ECON 209 Class Notes PDF

ONE: Introduction to Macroeconomics 4 September – Chapter 4 Syllabus Lectures on Monday and Wednesday Pick at least one conference to attend weekly Discussion boards are sorted by topic Exams are closed book and multiple choice ○ Midterm: October 23 30/20% ○ Fi...

ONE: Introduction to Macroeconomics 4 September – Chapter 4 Syllabus Lectures on Monday and Wednesday Pick at least one conference to attend weekly Discussion boards are sorted by topic Exams are closed book and multiple choice ○ Midterm: October 23 30/20% ○ Final: December 70/80% Textbook: Ragan Macroeconomics 17th ed. Micro vs. Macro ○ Microeconomics: individual economics units ex. markets, consumers, firms, etc ○ Macroeconomics: the overall economy Macroeconomics topics: ○ National income ○ The standard of living ○ Economic growth ○ Employment and unemployment ○ Prices and inflation ○ Exchange rates ○ Imports and exports ○ Monetary and fiscal policies Each stage in the course: ○ Learn the basic theory of how the economy works ○ Apply the basic theory to aspects of concern ○ Expand the basic theories The Circular Flow of Income and Expenditure Injections = Withdrawals ○ No change in economic growth ○ Equilibrium Macroeconomic Variables (4.1) Output generates income Total $ value of domestically produced G & S is nominal national income or nominal GDP  ○ Note: nominal refers to values measured in current prices without adjusting for inflation Must adjust for inflation to find annual change in Q of production between years (measuring in constant dollars) Total value of current output at some base-period prices is real national income or real GDP ○ Text refers to real GDP (unless otherwise specified) Real economic growth = incr. in real GDP ○ Real per capita economic growth = incr. in real per capita GDP ○ Remember: this is an average value Real GDP measures the Q of total output produced by the nation’s economy during a year ○ Fluctuates around a rising trend: Long-run economic growth Short-run fluctuations of the business cycle Recession is a period of negative economic growth ○ Loosely defined to be at least 2 consecutive quarters Potential output Y* is the real GDP if all available resources are employed at the normal intensity of use ○ Sometimes known as full-employment output Upward trend in Y* caused by growth in the economy’s productive capacity ○ Labor force ○ Capital stock ○ Technological change The output gap is the difference between the potential and actual output ○ Recessionary gap: Y < Y* ○ Inflationary gap: Y > Y* The Business Cycle TWO: Macroeconomic Variables 9 September – Chapter 4 National Income National income is an important measure of economic performance ○ Recessions are associated with unemployment and lost output ○ Booms can bring inflation The long-run trend in real per capita is an important determinant of standard of living ○ Economic growth does not make everyone better off Employment and Unemployment Employment E: the number of workers (ages 15 plus) who hold jobs Unemployment U: the number of workers (ages 15 plus) not employed but actively looking for a job Labor force LF = E + U ○ Employment grows roughly in line with the growth in the labor force Unemployment rate U/LF ○ Percent of the labor force ○ Note: the number of unemployed people can increase even if the U rate is unchanged ○ Short-term fluctuations in the unemployment rate are substantial Even when Y = Y*, some unemployment exists: ○ Frictional unemployment: the natural short-term turnover ○ Structural unemployment: mismatch of skills between jobs and workers Possible causes: technological advancements, changes in consumer demands, globalization, etc In a recessionary gap Y < Y*: ○ Cyclical unemployment: tied to the economic cycle In a recession, firms cut costs by laying off workers In an expansion, firms have the funds to hire more workers Who are the unemployed? People in the labor force are classified as unemployed if: ○ They are available for work ○ Have actively searched for a job in the last 4 weeks US Bureau of Labor Statistics calculates both an Official and Real unemployment rate ○ Official: used by governments to assess their policies and determine maximum duration of unemployment insurance benefits ○ Real:  Discouraged workers: have not looked for a job in the last year because they believe they will not find one Marginally attached workers: want to work and are available for work, have not actively looked in the past 4 weeks but have searched sometime in the past 12 months Underemployed workers: part-time workers who would prefer full-time jobs Why does unemployment matter? General hardship = loss of output and income ○ Mental illness, crime, and general social unrest tend to be associated with long-term unemployment Some types of unemployment is desirable or natural ○ Frictional reflects the time needed for workers and firms to seek each other out ○ Cyclical reflects the natural ebbs and flows of the business cycle But some unemployment is associated with human hardship ○ Structural is long-term unemployment caused by workers possessing skills not in demand by firms Productivity Output per unit of input ○ Real GDP per worker or real GDP per hour of work Incr. in productivity probably single largest cause of LR incr. in the standard of living ○ New and better technology ○ Improvement in skills Note: a 3% incr. in real GDP with a 4% incr. in population gives reduction in the average standard of living Inflation and Price Level P level: average level of all prices expressed as an index number Inflation: percent incr. in P level Consumer price index CPI: index of the average prices of G & S bought by average households ○ Based on the price of a typical ‘consumption basket’ relative to its base year price ○ Weighted average of price changes in the basket of G purchases by the average family/household Why does inflation matter? The value of money is attributed to what we can purchase with it  The purchasing power of money is the amount of goods and services that can be purchases with a unit of money ○ Inflation reduces the purchasing power of money ○ Reduces the real value of any sum fixed in nominal terms If households and firms fully anticipate inflation over the coming year: ○ They will be able to adjust many nominal prices and wages to maintain their real values Unanticipated inflation generally leads to more changes in the real values of prices and wages ○ In reality: inflation is rarely fully anticipated or unanticipated Result: there is some adjustment in wages and prices but not enough to leave unchanged the economy’s allocation of resources Importance of Inflation Purchasing power of money negatively related to the P level Inflation: ○ Hurts people on fixed income (refer to the rule of 72) ○ Reduces the real value of things with a fixed price ○ Creates expectations of further inflation, which affects other behavior (ex. US house prices and savings rate) Deficiencies of the CPI [LR] Changes in the quality of output Needs periodic updating of the base year ○ New products (goods in the basket) ○ Changes in spending patterns (weight of each good) Note: the calculated inflation rate using the CPI is for the goods consumed by the average household ○ The actual inflation rate for low-income households may be quite different than for high-income households Interest Rates The interest rate is the price of “credit” ○ Flow of credit crucial to firms and households in a modern economy Nominal i: expressed in money terms Real i: expressed in terms of purchasing power ○ Real interest rate = nominal rate - inflation rate The effects of unanticipated inflation on borrowers and lenders depends on the real interest rate: ○ Hurts the lender  ○ Benefits the borrower The International Economy Foreign exchange: foreign currencies Exchange rate: number of CAD to buy/sell unit of foreign currency Depreciation of the CAD = worth less on the foreign exchange market ○ Rise in the exchange rate ○ Takes more CAD to buy unit of foreign currency What happens? ○ Domestic P of Canada’s imports rise ○ Foreign P of Canada’s exports fall THREE: Measuring GDP 11 September – Chapter 5 Balance of Payments (always = 0) The balance of payments accounts record all payments made in international transactions (G & S, assets): Trade balance Capital account balance [Canada]: exports and imports are large (roughly 35 percent of GDP) but the balance of trade is usually small Long-Term Growth: important for society’s living standards How much can government actions affect the economy’s LR growth rate? Short-Term Fluctuations: business cycles Different views on effectiveness of monetary and fiscal policy influence fluctuations ○ Economics argue governments should not attempt fine-tuning Can recessions and booms be self-fulfilling prophecies? General pessimism about the future Consumers expect average incomes to stop growing Firms expect sales to stop growing Firms cut investment spending Less intermediate capital goods are produced Workers are laid off Laid-off workers buy less G & S Incr. fear of lay-off means households incr. saving and decr. spending Firms reduce production of final G Cycle continues into recession [Result] Expectations seem to have been correct. But the economy reacted to expectations. National Output and Value Added (5.1) Production stages: Intermediate products Final products (G & S) GDP = value of final G & S produced in the domestic economy ○ Incl. additions to inventory produced that year ○ Incl. exports of intermediate goods (final sales domestically) ○ Excl. imported final goods, not domestic production Problem: distinguishing between final goods and intermediate goods Double counting is avoided by value added ○ = revenues - cost of intermediate goods ○ = incomes to factors of production (at the firm) Total value added gives GDP National Income Accounting: The Basics (5.2) Three methods for measuring national income (output): Total value added from domestic production Total expenditures on domestic output Total income generated by domestic production GDP from Expenditures Four broad categories to sum expenditures need to buy total year’s output: Consumption C is actual spending on final G & S consumed in a given period ○ Final goods only to avoid double counting ○ Home ownership valued at estimated rental value Investment I is actual spending on production not for