tricky tricky Flashcards
1
Q
the larger the value of the simple multiplier, the ________ the AE curve
A
FLATTER
this is because larger simple multiplier means that GDP will change by a larger amount in response to a change in AE
the larger horizontal shift (GDP change) compared to the vertical shift (price change) manifests in a flatter AE curve
2
Q
the larger the value of z, the __________ the AE curve
A
STEEPER
recall when we add t and m to the multiplier function, AE gets flatter because we’re making the value of z smaller
3
Q
a flatter AD curve means that GDP will be MORE or LESS responsive to a change in AE?
A
flatter = more responsive
4
Q
business cycle dynamics in closing inflationary gaps
A
- when Y > Y, shortages eventually arise and restrict further expansion
- revision of firms expectations - they reduce their desired investment
- there’s a reduction in consumer confidence and a reduction in desired consumption
(real GDP moves back to Y)
5
Q
business cycle dynamics in closing recessionary gaps
A
- when Y < Y*, surpluses make consumer goods obsolete
- normal replacement expenditures and firms’ replacement investments recover
- revival of favourable expectations
(real GDP moves back to Y)
6
Q
why doesn’t the paradox of thrift apply in the long run?
A
because in long run, output is determined by potential output (labour, technology, physical capital, labour) - not by AD
savings in the long run will actually boost output and investment
7
Q
we can change T to…
A
keep output closer to potential
when we increase t, the AE curve becomes flatter
this automatically stabilizes the economy
8
Q
excess reserves are central to what?
A
the money creation process
9
Q
deposits versus reserves
A
DEPOSITS: money that customers put in the bank (chequing or savings accounts). these are a LIABILITY for commercial banks.
RESERVES: money that commercial banks have stored in the vault or as deposits at the central bank. these are an ASSET for commercial banks.
10
Q
reserves for _____ _____ are deposits at _____ ______
A
reserves for COMMERCIAL BANKS
are deposits at CENTRAL BANK
11
Q
if firms need to borrow, what can they do?
A
issue bonds
12
Q
what do you need to calculate the yield of a bond?
A
the PV
the current price
13
Q
PV and interest rate when there’s no risk
A
PV = price
interest rate = yield
14
Q
what’s the relationship between the demand for money and the interest rate?
A
negative
because when interest rates are high, then putting money into savings/chequing accounts will make you a lot of money
when interest rates are high, there’s a HIGHER OPPORTUNITY COST for holding money as opposed to putting it in savings/chequing account
15
Q
when interest rates are low, people hold on to _________ money
A
more
(because opportunity cost of holding money is smaller)
16
Q
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?
A
SHIFTS are caused by changes in Y or P
MOVEMENTS are caused by changes in the interest rate
17
Q
excess demand for money does what?
A
causes interest rates to rise
18
Q
excess supply of money does what?
A
causes interest rates to fall
19
Q
3 general stages of the monetary transmission mechanism
A
- changes in the equilibrium interest rate
- changes in investment
- changes in AD
20
Q
hysteresis
A
challenges the idea of the long run neutrality of money
says that Y* is affected by the short term path of GDP
- money supply, through its effect on the interest rate, influences INVESTMENT and TECHNOLOGICAL CHANGE
- after a period of long unemployment, workers can LOSE HUMAN CAPITAL, which will affect future growth rates
21
Q
when the interest rate decreases, what happens to the money demand curve?
A
the money demanded increases
(because the opportunity cost of holding money is now lower)
there’s a shift along the same money demand curve
22
Q
school of thought that believes the activist policies of the central bank EXACERBATE economic fluctuations
A
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)
23
Q
what theory advocates for active government intervention via fiscal policy when economy is in recession?
