Transcript Ragan_13ce_ch19_ch29Review

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Chapter 19
What Macroeconomics Is
All About
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Output and Income
National output of goods and services during a given period is
measured as gross domestic product - GDP
A nation’s income during a given period is exactly equal to
the total of all goods and services it creates during a given
period
Therefore
Y = GDP
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Potential output is what the economy could produce if all
resources were employed at their normal levels of utilization
- often called full-employment output
Output Gap = Y-Y*
When Y < Y* , there is a recessionary gap.
When Y > Y*, there is an inflationary gap.
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Real GDP
Recessionary Gap
Peak
Actual GDP
Potential GDP
Peak
Trough
Inflationary Gap
Time
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Employment, Unemployment, and the Labour
Force
Productivity
Inflation and the Price Level
Interest Rates
The International Economy
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Chapter 20
The Measurement of
National Income
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IMa
Ca
Ia
Ga
Xa
Ca + Ia + Ga + (Xa - IMa)
= GDP
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Does the accounting identity
GDP = Ca + Ia + Ga + (Xa - IMa)
imply that everything that firms produce each
year is automatically sold to customers?
NO!
INVENTORIES!
INVENTORIES!
INVENTORIES!
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Chapter 21
The Simplest Short-Run Macro
Model
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We use the same
conceptual set
up to do
macroeconomic
theory
as the national
income
accountants
IM
But we are
doing
something
quite
different
C
I
G
X
C + I + G + (X - IM)
= Desired Aggregate Expenditure
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Two general types of expenditures:
- autonomous expenditures do not depend on the level
of national income
- induced expenditures do depend on the level of
national income
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The Aggregate Expenditure Function
The AE function:
- relates desired aggregate expenditure to actual
national income
In the absence of government and international trade, desired
aggregate expenditure is:
AE = C + I
This is called a ‘closed economy with no government’
no Government, no Trade AE = C + I + G + NX
A Lou Dobbs economy (or perhaps the Fox Network economy).
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The simple consumption function is written as:
C = a + bYD
where a represents autonomous consumption expenditure
and bYd represents induced consumption expenditure.
C
a
45º line
C
Slope = b
Note: the
slope of this
simple
consumption
function (b) is
less than one.
YD
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Shifts in the Consumption Function
What might cause a shift in the consumption function
(the amount of consumption desired by all
households at all levels of income)?
- change in wealth
- change in interest rates
- change in expectations
- change in population size or age distribution
- change in taste
- ?
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Desired Investment Expenditure
Recall: Investment refers to purchases of
- capital stock (plant & equipment)
- residential building
- business inventories
Investment expenditure is the most volatile component of
GDP:  changes in investment expenditure are strongly
associated with short-run fluctuations
Three important determinants of aggregate investment
expenditure are:
• the real interest rate
• changes in the level of sales
• business confidence
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The equilibrium
condition is:
Y = AE(Y)
Desired A.E.
In this model, output
is said to be demand
determined.
45º line
AE
900
600
•
300
105
300
600
900
Actual National Income
In words: Equilibrium national income is that level
of national income where desired aggregate
expenditure equals actual national income.
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21.2 Equilibrium National Income
Recall:
desired aggregate expenditure is what buyers want to buy
during the period (C + I in our simple model)
actual output is what firms actually produce during the period (Y or GDP)
If desired aggregate expenditure exceeds actual output:
- what is happening to inventories?
falling
- there is pressure for output to rise
If desired aggregate expenditure is less than actual output:
- what is happening to inventories?
rising
- there is pressure for output to fall
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Simple multiplier =
Y
1
=
A
1-z
AE
AE =Y
E1
•
e1
•
e´1
where z is the
marginal propensity to
spend out of national
income and A is the
change in autonomous
expenditure.
AE0
A
e0
• E0
Y0
AE1
Y
Y1
Y
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Chapter 22
Adding Government and Trade
to the Simple Macro Model
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In this chapter
we consider all
of the economic
agents who
might buy final
goods and
services from
Canadian firms
C
IM
I
X
G
C + I + G + (X - IM)
= Desired Aggregate Expenditure
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22.1 Introducing Government
Government Purchases
Net Tax Revenues
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22.2 Introducing Foreign Trade
Net Exports
For imports, we assume:
IM = mY
where m is the marginal propensity to import.
Thus, net exports are given by:
NX = X - mY
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Shifts in the Net Export Function - Summary
*
Foreign Income - An increase in foreign income results in an increase in
Canadian exports - NX function shifts up.