present consumption ○ Change in inventories (at market value) ○ Plant and equipment ○ Residential investment (new housing construction is treated as an investment) Note: gross investment has two components ○ Replacement investment maintains level of capital stock ○ Net investment adds to capital stock Government purchases G ○ Excludes transfer payments ○ Valued at cost ○ Denationalization: moving government production to the private sector (unchanged total output) incr. GDP Production is now valued at market value Net exports NX = X - IM ○ Exports added = produced in Canada ○ Imports subtracted = produced elsewhere GDP: sum of all categories = C + I + G + (X - IM) GDP from Income Factor incomes and non-factor payments: Factor incomes (net domestic income)  ○ Labor wages and salaries (before deductions) ○ Capital: rent, interest, and profits Interest excl. interest on government bonds (transfer payment) Non-factor payments ○ Indirect taxes (non-income) minus subsidies Ex. firm revenue is 10000, government subsidy is 2000, thus market value is 8000 ○ Depreciation (K) Physical capital depreciates as it helps produce current output K produced in previous years = created income in current year Depreciation measured by Capital Consumption Allowance GDP: sum of net domestic income, indirect taxes, and depreciation Note: additions to inventory are valued at market prices Further Issues on National Income Accounting (5.3) Difference in nominal and real GDP changes vary yearly = caused by change in P ○ This year’s output valued at current prices = nominal GDP ○ This year’s output valued at base period prices = real GDP Get another measure of inflation from the GDP deflator ○ Index number derived by dividing nominal GDP by real GDP ○ Measures average change in P of all the items in GDP Changes in GDP deflator not the same as changes in the CPI ○ Change in CPI reflects change in average P of G consumed in Canada ○ Change in GDP deflator reflects change in average P of G produced in Canada Omissions from GDP Economic activity outside of regular, legal markets: Illegal activities Leisure Underground economy Home production (DIY) Economic ‘bads’ Do omissions matter? Difficult to correct for major omissions Level of GDP may be inaccurate but change in GDP is a good indication of changes in economic activity  Need to know how monetary value of G & S change to make policy decisions on inflation ○ Incl. non-market activities distorts figures and leads to policy errors Living Standards Well-being is a broader concept than material living standards ○ GDP not a complete measure of economic well-being Measurable G & S are only part of what most people see as standard of living ○ Changes in real per capita income are a good indicator of changes in average material living standards Note: non-market activities and economic bads are a problem when comparing different countries (ex. prevalence in rural vs. urban settings) FOUR: The Simple Short-Run Model 16 September – Chapter 6 Desired Aggregate Expenditure Divided into the same categories as GDP Two types of expenditure: ○ Expenditures independent of the level of national income are autonomous ○ Expenditures dependent on the level of national income are induced The First Step: a simple economy Does not include the government or trade (AE = C + I) ○ This is called a closed economy Investment is autonomous P is constant thus no inflation Highly unrealistic! What does “desired” really mean? NOT what consumers and firms would buy if their spending had no constraints ○ Take real-world constraints of income and market prices and find what consumers and firms would like to purchase Desired Consumption Expenditure Disposable income is used for either consumption C or saving S Simplest theory: C determined by current disposable income YD ○ But in advanced theories: C will depend on ‘lifetime’ income ○ Consumption decisions made using both current Y and expected future Y Expected future Y has a smoothing effect on C: ○ The anticipated changes in Y already influence ‘lifetime’ C decisions This causes less change in current C than with our simplified Keynesian C function ○ Even unanticipated changes in current Y affect C if there is a change in expectations of future Y Simplified Keynesian Function (not ignoring expectations) C = a + bYD a is autonomous C bYD is induced C Slope b is less than one Marginal Propensity to Consume Marginal propensity to consume MPC is the change in desired consumption as disposable income changes ○ MPC = ΔC/ΔYD MPC is the slope of the C function ○ MPC same at any level of income Average Propensity to Consume Average propensity to consume APC is the total consumption as a proportion of total disposable income ○ APC = C/YD APC falls as the level of income rises Conclusion: all of disposable income is either consumed or saved APC + APS = 1 MPC + MPS = 1 Shifting the Consumption Function C function shifts up = S function must shift down Shifts are: ○ Parallel: no change in MPC and MPS ○ Change in slope: changes MPC, APC, MPS, and APS What causes a shift in C and S functions? Incr. in wealth: shifts C function up and S function down ○ People save less for the future (retirement/children’s education) and can incr. desired spending on current C Decr. in i: shifts C function up and S function down ○ Fall in real i cuts the cost of borrowing thus cutting the cost of higher-priced durable goods ○ Reduces the rate of return on savings Change in expectations: shifts C function down and S function up ○ Incr. pessimism about future earnings and employment prospects ○ Expectations can be a self-fulfilling prophecy Desired Investment Expenditure Most volatile component of GDP ○ Changes strongly associated with short-run GDP fluctuations Three important determinants of aggregate investment expenditure: ○ Real interest rate ○ Changes in the level of sales ○ Business confidence/expectations Expecting growth can cause a deficit The Real Interest Rate The real interest rate is the opportunity cost of: ○ I in new plant and equipment ○ I in inventories (small $ value but volatile) ○ I in residential construction (volatile because the change in real i affects the D for housing via the cost of mortgages) Ceteris paribus: negative relations to i Changes in Sales Higher level of production and sales = larger desired inventory level ○ Change in sales can cause temporary changes in I in inventories Change stops at new desired level Business Confidence Business confidence improves = more likely to invest ○ Expect higher profits Business and consumer confidence go hand in hand The Aggregate Expenditure Function  Relates desired aggregate expenditure AE and actual national income ○ In a simple economy (without government and international trade): AE = C + I The slope of the AE function is the marginal propensity to spend MPS (out of national income) ○ In the simple model it is just MPC Equilibrium National Income (6.2) If desired aggregate expenditure exceeds actual output: ○ What is happening to inventories? Pressure for output to rise If desired aggregate expenditure is less than actual output: ○ What is happening to inventories? Pressure for output to fall The economy is in equilibrium when desired aggregate expenditure equals actual national income. The equilibrium condition is: Y = AE(Y) ○ Desired AE out of national income = actual national income Injections = Withdrawals Recall: in the simple model, P was kept constant Thus as the economy wishes to consume more, it will be produced w/o any change in price ○ Incr. demand for output will not be squeezed out by higher prices Production (aggregate supply of output) in this highly simplified economy is demand determined Changes in Equilibrium National Income Two types of shifts of the AE function: Parallel Change in slope The Multiplier The multiplier measures the change in equilibrium Y resulting from the change in autonomous expenditure In equilibrium: ∆𝑌/∆𝐴 = 1/(1 − 𝑏) ○ In the simple model z = b ○ z is the marginal propensity to spend MPS out of national income Larger z = steeper AE curve = larger simple multiplier ○ Flat AE means multiplier = 1 How does the multiplier effect work? One agent’s spending is another agent’s income. First person spends = second person’s income Second person spends (and saves) = third person’s income Third person spends (and saves) = fourth person’s income Etc. This process continues until: The extra savings at each step (incr. in withdrawals) add up to The initial incr. in investment (incr. in injections) Thus injections = withdrawals. FIVE: Introducing Government and Trade 18 September – Chapter 7 Introducing Government (7.1) Government purchases of G & S are part of desired AE ○ Does not include transfer payments Includes all levels of government: federal, provincial, territorial, municipal Net taxes T are total tax revenues net of transfer payments ○ In the simple model: G is autonomous and T is induced ○ Assume the net tax function is: T = tY t is the net tax rate (assumed to be autonomous and average = marginal) ○ T enters the AE function indirectly via the C function: C = a + b(Y-T) The Budget Balance The budget balance is the difference between G and T (ignoring debt-service payments) ○ Budget surplus: G < T ○ Budget deficit: G > T Introducing Foreign Trade (7.2) Two assumptions about net exports: Canada’s exports are autonomous with respect to Canadian GDP Canada’s imports rise as Canadian GDP rises ○ IM = mY ○ m is the marginal propensity to import Thus the net exports are given by: NX = X - mY Ceteris paribus: changes in domestic GDP lead to changes in net exports ○ Y rises = IM rises = NX falls ○ Y falls = IM falls = NX rises Relationship between Y and NX shown by the net export function holding constant: ○ Foreign GDP ○ Domestic and foreign P ○ The exchange rate Net Exports Imports are induced by national income Exports are autonomous with respect to domestic GDP They do depend on: ○ Foreign income ○ Domestic and foreign prices ○ The exchange rate  ○ Tastes Shifts in the Net Export Function Incr. in foreign income: higher foreign demand for Canadian G ○ NX function shifted upwards Incr. in Canadian prices: increases the relative P of Canadian G & S ○ NX function shifted downwards ○ IM function is steeper as Canadians switch to foreign goods (foreign prices are constant) NX function shifts down and steeper ○ Possible causes: