Macroeconomics Mid-Term Notes

Chapter 4 Notes
Macroeconomics - The study of the economy as a whole. Includes topics such as inflation, unemployment,
and economic growth. In microeconomics, typically one market is being focused on. When it comes to
macroeconomics, the effects of something are typically studied on more than one market.
Business Cycle - Refers to the alternating periods of expansion and recession that a given market can go
through.
Expansion - Period where total production and total employment is increasing.
Recession - Period where total production and total employment are decreasing.
Economic Growth - When an economy produces an increasing amount of goods and services.
Inflation Rate - The average rate at which prices increase over a given period of time.
Gross Domestic Product (GDP) - A measure of the total production of a company or sector over a given
period of time.
GDP only includes the final goods and services that were provided over that period of time.
Final good and services - Goods and services purchased by the final user of the product. (I.E. A car, not a
wheel.)
Intermediate good or service - This is a good or service that is used as an input into another good or
service, such as a car seat. (A car seat is an intermediate good or service, a car is a final good or service.)
These are not included in GDP unless they were purchased separately from the final product.
Another way to look at GDP is thinking about it as the total value of income in the market. Every time Honda
sells a car, all of that money goes back into the company, and spread out through itself and employees as
income. Tax on the other hand, goes to the government, and eventually becomes income to someone when
the government spends the money.
Transfer Payments - These are payments the government makes to households where it does not receive a
new good or service in return.
Four Major Categories of Components of GDP (Consumption, Investment, Government Purchases,
Net Exports)
(C) Personal Consumption Expenditures (aka consumption)
Includes expenditures include; Food, clothing, services like haircuts and school, vacation, and cars.
(I) Gross Private Domestic Investment (aka Investment)
Split into three separate categories
Business Fixed Capital investments - These are investments made by companies in new factories,
equipment, etc.
Residential Structures - These are investments made by households, individuals, or firms on NEW houses.
Investment in Inventory - These are investments made by companies on their inventory. If Honda has
100,000,000 dollars' worth of new unsold cars in inventory at the beginning of the year, and 200,000,000
dollars' worth of unsold new cars in inventory at the end of the year, Honda has spent 100,000,000 dollars on
inventory investment over the year.
(G) Government Consumption and Gross Investment (aka Government Purchases)
Includes money spent by federal, provincial, and local governments on goods and services such as teachers,
salaries, highways, and hospitals. This DOES NOT INCLUDE transfers to individuals.
(NX) Net Exports of Goods and Services (aka Net Exports)
This is the total of exports minus imports. (aka Net Exports)
Exports - Goods and Services produced domestically and sold to foreign households or firms.
Imports - Goods and services produced in foreign countries, but purchased domestically.
Net Exports - The value of a counties total exports minus the value of a counties total imports.
EQUATION FOR GDP
Y = C + I + G + NX
Total GDP = Consumption + Investment + Government Purchases + Net Exports
Value Added - The additional market value a firm adds to a product. For example, a raw diamond is worth
$500. A gem cutter cuts the diamond and increases the total value to $700. The value added is $200. Then a
Jewellery designer sets the diamond and increases its value to $1000. The value added is $300. Then a
jewellery store buys it and sells it for $1500. The value added is $500.
Note the final seller adds an equal amount of value added when compared to all the other players who
added value.
Shortcomings of GDP as a Measure of Total Production
Household Production
This refers to any sort of good people build or make for themselves. (I.E. if you make a bookcase for yourself,
that amount is not included in the total value of GDP.)

