ECON 295 Quiz: Midterm 2 summaries
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Department
Economics (Arts)
Course
ECON 295
Professor
Mayssun El- Attar Vilalta
Semester
Winter

Description
1. Macroeconomics policy – Midterm 2 summaries Chapter 25: The difference between short-run and long-run macroeconomics Bank’s policy to reduce inflation - An increase in inflation pushes up nominal interest rates - High nominal interest rates of the past were caused mostly by high inflation because lenders need to be compensated - He argues that to reduce the rate of inflation the Bank of Canada has to reduce the growth rate of the money supply tighten up credit-market conditions and push up interest rates - To have an effect on the company, they must affect the level of potential output Short run - Reduction in the growth of money will make credit scarcer:  Nominal interest rates will rise  Less investment and less expenditure  Reduction of real GDP - The rise in interest rates causes aggregate expenditure to fall, reducing output - Limited price and wage adjustment Adjustment Wages and other factor prices adjust, the rate of inflation falls, and nominal interest rates also fall Long run - The economy is in a new equilibrium. Inflation and nominal rates will be lower than before the policy was initiated - In the long run, the downward pressure on wages (recessionary gap) causes inflation to fall, interest rates too, which is good for output Japan case - Economy is stagnant, too much saving, too little spending - Economic success is due in part to its high saving rate - In the short run an increase in desired savings leads to less aggregate desired spending = economic slump - In the long run, greater savings expend the pool of funds, drives down interest rates, and makes investment more attractive, which leads to economic growth GDP accounting: The basic principle - Suppose we could break down any change in GDP into its component parts. Understanding how these components change we can understand how GDP changes in the long-run - - Any change in GDP must be associated with a change in one or more of these things - How do these three components change over time  Factor suppliers: Supplies of labor and capital change only gradually  Productivity: Changes only gradually  Factor utilization rate: Fluctuates a lot in the short run, but very little in the long run Factor supply change increase for two reasons: - Labor: Greater immigration, an increase in birth rates or decrease in the mortality rates. Also, an increase in the labor-force participation - Capital: Changes in the rate of investment generate changes in the economy’s capital stock. But dramatic changes in the annual flow of investment generate almost imperceptible changes in the stock of capital  long run changes Productivity - Measures the average amount of output that is produced per unit of input - Output per employed factor - Long run changes Factor utilization - The fraction of the total supply of factors that is employed - Fluctuates in response to short-run changes in output caused by aggregate demand or aggregate supply shocks - Over time, however, excess supply or excess demand for factors causes an adjustment in factor prices that brings the factor of utilization back to its “normal level” - These changes are not important for explaining long-run changes in GDP What does productivity growth really look like - When new capital or new techniques raise output proportionally more than raise labour input  increases in labour productivity - The amount of work is unchanged but the output rises. When workers are released from these activities and move to work somewhere else, their new production will constitute an increase in GDP Summing up - Long-run changes in GDP  Need to understand labor force growth, capital accumulation and productivity growth  Increases usually related to increases in factor supply - Short-run changes in GDP  Need to understand changes in the utilization rate of labor – the employment rate  Decreases with an increase in the interest rates  When short-run actual GDP is above potential GDP, utilization rates of factors are above “normal” levels Policy implications - Fiscal and monetary policies affect the level of aggregate demand (therefore GDP) - No effect on the long-run GDP Chapter review - Changes in national income in the short run are primarily caused by shocks in aggregate demand and supply - What can decrease real GDP  Decreases in capital stock of the country  Decreases in labor participation rates  Decreases in land productivity  Increases in mortality rates - More immigration = increase in supply of labor - Changes in factor supplies are important determinants of long-term economic growth - All else equal, an increase in the labour force participation rate and productivity growth might explain an increase in income per capita - Economists, when thinking about business cycles, focus on understanding why actual GDP deviates from potential GDP - Increases in government spending on health and education would contribute to both the reduction of a recessionary gap and the increase of potential output and increase of per capita income in the long run Chapter 26: Money and Banking Nature of economic growth - Economic growth: Ongoing increases in the level of real potential GDP - Sustained increases in Y* = more powerful method of raising material living standards