Canada’s inflation rate greater than the foreign rate Exchange rate changes Ex. a fall in the exchange rate (incr. in the value of the CAD) ○ Incr. foreign price of exports (X fall) ○ Decr. the Canadian price of imports (IM rise) Equilibrium National Income (7.3) T = (0.1)Y then YD = (0.9)Y ○ C = 30 + (0.8)YD = 30 + (0.8)(0.9)Y = 30 + (0.72)Y ○ MPC out of national income is 0.72 ○ MPC out of disposable income is 0.8 Output is still assumed to be demand determined: ○ Equilibrium condition is AE = Y But when AE ≠ Y: ○ There are unintended changes in inventory ○ Firms have an incentive to change production Thus output moves toward equilibrium Another way to show the equilibrium condition: ○ Desired national saving = desired national asset formation ○ S + (T - G) = I + (X - IM) The Aggregate Expenditure Function: AE = C + I + G + NX Expand: AE = a + b(1-t)Y + I + G + X - mY Slope of the AE function is the marginal propensity to spend MPS out of national income or z ○ In this model: z = MPC(1 - t) - m Fiscal Policy  Refers to government spending and tax policies which influence the budget deficit or surplus Stabilization policies keep Y at or near Y* ○ Recessionary gaps suggest an increase in G and/or decrease in T ○ Inflationary gaps suggest a decrease in G and/or increase in T Direction for fiscal policy is clear BUT how to determine how much adjustment is needed? ○ Contractionary fiscal policy by reducing G (reversed for expansionary) ○ Expansionary fiscal policy by a reduction in t (reversed for contractionary) The autonomous change in the t changes the induced T The Balanced-Budget Multiplier Equal increase in G and T so the budget deficit or surplus does not change ○ In principle, this can have a mild expansionary effect: Equal increase in government injections and withdrawals But for the economy: increase in injections exceeds the increase in withdrawals Increase in T reduces YD Decrease in YD reduces S The net change in withdrawals = incr. T - decr. S ○ The net injection means C doesn’t fall by the full rise in T Demand Determined Output The simple macro model is based on three central concepts: ○ Equilibrium national income ○ The simple multiplier ○ Demand-determined output Implicit in the assumption that firms will produce all that is demanded at the current P level Both the simple multiplier and demand-determined output are closely connected to the assumption of a constant P level ○ Determined exogenously SIX: Aggregate Supply and Demand 23 September – Chapter 8 The Aggregate Demand Curve (23.1) Relates equilibrium real GDP to P level ○ [P] The AD curve shows real GDP where desired aggregate expenditure AE = actual GDP Movement along AD curve = change in AE curve caused by change in P level ○ But changes in anything else that change the AE curve = a shift of the AD curve ○ Points off of the AD curve are combinations of P & Y where desired AE ≠ actual GDP Why is the AD curve for an individual G & S negatively sloped? Remember ceteris parabus: change in price changes its opportunity cost ○ [AD curve] CPI is changing Reasons for negative AD slope: ○ P decr. = real value of $ incr. = consumer wealth incr. = AD incr. ○ P decr. = i decr. = consumer investment and consumption incr. = AD incr. ○ P decr. = X incr. = AD incr. Shifting the Aggregate Demand Curve Shocks that incr. equilibrium GDP at given P shift AD curve to the right Horizontal shift of AD curve: ∆𝐴/(1 − 𝑧) How much does a shift in AD translate to: ○ Incr. in Y ○ Incr. in P The Aggregate Supply Curve (23.2) Relates P to Q of output that firms would like to produce and sell ○ Level of technology ○ Set of factor prices Incr. output = incr. unit costs (not caused by a change in factor Ps) = incr. unit production if product P incr. ○ The AS curve is positively sloped If factor prices are unchanged along an AS curve, why is it positively sloped? Low output = excess capacity = slow incr. to costs High output = zero excess capacity = costs incr. = P incr. Shifting the Aggregate Supply Curve  Incr. in firms’ costs = leftward shift in AS curve ○ P incr. for factors ○ Technology Reverse for new tech. that incr. productivity Macroeconomic Equilibrium E0 is macroeconomic equilibrium ○ Intersection of AD & AS curves = consistent demand and supply behaviors Example of how unit costs of production incr. even if factor prices do not: Less efficient factors of production Efficiency of interaction between factors of production changes ○ Diminishing returns Changes in Macroeconomic Equilibrium Demand and supply shocks are either expansionary or contractionary ○ Referring to the effect on the equilibrium output Aggregate Demand Shocks  Demand shocks change P and Y in the same direction ○ Positive changes of G, I, X, or C The Mechanics ○ Incr. AE = incr. P ○ Higher P = incr. output and decr. AD Thus the final multiplier is less than the simple multiplier ○ Difference varies with the slope of the AS curve Larger price effect Smaller output effect Aggregate Supply Shocks P & Y change in opposite directions Decr. in AS = AD > AS ○ Incr. P = decr. AE Movement along the previous AD and the newest AS ○ New equilibrium at a higher P and lower Y Some possible causes: ○ Change in P of inputs ○ Change in wages ○ Change in technology Warning: many economic events will cause both AD and AS shocks (complex shocks) SEVEN: Adjusting Output Gaps 25 September – Chapter 9 Bronfman 151 Three Macroeconomic States (9.1) The Short Run ○ Factor prices assumed to be const. ○ Technology and factor supplies assumed to be const. The Adjustment of Factor Prices ○ Flexible factor prices ○ Technology and factor supplies are const. The Long Run ○ Fully adjusted factor prices ○ Technology and factor supplies are changing Output Gaps in the Short Run Factor Prices and the Output Gap Inflationary output gap ○ Relatively high demand for labor ○ High profits for firms ○ Incr. in wages and unit costs Recessionary output gap ○ Relatively low demand for labor ○ Low profits for firms  AS shift down = economy shifts down AD curve ○ Decr. in wages and unit costs Adjustment Asymmetry Inflationary output gaps raise wages rapidly Recessionary output gaps reduce wages slowly (ex. downward stickiness in money wages) Phillips Curve: summarizes the general adjustment process How does adjustment speed/pressure differ depending on size and direction of output gap? ○ Relationships are negative (ex. high unemployment rate = slow decr. in wages) Recessionary gap but wages sticky downwards, what other pressures help to close the gap? Expectations of recovery = raise stock prices = increase wealth and consumption Replace durables = raise confidence = increase investment and employment ○ Might close a recessionary gap better than falling wages Y* is an anchor for the output ○ [Y = Y*] Non-Accelerating Inflation Rate of Unemployment (U*) There is no cyclical unemployment Both structural and frictional unemployment Positive Aggregate Demand Shocks Inflationary gap opens Price level rises ○ Equilibrium at a higher price but same Y* Negative Aggregate Demand Shocks Ex. incr. P of raw materials imported by Canada  Recessionary gap opens Price level falls ○ Equilibrium at a lower price but same Y* Result: speed of return to Y* depends on wage flexibility Flexible wages = quick adjustment process Rigid wages = slow adjustment process ○ Downward wage rigidity can make other forces more powerful Long-Run Equilibrium Y = Y* [LR] No relationship between price level and potential output AS is a vertical line at Y* = long-run aggregate supply curve or classical aggregate supply curve Changes in Long-Run Equilibrium [LR] Y* determines Y AD determines P [LR] growth in Y*: Growth in factors of production Improved productivity Automatic vs. Discretionary Fiscal Policy Fiscal stabilization automatically built in the design of the tax and transfer system ○ Progressive taxation 1 ○ Low tax rate incr. the simple multiplier: 1−[𝑏(1−𝑡)−𝑚] Both dampen the output response to shocks Marginal propensity to spend is more at higher income ○ Ex. incr. AD and automatic stabilizers (AD shifts right and incr. real GDP): Incr. government tax revenue Decr. government transfers Incr. net tax revenues Dampen incr. in real GDP caused by initial shock Note: the tax and transfer system reduces the value of the multiplier and acts as an automatic stabilizer for the economy Discretionary fiscal stabilization policy ○ The government changes G and/or T to change real GDP EIGHT: Fiscal Stabilization Policy 30 September – Chapter 9 Fiscal Stabilization Policy (9.4) Motivation: reduce volatility of aggregate outcomes When an AD or AS shock separates Y and Y* (recessionary gap)? ○ Fiscal stabilization policy ○ Wait for recovery of private sector demand = rightward shift in AD curve ○ Wait for economy’s supply-side adjustment process = rightward shift in AS curve The Closing of a Recessionary Gap What about an inflationary gap? ○ Leftward shift in AD curve (reduce aggregate demand) ○ Leftward shift in AS curve The Closing of an Inflationary Gap Remember: recessionary gap = rightward shift / inflationary gap = leftward shift The Paradox of Thrift and Recession Need to get economy out of recession in SR: best for spending to increase & saving to fall ○ But individuals prefer: spending to decrease & saving to rise ○ Paradox: good for the individual ≠ good for the economy No such paradox in the long run (Y*) ○ Positive relationship between S & GDP ○ More saving = more investment Practical Limitations of Discretionary Fiscal Policy Decision / execution lags = multiplier effect takes time to work through the system Impacts of temporary vs. permanent policy changes ○ Ex. households save more with temporary tax cuts Difficulties of fine tuning (overshooting) ○ Leave small gaps alone Possibly good for ‘gross tuning’ of big output gaps Fiscal Policy and Growth: policy in short-run will generally have an effect on long-run economic growth Do I accept the negative long-term effect of a policy helping people in the short-term? ○ In theory: no obvious trade off for short-run/long-run when cutting tax rates  ○ In practice: an illusion since long-run effect of lower t (tax rates) incl. a fall in revenues: Lower productivity in the private sector = less government spending on R&D, infrastructure G & S of social value (ex. health care, national parks, etc) Immeasurable thus not accounted for in National Accounts May be