There are three reasons a company may try to hide the purchase or sales of a given product.
They're dealing with illegal products or drugs.
They want to avoid paying income on profit they make
They want to avoid government regulation (I.E. Quotas put on milk)
These kinds of transactions are defined as the Underground Economy
Shortcomings of GDP as a Measure of Well-Being
The Value of Leisure is Not Included in GDP
If someone decides to retire, the GDP of a country will inevitably decrease unless they are replaced. While this
will decrease the GDP of the country, it may increase that person's satisfaction with their place in life.
Therefore, GDP would not be a good representation of that persons happiness just because GDP is lower.
GDP Does Not Consider the State of the Environment
GDP is not adjusted to include the cost of creating pollution.
GDP is Not Adjusted for Changes in Crime and Other Social Problems.
Increases in crime rates can reduce well-being, but may increase GDP spending on police, security, etc.
GDP Measures the Size of the Pie but Not How the Pie is Divided.
Does not account for unequally distributed goods or services throughout a country. (I.E. There are some very
rich and very poor parts in places like China.)
Nominal GDP - When GDP is calculated using the current inflation rates at the end of the year. (Includes
inflation)
Real GDP - When GDP is calculated using the prices from a nominal year (excluding GDP) I.E. A nominal year
such as 2007, where all the years proceeding it are compared to it to see if the economy has actually grown or
not.
Using Real GDP is a more accurate representation of how well an economy is doing, and if it has actually
grown or not.
One problem with Real GDP is if prices have changed in markets relative to each other. I.E. The
price of cell phones may have come down in relation to that of a pizza. But since we are using a
frozen year in time, it may not be 100% accurate.
Price Level - A measure of the average prices of goods and services in the economy.
GDP Deflator - A measure of the price level, calculated by dividing nominal GDP by Real GDP and multiplying
by 100
GDP Deflator = Nominal GDP / Real GDP x 100
Other Measures of Total Production and Total Income
Gross National Product (GNP)
The value of final goods and services produced by the labour and resources of Canadians, even if the
production takes place outside of Canada. Therefore, while GNP includes the production of Canadian
companies outside of Canada, it does not include the production of companies outside of Canada in Canada.
National Income
Consumption of Fixed Capital - AKA depreciation of the value of the machinery used to produce various goods
and services. If we take the value of GDP and subtract the depreciation costs from all the machinery used to
produce in Canada, we get the National Income.
Household Income
Income received by households. To calculate, we subtract the earnings that corporations retain rather than pay
to shareholders through dividends. We also add in payment that households receive from the government as
transferable payments
Household Disposable Income
Household income minus any tax payments that must be made. This is the most accurate representation of the
money that households actually have to spend as they see fit.
Chapter 5 Notes
Unemployment Rate - The percent of the workforce actively seeking a job that cannot find or do not have
one.
Working Age Population - People that are 15 years of age or older who are legally entitled to work in
Canada.
Employed - Anyone who did paid work, unpaid work for a family business, or worked for themselves.
Unemployed - People who do not have a job, but are willing and able to work, and have looked for a job in the
last 4 weeks.

Not in the Labour Force - People who are unwilling or unable to perform paid work. This includes people who
have given up trying to find a job.
Labour Force - The sum of employed and unemployed workers in the economy.
Calculating Unemployment rate;
Unemployment rate = Number of unemployed / Labour Force x 100
Labour Force Participation Rate - The percentage of the working age population in the labour workforce.
Participation Rate = Labour Force / Working Age Population
Employment-Population Ratio - A measure of the portion of the population engaged in paid work.
Employment-Population Ratio = Number of Employed / Working Age Population x 100

Problems with Measuring the Unemployment Rate

Discouraged workers - These are workers who are willing and able to work, but have not been able to find a
job and therefore have not been searching for a job in the last four weeks. In this case, these people are
considered to not be a part of the labour force.

Four Main Types of Unemployment (Frictional, Structural, Cyclical, Seasonal)

Frictional Unemployment and Job Search
This is the short term unemployment that arises with the process of matching workers with certain skills to the
correct job. This is natural when searching for a job, as it is the typical time that a person spends finding a job,
and the typical time a business spends trying to find a worker to fill a position.
Structural Unemployment
Unemployment that arises from a persistent mismatch between the skills and attributes of workers and the
requirements of the job.
Cyclical Unemployment
Unemployment caused by a business cycle recession. (Aka when the economy goes into a recession, people
are either let go or businesses are simply not looking to expand their workforce, so people are unable to find
jobs and are left to be unemployed.
Seasonal Unemployment
Unemployment that is due to season factors, such as weather or the fluctuation in demand for some products
during the year like bathing suits or snowmobiles.
Natural Rate of Unemployment - The normal rate of unemployment, consisting of frictional and structural
unemployment. There are always people between jobs, just getting out of school, etc. that do not have a job.
The natural rate of unemployment is also the point at which an economy would be considered at FULL
EMPLOYMENT.

