Macroeconomics Lecture Notes
Jan 13 2009
microeconomics is the study of individual decision making by consumers, firms
and governments.
macroeconomics is the study of the economy as a whole. It considers the
problems of inflation, unemployment, business cycles, and economic growth.
economic policies - actions taken by government to influence economic activity
quota - the maximum amount of imports for a certain good into the nation
positive economics - the study of how the economy works
normative economics - the study of how the economy should work
science of economies - the application of the knowledge leaned in positive
economics to achieve the goals of normative economics.
Jan 15 2009
capitalism - an economic system based on private property and freedom of
choice
the governments role in a capital economy is the protection of property rights
prices coordinate an individuals wants
Socialism - is an economic system that tries to organize society in the same way
as families are organized
soviet style socialism - economic system that uses central planning to solve the
coordination problems
Production possibility frontier = Production possibility curve
collaboration and specialization and trade can lead to an increase in total
production
markets allow specialization and the division of labour. they allow individuals to
develop their comparative advantages.
Jan 27 2009
economic growth is measured in real GDP - the market value of goods and
services stated in the prices of a given year
the avg annual growth rate is called the secular growth rate
per capita real output is real GDP divided by total pop
the business cycle is the upward/downward movement of economic activity that
occurs around growth trends
the unemployment rate is the number of people who are willing and able to work
but do not have a job
cyclical unemployment is cause by economic restructuring that makes some
skills obsolete
full employment - when every one who wants a job and can work has a job
frictional unemployment - the unemployment caused by new entrants to
the job market and people who quit a job just long enough to find another
Cyclical unemployment - fluctuations in economic activity (boom and bust)
Structural unemployment - caused by economic restructuring that makes
some jobs and skills obsolete
target rate of unemployment - the lowest sustainable rate of unemployment
that policy makers believe is possible under existing conditions aka the
natural rate of unemployment
unemployment rate = unemployed/labour force
labour force - people willing and able to work, doesn’t include the incapable or
those not looking for work
discouraged workers - people who don’t look for a job because they don’t think
they will get one.
labour force participation rate - the percentage of the population above 15 years
of age.
the capacity utilization rate indicates how much capital is available for economic
growth = output/max possible output
potential output - output that would be achieved at target unemployment and
capacity utilization
Okun’s ruler of thumb is used to determine the effects or changes in income
related to unemployment
inflation is a continual rise is the price level
price index is calculated by dividing the current price of a basket of goods
by the price of the same basket in a base year
GDP deflator - an index of the price level of aggregate output relative to a base
year
consumer price index - measures the prices of a fixed basket of consumer
hoods. it is weighted according to each component’s share of an avg consumers
expenditures
nominal output is the total amount of goods and services measured at current
prices
real output - is the total amounts of goods and services produced adjusted
for inflation real output = nominal output/ price index
hyperinflation breaks down confidence in the monetary system, government and
financial institutions
Jan 29 2009
national income accounting - a set of rules and definitions for measuring
economic activity in the aggregate economy. it is one way of measuring
aggregate production.
Gross National Income aka GNP - is the aggregate final output of citizens and
businesses in one year
Net foreign factor income - the income from foreign domestic factor
sources minus foreign factor incomes earned domestically
Final output goods and services purchased for final use
intermediate goods - goods used in the production of other goods
GDP is equal to the sum of the four categories of expenditures;
consumption, investment, government spending, and (exports - imports)
consumption - when individuals receive income they can either spend it on
foreign or domestic goods, save it, or pay taxes with it.
personal consumption expenditures - payments by households for goods and
services
investments - the portion of income that individuals save leaving the
spending stream and goes into financial markets
gross private investment - business spending plus household spending on new
owner-occupied housing
depreciation - the decrease in an asset’s value due to it wearing out
net private investments = gross private investment minus depreciation. it is
the new investment above and beyond the replacement investment
government expenditures - gov payment for goods and services. govs
borrow from financial markets to make up for deficits
net exports (exports minus imports) are added to total expenditures
net domestic product - the sum of all expenditures minus depreciation
national income consists of employee compensation, interest, rent wages
and profit. it is a measure of all income of citizens and businesses in a
country
personal income is income by households
personal income = national income + transfer payments - corporate
retained earnings - corporate income tax - employment taxes
disposable personal income = personal income - personal taxes
purchasing power parity - adjusts for different relative prices among nations
before making comparisons
GDP - doesn’t figure in illegal activities which can range from 1.5-20% of some
nations GDP
Feb 3 2009
long-run growth focuses on supply. it assumes Say’s law - supply creates
its own demand. demand is sufficient to buy what is produced.
in the short run, economists consider potential output to be fixed. they
focus on how to get the economy operating at its potential if it isn’t
growth improves living standards b/c more goods are available to more
The rule of 72 is used to determine how long it takes to double income at
different rates of growth
rule of 72 - the number of years it takes for an amount to double in value is
equal to 72 divided by the growth rate.
