
1. someone may IMMIGRATE to Canada
2. someone deposits cash that was being STORED UNDER THE BED
3. BoC purchases a GOV SECURITY from an individual/firm
121
with no cash drain, a banking system with a target reserve ratio of v will change its deposits by…
1/v times any change in reserves (the new deposit)
change in deposit = (1/v) (change in new deposits)
122
deposits versus reserves
DEPOSITS: money that customers put into banks (chequing or savings accounts)
^ LIABILITY for bank - it owes this money to depositors
RESERVES: portion of deposits that the bank keeps on hand (either in vault or in deposits with central bank)
^ ASSET for the bank
123
difference between new deposits and addition to reserves
new loans
124
if c is the currency-deposit ratio, the final change in deposits is given by:
change in deposits = (1/(c+v) (new cash deposit)
^ accounts for the cash drain
125
c and v
c = currency-deposit ratio (in case of a cash drain)
v = target reserve ratio
126
generally, money supply equals what?
currency + deposits
127
near money
1. store of value
2. readily converted into a medium of exchange
ie. SHORT TERM BONDS
ie. TERM DEPOSITS
128
money substitutes
1. serve as a TEMPORARY medium of exchange but are not a store of value
ie. CREDIT CARD
129
if firms need to borrow, what can they do?
issue bonds
130
what do people look at when deciding whether to buy a bond or store money in a savings account?
the market interest rate
if market interest rate fosters a profit higher than the bond yield, they'll be willing to pay less for the bond
(higher market interest rate = you'll earn more on money stored in a savings account)
131
present value (PV)
the value NOW of one or more payments or receipts in the future
132
what happens to PV of bonds if market interest rate increases?
PV decreases
algebraically, this happens because interest rate is in denominator so we're dividing the return by a larger number
133
what do you need to calculate the yield of a bond?
the PV and the price
if there's no risk at all, you should get the market interest rate
Price = $X / (1 + yield)
134
PV and interest rate when there's no risk
PV = price of bond
interest rate = yield
135
with higher interest rate, what happens to bond PRICE and YIELD?
price decreases
yield increases
(because for the same sequence of payments you are paying less)
136
higher market interest rate = _______ in price of bonds = _______ in bond yields
higher market interest rate
DECREASE in price of bonds
INCREASE in bond yields
137
if a bond is high risk, what's its yield?
also high
high risk = lower PV = lower price = higher yield
138
relationship between demand for money and interest rate
negative
139
3 reasons for holding money
1. transactions motive
2. precautionary motive
3. speculative motive
140
speculative motive for holding money
if interest rates are expected to rise in the future, bond prices are expected to fall, and bondholders will experience a decline in the value of their bond holdings
expectations of higher interest rates in the future will lead to HOLDING OF MORE MONEY NOW
141
equilibrium market price of a bond
the PV of the stream of income generated by the bond
(should be no higher and no lower than the PV)
142
opportunity cost of holding money
the INTEREST that could've been earned had that money been used to buy bonds/invest
143
3 determinants of money demand
1. GDP (+)
2. price level (+)
3. interest rate (-)
144
why is interest rate negatively related to money demand?
because it's the OPPORTUNITY COST of holding money
(fall in interest rate reduces the opportunity cost of holding money because the rate of return on bonds declines)
145
money demanded as a function of the interest rate, real GDP and the price level: what causes shifts versus movements of/along the MD curve?
SHIFTS: caused by changes in Y or P
MOVEMENTS: caused by changes in the interest rate
146
monetary equilibrium
occurs at intersection of money supply and money demand curve
occurs at the equilibrium interest rate
147
2 forces that act to achieve monetary equilibrium
1. excess demand for money causes interest raise to rise
2. excess supply of money causes interest rate to fall
148
monetary transmission mechanism
connects money demand and money supply to aggregate demand
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3 stages of monetary transmission mechanism
1. change in money demand or money supply leads to change in EQUILIBRIUM INTEREST RATE
2. change in interest rate leads to change in DESIRED INVESTMENT EXPENDITURE
3. change in desired investment expenditure leads to change in AGGREGATE DEMAND
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summary of the money transmission mechanism
1. increase in money supply or decrease in demand for money
2. excess supply of money
3. fall in equilibrium interest rate
4. increase in desired investment expenditure
5. upward shift in AE curve
6. rightward shift in AD curve
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how does an open economy modify the money transmission mechanism?
with mobile financial capital, an EXTRA CHANNEL is added to the transmission mechanism
1. as interest rates change, financial capital flows between countries
2. this puts pressure on exchange rate
3. as exchange rate changes, net exports change - this adds to the effects on AD
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money transmission mechanism in an open economy summary
1. increase in money supply or decrease in money demand
2. excess supply of money
3. fall in equilibrium interest rate
4. a) increase in desired investment expenditure
4. b) CAPITAL OUTFLOW AND CURRENCY DEPRECIATION (CAD dollars = sold in exchange for foreign currencies in order to buy foreign bonds)
c) increase in net exports (because CAD exporters benefit from depreciated CAD dollar)
5. upward shift of AE curve
6. rightward shift of AD curve
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3 reasons for negative slope of AD curve
1. higher P = lower wealth
2. higher P = lower NX
1. higher P = increased money demand = higher interest rates = LOWER INVESTMENT
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long run neutrality of money
shift in AD curve has different effects in SHORT and LONG run
in long run, output eventually returns to Y*
MONEY NEUTRALITY is the idea that changes in money supply don't have REAL EFFECTS on the economy
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hysteresis
challenges long run money neutrality idea
growth rate of Y* may be affected by short-run path of GDP
1. change in money supply (through effect on interest rate) can affect investment and technological change
2. in long period of unemployment, workers can lose human capital, which will affect future growth rates
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how does the central bank keep the interest rate constant?
shifts the money supply
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how do banks get closer to their target level for reserves?