Government Policies and the Unemployment Rate

Employment Insurance
Employment insurance is paid to those who are unemployed. Often times, if someone loses their job, they
can either quickly pick up a low paying job somewhere like Wal-Mart, or they can hold out and wait for a
better job and still get some support from the employment insurance.
Minimum Wage Laws
If the minimum wage is above the market clearing wage (The wage determined by the supply and
demand graph), there will be excess supply and not enough demand. (Too many people wanting jobs and
not enough businesses offering jobs.)
Labour Unions - Organizations of workers that bargain with employers for better wages and working
conditions.
Efficiency Wages - A higher-than-market average wage that a firm pays to motivate workers to be more
productive.
Inflation - The average rise in market prices over a given period of time.
Inflation Rate - The percentage that prices rise over a given period of time.
Price Level - Measures the average price of goods and services in an economy.
Consumer Price Index - An average of the prices of the goods and services purchased by a typical
household.
The easiest way to make this basket is to make it out of 100. I.E. Each point for each section is 1% of a
households income. (I.E. If food is 16, that means it accounts for 16% of the households income.)
When calculating CPI, there is typically a base year like comparing real GDP, and all the other years are
compared to it.
CPI = Expenditures Now / Expenditures in base year x 100
How to measure change over the years?
Change in cost of living = (More recent year CPI - Less recent year CPI) / Less recent year CPI x 100
Four Biases that cause changes in the CPI to overstate the real inflation experienced by
households
Substitution Bias
Statistics Canada is assuming that households buy the same amount of every product every month. In
reality, households buy less of a product the more expensive it gets, especially in relation to substitutes.
Therefore, since they sometimes change products, the prices in the basket the household actually
experiences vs that of statistic Canada rise less.
Increase in Quality Bias

Often times goods and services included in Statistics Canada's basket increase in quality. An example of
this could be a car, that becomes safer, more fuel efficient, nicer inside, or faster. All of these
characteristics of the car warrant the added cost, and therefore the price is actually increasing less than
Statistics Canada says it is.
New Product Bias
The basket is not adjusted as new products come out. Therefore, if since the last time the basket was
updated IPad came out, any price fluctuation in IPads would not be captured in the CPI. Additionally, if
IPads replaced computers all together, this would also not be captured in the basket.
Outlet Bias
Many people have begun buying products either online or in big box stores like Costco, because it saves
them money. If the CPI does not account for the places where people buy their goods and services, and
the discounts that are offered to them for shopping in new places, it will overstate the actual inflation.
Producer Price Index (PPI) - An average of the prices received by producers of goods and services at all
stages of production. It's like CPI, only it is a basket of goods for producers and not consumers.
Real Interest Rate - The nominal interest rate minus the inflation rate.
Nominal Interest Rate - The stated interest rate of a loan.
Real Interest Rate = Nominal Interest Rate - Inflation Rate
Inflation Affects the Distribution of Income
Since there are very few average people, households will find their income raising faster than the rate of
inflations, while others slower. This leaves people in two groups. Either those with rising purchasing power
or those with falling purchasing power. This causes the distribution of income to be uneven, and buying
power to also be uneven in an economy.
Menu Costs - The cost to firms of changing prices.
Nominal income generally increases with inflation because when inflation is anticipated, average nominal
income also increases by the same percentage as the rate of inflation.
Since nominal income increases with inflation, expected inflation does not affect the purchasing power of the
average consumer.
Real GDP = Nominal / Price Deflator.
Change = later year / earlier year
CPI = Expenditures now / base year.
Finding inflation
CPI of New Year - CPI of old / cpi of old x 100

Chapter 6 Notes

Long-Run Economic Growth - The process by which rising productivity increases the average standard of
living.
Rule of 70 - How many years will it take real GDP per capita to double. - Number of years to double =
70/Growth Rate
Labour Productivity - The quantity of goods and services that can be produced by one worker or by one hour
of work.
Capital - Manufactured goods that are used to produce other goods and services. Examples are machines,
computers, factories, and buildings.
Potential GDP - The level of real GDP attained when all firms are producing at capacity.
Output Gap - The gap between real GDP and potential GDP.
Financial System - The system of financial markets and financial intermediaries through which firms acquire
funds from households.
Channels funds from savers to borrowers and channels the returns on borrowed funds back to savers.
Financial Markets - Markets where financial securities, such as stocks and bonds, are also sold.
Financial Intermediaries - Firms, such as banks, mutual funds, pension funds, and insurance companies,
that borrow funds from savers and lend them to borrowers.
Investment = Y (GDP) - C (Consumption) - G (Government Purchases)
Private Savings = Y (GDP) + TR (Government Transfers) - C (Consumption) - T (Paid Taxes)
Public Savings = T (Paid Taxes) - G (Government Spending) - TR ( Government Transfers)
Savings = Private Savings + Public Savings
Savings = Y (GDP) - C (Consumption) - G (Government Spending)
Total Savings MUST Equal total investment
Balanced Budget - When the government spends as much as it collects in tax dollars.
Budget Deficit - When the government spends more than it collects in tax dollars.
Market for Loanable Funds - The interaction of borrowers and lenders that determines the market interest
rate and the quantity of loanable funds exchanged.
An increase in the demand for loanable funds increases the equilibrium interest rate.

