Transcript review lovewellch13

Understanding Economics
5th edition
by Mark Lovewell
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5th edition
by Mark Lovewell
Review Chapters 13, 14 and 15
The Bank of Canada (a)

The Bank of Canada performs four basic functions:
 It manages the money supply.
 It acts as the bankers’ bank:


holding deposits of members of the Canadian Payments
Association
making advances to CPA members at the bank rate
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The Bank of Canada (b)
 It acts as the federal government’s fiscal agent:



holding some of the government’s bank deposits
clearing the government’s cheques
handling the financing of the government’s debt by issuing
bonds (including Canada Savings Bonds and treasury bills)
 It helps supervise the operations of financial markets to
ensure their stability.
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Expansionary Monetary Policy (b)
Figure 13.1, page 360
The Economy
The Money Market
Sm0
Initial Recessionary Gap
Sm1
AS
4
3
a
2
b
Dm
1
0
30
40
50
Price Level (GDP deflator,
2002 = 100)
Nominal Interest Rate (%)
5
60
Quantity of Money
($ billions)
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d
140
e
130
c
120
AD1
110
100
0
Potential
Output
790
795
800
Real GDP
(2002 $ billions)
AD0
805
Contractionary Monetary Policy (b)
Figure 13.2, page 360
The Economy
The Money Market
Sm1
150
4
a
3
b
Dm
2
1
0
30
40
50
Quantity of Money
($ billions)
60
Price Level (GDP deflator,
2002 = 100)
Nominal Interest Rate (%)
5
Initial Inflationary Gap
Sm0
AS
e
c
AD0
140
d
130
AD1
120
110
Potential
Output
100
0
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790
795
800
Real GDP
(2002 $ billions)
805
Open Market Operations

Open market operations are a tool the Bank of Canada
uses to conduct monetary policy.
 A sale of bonds lowers a CPA member’s deposit liabilities
and reserves, which causes a magnified decrease in the
money supply using the money multiplier.
 A purchase of bonds raises a CPA member’s deposit
liabilities and reserves, which causes a magnified
increase in the money supply using the money
multiplier.
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Changes in the Target Overnight
Rate (a)

Changing the target overnight rate is a tool the Bank of
Canada uses to signify its monetary policy intentions.
 When the Bank of Canada changes its target band for
the overnight rate it also automatically adjusts the bank
rate since this rate is at the top end of the target band.
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Changes in the Target Overnight
Rate (b)
 A rise in the target overnight rate signifies a
contractionary policy in the near future while a fall
in the target overnight rate signifies an expansionary
policy.
 If the change in the target overnight rate is
substantial, then deposit-takers also adjust their
prime rate, which is the lowest possible rate charged
on loans to deposit-takers’ best corporate
customers.
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The Benefits and Drawbacks of
Monetary Policy

Monetary policy has two main benefits:
 It is separated from day-to-day politics.
 Decisions regarding monetary policy can be made quickly.

Monetary policy has two main drawbacks:
 It is less effective as an expansionary tool than as a
contractionary tool.
 It cannot be focused on particular regions.
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Types of Inflation

There are two main types of inflation:
 Demand-pull inflation occurs as rightward shifts in the
AD curve pull up prices.
 Cost-push inflation occurs as leftward shifts in the AS
curve push up prices.
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Demand-Pull Inflation
Price Level (GDP deflator,
2002 = 100)
Figure 13.5, Page 365
AS
150
b
a
140
AD1
AD0
750
0
Real GDP (2002 $ billions)
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770
Cost-Push Inflation
Figure 13.8, Page 368
Price Level (GDP deflator,
2002 = 100)
AS1
AS0
c
150
d
140
AD
750 770
0
Real GDP (2002 $ billions)
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The Self-Stabilizing Economy (a)

The economy has a self-stabilizing tendency due to
long-run movements in the AS curve.
 If equilibrium real output is above potential output, then
higher wages gradually push the AS curve leftward and
decrease equilibrium output.
 If equilibrium real output is below potential output, then
lower wages gradually push the AS curve rightward and
increase equilibrium output.
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The Self-Stabilizing Economy (b)
Price Level (GDP deflator,
2002 = 100)
Figure 13.9, Page 369
Potential AS
Output
c
110
b
100
95
a
0
700
725 730
Real GDP (2002 $ billions)
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The Balance of Payments Accounts

The balance of payments accounts provide a summary
of all transactions between Canadian residents and
foreigners that involve exchanging Canadian dollars
for some other currency.
Receipts (shown by a + sign) represent monetary inflows
to the Canadian economy.
 Payments (shown by a - sign) represent monetary
outflows from the Canadian economy.