(and the reverse)
Relative International Prices - A rise in Canadian prices relative to
foreign prices reduces Canadian exports (X shifts down). The IM function
also rotates up since Canadians now spend a higher fraction of income
on foreign goods. The NX (=X-IM) function shifts down and also gets
steeper. (and the reverse)
Appreciation of the Canadian dollar - A rise in the value of the
Canadian dollar reduces Canadian exports (X shifts down). The IM
function also rotates up since Canadians now spend a higher fraction of
income on foreign goods. The NX (=X-IM) function shifts down and also
gets steeper. (and the reverse)
Other considerations: Barriers to trade – tariffs, quotas, regulations, etc.
Mad cow disease, lead paint on toys, etc.
Taste – trade promotion, ‘buy Canadian’
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The Multiplier with Taxes and Imports
Imports and taxes make z smaller
 the simple multiplier is also smaller
z = b(1 - t) - m
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What might cause the AE line to
shift upwards or downwards?
*
AE
AE =Y
- interest rate
E0
•
e0
- exchange rate
- expectations (confidence)
- wealth
e´1
- Canadian prices relative to
foreign prices
e1
•
AE0
AE
AE1
•E
1
- foreign incomes
-G
Y1
- etc.
Y
What might cause the slope of the AE line to change?
MPC (or b),
t,
m
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Y0
Y
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Chapter 23
Output and Prices in
the Short Run
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The Aggregate Demand Curve
The aggregate demand (AD) curve relates
equilibrium real GDP to the price level.
For any given P, the AD curve shows the level of real
GDP for which desired aggregate expenditure equals
actual GDP.
Changes in the price level cause movements along
the AD curve.
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AE
E0
•
E1
•
AE =Y
AE0 ( at P0)
AE1 (at P1 > P0)
AE2 (at P2 > P1)
E2
•
Y2
Y1
Y0
P
P2
Y
The AE curve shifts
down, but we move
along the AD curve.
•
•
P1
P0
Y2
Y1
Consider a rise in the
price level, from P0 to
P2:
•
Y0
AD
Y
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Price Level
Shifts in the Aggregate Supply Curve
Anything that increases
firms’ costs causes the
AS curve to shift up:
AS1
•
P1
AS0
- factor prices
- technology
P0
•
Y1
•
Y0
- regulation
Real GDP
Why does AS get
steeper as output
rises?
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What does the Aggregate Supply Curve look like?
Price Level
Unless, the economy is in a serious recession and firms have a lot of
unused capacity, unit costs rise with output (Marginal Costs generally
increases as output increases) firms will produce more output only if prices
increase.
The AS curve is therefore upward sloping (except at very
levels of output).
AS1
•
P1
P0
In the short run firms
generally find that MC
increases as output increases
so they will increase
production only if they get
higher prices.
•
Y0
This is straight out of the
microeconomics of the firm.
Y1
Y (GDP)
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23.3 Macroeconomic Equilibrium
E0 is the
macroeconomic
equilibrium.
AD
AS
Price Level
Demand
behaviour is
consistent with
supply behaviour
only at the
intersection of the
two curves.
E0
P0
P1
•
Y1
•
•
Y0
Y2
Real GDP
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Aggregate Demand Shocks
Possible causes:
- ΔG > 0
AD1
Price Level
Demand shocks cause
P and Y to change in
the same direction.
AS
AD0
P1
P0
E0
• E1
•
- ΔI > 0
- ΔX > 0
Y0
Y1 Real GDP
- ΔC > 0
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Aggregate Supply Shocks
Aggregate supply
shocks cause P and Y
to change in opposite
directions.
Possible causes:
- Δ price of inputs
- Δ wages
- Δ technology
- Δ regulation
P
AS1
AS0
P1
P0
E1
•
•
Y1
E0
AD
Y0
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Chapter 24
From the Short Run to the
Long Run: The Adjustment of
Factor Prices
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24.1 The Adjustment Process
Potential Output and the Output Gap
AS
P
AS
P
E0
E1
•
Output
gap
Y*
Y0
•
AD
AD
Output
gap
Y
Output Gap = Y -
Y1
Y*
Y
Y*
NOTE: The adjustment
to E0 or E1 occurs fairly quickly
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Factor Prices and the Output Gap
Really, what we are interested in is: How fast are wages rising relative to
productivity growth? If productivity (output per person hour) grows at 2%
then wages can grow at 2% without any effect on cost per unit (the AS
curve will not shift).