counted at cost rather than societal value Case One: starting at Y* Incr. G = incr. real GDP ○ [LR] return from Y < Y* back to Y* [Y*] Higher G has ‘crowded out’ some private spending ○ Reduce other expenditures to compensate ○ Thus I (and private sector asset formation I + NX) is lower at the starting Y* May reduce future rate of growth of potential output Y* Question: Is there any type of incr. G that can incr. Y*? Purchasing durable goods not made by the private sector (ex. infrastructure) Case Two: starting at Y* and reducing taxes/tax revenue The stimulus in the SR shifts AD and incr. GDP ○ Who gets the tax cut? ○ How big will the SR stimulus be? [LR] More incentives for work effort (shift AS) and for investment (shift AD) Result = incr. in available resources (labor force and capital stock) incr. Y* To Summarize Incr. G: ○ [SR] Incr. Y ○ [LR] Rate of growth Y*: Lower if private investment lower Higher if private production higher Decr. t: ○ [SR] Demand stimulus ○ No obvious tradeoff if LR growth incr. & higher tax revenues CHAPTER TEN The Nature of Economic Growth (10.1)  Powerful method to incr. material living standards = sustained incr. in Y* ○ Even small differences in annual growth rates = cumulative effect Rule of 72: simple formula to calculate how long it will take for an investment to double based on rate of return 72 𝑡≈ 𝑟 Difference between GDP, GDP/worker, GDP per capita Benefits of Economic Growth Rising average living standards ○ Spin-off: higher living standards help people feel they can afford to be concerned about environmental protection Alleviation of poverty ○ Many do not share this growth directly ○ Redistribution is easier in a growing economy (no decr. in purchasing power) ○ Spin-off: rising average income = rising income inequality (growth goes to top percent of income distribution) NINE: Long-Run Economic Growth 02 October – Chapter 10 Costs of Economic Growth Sacrifice of current consumption ○ Saving helps to finance current I and future C ○ More saving = less current C Trade-off: opportunity cost of growth = decr. C ○ [LR] But it can mean higher standards of living Trade off between now & the future Social costs of growth ○ Displacement of some firms and workers ○ Real transition costs caused by new products & new production techniques = can hurt people Ex. transition from people-operated production lines to computer-operated production lines Issue: How much is the reduction in natural resources a ‘cost’ of economic growth? ‘Quick and dirty’ explanation: falling supply of natural resources cause their prices to rise, which gives incentives for two things: ○ More exploration to find more of the same resource (ex. offshore oil drilling) ○ The development of new substitute resources (ex. wind, hydrogen, electric vehicles, solar, etc) Sources of Economic Growth (four fundamental sources) Different theories emphasize different sources of growth. Growth in the labor force (via population or labor force participation rate) Growth in human capital (formal education or on-the-job training) Growth in physical capital (quantity & quality) Technological improvement (new products, new production techniques, new forms of business organization, etc) Basic Relationships of Economic Growth (10.2) Focus on the Long-Run: when real GDP = potential output Y* ○ Let interest rate be determined endogenously by desired S and desired I ○ Assuming a closed economy (no trade in G & S) Investment, Saving, & Growth  ○ Look at the simple economy, in equilibrium: (𝐴𝐸 =) 𝑌 = 𝐶 + 𝐼, 𝑌 − 𝐶 = 𝐼, 𝑆 = 𝐼 ○ Investment financed by saving of domestic households (and firms) ○ Investment (which incr. capital stock) incr. the future level of Y* Investment negatively related to the (real) rate of interest Saving positively related to the (real) rate of interest Thus the interest rate is the ‘price’ that equilibrates this market ○ Remember: negative relationship between I and interest rate on demand side & positive relationship between S and interest rate on supply side Add in the Government ○ National saving = private sector saving & public sector saving 𝑁𝑆 = 𝑆 + (𝑇 − 𝐺) = (𝑌 * − 𝑇 − 𝐶) + (𝑇 − 𝐺) 𝑁𝑆 = 𝑌 * − 𝐶 − 𝐺 ○ G (net of transfers) is autonomous (& unrelated to r) ○ Current C is negatively related to r (via opportunity cost): S is positively related to interest rate NS is positively related to interest rate ○ Equilibrium: desired NS = desired national asset formation I + (X – IM) Y* - C - G = I The Long-Run Connection Between S and I [Y = Y*] desired national saving = desired investment ○ Determines the equilibrium E interest rate i* Increase in the Supply of Saving Incr. NS = decr. real i ○ More I leads to higher growth rate of Y* Increase in the Demand for Investment Incr. I = incr. I ○ More S leads to higher growth rate of Y* Neoclassical Growth Theory Theory begins with the idea of an aggregate production function: 𝐺𝐷𝑃 = 𝐹𝑇(𝐿, 𝐾, 𝐻) ○ 𝐹𝑇 is the assumption that change in tech. = change in production function Key assumptions about the aggregate production function are: ○ Diminishing marginal product of both K and L individually ○ Constant returns to scale for all factors jointly (change in equal proportions) Central Predictions Diminishing MP individually ○ Law of Diminishing Returns: the MP of L eventually falls as each successive unit of L is used (for a fixed amount of other factors) Incr. in population lead to incr. in GDP but eventually leads to decr. in per capita GDP Falling average living standards ○ Similar: diminishing MP of K means K accumulation on its own brings progressively smaller incr. in real per capita GDP K or L is incr. on its own, the principle of diminishing MP of L or of K predicts that avg. standard of living will eventually decr. Note: limit to LPFR, higher % of pop is producing and can get higher per capita GDP Implications of constant returns to scale jointly ○ K and L grow at the same rate (balanced growth) then: % increase in output = % increase in population (same LFPR) Zero improvements in material living standards GDP incr. but per capita GDP remains const. Simplified Model 𝐺𝐷𝑃 = 𝐹𝑇(𝐿, 𝐾) Hard to achieve higher standards of living from incr. factor inputs ○ Requires technological change for sustained growth in living standards Technological Change: the two types Disembodied: not contained within new capital but comes from newly-generated sources ○ Materials ○ Products ○ Production processes ○ Managerial techniques  Embodied: contained within the new capital equipment (higher quality and more productive) ○ Even replacement I contains embodied technological change, disembodied can soon become embodied Ex. buying a new car that has new features built in Note: technological change can also be embodied within the work force L and K Investment in human capital - more and better skills The Information Technology revolution likely improved both physical and human capital productivity so better: ○ Information flows ○ Management techniques ○ Quality of learning Question: how much of an increase in GDP results from technological change and how much from other things? Cannot be measured directly Resort to indirect measurement TEN: Economic Growth Theories 07 October Measure GDP incr. from technological change indirectly The Solow Residual In Robert Solow’s growth accounting: ○ Estimates what part of the growth in GDP can be explained by growth in Q of capital stock or the labor force ○ The residual (the part of growth in GDP that is not explained by changes in Q of inputs) is by implication, explained by technological change Note: may be referred to as the rate of growth of Total Factor Productivity TFP More (from conferences) Cobb-Douglas: Y = AK𝛼L1-𝛼 Solow Residual A is an estimate of TFP ○ K ideally ⅓ Problems with the Solow Residual Underestimates the true contribution of tech change ○ K = L may produce new and better products Not reflected in changes in Q of output (GDP) ○ Incr. in the Q of output attributed to incr. in Q of K can be overestimated Some caused by new tech. incorporated within the new K (incr. in the Q of K) These aspects are not counted within the residual Endogenous Technological Change (growth built into the system) Neoclassical growth theory treats tech. change as exogenous New approach treats R&D as endogenous (determined within the system) ○ Profit motive: R&D is expensive and risky but high potential profits = big incentive ○ Learning-by-doing: increasing productivity of new innovations incl. feedback from ‘downstream’ to ‘upstream’ ○ Knowledge transfer: R&D benefits increase over time as knowledge spreads (lower cost per use because R&D is done) ○ Market structure and innovation: first to innovate is the most profitable in larger, international markets ○ Economic shocks: big changes in P of inputs stimulates a search for alternatives Increasing Marginal Returns Each new increment of investment is more productive than the last ○ In direct contrast with the neoclassical assumption of diminishing marginal returns ○ Historical evidence supports there has not been diminishing marginal returns to innovation Sources of increasing returns: ○ Market-development costs ○ Increasing returns to knowledge Market-Development Costs Initial R&D and marketing are one-time fixed costs Subsequent investments give increasing marginal returns in other ways: ○ Benefits other firms and industries Makes new skills available to them Resolves practical problems = new investments are more profitable New technology makes the infrastructure for efficient use ○ New attitudes among consumers More receptive to new products No. of new consumers grows when they see advantages The Knowledge Element New Growth Theories place much more emphasis on the economics of ideas ○ Knowledge is a public good: non-diminishable and non-excludable ○ Property of non-diminishability: marginal cost MC = 0 ○ Knowledge not subject to diminishing marginal returns The current emphasis is on such knowledge-driven growth Rate at which we are acquiring knowledge seems to be rising Resource Exhaustion: current technology and resources could not support the entire world’s population at Canada’s average standard of living Does this imply absolute limits to growth? ○ Technology is constantly improving ○ Resources constantly being discovered and invented We can have expectations about what might happen in the future but do not know what exactly will happen Lesson: