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ECO105 Test 4 Review.docx

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Avi Cohen

Test 4 Review: Chapter 4:Aggregate Supply and Aggregate Demand Origins of Shocks and Business Cycles: Yes Camp -origin of shocks -external to the economy -nature, science and mistaken gov’t policy -most important shocks -supply shocks -expectations -rational expectations of investors and logical choices -make decisions like Spok from Star Trek -cool, calm, collected -price adjustments in response to business cycles -work together to quickly restore equilibrium -match between aggregate supply and demand -most important influence changing business investment spending -interest as cost of borrowing -savings and loanable funds market -interest rate in loanable funds market adjusts so investment spending offsets savings, maintaining aggregate demand No Camp -origin of shocks -internal to economy -most important shocks -demand shocks -expectations -based on animal spirits -herd mentality -volatile -price adjustments in response to business cycles -adjustment problems in all markets fail to restore equilibrium -most important influence changing business investment spending -expectations of future profits -savings and loanable funds market -savings cause negative demand shock -falling sales and expectations decrease investment spending -a change in aggregate quantity supplied is due only to a change in average price levels, a change in aggregate supply (economy’s capacity to produce real GDP) is caused by an increase in quantity/quality of inputs OR supply shocks -an increase in the CPI does not necessarily mean there is economic growth -could be due to inflation -economic growth -occurs if there is an increase in the quantity or quality of inputs -an increase in aggregate supply not aggregate quantity supplied -an increase in inputs costs is a negative supply shock which decreases aggregate supply -a decrease in the hours worked by households is a decrease in aggregate quantity supplied -a decrease in the choices about how many hours to work by existing labour inputs -gov’t transfer payments are not a part of direct spending by the gov’t (G) -transfer payments increase aggregate demand by increasing planned consumer spending (C) -when the Canadian dollar rises in value our exports become more expensive and the US demands fewer of them -all economists agree on descriptions of equilibrium and on the impact of demand/supply shocks -in a recession, the Yes camp believes that full employment is restored quickly because unemployment will cause wages to fall and employment to increase -also believe that during a recession potential GDP is restored quickly because surpluses of products/services will cause prices to fall and sales to increase -believes potential GDP is quickly restored because additional savings will cause interest rates to fall and investment spending to increase -aggregate supply of real GDP increases if productivity increase or input prices decrease -business investment spending (I) is the most volatile, unpredictable and can be postponed -higher taxes or reduced gov’t transfers decrease aggregate demand -more disposable income increases planned consumption spending (C) and aggregate demand -positive demand shock -during the Great Recession, changes in unemployment and inflation went in opposite direction (unemployment went up and inflation went down) -suggests it was a result of a negative demand shock -demand shocks cause unemployment and inflation to move in opposite directions -negative supply shocks cause stagflation -unemployment and inflation are both increasing together -when consumers are saving money business investment spending based on borrowed funds can save Say’s law (supply creates its own demand) -both Yes and No camps agree on shocks and equilibrium but they disagree on the role of government -wages are sticky because employment contracts can’t be quickly changed, workers resist having their wages reduced, and employer resist wage cuts unless absolutely necessary because wage cuts hurt productivity -Yes camp of economists emphasizes that individuals and businesses make rational choices based on the best information available -Keynesian view of sticky wages is that during a recession is that workers will be laid off to save costs rather than wages being reduced -market equilibrium is when aggregate supply= aggregate demand -no one is kicking themselves -a mismatch can occur when there is unsold products/services (aggregate demand less than aggregate supply) -or not there is a shortage (aggregate supply less than aggregate demand) -success in business depends on predicting where the market will be because you can get rich if you produce products/services that consumers want at the time consumers want them, or if you correctly anticipate where stock prices and real estate values will be -business supply plans are like skating to where the puck will be going because it takes time for production to complete to bring goods to market -must anticipate consumers’demand and where the market will be -recessions