Markets, specialization and the division of labour increase productivity and
growth
specialization - the concentration of individuals on certain aspects of
production
division of labour - the splitting up of a tasks to allow for
specialization of production
productivity = output/units of input
per capita output increases when output increases faster than the total
population.
per capita growth - producing more goods and services per person
= %change in output - % change in population
in many developing nations the population is rising much faster than the GDP
resulting in a lower per capita growth rate.
sources of growth
capital accumulation - investment in productive capacity
available resources
growth of compatible institutions - economic development boards
technological development
entrepreneurship
years ago it was thought that physical capital was the key to growth. The flow of
investments led to the growth of the stock capital. However capital accumulation
does not necessarily lead to growth. products change and useful buildings and
machines become useless
capital includes the skills embodied in workers through experience,
education and on the job training
social capital - the habitual way of doing things that guides people in how
they approach their position
technology - changes the way we make goods and supply services as well
as the goods and services be buy. technology translates into growth and
is visible through the total factor productivity (TFP) - the weighted avg of
real GDP per worker and real GDP per $1000 of capital stock
entrepreneurship is the ability to get things done. it involves creativity, vision, and
a talent for translating that vision into reality
the production function shows the relationship b/w the quantity of inputs used in
production and the quantity of outputs resulting from production
the production function has land, labour, and capital as factors in production
“A” is an adjustment factor that captures the effect of technology on production
Output = A times F(labour, capital, land)
scale economies describe what happens in a production function when all
inputs increase equally
constant returns to scale - increases in outputs = increases in inputs
increasing RTS - increases in outputs > increases in inputs
decreasing RTS - increases in outputs < increases in inputs
diminishing marginal productivity describes what happens when more of one
input is added w/o increasing any other inputs
law of diminishing marginal production - increasing one input, keeping all
others constant will lead to smaller and smaller gains in output - increasing
at a decreasing rate
the classical growth model focuses on capital accumulation in the growth
process. the more capital an economy has, the faster it will grow. B/c of
this emphasis on capital our economic system is called capitalism
classical economists focused on how to increase investment by saving
saving => investments => increase in capital => growth
classical growth model focused on how diminishing marginal productivity of
labour placed limitations on growth.
Feb 5 2009
Diminishing Marginal productivity of capital (DMPC) - capital grows faster
than labour => capital is less productive => slower economic output => per
capita growth stagnates => per capita income stops rising
DMPC is stronger for developed nations than undeveloped b/c they already
have lots of capital and therefore their growth rate is slower with the
addition of capital
poor countries w/ little capital grow faster w/ increases in capital
it shold then be expected that per capita incomes in rich and poor nations should
converge but they don’t
economists separate labour into two components
standard labour - the actual number of hours worked
human capital - the skills embedded in workers through experience,
education and on-the-job training
increases in human capital have allowed labour to keep pace w/ capital and
this allows economies to avoid DMPC
if skills are increasing faster in a rich nation than in a poor nation incomes in the
two nations would not be expected to converge
technology overwhelms DMPC so that growth rates can increase over time
New Growth theory (NGT) - emphasizes the role of tech rather than capital
in the growth process
tech is the result of investments in creating tech (r and d) investments in tech
increases the technological stock of an economy
NGT - separates investment in capital and investment in tech. increases in
tech are not as directly linked to investment as capital
increases in tech often have an large positive spill over effect
technological advances in one sector of the economy can lead to advances
in a completely different sector
technological advances have positive externalities - positive effects on others not
taken into account by the decision maker
NGT also highlights learning by doing - which increases worker
productivity and can overcome DMPC
technological lock-in - the economy doesn’t use the best tech available as it has
become intrenched in an older tech.
network externalities - an externality in which the use of a good by one
individual makes it more valuable to others
Economic policies to encourage per capita growth
encourage savings and investment
improve incentives to work
control pop growth
increase the level of education
create institutions that encourage technological innovations
provide funding for basic research
increase the economies openness to trade
modern growth theories have downplayed the importance of capital in the growth
process although they still recognize its importance
Canada uses tax incentives to increase savings (RRSP, TFSA)
it is difficult for poor countries to generate savings and investments as money is
often invested abroad
forging investment provides another source of savings
developing nations can borrow money from the IMF or the World Bank or
even private banks but this money often comes with large strings attached
income tax cuts to increase labour is known as supply-side economics. it
results in the substitution effect and the income effect which are opposites
when the substitution effect outweighs the income effect, then the tax cut
will increase labour supplied
nations who’s pop is rapidly growing have difficulty supplying capital and
education for everyone and thus per capita income decreases
some economists argue that to reduce pop growth, a nation must economically
grow first. the opportunity cost for women of having children is then high enough
to discourage it.
increasing the educational level and skills of the workforce increases labour
productivity, in developing nations the return on education is higher than in
developed nations b/c of diminishing marginal returns. although the education
must be of the correct type
Feb 10 2009
macroeconomics and aggregate demand are tools used to deal with recessions.
during the depression in the 30’s output fell by 30% and unemployment rose by
25%
the classical economists approach to the depression was to let the market
work it out and for the gov to do nothing. they applied microeconomic
theories to the depression. their solution to the high unemployment was to
eliminate the labour unions and high wages.
after the depression most people believed that the gov should take a role in
regulating the economy. People believed that the depression was caused by over
supply. they wanted the government to hire the unemployed even if the work was
not needed.
classical economists oppose deficit spending arguing that the money to
create jobs had to be borrowed. this money would have financed private
economic activity and jobs so everything would cancel out in the end.
