Macro Study 0.5 (3) PDF

Chapter 15  What is Money? Best way to understand money is to imagine an economy without money. A barter economy is an economy that can still carry out exchanges of goods and services without money. There are two problems inherited with barters: (1) double coincidence of wants and (2) indi...

Chapter 15  What is Money? Best way to understand money is to imagine an economy without money. A barter economy is an economy that can still carry out exchanges of goods and services without money. There are two problems inherited with barters: (1) double coincidence of wants and (2) indivisibility. Money solves both of these problems. Functions of money Money is the set of all assets regularly used to directly purchase goods and services. Money serves three major functions: 1\. Medium of exchange is an item that can use to purchase goods and services. 2\. Unit of account is the yardstick that serves as a standard unit of comparing and posting prices. 3\. Store of value represents a certain amount of purchasing power that lasts over time. Types of money Fiat money is money created by government decree, without any commodity to back it (e.g. banknotes). Fiat is a Latin term that roughly translates to \"it shall be\". Assets that fit the above definition of money include: 1\. Currency 2\. Demand deposits (chequable deposits) 3\. Notice deposits (non-chequable deposits) 4\. Canada Savings Bonds 5\. Money market mutual funds Money in Canada The quantity of money circulating in the economy is called the money stock (or money supply). It has a powerful influence on many economic variables. Monetary policy is the setting of the money supply by policymakers in the central bank. Central bank is an institution designed to regulate the quantity of money in the economy and coordinate the banking system to ensure a sound economy. Bank of Canada The primary responsibility of the BoC is to act in the national interest. The BoC has four main mandates: Issue and distribute Canadian banknotes. Lender of last resort (banker to the commercial banks). Fiscal agent for the federal government (banker to the Canadian government). Control the money supply. Money supply Most common classifications of money supply (monetary aggregates) are: 1\. M1+: currency outside banks plus personal and non-personal chequable deposits held at commercial banks (chartered banks and credit unions, caisses populaires, and trust companies) 2\. M2: all items in M1 plus personal savings and term deposits and non-personal notice deposits at chartered banks. 3\. Monetary base: what is being \"multiplied\" by the banking system. Money supply BoC has the power to increase or decrease the number of dollars in the economy. BoC is an important institution because changes in the money supply can profoundly affect the economy. Although the BoC alone is responsible for Canadian monetary policy, the central bank can control the supply of money only through its influence on the entire banking system. What is the role played by commercial banks (which include credit unions, caisses populaires, and trust companies) in the monetary system? Money Creation Banks accept deposits and make loans. Demand deposits (dep) are funds held in bank accounts that can be withdrawn (on demand) by depositors at any time without advance notice. When people deposit their currencies at banks, it create both an asset (a resource the bank possesses) and a liability (an amount the bank owes). Reserves (res) are cash deposits that banks keep in their vault. Desired reserves is the amount of reserves bank desires to keep on hand to meet withdraw demand from deposits. Reserves ratio (R) is the fraction of deposits that banks hold as reserves. Fractional-reserve banking is a banking system in which banks keep on reserves less than 100 percent of their deposits. As money deposits into bank and is loaned out, money is created. Money Multiplier \- In the previous example, how much money can be created from the initial \$1,000 deposit? Instead of using the table, we can estimate the change in money supply using the money multiplier. Money multiplier is the ratio of money created by leading activities to the money created by the central bank. 1 Money multiplier is the reciprocal of the reserve ratio: Given we have \$1,000 of reserves and the money multiplier is 10 (1/0.1), the amount of money generates will be \$10,000. If the reserve ratio becomes very small, the money multiplier can get very large and this will make money close to worthless. Bank run: many depositors withdraw deposits thinking bank might not able to satisfy their requests (e.g. UK\'s Northern Rock Bank in 2007). BoC\'s tools of monetary control Central banks have three main tools for monetary control: 1\. Changes in reserve requirements: minimum fraction of deposits banks must hold as reserves 2\. Open-market operations: buying/selling government securities from/to banks on the open market 3\. Changes in the overnight rate Change in