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Econ 202 - Section 002 Notes

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University of Waterloo
ECON 202
Maryann Vaughan

Chap 1-2 (from Sabrina) 1/17/2013 7:39:00 AM The Focus of Macroeconomics  Macroeconomics focuses on the behavior of key macroeconomic variables including: o ???  Since the early 1990s, the inflation rate has been in the narrow range of 1-3% per year - consistent with the Bank of Canada target. 3. The unemployment rate – the proportion of the labour force out of work (Fig 1-3) Canadian Historical Data on the UR  The UR is strangely countercyclical with GDP o Rising in recessions and falling in expansions  Unemployment was highest in the 1930s [during the Great Depression] and lowest in the 1940s [during WWI]  Since 1945, there has been a gradual upward trend in unemployment, but endence in recent years suggest this trend may be easing. 4. The interest rate – the cost of borrowing and return to saving 5. The (nominal) exchange rate – the cost of one currency in terms of another Behavior of prices: tlekible (LR) & sticky (SR)  D ≠ S (many not). ↪ Market clearing (equilibrium) (ch 7-8)  OMIT (ch 9-13) Chap 2 (Jan. 10) (S 6) Some Rule for Calculating GDP 1 1. The importance of inventories. Since we want to measure production in a given year, we add the value of unsold goods to inventories, and include this value in the GDP calculation. 2. We add-up the many and varied goods and services by multiplying the quantity by the market price. 3. Exclude intermediate goods. Count the value of final goods & services only in the GDP calculation, otherwise, double-counting will occur. 4. If goods or services don’t have a price, use an imputed value Ex. (1) imputed rent on owner-occupied housing (2) government services are valued at cost 5. Excluded:  Used goods (b/c been included)  Home production  Underground economy (transaction that don’t go through market)  Services of durable goods (S 7) Investment (I)  (net financial investment) i.e. Domino Pizza buying a store Notes: Investment – the purchase of newly produced goods/services to add to the capital stock.  Purchase made by businesses & firms  By convention, the purchase of new housing stock  The value of inventories (S 16) Government (All government levels) Defn: Transfer Payments  Direct transfers of money from the government to individuals not in exchange for production. (no production involved)  Net exports: NX = EX – IM  GNP  everything owned by Canada  GDP  everything in Canada (S 25) 2 Real vs Nominal GDP  Nominal GDP – output valued at current year prices  Nominal_GDP= å Q2010 2010 i  Nominal GDP measures the value of goods & services produced in Canada  can’t compare nominal GDP annually  Real GDP – output valued at constant (base year) prices i i  Real_GDP = å Q2010 2012 i  Real GDP measures the volume of goods & services produced in Canada. (s 30) GDP Deflator (price index)  Defn: The GDP deflator measures the price of output relative to its level in the base year.  The GDP deflator is a price index which measures the overall price level.  Calculation: GDP_Deflator = Nominal_GDP ´100 Real_GDP i i å Q2010 2010 GDP_Deflator = i ´100 å Q2010 2012 EX. i  In this definition of the GDP Deflator, all the quantity terms will be the same, reflecting only the relative change in prices. Jan 15, 2013 (s 44) CPI weights is fixed (csp SR) whereas GDP deflator rate is not. (s 46) Canada – (0.5% - 1%)  Flexed weight (Laspeyres)  CPI  Changing weight (Paasche)  GDP deflator 3 (s 48) 1. prices of capital goods (Canadian households don’t buy these  excluded from CPI) 2. price of imported (net import included in GDP) 3. basket of goods (GDP changes, because we produce different every year) Fig 2-3  CPI & GDP move in the same way (not always) Note: measuring bhlessnecs: the unemployment rate.  A well-functioning economy will use all its resources 1. unemployment may signal wasted resources 2. The costs of unemployment aren’t evenly distributed across the population Based on the Labour Force Survey of about 56,000 households, the population [15 years+] is categorized as: POP = employed + unemployed + not in the LF Labour Force (LF) = employed + unemployed #unemployed ÞUR= ´100 Labour_Force Labour_Force Þ Labour_Force_Participation_Rate=Adult_Population´100 Fig 2-4 p40 (Canadian Rules) ↪ This figure shows the # of people in each category in 2008 The Labour Force Survey deliberately excludes individuals in all of the following categories: 1. Persons younger than 15 years old 2. Persons residing in the Yukon, the NW territories, Nunaunt and an Native reserves 3. Full-time members of the armed forces 4. Inmates in institutions. (ie. Hospitals) 4 Chapter 3 1/17/2013 7:39:00 AM  Lecture 3  From Sabrina (Slide 38) Carsian Consumption Equation C = a + NPC (Y-I), where a = (Slide 41)  How is GDP ALLOCATED to consumption (C), investment (I), and government spending (G)?  