than removing recessionary gap - Even small differences in annual growth rate can result in larger changes in living standards after many years Benefits of economic growth 1. Rising average living standards a.i. Change the society’s consumption patterns a.ii. More environmental protection 2. Alleviation of poverty a.i. Not everyone benefits directly from growth a.ii. But redistribution is easier in a growing economy Costs of economic growth 1. Sacrifice of current consumption a.i. Growth Is often encouraged by increasing investment and saving, which requires less consumption 2. Social costs of growth a.i. Involves the displacement of some firms and workers a.ii. Involves real transition costs 3. Rapid adjustments that can cause much upset and misery to some people 4. More wealth concentrated in the hands of a few citizens Sources of economic growth - Fundamental sources:  Growth in the labour force  Growth in human capital (workers’ skills)  Growth in physical capital  Technological improvement Long run analysis of established theories of economic growth - Short run, equilibrium interest rate  desired savings = desired investment - Long run  real GDP = Y* A theory of investment, saving and growth - Investment = increases in the stock of capital – leads to increases in the future level of Y* - Saving by households (and firms) is used to finance this investment  The interest rate is the “price” that equilibrates this market  Firm’s investment demand is negatively related to the real interest rate  National saving is positively related to the interest rate Adding government sector to our model - Private saving = Y* - T – C - Public saving = T – G - National saving = Private saving + Public saving o NS = Y* - T – C + (T – G) o NS = Y* - C – G o If C is negatively related to the interest rate, then NS is positively related to the interest rate The long-run connection between saving and investment - Y = Y*  equilibrium  Desired national savings = desired investment determines the equilibrium interest rate Increase in the supply of saving - The NS curve shifts to the right - Real interest rate is reduced - More investment is encouraged  higher growth rate of potential output Increases in the demand for investment - The I curve shifts to the right - More investment = increase in the interest rate - More savings by households  higher growth rate of Y* Investment and saving in globalized financial markets - Closed-economy = change in investment, national savings = change in Canada’s equilibrium interest rate - Open-economy = interest rates on similar assets tend to move together - The law of one price in a globalized financial market  Assumptions: Financial capital is highly mobile and can be freely traded internationally and there is a single type of financial capital in the world - Excess supply for financial capital at the equilibrium world interest rate, the extra saving can be used to acquire foreign assets (capital outlflow) Neoclassical growth theory - Aggregate production function  GDP = F TL, K, H)  L = total amount of labor  K = stock of physical capital  H = quality of human capital  T = state of technology - Assumptions  Diminishing marginal product of both K and L  When either factor is changed in isolation  Constant returns to scale  When both K and L are changed in equal proportions - Predictions  According to the 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) (successive increases in one factor to a fixed stock of other factors of production cause output to increase at a decreasing rate) o Can’t explain rising material living standards in the long run - Increases in population lead to increases in GDP but eventually to reductions in per capital GDP - Falling average living standards - Diminishing MP of K means that capital accumulation on its own brings smaller and smaller increases in real per capita GDP - Assumption of constant returns to scale means that if K and L grow at the same rate there will be no improvements in material living standards  GDP will grow but per capita GDP will be constant - Technological change is necessary for sustained growth in living standards, investment is crucial The aggregate production function and diminishing marginal returns - Holding K constant, increases in L generate positive but diminishing increments to output Robert Solow (MIT) - Estimates technical change as the part of growth that is unexplained by capital accumulation or labor-force growth = “Solow Residual” - New computers = increase in capital stock but the change doesn’t come only from that, the true amount of technological change would be underestimated Should workers be afraid of technological change? - What worries? Knowledge intensive - Unskilled workers in advanced countries compete with unskilled workers everywhere - Blame the high unemployment rates in Europe on new technologies Newer growth theories – Exogenous technological change - It’s the case in the Neoclassical growth theory - Capital: Decreasing marginal returns to investment, which implies a limit to the possible increase of per capita GDP Newer growth theories – Endogenous technological change - Technological change is responsive to economic signals as prices and profits  Change is endogenous to the economic system  Capital: Increasing marginal returns - New growth theory: Emphasizes the process of innovation and the incorporation of new technology. It