reserve requirements 1\. Reserve requirements are the regulations on the minimum amount of reserves that banks must hold against deposits. An increase means that banks must hold more reserves. It raises the reserve ratio (R). This lowers the money multiplier (1/R). The money supply decreases. Open-Market Operations 2\. Open-market operations is the purchase or sale of Government of Canada bonds by the Bank of Canada. To increase the money supply, the BoC buys bonds (or/and Treasury bills) from the public. To reduce the money supply, the BoC sells bonds (or/and Treasury bills) to the public. Quantitative easing is the purchase and sale by the central bank of non-government securities or government securities with long maturity terms. Changes in the Overnight Rate 3\. The BoC can alter the money supply by changing the bank rate, causing an equal change in the overnight rate. Bank rate is the interest rate charged by the Bank of Canada on loans to the commercial banks (currently at 5.25%). Overnight rate is the interest rate on very short-term loans between commercial banks (currently at 5%). Changes in the Overnight Rate A higher overnight rate discourages banks from borrowing reserves from the BoC, thus reducing reserves in the banking system (i.e., the money supply contracts). In November 2000, BoC introduced a system of eight fixed dates each year on which it announces whether or not it will change the rate. The BoC can also change the overnight rate at any time, if extraordinary action is needed. Zero lower bound: a natural limit to how low the overnight rate (or any other nominal interest rate) can go. Economic Effects of Monetary Policy Interest rate, r Liquidity-preference model: Quantity of money people want to hold is a function of the real interest rate. The point where the supply of money (controlled by BoC) meets the demand for money (r\* determine the real interest rate, stated price of money in the economy. Economic Effects of Monetary Policy Interest rate, r Expansionary monetary policy (re) \- increase in money supply to lower the equilibrium interest rate. Contractionary monetary policy \(r) - decrease in money supply to increase the equilibrium interest rate. Expansionary Monetary Policy \(A) Expansionary monetary policy Expansionary monetary policy pushes interest rate lower and puts more money into the economy. Expansionary Monetary Policy Price level The lower cost of borrowing encourages households to spend more and businesses to invest more, increasing AD. In this case, monetary policy was able to pull the economy out of recession. Economic Effects of Monetary Policy If quantity of money demanded is really responsive to changes to the interest rate (a flat, elastic demand curve), then changes to the money supply will have a smaller effect on interest rates. If quantity of money demanded is less responsive to changes to the interest rate (a steep, inelastic demand curve), then changes to the money supply will have a larger effect on interest rates. Contractionary Monetary Policy Interest rate, r Contractionary monetary policy decreases the money supply, increasing the interest Decreasing the money supply can cool down the economy when it overheats. Benefits of Monetary Policy Unlike fiscal policy, the central bank does not have to wait for politicians to come to a consensus about the best policy to help the economy. Instead, the board of directors (and the governing council) can change monetary policy relatively quicker and the time lag is generally shorter for contractionary monetary policy. Chapter 16 Inflation What determines whether an economy experiences inflation and, if so, how much? Inflation is an increase in the overall level of prices. Deflation is a fall in the overall level of prices. The inflation rate is the percentage change in either the: CP\| GDP deflator Other index of the overall price level Statistics Canada measures two inflation numbers: 1\. Core inflation excludes goods with historically volatile price changes. 2\. All-items inflation (headline inflation) includes all of the goods that the average consumer buys. The Classical Theory of inflation The quantity theory of money will be used to understand inflation. It is often called classical because it was developed by some of the earliest thinkers about economic issues. The economy\'s overall price level can be viewed in two ways: As the price of a basket of goods and services. As a measure of the value of money. The Classical Theory of inflation The value of money is determined by the supply and demand for money. The supply of money is controlled by the Bank of Canada and the banking system. The demand for money reflects how much people will want to hold in liquid form. The demand for money is sometimes referred to as \"liquidity preference.