A
Keynesians
Keynes believed that sticky wages and prices would keep the economy from adjusting without gov intervention
24
Q
stance of new classical theorists on a monetary growth rule
A
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
25
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 (because of high interest rates)
3. pressure to cut spending
26
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 less and invest less
5. leads to slow growth in AD - helps to cool inflation and slow economic activity
27
why does the overall budget deficit tend to rise during recessions and fall during booms?
because as GDP rises, so do tax revenues
and as GDP falls, so do tax revenues
(this makes the budget deficit a bad measure of the stance of fiscal policy)
28
budget deficit equation
G + (i x D) = T + Borrowing
G + (i x D) - T = Borrowing
29
structural budget deficit
the budget deficit that would exist with the current set of fiscal policies if real GDP were equal to potential GDP
changes in the structural budget deficit reflect changes in the stance of fiscal policy
30
change in the debt-to-GDP ratio is reflected by what equation?
change in d = x + (r - g) x d
31
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
32
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
33
large debt-to-GDP ratio may lead creditors to expect what?
monetization of debt
entails 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
34
legislation requiring an annually balanced budget forces what?
in a balanced budget, T = G
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
35
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
36
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
37
what are the short term benefits of deficits?
(these are enabled by cyclically balanced budgets)
1. automatic stabilizers (unemployment insurance and welfare payments automatically increase when economy slows)
2. allows for counter-fiscal policy (ie. increasing spending during recession)
38
what's the role of the primary budget deficit (G − T ) in public debt dynamics?
the primary budget deficit (government spending minus tax revenues, excluding interest payments) directly increases the debt-to-GDP ratio
if the government consistently runs primary deficits, the debt will grow, even if interest rates and growth rates are favourable
according to the article, the U.S. is running a large primary deficit (IMF projects a 6.5% deficit in 2024), which contributes to the continued increase in debt
without significant spending cuts or tax increases, this term alone keeps pushing debt upward
39
how do interest rates affect debt sustainability?
when the interest rate on government debt is higher than the growth rate of the economy (r > g), debt becomes harder to sustain because the cost of servicing the debt grows faster than the government’s ability to generate tax revenues
the article notes that while low interest rates after 2008 helped keep debt manageable, recent rate hikes are reversing that trend
as older debt is refinanced at higher rates, interest payments will rise sharply—projected to reach $728 billion (16% of revenues) in 2024—making debt
sustainability a growing concern
40
how does nominal GDP growth (g) influence the debt-to-GDP ratio?
nominal GDP growth helps reduce the debt-to-GDP ratio by expanding the tax
base
if the economy grows faster than the interest rate (g > r), it becomes easier to
stabilize or reduce the debt burden even with moderate deficits
but, without strong economic growth going forward, the U.S. will struggle to offset its rising interest costs and deficits
41
According to the article, tariffs can affect the exchange rate by reducing imports, which lowers demand for foreign currency. Explain how this mechanism can lead to an appreciation of the domestic currency. Why might this appreciation hurt exporters, and why does the article suggest the actual effect on the dollar was modest in 2018–19?
When tariffs reduce imports, domestic consumers buy fewer foreign goods, decreasing their need to exchange domestic currency for foreign currency.
This reduced demand for foreign currency can lead to an appreciation of the domestic currency (e.g. the U.S. dollar).
A stronger currency makes exports more expensive for foreign buyers, hurting domestic exporters.
However, the article notes that during the 2018–19 tariff period, the effect on the exchange rate was small, explaining only about one-fifth of the dollar’s movement.
This is because exchange rates are influenced by many other factors, such as interest rate differentials and capital flows.
42
The article notes that a one-time increase in prices due to tariffs might be temporary, but also warns of a risk of a wage–price spiral. Explain what a wage–price spiral is and under what conditions a tariff-induced price shock could trigger one.
A wage–price spiral occurs when higher prices lead workers to demand higher
wages to maintain their purchasing power.
If employers grant these increases, they may raise prices further to cover higher labor costs, leading to another round of wage demands.
This feedback loop can cause sustained inflation.
A one-time tariff-induced price increase could trigger a wage–price spiral if inflation expectations are already unanchored (e.g. after several years of high inflation), and if labor markets are tight enough for workers to
negotiate wage increases successfully.
43
The article argues that tariffs reduce firms’ incentives to innovate. What is the economic mechanism behind this? Use the concept of competition and efficiency to explain why protectionism might lead to lower productivity over time.
Tariffs shield domestic firms from foreign competition by making imported goods more expensive.
Without pressure from more efficient foreign producers, domestic firms have less incentive to innovate or improve efficiency. Over time, this can lead to lower productivity growth.