according to Keynes a decrease in spending lead to job layoffs which
would lead to a fall in consumer demand and a further decrease in
production and more job layoffs. the economy would get stuck in a
feedback cycle.
income is not fixed at the economy’s long run potential income - it can fluctuate
for Keynes there was a difference b/w equilibrium income and potential income
Equilibrium income - the level of income to which the income gravitates in
the short run b/c of the cumulative cycles of declining or increasing
production
Potential income - the level of income that the economy is technically
capable of producing w/o out generating accelerating inflation.
keynes felt that at certain times the economy needed to help to reach its potential
income
he believed that market forces would not work fast enough or strong enough to
be strong enough to get the economy out of a recession
b/c short run aggregate production decisions and expenditure decisions are
interdependent, the downward spiral could start at any time
incomes would fall as people lost their jobs causing both consumption and
savings would fall as well
the economy would reach a new lower equilibrium
Paradox of thrift - an increase in savings can lead to a decrease in expenditures,
decreasing output and causing a recession.
the aggregate expenditure model looks at how real income is determined in an
economy
the AE model assumes that price level is fixed,and explores how an initial shift in
expenditures changes equilibrium output
Aggregate production - the total amount of goods and services produced in
every industry in an economy
production creates an equal amount of income. thus actual prod and actual
income are always equal
at all points on the aggregate production curve income is equal to production
aggregate expenditures - the total amount of spending on final goods and
services in the economy
consumption - spending by households
investment - spending by businesses
spending by gov
net foreign spending on Canadian goods - the difference b/w canadian
exports and imports (exports - imports)
autonomous expenditures - expenditures that are independent of income. they
change b/c of something other than income changes
induced expenditures - expenditures that change as income changes
autonomous expenditures is the level of expenditure that would exist at
zero income. they remain constant at all income levels
when income rises induced expenditures rise but by less than the change
in income thus it is inelastic
the relationship b/w expenditures and income can be expressed as an expend
function
and expend function is a representation of the relationship b/w aggregate expend
and income.
AE = AEo + (mpc.Y)
mpc.Y is the same as AEinduced
AEo - autonomous expenditures
Y - income
marginal propensity to consume (mpc) - the change in consumption that occurs
with a change in income. mpc is b/w 0 and 1 b/c individuals tend to save a
portion of an income increase
the mpc is the fraction spent from an additional dollar of income.
mpc = change in consumption/change in income
autonomous expends is the sum of the autonomous components of expends
AE = c + i + g +f
the slope of the expend function tells us the relationship b/w real expends and
income
feb, 24 2009
the MPC is the ratio of change in consumption to a change in income
autonomous expend is the sum of the autonomous components of
expends
AEo = Co+Io+Go+(X-IM)o
(all are autonomous)
a change in AEo or any of its components graphically result in a shift in the
line along the Y-intercept.
a change in MPC results in the change of the slope in the line
a change in income results in a move along the line
autonomous investment is the most volatile component of the GDP
AEo imports and exports depend on foreign and domestic incomes and relative
prices
Gov expends may also change as policies change.
at equilibrium expenditures must equal income
Y=AE => Y=AEo + mpc.Y => Y= (1-mpc) . AEo => Y = [1/(1-mpc)] . AEo
the multiplier equation tells us that the income equals the multiplier times
AEo
the process of adjustment ends when equilibrium is reached. firms are selling
what they produce, so they have no reason to change their production levels.
MPC marginal propensity to save - percentage of income that is withdrawn
from the economy for each round of the circular flow.
multiplier is calculated by 1/(1-mpc)
feb 26 2009
autonomous consumption expends respond to changes in
interest rates
household wealth
expectations of the future
the mpc + mps = 1 b/c you only have two choices with a dollar to save it or
to spend it.
when mpc increases the multiplier will increase and graphically this means
the intersects remain the same and the AE line gets steeper and the
equilibrium also increases
END OF CHAPTER 8
AD = Aggregate demand
the AD curve shows the combinations of price levels and real income
where the goods market is in equilibrium
the AD curve is an equilibrium curve
wealth effect - a fall in the price level will make the holders of money and
other financial assets richer, so that they can buy more goods and
services.
interest rate effect - a lower price level raises real money balances, lowers
the interest rate and increases the investment spending.
the interest rate goes down b/c the real value of the banks money has
increased and thus they are more encouraged to lend it out and thus they
must lower interest rates
the international effect - as the price levels in a nation fall the net exports
will rise and imports will fall.
initial changes in expends set in motion a process in the economy that amplifies
the initial effect. this is the multiplier effect.
internationally the multiplier effect usually occurs in the nation where the
price has fallen
anything that changes AE shifts the AD curve, but a change in price only
moves along the AD curve
the main shift factors are
foreign income
exchange rate fluctuation
expectations about output or prices
the distribution of income (local income either increases or decreases and is
affected by the mpc)
Macro policy - deliberate shifting of the AD curve by gov policies
expansionary macro policy- shifts AD curve to the right
contractionary macro policy - shifts AD curve to the left
the short run aggregate supply (SAS) curve - shows how firms adjust the
quantity of output when the price level is changed all other factors
constant
the SAS curve shifts when
change in production costs
changes in expectations of inflation
productivity
excise and sales taxes
import prices
when the price changes this is represented by moving along the SAS curve.
