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EC140 Final Course Package.pdf

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Department
Economics
Course
EC140
Professor
Rizwan Tahir
Semester
Winter

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EC140 Final Exam Review Package Sign up for BU121 Final exam sessions! ONLY $15!  www.getyoureza.ca Chapter 20: Measuring GDP and Economic Growth GDP or gross domestic product is the market value of all final goods and services produced in a country in a given time period.  Market Value: goods and services are valued at their market prices. o To add apples and oranges, computers and popcorn, we add the market values so we have a total value of output in dollars.  Final Goods and Services: items or services bought by its final user during a specified time period. o A final good contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. o Excluding the value of intermediate goods and services avoids counting the same value more than once. GDP and the Circular Flow of Expenditure and Income Gross Domestic Product (GDP) measures two things at once:  total income of everyone in the economy.  total expenditure on the economy’s output of goods & services.  For the economy as a whole, income equals expenditure, because every dollar of expenditure by a buyer is a dollar of income for the seller. Approaches to Measure GDP 1. The Expenditure Approach: measures GDP as the sum of consumption expenditure (C), investment (I), government purchases of goods and services (G), and net exports (NX). Y = C + I + G + NX  CONSUMPTION EXPENDITURES (C): Total spending by households on goods & services. Buying/Selling of houses are not included in this category  GROSS INVESTMENT EXPENDITURES (I): Total spending on goods that will be used in the future to produce more goods. Includes spending on: o capital equipment (e.g., machines, tools) o structures (factories, office buildings, houses) o inventories (goods produced but not yet sold)  Note: Gross Investment = Net Investment + Depreciation.  “Investment” does not mean the purchase of financial assets like stocks and bonds. • Government Purchases (G): All the goods & services purchased by local, provincial, and federal governments. o Excludes transfer payments, such as Canada pension Plan benefits or employment insurance benefits. These payments represent transfers of income, not purchases of goods & services and do not represent production.  Net Exports (NX)= exports – imports o Exports represent foreign spending on domestically produced goods & services. o Imports are the portions of C, I, and G that are spent on goods & services produced abroad. 2. The Income Approach: measures GDP by summing the incomes that firms pay households for the factors of production they hire.  Compensation of employees  Net interest  Rental income  Corporate profits  Proprietors’ income  The sum of these five income components is net domestic income/Product (NDP) at factor cost. Two adjustments must be made to get GDP: 1. Indirect taxes minus subsidies (NIBT) are added to NDP 2. Depreciation is added to NDP GDP= NDP + NIBT + Depreciation Gross Domestic Product  The blue and red flows are the circular flow of expenditure and income.  The sum of the red flows equals the blue flow. Measuring Canadian GDP Nominal GDP and Real GDP  Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year.  Nominal GDP is the value of goods and services produced during a given year valued at the prices that prevailed in that same year. Chained-Dollar Real GDP  Statistics Canada uses a measure of real GDP called chained-dollar real GDP.  Three steps are needed to calculate this measure: o Value production in the prices of adjacent years o Find the average of two percentage changes o Link (chain) to the reference year The Uses and Limitations of Real GDP Economists use estimates of real GDP for two main purposes: 1. The Standard of Living Over Time  Real GDP per person is real GDP divided by the population, and tells us the value of goods and services that the average person can enjoy.  By using real GDP, we remove any influence that rising prices and a rising cost of living might have had on our comparison.  Long-Term Trend- A handy way of comparing real GDP per person over time is to express it as a ratio of some reference year.  Two features of our expanding living standard are: o The growth of potential GDP per person o Fluctuations of real GDP around potential GDP  The value of real GDP when all the economy’s labour, capital, land, and entrepreneurial ability are fully employed is called potential GDP. It grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace; Real GDP fluctuates around potential GDP.  Lucas wedge is the dollar value of the accumulated gap between what real GDP per person would have been if the 1960s growth rate had persisted and what real GDP per person turned out to be.  A business cycle is a periodic but irregular up-and-down movement of total production and other measures of economic activity. o Expansion- a period during which real GDP increases—from a trough to a peak o Recession- a period during which real GDP decreases—its growth rate is negative for at least two successive quarters. o Two turning points: Peak & trough 2. The Standard of Living Across Countries  Two problems arise in using real GDP to compare living standards across countries: 1. The real GDP of one country must be converted into the same currency units as the real GDP of the other country. 2. The goods and services in both countries must be valued at the same prices.  