lOMoARcPSD|5851799
EC290 Macroeconomics final exam
intermediate macro (Wilfrid Laurier University)
StuDocu is not sponsored or endorsed by any college or university
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
EC290 Macroeconomics
Slides 1: introduction to macroeconomics
What macroeconomics is about
 Macroeconomics is the study of the structure and performance of national economies and
of the policies that governments use to try to affect economic performance
 What determines a nation’s long run economic growth?
 What Causes a nation’s economic activity to fluctuate?
 What. Causes unemployment?
 What causes prices to rise?
 How does being part of a global economic system affect nations’ economies?
 Can governemnt policies be used to improve economic performance?
What macroeconomist do
 Macroeconomic forecasting - prediction of future economic trends
 Macroeconomics analysis - monitoring and interpreting events as they happen
 Macroeconomic research - trying to understand the structure of the economy in general
which forms the basis for macroeconomic analysis and forecasting
o
Both theoretical and empirical research are necessary to make general statement
about how the economy works
o
Economic theory - a set of ideas about the economy to be organized in a logical
framework
o
Economic model - a simplified description of some aspects of the economy
o
Quantitative and empirical analysis
Developing and testing a theory

State the research question

Make provisional assumptions

Work out the implications of the theory

Conduct an empirical analysis

Evaluate the results
Criteria for evaluating an economic model

Are assumptions reasonable?

Can it be used to study real problems?

Can it be tested with empirical analysis?

Are the implications consistent with the data?
Comparative static experiments

Experiments conducted by macroeconomists
o
First, the economic model is assumed to be in equilibrium (quantities demanded
and supplied are equal in all markets)
o
Second, we change the value of one variable in the model, a variable whose value
is not affected by changes in other variables in the model (called shocks by
economist)
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
o
Third, we observe how our economic model responds to the shock
Data development

Macroeconomist use data to assess the state of the economy, make forecast, analyze
policy alternatives and test theories

Providers of data must:
o
Decides what type of data should be collected based on who is expected to use the
data and how
o
Ensure the measure of economic activity correspond to economic concepts
o
Guarantee the confidentiality of data
Why macroeconomics disagrees

A positive analysis examines the economic consequence of an economic policy, but it
does not address its desirability

A normative analysis tried to determine whether a certain economic policy should be
used

Economists can disagree on normative issues because of difference in values

Economist disagree on positive issues because of different schools of thought (e.g.
classical vs Keynesian)
Unified approach to macroeconomics

Individuals, firms, and the governemnt interact in goods, assets and labor markets

Components or extensions of the basic model will be used to study issues such as
economic growth, business cycles, inflation, and policy

There are many limitations in this approach, but it provides a starting point for us to
understand macroeconomics
Slides 2: the measurement and structure of the Canadian economy
National income accounting
 The national income accounts are an accounting framework used in measuring current
economic activity
 There are 3 approaches to calculate the amount of economic activity
o The product approach measures the amount of output produced, excluding output
used up in intermediate stages of production
o The income approach measures the income received by the producers of output
o The expedniture approach measures the amount of spending by the ultimate
purchaser of output
o All 3 approaches give identical measurements of the amount of current economic
activity (except for such problems as incomplete or misreported data)
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Why the 3 approaches are equivalent
 Fundamental identify of national income accounting:
o Total production = total income = total expenditure
 The market value of a good (product) and the spending on a good. (expenditure) are
always the same
 The seller’s receipts (product = expenditure) are equal to the total income generated by
the economic activity (incomes include the incomes paid to workers and suppliers, taxes
paid to the government, and profits)
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
GDP: the product approach
 A nation’s gross domestic product (GDP) is the market value of final goods and services
newly produced within a nation during a fixed period of time
 Using market values allows adding the production of different goods and services
 Problems with the market values:
o Some goods are not sold in market (e.g. housework, childcare, volunteer
activities)
o The underground economy: illegal activites and legal activites hidden from the
governemnt
o Lack of market values to use when calculating the governments contribution to
the GDP. Solution: value. Government services at their cost of production.
 GDP includes only goods and services newly produced within the current period. It is a
sum of value added (i.e. value of an output minus value of its inputs)
 The reason that GDP included only final products is to avoid double-counting
 GDP excludes purchases or sale of goods that were produced on previous periods
 Housings contributions to gross domestic product (GDP)
o Residential investments which included construction of new single family and
multifamily structures, residential remodeling, production of manufactured
homes, home inspection, insurance and broker fees
o Consumption spending on housing services which includes gross rents and
utilities paid by renters, as well as owners imputed rents and utility payments
 In principle, sales of a used house or exchanges of existing stocks are not counted in GDP
 Capital gains are also not counted as income for GDP purposes
 However, research has shown that there exists a strong inverse correlation between the
size of the statistical discrepancy (i.e. output minus income) and capital gains in the stock
market and housing especially in the peak years of a stock or housing buddle
 This finding suggests that the product approach may be more robust than the income
approach (At least sometimes), given the fact that some amount of capital gains bet
misclassified as income in national accounts
GDP vs. GNP
 Gross national product (GNP) is the market value of final goods and services newly
produced by domestic factor of production (capital and labor) during the current period
 Canadian owned capital and labor used abroad produce output and earn income. They are
included in Canadian GNP but not in Canadian GDP
 Foreign owned capital and labor used in Canadian produces output and earn income.
They are included in Canadian GDP, but not in Canadian GNP
 Net factor payments from abroad (NFP) is defined as income paid to domestic factors of
production by the rest of the world, minus income paid to foreign factors of production
by the domestic economy
o GDP + NFP = GNP
GDP: the expenditure approach
 Y = C + I + G + NX
o Y – GDP
o C – consumption
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
o
o
o
I - investment
G – governemnt purchases of goods and services
NX – net exports of goods and services. (i.e. export minus imports)
GDP: the income approach
 Compensation of employees: total remuneration, in cash or in kind, payable by an
enterprise to an employee in return for work done
 Gross operating surplus: income earned form the production of goods and services that is
paid to the owners of incorporated companies
o Owners – corporations, governments, households, and non-profit institutions
o Forms – dividends, and interest received, profits, etc.
 Gross mixed income – incomes paid to unincorporated enterprises
 Taxes less subsidies on production: taxes (less subsides received) that companies pay on
the use of labor, machinery, buildings or other assets used in the production of goods and
services
 Taxes less subsidies on products and imports: taxes payable after a product is produced
and sold in Canada or imported from abroad
Private sector and governemnt sector income
 Private disposable income (PDI) is the amount of income the private sector has available
to spend after paying taxes and receiving governemnt transfers
 PDI = Y + NFP + TR + INT – T
o Y – gross domestic product (GDP)
o NFP – net factor payments from abroad
o TR – transfer payments form the government
o INT – interest payments on the governemnt debt
o T – taxes
 Net government income = T – TR – INT
Savings and wealth
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
















Wealth is the difference between assets and liabilities
National wealth is the wealth of an entire nation
Saving is current income minus spending on current needs
o Private saving
o Government savings
o National saving
Private savings (SPVT) is the saving of the private sector
o SPVT = PDI – consumption = (Y + NFP + TR + INT – T) – C
Government saving (SGOVT) equals net government income minus governemnt purchases
of goods and services:
o SGOVT = (T – TR – INT) – G = T – (G + TR + INT)
The government budget surplus equals governemnt revenue (T) minus governemnt
expenditure (G + TR + INT)
Governemnt saving is positive (negative) when the government runs a budget surplus
(deficit)
National saving (S) equals private plus governemnt saving
o S = SPVT + SGOVT
o = [(Y + NFP + TR + INT – T) – C] + [T – (G + TR + INT)]
o = Y + NFP – C – G
o (C + I + G + NX) + NFP – C – G
o I + (NX + NFP)
o I + CA
CA is current account balance: payments received from abroad in exchnage for currently
produced goods and services (including factor services), minus the analogous payments
made to foreigners by the domestic economy
Private saving can be expressed as
o S - SGOVT = I + CA - SGOVT
o SPVT = I - SGOVT + CA
Private saving is used in 3 ways
o Investment. (I)
o The governemnt budget deficit (-SGOVT)
o The current account balance (CA)
Saving is a flow variable (i.e. a variable that is measured per unit of time)
Wealth is a stock variable (i.e. a variable that is measured at a point in time)
National wealth is the total wealth of the resident of a country and consist of 2 parts
o Country domestic physical assets
o Country net foreign assets (i.e. country’s foreign assets minus its foreign
liabilities)
Note that domestic financial assets held by domestic residents are not part of national
wealth because the value of any domestic financial assets is offset by a domestic financial
liability
National wealth may change
o Due to changes in the value of the existing assets or liabilities that make up the
national wealth
o Through national saving (S = I + CA)
 I increase the stock of domestic physical capital
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

CA increases the nations stock of net foreign assets
Real GDP
 Nominal GDP (or current dollar GDP) is the dollar value of an economy’s final output at
current market prices
 Real GDP (or constant dollar GDP) is the physical volume of an economy’s final output
using the prices of a base year
GDP deflator
 A price index is. A measure of the average level of prices for some specified set of goods
and services
 The rate of inflation is the percentage rate of increase in a price index per period
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799