the net effect on prices is
% changes in prices = % change in wages - % change in productivity
the long run aggregate supply (LAS) curve - shows the amount of goods
and services an economy can produces when both labour and capital are
fully employed. Graphically it is a vertical line.
the position of the LAS curve is determined by potential output.
the LAS curve will shift when there are changes in
capital
available resources
growth-compatible institutions
technology
entrepreneurship
Mar 3, 2009
a recessionary gap is the amount by which equilibrium output is below
potential output. recessionary gap is at its largest when the bottom of the
recession is reached.
inflationary gap is the amount by which equilibrium income and potential
income when equilibrium income exceeds potential income
Fiscal policy - the deliberate change in either gov spending or taxes to
stimulate or slow down the economy.
expansionary fiscal policy - is appropriates if aggregate income is too low the gov can decrease taxes or increase spending - the deficit will increase.
the AD curve shifts to the right under expansionary fiscal policy.
contractionary fiscal policy - appropriate if aggregate income is too high the gov increases taxes or decreases spending - usually occurs when
inflation is too high.
deficit will decrease and the AD curve will shift to the left.
an economy has three policy ranges where the effect of an expansion of AD on
the price level will be different
Keynesian - price levels fixed
Intermediate - price levels are partially flexible
Classical - price level is very flexible
knowing potential output is crucial in knowing what policy to advocate
according to real business cycle economists, the best estimate of the potential
output of an economy is its actual income.
CHAPTER 10
an economy needs a counter-shock to get out of a deep recession because
of the multiplier effect.
Counter-shock - a jolt in the opposite direction of the shift in aggregate demand
to get the multiplier effect going
individuals, as individuals, are often not prepared to increase their
spending during a recession. Collective action is needed but often doesn’t
happen.
w/ fiscal policy the gov can provide the needed increase in spending by
decreasing taxes or increasing spending. the multiplier effect would then take
over.
Aggregate demand management - govs attempt to control the aggregate level of
spending in the economy
demand management is necessary b/c the effects are significantly different when
one person does something rather than everyone doing the same thing
Keynesians argue that in time of recession spending is a public good that
benefits everyone. therefore everyone must collectively spend their money.
during a recession an economy is below its potential income and there is a
recessionary gap. expansionary fiscal policy is required to combat a
recession
assuming the gov knows the value of the multiplier effect they can inject the right
amount of money into the economy to close the recessionary gap.
when inflation begins to accelerate beyond potential output fiscal policy
works in reverse by deceasing expenditures that are too high. this can be
very hard as one doesn’t want to combat inflation and in so doing cause a
recession
output may temporarily exceed potential output b/c firms and workers may be
slow to raise prices and wages.
govs decrease expenditures by an amount that reflects the magnitude of the
multiplier effect
there are two ways to think about fiscal policy in the model and in reality
in the model if a gov acts quickly in a counter cyclical way, depressions can be
avoided.
unfortunately the target rate of unemployment fluctuates and is difficult to predict
ex we don’t know if we are dealing with structural or cyclical unemployment.
it is extremely difficult to determine what the potential level of an economy
is.
fine tuning - a fiscal policy designed to keep the economy always at its
target or potential level of income.
changes in any of the five areas of autonomous expenditures can achieve the
same result as fiscal policies
Mar 5, 2009
there are three alternatives to fiscal policies
directed investment policies - are those affecting expectations to
increase incomes
trade policies
autonomous consumption policies
rosy scenario - gov policy of making optimistic predictions and never making
gloomy predictions
another way to influence investment is to protect the financial system by
gov guarantees or promises of guarantees ex gov policy preventing bank
failures
export-led growth policies - policies designed to stimulate exports and aggregate
expenditures on canadian goods ex trade agreements
exchange rate policy - a policy of deliberately affecting a country’s
exchange rate in order to affect its trade balance
a low value of a nations currency compared to other nations currencies
encourages exports and discourages imports
autonomous consumption policy is a third alternative. increasing the
availability of consumer credit to individuals increase consumption
multiplier is calculated by 1/(1-mpc)
activist gov policy seems so simple but in real life the model must be modified to
work
there are 6 assumptions of the AD-AS model which can lead to problems in the
real world
financing the deficit doesn’t have any offsetting effect
the gov knows what the situation is
the gov knows the economy’s potential output level
the gov has flexibility in changing spending and taxes
the size of the gov debt doesn’t matter
fiscal policy doesn’t negatively affect other gov goals
some economists believe that the gov financing of deficit spending offsets the
deficit’s expansionary effect
they believe that gov borrowing increases interests rates and crowds out private
investment thus the increase in gov expends is offset by a reduction in private
investments
in the formula the change in G will increase will decrease the change in I
crowding out - a change in gov expends is offset by a change in private expends
in the opposite direction
data problems limit the use of fine tuning policy as getting reliable numbers on
the economy takes time. It is possible for a nation to be in a recession and not
know it.
the gov has large econometric models and leading indicators to predict where the
economy will be in the near future.