Using the exchange rate to compare GDP in one country with GDP in another country is problematic because prices of particular products in one country may be much less or much more than in the other country. Limitations of Real GDP Real GDP measures the value of goods and services that are bought in markets. Some of the factors that influence the standard of living and that are not part of GDP are  Household production  Underground economic activity  Health and life expectancy  Leisure time  Environmental quality  Political freedom and social justice Chapter 21: Monitoring Jobs and Inflation Employment and Unemployment Why Unemployment Is a Problem  Lost incomes and production  Lost human capital Labour Force Survey Every month, Statistics Canada conducts a Labour Force Survey in which it asks 54,000 households.  The population is divided into two groups: 1. The working-age population—the number of people aged 15 years and older who are not in institutional care (long term institutionalized- hospital, jail, etc.) 2. People too young to work (under 15 years of age) or in institutional care  The working-age population is divided into two groups: 1. People in the labour force 2. People not in the labour force  The labour force is the sum of employed and unemployed workers.  To be counted as unemployed, a person must be in one of the following three categories: 1. Without work but has made specific efforts to find a job within the previous four weeks 2. Waiting to be called back to a job from which he or she has been laid off 3. Waiting to start a new job within four weeks ** Must be available for work and actively seeking work** Four Labour Market Indicators  The Unemployment Rate- the percentage of the labour force that is unemployed. = (Number of people unemployed ÷ labour force)  100 o The unemployment rate increases in a recession and reaches its peak value after the recession ends.  The Involuntary Part-Time Rate- the percentage of the labour force who work part time but want full-time jobs. = (Number of involuntary part-time workers ÷ Labour force)  100  The Labour Force Participation Rate- the percentage of the working-age population who are members of the labour force. = (Labour force ÷ Working-age population)  100  The Employment-to-Population Ratio- the percentage of the working-age population who have jobs. = (Employment ÷ Working-age population)  100. Other Definitions of Unemployment  The purpose of the unemployment rate is to measure the underutilization of labour resources.  Statistics Canada believes that the unemployment rate gives a correct measure, but the official measure is an imperfect measure because it excludes o Part-time workers who want full-time jobs o Marginally Attached Workers- person who currently is neither working nor looking for work but has indicated that he or she wants and is available for a job and has looked for work sometime in the recent past.  A discouraged worker is a marginally attached worker who has stopped looking for a job because of repeated failure to find one – NOT CONSIDERED UNEMPLOYED  All unemployment is costly, but the most costly is long-term unemployment that results from job loss. Unemployment and Full Employment  Frictional unemployment is unemployment that arises from normal labour market turnover. o Creation & destruction of jobs requires that unemployed workers search for new jobs. o Increases in the number of people entering and reentering the labour force and increases in unemployment benefits raise frictional unemployment. • Structural unemployment is unemployment created by changes in technology and foreign competition that change the skills needed to perform jobs or the locations of jobs. o Structural unemployment lasts longer than frictional unemployment. o Minimum wage imposed at micro and macro levels induce unemployment • Cyclical unemployment is the higher than normal unemployment at a business cycle trough and lower than normal unemployment at a business cycle peak. o A worker laid off because the economy is in a recession and is then rehired when the expansion begins experiences cyclical unemployment. “Natural” Unemployment • Natural unemployment is the unemployment that arises from frictions and structural change when there is no cyclical unemployment. • The natural unemployment rate is natural unemployment as a percentage of labour force. • Full employment is defines as the situation in which the unemployment rate equals the natural unemployment rate. UActualU Naturalcyclical where U naturalfrictionaStructural • The natural unemployment rate changes over time and is influenced by many factors: o The age distribution of the population- an economy with a young population has a larger number of new job seekers every year and has a high level of frictional unemployment o The scale of structural change- sometimes there is a technological upheaval. When the pace and volume of technological change and when the change is driven by international competition increases, natural unemployment increases o The real wage rate- natural unemployment increase if minimum wage is raised to exceed the equilibrium wage rate or if more firms use an efficiency wage (a wage set above the equilibrium real wage to enable the firm to attract most productive workers and motivate them to work hard and discourage them from quitting) o Unemployment benefits- unemployment benefits increase natural unemployment by lowering the opportunity cost of job search Real GDP and Unemployment Over the Cycle  Potential GDP is the quantity of real GDP produced at full employment.  Real GDP minus potential GDP is the output gap.  Over the business cycle, the output gap fluctuates and the unemployment rate fluctuates around the natural unemployment rate.  