Y > Y* => excess demand for labour => wages tend to
rise faster than productivity (AS shifts up and back)
Y < Y* => excess supply for labour
=> wages tend to
rise more slowly than productivity (AS shift down and out)
Y = Y* => no excess supply/demand => wages rise and
the same rate as productivity (AS does not shift)
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24.2 Aggregate Demand and
Supply Shocks
Expansionary AD Shocks
The economy’s
adjustment process
eventually
eliminates any
boom caused by a
demand shock,
returning Y to Y*.
P
P2
P1
P0
AS1
Price level
rises further
Price level
rises
AS0
• E2
•
• E0
Inflationary gap
opens
Inflationary Y*
gap closes
E1
AD1
AD0
Y1
Y
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Contractionary AD Shocks
The economy’s
adjustment process
works following
negative demand
shocks, too.
- although it may be
slower because of
“sticky wages”
P
P0
P1
AS0
AS1
Price level
falls further
• E0
•
P2 Recessionary
gap closes
opens
Y1
E1
•
E2
AD0
AD1
Y*
Y
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Aggregate Supply Shocks
P
P1
AS1
Price level
rises
falls
AS0
E1
•
After a negative
supply shock, the
adjustment of factor
prices reverses the
AS shift and returns
real GDP to Y*.
• E0
P0
Recessionary
gap closes
opens
Y1
AD
Y*
Y
Example: Consider an
increase in the world
price of some important
raw materials.
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P
In the long run, Y is
determined only by
potential output —
aggregate demand
determines P.
E1
•
P1
E0
•
P0
AD1
AD0
Y
Y0*
P
For a given AD curve,
long-run growth in Y*
results in a lower
price level.
P0
E0
•
•
P1
Y0*
E2
Y1*
AD0
Y
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The Basic Theory of Fiscal Stabilization
P
P
AS0
AS
AS1
P1
P0
E0
•
• E1
P0
P1
AD1
E0
•
•
AD0
Y0 Y*
E1
AD
Y
Y0
Y*
Y
A recessionary gap may be closed by a rightward
shift in AD or by a (possibly slow) rightward shift in
the AS curve.
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P
P
AS1
AS0
AS
E1
• E0
P0
P1
E1
•
Y*
P1
P0
AD0
•
• E0
AD
AD1
Y0
Y
Y*
Y0
Y
An inflationary gap may be removed by a leftward
shift in AD, or by a leftward shift of AS.
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Practical Limitations of Discretionary Fiscal Policy
Most economists agree that automatic fiscal stabilizers are
desirable and generally work well, but they have concerns
about discretionary fiscal policy.
Limitations come from:
• long and uncertain lags
• temporary versus permanent changes in policy
• the impossibility of “fine tuning”
• regionalized nature of Canada
• Federal/Provincial powers
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18
Chapter 25
The Difference Between
Short-Run and Long-Run
Macroeconomics
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GDP = F x (FE/F) x (GDP/FE)
What are the three separate terms?
1. F is the factor supply.
2. FE/F is the factor utilization rate.
3. GDP/FE is a simple measure of productivity.
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?
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1. Factor Supplies
- supplies of labour and capital change only gradually
labour – population growth, immigration, higher participation rates)
capital – more investment
2. Productivity
- productivity changes only gradually
improved labour – healthier, better trained and educated
improved capital – embodied technical change
improved technology – disembodied technical change
3. Factor Utilization Rate – output gap as a percentage of Y*
(Y-Y*)/Y * 100
- fluctuates a lot in the short run
- fluctuates very little in the long run
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Chapter 26
Long-Run
Economic Growth
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Investment, Saving, and Growth
Our model has two parts:
Investment — increases in the stock of capital — lead to
increases in the future level of Y*.
Saving by households (and firms) is used to finance this
investment.
 interest rate is the “price” that equilibrates this
market
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Suppose the supply of national saving increases:
 the NS curve shifts to the right
Increased national saving
reduces the real interest
rate and encourages more
investment
NS0
NS1
- change in tax laws
E0
i0*
i1*
•
- change in taste
- gov’t surpluses
•
E1
I0* I1*
I
Loanable Funds
Greater flow of investment
leads to a higher growth rate
of potential output.
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Now suppose that investment demand increases
 the I curve shifts to the right
Increased investment demand
pushes up the interest rate and
encourages more saving by
households
- new products/technology
NS
- change in expectations
i1*
i0*
E0
•
• E1
I1
I0
I0* I1*
Greater flow of saving (and
investment) leads to a
higher growth rate of Y*.
Loanable Funds
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Neoclassical Growth Theory
This theory begins with the idea of an aggregate production
function:
GDP = FT(L,K,H)
- L is the total amount of labour
- K is the stock of physical capital (including natural resources)
- H is the quality of human capital
- T is the state of technology
The notation FT reflects the assumption that changes in
technology will change the production function.