but we never know for sure the level of potential income
differences in estimates of potential income often lead to different policy
recommendations
Okun’s rule of thumb - translates the changes in unemployment into
change in income
there is no inherent reason why adoption of activist policies should cause high
deficits year after year
politically it is easier to increase spending and decrease taxes than vice versa
automatic stabilizers - any gov program or policy that counteracts the
business cycle w/o new gov actions include welfare payments, EI, and
income taxes
unemployment benefits are automatically paid out to the unemployed offsetting
some of the effects of not having a job
when the economy rises taxes get more money slowing the economy. when the
economy falls taxes collect less money and this encourages the economy
modern economic theories have limited the fluctuations of economies
Mar 10, 2009
surplus - an excess of revenue over payments
deficit - a shortfall of revenue relative to payments
debt - the accumulated deficits
in the long run framework surpluses have both desirable and undesirable effects
good b/c they provide additional saving that can be used to boost
investment this assumes that the gov does investment better than the private
sector, which of course is not always true
deficits can be good b/c they allow the economy to maintain a level of GDP
at or beyond its potential
if the economy is running below potential, deficits can be used to stimulate
the economy.
if the economy is booming surpluses can be used to pay down the debt
the gov finances it’s deficits by selling bonds to private individuals and to
the central bank
bonds - promises to pay back the money in the future
a central bank is able to print money to buy gov bonds but are limited in
the amount they can print by inflation.
whether a nation has a deficit depends on what is included as revenue and what
is included as an expenditure. this accounting issue is central to the debate on
whether we should be concerned about deficits
retirement income system - social insurance that promises to pay people when
they are no longer working
what is important is not whether a budget is a surplus or deficit but on the
economic health of the economy.
debt must be compared in terms of the GDP
a nominal deficit is determined by looking at the difference b/w expenditures and
receipts
a real deficit is the nominal deficit adjusted for inflation
real deficit = nominal deficit - (inflation * total debt)
inflation reduces the value of the debt. the larger the debt and the larger the
inflation the more debt will be eliminated by inflation.
real surplus is nominal surplus what had been eliminated from the debt by
inflation
the lowering of the real deficit by inflation is not costless to the gov as it
can lead to higher interest rates
not all gov expenditures are independent of the level of income in the economy. a
deficit could result from policies designed to affect the economy or from income
deviating from its potential.
a structural deficit or surplus - the part of the budget deficit or surplus that
would exist even if the economy were at its potential level
a passive deficit or surplus is a deficit or surplus that exists b/c the
economy is operating below or above its potential. AKA cyclical deficit or
surplus
when the gov runs a deficit, it might be spending on projects that increase its
assets. if the assets are valued at more than their cost. then the deficit is making
society better off
there is no perfect answer as to how assets and debt should be valued. a nations
debt may not be indicative of an economies health
the total stock of gross debt can be broken down into market and non-market
debt
market debt - includes marketable bonds, treasury bills and other
securities
non-market debt - includes federal public sector pension liabilities and
other non-marketable debts
to calculate debt we add market and non-market debt and subtract the
value of financial assets held by gov such as cash reserves and loans
gov debt and individual debt are different for three reasons
gov debt is ongoing - it doesn’t die
gov can print money to pay off debts - individuals cannot
82% of gov debt is internal debt - debt owed to other gov agencies or
its citizens
paying interest on internal debt involves a redistribution of money among
citizens of the country. it doesn’t involve a net reduction in income of the
avg citizen
external debt is more like an individuals debt. it is money the gov owes to
individuals in foreign countries
most economists are most concerned with debt and deficits relative to the GDP
of a nation
most of the decreases in the debt to GDP ratio occurs through growth in
the GDP. when the GDp grow the gov can handle more debt.
real growth in Canada has averaged about 2.5-3.5 % per year (GDP) thus debt
can grow by the same amount without increasing the ration
the annual debt service - the interest rate on the debt times the total debt
Mar 12, 2009
Riacardain equivalence - a raise in gov spending leads to an equal raise in
taxes leads to an equal raise in equilibrium income
Ch 12
w/o the money market you cannot discuss inflation, interest rate, credit
availability or exchange rate management as all of these things are functions of
money
money is a medium of exchange. it is a unit of account and a store of wealth
money facilitates exchange by reducing the costs of trading as w/o money we
would have to barter which takes time and energy that isn’t required when you
use money
money doesn’t have to have any inherent value to function as a medium of
exchange. all that is necessary is that everyone believes that other people
will exchange it for their goods.
the bank of Canada’s job is not to issue too much or to little money. it must
compare the amount of money available to the amount of goods available
Money prices are actually relative prices
a single unit of accounts saves our limited memories and helps us make
reasonable decisions based on relative cost
money is a useful unit of account as long as its value relative to other prices
doesn’t change to quickly if this happens then it uses its usefulness as a unit of
measurement
as long as money is serving as a medium of exchange, it automatically also
serves as a store of wealth. it’s usefulness as its store of wealth also
depends upon how well it maintains its value.
we hold money even when it doesn’t pay interest b/c it is worthwhile to use to buy
goods
the demand for money is how much money people wish to hold as cash.
The Money supply is determined by the Bank of Canada
the interest rate results from the interaction of money demand and money
supply
Quantity Theory of Money
- every transaction must have a buyer and seller
- velocity - the speed at which each dollar changes hands in a new
transaction
aggregate purchases equal aggregate sales = number of transactions times
avg price/transaction
TxP
total sales equals the amount of money in the economy (M) times the avg
number of times it changes hands (V)
M x V (all transactions are
assumed to be paid for by money)
the equation of exchange is an identity:
MV = PT
V is the transaction velocity of money - the avg number of times a dollar is
exchanged b/w a buyer and a seller in a given year.