If Y = Yp  no output gap  full employment Y = Real GDP Yp = Potential GDP  If Y > Yp  Inflationary gap  above full employment U = actual unemployment  U < Un  Uc < 0 Un = Natural unemployment  If Y < Yp Recessionary gap Bellow full employment  U > Un  Uc > 0 Price Level, Inflation, and Deflation  The price level is the average level of prices and the value of money.  A persistently rising price level is called inflation.  A persistently falling price level is called deflation.  We are interested in the price level because we want to 1. Measure the inflation rate or the deflation rate 2. Distinguish between money values and real values of economic variables. Why Inflation and Deflation Are Problems  Low, steady, and anticipated inflation or deflation is not a problem.  Unpredictable inflation or deflation is a problem because it o Redistributes income and wealth o Lowers real GDP and employment o Diverts resources from production  At its worse, inflation becomes hyperinflation—an inflation rate that is so rapid that workers are paid twice a day because money loses its value so quickly. The Consumer Price Index  The Consumer Price Index, or CPI, measures the average of the prices paid by urban consumers for a “fixed” basket of consumer goods and services.  The CPI is defined to equal 100 for the reference base period. Currently, the reference base period is 2002.That is, for the average CPI of the 12 months of 2002 equals 100. Constructing the CPI Constructing the CPI involves three stages:  Selecting the CPI basket- based on household expenditures survey  Conducting a monthly price survey  Calculating the CPI 1. Find the cost of the CPI basket at base-period prices. 2. Find the cost of the CPI basket at current-period prices. 3. Calculate the CPI for the current period. CPI = (Cost of basket at current-period prices ÷ Cost of basket at base-period prices) x 100 Measuring the Inflation Rate  The major purpose of the CPI is to measure inflation.  The inflation rate is the percentage change in the price level from one year to the next. Inflation rate = [(CPI this year – CPI last year) ÷ CPI last year]  100 The Biased CPI The CPI might overstate the true inflation for four reasons:  New Goods Bias- New goods that were not available in the base year appear and, if they are more expensive than the goods they replace, they put an upward bias into the CPI.  Quality Change Bias- Quality improvements occur every year. Part of the rise in the price is payment for improved quality and is not inflation.  Commodity Substitution Bias- The market basket of goods used in calculating the CPI is fixed and does not take into account consumers’ substitutions away from goods whose relative prices increase. If a customer reduces his or her consumption of a particular good whose price has risen, his last or her total expenditure on that item may not be any greater than before  Outlet Substitution Bias- As the structure of retailing changes, people switch to buying from cheaper sources, but the CPI, as measured, does not take account of this outlet substitution. The Magnitude of the Bias  This places an upward bias in the CPI measurement  Estimates say that the CPI overstates inflation by 1.1 percentage points a year. Some Consequences of the Bias  Distorts private contracts.  Increases government outlays (close to 1/3 of federal government outlays linked to the CPI) o A bias of 1 percent is small, but over a decade adds up to almost $1 trillion of additional expenditure. Alternative Price Indexes  GDP Deflator- broader measure of the price level than the CPI because it includes all consumption expenditure, investment, government expenditure on goods, and services, and net exports. = (Nominal GDP ÷ Real GDP) x 100  The core inflation rate is an inflation rate excluding the volatile elements (of food and fuel), and attempts to reveal the underlying inflation trend. The Real Variables in Macroeconomics  We can use the GPD deflator to deflate nominal variables to find their real values.  Real wage rate = (Nominal wage rate ÷ GDP deflator) x 100 Chapter 22: Economic Growth The Basics of Economic Growth • Economic growth is the sustained expansion of production possibilities measured as the increase in real GDP over a given period. Calculating Growth Rates • The economic growth rate is the annual percentage change of real GDP. • The standard of living depends on real GDP per person. • Real GDP per person is real GDP divided by the population. • Real GDP per person grows only if real GDP grows faster than the population grows. The Magic of Sustained Growth • The Rule of 70 is useful for determining how long it will take for a variable to double. • The Rule of 70 states that the number of years it takes for the level of a variable to double is approximately 70 divided by the annual percentage growth rate of the variable. • The lower the growth rate, the longer it takes to double. Economic Growth Trends Growth in the Canadian Economy • The growth of real GDP per person in Canada has fluctuated. • From 1926 to 2010, growth in real GDP per person in Canada averaged 2 percent a year. • Real GDP per person fell precipitously during the Great Depression and rose rapidly during World War II. • Growth was most rapid during the 1960s. • Growth slowed during the 1970s and sped up again in the 1980s and1990s. Real GDP Growth in the World Economy • Growth in the rich countries: Japan grew rapidly in the 1960s, slower in the 1980s, and even slower in the 1990s. Growth in Canada, the United States, and Europe Big 4 has been similar. • Growth in the poor countries: The gaps between real GDP per person in Canada and in these countries have widened. How Potential GDP Grows What Determines Potential GDP? • Potential GDP is the quantity of real GDP produced