A decrease in the demand for loanable funds decreases the equilibrium interest rate.

An increase in the supply of loanable funds decreases the equilibrium interest rate.

A decrease in the supply of loanable funds increases the equilibrium interest rate. This often happens

when the government is running a budget deficit. This causes both saving and investments to decrease.
Crowding Out - A decline in private investment expenditures as a result of an increase in government
purchases.
During a recession.
Inflation decreases dramatically
Unemployment increases a notable amount.
Leading up to a recession.
Inflation often spikes
No given pattern for unemployment, but it is normally slowly rising from a low.
Real Wages = Nominal Wages / CPI (Decimals) -----> What if the CPI raises by 2%, but your employer says
they can only give you a 1% raise. Therefore, your income actually went down. When real wages go down (CPI
increases more than Wages), employers can actually hire more people.
When real wages fall, you begin to hire more people because the cost is going down, so your demand for
labour is actually increasing.
Real GDP Per Capita - Real output per person in the country. Been going up steadily in Canada for the past
55 odd years based on the graph in the text book.
Real GDP - Drawing the graph, there will be an average trend line. Whenever there is a gap, we are either
sitting above or below the line. When you're below, we're in or entering a recession. If we are above the line,
we are operating above potential. (I.E. If you own a business and you are working more than 40 hours a week,
you could be working over potential. (Looks like a curvy line with a straight line through the middle.) One cycle
is a high to a high or a low to a low or a mid to a mid.
Whenever you are sitting on the trend line, you have no issues with unemployment.
If you are sitting above the line, unemployment will be below its natural rate.
If you are sitting below the line, unemployment will be above its natural rate.

Chapter 7 Notes

Industrial Revolution - The application of mechanical power to the production of goods, beginning in
England 1750s
The change in real GDP Between two years uses the following equation.
(Year 1 - Year 0 / Year 0) x 100 = Percentage change in real GDP between the two years.
The Average growth rate per year between a set of years uses the following equation.
Average Annual Growth Rate = (Year(t)/Year(0)) ^(1/t) - 1
Economic Growth Model - A model that explains growth rates in real GDP per capita over the long-run.
Labour Productivity - The quantity of goods and services that can be produced by one worker or by one hour
of work.
Technological Change - A change in the quantity of output a firm can produce sing a given quantity of
inputs.
Three Main Sources of Technological Change
Better Machinery and Equipment
Increases in Human Capital
Better Means of Organizing and Managing Production
Per-Worker Production Function - The relationship between real GDP per hour worked and capital per hour
worked, holding the level of technology constant.
Equal Increases in capital per worker lead to diminishing increases in output per hour worked.
Technological change causes the per-worker production to increase. This also causes the resulting
real GDP to increase.
Simply increasing capital just causes diminishing returns without any technological advancements.
New Growth Theory - A model of long-run economic growth that emphasises that technological change is
influenced by economic incentives and is determined by the working of the market system.
Protecting Intellectual Property with Patents and Copyright - Increases the incentive for
companies to invest in new and better technology to make sure that it is worth it to them to spend the
time and money in order to develop it.
Patent - The exclusive right to produce a product for a period of 20 years from the date the patent
is applied for.
Subsidizing research and development - The government can use subsidies to increase the quantity
of research and development that takes place in a given market or company.
Subsidizing Education - People with technical training carry out research and development. Therefore,
through the government subsidizing education, it gives businesses more access to more people who are
willing and able to fit the job.
Catch-Up - The prediction that the level of GDP per capita (or income per capita) in poor countries will grow
faster than in rich countries.
Why dont more low-income countries experience rapid growth?
Failure to enforce the rule of law
Rule of Law - The ability of a government to enforce the laws of the country, particularly with
respect to protecting private property and enforcing contracts.
Property Rights - The rights individuals or firms have to the exclusive use of their property,
including the right to buy or sell it.
Wars and Revolutions - Many countries that were very poor in the 1960's have experience extended
period of war and rebelliance against the government.
Poor Public Education and Health
Low rate of saving and investment
The Benefits of Globalization
Foreign Direct Investment (FDI) - The Purchase or building by a corporation of a facility in a foreign
country.
Foreign Portfolio Investment - The purchase by an individual or a firm of stocks or bonds issued in
another country.
Globalization - The process of countries becoming more open to foreign trade and investment
Chapter 8 Notes
Aggregate Expenditure (AE) - Total spending in the economy (The sum of consumption, planned
investment, government purchases, and net exports.)
Aggregate Expenditure Model - A macroeconomic model that focuses on the short-run relationship
between total spending and real GDP, assuming that the price level is constant.
(AE = C + Ip + G + NX)
C = Consumption
Ip = Planned Investment
G = Government Purchases
NX = Net Exports