V is assumed to be constant.
P is measured by the consumer price index
M is measured as M1 or other measure of money stock
T is more difficult to quantify. the volume of transactions moves in a stable
proportion to people’s nominal income, P*Y so the demand for money is
proportional to Y
we can write the demand for money as Md = kPY
the k translates the economies nominal income (PY) into nominal money
demand. it is called the Cambridge k. it turns the equation of exchange into
a theory of money. the cambridge k is a function of velocity
the income velocity of money is the avg. number of times a dollar is
exchanged to generate the observed level of nominal income.
V = PY/M
Mar 17, 2009
income velocity of money is relatively stable but has changed due to
financial innovations - ATM and new types of bank accounts
interest rates- as interest rates rise, we hold our wealth and income in
assets which pay interest - money doesn’t pay interest
Keynes believed there were three reasons for people to hold money:
transactions demand - is money that is needed to undertake the
purchases of goods and services. It increases with increases in income.
precautionary demand - is money that is needed to meet unforeseen
expenses. people hold money over and above what is necessary to meet
normal expenses.
speculative demand - money that forms part of an individual’s
portfolio of assets. Keynes considered a portfolio to be composed of two
types of assets, money and bonds.
money doesn’t pay interest when it is held outside of a bank, but it can
increase in value when the price level falls.
bonds pay interest and may generate a capital gain when sold.
secondary financial markets encourage people to own financial assets by
providing liquidity - the ability to turn an asset into cash quickly.
when a bond matures, the holder is paid the face value of the bond. the
difference b/w the face value and the purchase price of the bond is the
yield - it is calculated as a %
maturity refers to the date that the issuer must pay back the money that was
borrowed plus any remaining interest, as agreed when the asset was issued.
the profit from holding a bond is greater than the profit from holding money, yet
people still hold money for liquidity purposes.
liquidity preference is the choice b/w holding bond or money.
Keynes believed individuals formed a “normal” rate of interest - the rate
they believe rates will return to in normal conditions. everyone has a
different value for the “normal” rate of interest
Keynes believed that people’s expectations regarding interest rates
affected the liquidity preference. above the normal rate of interest people
will choose to invest all of their portfolio in bonds. below that rate people
will hold only money.
money demand is zero above the normal rate of interest. the relationship b/w
money and bond demand is inverse
the money demand curve curve is a smooth down-ward sloping function b/c
everyone has a different beliefs about what the normal rate of interest should be.
there is a negative relationship b/w the interest rate and money demanded.
the demand for money combines the three types of demand for money
money demand is a positive function of the price level and real income.
autonomous money demand is the amount of money held if income is zero.
people may have accumulated savings, borrow money, or may receive
transfer payments
to find equilibrium we set money demand equal to money supply. this
yields the equilibrium interest rate
the opportunity cost of holding money is the interest rate, since the money
could be invested in an interest earning asset.
the money demand curve would shift when real income or autonomous
money demand changes. it will shift right when real income rises. it would
also shift right if autonomous money demand rises
given a fixed supply of money, an increase in money demand will cause
equilibrium interest rates to rise. a shortage in money causes its price to
rise. the price of money is the interest rate.
Md=P(Md0+hY-li) this is the equation for money demand
Mar 24, 2009
h is the sensitivity of money demand to changes in real income
l is the sensitivity of money demand to changes in interest rates
end of chapter 12
the financial sector plays a central role in organizing and coordinating the
economy.
financial sector - the market for the creation and exchange of financial
assets such as money, stocks and bonds.
savings are channeled into the financial sector when individuals buy
financial assets and then the money is sent back into the spending stream
as investments.
financial assets are stocks or bonds whose benefit to the owner depends on the
issuer of the asset meeting certain obligations.
financial liabilities - obligations by the issuer of financial assets
while price is the mechanism that balances supply and demand in the real sector,
interest rates do the same in the financial sector.
the interest rate is the price paid for the use of a financial asset.
bonds are promises to pay a certain amount plus interest in the future.
the price of the bond is determined by the market interest rate. the credibility of a
bond is based on the credibility of the financial institute that issues the bond.
the price of bonds varies inversely with the interest rate.
as the market interest rate goes up the price of the bond goes down
and vice versus. this is because there are now more valuable bonds in the
market and the current bonds don’t pay out as much interest rate.
when the interest rates rise the value of the flow of payments from fixed-
interest-rate bonds goes down b/c more can be earned on new bonds that
pay the new higher interest.
savings held in bonds eventually work their way back into the money stream
through investments
Bank of Canada - the Canadian central bank whose liabilities (bank note) serve
as cash in Canada.
a number of different financial assets serve the same function of money
and thus have a claim to be called money and thus economists have
defined different measures of money.
M1 - consists of currency in circulation and chequing account balances at
chartered banks
Chequing account deposits are included in all other definitions of money.
M2 - is M1 plus the personal savings deposits, and the non personal notice
deposits (term deposits) held at chartered banks.