1. when has EXCESS reserves, it can LEND
2. when has NOT ENOUGH reserves, it can BORROW
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when the interest rate decreases, what happens to the money demand curve?
have a move down the money demand curve
essentially, the money demanded increases
(because the lower interest rate reduces the opportunity cost of holding money)
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school of thought that believes the activist policies of the central bank EXACERBATE economic fluctuations
monetary theory
monetarists advocate a monetary growth rule where the money supply shifts by a fixed amount
(but monetarists do believe in the ability of monetary supply to shift aggregate demand)
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what theory advocates for active government intervention via fiscal policy when economy is in recession?
Keynesians
Keynes believed that sticky wages and prices would keep the economy from adjusting without gov intervention
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stance of new classical theorists on a monetary growth rule
pro monetary growth rule
they believe the public uses rational expectations to formulate opinions about inflation
and economic fluctuations
occur when those expectations differ from reality
they also advocate a monetary growth rule because it would help the public create better inflation forecasts
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how does contractionary monetary policy impact fiscal policy?
contractionary monetary policy (like raising interest rates or selling gov securities) tends to INCREASE BORROWING COSTS and REDUCE OVERALL SPENDING
this impacts fiscal policy:
1. HIGHER DEBT SERVICING COSTS (govs have to spend more on interest payments for existing debt)
2. reduced effectiveness of fiscal stimulus
3. pressure to cut spending
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how is selling government securities a type of contractionary monetary policy?
because it reduces the money supply
here's how it works:
1. central bank sells securities (bonds) to banks and other financial institutions
2. to pay for these bonds, banks use their reserves (money they'd otherwise use to lend)
3. as reserves decrease, banks have less money to lend, so interest rates increase
4. higher interest rates make borrowing more expensive and saving more attractive - people spend and invest less
5. leads to slow growth in AD - helps to cool inflation and slow economic activity
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bond
a debt security
that promises to make periodic payments for a specific period of time
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a rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are _______ than their holding periods
longer
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transmission mechanism - BoC
1. BoC increases target for OVERNIGHT INTEREST RATE
2. commercial bank interest rates go up too
3. higher interest rates dampen consumer spending and reduce business investment
thus, the change is transmitted through its impact on employment and GDP
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why is the annual deficit equal to the annual increase in the stock of government debt?
because the government must BORROW to finance any shortfall in revenues
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why does the overall budget deficit tend to rise during recessions and fall during booms?
because tax revenues tend to rise when real GDP rises, and fall when real GDP falls
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what makes the budget deficit a poor measure of the stance of fiscal policy?
the fact that tax revenues tend to rise when real GDP rises, and fall when real GDP falls
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structural budget deficit
the budget deficit that would exist with the current set of fiscal policies if real GDP were equal to potential GDP
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what do changes in the structural deficit reflect?
changes in the stance of fiscal policy
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The change in the debt-to-GDP ratio from one year to the next is given by
change in d = x + (r - g) x d
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what's the effect of long-run increase in budget deficit in a closed economy?
reduce national saving and increase real interest rates
this increase in interest rates reduces the amount of investment
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what's the effect of long-run increase in budget deficit in an open economy?
push up interest rates and attract foreign financial capital
this leads to a currency appreciation and a reduction in net exports
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unless government debt is incurred to finance worthwhile public investments, the long-term burden of the debt is what?
redistribution of resources away from future generations and toward current generations
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large debt-to-GDP ratio may lead creditors to expect what?
increases in inflation, as the government attempts to finance deficits through the creation of money
such increases in inflationary expectations hamper the conduct of monetary policy
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the higher is the debt-to-GDP ratio, the more __________ is the government in conducting counter-cyclical fiscal policy
constrained
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legislation requiring an annually balanced budget forces what?
forces either expenditures to rise or tax rates to fall during booms
(because tax revenues naturally rise as real GDP increases)
such a requirement produces DESTABILIZING fiscal policy
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cyclically balanced budgets - benefits and difficulties
BENEFITS:
permit short-run benefits of deficits to be realized without incurring the long-run costs of debt accumulation
DIFFICULTIES:
implementation of this policy is difficult, however, since the precise identification of the business cycle is controversial
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Small budget deficits need not lead to increases in the debt-to-GDP ratio if...
the economy is growing
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prudent fiscal policy can permit ________ ______ during recessions and allow the financing of worthwhile public investments, while ensuring what?
budget deficits
while ensuring that the debt-to-GDP ratio does not become excessive
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which of the following purchases by households is considered a CONSUMPTION EXPENDITURE for the purposes of national-income accounting?
1. legal services
2. gov of Cad treasury bill
3. tractors for use on family farm
4. new house
5. purchase of company stock
legal services
(others would be classed under INVESTMENT)
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for a country like Canada, that uses oil as an input and produces & exports oil, a decrease in the world oil price will do what to the AS and AD curves?
AS: decrease it oil price will cause a RIGHTWARD SHIFT of the AS curve
^ because oil is an input and it has just become cheaper
AD: decrease in oil price will cause a LEFTWARD SHIFT of the AD curve
^ because lower oil prices mean less income for oil producers/exporters - so they'll have less money for consumption etc
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which of the following macroeconomic variables in Canada does not display a significant long-run trend over recent decades?
1. level of unemployment
2. price level
3. real GDP
4. unemployment rate
5. level of labour productivity
5. level of labour productivity
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assets and liabilities of commercial banks
ASSETS:
- loans
- reserves
- gov securities
LIABILITIES:
- deposits
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assets and liabilities of central bank
ASSETS:
- gov securities
LIABILITIES:
- deposits (reserves)
- notes in circulation