We use the term Aggregate Expenditure because we are looking at the desired (rather than actual)
spending of an economy in a given period of time.
The Difference Between Planned Investment and Actual Investment
Investment - Goods that have been produced but not yet sold.
Take Tim Hortons as an example.
Actual Investment for Tim Hortons would include its bakeries and stores, or doughnuts and coffee
that it has not sold yet.
Actual Investment spending will be greater than planned investment spending when there is an
unplanned increase in inventory, because more was spent than actually planned for.
Similarly, actual investment spending will be lower than planned investment spending when there
is an unplanned decrease in inventory, because less was spent than they had planned for.
The only time actual and planned investment are going to be equal, is when there is no unplanned
change in inventory.
Macroeconomic Equilibrium - This equilibrium occurs when total spending (or planned aggregate
expenditure) equals total product (or GDP.)
Planned Aggregate Expenditure = GDP
In a microeconomic equilibrium, we assume that the price will change to reflect where the quantity supplied is
equal to the quantity demanded.
In a macroeconomic equilibrium, we assume that the price level is constant, so that price adjustments cannot
cause the market to move to equilibrium.

When planned aggregate expenditure is greater than GDP, inventories will fall, which causes firms to
react to the fallen inventories, which causes a growth in GDP and a decrease in unemployment.
When planned aggregate expenditure is lower than GDP, inventories will rise, which causes firms to
react to an overstock of products, which causes a decrease in GDP and an increase in unemployment.
When planned aggregate expenditure is equal to GDP, inventories will stay constant, which means that
the economy is in macroeconomic equilibrium.

Five Most Important Variables that Determine the Level of Consumption

Current Disposable Income - For most households, the higher the disposable income, the more they
spend, and they lower the disposable income, the less they spend.
Household Wealth - The value of a households assets, minus the value of its liabilities. A house with 10
Million in wealth is likely to spend more than a household with $10,000 in wealth, even if the disposable
income is the same.
Expected Future Income - Consumers spend more when they are confident that their future income is
going to rise, while they spend less when they are confident their future income is going to decrease.
The Price Level - A measure of the average price of goods and services in an economy - Increases in
price will decrease consumption as it makes it more expensive for households to attain the same
products. Similarly - if when prices fall (which is rare), consumption will increase as households will be
able to purchase more products for the same amount of money.
The Interest Rate - If interest rates are high, it is more rewarding for households to save, which causes
them to consume less. Likewise, when interest rates are low, it makes saving money less beneficial, and
people spend more. Durable goods, such as cars, are the most influenced here, as paying a loan on a car
can increase or decrease in cost with the current rate of interest.
The Consumption Function - The relationship between consumption spending and disposable income.
Marginal Propensity to Consume (MPC) - The slope of the consumption function. The mount by which
consumption spending changes when disposable income changes.
MPC = Change in Consumption / Change in Disposable Income (MPC = C/YD - Both delta triangle)
Change in Consumption = MPC x Change in Disposable Income
The Relationship Between Consumption and National Income
Disposable Income = National Income - Taxes
National Income = Disposable Income + Net Taxes
National Income = GDP
National Income = Consumption + Savings + Taxes
Change in National Income = Change in Consumption + Change in Savings + Change in Taxes
Writing these out properly
Y=C+S+T
For the changes in everything - just add delta in front.
Marginal Propensity to Save (MPS) - The amount by which saving changes when disposable income
changes
D = Delta

DY = DC + DS
---- ---- ---DY DY
DY
1 = MPC + MPS
The marginal propensity to consume plus the marginal propensity to save must be equal to 1 when taxes are
constant.
The Four Most Important Variables that Determine the Level of Investment
Expectations of Future Profits - The optimism or pessimism of firms is an important determinant of
investment spending.
During an economic expansion, if firms feel like there will be a sustained or increased demand for their

product, they will invest in new plants etc.