\" Many factors affect the demand for money. For example, the amount of currency that people hold in their wallets can depend on how much they rely on credit cards or the accessibility of ATMs. The most important variable that explains the demand for money is the level of prices in the economy. In the long run, the overall level of prices adjusts to the level at which demand for money equals the supply. The effects of a monetary injection Short run - output and prices rise (E,) Workers want higher wage (SRAS, to SRAS,) Long run - more money supply will leads to higher prices (P3); output stays same (\'1,3) Quantity theory of money This explanation of how the price level is determined and why it might change over time is called the quantity theory of money. Quantity theory of money is a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate. Monetary neutrality Economic variables can be divided into two groups: 1\. Nominal variables are variables measured in monetary units. 2\. Real variables are variables measured in physical units. Classical dichotomy: The theoretical separation of nominal and real variables. Monetary neutrality is the proposition that changes in the money supply do not affect real variables. Quantity equation The quantity theory of money can be seen mathematically through the quantity equation: MV = PY V: Velocity of money Y: Real GDP P: Price level M: Quantity of money  Velocity of money The velocity of money, V, is the number of times that the entire money supply turns over in a given period. The elements for explaining the equilibrium price level: 1\. Velocity (V) is stable over time. 2\. Because V is stable, when the central bank changes the quantity of money (M), it causes proportionate changes in the nominal value of output (P x Y). 3 The economy\'s output of goods and services (Y) is primarily determined by factor supplies and technology. In particular, because money is neutral, money does not affect output. 4\. With output (Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P x Y), these changes are reflected in changes in the price level. 5\. Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation. Quantity theory of money The quantity equation implies that increasing the money supply leads to inflation and decreasing the money supply leads to deflation. The economy adjusts to a different nominal price level when the money supply changes. Leads to the conclusion that the price level is immaterial. Changes in the price level can have a big effect on economic behavior. A modest and predictable level of inflation can be a good thing. High inflation, unpredictable inflation, and deflation are bad for economies. Costs of inflation There are costs of predictable inflation. Menu costs are the money, time, and opportunity costs of changing prices to keep up with inflation. Shoe-leather costs are the time, money, and effort costs of managing cash in the face of inflation. Tax distortion (bracket creep) refers to the fact that tax laws only take into consideration nominal income, not what you can buy with it. There are also problems with unpredictable inflation. Changing prices affects interest rates. The nominal interest rate is the reported interest rate that is not adjusted for the effects of inflation. The real interest rate is adjusted for the effects of inflation. Mathematically, this relationship can be established as: Real interest rate = Nominal interest rate - Inflation rate Inflation The analysis suggests that savers are worse off, while borrowers are better off, from inflation. If inflation is predictable, then this redistributive effect need not happen. Even if inflation is high, savers will not lose out as long as banks offer nominal interest rates above inflation. Changes in the inflation rate often come as a surprise, and it can take time for nominal interest rates to adjust. Deflation Deflation is a sustained fall in the aggregate price level. Periods of deflation occur less often than inflation. Deflation causes aggregate demand to decrease. Increases the burden of debt, which leads to a decrease in consumption. Companies are less willing to borrow money, which leads to a decrease in investment. Disinflation and hyperinflation Disinflation is a period where inflation rates are falling, but still positive. This usually occurs when the central bank aggressively tries to contain inflation via contractionary monetary policy. Hyperinflation refers to extremely long-lasting and painful increases in the price level. This can leave currency completely valueless or close to it. Inflation as a buffer against deflation Preferred monetary policy is to promote modest positive inflation around 2-3% per year. Inflation reduces the risk of deflation. Permits the central bank to implement expansionary monetary policy. Makes it easier for firms to adjust real wages in response to changing labour demand conditions without affecting productivity.  