The GDP deflator is a price index that measures the overall level of prices of goods and
services included in GDP
o GDP deflator = nominal GDP / Real GDP
The measurement of real GDP and the GDP deflator depends on a choice of a base Year.
in the above example,
o If the base year is year 1, GDP deflator is equal to 1 in year 1 and is equal to
66,000/62,000 = 1.065 in year 2, which implies that prices rise by about 6.5%
between year 1 and 2
o If the base year is year 2, GDP deflator is equals to 46,000/51,000 = 0.902 in year
1 and is equal to 1 in year 2, which implies that prices rise by about 10.9%
between Year 1 and year 2
Consumer prices index and inflation
 The consumer price index (CPI) measures the price of consumer goods and services
 Unlike the GDP deflator, which is a variable weight index, the CPI is a fixed weight
index. That is, it is calculated for a fixed consumer basket
 Due to things like new goods are introduced and people substitute cheaper goods for
higher priced goods, the basket should be occasionally updated, or chained weighted
indexes should be sued
 Let’s use the example in table 2.3 and assume year 1 is the base year.
o The total cost of goods is
 5 x $1,200 + 200 x $200 = $46,000 in year 1
 5 x $600 + 200 x $240 = $51,000 in year 2
o In this case, the CPI is equal to 1 in year 1 and is equal to 51,000/46,000 = 1.109
in year 2, which implies that prices rise by about 10.9% between year 1 and year 2
 Again, use the example in table 2.3 but assume year 2 is the base year
o The total cost of goods is
 10 x $1,200 + 250 x $200 = $62,000 in year 1
 10 x $600 + 250 x $240 = $66,000 in year 2
o In this case, the CPI is equal to 62,000/66,000 in year 1 and is equal to 1 in year 2,
which implies that prices by about 6.5% between year 1 and year 2
Real vs. nominal interest rates
 An interest rate is a rate of return promised by a borrower to a lender
 There are many interest rates, but they tend to move up and down together. We can
usually talk about “the” Interest rate as if there were only one
 The nominal interest rate (i) is the rate at which nominal value of an asset increases over
time
 The real interest rate, r, is the rate at which the real value or purchasing power of an asset
increases over time
 Real interest rate = I - π
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

The expected real interest rate, r, is the rate at which the real value of an asset is expected
to increase over time, r = I - πe
Slides 3: productivity, output and employment
Production function
 Factors of production are inputs to the production process:
o Capital (building, machines, vehicles)
o Labor (workers)
o Raw materials, land and energy
o Technology and management
 A production function is a mathematical expression relating the amount of output
produced to quantities of capital and labor utilized:
o Y = AF (K, N)
o Total factor productivity (A) measures the overall effectiveness with which
capital and labor are used

The marginal product of capital (MPK) is the increase in output produced resulting from
a one unit increase in the capital stock (other factors held constant)

The MPK equal the slope of the line drawn tangent to the production function at a given
level of capital stock (K)
The MPK is positive
The MPK declines as the capital stock increases


Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

The tendency for the MPK to decline as the amount of capital in use increases is called
diminishing marginal productivity of capital

The marginal product of labor (MPN) is the increase in output produced by each
additional units of labor (other factors held constant)

The MPN equals the slope of the line drawn tangent to the production function at a given
level of labor (N)
The MPN is positive
The MPN declines as labor increases
The tendency for the MPN to decline as the amount in use increases is called diminishing
marginal productivity of labor




Often, we assume the production function is a Cobb-Douglas production function:
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799



Under perfect competition, α corresponds to the share of income received by capital
owners (i.e. the share of capital income in GDP)
Empirically, α has been estimated to be approximately 1/3
Potential caveats
Supply shocks
 A supply shock, which is sometimes referred to as productivity shock, affects the amount
of output that can be produced for a given amount of inputs
 A positive (beneficial) shock raises the amount of output which can be produced with
each capital labor combination
 A negative (adverse) shock lowers the amount of output which can be produced with
each capital labor combination
 Positive shocks shift the production function upward
 Negative shocks shift the production function downward
Demand for labor
 Let’s assume the capital stock is fixed in the short run, but the amount of labor is variable
in the short run
 Also let’s assume that:
o Workers are all alike
o The wage is determined in a competitive labor market
o Firms employ workers to maximize their profits
 As long as the marginal benefits is greater than the marginal cost of hiring an extra
worker, hiring more labor will increase firms profits
 The marginal revenue product of labor (MRPN) measures the benefit of employing an
additional worker in terms of the extra revenue produced
o MRPN = P x MPN
 The cost of employing an additional worker is the nominal wage (W)
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

Firms will continue hiring more labor until
o MRPN = W
o P x MPN = W
o MPN = W/P = w
o P – price of output
o w- real wage



the MPN curve is downward sloping due to diminishing MPN
the relationship between the real wage and the quantity of labor demanded is negative
the labor demand curve is the same as the MPN curve, which shows the amount labor
demanded at any real wage
changes in the real wages are represented as movements along the labor demand curve
the labor demand curve shifts in response to factors that change the amount of labor that
firms want to employ at any given level of real wage


Supply of labor
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799



aggregate supply of labor is the sum of labor supplied by everyone in the economy
each person must decide how much time to work for income versus how much time to
allocate for leisure (off-work activites)
the labor supply decisions depend on the tradeoff between incomes and leisure
real wages and labor supply
 the real wage is the amount of real income that a worker receives in exchange for giving
up a unit of leisure for work
 an increase in the real wage generally affects the labor supply in two ways
o substitution effect – the tendency of workers to supply more labor and reduce
leisure in response to a higher reward for working
o income effect – the tendency of workers to supply less labor and increase leisure
as they enjoy higher incomes
o the 2 effects work in opposite directions
 the longer an increase in the real wage is expected to last, the larger is the income effect
 labor supply tends to rise in response to a temporary increase in real wage but fall in
response to a permanent increase in real wage

any factors which changes the amount of labor supply at given current real wage will
shift the labor supply curve
o wealth
o expected future real wage
o working age population
o labor force participation rate
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Labor market equilibrium
 the classical model of the labor market assumes that the real wage adjusts quickly to
equate labor supply and labor demand
 this assumption is appropriate when we focus on long run economic performance
 the equilibrium level of employment after the complete adjustment of wages and prices is
full-employment level of employment ( Ń ). The corresponding market clearing real wage
is ẃ
 factors that shift either the aggregate labor demand curve or the aggregate labor supply
curve affects the equilibrium real wage and the full employment level of employment
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799



full employment output (potential output), Ý . , the level of output that firms in the
economy supply when wages and prices are fully adjusted
o Ý = AF (K, N)
Following an adverse supply shock, full employment Ý falls due to reductions in
o Productivity A
o Full employment Ń (i.e. MPN falls which reduces labor demand)
One caveat here is that there is no cyclical unemployment, which indicates that is we
want to understand short-run economic fluctuations, we need to modify this basic model
Unemployment
 An employed person is someone who worked full time or part time during the past week
(or was on sick leave, vacation, or strike)
 An unemployed person is someone who did not work during the past week, but who had
actively sought work in the previous 4 weeks, and was available for work
 Someone not in labor force is a person who did not work during the past week and did
not look for work during the past 4 weeks
 The labor force consists of all employed and unemployed workers
 The unemployment rate is the fraction of the labor force that is unemployed
 The participation rate is the fraction of the labor force in the working age population
 The employment ratio is the fraction of the employed in the working age population
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
change in employment status
 Workers lose and find jobs continuously
 In a typical month,
o 21.8% of the unemployed workers will be employed the following month
o 17.2% of the unemployed become discouraged workers and leave the labor force
the next month
o The remaining 61% of the unemployed stay unemployed the following month
 An unemployment spell is the period of time that an individual is constantly unemployed.
Its lengths is called the duration of the unemployment spell
Why there is always unemployment
 Frictional unemployment – unemployment arises as workers search for suitable jobs and
firms search for suitable workers
o The search and match process take time
 Structural unemployment – the long term and chronic unemployment that exist even
when the economy is not in recession
o Unskilled or low skilled workers are unable to find long term jobs
o Reallocation of labor among industries takes time
 The natural rate of unemployment (ú) is the rate of unemployment that prevails when
output and employment are at their full employment levels
 The natural rate of unemployment exists due to frictional and structural unemployment
 As output fluctuates around its full employment level, the unemployment rate fluctuates
around the natural rate
 Cyclical unemployment – the difference between actual and natural unemployment rate,
u - ú
Slides 4: consumption, saving and investment
Consumption and saving
 Changes in consumers’ willingness to spend have major implications for the behaviour of
the economy
o Consumption accounts for about 60% of total spending
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
The decision to consume and to save are closely linked
Desired consumption (CD) is the aggregate quantity of goods and services that households
want to consume, given income and other factors
Desired national saving (SD) is the level of national saving that occurs when aggregate
consumption is a tits desired level
When NFP = 0, national saving is S = Y – C – G, therefore
o S D = Y – CD – G
Suppose the annual real interest rate is r
1 unit of current consumption will be worth 1+r units of future (next years) consumption
The real interest rate r determines the relative price of current consumption and future
consumption
How should consumption decisions be made?
Most people try to avoid sharp fluctuations in consumption
The desire to have a relatively even pattern of consumption over time is known as the
consumption smoothing motive
For instance, a one-time income bonus is more likely to be saved so that both current and
future consumption will increase
A permanent income raises, on the other hand, is more likely to be spent. Because the
raise is permanent, both current and future consumption will increase
The above example shows that consumption smoothing motive guides individuals
consumptions and saving. Decisions. When factors such as current incomes, expected
future income and wealth changes
o