is achieved through costly, risky, innovative activity that often occurs in response to economic signals  Learning by doing: Learning process at all the stages of production. Encouraging feedback from more applied steps to the purer researchers and from users to designers  Knowledge transfer: Diffusion of technological knowledge is not costless. Firms need research capacity to adopt new technologies, some of this knowledge is learned only through experience  Market structure and innovation: Innovation is encouraged by strong rivalry among firms and discouraged by monopoly practices  Shocks and innovation: Shocks that would be adverse to an economy operating with a fixed technology can provide a spur to innovation - Investment alone can hold an economy on a “sustained growth path” in which per capita GDP increases without limit Increasing marginal returns - Each new increment of investment is more productive than the last - The sources of increasing returns usually fall into one of two categories: o Market-development costs: The returns to later investment are greater than the returns to the same investment made earlier  Creation of new skills and attitudes in the workforce available to all subsequent firms (externalities)  Physical infrastructure  The first investment will have more production problems  Slow acceptance of new products by customers o Increasing returns to knowledge  Ideas can be used by one person without reducing their use by others  Ideas not necessarily subject to decreasing marginal returns  Knowledge – driven growth has unlimited potential Limits to growth Resource exhaustion - Current technology and resources could not support the entire world’s population at the average Canadian standard of living - Most economists agree that absolute limits to growth, based on the assumptions of constant technology and fixed resources, are not relevant  New resources and more efficient technologies  But technological improvements are not automatic Environmental degradation - Conscious management of pollution is necessary - Active environmental protection - Living standards will suffer if management of these issues is inadequate Summary - “Investors who follow “pioneer” investors face lower investment costs and therefore higher rates of return” = feature of the increasing returns theory of economic growth - “Shocks can sometimes provide a spur to innovation” = Feature of the endogenous technological change theories - “New knowledge provides the input that allows investment to produce increasing marginal returns” = Feature of knowledge-driven growth theory - “The capacity of the Earth’s natural processes to cope with the pollution created by a growing population cannot be sustained” = Issue related to economic growth Chapter 27 What is money - Medium of exchange As a medium of exchange - Otherwise, trade goods by barter - The double coincidence of wants is unnecessary - Makes possible the benefits of specialization and the division of labor As a store value - Storing purchasing power - Has to have a relatively stable value As a unit of account - Used for accounting Hyperinflation and the value of money - Hyperinflation: Inflation that exceeds 50% per month - Accompanied by great increases in money supply: New money printed - Unlikely to see hyperinflation in the absence of civil war, revolution or collapse of the government - Situations that can cause it: spend it as soon as possible, increasing reluctance to accept it, holding foreign currency instead of domestic currency The origins of money Metallic money - Market value of the metal was equal to the face value of the coin - Led to debasing  Gresham’s Law = theory that “bad” or debased money drives “good” or undebased, money out of circulation  Predicts that when two types of money are used side by side, the one with the greater intrinsic value will be driven out of  Debasing metal coinage had the effect of causing inflation Paper money - Initially backed by precious metal (gold). Redeemable for gold - Bank notes Fractionally backed paper money - Goldsmiths and banks began to issue more notes than the amount of gold held in their vaults Fiat money - Not backed - Not convertible - Decreed by the government to be legal tender - Almost all of today’s currency - Initially, only central banks were permitted by law to issue currency. Reserves of gold setting an upper limit on the amount of currency that could circulate in the economy  gold standard - Then, could issue more than their gold reserves - If its purchasing power remains table = satisfactory Modern money: Deposit money - Deposit money: Money held as deposits with commercial banks and other financial institutions - Important part of the money supply - As in the past, banks create money by issuing more promises to pay (deposits) than they have in cash reserves Intro to financial assets - Debt: Refers to assets issued by firms and governments that promise to pay at a specified rate of interest over a specified period of time  Taxes must be paid whether the firm is profitable or not  Bonds - Transferability: Financial assets can be bought and sold in financial markets. The price of financial assets fluctuates in response to shifts in supply and demand - Liquidity: Refers to their usefulness as a ready means of payment. Money can always be used as a means of payment. Therefore, it’s a perfectly liquid asset - Riskiness: Refers to