we must use caution when generating economic growth Pollution & Environmental Degradation Cleaning up the environment does not necessarily require less economic growth  ○ Policies like taxes on negative externalities (ex. the carbon output from production) hurts polluting producers in the SR but may not reduce overall economic output in the LR Pollution taxes create greater incentives to develop technology for alternative energy sources Conclusion Economic growth may help the world with many problems ○ Must be sustainable based on knowledge-driven technological change Issue of equity for developing countries Has the world already passed the point of no return? CHAPTER ELEVEN What is Money? Money is a medium of exchange ○ Must be generally acceptable to perform this function ○ Goods would have to be exchanged in a system of barter Very inefficient - needs double coincidence of wants Money retains its value (w/o high inflation) ○ But with hyperinflation: Rush to spend before value falls even more The rush to spend further increases inflation People will not accept money so back to barter Money is a unit of account ○ Keep our financial accounts The Origins of Money Money has evolved over time: Metallic money: ○ Market value of metal = face value of coin ○ Leads to debasing (melt and fill coins with extra material, incr. P) and clipping (milled edges to reduce weight) ○ Inflation = value of precious metals fall ○ ‘Good money’ drops out of circulation Gresham’s Law: Bad Money Drives Out Good Paper money: ○ Initially fully backed by precious metal, convertible on demand ○ Referred to as bank notes (issued by banks) Fractionally backed paper money: ○ Goldsmith and banks issued more notes than amt. of gold in vaults  ○ Possible because only small % want to redeem notes at the same time ○ Loss of confidence = ‘run’ on banks Fiat money (by order): ○ Not backed, not convertible into anything else ○ Decreed by the government to be legal tender Note: check the writing on a $20 bill ○ Almost all currency today Modern Money Government creates currency but banks and financial institutions create deposit money ○ Bank deposits are an important part of the money supply Majority of today’s money is deposit money ○ Most transactions are a net transfer of deposits between accounts Banks create money by issuing more promises to pay deposits than they have in cash reserves ○ Typically only 2﹪ backing your balance Money vs. currency ELEVEN: Banking 09 October – Chapter 11 The Canadian Banking System (11.2) Most banking systems have: ○ Central bank ○ Many commercial banks The central bank acts as a bank to the banking system ○ Usually a government-owned institution ○ The sole money-issuing authority The Bank of Canada Commercial Banks Privately owned, profit-seeking institution that provides a variety of financial services ○ Accept deposits, make loans, provide credit ○ Other services: credit-card services, wealth-managements services, etc Important financial intermediaries Needed for the smooth operation of credit markets Reserves Bank cash reserves typically small ○ Tiny fraction of depositors want their money at any time Reserve ratio: fraction of its deposit liabilities that it actually holds as reserves ○ Either vault cash or deposits with the central banks Target reserve ratio: fraction of its deposits it wishes to hold as reserves Reserves greater than target reserves are excess reserves ○ Financial institutions make money by lending out (and investing) their excess reserves ○ Becomes the basis for creating more deposit money The Canadian banking system is a fractional-reserve system: [March 2006] Commercial banks in Canada held less than 1﹪of their deposits in reserves [March 2018] 2.5﹪in reserves Simplifying Assumptions Suppose: Banks invest only in loans There are only demand deposits  Fixed target reserve ratio No cash drain from the banking system Creating Deposit Money Initial bank (desired & actual) reserve ratio New deposit will raise the bank reserve ratio ○ Begins a long sequence of deposit creation But with no cash drain and fixed target reserve ratio: ○ Eventually expands deposits By then: full amount of new currency deposit has been absorbed by banks as an increase in desired reserves ○ Generic: ΔFinal Deposits = ΔReserves/v ○ v = target reserve ratio Make sure that the sum of the additions to reserves = target ratio of the sum of the new deposits created (per round) ○ Totaling all rounds: expansion of deposits is 1/v times the first deposit Excess Reserves and Cash Drains Deposit creation is not automatic but dependent on: ○ The central bank which determines the amount of cash in the economy ○ The public who determine what proportion of total cash will remain for use as reserves by the commercial banks ○ The commercial banks which decide what proportion of deposits they wish to have as reserves = target reserve ratio Beginning assumption: 100﹪ of any change in cash becomes the change in reserves ○ Change the assumption and allow for a cash drain Households holding a fraction of their deposits in cash = dampening of the deposit-creation process Assume a fixed proportion so the cash drain = cΔD = change in cash held by the general public c is the cash-deposit ratio EQUATION: ΔCurrency = ΔReserves + Cash Drain ○ Change in cash held by banks = ΔReserves = vΔD ○ Change in cash held by the public = Cash Drain = cΔD ○ ΔCurrency = vΔD + cΔD = (v + c)ΔD ΔD = ΔCurrency/(v + c) Deposit multiplier = 1/(v + c) Increase in money supply = increase in bank deposits + increase in the cash held by the public ○ Excluding the reserves in the banks  ○ Equation from above: ΔD = ΔCurrency/(v + c) Cash Drain = cΔD = (cΔCurrency)/(v + c) ΔMs = ΔD + Cash Drain = ΔCurrency/(v + c) + (cΔCurrency)/(v + c) ΔMs = ΔCurrency(1 + c)/(v + c) Money multiplier = (1 + c)/(v + c) The conclusion: money supply and deposit expansion per dollar of change in total cash in the economy will be greater: ○ The smaller the target reserve ratio of commercial banks ○ The smaller the public’s cash drain from the banking system Example: December 2008 with v approximately 1﹪ and c between 1 and 5﹪ If c = 5 ﹪ and v = 1﹪: ○ Deposit multiplier = 1/(v + c) = 16.67 ○ Money multiplier = (1 + c)/(v + c) = 17.5 If c = 1 ﹪ and v = 1﹪: ○ Deposit multiplier = 1/(v + c) = 50 ○ Money multiplier = (1 + c)/(v + c) = 50.5 TWELVE: What is Money 21 October – Chapter 11 Definitions of the Money Supply Money supply: the total quantity of money that is in the economy at any time The narrowest definition of money is M1: ○ M1 = currency + chequable deposits Common definition is broader M2: ○ M2 = M1 + non-chequable deposits at chartered banks Broader measure is M2+: ○ M2+ = M2 + deposits held at institutions that are not chartered banks *all are easily convertible* Types of Deposits The long standing distinction between money and other highly liquid assets used to be: Money was a medium of exchange that did not earn interest Other assets earned interest but were not a medium of exchange Today: distinction is extremely blurred because transfer between accounts can be made quickly Near Money Store of value assets readily converted into a medium of exchange Short-term bonds Term deposits (many can be withdrawn before the term is up, with interest penalty) Money Substitutes Things that serve as a temporary medium of exchange but are not a store of value Credit cards Choosing a Measure No timeless or best definition of money New financial assets continually being developed that serve some of the functions of money The Role of the Bank of Canada Commercial banks can expand reserves into deposit money Bank of Canada has great influence over the amount of reserves in the banking system Perspective Classical View: dichotomy between monetary & real sectors of the economy  In the real sector, resources allocated among production of various G & S by relative P “The Neutrality of Money”: change in quantity of money affects only the P level so has no effect on allocation of resources & output level Economy adjusts quickly to output gap that SR AS curve is vertical at Y* ○ Change in AD = change in P Modern View [LR] money is “neutral” [SR] do not accept that it is neutral Where are we going? So far our model has treated investment as autonomous. But: Investment is negatively related to rate of interest Changes in D or S of money affect the rate of interest Money affects the real sector by affecting the rate of interest which then affects investment which then affects AD and output Link Between Md and i D for money influenced by opportunity cost of holding it ○ Interest that people could have earned if they had purchased an alternative asset instead of holding the money ○ Must first understand the relationship between the interest rate and the value of the assets other than money For simplicity: restrict alternative assets to government bonds ○ Similar as they are practically riskless but they pay interest Understanding Bonds (12.1) For simplicity we assume that people have two types of financial assets: Money (earns no interest) Bonds (earns interest) Present Value Present value: the value now of one or more payments to be made or value (interest) to be received in the future (1 years time) ○ Better understood by looking in reverse ○ 𝑃𝑉 = 𝐹𝑉/(1 + 𝑖) Square for 2 years, cube for 3 years, etc PV and Market Price In a competitive market for bonds:  Buyer should be prepared to pay no more than the bond’s PV Sellers should be prepared to accept no less than the bond’s PV ○ The equilibrium market price of a bond = PV of the stream of income generated by it THIRTEEN: Demand for Money 28 October – Chapter 12 Interest Rates, Market Prices, and Bond Yields Two important components: 1. The PV of a bond is negatively related to the market interest rate a. Higher interest rate = lower PV = lower market price b. Lower interest rate = makes your old bond more interesting because it grows at a higher rate 2. The market price for a bond should equal its PV Coupon payment on a bond is a constant number of money/year but the yield is that coupon payment as a percent of the bond’s market price. The sequence: ○ Rise in i on new bonds reduces market D for outstanding bonds ○ Fall in D for outstanding bonds reduces their market P ○ Fall in market P increases the yield on the outstanding bonds Example: a $5 coupon payment is a 5% yield if the bond price