M2 components are highly liquid and play an important role in providing
reserves and lending capacity for commercial banks
numerous financial assets have some attributes of money. that is why they are
included in some measures of money
the broadest is M2++ - includes almost all assets that can be turned in cash
at short notice
M1, M2, M3 measures only include deposits held at chartered banks
measures containing a + also include deposits at other financial
institutions, such as near banks - financial intermediaries which offer
services similar to banks but are not chartered banks
credit cars affect the amount of money people hold - generally credit card holders
carry less cash.
banks are both borrowers and lenders
banks take deposits and use that money they borrow to make loans to
others
banks make a profit by charging a higher interest rate on the money they
lend than the money they borrow.
banks can be analyzed from the perspective of asset management and liability
management.
asset management - is how a bank handles its loans and other assets
liability management - how a bank attracts deposits and how it pays for them.
Mar 26, 2009
assets - what the bank owns - buildings, equipment, securities, portfolios and
loans
liabilities - what the bank owes - customers deposits
net worth - bank assets minus liabilities.
banks keep reserves on hand in order to meet daily withdrawals by customers
cash and deposits with the bank of canada
the amount of reserves depend on profit maximization and prudence
excess reserves - cash reserves over and above the level of reserves banks
wish to hold. they are not needed, so the bank lends these out.
the reserve ratio is the ratio of reserves to deposits a bank keeps as a
reserve against cash withdrawals. usually around 5%
secondary deposits occur when money that is deposited is loaned out and then
re-deposited back into the bank.
the deposit multiplier tells you how much a new primary deposit can
expand total deposits the deposit multiplier - 1/r
the increase in money stock is determined by
(1/r X primary deposit) - primary deposit
the simple money multiplier is the measure of the amount of money
ultimately created per dollar deposited in the banking system. it equal 1/r
when no currency is held in reserve
currency drain - occurs when individuals do not deposit the entire amount into the
bank, but keep some of the loan as cash.
the money creation process assumes there is no currency drain.
if the original deposit is 100 and the reserve ratio is 10% then:
1/r = 1/.1 = 10 then 10 X 100 - 100 = 900
thus from the original 100 deposit 900 can be loaned out. the higher the r
the lower the amount can be loaned out.
the approximate real-world money multiplier in the economy is:
1/(r+c)
r = percentage of deposits banks must hold in reserve
c = percentage of money that people hold in cash to the money they
hold as deposits.
if a bank must hold 10% and the individuals cash holdings to their deposits is
25% then
1/(.1+.25) = 1/.35 = 2.9
promises to pay underlie any financial system
all that backs the modern money supply are promises to borrow to repay their
loans and the govs guarantees that banks’ liabilities to depositors will be met.
the banks ability to create money can present problems
banks borrow short and lend long.
if people lose faith in banks, the banks cannot keep their promises and the
financial system will fail.
to prevent panic govs will guarantees the obligations of many financial institutions
the Canada Deposit insurance Corporation - created in 1967 insure peoples
deposits in chartered banks
guarantees have two effects
they prevent unwarranted fear that causes financial crises
the prevent warranted fears
Chapter 16
the balance of payment is a country’s record of all transactions b/w its
residents and the residents of all foreign countries.
the current account - the part of the balance of payments in which all shortterm flows of payments are listed. it includes imports and exports of both
goods and services; net investment income; and net transfers.
the capital and financial accounts are the part of the balance of payments
account in which all long-term flows of payments are listed. when
canadians buy foreign securities or when foreigners buy canadian
securities, they are listed here as outflow and inflows respectively.
the gov can influence the exchange rate by buying and selling official reserves gov holdings of foreign currencies.
Mar 31, 2009
the balance of merchandise trade is the difference b/w the imports and exports of
goods
there is no reason that the balance of goods and the balance of services
should be equal
the capital account measures transactions such as international
inheritances, federal debt forgiveness and the transfer of intangible assets
the financial account measures transactions in financial assets and
liabilities . it includes Canadian portfolio investment abroad and foreign
investment in Canadian stocks and bonds.
when comparing the currencies of two countries the supply of one countries
currency must equal the demand for that currency by the other country.
it operates like any other good and is set by the supply and demand of the
currency
in order to demand one currency you must supply another
a surplus in the balance of payments means that the quantity supplied of a
currency exceeds the quantity demanded
when a nations income falls, the demand for imports falls, then the demand
for foreign currency falls. this means that the price of that country’s
currency rises relative to foreign currency b/c your demand for foreign
currency has decreased. it is cheaper to buy the foreign nations currency.
if a nation has higher inflation then foreign goods become cheaper. foreign
demand for currency would decrease as the nation with higher inflation
imports more and the domestic demand for foreign currency increases as it
is used up to buy foreign goods
a rise in the Canadian interest rate relative to those abroad will increase
foreign demand for Canadian Assets. This increases the demand for
Canadian dollars and the supply of Dollars decreases as Canadians are
more inclined to buy canadian assets instead of foreign ones.
currency support - is the buying of currency by gov to maintain its value above its
long run equilibrium value.
a country can maintain a fixed exchange rate only as long as it has the
official foreign currency reserves to maintain the rate. Once it runs out of
this reserve it will be unable to intervene and then they must either borrow
to support the rate or devalue the currency.
foreign reserves could also be made up of precious metals.
currency stabilization - the buying and selling of currencies by the gov to
offset temporary fluctuations in supply and demand for currencies. it is a
practical long-run exchange rate policy.
it is simply trying to keep the exchange rate at that long-run equilibrium not trying
to support the rate above or below the long run equilibrium.
if a nations runs out of official reserves it must adjust its economy to
maintain the exchange rate.
significant amounts of stabilization are impossible b/c the levels of official
reserves is too small relative to the enormous volume of private trading.
when there is healthy rate of exchange rate fluctuations, foreign currencies are
bought and sold fairly equally and there isn’t a fear of running out.
strategic currency stabilization - buying and selling at strategic moments to
affect the expectations of traders, and hence to affect their supply and
demand. this is used by nations with small official reserves.