Inflation and monetary policy The goals of maintain price stability and ensure full employment are often incompatible. An economy\'s potential output is the total amount of output a country could produce if all of its resources were fully engaged. This means that only frictional and structural unemployment occur. Ensuring full employment is really another way of keeping actual output near potential output. There is a strong positive relationship between the output gap and inflation. During recessionary periods, there is typically little to no threat of a rise in inflation. During expansionary periods, there is a higher threat of rising prices as resources become more scarce. A central bank can engage in expansionary monetary policy to increase employment. In the long-run, unemployment will decrease but prices will remain higher. Central banks can affect prices with no lasting impact on employment. The Phillips curve In strong economies, prices increase at a faster rate and unemployment is low. When unemployment increases, prices increase more slowly. The Phillips curve An increase in aggregate demand results in an increase in price and output in the short run. The Phillips curve shows that this is associated with higher inflation and lower unemployment. In the long-run, output returns to its earlier equilibrium, and so do levels of unemployment. Inflation rate (%) 10 -. 1\. When the central bank increases short-run aggregate demand, unemployment initially falls (A →B). 2\. However, once the economy returns to the long-run equilibrium, unemployment returns to the same level while inflation stays the same (B\>C). 3\. If the central bank again tries to reduce unemployment. it will succeed in the short run, but inflation will go up (C-\>D). The economy would return to long-run equilibrium and the pattern would continue with every effort. Long-run Phillips curve Individuals expect higher price levels, causing inflation to be permanently higher. Connecting the two long-run equilibrium points yields the long-run Phillips curve. The long-run Phillips curve shows that there is no tradeoff between inflation and unemployment in the long run. The long-run Phillips curve is also called the non-accelerating inflation rate of unemployment (NAIRU). Long-run Phillips curve The NAIRU can change over time due to structural changes in components of unemployment, regulatory and competitive environment. It is difficult to know the exact location of the NAIRU. It is easy to determine if the economy is above or below it. If unemployment is below the NAIRU, inflation generally accelerates. If involuntary unemployment rises, unemployment is above the NAIRU. Chapter 18 Open-economy Concepts The study of an open economy raises new insights into how trade can make every countries better off. Closed economy is an economy that does not interact with the rest of the world. Open economy is an economy that interacts with other economies around the world. An open economy interacts with other economies in two ways: Imports and exports are the most visible and straightforward aspects of international economics (International Trade). Countries interact in other ways as well, including through investment (International Finance). While the two activities are discussed separately here, they intertwine with each other very closely. International Trade Exports (X) are goods and services that are produced domestically and sold abroad. Imports (M) are goods and services that are produced abroad and sold domestically. Balance of trade (or net exports (NX)) is the value of exports (X) minus the value of imports (M). Trade deficit occurs when a country imports more than it exports (negative trade balance or -NX). Trade surplus occurs when a country exports more than it imports (positive trade balance or +NX). International Finance Net capital flow is the difference between capital inflows and capital outflows. Capital inflows are domestic investment (physical or financial) that is financed by savings from another country. Capital outflows are investment in foreign country (physical or financial) that is financed by savings from domestic country. Net capital outflow (NCO) is the net flow of funds invested outside of a country. Foreign Investment Foreign investment can take two forms: 1\. Foreign direct investment (FDI): domestic firms runs part of its operation abroad or invests in another company abroad. 2\. Foreign portfolio investment: investment funded by foreign sources but operated domestically. Domestic investors may purchase foreign financial assets (stocks or bonds). Portfolio investment flows across borders quickly; mainly involves transfers between bank accounts. Rapid movement of money across borders can overwhelm the country\'s financial markets. Balance-of-Payments Identity Net exports measures the imbalance between a country\'s exports and its imports. Net capital outflow measures the imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners. This gives rise to the balance-of-payments identity - an equation that shows the value of NX equals NCO (or balancing trade deficits/capital surpluses) NCO = NX Balance-of-Payments Identity The equation implies that when a country is having a trade deficit (NX\