is $100 but a 6.25% yield if the bond price is $80 Bond prices fall to where the $ coupon payment gives the same yield as the new higher interest rate Conclusion Bond yield inversely related to market P Bond market P inversely related to market i Thus: market i and bond yield move together The Demand for Money (12.2) Reasons for holding money: The transactions motive ○ Payments and receipts are not synchronized ○ Positively related to the level of GDP ○ Less important now with the use of credit cards The precautionary motive ○ Uncertainty about payments arising in near future ○ Receipts may be less synchronized then expected ○ Positively related to GDP Transaction and precautionary motives together create a cash drain The speculative motive  ○ Hedge against the risks of other assets ○ Most people are risk averse Prefer zero risk money to a risky asset with the same expected PV ○ Higher opportunity cost of holding money = more willing to take a risk Negatively related to i Influence of Expectations: expect i to rise = expect P of bonds to fall = hold more money and less bonds Reversed if i is expected to fall Effect of P Level Rise in P level = takes more money for same purchasing power (same real D for M) Nominal D for M positively related to P level/inflation rate Summary MD = MD(i, Y, P) Neg,pos,pos Decision to hold money is a decision not to hold bonds ○ Holding money has an opportunity cost Liquidity Preference Function i changes along MD Y or P changes shift MD ○ Increase in Y or P leads to an increase in money demand at a given interest rate Monetary Equilibrium Q of MD = Q of MS ○ Equilibrium interest rate The Money Transmission Mechanism The monetary transmission mechanism connects changes in MD and/or MS with aggregate demand The three stages: ○ Change in MD and/or MS = change in equilibrium interest rate ○ Change in i = change in ID ○ Change in ID = change in AD Stage 1: Changes in the Equilibrium Interest Rate Stage 2: Changes in Desired Investment Expenditure Stage 3: Changes in Aggregate Demand Previous assumptions of a closed economy Target inflation for the Bank of Canada is 2% Summary of the Monetary Transmission Mechanism (excl. trade) Open Economy Modification  Extra channel to transmission mechanism for an open economy with mobile financial capital Interest rate changes = financial capital flows between countries = pressure on the exchange rate Exchange rate changes = net export changes ○ Adds to the effect of aggregate demand Open Economy Monetary Transmission Mechanism Example: expansionary monetary policy (slide 30 and 31) 1. Increase Ms (Md constant) a. People hold more money than they want (at the old i) 2. Rise in D for bonds = increase in P of bonds = decrease i 3. Bond holders want to sell Canadian bonds a. Reinvest abroad at the higher i = P of bonds increase less than in a closed economy i. The fall in i is less b. Capital outflow weakens impact of monetary policy through the interest rate channel and also creates a new channel for the transmission 4. Capital outflow increases supply of CAD on international currency markets = P reduction 5. Depreciation of the CAD = IM less expensive and X more expensive a. NX rise and AD curve shifts to the right Slope of the AD Curve Two reasons for the negative slope of the AD curve: ○ P change = change in wealth = change in desired C ○ P change = change in relative P of IM and X = change in NX Now a third reason: ○ P changes Md and i = I changes Example: a rise in P leads to ○ Increase in Md (transactions demand) ○ Higher i ○ Reduces desired I These three effects are caused by a change in P = movement along the AD curve ○ For any other cause of change = shift of AD curve Example 1: rise in i decreases desired I Cause = increase in P ○ Effect = movement along AD curve Cause = fall in Ms ○ Effect = shift of the AD curve FOURTEEN: Economic Activity of Money 30 October – Chapter 12 Example 2: a fall in NX Cause = rise in the domestic P level ○ Effect = move along AD curve Cause = fall in Ms ○ Effect = shift the AD curve Fall in Ms = rise in i Induce capital inflow = reduce exchange rate = reduce NX Long-Run Neutrality of Money Shifts in the AD curve lead to different effects in the SR vs. the LR ○ [LR] The output eventually returns to Y* Money neutrality is the idea that changes in the money supply do not have real effects on the economy What does money neutrality look like? MD shifts up as P and Y adjust to new long-run equilibrium The real i returns to its initial level Classical Dichotomy (between the real and monetary sides of the economy) [LR] Real side of the economy independent of monetary side ○ Believed that the economy reacts almost instantaneously Thus no SR to be concerned about Modern View Economists think the classical view is too extreme ○ The real side of the economy will not react instantaneously  [SR] Money will affect real variables [SR] Money is not neutral Economists even question the neutrality of money in the LR ○ Economy returns to Y* after recessionary gap ○ But is Y* the same value throughout the business cycle? Hysteresis: the delay in the production of an effect by a cause The [LR] growth rate of Y* may be affected by the short run path of real GDP Example: if U in recession causes a deterioration of skills through lack of use ○ Workers are less productive after the recession than before it ○ Thus Y* will be lower Short-Run non-Neutrality of Money The SR effect of a change in the money supply depends on the extent of the shift of the AD curve Debate regarding the effectiveness of monetary policy ○ Keynesian: argue that monetary policy is not very effective MD curve is relatively flat ID curve is relatively steep ○ Monetarist: argue that monetary policy is very effective MD curve is relatively steep ID curve is relatively flat  Empirical evidence supports the idea that the MD curve is not flat: ○ Change in Ms = change in the equilibrium i ○ Thus monetary policy can be effective Much less compelling evidence regarding the slope of the ID curve How to separate the effect of expectations from the effect of interest rates? Example: assume the central bank expects an inflationary gap to open in the near future, uses contractionary monetary policy to increase i ○ Then suppose there is a small decrease in I ○ Does this imply that the ID curve is steep? Answer: suppose that an increase in i alone causes a big fall in desired I ○ But the private sector expectations of a boom shifts the ID curve to the right ○ Resulting small reduction in I = net effect of two opposing forces Not the result of I being insensitive to i Bank of Canada announcement effect ○ Influence of expectations CHAPTER THIRTEEN Money Supply vs. the Interest Rate The central bank must choose its target: ○ Money supply ○ Interest rate They are linked = cannot target independently ○ Target Ms = i predetermined ○ Target i = Ms predetermined Main target: always to control inflation Why does the Bank of Canada target the interest rate? The effect of commercial banks on change in Ms ○ Harder to estimate cash needed to get the desired i Unexpected changes in Md alters the Ms needed for the desired i Easier for the public and government to understand policy direction using a change in i ○ Likely for a larger announcement effect Overnight interest rate: rate banks borrow from and lend to each other for very short periods ○ Ex: the Federal Reserve sets the effective federal funds rate (EFFR) ○ Bank of Canada controls the overnight interest rate by: Set a target for the rate  Set the bank rate 0.25﹪ above the target Lend to commercial banks at this rate Set the borrowing rate 0.25﹪ below the target Rate the Bank of Canada pays commercial banks on their deposits ○ Thus the overnight rate is within the 0.5 ﹪ band FIFTEEN: Monetary Transmission and Inflation 04 November – Chapter 13 The Central Bank’s buying and selling bonds is called open-market operations ○ Used to accommodate the change in i by appropriate change in Ms ○ Appropriate change in Ms is what is needed to keep i on target ○ Ms endogenous Monetary Policies Expansionary: reduction in the target rate ○ Eventually the Bank of Canada increases Ms (or its growth rate) Contractionary: increase in the target rate ○ Eventually the Bank of Canada decreases Ms (or its growth rate) Why the growth rate? ○ If Md is increasing by 10 percent per year: Increasing Ms by 11 percent is expansionary Increasing Ms by 9 percent is contractionary Monetary policy influences aggregate demand through the monetary transmission mechanism Targeting Inflation Why is inflation the ultimate target of monetary policy? ○ Costly for individuals Hurts people on fixed incomes Hurts lenders & benefits borrowers ○ Costly for the economy Impact on NX Impact on economy’s ability to send signals Example: is an increase in the P of a good a rise in its relative P or just part of the increase in overall P level? ○ Difference in purchasing power The Role of the Output Gap When an output gap opens, the Bank of Canada has two choices: ○ To allow the adjustment process to operate ○ To intervene with monetary policy May intervene if expects output gap to keep output outside its target bands for a significant length of time ○ Remember: the target inflation rate is 2 percent in Canada May not intervene if expects output gap to be SR only Complications (Targeting Inflation) Volatile food and energy prices ○ Many Ps set in world markets (unrelated to Canadian output gaps) Bank of Canada also uses core inflation as a SR indicator Better reflects pressures of domestic output gaps ○ The core rate excludes food and energy prices Energy: influence of world markets Food: world and volatile ○ CPI is the Bank of Canada’s LR target Exchange rate complications for monetary policy: two examples of the appreciation of the CAD ○ Example 1: CAD appreciation caused by an increase in foreign D for Canadian X Increases AD Creates an inflationary gap Y > Y* Response: contractionary monetary policy ○ Example 2: CAD appreciation caused in an increase in foreign D for Canadian monetary assets Reduces NX (X fall and IM rise) Reduces AD Creates a recessionary gap Y < Y* Response: expansionary monetary policy ○ Thus the appropriate monetary policy response to the exchange rate change differs by the cause of the change Lags Long and variables time lags of monetary policy because: ○ Takes time for I and NX to respond