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In the Neoclassical growth model, technological change is
necessary for sustained growth in living standards.
Much technological change is embodied in new capital
equipment
 investment is crucial
Measuring the extent of technological change is difficult –
because it is not directly observable.
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Average Product
of Labour
In terms of Average Product of
labour
The economy can keep
getting bigger – more capital
and more labour – but it does
not get any better – no
increase in APL (no increase
in living standards – GDP per
capita)
APL
Population
Labour force = σ population
The APL curve just keep shifting to the right as more labour and capital
are added – we technical change to make the APL curve shift upwards.
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26.3 New Growth Theories
Endogenous Technological Change
New growth theory emphasizes the process of innovation and
the incorporation of new technology:
• learning-by-doing ‘the more you do the more you can do’
• knowledge transfer
‘hands on’ experience
• market structure and innovation
• shocks and innovation
competitive pressure
spur innovation
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Chapter 27
Money and Banking
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27.1 THE NATURE OF MONEY
What Is Money?
Modern Money: Deposit Money
Modern Money - two components
Currency in the hands of the non-bank public
- bills and coins about 5% of the total money supply
Deposit with commercial banks and other financial
institutions (deposit money)
– chequing accounts, savings accounts, etc. about 95%
of the total money supply
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What is money?
Money is a TECHNOLOGY (of exchange)
Money is TRUST (in the monetary authorities)
Money is CREDIT (created by banks as they create money)
Money is a claim on a goods and services. You get a claim on goods
and services by selling (producing) something of value in exchange
for money, or someone gives you some of their claims which they
got by selling (producing) something of value.
As long as the number of claims grows at the same rate as the output
of goods and services produced each period (GDP), then the money
is good in the sense that it retains its value – the amount of goods
and services that you can get with one unit of the money remains
constant.
A Simple Rule The money supply should grow at the same rate as the
growth in GDP (not everyone agrees with this rule).
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27.2 THE CANADIAN BANKING SYSTEM
Most modern banking systems have:
- a central bank
- many commercial banks
A central bank acts as a bank to the banking system:
- usually a government-owned institution
- the sole money-issuing authority
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Excess Reserves and Cash Drains
Deposit creation does not happen automatically; it depends
on the decisions of bankers. Bankers must find appropriate
borrowers to lend their excess reserves to.
A cash drain:
- if households hold a fraction of their deposits in
cash, the deposit-creation process is dampened
If c is the currency-deposit ratio, the final change in deposits
will be given by:
 Re serves
Deposits 
c v
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Chapter 28
Money, Interest Rates, and
Economic Activity
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Present Value and the Interest Rate
Present value:
- the value now of one or more payments or receipts
made in the future
Consider an asset that pays $X in one year’s time. If the
interest rate is i% per year, the PV of the asset is
PV = $X/(1+i)
Notice that, ceteris paribus, the PV is negatively related to the
interest rate.
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A Sequence of Future Payments - the general formula
PV =
R1 + R2 + … + RT
(1+i) (1+i)2
(1+i)T
This simple present value formula tells how to price
any promise of future payments.
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Interest Rates, Market Prices and Bond Yields
Conclusion: The price of bonds is inversely related to the
market rate of interest
As a simplification we can say that the price of bonds = 1/i
Note it works both ways:
If the demand for bonds increases this drives up the price of
bonds and i falls (since Pb = 1/i).
But also
If interest rates fall, then the price of bonds will increase (since
Pb = 1/i).
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There are three reasons for holding money:
• the transactions motive
f (P, real GDP)
• the precautionary motive - liquidity f (P, real GDP, i)
• the speculative motive
f (i, expectations)
The Determinants of Money Demand
We focus on three variables:
- real GDP (+)
- the price level (+)
- the interest rate (-)
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28.3 MONETARY EQUILIBRIUM AND
NATIONAL INCOME
Monetary Equilibrium
MS excess supply
of money
i2
i0
i1
•
•
excess demand
for money
•
M1
M2 M0
Quantity of Money
MD
Monetary equilibrium
occurs when the
quantity of money
demanded equals the
quantity of money
supplied:
 equilibrium interest
rate
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Monetary Equilibrium – what’s happening in the
bond market?
If MS > MD (excess supply of money) at the current i
BS
pB2
The public will want to
decrease their money
holdings.
•
By buying bonds.
pB0
pB1
B’D
•
•
B1
B2 B0
Quantity of Bonds
BD
The demand for bonds shifts
out and the equilibrium price
of bonds increases – but an
increase in the price of bonds
means the interest rate must
have fallen.