Effect of changes in current income
 Marginal propensity to consume (MPC) is the fraction of additional current income that
is consume din the current period
 Because of the consumption smoothing motive, 0 < MPC < 1
 Increases in current income Y leads to an increase in CD, however the increase in CD will
be less than the increase in Y (because MPC < 1), therefore SD will. also increase
Effects of changes in expected future income and wealth
 An increase in expected future income or wealth will increases current consumption and
decreases current saving
 Again, such decisions are guided by the consumption smoothing motive
Effect of changes in real interest rate
 Increased expected real interest rate has 2 opposing effects for a lender (i.e. saver)
o Substitution effect: since the rate of return on saving is higher, current
consumption falls and current saving rises
o Income effect: since it takes less to obtain a given amount in the future, current
consumption rises, and current savings falls
 For a borrower, when expected real interest rate increases, both the substitution and the
income effect result in decreased current consumption and increased current saving
 Since the national economy is composed of both borrowers and savers and saver could
either increase or decreases their saving in response to an increase in real interest rate, the
effect of an increase in real interest rate on national saving is ambiguous (in theory)
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

Some empirical studies show that an in. the real interest rate reduces current consumption
and increase saving. However, these results are not very robust
Taxes and the real return to saving
 The expected after-tax real interest rate (ra-t) is the after-tax nominal interest rate minus
the expected inflation rate
o ra-t = (1-t) I - π e

by reducing the tax rate on interest earned, the government can increase the real rate of
return for savers and (possibly) increase the rate if saving in the economy
o RRSP
o RESP
o TFSA
Effects of fiscal policy
 Let’s assume that the economy aggregate output is given that is Y is not affected by the
changes in fiscal policy
 Fiscal policy has 2 major components – the government purchases (G) and taxes (T)
 Fiscal policy affects desired national saving SD (SD = Y – CD – G) in 2 ways
o By affecting CD through affecting households current and expected future
incomes
o Direct impact on SD due to changes in G
 When the government increases its purchases temporarily
o Higher G financed by higher current taxes reduce current after tax incomes which
lowered CD, although by less than the increase in G because of the consumption
smoothing motive (or 0 < MPC < 1)
o Higher G financed by higher future taxes reduces future. After tac income which
lowers CD, although by less than the increase in G because of the consumption
smoothing motive and because some consumers may not understand that their
future taxes will increase
o SD falls in net terms
 Governemnt purchases reduce both desired consumption and desired national saving
 Now consider a governemnt tax cut without reduction of governemnt purchases G
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799






For simplicity, let’s assume that the tax cut is lump sum
Desired national saving, SD = Y – CD – G, will change only if CD changes
o The current tax cut increases current incomes which should increase CD
o People should also expect lower after-tax incomes in the future (i.e. current tax
cut has to be financed by higher future taxes) which will decrease CD
Ricardian equivalence proposition: the positive effect of increased current income and the
negative effects of decreased future income on CD should exactly cancel so that the
overall effect of a current tax cut on consumption hence national saving is zero
In other words, Ricardian equivalence proposition suggest that a cut in current taxes can
affect the timing of tax collections but not the ultimate tax burden borne by consumers.
As a result, consumption saving decision are not affected by tax cuts
Empirical evidence suggest that this is not the case. Following a tax cut, current
consumption (CD) increases by a fraction of the tax cut and national saving decreases
Why does Ricardian equivalence fail in reality?
o Some consumers are “myopia”
o Some consumers are finacnial constrained
o Taxes are distortionary
Investment
 A firm commits its current resource to increasing its capacity to produce and earn profits
in the future
 A firms desired capital stock is the amount of capital that allows the firms to earn the
largest expected profit
 To decide whether to add an additional unit of capita, expected future benefit (MPKf) and
the associated user cost of capital must be compared
 The expected marginal product of capital (MPKf) is the firms expected increase in future
output of using an additional unit of capital (other factors held constant)
 User cost of capital (uc) is the expected real cost of using a unit of capital for a specified
period of time
o uc= r x pk + d x pk = (r+d)pk
o pk – real price of capital goods
o r – expected real interest rate
o d – rate at which capital depreciates
determining the desired capital stock
 the MPKf curve slopes downward due to diminishing marginal productivity of capital
 the uc curve is horizontal because the user cost does not depend on the amount of capital
 if MPKf > uc, profits rise as K is added
 if MPKf < uc, profits rise as K is reduced
 the desired capital sock is the capital stock where expected profit is maximized -at which
MPKf = uc
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Changes in the desired capital stock
 factors that shift the MPKf curve or change the uc will cause the desired capital stock to
change
 if r (or d or pk) falls, the uc falls which leads to an increase in the desired capital stock

if a technological advance increases the MPKf at any given level of capital stock, the
MPKf curve. Shifts upward, which leads to an increase in the desired capital stock
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Taxes and the desired capital stock
 let T represent the effective tax rate which a single measure of the tax burden on capital
 the after tac return to capital is (1- τ) MPKf
 the desired capital stock is achieved when (1- τ) MPKf = uc
 dividing both sides by 1- τ, we have
o MPKf = uc/1- τ
 Uc/1- τ is the tax adjusted user cost of capital
 An increase in the tax rate τ raise the tax adjusted user cost therefore reduces the desired
capital stock
from the desired capital stock to investment
 The capital stock changes from 2 opposing channels:
o Gross investment is the total purchase or construction of new capital goods which
increases capital stock
o Depreciation is the capital wearing out which reduces capital stock
o The net investment, which is the difference between gross investment and
depreciation, determines the changes in capital stock
 Kt+1 – Kt = It -dkt
 It – gross investment during year t
 Kt and kt+1 – capital stock at the beginning of year t and t+1
 The firm’s gross investment (It = Kt+1 – Kt + dkt)
o The desired net increase in capital stock over the year (K* - Kt); (note that kt+1 =
K*)
o The investment needed to replace worn-out or depreciated capital (dkt)
 Factors that affect K* results in equal change in It
Other investment
 a firms inventories are unsold goods, unfinished foods, and raw materials
 inventory investment is the most volatile component of investment spending
 residential investments is the construction of housing or apartment buildings
 these investments decisions are made based on comparing the benefits of keeping higher
inventories or renting out housing and the respective user cost
goods market equilibrium
 the real interest rate adjusts to bring the goods market into equilibrium (i.e. demand =
supply)
 the goods market equilibrium condition (in a closed economy) is:
o Y = C d + Id + G
o Y – quantity of goods (and services) supplied by firms
o Right – hand - side – aggregate demand for goods (and services)
 Notice that
o S d = Y – Cd – G
o S d = Id
 Therefore, the goods market equilibrium condition (in a closed economy) can also be
expressed as:
o S d = Id
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Saving-investment diagram
 The saving curve, S, is upward sloping. A higher real interest rate raises desired national
saving (i.e. substitution effect > income effect)
 The investment curve, I, is downward sloping. A higher interest rate increases the user
cost of capital thus reduced desired investment
 Adjustments of the real interest rate, r, in response to excess supply or demand for saving,
brings the goods market into equilibrium
Shift of the saving curve and the investment curve
 The saving curve shifters are all factors, excluding the real interest rate, which affects
national saving
o Examples: saving curve shift right due to a rise in current output, a fall in
expected future output, a fall in government purchases
 The investment curve shifters are all factors which affects investment, excluding the real
interest rate
o Examples: investment curve shifts right due to a rise in the expected future
marginal productivity of capital or a fall in the effective tax rate
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Slides 5: saving and investment in the open economy
Balance of international payments
 The balance of international payments accounts records a country’s international
transaction in goods, services and assets
o Any transaction that involves a flow of. Funds into Canada is a credit item (+),
e.g. exports
o Any transaction that involves a flow of funds out of Canada is a debt item (-), e.g.
imports
current account
 Current account (CA) records trade transaction in currently produced goods and services
and international receipts or payments of income
 Current account = trade balance + income balance + net unilateral transfers
 If CA > 0, the country has a current account surplus
 If CA < 0, the country has a current account deficit
 Trade balance (net export of goods and services): the difference between export in goods
and services and import of goods and services
o Trade balance = merchandize trade balance + service trade balance
o Merchandize: imports of iPhone form the US (-)/ export of oil to the US (+)
o Service: drinks in a Paris bar (-)/ french tourist dining in Niagara Falls (+)
 Income balance: the difference between income received form the rest of the world and
incomes paid to the rest of the world
o Income balance = net investment income + net international payments to
employees
o Investment income: Scotiabank’s subsidiary. In Mexico make profits and rebates
then to the Canadian headquarters (+)/ dividends for American shareholders. Of
Canadian stocks (-)
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Compensation to employees: earning of Canadian professional temporarily
residing in foreign countries (+)/ earning of foreign temporary workers in Canada
(-)
Net unilateral transfer (current transfers): the difference between gifts from the rest of the
world and gift given to the rest of the world
o Net unilateral transfers = private remittances. + governemnt transfers
o Canadian residents send money to relatives in Philippine (-)/ foreign aid to
Canada for protecting the marine environment (+)
o

