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ECO102H1 (155)

ECO100 - MAR 6

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James Pesando

The Transmission Mechanism ● Monetary policy ● Shock to the money supply ● Equilibrium of the price of money will change ● Changes the preference for consumption and investment Closed Economy Example ● 1. Suppose the BoC decides to increase the money supply ○ It is participating in Open Market Operations ■ Buys government securities ● much like giving a loan to the gov’t ■ New money must come to existence to do that ■ Introducing new money into the economy ■ Increases the reserves in the banking system ● Interest rate will fall to increase demand while holding all else equal ● What’s the difference between M* and M’? ● Buys $100 in government securities and pays by issuing new currency ● Government will spend the new $100 will eventually be deposited into a bank ● Vendor deposits $100 of currency into Bank 1 Bank 1 Asset Liability Reserve +100 Deposit + 100 ● Bank 1 desires to hold 10% in additional reserves => Lends 90 to small business. Bank 1 A Le Reserve + 10 Deposit + 100 Loans + 90 ● Small business deposit 90 in Bank 2. Bank 2 holds 9 as additional reserves. Lends 81 to client. Etc. ○ Multiple deposit creation as studied before ● MS = Total deposits = Reserves *( 1/0.10) ○ = 100 * 10 ● 2. The decrease in i* will cause a change in desired autonomous investment when prices are held fixed ○ Change in interest rate will change the optimal investment amount ● Investment: of inventory ● Residential investment: mortage ● As interest rate falls, it costs less to invest ● This analysis is exactly the same for consumption (but the other sections like investment) ● The increase in desired investment will match the AE ● 3. The change in AE will also result in a change in AD ● The transmission mechanism: ○ Money Supply up ○ i* down (opp cost goes down) ○ I (desired investment) up and C (consumption) up ○ AD up (AE up) ○ All else constant: P up and Y up ● Constraint: ○ There will be a point where the interest rate cannot be dropped anymore ■ run out of options Open Economy Example ● Any countries that participate in international trade ○ imports and exports ● Difference currencies: exchange rate ● Interest rate ○ Suppose that interest rate falls in Canada, but is constant everywhere else ■ money supply increases => interest rate falls ■ Foreign investors will want to buy fewer Canadian bonds and more foreign bonds ■ If there is a drop in demand fo
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