to a change in i ○ Takes time for the full change in AD (via simple multiplier) ○ Takes time for output to respond to a change in AD  Similar to lags associated with fiscal policy But is monetary policy destabilizing because of these lags? Is monetary policy destabilizing? Some monetarists argue it is destabilizing: ○ Example: increase Ms to close a recessionary gap Lags allow other changes to happen before the full effect of change in Ms Overshooting creates the inflationary gap ○ This policy had the wrong strength/timing Some monetarists argue for a monetary rule: ○ Increase Ms at a rate consistent with long-term growth of population and productivity Thus most economists do agree that: ○ Monetary policy likely inappropriate for fine-tuning ○ Appropriate for gross-tuning of large and persistent shocks Because of the lags, the Bank of Canada must be forward-looking: ○ Must take pre-emptive actions ○ May appear inconsistent with the current state of the economy Ex: tighten policy in a recessionary gap because of expected future inflation Why is the Bank of Canada’s target inflation rate 2 percent? Inflation helps the economy’s adjustment process ○ Effect on real wages W/P Example: what about in a recession? ○ Objective: to close the recessionary gap May need reallocation of labor to other sectors Made difficult by downward-sticky money wages Inflation can speed up the reallocation by changing real wages ○ In contracting sectors: Constant money wages Rise in P level Fall in real wage W/P ○ In expanding sectors: Increase money wages more than the inflation rate Increase in W/P What should the Bank of Canada target? Target low inflation rate: ○ Inflations reduces W/P in contracting sectors where money wages are not rising ○ Stimulates reallocation to other productive sectors instead of prolonging U Target zero inflation: ○ Avoids the negative effects of inflation ○ Leaves reallocation to the market forces of D and S ○ The U will eventually accept lower money wages Overview: high inflation rates are undesirable because… Creates arbitrary redistributions of income Lowers standard living of people on fixed incomes Undermines the efficiency of the price system ○ Reduces the ability to identify the relative P of G&S CHAPTER FOURTEEN Why is high inflation undesirable? Arbitrary redistributions of income Lowers the standard of living for people on fixed incomes Undermines the efficiency of the price system ○ Reduces the ability to identify the relative Ps of G&S Change in Wages Output gaps ○ Inflationary gap Y > Y* = excess demand of labor U < NAIRU ○ Recessionary gap Y < Y* = excess supply of labor U > NAIRU NAIRU: non-accelerating inflation rate of unemployment Expectations ○ Some wages raised in anticipation of inflation Change in money wages = output-gap effect + expectational effect Wage to Price Change in W shifts the AS curve ○ Actual inflation = output-gap inflation + expected inflation + supply-shock inflation Supply-shocks shift AS curve by factors other than W changes ○ Ex. productivity change, changes in world oil prices, etc ○ These cannot be controlled by domestic policy so ignore in analysis  Y = Y*/U = NAIRU: actual inflation = expected inflation, no output gap Example: assuming an expected rate of inflation of 5 ﹪ ○ Y = Y*: wages rise by 5 ﹪ ○ Y > Y*: wages rise greater than 5 ﹪ Inflationary output gap places upward pressure on actual inflation Expectation of rising prices in the future ○ Y < Y*: wages rise less than 5 ﹪ Recessionary output gap places downward pressure on actual inflation Expectation of rising prices in the future Example: assuming productivity improves by 5 ﹪ ○ W incr. = 5 ﹪: no change in the AS Decr. in production costs by increased productivity = incr. in production costs due to higher wages ○ W incr. > 5 ﹪: vertical upward shift in the AS Decr. in production costs by increased productivity more than offset by incr. in wages ○ W incr. < 5 ﹪: vertical downward shift in the AS Decr. in production costs by increased productivity partially offset by incr. in wages SIXTEEN: Inflation Validation 06 November – Chapter 14 Constant Inflation Expected = actual / Y = Y* / no output gap How can inflation continue without an output gap? ○ AD must be constantly increasing Expectations of future inflation are false = subsequent expectations of future inflation become weaker ○ How to prevent this erosion of expectations: monetary authorities must make the expected inflation actually occur Must continually increase AD by incr. Ms Expectations validated by continual increases in Ms Economy remains at Y*: no output gap effect on prices How to validate expectations of inflation: monetary authorities increase the Ms by the expected inflation rate ○ Ms incr. > # ﹪: inflationary output gap opens and inflation rises above # ﹪ ○ Ms incr. < # ﹪: recessionary output gap opens and inflation falls below # ﹪ Constant Inflation with No Supply Shocks Continuous validation keeps the AD curve moving up at the same rate as the AS curve ○ Zero output gap ○ Actual inflation = expected inflation Demand Shocks Without validation: the demand shock increases the AD ○ Rate of increase of W rises ○ Production cost increases ○ AD remains at the new level: output gap is eroded until the GDP is back to Y*  Inflation is temporary without further validation With validation: the demand shock keeps AD increasing ○ Keeps inflationary gap open ○ Pressure on inflation ○ Inflation accelerates Why does sustained inflation accelerate? Assuming a constant expected inflation rate of 5 ﹪ at Y = Y* ○ Demand shock opens the inflationary gap Y > Y* ○ Add a 2 ﹪ demand inflation 7 ﹪ becomes the new expected rate ○ Validation keeps the inflationary gap and adds another 2 ﹪ 9 ﹪ becomes the new expected rate Summary: inflationary output gap kept open by central bank via continuous monetary validation Progressively increasing W rates Progressively bigger upward shifts in the AS curve Progressively greater increases in Ms to keep the inflationary gap Supply Shocks Without validation: negative supply shock decreases AS ○ Recessionary gap opens (increase in P) ○ AD remains at its level ○ Economy eventually returns to Y* How does this happen: upward pressure on W from expectations > downward pressure from the recessionary output gap = rising prices and falling output (stagflation) ○ Inflation declines due to opposing forces ○ Level of expected inflation falls ○ Downward pressure = upward pressure = reduction in AS stops Effect of output gap on P > effect of expectations on P Rightward shift in the AS Inflation falls Closing of the output gap Economy returns to Y* ○ Conclusion: recessionary gap and no monetary validation = Y returns to Y* slowly (W rates are downwardly sticky) With validation: monetary authority makes return to Y* quicker ○ AD increases ○ Potential danger of validation: rise in P and inflation rate becomes expected  W increase again AS may not return to baseline Recessionary gap may not close ○ Further validation will continue the process = wage-price spiral Summary: inflation as a monetary phenomenon Causes of inflation ○ Anything that increases AD will increase P ○ Rise in factor prices decrease AS and increase P ○ W/O continuous monetary expansion = increase in P will halt Consequences of inflation ○ Demand inflation = inflationary gap ○ Supply inflation = recessionary gap ○ [LR] Post full adjustment of costs and prices so shifts in AD/AS: Affected prices/inflation Unchanged output at Y* Conclusions of inflation ○ W/O monetary validation: positive AD shocks or negative AS shocks Temporary inflation Eventually returns to Y* ○ Inflation started by AD/AS shocks are only sustained with continuous monetary validation Thus sustained inflation is always a monetary phenomenon! Disinflation Reducing inflation is costly ○ Economy loses output ○ Unemployment is created What if there’s an inflationary gap and accelerating inflation because of continued validation? (3 policy phases) ○ Close the output gap ○ Break inflationary expectations ○ Recovery Phase 1: Removing Monetary Validation Inflationary equilibrium = starting point ○ Stop validation (no increase in Ms) ○ AD curve will stop shifting W continue to rise: ○ Inflationary expectations  ○ Inflationary output gap effect ○ Production cost increase ○ Upward shift in the AS Higher P = higher Md (transactions and precautionary motives) ○ Ms unchanged w/o validation ○ In the money market: Rise in i Reduction in I and NX Reduction in the AD Economy moves along the AD Inflationary output gap closes Phase 2: Stagflation [Y*] Expectations effect remains and W continue to rise ○ Upward shifts in the AS = higher P Remember stagflation: falling output, rising unemployment, and rising prices Recessionary output gap opens with two opposing pressures on W: ○ Upward pressure from expectation effect ○ Downward pressure from the recessionary gap effect [E] Pressures offset each other ○ AS stops shifting ○ Inflation stops Breaking inflationary expectations is a slow process Phase 3: Recovery Recovery takes output back to Y* and stabilizes P: ○ By waiting for W to fall = downward shift in AS ○ By the central bank increasing the Ms = upward shift in AD Trade-off that comes with increasing Ms: ○ Faster return to Y* ○ Rise in P may create new inflationary expectations What is the cost of disinflation? The sacrifice ratio: cumulative loss in real GDP / reduction in rate of inflation ○ The cumulative loss is a percent of Y* SEVENTEEN: Wages and Unemployment 11 November – Chapter 15 Flows in the Labor Market The annual U rate underestimates the number of people who have been unemployed at some time during the year ○ Example: [2014 - 2016] Canadian U rate approximately 7 ﹪ but the gross flows into and out of U: 500k plus workers per month became employed Roughly the same number became unemployed Thus the LF is approximately constant Measuring Unemployment The unemployment classification = people that are not working and are searching for work But the measured U rate understates the impact of recessions on U because: ○ Discouraged workers: they want to work but stop searching so leave the measured U and LF (until the economy improves) ○ Underemployment: they work at a part-time job but want a full-time job (counted as employed) Unemployment Fluctuations The market-clearing theories ○ Economy adjust so rapidly that output gaps close immediately ○ GDP = Y* and U = U* (NAIRU) ○ All U* is either frictional or structural ○ Characteristics of the market-clearing theories Wages are flexible downwards in recessions U is voluntary: in a recession some will choose a lower W to stay employed and some will choose to leave LF E fluctuates but U is static (see below) The labor market is always in equilibrium (Qd = Qs) = thus no unemployment  ○ Problems with the market-clearing theories: inconsistent with facts Real wages do not fall much in recessions Most workers who lose their job do not withdraw from LF Unemployed workers actually do want a job = unemployment is involuntary The non-market clearing theories ○ [LR] Y = Y* thus U = U* (NAIRU) ○ [SR] The economy can be at Y ≠ Y* and U ≠ U*; W are downwardly sticky; cyclical and involuntary U do exist ○ In a recession Excess supply of labor (U > U*) Ws sticky downwards so the labor market does not clear quickly ○ In a boom Excess demand for labor (U < U*) Ws flexible upwards so market clears quicker than in the recession Why are wages sticky? 