and expansions are the result of mismatches between aggregate supply and demand -according to No Camp -also believe that market adjusts slowly to aggregate supply and demand shocks -saltwater economists -more or less Keynesian view of what recessions are all about -No camp -freshwater economists -have a Say’s law outlook on recessions -Yes camp -if fewer individuals are available to work this is a negative supply shock -if planned consumer spending decreases, this will also be a negative demand shock -the Yes camp believes each of the 4 markets adjusts to restore equilibrium quickly after a negative demand shock that causes a recession -Labour market -unemployment causes wage rate to fall, increasing hiring of labour until full employment restored -Output markets -higher prices fall due to surpluses and falling wage costs, increasing sales 0f products/services until back to level of potential GDP -International trade market -falling Canadian prices increase net exports (X-IM), increasing Canadian real GDP and decreasing unemployment -Loanable funds market -additional savings cause interest rates to fall, increasing investment spending, increasing Canadian real GDP, and decreasing unemployment -if the average price level has risen businesses see the prices of their outputs rising while their inputs stay the same -smart decision to increase output which increases aggregate quantity supplied -positive supply shock -ex: input costs decrease -businesses willingness to supply products/services increases because more can be earned -if it affects all businesses this causes an increase in aggregate supply -the idea of savings seems to threaten Say’s law because not all income earned in input markets is spent -loanable funds market can save this law -if banks loan out savings to businesses who can use it for investment spending, that offsets consumer savings, this will restore equality between aggregate income and aggregate spending -in loanable funds market, banks coordinate the supply of loanable funds (savings) with demand for loanable funds (borrowing) -interest rate is the price of these funds -when interest rates decrease, borrowing to finance investment projects becomes cheaper and more investment projects become more profitable -consumers also borrow and spend more -aggregate demand increases -increased investment spending also increases quantity and quality of inputs -potential GDP and real GDP per person increase over time -when consumers are pessimistic about their economic future (i.e. expect they might be laid off or have their work hours reduced) they may reduce spending -consumer pessimism would reduce aggregate demand -when investors become more optimistic about future economic conditions investment spending increases which increases aggregate demand -if businesses expect increased demand, they will increase aggregate supply by increasing their inputs by investing in new technology or hiring new workers -falling oil prices is a positive supply shock -reduces cost of energy -falling value of the Canadian dollar is a positive demand shock -Canadian exports become cheaper to the rest of the world which increases exports and aggregate demand -rising oil prices is a negative supply shock which causes stagflation -rising average prices, decreased real GDP and increased unemployment -rising value of the Canadian dollar is a negative demand shock which causes a recessionary gap -falling average prices, decreased real GDP and increased unemployment -animal spirit-types -people who jump on bandwagon of investing without solid facts -potential GDP is also called long-run aggregate supply (LAS) -Short-run aggregate supply (SAS) -is Aggregate Supply -curve assumes that input prices are fixed -aggregate quantity supplied -quantity of real GDP macro players plan to spend at different average price levels -Business supply choices -with existing inputs -what to produce, quantities to produce, quantities of inputs to hire -determine aggregate quantity supplied -to increase quality or quantity of inputs -investing in new factories/equipment -searching for new resources -technology improvements -all change aggregate supply -increase potential GDP -Consumer supply choices -with existing inputs -to participate in labour force, number of hours to work, quantities pf owned input to supply -to increase quality/quantity of inputs -having, education and training -change AS -Gov’t supply choices -with existing inputs -quantities of resources to supply -to increase quantity/quality of inputs -build infrastructure, change rules of the game, policies affecting inputs -change AS -Aggregate demand changes with changes in…. -expectations -interest rates -gov’t policy -GDP in R.o.W -exchange rate -review SAS graph from Lecture 14 -planned business investment spending (I) is the most volatile -easily postponed -based on uncertain expectations that can shift quickly and dramatically -depend on borrowed money -changing interest rates change investment profitability Chapter 5: Demanders and Suppliers of Money -an increase in real GDP causes an increase in the demand for money -decrease