Capital and financial account
 The capital and financial account (KA) records trade in existing assets, either real or
financial
 The capital and financial account is equals to the difference between sale of assets to
foreigners. (financial inflow, +) and purchases of assets from foreigners (financial
outflow, -)
o KA = increase in foreign owned assets in Canada – increase in Canadian owned
assets abroad
o Purchasing a vacation home abroad (-)/ purchase Canadian stocks by foreigners
(+)
 The financial account records direct and porfolio investment
 The capital accounts. Records migrants funds, inheritance, transaction of intellectual
property
 Most transactions of assets are in the financial account
 If KA > 0, the country has capital and financial account surplus
 If KA < 0, the country has a capital and finacnial account deficit
Fundamental balance of payments identity
 Every movement in the current account must be reflected in a balancing movement in the
country’s capital and financial account
o Examples: a Canadian retailer imports $1,000 of Japanese TVs; Canadian current
account goes down by $1,000; at the same time, the Japanese Tv producer
purchases a financial asset (Canadian dollar) worth $1,000 hence the Canadian
financial account increases by $1,000
 In other words, the current account (CA) balance and the capital and financial account.
(KA) balance must sum to zero at each period of time
o CA + KA = 0
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Net foreign assets and the balance of payments
 Net foreign assets (NFA) of a country is defined as the foreign assets held by the country
residents minus the country foreign liabilities
 Net foreign assets can change when:
o The value of existing foreign assets and foreign liabilities changes (due to changes
in exchnage rates, asset prices, etc.)
o The country acquires new foreign assets or. Incurs new liabilities
 Abstract form the valuation changes, the net amount of new foreign asset that a country
acquires equals its current account surplus
o ∆ NFA=CA =−KA
 If CA > 0 => KA < 0, there is capital outflow, which implies a net increase in the holding
of foreign assets, ∆ NFA >0
 If CA < 0 => KA > 0, there is a capital inflow, which implies a net decrease in the
holding of foreign assets, ∆ NFA <0
National income accounting in an open economy
 Recall form chapter 2. The open economy national income accounting identity:
o S = Y + NFP – C – G
o = (C + I + G + NX) + NFP – C – G
o = I + (NX + NFP)
o = I + CA
 National saving (S) is used to increase:
o The nations stock of capital by funding investment. (I)
o The nations stock of net foreign assets by lending to foreigners (the available
funds are equals to CA)
Goods market equilibrium in an open economy
 The open economy goods market equilibrium condition is
o Sd = Id + CA = Id + (NX + NFP)
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
That is, in an open economy goods market equilibrium, the desired amount of
national spending (Sd) must equal the desired amount of domestic investment (Id)
plus the amount lent abroad CA
For simplicity, let’s assume NFP = 0. Then the open economy goods market equilibrium
condition can be written as
o Sd = Id + NX
o = Id + [Y – (Cd + Id + G)]
o Cd + Id + G is called adsorption, which represent the (desired) spending by
domestic residents
o

Saving and investment in a small open economy
 A small open economy is an economy that is too small to affect the world real interest
rate (I.e. the small open economy takes. The world real interest rate as given)
 The world real interest rate is the real interest rate that prevails in the international capital
market
 We also assume that there is free capital mobility. That is, domestic residents can borrow
or lend freely in the international financial markets. Foreigners can also borrow or lend
freely in the financial markets of the small open economy
 Therefore, domestic real interest rate will always adjust to equal the (expected) world real
interest rate, r = rw
 In an open economy, desired national saving need not equal desired investment
 Higher values of the world real interest rate (rw) imply:
o Lower levels of desired consumption (people save more)
o Lower desired investment (higher uc)
o The economy is more likely to tend to rather than to borrow from foreign
countries
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Supply shocks in a small open economy
 A change that increases desired national saving relative to desired investments at a given
world real interest rate (rw) will increase net foreign lending, the current account balance,
and net exports
 2 examples:
o A temporary adverse supply shock (e.g. bad weather)
o A permanent increase in the expected future MPK
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Saving and investment in a large open economy
 A large open economy is an economy large enough to affect the world real interest rate
 Suppose the world consisted of only 2 large economies: the domestic and the foreign
economy
 The world interest rate will be such that desired international lending by one country
equals desired international borrowing by the other country
o CAh + CAf = 0
o Sdh + S df =I dh + I df

For large open economies, the worl interest rate is not fixed but will change when desired
national saving or desired investment changes in either country
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799


Any factor that increases desired international lending relative to desired international
borrowing at the initial world real interest rate will cause the world interest rate to fall
o E.g. a temporary positive supply shock in the home country
Any factors that reduces the desired international lending relative to desired international
borrowing at the initial world real interest rate will cause the world interest rate to rise
o E.g. a permanent increase in the expected future MPK in the home country
Twin deficits
 Will an increase in the governemnt budget deficit lead to current account deficits?
o CA = S – I
o S = SPVT + SGOVT
 SPVT = private savings
 SGOVT = governemnt savings (i.e. fiscal surplus)
o If SGOVT ↓ (SPVT and I remain constant), then CA ↓






When Ricardian equivalence holds, cuts in current taxes. Do not affect desired
consumption. Private saving will increase, dollar for dollar, with the decrease in
government saving, leaving national saving and current account unchanged
In other words, when Ricardian equivalence holds and the fiscal deficit is the result of a
tax cut (governemnt spending remains constant), the twin deficit hypothesis fails
An increase in the government budget deficit will raise the current account deficit only if
the increase in the budget deficit reduces desired national saving
In 9180, there was a significant cut in taxes. As predicted by theory, the tax cut was
accompanied by a significant decline in governemnt saving. However, contrary to the
prediction of Ricardian equivalence, private saving did not increase by the same amount
as the decline in governemnt saving. As a result, both national savings and the current
account plummeted
The fiscal deficits of the 1980s were caused by tax cuts as well as increases in
governemnt spending
Failure of Ricardian equivalence
o Borrowing constraints
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Intergenerational effects
Distortionary taxation
Empirical evidence suggest that twin deficits have weakened over time
Potential factors explaining the decline impact of fiscal deficit on current account deficit
o Financial innovation which makes households less borrowing constraints
o Changes in demographics and the associated lengthening of work lifetimes which
reduced the intergenerational effects
o The adoption of “fiscal rules” has made households more forward looking
o
o


Slide 6: long run economic growth
A broader look across time and space
 Growth rates are generally not constant over time
o For individual countries. Growth rates change over time
o For the world as a whole, growth rates also vary; close to zero for a long time.
Then increased sharply since late. 19th century
 There are enormous variations in per capita income across economies. The poorest
countries have per capita incomes that are less than 1% of per capita incomes in the
richest countries
 Rates of economic growth vary substantially across countries
 A country relative position in the world distribution of per capita incomes is not
immutable. Countries can move from being poor to being rich and vice-versa
Source of economic growth
 The relationship between output and inputs described by the production function
o Y = AF (K, N)
 For Y to grow, either quantities of input (K and/or N) must grow or total factor
productivity (A) must improve or both
Growth accounting
 In 1957, Robert Solow introduced a simple accounting method to measure how much of
the growth in aggregate output (Y) over a given. Period of time is accounted for by
growth in different factors such as capital (K), labor (N), and productivity (A)
 The growth accounting equation:
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
The elasticity of output with respect to capital/labor is the percentage increase in
output resulting from a one person increase in the amount of capital stock/labor
used
Growth accounting measures empirically the relative importance of capital stock, labor
and productivity for economic growth
The impact of changes in capital and labor is estimated from historical data
The impact of changes in total factor productivity is treated as a residual, that is not
otherwise explained
o



Canada
 High growth during the 1961-1971 came from all sources
 Despite the productivity slowdown during the 1971-1981, output still grew at a
reasonably high rate because of high growth in factors of production (i.e. high rate of
capital accumulation and high employment growth in part due to a rapid increase in
female labor force participation rate)
 Although growth capital and labor declined during 1981-1991 and 1991-2001, the
increase in TFP growth during 1991-2001, explained the high growth in aggregate output
during the 1991-2001
 Growth in TFP slowed down again during the 2001-2007, but there was significant
growth in capital and labor inputs
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Productivity growth in advanced countries
 The productivity slowdown in the 1970s and the rise in productivity in the 1990s
occurred throughout the advanced countries of the world
 Various explanation for the productivity slowdown in the 1970s:
o The sectoral shift in the economy away from manufacturing towards services
o A slowdown in R&D spending in the late 1960s
o Reverse to the means: high growth in the 1950s and 1960s may simply because in
th years following WWII, new technologies created for the war were applied to
the private sector
o Large increases in oil prices in the 1970s
o A measurement problem
 The productivity surge in the 1990s is associated with the widespread adoption of
information technology
East Asia growth miracles
 High investment/saving rate => high growth in capital
 Population growth plus increases in labor force participation (especially among women)
=> high growth in labor
 TFP growth rates are high (Except Singapore), however, these numbers are far from
being miraculous
 The high growth in GDP was mainly the result of unusually high growth rates in capital
and labor
 A key source of the rapid growth of a number of Asia countries is. Factor accumulation
 Their total factor productivity growth is also typically higher than the advanced countries.
There are mainly 2 reasons:
o The sectoral shift in the economy from agriculture, where productivity is very
low, to manufacture and services, where productivity is much higher
o Import technology from more advanced countries; adapting and imitating existing
technology is typically easier than innovation; technological catch-up
Neoclassical growth model
 Let us assume that:
o Population (Nt) and workforce grow at the same fixed rate n (0 < n < 1)
o The economy Is closed and there are no governemnt purchases
o Technology (A) is exogenous – the technology available to firms is unaffected by
the action of the firms, including R&D
 The neoclassical growth model is built around 2 equations, a production function and a
capital accumulation equation
o The production function describes how inputs combine to produce output, Yt =
AtF (Kt, Nt)
o The capital accumulation equation describes how capital stock, Kt, changes over
time
 Assume that the aggregate production function has constant returns to scale (CRTS): if
the scale of. Operation change by a factor of λ, that is, if quantities of all inputs change
by a factor of λ, then output will change by the same factor
o λYt = AtF (λKt, λNt)
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

Let λ = 1/Nt, we can write the production function in per workers terms
o 1/Nt Yt = AtF (1/Nt Kt, 1/Nt Nt)
o Yt = AtF (1/Nt Kt, 1t)
o Yt = AtF (Kt)
o Yt – output per worker in period t, Yt = Yt/ Nt
o Kt - capital stock per worker in period t, Kt = Kt/ Nt