the probability that the future payments will not be made. The riskier an asset, the high is the yield Canadian banking system - Central Bank: A bank that acts as banker to the commercial banking system and often to the government as well. Usually a government-owned institution that is the sole money-issuing authority - Financial intermediaries: Privately owned institutions that serve the general public. They stand between savers, from whom they accept deposits, and borrowers, to whom they make loans - Commercial banks: To extend to all financial intermediaries that accept deposits and create deposit money, including chartered banks, trust companies, credit unions, and caisses populaires  They invest in government securities  Do securitization: Divide these loans into small pieces and re-package them into securities, each of which contains a diversified collection of many pieces from the original loans The bank of Canada - Created in 1935 - Crown corporation; all profits it earns are remitted to the Government of Canada - Designed to keep the operation of monetary policy free from day-to-day political influence - While ensuring that the government retains ultimate responsibility for monetary policy Basic functions of the Bank of Canada 1. Banker to the commercial banks 2. Banker to the federal government 3. Regulator of the money supply 4. Supporter of financial markets Commercial banks in Canada - They have a number of interbank cooperative relationships. Most important being cheque clearing and collection - Most important role = financial intermediary. Accept deposits and provide credit - Profit seeking Commercial banks’ reserves - The reserves needed to ensure that depositors can withdraw their deposits on demand will normally be quite small - Rumors it’s not going well at the bank  lead to a bank run  a situation in which many depositors rush to withdraw their money, possibly leading to a bank’s financial collapse - Reserve ratio: Fraction of its deposit liabilities that it actually holds as reserves  Either vault cash or deposits with the central bank - Target reserve ratio: Fraction of its deposits it wishes to hold as reserves - The Canadian banking system is a fractional-reserve system  In March 2006, they held less than 1% of their deposits in reserves - Excess reserves: Any reserves in excess of target reserves  These are central to the process of “money creation” - If actual reserve ratio >> desired reserve ratio = bank will lend out additional funds - If actual reserves >> desired reserves = bank will lend out additional funds Money creation by the banking system Some simplifying assumptions - Suppose:  Only invest in loans  They have only one kind of deposit  Fixed target reserve ratio  No cash drain from the banking system The creation of deposit money - New deposit: Deposit of cash that is new to the commercial banking system - Source of the new deposit is irrelevant The expansion of money from a single new deposit - If v is the target reserve ratio, a new deposit to the banking system will increase the total amount of deposits by 1/v times the new deposit - With no cash drain from the banking system, a banking system with a target ratio of v can change its deposits 1/v times any change in reserves - - The multiple expansion of deposits triggered by a $1 new deposit into the banking system will be reduced if every bank increases its target reserve ratio Excess reserves and cash drains - Deposit creation does not happen automatically, it depends on the decisions of bankers. If commercial banks do not choose to lend their excess reserves, there will not be a multiple expansion of deposits If the banks expect interest rates to rise in the future - If the commercial banks do not choose to lend their excess reserves, there will not be an expansion of deposits: - Cash drain - The larger is the cash drain from the banking system, the smaller will be the total expansion of deposits created by a new cash deposit - A cash drain = if households hold a fraction of their deposits in cash, the deposit- creation process is dampened - Reduces the ability of the banking system to expand or contract the money supply - If c is the currency-deposit ratio, the final change in deposits will be given by: Realistic expansion of deposits in Canada  Realistic value for currency-deposit ratio = 5%  Reserve-deposit ratio = 1% 27.4 The money supply - Money supply: The total quantity of money in an economy at a point in time. Also called the supply of money - Kinds 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  Distinction is now blurred because it is easy to transfer funds between almost all accounts - Term deposit: An interest-earning bank deposit, subject to notice before withdrawal. Also called a notice deposit Definitions of money supply - Common definition = M2, broader measure = M2+ - M2 = Currency + Chequable and non-chequable deposits held at the chartered banks - M2+: M2 + similar deposits held at institutions that are not chartered banks - M1 = Currency and chequable deposits at commercial banks Near money and money substitutes - Near money: Liquid assets that are easily convertible into money without risk of significant loss of value. They can be used as short-term stores of value but are not themselves media of exchange  Short-term bonds  Term deposits - Money substitutes: Something that serves as a medium of exchange but is not a