when the quantity of labour employed is the full-employment quantity. To determine potential GDP we use a model with two components:  Aggregate Production Function: Shows how real GDP changes as the quantity of labour changes when all other influences (capital & technology) on production remain the same. o An increase in labour (No. of hours) increases real GDP. o Diminishing marginal returns for labour  Aggregate Labour Market: o The demand for labour is the relationship between the quantity of labour demanded and the real wage rate (money wage rate divided by the price level). Because of diminishing returns, firms hire more labour only if the real wage falls to reflect the fall in the additional output the labour produces. There is a negative relationship b/w the real wage rate and the quantity of labour demanded. o The supply of labour shows the quantity of labour supplied and the real wage rate. o The labour market is in equilibrium at the real wage rate at which the quantity of labour demanded equals the quantity of labour supplied. Economy is at full employment, and quantity of real GDP produced is potential GDP. What Makes Potential GDP Grow? Growth in the Supply of Labour  Aggregate hours, the total number of hours worked by all the people employed, change as a result of changes in: 1. Average hours per worker 2. Employment-to-population ratio 3. The working-age population growth  Only increase in working-age population can cause persisting economic growth. Persisting increases in the working age population result from population growth.  An increase in population increases the supply of labor, which shifts the labour supply curve rightward. The real wage rate falls and the quantity of employment increases, therefore increasing the aggregate hours.  The increase in employment leads to a movement along the production function to a higher level of potential GDP.  The increase in aggregate hours increases potential GDP because the diminishing returns, the increased population increases real GDP but decreases real GDP per hour of labour. Growth of Labour Productivity  Labour productivity: Quantity of real GDP from 1 hour of labour.  Labour productivity equals real GDP divided by aggregate labour hours.  If labour become more productive, firms are willing to pay more for a given number of hours so the demand for labour increases.  Increase in labour productivity shifts the production function upward.  In the labour market, An increase in labour productivity increases the demand for labour. With no change in the supply of labour, the real wage rate rises and aggregate hours increase. With the increase in aggregate hours, potential GDP increases. Why Labour Productivity Grows Preconditions for Labour Productivity Growth • The fundamental precondition for labour productivity growth is the incentive system created by firms, markets, property rights, and money. • The growth of labour productivity depends on o Physical Capital Growth: The accumulation of new capital increases capital per worker and increases labour productivity. o Human Capital Growth: Acquired through education, on-the-job training, and learning- by-doing is the most fundamental source of labour productivity growth. o Technological Advances: the discovery and the application of new technologies and new goods—has contributed immensely to increasing labour productivity. Growth Theories, Evidence, and Policies Classical Growth Theory: The view that the growth of real GDP per person is temporary and that when it rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level. • Classical Theory of Population Growth: There is a subsistence real wage rate, which is the minimum real wage rate needed to maintain life. o Advances in technology lead to investment in new capital. o Labour productivity increases and the real wage rate rises above the subsistence level. o When the real wage rate is above the subsistence level, the population grows. o Population growth increases the supply of labour and brings diminishing returns to labour. As the population increases the real wage rate falls. o The population continues to grow until the real wage rate has been driven back to the subsistence real wage rate. o At this real wage rate, both population growth and economic growth stop. o Contrary to the assumption of the classical theory, the historical evidence is that population growth rate is not tightly linked to income per person, and population growth does not drive incomes back down to subsistence levels. Neoclassical Growth Theory: The proposition that real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labour grow. Growth ends only if technological change stops because of diminishing marginal returns to both labour and capital. • The Neoclassical Theory of Population Growth: The population growth rate is independent of real GDP and the real GDP growth rate. • Technological Change and Diminishing Returns: The rate of technological change influences the economic growth rate but economic growth does not influence the pace of technological change. It is assumed that technological change results from chance. • The Basic Neoclassical Idea: Technology begins to advance at a more rapid pace. New profit opportunities arise and investment and saving increase. o As technology advances and the capital stock grows, real GDP per person increases. o Diminishing returns to capital lower the real interest rate and eventually economic growth slows and just keeps up with population growth. o Capital per worker remains constant. • A Problem with Neoclassical Growth Theory: All economies have access to the same technologies and capital is free to roam the globe, seeking the highest available real interest rate. These facts imply that economic growth rates and real GDP per person across economies will converge. New growth theory: holds that real GDP per person grows because of choices that people make in the pursuit of profit and that growth can persist indefinitely.  