The production function slopes upward. With more capital each worker produces more
output (MPK > 0)
The slope gets flatter at higher levels of capital per worker. This reflects diminishing
MPK
Part of the output. Produced each year is invested in new capital or in replacing of wornout capital (It)
The rest of output is consumed by population (CT = YT – IT)
Suppose that saving is proportional to current income, ST = sYT, where s is the saving rate
(0 < s < 1)
Since saving equals investment in a closed economy, consumption can then be expressed
as CT = (1-s)YT
Timing of the model:
o The amount of capital determines the amount of output being produced each
period
o The amount of output further determines the amount of. Investment, and thus the
amount of capital being accumulated
o These 2 relations determine the evolution of output and capital in the economy






Steady states
 In the absence of productivity growth, a steady state is a situation in which the economy
output per worker (Yt), consumption per worker (Ct) and capital stock per worker (Kt) are
constant over time
 To break even (i.e. maintain K constant), we need enough investment to
o Worn out capital, dk
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Equip new workers with capital, nk
In other words, the steady state investment per worker I is given by
o I = (N+D) K
Since saving equals investment in a closed economy, the following condition must hold
in a steady state
o Sy = sAf(K) = (n+d) k
o c= Af(k) – (n+d) k
o






K* is the value of k at which the saving curve and the steady state investment line cross
K* is the only possible steady state capital per worker (capital-labor ratio) for this
economy
Steady state output per worker is y*= Af (k*)
Steady state consumption per worker is c* = Af(k*) – (n+d) k*
Dynamics
 The change in capital per worker between period t and t+1 is equal to the difference
between saving (or investment) per worker and the amount of investment needed to keep
k constant
o Kt+1 – kt = sAf(kt) – (n+d) kt
 Of k begins at some level other than k*, it will move towards k*

To summarize, with no productivity growth, the economy capital per worker has
tendency to go to k*. it will remain there forever, unless something changes
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
golden rule steady state
 Compare across different steady states, an increase in k*
o Raises the amount a worker can produce, Af (k*)
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

Increases the amount of output per worker that must be devoted to investment
(break-even), (n+d) k*
The golden rule level of the capital stock maximizes consumption per worker in the
steady state. That is, the golden rule steady state is the steady state with the highest level
of consumption in the long run
Note that higher income/output does not necessarily means higher utility because to earn
higher income and produce more goods and services, we need to save more (therefore
more capital) and work longer hours (therefore more labor). In this simple model, we
don’t deal with labor leisure choices, but there is tradeoff between consumption and
saving
The model shows that economic policy focused solely on increasing capital per worker
may do little to increase consumption
A simple optimization problem

Firs order condition (F.O.C)

Where Af’(k*G) represents the marginal productivity of capital evaluated at the golden
rule level of capital per worker
To get sense of the magnitude of the golden rule (optimal) levels 0f saving rate, let us use
the Cobb-Douglas specification of the production function
The golden rule steady state satisfies the following 2 conditions
o







sG = αk
the elasticity of output with respect to capital, αk, typically ranges from 0.3 to 0.4 in
developed countries
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

now we can see whether countries save to much or too little
policy implications
 subsidies and tax incentives: RRSP, TFSA, RESP
 reform of public pensions: CCP reform
o pay-as-you-go system: the system pays benefits out “as it goes”, that is, as it
collects them in contributions
o full funded system: the system had funds equals to the accumulated contribution
of workers, and from which it will be able to pay out benefits when they retire
o pay-as-you-go redistribution between generations
o fully funded: forced saving, which will lead to a higher saving rate, but as the cost
of current workers
o practical implications: move to a fully funded system slowly
determinants of long run living standards
 long run well-being is measured here by the steady state level of consumption per
worker, which depends on
o the saving rates
o the population growth rate
o the rate of productivity growth
long run living standards and saving rate
 conditional on the saving rate remain below the golden rule saving rate, a higher saving
rate implies a higher living standard
 a steady state with higher output and consumption per worker is attained in the long run
 an increase in the saving rate initially causes consumption per worker to fall. So, there is
a tradeoff between current and future consumption
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Long run living standards and population growth
 increased population growth tends to lover living standards
 when the workforce is growing rapidly, a large part of current output must be devoted to
just providing capital for the new workers to use, which lowers consumption per worker
 however, a reduction in population growth means
o lower population, lower total productive capacity and lower political influence in
the world
o lower ratio of working age population to total population and unsustainable.
pension system
Long run living standard and productivity growth
 by incorporating productivity growth, we can account for sustained growth in the long
run
 productivity growth raises output per worker at any given level of k, which increases the
supply of saving and cause long run capital per worker and consumption per worker to
rise
 a one-time productivity improvement shifts the economy form one steady state to a
higher one
 continuing increases in productivity can perpetually improve living standards
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Convergence revisited
 convergence of output per worker across countries has come from 2 sources:
o poorer countries have less capital to start with, over time, they accumulate capital
faster than others, which generates convergence
o poorer countries are less technologically advanced at the beginning over time,
they become more sophisticated, either by importing technology form advanced
countries or developing their own; as technologies catch up, so does output per
worker
 convergence is conditional (as we have observed earlier). That is living standard will
converge only within a group of countries with similar characteristics
 if social infrastructure (laws, government policies, and institutions) encourages
production and investment, the economy will prosper. Instead, if the social infrastructure
encourages diversion, the economy will not grow
 enforcing proper patent and copyright protection, fighting corruption and expropriation,
etc. can improve an economy social infrastructure
 a dilemma: a good social infrastructure is a very complex system; poor countries are
often too poor to afford or to maintain such a system; however, without good social
infrastructure, poor countries will become poorer, there will be even less reosurces
available for building good political, judicial and financial system, the economy will be
trapped in a vicious cycle
social infrastructure and growth
 dramatic difference between South and North Korea in terms of institutions and the
organization of the economy:
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799


South
Capitalist (market
economy)
North
Central planning
Private ownership and legal
protection of private
producers
No private property rights
east vs west Germany between 1945 and 1990
china before and after the 1978 economic reforms
Endogenous growth theory
 the neoclassical growth model assumes, rather than explains, productivity – the crucial
determinants of living standards
 endogenous groth theory tries to explain productivity growth within the model
(endogenously)
 one of the simplest models that allows for endogenous growth can be easily derived by
modifying the neoclassical growth model
 consider a production function of the following form:
o y = Ak
o where A is a positive constant
 for simplicity, assume that n=0
 the capital accumulation equation becomes:

it is easy to see that

implications of this model:
o as long as sA>d, the economy grows forever
o in this case, the growth rate of the economy is an increasing function of the saving
and investment rate
o policies that increases the saving and investment rate permanently will increase
the growth rate of the economy permanently
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Governemnt policies – recap
 governemnt policies that are useful in raising a country’s long run standard of living are:
o policies to raise the saving rate (e.g. taxing consumption, exempting taxation on
income that is saved, reducing fiscal deficit, increasing CPP contribution)
o policies to raise the rate of productivity (e.g. improving infrastructure, building
human capital through education policies, training programs, and health
programs, removing barriers to entrepreneurial activity, encouraging R&D,
industrial policy, market policy, and social insurance)
Slides 7: the asset market, money and prices
Asset market
 the asset market is the entire set of markets in which people buy and sell real and
financial assets, for example, gold, houses, stocks, and bonds
 money is an asset widely used and accepted as payments
function of money
 medium of exchange: money is a device for making transaction at less cost in time and
effort
o barter is inefficient
o money makes a double coincidence of wants unnecessary
o money also allows specialization, therefore, increase productivity
 unit of account – money is the basic unit for measuring economic value
o it simplifies the comparison of prices, wages and incomes
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
for countries with high and erratic inflation, people may switch to a more stable
unit of account
store of value – money is a way of holding wealth (mostly for a short period and for small
account)
o

measuring money – monetary aggregates
 money aggregates are different measures of the money supply
o for some assets (e.g. money market funds), there is no definitive answer whether
they are money or not
o there is no single best measure of the money stock
o most countries report several different monetary aggregates, which differ in how
narrowly they define the concept of money
 M1+ consist primarily of currency and balances held in chequing accounts
o All components of M1+ are used in making payments, so it is the closest money
measure to the theoretical definition of money
 M2 is M1+ plus personal and non-personal non-chequable deposits
 M3 is M2 plus non-personal term deposits held by businesses and foreign currency
deposit of Canadian residents
Money supply
 The money supply is the amount of money available in an economy
 How does the central bank influence the money supply?
 Open market operation:
o Open-market purchase: use newly printed money to buy financial assets from the
public in order to increase the money supply
o Open-market sales: sell financial assets to the public to remove money from
circulation in order to reduce the money supply
 The central bank could also buy newly issued governemnt bonds directly form the
government, which is equivalent to financing government expenditure through money
creation. It induces inflation
Portfolio allocation and the demand for assets
 A portfolio is a set of assets that holder of wealth chooses to own
 The portfolio allocation decision is based on
o Expected return
o Risk
o Liquidity
o Time to maturity
 Expected return: rate of return = the rate of increase in its value per unit of time
o Bank account: rate of return = interest rate
o Corporate stock: rate of return = dividend + increase in stock price
 Return are not always known in advance and people must make porfolio decision based
on their expected return
 Everything else being equal, the higher an asset expected return, the more attractive the
asset is to investors
 Risk: the degree of uncertainty in an asset expected return
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799