April 2, 2009
long run equilibrium exchange rate can be estimated using purchasing
power parity which is a method of calculating exchange rates that attempts
to value currencies at a rate such that each currency will buy an equal
basket of goods
there are three exchange rate regimes
fixed exchange rate - the gov chooses the exchange rate and then
intervenes to keep the exchange rate at that level
Flexible exchange rates - exchange rates are determined by the
market and are allowed to fluctuate
partially flexible exchange rates - the gov sometimes affects the
exchange rate and sometimes leaves it to the markets.
common currencies and monetary unions can have many advantages including:
price transparency - removes some economic barriers as all people now
what everything is worth
firms will consider the monetary union area as one “country” and this can
increase union wide foreign investment
ad valuem tariffs are based on the value of the good entering the country.
specific tariffs are based on the quantity of goods being imported
regulations barriers are an affective way of limiting imports or exports
without using tariffs (more common) and quota’s.
trade policy - involves gov creating trade restrictions on imports in order to
meet the balance of payments constraint w/o using traditional macro
policies or exchange rate
April 7, 2009
foreign producers like quotas more because they don’t have to pay they are only
limited on how much they can import into the nation. also the producers that are
able to import are paid more for their goods than if they sold them at home.
voluntary restraint agreements - a voluntary limitation of imports by foreign
firms
an embargo is an all out restriction on the import or export of a good.
embargoes are usually created for international political reasons rather
than for primary economic reasons.
regulatory trade restrictions are indirect methods of imposing
governmental procedural rules that limit imports. ex limiting or prohibiting
foodstuffs from being imported because a certain pesticide is used
Nationalistic appeals can also be used to restrict trade but it is implicit. the
two products must be of equal quality and appeal when compared.
protectionism resonates well with politicians and voters but economists agree
that free trade is better for the economy than trade restrictions.
trade restrictions lower aggregate output - one nation benefits while most
nations are hurt. Trade restrictions work only if there is no retaliation and
often retaliation is the rule.
trade restrictions lower international competition - domestic companies
become less efficient from a lack of competition. also less efficient
producers are not driven out of the market.
strategic trade policies are threats to implement tariffs to bring about a
reduction in trade or some other concession from the other country. Based
on the retaliation ability of the threatening nation and also the willingness
by that nation to implement these.
when tariffs are reduced domestic prices are reduced and the consumer
benefits. some high-cost producers will have to leave the industry and
production in the short term will decline. in the end only the most efficient
producers are left.
free trade is not necessarily fair trade.
Chapter 15
inflation - the average price level in a given economy increases!!!!!!!!!!!!!!!!!
know the different kinds of unemployment.
unexpected inflation redistributes income from the lender to the borrow. people
who do not expect inflation and are tied to fixed nominal contracts are likely to
loose money.
expectations play a key role in the inflationary process
rational expectations - the expectations that the economists models predict
adaptive expectations - are those based, in some way, on what has been in
the past
extrapolative expectations - are those that assume a trend will continue
the basic rule of thumb
Inflation = nominal wage increases - productivity Growth
this means that if the wage increases w/o an increase in productivity you have
inflation but if wage increase as productivity increases then there isn’t inflation
demand-pull inflation results from producers raising prices without
increasing output, the gov must then pump more money into the economy so
people can buy the goods. it is inflation that occurs when the economy is at
or above potential output - it is generally characterized by excess demand
for goods and workers. demand for goods pulls the inflation up.
cost-push inflation inflation that occurs when the economy is below
potential output. producers who raise their prices believe that they will sell
their goods b/c their products are essential and workers who raise their
wages believe they won’t lose their jobs.
the quantity theory of inflation emphasizes the connection b/w money and
inflation. more money induces inflation
the institutional theory of inflation emphasizes market structure and pricesetting institutions and inflation. higher prices induce inflation.
the equation of exchange - the quantity of money times the velocity of money
equals price levels times the quantity of real goods sold
MV=PY
in the short run V is constant
inflation tax - is an implicit tax on the holders of cash and assets as their money
and goods are now worth less in real terms.
according to the quantity theory of inflation the direction of causation of
inflation moves from left to right. the amount of money causes the inflation
MV => PY
the institutional theory is the opposite. increases in prices forces gov into
positions where it must increase money supply or cause unemployment
MV <= PY
April 14, 2009
inflation is a tax on money holders and lenders but a subsidy to borrowers
(in real terms)
the insider-outsider model is an institutionalist story of inflation where
insiders bid up wages and outsiders are unemployed. the higher wages
forces up the price level and that forces up the money demand and leads to
inflation. Insiders are business owners and workers with good job security
and excellent long-run prospects: outsiders are everyone else.
stagflation - the combination of high inflation and high unemployment at
the same time.