Process to Equilibrium  Y  Supply > Demand o Implies we need more demand.   r ->  I  until supply = demand.   The opposite is true Y  I  until supply = demand (S 43)  The Financial Market   Assumptions: 1. There is one financial market where loanable funds (LF) are traded. i. This is a simplifying assumptions. 2. All investment spending by firms is financed by new borrowing. i. This implies I(r) = LF and is inversely related to the interest rate (r). 3. Any government budget deficit is financed by new borrowing which reduces the pool of LF available to firms. 5 4. All private savings are used to make new loans to firms or to government.  From 3 and 4  S = (Y – T – C) + (T – G)  National Saving = Private savings + Public (dis)saving o private means people o S can be positive or negative o T: tax revenue o T-G  supplus/deficit  These assumptions also imply that S = LF S  Notes: from 3, government issues bonds to borrow money to cover deficit, this reduces private savings (C)  (s 45) loanable funds demand curve: investment D  I(r) = LF  The Model Let S = Y – C – G. This is the definition of National Savings. From the National Accounting Identity: Y = C + I + G Y – C – G = I Therefore, S = I Savings = Investment. This is the equilibrium condition in the Financial Market. Putting together all of our assumptions, we get: Y -C(Y -T)-G= I(r) Therefore, S = I(r) and, S =S Given the assumptions of the model, saving does not depend on the interest rate.  01/22  Slide 56: 6  We can show that financial market equilibrium eimplies goods market equilibrium.   Financial Market I(r) = S  Equilibrium  Condition  I(r)=Y -C(Y -T)-G  Substitute for S C(Y -T)+I(r)+G=Y  Rearrange Y =Y  Rename  OR Demand for goods/services = Supply of goods/services  OR Goods market equilibrium condition   7  Start: in eq’m at (A).  Shock:  G, T = T(bar) S=Y-C-G At r1, S < I or LF < LF D  r   quantity of LF demanded (along the demand curve).   The Effects of a Change in Fiscal Policy  Fig. 3-9 page 74  Shock:  G, T=T(bar) D S  At r1, I>S or LF > LF  Therefore, r and I(r)  until equilibrium is restored.  (We call this “crowding-out” of investment spending.)   Note:  The increase in G has no effect on the amount of output produced by the economy which is fixed by the given supplies of the factors of production: Y =Y =F(K,L)  The increase in G has no effect on total expenditure on output because the real interest rate [r] adjusts to keep Y =Y or demand = supply in the goods market.  The composition of demand changes with investment spending decreasing by exactly the amount by which G increased [the crowding out effect] while consumption spending remains unchanged.   Tax cut G =G  Shock:  T,   T implies (Y-T)    (Y-T) implies  C  S = Y – C - G   SLIDE 64  The Effects of Changes in Investment Demand 8  Fig. 3-11 page 78  In this analysis, we want to talk about exogenous changes to investment demand.  For example, a technological innovation or a change in tax laws would result in a change in investment for any interest rate.  In other words, a shift in the investment demand curve.  Note: a change in the interest rate (r) will change the quantity demanded along the demand curve. Model predicts: actual investment will be the same in equilibrium. Why? In equilibrium, I =S,S =S Therefore, a change in investment results in a change in the interest rate only.   The increase in investment demand has no effect on the levels of aggregate output because the real interest rate [r] adjusts to keep total demand for output [Y] equal to [fixed] total supply of output [ Y ].  There is no change in any of the components of demand, C, I, G.  While investment demand at a given real interest rate has increased, the actual amount of investment spending has not changed because the equilibrium value of r has risen.   Unless “saving depends on interest rate” is specified, it does NOT hold.  Special case: 9    SLIDE 66  An Increase in Investment Demand When Saving Depends on the Interest Rate  Fig. 3-13, pg. 79  Start in equilibrium at point A.  Assume there is an exogenous shock which increases investment demand. I(r) shifts to the right. D S  At the initial interest rate1r , LF > LF .  The real interest rate will start to rise. As a result, the quantity of LF demanded will  along the demand curve. The quantity of LF supplied will  along the supply curve. This will continue until we are back in equilibrium at point B.  