Everything else being equal, a riskier asset is less desirable for investors
Liquidity: the ease and speed with which an asset can be traded
o Money is very liquid
o Stocks and bonds are fairly liquid, some more so than others
o Automobiles and houses are quite illiquid
Everything else being equal, the more liquid an asset is, the more attractive it is to
investors
Time to maturity: the amount of time until a financial security
Bonds with different terms to maturity (but similar in all other respect) often have
different rates of return
The expectation theory of the term structure tells us the expected annual rate of return on
an n-year bond should equal the average expected return on 1-year bond during the
current year and the n-1 succeeding years
Yield to maturity
 Yield to maturity on an n-year bond (also known as the n-year interest rate) is defined as
the constant annual interest rate that makes the bond piece today equal to the present
value of the future payment on the bond

For example, $100, 2-yr bond with $P2t = 90, the yield to maturity can be calculated as
the following

The relation of the n-year rate to the current and expected future one-year rates:

The yield to maturity on an n-year bond is approximately equal to the average of current
and expected future one-year interest rates
Note that

Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Yield curve
 The yield curve (i.e. the terms structure of interest rates) plot the relation between yields
and maturity. It shows the yield on bonds of different maturities at any given time
 The slope of the yield curve tells us how financial markets think about future short-term
interest rates
o Upward-sloping yield curve => short term interest rates are expected to increase
o
in the future, i.e. if
Downward-sloping yield curve => short term interest rates are expected to
decrease in the future, i.e. if
Term premiums
 Term premiums: an interest rate on long term bonds that is somewhat higher than the
expectation theory would suggest
 Since long term bond prices are more sensitive to changes in market interest rates, they
have higher interest rates risk
 The term premium compensates bondholders for the increased risk
Type of assets
 Money – highly liquid, inflation risk, short term maturity
 Bonds – differing default risk, term to maturity and liquidity
 Stock – dividends not guaranteed, substantial price fluctuation, most shares in large
corporations are liquid, no maturity
 Real estate – very illiquid, provides shelter service, no maturity
Asset demand
 There is a trade-off among the 4 characteristics that make an asset desirable: expected
return, risk, liquidity, and term to maturity
 The exact mix of different assets (portfolio allocation decision) depends on households
wealth, age, risk perception and appetite, etc.
Demand for money
 The demand for money is the quality of monetary assets (e.g. cash and chequing
accounts) that people choose to hold in their portfolios
 The demand for money will depend on the expected return, risk and liquidity of money
relative to other assets
 Money is the most liquid asset but pays a low return (zero nominal return)
 The macroeconomics variable that have the greatest effects on money demand are the
price level, real incomes and interest rates
o Higher price or incomes increase peoples need for liquidity => higher demand for
money
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Higher interest rates paid on alternative assets to money => lower demand for
money
The higher the general levels of prices, the more dollar people need to conduct
transaction
To meet the. Increased need for liquidity, people want to hold more dollar
Everything else being equal. The nominal demand for money is directly proportional to
the price level
Higher real income means more transaction and a greater need for liquidity, therefore, the
demand for money should increase
However, the increase in money demand need not be proportional to an increase in real
income, since higher income individuals use money more efficiently and nation financial
sophistication tend to increase as national income grows
Result: money demand rises less than one to one with an increase in real income
An increase in the expected return on money, i.e. interest rate on monetary assets, im,
increases the demand for money
An increase in the expected return on alternative assets, i.e. I, causes holder of wealth to
switch form money to higher return alternatives
This occurs as people trade off liquidity for return
o









Money demand function
 Md = P x L(Y,i)
o Md – aggregate demand for money
o P – price level
o Y – real income or output
o I – interest rate earned on nonmonetary assets
o L – function relating Md to Y and i
 Md = P x L(Y,r + π e )
o R – expected real interest rate
o π e – expected rate of inflation
o For any π e, an increase r increases I, hence reduces the demand
o For any r, an increase in π e increase I, hence reduces the demand for money
M d = L (Y, r + e)

π
P
Md
o
– real money demand (demand for real balances)
P
o L – the function that relates real money demand to output and interest rate is
called the real money demand function
Other factors affecting money demand
 Money demand increases a result of:
o Higher wealth (but the effect is likely to be small)
o Higher riskiness of alternative assets (relative to money)
o Lower liquidity of alternative assets (deregulation, competition, and innovation in
the financial sector has made alternative assets more liquid, reducing the demand
for money)
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

Note that higher efficiency of payment technologies (e.g. credit card) has reduced the
demand for money
Elasticities of money demand

The income elasticity of money demand is the percentage change in money demand
resulting from a 1% increase in real income
 The interest elasticity of money demand is the percentage change in money demand
resulting from a 1% increase in the interest rate
 The empirical evidence suggests that
o The income elasticity of money demand is positive but less than one (about 0.5)
o The interest elasticity of money demand is small and negative (About -0.3)
o The price elasticity of money demand is unitary (i.e. the nominal money demand
is proportional to the price level)
Velocity
 Velocity (V) measures how often the money stock “turns over” each period
nominal GDP
PY
o V=
=
nominal money stock
M
 Velocity is not constant
 M1+ velocity rose steadily during the 1970s, then became more volatile in the 1980s
before declining steadily since then
 Potential reasons
o Oil crisis in the 1970s
o Financial innovation since the early 1980s
o Lower interest rates in the 1990s and 2000s
 M2 velocity is more stable. The noticeable fall in 2008 was mainly because people
shifted their wealth out of risk assets (such as stocks and mutual funds) and back into
cash and bank accounts
Asset market equilibrium
 The asset market is in the equilibrium when the quantity of each asset that holders of
wealth demand equals the (fixed) avalaible supply of assets
 We assume that all assets may be grouped into monetary and nonmonetary assets
 Money includes currency and chequing accounts, pays interest rate, im, and has a fixed
nominal supply M
 Nonmonetary assets include stock, bonds, real estate, etc. pays interest rate I, and has a
fixed nominal supply NM
 The sum of all individual demand equals the economy total nominal wealth
o Md + NMd = aggregate nominal wealth
 Because there are only 2 types of assets in the economy, aggregate nominal wealth equals
the supply of money (M) plus the supply of nonmonetary assets (NM)
o M + NM = aggregate nominal wealth
 Thus, he equilibrium condition is
o Md + NMd = M + NM or
o (Md – M) + (NMd – NM) = 0
 If Md – M = 0 then NMd – NM = 0
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799







Asset market equilibrium reduces to the condition that the quantity of money supplied
equals the quantity of money demanded
In other words, as long as the amount of money supplied and demanded are equals, the
entire asset market will be in equilibrium
The asset market equilibrium condition is
M
= L (Y, r + π e)
o
P
M is determined by the central bank
Y and r are determined by equilibrium condition in labor and goods market
P is determined by the asset market equilibrium condition
M
o P=
e
L(Y ,r + π )
With other. Factors held constant, the price level is proportional to the nominal money
supply
Money growth and inflation
 The rate of inflation in s full employment economy equals the growth rate of the nominal
money supply minus the growth rate of real money demanded


The rate of inflation is closely related to the rate of growth of nominal money supply
Money is neutral in the long run. A change in the growth rate of money will lead to
higher inflation, price and nominal interest rate, but it won’t affect real variable such as
output, employment and real interest rate
Expected inflation rate
 Expected inflation rate is not directly observable
 It can be inferred from consumers and business surveys
 It can be calculated based on the difference in interest rate on real return bond and
conventional bonds
 In practice, the current inflation rate often approximates the expected inflation rate, as
long as people do not expect money or income growth to change too much in the near
future
 Policy actions (such as rapid expansion of money) that causes people to fear future
increases in inflation should cause the nominal interest rate to rise, all being equal
Slide 8: business cycle
Introduction to business cycles
 The business cycle is a central concern in macroeconomics, because business cycle
fluctuations are felt throughout the economy
 Classical economy views business cycles as representing the economy best response to
disturbance in production and spending
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

Keynesian economist argues that because wages and prices adjust slowly, disturbance in
production and spending may drive the economy away from its most desirable level of
output and employment for long periods of time
What is a business cycle?
 Business cycle are fluctuations of aggregate economic activity (such as real GDP,
employment, consumption, etc.)
 There are expansions and contractions:
o Aggregate economic activity declines in a contraction (or recession or depression)
until it reaches a trough
o Then activity increases in an expansion (or boom) until it reaches a peak
o The sequence from one peek to the next, or from one trough to the next, is a
business cycle
o Peaks and troughs are turning points, which can only be identified after the fact
due to lags in compiling national account data
 Persistence: once an expansion or contraction begins, it tends to continue for a period of
time
Canadian business cycle: historical record
 Recessions were common from 1867-1918. There were almost as many months of
contraction as months of expansion
 Since the end of WWII in 1945 the numbers of months of expansion have outcome the
months of contraction by more than five to one
 The worst economic contraction in the history of Canada was the great depression of the
1930s
o Stock market crashed and international trade halted
o Real GDP fell over 30% from the peak in April 1929 to the trough in March 1933
o Unemployment rate rose from 3% to 20%
 The great depression needed with the start of WWII
o Wartime production brought the unemployment rate below 2%
o Real GDP almost doubles between 1938-1944
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799







