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When one earns a dollarthe part of the dollar you spend C/YD
MPC + MPS = 1
The Multiplier
The multiplier is the ratio of the total change in real GDP caused by an
autonomous change in aggregate spending to the size of that autonomous
change.
The change in real GDP equals the multiplier times the autonomous
expenditure
Its linear
Linear function-upward sloping an increase in disposable income causes
an increase in consumption
Slope is the MPC
Aggregate Consumption Function
interest rate
existing production capacity
And positively on:
Inventories
Income Expenditure
Assumptions underlying the multiplier process:
Paradox of Thrift
Aggregate Demand
Aggregate demand curve: shows the relationship between the aggregate
price level and the quantity of aggregate output demanded by households,
businesses, the government, and the rest of the world.
The curve is downward-sloping because
1. Wealth Effect: higher aggregate price level reduces the purchasing power of
households wealth and reduces consumer spending.
2. Interest Rate: higher aggregate price level reduces the purchasing power of
households money holdings, leading to a rise in interest rates and a fall in
investment spending and consumer spending.
Substitution and wealth effect wealth= Income / price level
Interest rateReal balance = money in your wallet / price level
Price goes up purchasing power goes down and interest rates goes up
They both say different things
Shifts caused by
The aggregate demand curve shifts because of:
changes in expectations
If consumers and firms become more optimistic, aggregate
demand increases and vice versa
Wealth
If the real value of household assets rises, aggregate demand
increases and vice versa
government policies
fiscal policy
monetary policy
Shows the relationship between the aggregate price level and the quantity of
aggregate output in the economy.
Upward-sloping because nominal wages are sticky in the short run:
o A higher aggregate price level leads to higher profits and increased
aggregate output in the short run.
o they dont adjust easily
Nominal wage: the dollar amount of the wage paid.
Sticky Wages: nominal wages that are slow to fall even in the face of high
unemployment and slow to rise even in the face of labour shortages.
Note: In the short run wages are fixed
Shifts of the Short-Run Aggregate Supply Curve
Changes in
commodity prices
o If commodity prices fall, short-run aggregate supply increases
and vice versa
nominal wages
o If nominal wages fall, short-run aggregate supply increases and
vice versa
Productivity
o If workers become more productive, short-run aggregate supply
increases and vice versa
. lead to changes in producers profits and shift the short-run aggregate supply
curve.
Long-Run Aggregate Supply Curve
Shows the relationship between the aggregate price level and the quantity of
aggregate output supplied that would exist if all prices, including nominal
wages, were fully flexible.
RW wont change over time
P goes up wages goes up
The AD AS Model
Uses the aggregate supply curve and the aggregate demand curve together
to analyze economic fluctuations.
Short-run macroeconomic equilibrium: when the quantity of aggregate
output supplied in the short run is equal to the quantity demanded.
Short-run equilibrium aggregate price level: the aggregate price level in the
short-run macroeconomic equilibrium.
Short-run equilibrium aggregate output: the quantity of aggregate output
produced in the short-run macroeconomic equilibrium.
Long Run Macroeconomic Equilibrium
When the point of short-run macroeconomic equilibrium is on the long-run
aggregate supply curve.
Triple intersection
Gap Recap
Recessionary Gap: when aggregate output is below potential output
o When short run equilibrium is to the left LRE
Inflationary Gap: when aggregate output is above potential output
o When SRE is to the right LRE
Output Gap: the percentage difference between actual aggregate output and
potential output
Macro Policy
Active stabilization policy: using fiscal or monetary policy to offset shocks.
Policy in the face of supply shocks:
o There are no easy policies to shift the short-run aggregate supply
curve.
o Policy dilemma: a policy that counteracts the fall in aggregate output
by increasing aggregate demand will lead to higher inflation, but a
policy that counteracts inflation by reducing aggregate demand will
deepen the output slump.
Money: any asset that can easily be used to purchase goods and services
Currency in circulation: money that is held by the public
Bank reserves: the currency banks hold in their vaults plus their deposits at
the Bank of Canada.
Reserve ratio: the fraction of bank deposits that a bank holds as reserves.
Reserve requirements: rules set by the central bank that determine the
minimum reserve ratio banks.
The desired (or voluntary) reserve ratio: the fraction of deposits that banks
want to hold as reserves.
Excess reserves: bank reserves over and above the banks required reserves
o Ex. Increase in bank deposits from $1,000 in excess reserves =
$1,000/rr
Money Multiplier
Monetary base: the sum of currency in circulation and bank reserves.
Money multiplier: the ratio of the money supply to the monetary base.
Central Banks
Central bank: an institution that oversees and regulates the banking system
and controls the monetary base.