1. Long-term relationships between workers and employers a. Quasi-fixed costs: hiring and training costs incurred only once per worker, fluctuating by the number of workers hired not by hours per worker i. Thus the employer has an incentive to keep the worker longer to recover this cost ii. Disincentivized to lay off a worker in recession = more quasi-fixed hiring and training costs of a replacement worker if the trained laid-off worker does not return at the recovery of the economy 2. Menu costs a. Various administrative costs when changing P and W b. Temporary fall in output so change output and employment 3. Efficiency costs a. Employers pays W greater than the market-clearing equilibrium W  i. To send signal to attract highly-productive workers ii. Less-productive works do not apply because the know they will not be retained b. Efficiency wages = greater employment stability i. The worker has the incentive to maintain higher productivity if employed and a high opportunity cost associated with leaving (sacrificing the difference between the efficiency W and the equilibrium W) ii. The firm has the incentive to keep these high-productivity workers during temp. downturn in the economy (avoid risk of losing workers when product demand rises) 4. Union bargaining a. Demand falls: unions prefer laid-off workers rather than a reduction in wages b. Demand rises: employer will rehire workers at previous W with no union bargaining necessary c. Result i. W downwardly sticky in recessions ii. Members of union unemployment rate is higher than with flexible W CHAPTER SIXTEEN Government Budget Constraint Government expenditure must be financed by taxes or borrowing: ○ Government Expenditure = Tax Revenue + Borrowing Government expenditures include: ○ Purchases of G&S ○ Debt-service payments ○ Transfers Budget constraint: ○ G + iD = T + Borrowing ○ (G + iD) - T = Borrowing Remember T is the net tax revenue after transfers The government’s annual budget deficit funded by: ○ The annual flow of borrowing = the change in the stock of national debt ○ Budget Deficit = ΔD = (G + rD) - T Budget values: ○ Deficit (positive value) = the debt D rises ○ Surplus (negative value = the debt D falls EIGHTEEN: Debt and Budget Deficits 13 November – Chapter 16 The primary budget deficit: Deficit on the non-interest part of the budget ○ = (G + rD - T) - rD = G - T G - T shows how much of current program spending can be paid by current tax revenues First Issue: the Stance of Fiscal Policy Change in budget deficit can be caused by: ○ Changes in economic activity (GDP) ○ Changes in government fiscal policy to influence GDP Stance: the basic direction of fiscal policy ex. expansionary, contractionary, or neutral The Budget Deficit Function Budget deficit = (G + rD) - T ○ (G + rD): anchor point ○ GDP = 0: deficit = total government spending = G + iD GDP incr. so does T ○ T = tY Marginal tax rate incr. as individual income rises ○ Deficit negatively related to GDP Fiscal policy sets the position and slope of the budget deficit function: ○ G&D&i affect the position ○ t affects the slope Change in real GDP moves along the budget deficit function Structural and Cyclical Budget Deficits Structural component: whatever the actual Y the deficit that would exist at Y* ○ Maintaining current fiscal policies = structural budget deficit Cyclical component: difference between the actual deficit and the structural deficit ○ Y < Y*: actual deficit > structural deficit ○ Y > Y*: actual deficit < structural deficit Changes in total deficit can be caused by: ○ Structural deficit changes (changes in fiscal policy) ○ Cyclical deficit changes (changes in GDP but not in fiscal policy) Change in structural deficit reflects change in stance of fiscal policy: ○ Expansionary: policy change increases the structural deficit Shifts up budget function Structural deficit rises  Actual deficit rises (at a given Y) ○ Contractionary: policy changes decreases the structural deficit Second Issue: Debt Dynamics Δd = x + (r - g)d ○ Lowercase d is the change in the D/GDP ratio ○ X = (G - T)/GDP = the rise in D/GDP caused by primary budget deficit ○ rd = (rd)/GDP = the rise in D/GDP ratio caused by debt service payments ○ gd = D/gGDP = fall in D/GDP ratio caused by the rate of growth of GDP Must look at this debt in the context of the national income The Three Cases Case One: r = g ○ (r - g)d = 0 ○ Change in D/GDP ratio must be caused by x Primary deficit increases the D/GDP ratio Primary surplus reduced the D/GDP ratio Balanced primary budget means no change Case Two: r > g ○ (r - g)d > 0 (incr. D/GDP ratio on its own) Positive X (primary deficit) also increases D/GDP Negative X (primary surplus) pushes D/GDP in the opposite direction D/GDP will fall if the primary surplus is big enough to dominate effects of the debt service payments Case Three: r < g ○ (r - g)d < 0 Negative X (primary surplus) decreases D/GDP Positive X (primary deficit): D/GDP will fall if the primary deficit is not big enough to offset effects of the debt service payments Two Lessons GDP is growing: ○ D/GDP ratio falls if budget is not in deficit ○ Budget deficit may or may not decrease D/GDP ratio Dependent on the magnitude of the primary deficit component The Effects of Debt and Deficits (16.3) National saving = public saving + private saving National saving = government budget surplus + private saving  Assume that changes in government saving are not offset by changes in private saving ○ Changes in the budget surplus/deficit changes national saving Why is this an assumption? ○ Deficit is deferred taxes ○ Taxpayers increase their savings now in anticipation of higher taxes in the future This total offset is called the Ricardian Equivalence NINETEEN: Debt and Fiscal Policy 18 November – Chapter 16 Do deficits crowd out private activity? Possible effects on investments and net exports Crowding out: expansionary fiscal policy reduces private spending ○ Government sells more bonds to finance the deficit Increases the supply of bonds Reduces P of bonds Increases the interest rate Reduces private investment Causes capital inflow Appreciates the currency Reduces net exports The economy returns to Y* = something has been crowded out ○ Is it always the same Y*? ○ Increased G that caused budget deficit may be spent in ways to increase future Y*? Infrastructure, R&D, health, etc ○ Potential to crowd in private-sector activity Conclusion [LR] The net difference between crowding out and crowding in depends on: ○ How much Y* rises ○ How the extra G is spent Do deficits harm future generations? Debt redistributes resources and consumption ○ Toward the current generations ○ Away from future generations Financing public investments (ex. infrastructure, medical research, etc) ○ May have no net burden for future generations Paid for (via more debt) Receive many benefits Problem: many government expenditures can be hard to classify as consumption or investment Does government debt make economic policy more difficult? Monetary policy ○ High D/GDP with little prospect of future surpluses may cause:  Expectations that the central bank will monetize the debt by purchasing bonds to finance it Basically an expectation of expansionary monetary policy ○ Expectations of monetization = expectations of inflation Fuels actual inflation Makes monetary policy more difficult Fiscal policy ○ High D/GDP ratio severely restricts the ability to use counter cyclical fiscal policy Debt service payments are a high percent of tax revenue Restricts ability to use fiscal policy Less room for debt-financed deficits in recessions ○ May be unable to have stabilizing fiscal policy (especially in recessions) Formal Fiscal Rules (16.4) Can formal fiscal rules prevent excessive build-up of debt? ○ Annually balanced budgets Forces discipline on governments but leads to pro cyclical fiscal policy Must raise tax rates and reduce G spending to balance the budget in recessions This is opposite to what is needed in recessions Reverse in a boom Result: will accentuate the recession ○ Cyclically balanced budgets Balance the budget over the business cycle The surplus in a boom will pay for the deficits in recession Good in theory but difficult to define and implement Accurate predictions of the business cycle? Expect political problems Raise tax rates just before an election? Having the discipline not to increase G when T is high ○ Keeping a prudent D/GDP ratio (allowing for growth) Formal fiscal rules emphasize the budget deficit D/GDP ratio more important than deficits Δd = x + (r - g)d ○ g = ﹪ increase in the GDP which reduces the D/GDP ratio Have budget deficit with no rise in D/GDP r < g: deficit and falling D/GDP What caused the rise in Canadian federal debt? Rise from 20 percent of GDP to 68 percent Take the primary deficit and split into two components: ○ Structural Cyclically adjusted primary deficit ○ Cyclical The difference between: [Y*] Primary deficit actual [G - T at Y*] The structural component Δd = x* + (x - x*) + (r - g)d ○ x* = the structural component ○ (x - x*) = the cyclical component ○ (r - g)d = the rate component The cyclical component cancels itself out over relatively long periods of time ○ Stage 1 [1970s - 1980s] r < g: rate component alone reduced D/GDP Substantial increase in the structural component Result: not a large increase in D/GDP ratio