During an economic recession, if firms fee like there is or will be a decrease in the demand for their

product, they will wait to invest because they don't know if they investment will be worth it for them in
the long run.
Interest Rate - Often times, when businesses or households invest in new factories, homes, or other large
expenditures where costs could be financed, the interest rate will have a large influence on the amount of
investment.
If rates are high, it is expensive for households and firms to borrow money, and therefore investment

will decrease.
If interest rates are low, it is less expensive for households and firms to borrow money, and therefore

they will invest more and total investment will increase.

Taxes - Governments implement a corporate income tax on companies, that is applied to the profit that they
make through their actions as a business.
If governments lower these tax rates, more of the profit attained from investing in new factories is kept

by the firm, and therefore makes it more worth their while to invest.
If governments raise these tax rates, less of the profit attained from investing in new factories is kept by

the firm, and this lowers the overall benefit received by the firm. This will then decrease the amount of
investment because they have less of a reason to invest.
Cash Flow - The difference between the cash revenues received by a firm and the cash spending by the firm.
The greater a company's cash flow, the greater its ability to finance and invest on its own without the

need for borrowing. The more cash flow a firm has, the more investing it will do.
Government Purchases - Include all spending by federal, provincial, and local governments for goods and
services.
Net Exports - Total Exports minus Total Imports. This can be both positive and negative - positive is better.
The three are the following most important variables that determine the level of net exports
The Price Level in Canada Relative to the Price Level in Other Countries - This has a lot to do with
inflation rates.
If inflation rates in Canada are lower than they are elsewhere, the demand for products from Canada

will increase, and Canadian demand for foreign products will decrease - increasing net exports.
Likewise, if inflation rates in Canada are higher than they are elsewhere, the demand for Canadian

products will decrease, and Canadian demand for foreign products will increase - decreasing net exports.
The Growth Rate of GDP in Canada Relative to the Growth Rate in Other Countries - Has to do with
income
As GDP rises in Canada, this increases the income of households, which increases their purchasing

power for foreign goods. This increases imports, and decreases total net exports.
When GDP in other countries rise, this will increase their household income, and increase their buying

power of Canadian goods. This increases exports, and therefore net exports.
This all depends on who's GDP/Household income is rising faster.

The Exchange Rate Between the Canadian Dollar and Other Currencies As the value of the Canadian dollar rises, this makes it more expensive for people from foreign countries

to buy our products. Therefore, as the value of our dollar rises, it will decrease the dollar value of total
exports - causing net exports to fall.
If the value of foreign currencies increase, this makes it less expensive for foreigners to purchase goods

from Canada, which increases the dollar worth of exports - increasing total net exports.
Graphing Macroeconomic Equilibrium

Macroeconomic Equilibrium occurs when GDP is equal to aggregate expenditure (GDP is equal to expected
expenditure.) - The amount spent on goods is equal to the amount of goods produced.
This graph is known as the 45 degree -line diagram.
Relationship is between real aggregate expenditure and real GDP (aka National Income)

o
Any point above the line occurs when planned AE exceeds GDP.
o
Any point below the line occurs when planned AE fails to meet GDP.
All possible points of Macroeconomic equilibrium lie on the 45 degree line.
Aggregate Expenditure Function - Shows the amount of planned aggregate expenditure that will occur at
every level of national income.
Won't on the graph, but can be broken down into
Consumption
Consumption + Investment
Consumption + Investment + Government spending
Consumption + Investment + Government Spending + Net Exports = AE
When aggregate Expenditure exceeds GDP, this causes an unexpected decrease in inventories,
which causes firms to increase production to near equilibrium.
When Aggregate Expenditure is less than GDP, this causes an unexpected increase in inventories,
which causes firms to decrease production to near equilibrium.
45 Degree - Line Diagram Recession - A recession can be seen on the 45 Degree - Line Diagram whenever
aggregate demand does not reach GDP levels, because this decreases production and often causes firms to lay
off numerous workers.
Autonomous Expenditure - An expenditure that does not depend on the level of GDP/National Income.
(Planned investment, government spending, and net exports are all examples of these kinds of expenditures.)
Multiplier - The increase in equilibrium real GDP divided by the increase in autonomous expenditure.
Multiplier Effect - The process by which an increase in autonomous expenditure leads to a larger increase in
real GDP.
Multiplier = Change in Real GDP / Change in Investment Spending
IF Multiplier = 5
This would mean for every $1 increase in autonomous expenditure, it will result in an increase of equilibrium
GDP of $5.
Multiplier = Change in Equilibrium Real GDP / Change in Autonomous Expenditure (1/1-MPC)
The Paradox of Thrift - If too many people try to save at the same time, this can decrease aggregate
expenditure, and cause a recession. If people have lower incomes during a recession, the people who tried to
save will not actually make any more money. Therefore, people trying to achieve the same goal of saving all at
the same time can be bad for the economy and actually halt or reduce the growth of savings.
Three main reasons that as the price falls in a market, aggregate expenditure rises.
A rising price level decreases consumption by decreasing the real value of household wealth; a falling