The theory begins with two facts about market economies: o Discoveries result from choices. o Discoveries bring profit and competition destroys profit.  Two further facts play a key role: o Discoveries are a public capital good. o Knowledge is not subject to diminishing returns.  Increasing the stock of knowledge makes capital and labour more productive.  Knowledge capital does not experience diminishing returns is the central proposition of new growth theory. Policies for Achieving Faster Growth  Growth accounting tells us that to achieve faster economic growth we must either increase the growth rate of capital per hour of labour or increase the pace of technological change.  The main suggestions for achieving these objectives are  Stimulate Saving: Saving finances investment. So higher saving rates might increase physical capital growth. Tax incentives might be provided to boost saving.  Stimulate Research and Development: Because the fruits of basic research and development efforts can be used by everyone, not all the benefit of a discovery falls to the initial discoverer. o So the market might allocate too few resources to research and development. o Government subsidies and direct funding might stimulate basic research and development.  Improve the Quality of Education: The benefits from education spread beyond the person being educated, so there is a tendency to under invest in education.  Provide International Aid to Developing Countries: If rich countries give financial aid to developing countries, investment and growth will increase. o But data on the effect of aid shows that it has had zero or a negative effect.  Encourage International Trade: Free international trade stimulates growth by extracting all the available gains from specialization and trade. o The fastest growing nations are the ones with the fastest growing exports and imports. Chapter 23: Finance, Saving, and Investment The Loanable Funds Market • The market for loanable funds is the aggregate of all the individual financial markets. Funds that Finance Investment 1. Household saving S 2. Government budget surplus (T – G) 3. Borrowing from the rest of the world (M – X) • The figure on the right illustrates the flows of funds that finance investment. • Household’s income is consumed, saved, or paid in net taxes. Y = C + S + T ----> 1 • EDP equals income and also aggregate expenditure. Y = C + I + G + X – M ----> 2 • Combine the 2 equations above and rearrange to get the funds that finance investment I = S + (T – G) + (X – M) • S is private saving and (T – G) is Government saving • The sum of two is National savings The Real Interest Rate • The nominal interest rate is the number of dollars that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed and lent. • The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. • The real interest rate is approximately equal to the nominal interest rate minus the inflation rate, and is the opportunity coast of borrowing. • The market for loanable funds determines the real interest rate, the quantity of funds loaned, saving, and investment. • Start by ignoring the government and the rest of the world. (makes it easier to understand!!) The Demand for Loanable Funds • The quantity of loanable funds demanded depends on 1. The real interest rate: increase in interest rate decreases quantity of loanable funds demanded, and a fall in the real interest rate increase quantity of funds demanded (movement along the curve) 2. Expected profit: When the expected profit changes, the demand for loanable funds changes (shifts). Other things remaining the same, the greater the expected profit from new capital, the greater is the amount of investment and the greater the demand for loanable funds. • Demand for loanable funds- relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same. • Business investment is the main item that makes up the demand for loanable funds. The Supply of Loanable Funds • The quantity of loanable funds supplied depends on 1. The real interest rate: A rise in the real interest rate increases the quantity of loanable funds supplied. A fall in the real interest rate decreases the quantity of loanable funds supplied. (Movement along the curve) 2. Disposable income: An increase in YD increases the supply of loanable funds (Shift) 3. Expected future income: a decrease in expected future income increases the supply of loanable funds today (shift) 4. Wealth: a decrease in wealth increases the supply of loanable funds (shift) 5. Default risk: A decrease in default risk increases savings and increases the supply of loanable funds (shift) • Supply of loanable funds- relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same. • Saving is the main item that makes up supply of loanable funds. Equilibrium in the Loanable Funds Market • The loanable funds market is in equilibrium at the real interest rate at which the quantity of loanable funds demanded equals the quantity of loanable funds supplied. Changes in Demand and Supply • Financial markets are highly volatile in the short run but remarkably stable in the long run. • Volatility comes from fluctuations in either the demand for loanable funds or the supply of loanable funds. • These fluctuations bring fluctuations in the real interest rate and in the equilibrium quantity of funds lent and borrowed, and in asset prices. • An increase in expected profits increases the demand for funds today. The real