store of value (credit cards) Choosing a measure There is no single timeless or best definition of money. New financial assets are continually being developed that serve some of the functions of money Summary - The deposits of banks at the Bank of Canada, which constitute one component of bank reserves, appear as a liability on the Bank of Canada’s balance sheet and as an asset on the balance sheet of the banks - Transfer between 2 banks  an increase in reserves and deposits of $X each - The government of Canada deposits is a liability of the Bank of Canada - More reserves than the (Target reserve ratio X deposits) = Excess reserves Chapter 28: Money, interest rates, and economic activity Present value and interest rate - Present value: The value now of one more payments or receipts made in the future - - PV is negatively related to the interest rate Present vale and market price - Considering a competitive market for bonds  Buyers 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 (or other financial asset) should be the PV of the stream of income generated by the bond Interest rates, market prices, and bond yields - Propositions  The PV of a bond is negatively related to the market interest rate  Since a bond’s yield is inversely related to its price, we conclude that the market interest rates and bond yields tend to move together - An increase in the market interest rate leads to a fall in the price of any given bond. A decrease in the market interest rate leads to an increase in the price of any given bond - An increase in the market interest rate will reduce bond prices and increase bond yields. A reduction in the market interest rate will increase bond prices and reduce bond yields. Therefore, market interest rates and bond yields tend to move together Bond riskiness - An increase in the riskiness of any bond leads to a decline in its expected present value and thus to a decline in the bond’s price. The lower bond price implies a higher bond yield - In Canada, government bonds are not perceived as risky, but recently the bonds issued by some European countries have been viewed as high-risk assets The theory of money demand - Hold more bonds = hold less money - Demand for money: The total amount of money balances that the public wants to hold for all purposes - Opportunity cost of holding money: Interest that could had been earned if the money had been used to purchase bonds 3 reasons for holding money - Households and firms hold money in order to carry out transactions = transaction demand for money. Transaction motive - Hold money because they are uncertain about when some expenditures will be necessary, and they hold money as a precaution to avoid the problems associated with missing a transaction. Precautionary motive - New reason to hold money applies more to large businesses and to professional money managers than to individuals because it involves speculating about how interest rates are likely to change in the future. Speculative demand for money.  Expectation of higher interest rates in the future will lead to the holding of more money now The determinants of money demand The interest rate - Increase in the interest rates leads firms and households to reduce their desired money holdings  Other things being equal, the demand for money is assumed to be negatively related to the interest rate Real GDP - The demand for money is assumed to be positively related to real GDP (for any given interest rate) and shift the MD curve up and to the right The price level - The demand for money is assumed to be positively related to the price level (for any given interest rate) - If prices are higher, households and firms will need to hold more money in order to carry out the same real value of transactions Money demand as a function of the interest rate, real GDP, and the price level - The money demand (M ) curvD = the liquidity preference function - Changes in Y or P cause the M curve to shift D - Changes in the interest rate cause movements along the M curve D Monetary equilibrium and national income - Monetary equilibrium: Situation in which the quantity of money demanded equals the quantity of money supplied - - When all the firms and households try to add to their money balances, they all try to sell bonds to obtain the extra money they desire, excess supply of bonds develops and excess demand for money - When there is an excess supply of bonds it causes a fall in the market price, which implies an increase in the interest rate  It will rise enough that people will no longer be trying to add to their money balances because the opportunity cost of holding such balances is rising  Equilibrium will be achieved Monetary transmission mechanism - Monetary transmission mechanism: The channels by which a change in the demand for or supply of money leads to a shift of the aggregate demand curve 1. Changes in the demand for money or the supply of money cause a change in the equilibrium interest rate in the short run  Increase in money supply leads to o Excess supply of money at initial interest rate o Firms and households buy bonds o Increase in bond prices o Decrease in the equilibrium interest rate 2. The change in the equilibrium interest rate leads to a change in desired investment and consumption expenditure (and net exports in an open economy)  Increases in the money supply reduce
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