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What’s happening in the financial (asset) markets in general?
If MS > MD (excess supply of money) at the current i, the public might
buy bonds but they might also buy other assets (anything that
promises a return on their investment (money).
Equities S
•
TSXB2
TSXB0
In general this situation means
that the public will want to look
for a place to ‘invest’ the excess
money that they hold.
Equities D’
•
Equities D
E0
We keep the story simple by
focusing on the bond market but the
excess money might end up flowing
into any asset – the stock market,
junk bonds, housing, foreign debt,
etc.
Sub-prime mortgages
E1
Quantity of Equities
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What’s happening in the financial (asset) markets in general?
If MS > MD (excess supply of money) at the current i
What determines where the ‘new
money’ shows up? Many things but
basically banks must find new
borrowers – so the demand for
loans often leads the way.
HS
•
hB2
hB0
H’D
•
HD
H2
H0
H1
Quantity of Housing
If banks have too much money to
lend they may be tempted to lend
to higher risk borrowers (higher
defaults and financial instability
follow). Maybe they lend to
borrowers investing in housing sub-prime mortgages, maybe
‘dot com companies’, maybe
junk bonds.
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The Monetary Transmission Mechanism
Monetary transmission mechanism:
- connects changes in MD and/or MS with aggregate
demand
Three stages:
1. ΔMD or ΔMS  Δ in equilibrium interest rate
2. Δi  Δ in desired investment (and consumption) expenditure
3. ΔID and ΔC and Δ NX  Δ in AD
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An increase in the
supply of money
or
A decrease in the
demand for money
Excess supply of money
A fall in interest rates
An increase in desired
investment expenditure
Capital outflow and
currency depreciation
Increase in net exports
An upward shift in the AE curve
A rightward shift in the AD curve
AS0
Interest Rate
Price Level
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MS0
i0
P1
P0
•
•
E0
E1
Y0 Y*
AD1
AD0
i1
i1’
E0
MS1
•
• E1
•
MD0
MD1
Quantity of Money
Real GDP
But in the long-run
- P increases (in short-run) causing MD to shift out a bit
- But Y0 goes to Y* (normal level of employment) therefore no
unusual increases in wages and no shift in AS
P1
P0
AS0
•
•
E1
E0
Y0 Y*
AD1
AD0
Interest Rate
Price Level
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MS0
MS1
i0
•
i1
• E1
•
i1’
MD0
MD1
Quantity of Money
Real GDP
Finally after the long-run adjustment is finished
- i is lower
- Y has returned to Y* (we are out of the recession – money is
not neutral)
- P has changed (increased – inflation) – more M, higher P
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Chapter 29
Monetary Policy
in Canada
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29.1 HOW THE BANK OF CANADA
IMPLEMENTS MONETARY POLICY
Money Supply Versus the Interest Rate
For any given money demand curve, any central bank must
choose between:
- setting the money supply
- setting the interest rate
Both cannot be set independently.
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How could the Bank of Canada actually try to increase the MS?
1. Simply lend reserves to commercial banks
2. Open Market Operations
1. B of C buys G of C bonds in the open market
2. B of C pays for the bonds by writing a cheque cashable at the B of C
3. Seller of G of C bonds deposits the cheque in her commercial bank
account
4. Her commercial bank deposits the cheque at the B of C –
commercial bank reserves have just increased
How to decrease the MS? Do the reverse
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The Bank of Canada and
the Overnight Interest Rate
The Overnight Interest Rate
Commercial banks borrow and lend reserves to each other
overnight.
The Overnight Interest Rate is the interest rate in this
overnight market.
You can think of this rate as the cost of reserves to
commercial banks.
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The Bank of Canada can more-or-less control the overnight
interest rate. It does this by:
1. Setting a target for the overnight interest rate
2. Establishing the Bank Rate 0.25% above this target
B of C will lend any amount of reserves at this rate
3. Establishing a borrowing rate 0.25% below target
B of C will borrow any amount of reserves at this rate
 keep actual overnight rate within 0.5% band
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29.2 INFLATION TARGETING
Inflation Targeting as a Stabilizing Policy
What Are the Lags in Monetary Policy?
Monetary policy operates with a time lag that is long and
variable for two main reasons:
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Destabilizing Policy?
Long and variable lags  some monetarists argued that
central banks should not try to stabilize national income.
They argued that attempts to stabilize will more likely be
destabilizing
- they advocate the use of a monetary rule
- increase bank reserves at a constant rate
Most economists now agree that monetary policy can lead
to more economic stability. ????
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