interest rate rises. Saving and quantity of funds supplied increases. • If one of the influences on saving plans changes and saving increases, the supply of funds increases. The real interest rat falls. Investment increases. Government in the Loanable Funds Market • Government enters the financial loanable market when it has a budget surplus or deficit. • A government budget surplus increases the supply of funds. The real interest rate falls. Investment increases. Saving decreases. • A government budget deficit increases the demand for funds. The real interest rate rises. Saving increases. Investment decreases. Ricardo-Barro effect • A budget deficit increases the demand for funds. • Rational taxpayers increase saving, which increases the supply of funds. • Crowding-out is avoided. • Increased saving finances the deficit. The Global Loanable Funds Market • The loanable funds market is global, not national. • Lenders want to earn the highest possible real interest rate and they will seek it by looking around the world, and borrowers want to pay the lowest possible real interest rate and they will seek it by looking around the world. • Financial capital is mobile: It moves to the best advantage of lenders and borrowers. International Capital Mobility • Because lenders are free to seek the highest real interest rate and borrowers are free to seek the lowest real interest rate, the loanable funds market is a single, integrated, global market. • Funds flow into the country in which the real interest rate is highest and out of the country in which the real interest rate is lowest. International Borrowing and Lending • A country’s loanable funds market connects with the global market through net exports. • If a country’s net exports are negative, the rest of the world supplies funds to that country and the quantity of loanable funds in that country is greater than national saving. • If a country’s net exports are positive, the country is a net supplier of funds to the rest of the world and the quantity of loanable funds in that country is less than national saving. Chapter 24: Money, the Price Level, and Inflation What is Money?  Money is any commodity or token that is generally acceptable as a means of payment.  A means of payment is a method of settling a debt. Money has three other functions:  Medium of Exchange: an object that is generally accepted in exchange for goods and services. o In the absence of money, people would need to exchange goods and services directly, which is called barter. o Barter requires a double coincidence of wants, which is rare, so barter is costly and highly inefficient  Unit of Account: an agreed measure for stating the prices of goods and services.  Store of Value: money can be held for a time and later exchanged for goods and services. o If there is no inflation, money will keep it value, but with inflation, the value of money decreases over time proportional to the rate of inflation • Commodity money- takes the form of commodity with intrinsic value (eg. Gold coins, cigarettes in POW camps) • Fiat money- money without intrinsic value used as money because of government decree (token money-legal tender: eg. The canadian dollar) Money in Canada Today  Money in Canada consists of: o Currency: the notes and coins held by individuals and businesses o Deposits at banks and other depository institutions  The two main official measures of money in Canada are M1 and M2. o M1 consists of currency held by individuals and businesses (currency outside the banking system) plus chequable deposits owned by individuals and businesses. o M2 consists of M1 plus all other deposits─non-chequable deposits and fixed term deposits.  All the items in M1 are means of payment. They are money.  Some savings deposits in M2 are not means of payments, due to liquidity problem.  Liquidity is the property of being instantly convertible into a means of payment with little loss of value.  Deposits are money, but cheques are not—a cheque is an instruction to a bank to transfer money.  Credit cards are not money. A credit card enables the holder to obtain a loan, but it must be repaid with money. The Banking System  The banking system consists of private and public institutions that create money and manage the nation’s monetary and payments systems. Depository Institutions A depository institution is a firm that takes deposits from households and firms and makes loans to other households and firms.  A chartered bank is a private firm, chartered under the Bank Act of 1992 to receive deposits and make loans.  A credit union is a cooperative organization that operates under the Cooperative Credit Association Act of 1992 and that receives deposits from and makes loans to its members.  A caisse populaire is a similar type of institution that operates in Quebec.  To goal of any bank is to maximize the wealth of its owners. To achieve this objective, the interest rate at which it lends exceeds the interest rate it pays on deposits.  But the banks must balance profit and prudence: o Loans generate profit. o Depositors must be able to obtain their funds when they want them. • A chartered bank puts the depositors’ funds into four types of assets: 1. Reserves—notes and coins in its vault or its deposit at the Bank of Canada 2. Liquid assets—Canadian government Treasury bills and commercial bills 3. Securities—longer–term Canadian government bonds and other bonds such as mortgage-backed securities 4. Loans—commitments of fixed amounts of money for agreed-upon periods of time Economic Benefits Provided by Depository Institutions  Depository institutions make a profit from the spread between the interest rate they pay on their deposits and the interest rate they charge on their loans.  