price has to reverse affect.

If the price level in Canada rises relative to the price levels of other countries, Canadian exports become

relatively more expensive, and foreign imports become less expensive, causing net exports to fall. A
falling price level in Canada has the opposite effect.
When prices rise, firms and households need more money to finance buying and selling. If the central

bank does not increase the money supply, the result will be an increasing interest rate. If this occurs,
investment will fall, and therefore aggregate expenditure will fall. If prices fall, the reverse will occur.
Aggregate Demand Curve (AD) - A curve that shows the relationship between the price level and the level
of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate
expenditure.
Government Purchases Multiplier = 1 / (1 - (MPC (1 - T) - MPI)
MPC = Marginal Propensity to Consume
T = Tax Rate
MPI = Marginal Propensity to Import
Tax Multiplier = (-MPC) / (1 - MPC)
Government Purchases Multiplier (without tax or imports) = 1 / (1-MPC)
The Balanced Budget Multiplier is ALWAYS = 1 (1 - MPC) / (1 MPC)
*****Second Half of Semester*****
Aggregate Demand and Aggregate Supply - A model that explains short-run fluctuations in real GDP and
price level.

Aggregate Demand Curve (AD) - A curve that shows the relationship between the price level and the
quantity of real GDP demanded by households, firms, and the government.
The aggregate demand curve is downward sloping because as the price level falls, there is an increase in
the amount of real GDP demanded.
Short-Run Aggregate Supply Curve (SRAS) - A curve that shows the relationship in the short run between
the price level and the quantity of real GDP supplied by firms.
How a change in price level affects consumption
If price levels fall, the real wealth of a household will increase, so they are going to increase their total
consumption.
If price levels rise, the real wealth of a household will decrease, so they are going to decrease their total
consumption.
How a change in the price level affects investment
If price levels rise, people have to borrow more money in order to afford investments. This causes
interests rates to rise since demand is increasing, which reduces the investments by firms because it
costs them more money to borrow.
Likewise, if price levels fall, people have to borrow less money to afford the things they need, and
therefore the demand for loanable funds fall, it becomes cheaper for companies to invest, and they
begin to invest more since it is cheaper to do so.
How a change in the price level affects net exports
As prices rise in Canada relative to other countries, exports will fall and imports will rise due to the
fluctuation in the real costs of goods in Canada and outside of Canada.
As prices fall in Canada relative to other countries, exports and rise and imports will fall due to the
fluctuation in the real costs of goods in Canada and outside of Canada.
Shifts of the Aggregate Demand Curve versus Movements along It
If the price level in the economy changes, there will be a move along the demand curve.
All other factors affecting the demand will cause a shift in the demand curve in the market (I.E. if government
purchases increased with no relation to what the current price level was doing.)
Variables that Shift Aggregate Demand
Changes in Government Policy - For example, the bank of Canada could adjust the interest rates to be
higher or lower based on whether they want to increase or decrease demand. Or, the government can increase
or decrease its own spending, which would move the demand curse.
Monetary Policy - The actions the bank of Canada takes to manage the money supply and interest
rates to pursue macroeconomic policy goals.
Fiscal Policy - Changes in the federal taxes and purchases that are intended to achieve macroeconomic
policy objectives.
Changes in Expectations of Households and Firms - If households and firms become more optimistic
about their futures, they are likely to spend/invest more, which will increase the aggregate demand. (And Vice
Versa)
Changes in Foreign Variables - If prices in other countries rise, Canadians will import less, export more, and
there will be a rise in aggregate demand for Canadian-made goods. (And Vice Versa)
The Role of Exports in Aggregate Demand
It can be considered bad if a country's aggregate demand is made up of a high percentage of exports. The
reason being that if a country that imports a lot from Canada goes into a recession, they are going to import
less, affecting Canada. If Canada relies too heavily on imports, then a recession in another country could have
a larger than anticipated effect on the Canadian economy.
Summary of the variables that can shift the Aggregate Demand Curve
An increase in interest rates will shift the curve to the left.
An increase in personal income taxes will shift the curve to the left.
An increase in the growth rate of GDP at a rate greater than other countries will shift the curve to the left.
An increase in the exchange rate value of the dollar will shift the curve to the left.
An increase in a household's expected future income will shift the curve to the right.
An increase in firm's expected profitability of future investments will shift the curve to the right.
An increase in government purchases will shift the curve to the right
Leading Economic Indicator Index - When the index is high, there is a good outlook for the economy, and
vice versa.
The Long-Run Aggregate Supply Curve
The LRAS curve is vertical.
In the long run, the level of real GDP is determined by the supply of inputs, the labour force and the capital
stock, and the available technology. (# of people working, amount of physical capital (factories, land, etc.))
Potential GDP - The level of real GDP attained when all firms are producing at capacity.
The Short-Run Aggregate Supply Curve (SRAS)