The article cites evidence from Canada in the 1980s–1990s showing that tariff reductions led to more innovation and technology adoption.
Protectionism can thus result in a misallocation of resources and technological stagnation.
44
Who are the main winners and losers from the imposition of tariffs, according to the article? Consider households, domestic producers, exporters, and trading partners in your answer.
Winners include some domestic producers who are protected from foreign competition and can raise prices without losing market share.
However, this comes at a cost: households (consumers) face higher prices; exporters may suffer due to currency appreciation and retaliatory tariffs; and foreign trading partners may experience a loss of output as their exports will decline.
In the long run, the domestic economy as a whole may lose due to inefficiencies, slower innovation, and reduced productivity.
The article also highlights the political risk of favouritism and lobbying for tariff exemptions, which can further distort the system.
45
“will fiscal stimulus overheat the American economy?” - explain why low interest rates may contribute to setting off inflation
REASON ONE: CHEAPER BORROWING
1. low interest rates decrease the cost of borrowing
2. lower costs of borrowing mean more people will take out loans
3. this increases investment and consumption
4. AD will shift to the right
5. if AS doesn't adjust in tandem, then prices will increase and inflation will occur
REASON TWO: MORE EXPENSIVE ASSETS
1. low interest rates increase asset prices (more expensive houses, stocks etc)
2. this leads to wealth effects and increased spending
REASON THREE: WEAKENED CURRENCY
1. low interest rates can decrease the value of a country's currency
2. makes imports more expensive and contributes to higher prices
46
3 reasons why the AD curve is negatively sloped
1. increase in P = decrease in wealth
2. increase in P = decrease in NX
3. increase in P = increase in money demand > increase in interest rates > reduced investment
47
what does the long run Phillips curve look like at the NAIRU?
vertical
48
in order to finance a budget deficit, what must the government do?
sell government securities
finances the deficit by selling bonds, and uses the proceeds from the bonds to fund gov operations
49
3 options in response to demand inflation
1. SMALL rightward AD shock - central bank can afford to do NOTHING
^ will allow economy to have temporary inflation a bit above 2%
^ as long as expectations haven't changed
2. LARGE rightward AD shock - CONTRACTIONARY MONETARY POLICY
^ necessary if inflation has been brought high enough that expectations have begun to change
^ increase interest rates, reduce AD to keep us near Y*
3. MONETARY VALIDATION
^ central bank attempts to keep output gap open (either by keep MS constant or by increasing it)
^ wages are increasing, output is increasing, expectations about inflation are increasing and bank validates these expectations
^ PROBLEM: inflation will accelerate, fast
50
what would happen if bank acted to keep output above Y*?
the ACCELERATION HYPOTHESIS predicts what would happen
states that when real GDP is held above potential, the PERSISTENT INFLATIONARY GAP WILL CAUSE INFLATION TO ACCELERATE
51
potential danger of validating a negative AS shock
wage-price spiral
workers will expect higher wages in response to higher prices
shifts AS curve up
increased prices = more desire for higher wages
inflation expectations have been solidly changed
52
why is reducing inflation costly?
1. lost output
2. unemployment
53
Canada’s 3 notable periods of disinflation
1. 1981-1982: when inflation fell from more than 12% to 4%
^ accompanied by a RECESSION
2. 1990-1992: when inflation fell from 6% to less than 2%
^ led to a RECESSION
3. 2022-2024: inflation went from 8% to 2% WITHOUT RECESSION
^ rare case of disinflation without a major economic downturn
54
3 phases of eliminating a sustained inflation
1. removing monetary validation
2. stagflation
3. resolution
55
sacrifice ratio
the cost of disinflation
(the percentage of lost output/GDP) / (rate of inflation)
56
what does gov do when in a surplus?
uses the opportunity to buy outstanding gov debt
57
positive deficit means gov is...
borrowing
58
negative deficit means gov is...
saving
59
the gov's budget deficit is the same as the change in...
debt
because their deficit is the amount they have to borrow
60
primary budget deficit
the budget deficit minus interest components
primary budget deficit = budget deficit - debt service payments
primary budget deficit = G - T
61
what does the primary budget deficit show?