Depository institutions provide four benefits: o Create liquidity o Pool risk o Lower the cost of borrowing o Lower the cost of monitoring borrowers The Bank of Canada  The Bank of Canada is the central bank of Canada.  A central bank is the public authority that regulates a nation’s depository institutions and control the quantity of money. The Bank of Canada is:  Banker to Banks and Government: The Bank of Canada accepts deposits from depository institutions that make up the payments system and the government of Canada.  Lender of Last Resort: The Bank of Canada stands ready to make loans when the banking system as a whole is short of reserves. Banks lend and borrow reserves from other banks in the overnight loans market.  Sole Issuer of Bank Notes: The Bank of Canada is the only bank that is permitted to issue bank notes. The Bank of Canada has a monopoly on this activity.  The Bank of Canada’s Balance Sheet: The Bank of Canada’s assets are government securities (largest and most important asset) and last-resort loans to banks. o The most important liabilities are Bank of Canada notes in circulation and deposits of banks and the government  The liabilities of the Bank of Canada (plus coins issued by the Canadian Mint) form the monetary base.  The monetary base is the sum of Bank of Canada notes outside the Bank of Canada, banks’ deposits at the Bank of Canada, and coins held by households, firms, and banks.  To change the monetary base, the Bank of Canada conducts an open market operation, which is the purchase or sale of government of Canada securities by the Bank of Canada in the open market. o An open market operation is the purchase or sale of government securities by the Bank of Canada from or to a chartered bank or the public. o When the Bank of Canada buys securities, it pays for them with newly created reserves held by the banks. o When the Bank of Canada sells securities, they are paid for with reserves held by banks. How Banks Create Money Creating Deposits by Making Loans  Banks create deposits when they make loans and the new deposits created are new money. The quantity of deposits that banks can create is limited by three factors:  Monetary Base: sum of Bank of Canada notes, coins, and banks’ deposits at the BOC o The size of the monetary base limits the total quantity of money that the banking system can create because Banks have desired reserves and Households and firms have desired currency holdings. o Both these desired holdings of monetary base depend on the quantity of money.  Desired Reserves: A bank’s actual reserves consist of notes and coins in its vault and its deposit at the Bank of Canada. o The desired reserve ratio is the ratio of the bank’s reserves to total deposits that a bank plans to hold. o The desired reserve ratio exceeds the required reserve ratio by the amount that the bank determines to be prudent for its daily business.  Desired Currency Holding: People hold some fraction of their money as currency. So when the total quantity of money increases, so does the quantity of currency that people plan to hold. Because desired currency holding increases when deposits increase, currency leaves the banks when they make loans and increase deposits. o This leakage of reserves into currency is called the currency drain. o The ratio of currency to deposits is the currency drain ratio. The Money Creation Process  Money creation process begins with an increase in the monetary base.  The Bank of Canada conducts an open market operation in which it buys securities from banks.  The Bank of Canada pays for the securities with newly created bank reserves.  Banks now have more reserves but the same amount of deposits, so they have excess reserves. Excess reserves = Actual reserves – desired reserves.  T-account: a simplified accounting statement that shows a bank’s assets & liabilities. o Banks’ liabilities include deposits, assets include loans & reserves. The Money Multiplier  The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base.  The quantity of money created depends on the desired reserve ratio and the currency drain ratio. The smaller these ratios, the larger is the money multiplier. money supply (1cr) Money multiplier  money base (rrcr) The Money Market The Influences on Money Holding  The Price Level: A rise in the price level increases the quantity of nominal money but doesn’t change the quantity of real money that people plan to hold. o Nominal money is the amount of money measured in dollars. o Real money equals Nominal money ÷ Price level. o The quantity of nominal money demanded is proportional to the price level—a 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent.  The Nominal Interest Rate: the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset. o A rise in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold.  Real GDP: An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.  Financial Innovation: Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold. The Demand for Money  The demand for money is the relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same.  A rise in the interest rate brings a decrease in the quantity of real money demanded.  A fall in the interest rate brings an increase in the quantity of real money demanded. Shifts in the Demand for Money Curve  A decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward.  An increase in real GDP increases the demand for money and shifts the demand curve rightward. Money Market Equilibrium  Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied.  