Ex. Bank of Canada
o Banker for commercial banks the BOC will normally act as a lender
of last resort for a commercial bank with sound investments that is in
urgent need of cash and cannot find a lender.
o Banker for the federal government the BOC not only manages federal
government bank accounts, but it also occasionally lends money to the
federal government through buying some of the securities that the
government issues.
o Issues currency ensures the supply of banknotes meets public
demand and prevent counterfeiting.
o Conducts monetary policy controls interest rates, the quantity of
money, the exchange rate, or some combination of these actions.
Open Market
Open Market Operation: is the purchase or sale of assets by a central bank.
Bank of Canadas assets and Liabilities:
o
o
Lower than equilibrium interest rate, money demand is greater than money
supply and prices go up
Higher than equilibrium interest rate, money demand is lower than money
Increased money supply which causes excess supply of money which pushes
down the prices of money, which pushes down the interest rate
Effects
Inflation Targeting
Occurs when the central bank sets an explicit target for the inflation rate and
sets monetary policy to hit that target.
More or less, a zone rather than target
Advantages of inflation targeting:
Economic uncertainty is reduced because the central banks plan is
transparent.
The central banks success can be judged by the gap between the
actual inflation and the inflation target, making central bankers
accountable.
Note: One disadvantage of inflation targeting is that its too restrictive when
there are other concerns, such as financial system stability, that may require
more attention.
Zero Bound and QE
Zero lower bound for interest rate: interest rates cannot fall below zero, which
sets limits to the power of monetary policy.
Money Neutrality
Increased money supply MS1 to MS2 , Equilibrium drops, interest rates are
lowered , creates demand for money and all this in the long run raise interest
rate and alters equilibrium again
Money doesnt affect GDP
Chapter 16
Inflation
Classical Model of the price level: real quantity of money is always at its longrun equilibrium
Aka its neutral
Inflation Tax: the reduction in the value of money held by the public caused
by inflation
Seigniorage: the revenue generated by the governments right to print
money
Print more money it creates inflation which lowers purchasing power
and value of money
Formuala: Seigniorage= M
Real seigniorage=
M M
=
P
M
( )( MP )
When the output gap is positive (an inflationary gap), the unemployment rate
is below the natural rate.
Short Run Phillips Curve: the negative short-run relationship between the
unemployment rate and the inflation rate.
Downward sloping relationship
Short-Run
Unemployment low, inflation high and vice versa
NAIRU (Nonaccelerating Inflation Rate of Unemployment): the unemployment
rate at which inflation does not change over time.
Is there some level of unemployment where inflation is fixed?
Long-Run Phillips Curve: shows the relationship between unemployment and
inflation after expectations of inflation have had time to adjust to experience.
Disinflation: is the process of bringing down inflation that is embedded in
expectations.
Keynesian Economics
Keynes brought a new economic theory
He believed:
Wages are not flexible, there is stickiness, rigidness in the economy
Wages and prices do not adjust easily
o Explained with unions and how price dont change every day therefore
W/P cant be fixed
As a result, SRAS is upward sloping not vertical
In the long run, we are all dead
Monetarism: believes that GDP will grow if money supply grows steadily
In other words, money matters
Believes the solution is to inject money in the economy
Discretionary Monetary Policy: when the central bank changes interest rates or
money supply based on their assessment of the state of the economy
Basically, when they have to make a change
Monetary policy rule decides the central banks actions
Velocity of money equation: M x V = P x Y
o Where V = velocity
o Classical believes: PY determines MV
o Keynes believes: MV determines PY
o When V is stable. M = PY (aka Nominal GDP)
Chapter 19
Exchange Rates
Currencies are traded in the foreign exchange market
o Aka wherever you can buy foreign currency
When currency becomes stronger, more valuable it appreciates. Vice versa
it will depreciate
Equilibrium Exchange Rate
The exchange rate at which the quantity of a currency demanded in the
foreign exchange market is equal to the quantity supplied
o The equilibrium price at which currency is exchanged
Excess demand pushes the demand curve, leads to an appreciation for the
Canadian dollar
o Thus, Canadian dollars are more valuable
Real Exchange Rates
Mexican pesos per Canadian dollar this would be nominal exchange rate
REAL exchange rate is Mexican pesos per Canadian dollar X (Price of Canadian /
Price of Mexican)
Purchasing Power Parity
If you hold the price level constant then this price should be constant
worldwide
o In reality, doesnt work
Exchange Rate Policy
A country has the right to fix the exchange against some other currency
Floating exchange rate, is letting the market forces be flexible with the
exchange rate
If you have a flexible exchange rate, then you only have monetary policy and
lose mobility of controlling it
If an exchange rate isnt fixed it would adjust back to equilibrium
Dilemmas
Money only goes so far theres only so many things that the policy can do,
it cant be controlled all at once in the market
A country can set whatever rate it wants
Monetary policy under floating exchange rates
If you expand the money supply, you decrease the interest rate, deprecate
the value of the Canadian dollar, a lot more would be exported, the dollar is
worth less than prior to
Decreasing the exchange rate
Aggregate demand would go up