the extent to which tax revenues can cover government expenditures
(G - T)
62
cyclically adjusted deficit (CAD)
aka structural deficit
the deficit adjusted for the effects of the economic cycle
shows what the deficit would be if economy were operating at FULL POTENTIAL (Y*)
63
why is the CAD useful?
during RECESSIONS, gov tax revenues fall and spending on things like unemployment benefits rises - this increases the deficit (but not necessarily because of poor fiscal management)
during BOOMS, gov tax revenues increase and spending on things like unemployment benefits falls
the CAD filters out any of these temporary effects to give a clearer picture of the GOV'S UNDERLYING FISCAL POSITION
64
CAD gives us a clearer picture of the gov's...
underlying fiscal position
(it filters out the temporary changes in T and G that occur when Y doesn't equal Y*)
65
change in d = x + (r - g) x d
d = dept-to-GDP ratio
x = gov’s primary budget deficit as percentage of GDP
r = real interest rate
g = growth rate of real GDP
66
2 implications coming out of change in d = x + (r - g) x d equation
1. if r > g, then debt will rise unless there's a sufficient surplus
2. if r = g, then all that's required to keep d constant is a primary budget balance
67
why was the Greek economy cutting spending if it was in a deep recession?
at beginning of 2011...
Greece's public debt = 143% of GDP
d = 1.43
average interest rate on gov debt = 1.2%
r = 0.012
real GDP growth = -6.9%
g = -0.069
so to stabilize the Greek debt-to-GDP ratio...
we'd need a primary budget surplus of 11.6%
but in 2011, Greece had a budget deficit of 2.3%
68
crowding out
reduction in private expenditure caused by expansionary fiscal policy
1. higher interest rates (lowers investment)
2. appreciated currency (higher interest rates = more conversions to domestic dollar = lower net exports)
69
crowding out investment - consider a closed economy at Y*
1. expansion in G - reduces national savings
2. increased interest rates
3. increased rates make investment by private firms more expensive
investment falls
70
crowding out investment - consider an open economy
1. expansion in G - reduces national savings
2. increased interest rates
3. higher interest rates attracts foreign capital
4. appreciation of the Canadian dollar
5. lowered net exports
71
if fiscal expansion also increases ____, then what?
if it also increases Y*
then private expenditure will be less crowded out
72
how does the monetization of debt work?
1. gov runs a deficit and ISSUES BONDS
2. central bank buys these bonds, often by CREATING NEW MONEY
3. that money enters the economy (either directly or through banks)
this will stimulate the economy and keep interest rates low
but it risks leading to inflation
73
does gov debt hamper monetary policy?
LEADS TO HIGHER INFLATION EXPECTATIONS
1. consider a very high debt-to-GDP ratio
2. creditors may come to expect the MONETIZATION OF DEBT
this monetization increases inflation expectations
and this makes monetary policy harder
74
does gov debt hamper fiscal policy?
1. govs often try to implement COUNTER-CYCLICAL FISCAL POLICY to smooth out the economic cycle (stabilize)
ie. they increase spending or cut taxes during recessions, and during booms they decrease spending and increase taxes
2. but a HIGH DEBT-TO-GDP RATIO may restrict the gov severely and make them unable to implement stabilizing fiscal policy
75
3 possibilities for formal fiscal rules to prevent excessive debt-buildup
1. annually balanced budgets
2. cyclically balanced budgets
3. maintaining a prudent dept-to-GDP ratio
76
maintaining a prudent debt-to-GDP ratio relies on...
permitting a budget deficit such that stock of debt grows no faster than GDP
77
what was Canada's debt-to-GDP ratio in 2020 and what did policy do and how did their actions change the ratio?
2020 debt-to-GDP ratio = 33%
massive spending increases during pandemic
pushed up the debt ratio by 20%
78
4 factors affecting the exchange rate
1. MONETARY POLICY
^ higher interest rates attract foreign capital (appreciation)
2. FISCAL POLICY
^ recessions weaken the dollar, economic growth can strengthen it
3. INFLATION
^ inflation depreciates the dollar (higher prices reduce demand)
4. TRADE BALANCE
^ surpluses strengthen CAD, deficit weaken it
79