Real GDP growth and the unemployment rates are measured to be less volatile after 1945
There were 5 mild contractions form 1945-1961, followed by the longest expansion on
record of 160 month, from February 1961 to June 1974
The OPEC oil shock caused a recession between December 1974 and March 1975, less
severe than in the US but with soaring inflation and unemployment rate rising to 7%
The 1981-1982 recession was also severe, with unemployment rate over 12%
The 1990-1992 recession was milder, but the recovery was slow and erratic
The economy continued to expand since 1992 until January 2008. Growth slowed in 2000
and again in 2003 during that period
The sharp recession starting in 2008 lasted until May 2009, with unemployment rate
increased form5.9% to 8.6% and real GDP per capita fell by 3.8%
Have business cycles become less severe?
 Volatility in the economy has fallen a great deal after 1945 (especially since early 1980s)
 The decline in volatility of macroeconomic variable (such as real GDP and
unemployment rate) is called “the great moderation”
o Small realized shocks (i.e. luck)
o Better management of the business cycle
 More active and efficient macroeconomic policies (i.e. fiscal and
monetary policies)
 Established international institutions (e.g. IMF, world bank, etc.) which
facilitates coordination among countries in terms of their trade and
financial relationship
Business cycle facts
 Knowing the business cycle facts is useful interpreting economic data and evaluating the
state of the economy
 They provide guidance and discipline for developing economic theories of the business
cycle
 2 important characteristics of the cyclical behavior
o The direction in which a macroeconomic variable moves relative to the direction
of aggregate economic activity
o The timing of the variable turning point relative to the turning point of the
business cycle
 Procyclical variable moves in the same direction as aggregate economic activity
 A countercyclical variable moves in the opposite direction to aggregate economic activity
 An acyclical variable does not display a clear pattern over the business cycle
 A leading variable turning point occurs before those of the business cycle
 A coincident variable turning point occurs around the same time as those of the business
cycle
 A lagging variable turning point occurs later than those of the business cycle
 Cyclical behavior of key macroeconomic variables:
o Procyclical
 Coincident – industrial production, consumption, business fixed
investment, employment, import expenditure
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Leading - inventory investment, average labor productivity, money
growth, stock prices, trade balance
 Lagging – inflation, nominal interest rate
 Timing not designed – government purchases
o Countercyclical – unemployment (timing is coincident)
o Acyclical – real interest rate (timing is not designated)
Volatility – durable goods production is more volatile than nondurable goods and
services; investment spending is more volatile than consumption
Export expenditure are a reflection of foreign business cycles, not Canadas
Business cycles are often transmitted between countries through trade and financial
markets




Real wages
 In Canada, the real wage, measured as the total real compensation paid to all workers in
the economy divided by the total number of hours worked, is acyclical or mildly
procyclical
 Study based on disaggregated date, which takes into account the differences in terms of
industry, province, and both employee and job characteristics, finds that the real wage is
procyclical
Business cycle analysis preview
 Economic shocks are typically unpredictable forces hitting the economy (e.g. new
inventions, weather, government policy)
 An economic model describes how the economy responds to various economic shock
 Both classical and Keynesian theories can be presented within a general framework
called the aggregate demand – aggregate supply (AD-AS) model
Slides 9: the IS-LM-FE model: a general framework for macroeconomic analysis
Introduction to the Is-LM model
 This name originates from its basic equilibrium condition (for a closed economy)
o Investment, I, must equal saving, S
o Money demanded, L, must equal money supplied, M
 The model was first developed by Keynesians. By the addition of the FE (i.e. full
employment) condition, it can be used to present and discuss both Keynesian and
classical approaches to business cycle analysis
The FE line: equilibrium in the labor market
 Equilibrium in the labor market is represented by full employment line, FE
 When the labor market is in equilibrium, output equals its full employment (Ý = AF (K,
Ń )), regardless of the interest rate (FE line Is vertical)
 Full employment level of output, Ý , is determined by the full employment level of
employment ( Ń ¿, capital and productivity, any changes in these variables shifts the FE
line
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
the FE line: equilibrium in the labor market
The Is curve: equilibrium in the goods market
 The IS curve shows for any level of output (income), Y, the real interest rate, r, for which
the goods market is in equilibrium
 At all points on the curve, Id = Sd
 The IS curve slopes downward
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Factors that shift the IS curve
 For constant output, any changes in the economy that reduces desired national saving
relative to the desired investment will increase the real interest rate that clears the goods
market and thus shift the IS curve up and to the right. For example
o An increase in expected capital future output, wealth, expected future marginal
product of capital, or government purchases
o A decrease in effective tax rate on capital
 The IS curve in terms of goods equilibrium condition (AD = AS): for a given level of
output, any changes that increases the aggregate demand for goods shifts the IS curve up
and to the right because real interest rate must rise to reduce desired consumption and
investment and restore equilibrium. In a closed economy,
o AD = Cd + Id + G = AS = Y
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
The LM curve: asset market equilibrium
 The price of a nonmonetary asset is inversely related to its interest rate or yield
 That is, given the promised schedule of repayment of a bond or other nonmonetary asset,
the higher the price of the asset, the lower is the nominal interest rate of the asset
 For a given, rate of inflation, the price of nonmonetary asset is inversely related to the
real interest rate
 Higher r reduces the attractiveness sof money as an asset, hence, real money demand falls
as the real interest rate rises
 The money demand curve (MD) slope downward
 An increase in the level of output, Y, shifts the money demanded curve (MD) up and to
the right
 The real money supply curve (MS) is a vertical line. It is determined by the central bank
and does not depend on the real interest rate
 Equilibrium in the asset market requires that the real money supply equal the real
quantity of money demanded
 Starting at equilibrium, suppose output rises so real money demand increases. People sell
nonmonetary assets; hence the price of other assets falls, and the real interest rate rises.
As the real interest rate increases, the demand for money declines until equilibrium is
restored
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799



The LM curve shows the combination of the real interest rate and output that clears the
asset market
In other words, for any given level of output, the LM curve shows the real interest rate
necessary to equate real money demand and real money supply (MD = MS)
The LM curve slopes upward for left to right
Factors that shift the LM curve
 For constant output, any change that reduces the real money supply relative to the real
demand for money, will increase the real interest rate that clears the asset market, and
cause the LM curve to shift up for example,
o An increase in price level (P), nominal interest rate on money (im), wealth or risk
of holding nonmonetary assets relative to holding money
o A decrease in nominal money supply (M), expected inflation (π e), liquidity of
nonmonetary assets, or efficiency of payment technologies
 An increase in the money supply (M/P) will recue r and shift the LM curve down
 With an excess supply of money, holders of wealth try to purchase nonmonetary assets
causing their prices to go up and r to do down
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799


A change in any variable that affects real money demand, other than output or real
interest rate, will also shift the LM curve
An increase in real money demand will raise r and shift LM curve up
General equilibrium in the complete IS-LM-FE model
 When all markets are simultaneously in equilibrium, the economy is in general
equilibrium
 The general equilibrium of the economy occurs at the intersection of the FE line, the IS
curve and the LM curve
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Temporary adverse supply shock
 Suppose the productivity parameter A in the production function falls temporarily
 The supply shock reduces the marginal product of labor, hence, labor demand
 Lower labor demand reduces equilibrium real wage and employment
 Lower employment and lower productivity both reduce the equilibrium level of output
 The FE line shifts left
 A temporary adverse supply shock has no direct effect on the IS or the. LM curve
 Since the FE, IS, LM curves do not intersect (in this case AD > AS), the price level needs
to adjust (rise) until a new general equilibrium is reached
 The LM curve shifts up until it passes through the intersection of the new FE line and the.
IS curve
 A temporary supply shock causes a temporary increase in the rate of inflation
 Since the real interest rate is higher and output is lower, consumption and investment bust
be lower than before
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
A monetary expansion
 Suppose that the central bank decides to raise M
 P is constant (in the short run), so M/P increases
 The LM curve shifts down which leads to lower interest rate and higher output
 A short run equilibrium is reached at the intersection of the IS and the new LM curve
 In meeting the higher level of aggregate demand, firms are producing more output than
they want to in the short run. Eventually firms begin to raise their prices
 The rise in the price level causes the LM curve to shift up
 The LM curve keeps shifting until it is in its initial position, where the aggregate quantity
of goods demanded equals full-employment output
 The result is no change in employment, output, real wage or real interest rate
 The change in the nominal money supply causes the price level (as well as the nominal
wage) to change proportionately
 Money is neutral in medium run and long run
Trend money growth and inflation
 In practice, it makes more sense to assume that the money supply is growing
continuously
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

The above example can then be interpreted as an increase in the growth rate of M or P
relative to the expected or trend growth of money or inflation
A fiscal expansion
 An increase in governemnt purchases shifts the IS curve to the right and push the
economy out of its original general equilibrium
 P is constant (in the short run), and there is no change in real money supply
 A short run equilibrium is reached at the intersection of the new IS and the LM curve
 2 forces affect aggregate demand:
o Multiplier effect: the increase in G expand the demand for goods and increases
the number of transactions in the economy
o Crowding out effect: the increase in G raises the real interest rate which causes
private investment to fall
 Assume that the net influence of the multiplier effect and the crowding effect is an
increase in aggregate demand
 Firms produce extra output to meet the net increase in aggregate demand, so output rises
in short run
 Because aggregate demand exceeds full employment output, firms eventually begin to
raise their prices
 Increases in the price level reduces real money supply and shift the LM curve up to the
left until the aggregate quality of goods demanded equals full employment output
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
The. Debate between classical and Keynesian approaches
 There are 2 questions central to the debate:
o How rapidly does the economy reach general equilibrium?
o What are the effects of monetary policy on the economy?
 The economy is brought into general equilibrium by adjustment of the price level. The
speed at which this adjustment occurs is in the center of the debate
o Classical economist sees rapid adjustment of the price level, so the economy
returns quickly to full employment after a shock
o Keynesian economist sees slow adjustment of the price level. Therefore, it may
take several quarters even years before prices and wages adjust fully. When the
economy is not in general equilibrium, output is determined by aggregate demand
at the intersection of the IS and LM curve, and the labor market is not in
equilibrium
 Money is neutral if a change in the nominal money supply changes the price level
proportionally but has no effect on real variables
o Classical economist believe that a monetary expansion affects prices quickly with
at most a transitory effect on real variable
o Keynesian economist think that sluggish adjustment of prices might prevent
general equilibrium from being attained for a long period of time. Therefore,
although they believe in money neutrality in the long run, they reject money
neutrality in the short run
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Stabilization policy
 Unexpected shifts in the Is, LM and the FE curves are the sources of business cycles
 Stabilization policy is the use of fiscal and monetary policy to shift the position of the IS
and LM curves so as to offset the effect of such shocks
 Classical economist tends to think that the economy is quickly self-correcting. Thus,
there is no need for stabilization policies
 Keynesian economist in contrary stress that prices can be slow to adjust. Fiscal and
monetary policies can be implemented (especially during prolonged disequilibrium) in a
way to return the economy to general equilibrium more quickly (therefore, enhance
welfare)
The aggregate demand (AD) curve
 The AD curve represents the price level and output at which the IS and LM curve
intersect
 The AD curve shows the relation between the aggregate quantity of goods demanded (Cd
+ Id + G) and the general price level, P
 The Ad curve slopes downward because a higher price level is associated with lower real
money supply, which shifts the LM curve up, raises the real interest rate, and lowers
output demanded
Factors that shift the AD curve
 For a constant price level
o Any factor that changes the aggregate demand for output will cause the AD curve
to shift
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799