in real GDP causes a decrease in the demand for money How much does money matter for business cycles: Yes Camp -how often business cycles happen -money has no effect -money does not affect external supply shocks that are main source of business cycles -how quickly markets adjust -money helps loanable funds market quickly adjust to equilibrium No Camp -how often business cycles happen -money creates new shocks -money gives people a way not to spend, adding new internal demand shocks -how quickly markets adjust -money blocks transmission mechanism, slowing adjustment to equilibrium -an increase in the interest rate is the opportunity cost of holding more money -decreases quantity demanded of money -purchasing power of money is threatened by inflation -taking money out of your bank account shifts money from one component of M1 (demand deposits) to another (currency) -currency is a small fraction of the money supply -6% of M2 -Government-issued paper bills and coins are fiat money -the quantity demanded of money depends on the interest rate -bonds are riskier than money as a store of value because of the interest rate -changes in the interest rate cause changes in the market price of bonds -inflation reduces purchasing power of both money and bonds -bonds promise to pay back the original value plus a fixed dollar amount of money -when the interest rate is above the market-clearing rate people the opportunity cost of holding money is high -people use more money to buy bonds -excess demand for bonds -economists disagree about whether money helps or slows down the economy’s adjustment to equilibrium -Yes camp believes that external shocks, not money, are the main source of business cycles -economists agree on the functions of money (medium of exchange, unit of account) except for its function as a store of value -in the double coincidence of wants, the problem is finding a seller who has what you want and who wants what you are selling -money has taken the form of cattle, metal, and fur -when you pay for lunch using your debit card you are using deposit money -money in a chequing account counts for M1 and M2, a savings account counts only for M2 -coins and paper money are both fiat money and they both count for both M1, M2 -loans to consumers and businesses are riskiest and earn the banks the highest interest rates -Government of Canada treasury bills are low risk and low interest rate -the Northern Rock Bank in the UK had a bank run in 2007 -bank had lost its credibility with depositors and had many of them try to withdraw their funds all at once -the Bank of Canada does not make currency, the Royal Mint does so at the request of the BoC -the interest rate and market prices of bonds move in opposite directions -when one rises the other falls -excess demand for money causes people to sell bonds, lowers bond prices and raises interest rates -both Yes & No camps agree that …. -money affects prices and inflation -money exchange is better than barter exchange -monetary transmission mechanism indirectly affects real GDP -money directly affects inflation through the quantity theory of money -indirect effect on GDP and unemployment -money indirectly affects real GDP and unemployment through the monetary transmission mechanism -included in this are the interest rates and aggregate demand -money is anything that is acceptable as a medium of exchange -Governor of New Franc addressed a shortage of coins 1685 by issuing paper money printed on playing cards -the cards were a promise to repay at a later date and because they had been issued by the government the populace trusted them -when interest rates rise so does the opportunity cost of holding more of your wealth as money -prices of bonds also fall when the interest rate rises -if more money is moved from bank accounts to bonds then both M1 & M2 decrease because bonds are a part of neither -the market-clearing interest rate balances quantity demanded and quantity supplied -no tendency for change -when your income increases so does your demand for money -you buy more stuff which means you need more money to finance those transactions -hold more fiat money (for smaller day-to-day transactions) and demand deposits (for larger purchases) -banks face a trade-off between profits and prudence -smaller fraction of reserves and higher risk loans may get banks more profits but at the cost of giving up safety and risking customers’deposits and trust -when a bank loans you money for a car or mortgage the banks own the car or house until you’ve paid off the loan -they use it as collateral in case you default so they can sell the property and recover the value of the loan -also charge higher interest rates on loans that they consider to be riskier -banks are regulated because without regulation banks may take greater risks in pursuit of higher profits which could lead to the failure of the bank if they take too great a risk and it fails -could cause bank owns and trusting depositors to lose money -with fractional-reserve banking there is a risk of a bank run -many depositors withdrawing cash at the same time -bank may not have enough