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The Current Account (a)

The current account (which summarizes all foreign
transactions associated with current economic activity
in Canada and involving Canadian dollars) includes
four types of transactions:
trade in merchandise
 trade in services
 flows of investment income
 transfers

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Canada’s Current Account (2007)
Figure 14.1, Page 380
(Canadian $ billions)
Payments (-)
(Canadian
$ outflows)
Receipts (+)
(Canadian $
inflows)
Merchandise trade
Trade in services
Balance of trade (net exports)
Investment Income
Transfers
Balance (net)
(Canadian
$ inflows –
Outflows)
463.1
67.3
-
415.0
86.5
=
=
71.4
9.5
-
85.6
10.6
=
=
+48.0
-19.2
+28.9
-14.2
-1.1
=
+13.6
Current account surplus
(+) or deficit (-)
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Canada’s Capital and Financial Accounts (2007)
Figure 14.2, Page 382
(Canadian $ billions)
Payments (-)
(Canadian
$ outflows)
Receipts (+)
(Canadian
$ inflows)
Capital Account
Financial Account
Direct investment
Portfolio investment
Other financial investment
Total capital and financial
account surplus (+) or
deficit (-) (excl. official reserves)
Balance (net)
(Canadian
$ inflows –
outflows)
5.0
-
0.8
=
+5.9
116.7
-
57.8
=
+58.9
-80.0
+3.8
9
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-13.1
Canada’s Balance of Payments (2007)
Figure 14.3, Page 384
(Canadian $ billions)
Balance
(net)
1.
2.
3.
4.
Current account
Capital and financial accounts
Statistical discrepancy
Balance-of-payments surplus (+) or deficit (-)
Changes in official reserves
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+13.6
-13.1
+4.1
+4.6
-4.6
Changes in Official Reserves (a)

The change in official reserves:
 shows the effect of the Bank of Canada’s buying and
selling of foreign currency on the flow of Canadian
dollars
 is equal in value (and opposite in sign) to the surplus or
deficit noted in the balance of payments
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Exchange Rates and Prices

The impact of exchange rates on prices can be
illustrated using Canadian and U.S. dollars.
 A product’s U.S. dollar price = the Canadian dollar price
x U.S. dollars to buy CDN$1.00.
 A product’s Canadian dollar price = the U.S. dollar price
x Canadian dollars to buy US$1.00.
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A Foreign Exchange Market
Figure 14.4, Page 387
Canadian Dollar Demand and Supply Curves
Surplus
Canadian Dollar Demand and
Supply Schedules
Price of Quantity of
Quantity of
Cdn.
Cdn. Dollars - Cdn. Dollars
Dollar
Supplied
Supplied
(in $US)
($ billions)
(surplus (+) or shortage (-))
US$0.78
US$0.76
US$0.75
60 – 40 = +20
50 – 50 =
0
45 – 55 = -10
Price of Canadian Dollar (in $US)
0.78
S
a
a
0.77
b
0.76
c
0.75
c
Shortage
D
0
40
45
50
55
60
Quantity of Canadian Dollars (billions)
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Canadian Exchange Rates
Figure 14.7, Page 396
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The Importance of Trade (b)
Figure 15.1, Page 406
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Canada’s Merchandise Trade by Region (2007)
Figure 15.2, Page 407
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Canada’s Merchandise Trade by Type of Product (2007)
Figure 15.3, Page 408
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What is Traded

Three main factors determine what products a country
exports and imports:
 resources
 market size
 climate
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The Case for Trade

International trade brings three main economic gains:
 product variety
 competition
 specialization
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Absolute and Comparative
Advantage

Specialization can be based on either absolute
advantage or comparative advantage.
 Absolute advantage is exhibited by a producer who can
supply a certain quantity of an item more efficiently
than can other producers.
 Comparative advantage is exhibited by a producer who
can supply a certain item with a lower opportunity cost
than can other producers.
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Gains from Trade Based on Absolute Advantage
Figure 15.4, Page 410
Lawyer
Carpenter
Time Spent
Building
Furniture
Time Spent
Preparing
a Will
Time Saved
through
Specialization
20 hours
5 hours
2 hours
10 hours
20 – 2 = 18 hours
10 – 5 = 5 hours
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Gains from Trade Based on Comparative Advantage
Figure 15.5, Page 411
Hypothetical Output
Per Worker
Canada
Mexico
Opportunity
Cost
Paper
Computers
of 1 tonne
of paper
12 tonnes
3 tonnes
12 computers
9 computers
1.0 computer
3.0 computers
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of 1
computer
1.0 tonnes paper
0.33 tonnes paper
Total Gains from Specialization
Figure 15.6, Page 412
Before Trade
Canada
Mexico
After Trade
Paper
Computers
Paper
60 tonnes
30 tonnes
60 computers
90 computers
120 tonnes
0 tonnes
0 computers
180 computers
90 tonnes
150 computers
120 tonnes
180 computers
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Computers
The Impact of Trade Protection (a)

In a perfectly competitive market:
 a tariff (which is an excise tax on imported goods)
decreases consumption and foreign imports, while it
increases domestic production and government
revenues
 an import quota (which is a non-tariff barrier) has the
same effect as a tariff, except that the increase in
government revenues is replaced by an increase in the
price of foreign imports
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The Impact of Import Barriers
Figure 15.7, Page 415
c
Price ($ per bicycle)
150
b
125
100
a
Import Quota
Sd0
dS
i1
e
Si0
D
0
Sd0
S1
150
Price ($ per bicycle)
Tariff
50 70 90 110 130
Quantity (thousands
of bicycles per year)
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125
100
f
g
D
0
50 70 90 110 130
Quantity (thousands
of bicycles per year)
The Case for Trade Protection

Seven arguments are used to support trade protection:
 domestic employment
 infant industries
 terms of trade
 environment and safety standards
 cheap foreign labour
 national security
 cultural sovereignty
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Average Tariff Rates in Canada
Figure 15.8, Page 414
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5th edition
by Mark Lovewell
The End
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