o Since aggregate demand is determined by the intersection of the IS and LM curve,
it is equivalent to say that any factor that causes the intersection of the IS and the
LM curve to shift will cause the AD to shift
Factors that shift the LM curve down and to the right will shift the AD curve to the right,
e.g.
o An increase in the nominal money supply, M
o A rise in expected inflation, π e
o A decrease in the nominal interest rate on money, Im
Factors that shift the IS curve UP and to the right will shift the AD curve up to the right,
e.g.
o An increase in expected future output
o An increase in wealth
o An increase in government purchases
o A reduction in taxes, T, assuming no Ricardian. Equivalence
o An increase in the expected future MPK
o A reduction in the effective tax rate on capital
Note that because monetary and fiscal policies shift the AD curve, they are often referred
to as aggregate demand policies
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799
Slides 10: monetary policy in Canada
Overview of Canadas monetary policy
 Monetary policy is concerned with how much money circulates in the economy and what
that money is worth
 Bank of Canada monetary policy is built on a framework consisting of 2 key components
o Inflation control target
o Flexible exchange rate
 Inflation control target is the cornerstone of Canada monetary policy since its
introduction in 1991
o Every 5 years, the bank of Canada and the government of Canada jointly renew
the inflation control target
o The latest one in October 2016 (till the end of 2021)
o Since 1995 the target range has been 1-3 per cent, with the bank’s monetary
policy aimed at keeping at the 2 per cent target midpoint
o The inflation control target is symmetric, i.e. the bank is equally concerned about
inflation rising above or falling below the 2 per cent target
o Inflation is measured at the 12-month rate of change in the total consumer price
index (CPI). In order to look through temporary changes in total CPI inflation, the
banks also monitor a set of core inflation measures, in particular, CPI-trim, CPImedian and CPI-common
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799






The inflation control target has helped to make the bank’s monetary policy action more
readily understandable to financial markets and the public
The target also provides a clear measure of the effectiveness of monetary policy
One of the most important benefit of a clear inflation target is its role in anchoring
expectation (predictability) of future inflation
The flexible exchange rate allows the bank of Canada to pursue an independent monetary
policy suited to the needs of the Canadian economy and acts as a “shock absorber”
Although there is no target for the external value of the Canadian dollar, the banks
closely monitor the exchange rate movements and takes into account their effect on total
demand and inflation in Canada
Factors affect the exchange rate of the Canadian dollar: world commodity prices, relative
economic performance, relative inflation rates, relative interest rates, relative productivity
(growth), trade and current account balance, short term capital flows, political turmoil,
etc.
Bank of Canada approach to monetary policy
 low stable and predictable inflation is the best contribution that monetary policy can
make to a productive, well-functioning economy
o allow Canadian to make spending and investment decisions with more
confidence
o encourage longer term investment in Canada economy, contribute to sustained
job creation and greater productivity, and lead to real improvements in our
standard of. Living
o contribute to the long-term soundness sof the Canadian dollar and the overall
health of the economy
 the bank carries out monetary policy through changes in its policy interest rate, i.e.
raising and lowering the target for the overnight rate
o the overnight rate is the interest rate at which major financial institutions borrow
and lend one day (or overnight) funds among themselves
o changes in the target for the overnight rate usually leads to changes in other
markets interest rate, asset prices and the exchange rate, therefore affect the total
demand and spending in the economy
o monetary policy actions usually. Take about 4-6 quarters to have their full effect
on economic activity and six to eight quarters to have their full effect on
inflation. As a result, monetary policy decisions must be forward looking
 in November 2000, the bank introduced a system of 8 “fixed” dates each year on which
it announces whether or not it will change the target for the overnight rate
o the scheduled approach reduces uncertainty and makes the operating process
more predictable
o the specific scheduling of the 8 dates reflect the flow of data and information that
the bank uses to gauge changing trends in the economy and in inflation pressures
o the bank retains the option of taking action between fixed dates, although it
would exercise this option only. In the vent of extraordinary circumstances
(September 17, 2001 and October 8, 2008)
why focus on inflation?
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799




Central banks are unable to directly influence variable other than inflation for any
sustained period of time
Both theory and empirical evidence suggest that monetary policy cannot have a
systematic and sustained effect on macroeconomic variables other than the inflation rate,
which limits the scope for monetary policy
It will make little sense for monetary policy to adopt other medium run (long run) targets
such as unemployment rate of the growth rate of real output
Both high inflation and deflation are bad for the economy
o Shoe leather cost, tax distortions, money illusion, speculations, uncertainty about
future inflation
o Downward spiral and effective lower bound
o The goal of the bank – low, stable and predictable inflation
Optimal inflation target
 Why should the inflation target be above zero?
o Measurement error – available measure of inflation is imperfect and tend to be
biased upward
o Downwards wage rigidity – workers are unwilling to accept cuts in nominal
wages
o Deflation and debt deflation
o Effective lower bound (ELB) – nominal interest rate cannot fall below zero too
much (current estimate for Canada – 0.5%)
Recent rebate about pursuing a higher inflation target
 Setting higher inflation may help alleviating the risk of hitting the ELC. However the cost
during transitioning to a higher target and the usual cost associated with higher inflation,
and more importantly the existence of unconventional monetary policy tools (i.e forward
guidance and funding for credit) lead the ban k to conclude that the current 2% inflation
target is appropriate
The conduct of monetary policy
 To keep inflation rate from below the target (i.e. overall demand is less than the overall
capacity to supply): decreases the target for the overnight rate => other markets interest
rate goes down, asset prices go up, Canadian dollar depreciated and inflation is expected
to rise in the future leading to higher future expected interest rate => increases in demand
=> rate of inflation rises
 To keep inflation rate from moving above the target (i.e. overall demand exceed the
overall capacity to supply): increase the target for the overnight rate => other markets
interest rate goes up, asset prices goes down, Canadian dollar appreciates, and inflation is
expected to fall in the future leading to lower future expected interest rate => decrease in
demand => rate of inflation falls
Time and uncertainty for monetary policy
 There exist various lags in the transmission mechanism
o Central banks must be forward looking
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)
lOMoARcPSD|5851799

o Policy makers should place more emphasis on long lasting shocks than shocks
believed to be short lived
o Policymakers need to use their best judgement and be flexible with the time
horizon for returning inflation to target
There are 2 types of uncertainties faced by monetary policy
o About the details in the transmission mechanism (about the precise nature of the
linkages between key macroeconomic variables)
o About current and future economic developments (both domestic and global
economies)
3 key activites of the central bank
 Research – economic relation are complex and are constantly changing which requires
continuous research on the nature of the transmission mechanism
 current analysis – in order to know what events are occurring and what events are likely
to occur in near future, central banks need to collect and analyze a great deal of current
data
 economic projection – feed past and current data into a model based on the knowledge
of economic relations understand from years of research and forecast the most likely
future path of macro variables, such as output, unemployment rate, wages, and prices;
this provides a starting point regarding the future evolution of the economy and the likely
future impacts of a certain policy action
decision-makers at the bank of Canada
 governing council – governor, senior deputy governor and 4 deputy governors
 monetary policy review committee (MPRC) – governing council plus 5-6 advisors, chiefs
of the 4 economic departments, the heads of the Montreal and Toronto regional offices,
and other senior personnel
 4 economic departments at the bank: Canadian economic analysis, international
economic analysis, financial stability and financial markets
 The staff projection presents a base case (most likely scenario) and identify key risk
(alternative scenarios) based on ToTEM II, GMUSE and other models
 Major briefing includes all 4 economic departments: (1) updates on economic
development and risk; (2) business outlook survey; (3) a report on capacity pressure and
alternative inflation measure; (4) an analysis of money and credit conditions; (5) senior
loan officer survey; (6) an overview in Canada, the Us and the rest of the world
 Staff recommendation starts with a senior member of the Canadian economic analysis
department or international economic analysis department summarizing and updating the
outlook and risk that have been presented in stages 1 and 2 and providing a
recommendation regarding any policy action to be taken, followed by an extensive
discussion by the entire MPRC. The meeting concludes with each member of the MPRC,
except for the 6 governing council members providing a policy recommendation
 The governing council reviews all information and recommendations, explores any
outstanding issues and difference in opinion and makes a decision by consensus. Then a
press release is drafter and approved
 The final stages focus on communication
Downloaded by tiffany liu (thao.nguyen2284@gmail.com)