cash reserves to pay all depositors -unlikely to happen in Canada because….. -most banking customers rarely demand cash -in the rare event that more customers demand to withdraw cash than is available chartered banks can borrow from one another and the Bank of Canada (lender of last resort) to meet customers’demands and maintain trust -mobile money (talked about in the Economist article “The Power of Mobile Money”) is a form of deposit money since it can be withdrawn quickly without penalty -the No camp says that when people have pessimistic expectations they are more likely to want to hold their wealth as more money -avoids risk of holding bonds -have benefits of liquidity -betting that holding money will be safer than losing their savings with higher-interest but risky investments -Government of Canada treasury bills are not a part of M1, M2 -if interest rates are above the market-clearing rate, there is an excess supply of money -people buy bonds to get rid of money -this increased demand for bonds causes bond prices to rise and interest rates to fall -lower interest rates reduce the cost of consumer and business borrowing -increases C and I spending -positive aggregate demand shock -real GDP increases -if interest rates are set below the market-clearing price, there is an excess demand for money -people sell bonds to hold onto more money -reduced demand for bonds causes bonds prices to fall and interest rates to rise -higher interest rates makes consumer and business borrowing more expensive -decreases C and I spending -negative aggregate demand shock -real GDP decreases -followers of Keynes and Say would agree that: -money solves the problem of the double coincidence of wants -causes inflation (through quantity theory of money) -changes in the demand and supply of money can indirectly affect key macroeconomic outcomes through the monetary transmission mechanism -through the interest rate -followers of Keynes (No camp) believe money gives people a way not to spend -worried businesses and consumers may not put their savings into the loanable funds market; businesses may postpone I spending -holding money can block the transmission mechanism so the loanable funds market does not match spending to savings -followers of Say (Yes camp) argue the opposite -money allows savings to flow easily through the loanable funds market to facilitate business borrowing for I -economy quickly ends up with a match of aggregate supply and aggregate demand -3 functions of money -unit of account -standard unit for measuring, comparing prices -medium of exchange -acceptability solves barter problem of double coincidence of wants -store of value -time machine for moving purchasing power from present to future -earn now, spend later Why hold money as a store of value? Yes camp -hold more wealth as interest-paying bonds, since savings safely invested in loanable funds (bonds) -belief that supply creates its own demand and that market not in equilibrium is due to outside forces -financial crises don’t exist -bonds are reasonable investment because business cycles don’t exist No camp -hold more wealth as money because fundamental uncertainty about future makes bond investments risky Law of demand for money -as the price of money (interest rate) ruses the quantity demanded of money decreases -more profitable to hold more wealth in bonds that earn interest when interest rate is higher -changes in real GDP or average prices cause change in demand for money -changes in the price of money change quantity demanded -crucial question in talking about demand for money is… -if you have assets or wealth how much of those do you want to hold in the form of money (which is liquid but pays no interest) versus what you want to hold in the forms of bonds (which pay interest but come with risk) -forms of money -commodity money -saleable product with alternative uses -fur, gold, livestock -convertible paper money -paper money converted into gold on demand -original paper bills in Canada during 17 century could be taken into banks and turned into gold -fiat money -government-issued paper bills and coins with no alternative uses -valuable only by gov’t decree -playing cards that were used in New France would an example of this -everyone trusted the word of the Governor there that the promises of payment on the cards would be paid -deposit money (demand deposits) -balances in bank accounts depositors withdraw on demand using a debit card or cheque -supply of money is currency & demand deposits -M1= currency in circulation and demand deposits -demand deposits are much bigger than currency in circulation -demand deposits are the account balances that are sitting in the different chartered banks -M2= M1 + all other less liquid assets -less liquid assets are things like GICs, savings accounts -have to apply to withdraw them or take a penalty -who creates the money supply -Bank of Canada creates the currency in circulation -chartered banks are the ones who creates the demand deposits -Bank of Canada roles -issuing currency -banker to chartered banks -len
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