Adjustments that occur to bring about money market equilibrium are fundamentally different in the short run and the long run. Short-Run Equilibrium The Short-Run Effect of a Change in the Supply of Money Long-Run Equilibrium  In the long run, the loanable funds market determines the real interest rate.  Nominal interest rate equals the equilibrium real interest rate plus the expected inflation rate.  In the long run, real GDP equals potential GDP, so the only variable left to adjust in the long run is the price level.  The price level adjusts to make the quantity of real money supplied equal to the quantity demanded.  If in long-run equilibrium, the Bank of Canada increases the quantity of money, the price level changes to move the money market to a new long-run equilibrium.  In the long run, nothing real has changed.  Real GDP, employment, quantity of real money, and the real interest rate are unchanged.  In the long run, the price level rises by the same percentage as the increase in the quantity of money. The Transition from the Short Run to the Long Run  Start in full-employment equilibrium: If the Bank of Canada increases the quantity of money by 10 percent, the nominal interest rate falls. As people buy bonds, the real interest rate falls.  As the real interest rate falls, consumption expenditure and investment increase. Aggregate demand increases.  With the economy at full employment, the price level rises. As the price level rises, the quantity of real money decreases.  The nominal interest rate & real interest rate rise. As the real interest rate rises, expenditure plans are cut back & eventually the original full-employment equilibrium is restored.  In the new long-run equilibrium, price level has risen 10 percent but nothing real has changed. The Quantity Theory of Money  The quantity theory of money is the proposition that, in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.  The quantity theory of money is based on the velocity of circulation and the equation of exchange.  The velocity of circulation is the average number of times in a year a dollar is used to purchase goods and services in GDP.  Calling the velocity of circulation V, the price level P, real GDP Y, and the quantity of money M: V = PY ÷ M.  The equation of exchange states that: MV = PY.  This equation becomes the quantity theory of money if M does not influence V or Y.  So in the long run, the change in P is proportional to the change in M.  Expressing the equation of exchange in growth rates: Money growth rate + Rate of velocity change = Inflation rate + Real GDP growth  In the long run, velocity does not change, so Inflation rate = Money growth rate  Real GDP growth Chapter 25: Exchange Rates The Foreign Exchange Market  To buy goods and services produced in another country we need money of that country.  Foreign bank notes, coins, and bank deposits are called foreign currency.  The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. Exchange Rates  The price at which one currency exchanges for another is called a foreign exchange rate.  Currency value → value of a currency is always given in terms of another currency o £/$ → Value of Canadian Dollar in terms of pounds (pounds per dollar) o $/£ → Value of pounds in terms of Canadian Dollar (dollars per pound)  Currency appreciation/depreciation → Occurs when currency’s value increases/decreases in terms of another currency  An exchange rate is the price—the price of one currency in terms of another. Like all prices, an exchange rate is determined in a market—the foreign exchange market.  The Canadian dollar is demanded and supplied by thousands of traders every hour of every day. With many traders and no restrictions, the foreign exchange market is a competitive market. The Demand for One Money Is the Supply of Another Money  When people who are holding one money want to exchange it for Canadian dollars, they demand Canadian dollars and they supply that other country’s money. Demand in the Foreign Exchange Market  The quantity of Canadian dollars that traders/Investors plan to buy in the foreign exchange market during a given period depends on 1. The exchange rate 2. World demand for Canadian exports 3. Interest rates in the US and other countries, in comparison to those in Canada 4. The expected future exchange rate  The demand for dollars is a derived demand: People buy Canadian dollars so that they can buy Canadian-produced goods and services or Canadian assets, not just to have the actual Canadian Dollar in hand. Other things remaining the same, the higher the exchange rate, the smaller is the quantity of Canadian dollars demanded in the foreign exchange market. The exchange rate influences the quantity of Canadian dollars demanded for two reasons:  Exports Effect: The larger the value of Canadian exports, the greater is the quantity of Canadian dollars demanded on the foreign exchange market. The lower the exchange rate, the greater is the value of Canadian exports, so the greater is the quantity of CAD demanded.  Expected Profit Effect: The larger the expected profit from holding CAD, the greater is the quantity of CAD demanded today. But expected profit depends on the exchange rate. The lower today’s exchange rate, other things remaining the same, the larger is the expected profit from buying CAD and the greater is the quantity of CAD demanded today. Supply in the Foreign Exchange Market  The quantity of Canadian dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate, & depends on: 1. The exchange rate 2. Canadian demand for imports 3. Interest rates in Canada and other countries 4. The expected future exchange rate  Other things remaining the same, the higher the exchange rate, the greater is the quantity of Canadian dollars supplied in the foreign exchange
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