Outcome: We have more saving which finances more investment.   10 Chap 4 1/17/2013 7:39:00 AM Functions of Money  Medium of Exchange – emphasized that money makes exchange easier and more efficient.  Store of Value – people will hold money only if they believe it will continue to have value.  Unit of Account – identifies the convenience of having a widely recognized measure for accounting and transactions.  (Jan. 24 – Lecture 6) Control of the money supply  This is one of the most important responsibilities of Canada’s central bank – the Bank of Canada.  Decisions regarding the size of the money supply are the responsibility of the Governor of the Bank of Canada,  with input from the Federal Minister of Finance,  and constitute the government’s monetary policy.  The main method of control of the money supply is through open market operations – the purchase or sale of outstanding government bonds by the Bank of Canada. Open Market Operations  Increase the money supply - Bank BUYS government bonds & securities from the public, putting money in circulation  Decrease the money supply - Bank SELLS government bonds & securities to the public, taking money out of acculation. Note: money held by the Bank of Canada is not included in the money supply. Table 4-1 The Measures of Money 4 Measure of the money stock for Canadian Economy  Money consist of coins, bank notes, and chequable deposits. 11 1. M1 = currency (bank notes + coins) outside the banks + demand deposits located in chartered banks (very liquid)  Demand deposits – funds in accounts that can be removed without notice & usually pay little or no interest. Examples: current accounts, personal chequable accounts. 2. M2 = M1 +personal savings deposits + non-personal notice deposits located in chartered banks.  Saving deposits – bank deposits that typically earn a rate of return and return a stipulated amount of notice to be withdrawn, though rarely enforced.  Notice deposits – deposits which have a notice requirement in the contractual agreement with the client, although banks almost never enforce this clause.  Term deposits – bank deposits paying a market rate of return which are deposited for a fixed term and thus have limited liquidity. (M1 + M2 are all in chartered banks) 3. M2+ = M2 + all deposits at non-bank-taking institutions (trust, mortgage & loan companies; credit unions and caisses populaires), money-market mutual funds, and individual annuities at life insurance companies. 4. M3 = M2 + chartered bank non-personal term deposits and foreign currency deposits of Canadian residents.  Non-personal term deposits o Deposits held by provincial and municipal governments, corporations, and institutions, and also include deposits held by one bank with another, known as interbank deposits. Demand For Money (s17 - replace with notes) Assume the amount of money people wish to hold is proportional to income: d M = kPY  (M/P) = kY d Where: M = demand for money 12 (M/P) = demand for real balance k = a constant proportion of income Equilibrium in the money market: d M / P = (M / P) Supply = Demand  M / P = kY  M(1/k) = PY Result: Money demand is equivalent to the quantity equation if: i. V = 1/k ii. There is equilibrium in the money market. 5.  V = 1/k shows the link between demand for money and velocity of money.  When k is large, that implies velocity is small.  In other words, when people want to hold a large proportion of money for each dollar of income, then money changes hands infrequently.  Compare: MV=PV to M(1/k)=PV.  If V=1/k, then money demand is equivalent to the quantity equation. Y = F(k,L) (S19, chap3) (S20) The Quantity Theory of Money  Quantity Equation o MV = PY  Quantity Equation in Growth Rate Terms o %DM+%DV =%DP+%DY  NOTE: since we assume V =V ,  Then %DV =0 Let ∏ denote the inflation rate. p =%DP Now: 13 %DM+%DV =%DP+%DY Can be written as: %DM =p +%DY Solve for ∏: p =%DM-%DY The Quantity Theory of Money MV = PY a. The money supply determines the price level. %DM+%DV =%DP+%DY b. The growth rate of the money supply determines the inflation rate. Seigniorage (S27)  Definition: the revenue the government obtains by printing money.  A government can finance its deficit by: i. increase taxes, ii. borrowing (selling bonds), iii. printing money ( M, then  π) Why Inflation?   M   P from the Quantity Equation.  Existing money is now worth less than before because higher prices means each dollar buys less.  This is “similar to” a tax on real balances. Lecture 7 (Jan. 29) (s28) Note: Nominal Interest Rate The costs of borrowing or the return to lending measured in monetary units. Real Interest Rate The cost of borrowing or th
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