Over the short run, as the price level increases, the quantity of goods and services demanded firms are willing
to supply will increase. Vice versa when the price levels are decreasing over the short run.
How does the failure of workers and firms to perfectly predict the price level result in an upward
sloping SRAS curve?
Contracts make some wages and prices "sticky" - This occurs when given prices or wages do not respond
quickly to changes in supply or demand. If a company makes a contract with its workers to hold their wage
steady for three years, while their wage is the same the amount they can charge for their services may
increase.
Firms are often slow to adjust wages - If you are given a wage for a year, it is likely your wage will not
change until at least the following year. If prices begin to rise while your wage stays the same, the company is
going to be willing to offer more supply because they are making more profit from it.
Menu Costs make some prices sticky Companies dont want to pay to constantly change their menus, as
it might not be worth the miniscule price increases.
Shifts of the Short-Run Aggregate Supply Curve versus Movements Along it
A change in the price level will cause a move along the Supply curve.
Any other factor that changes in the market will cause there to be a shift in the aggregate supply.
Variables that Shift the Short-Run Aggregate Supply Curve
Increases in the Labour Force and Capital Stock - The more labour and capital stock a company has, the
more output is it willing to offer at each price level.
Technological Change - As technology increases, this increases what a company/economy can do with a
given level of input.
Expected Change in Future Price - The Short-Run Aggregate Supply curve will shift to the left for the given
amount that unions and employees estimate and demand inflation/wage increases.
Adjustments of Workers and Firms to Errors in Past Expectation About the Price Level - If during the
last contract workers underestimated how much price levels would increase, they would have been at a loss
and the SRAS curve would have shifted to the right for firms. This time around, the firm will try to correct the
lower than average wages for the workers and give them slight bumps above what is expected, which will in
turn shift the SRAS to the left.
Unexpected Changes in the Price of an Important Natural Resource - If the price of oil rises
unexpectedly, there is going to be a shift left in the SRAS because firms have to adjust their business for the
higher cost of an input.
Supply Shock - An unexpected event that causes the short-run aggregate supply curve to shift.
Equilibrium in the Short Run and Long Run
If the macroeconomic equilibrium occurs where all three lines are equal, the economy is producing at potential.
If it is to the left of the LRAS curve, it is below, and to the right is it above.
Recessions, Expansions, and Supply Shocks
Recession
The Short-Run Effect of a Decline in Aggregate Demand
If there is a decline in aggregate Demand, this will cause demand in an economy to decrease. This will
decrease the short run equilibrium, causing firms to need to produce less. This will cause them to let
some employees go, increasing the unemployment rate and resulting in a recession.
Adjustment Back to Potential GDP in the long-run
Once the Aggregate demand has fallen, resulting in lower prices, there are forces to bring the economy
back to potential. First of all, firms will be willing to accept lower prices for their goods, and employees
will be willing to accept lower wages because they will otherwise be unemployed. This will cause shortrun supply to increase because the firms have the employees to do so, and are not accepting lower
wages. The short-run supply shifts to the right. This results in macroeconomic Equilibrium at a lower price
than before the recession.
Expansion
The Short-Run Effect of an Increase in Aggregate Demand
If firms become more optimistic in the future and increase their investment spending, this will increase
the short-run aggregate demand. In doing so, this will increase the equilibrium GDP and equilibrium price
by shifting the curve to the right.
Adjustment Back to Potential GDP in the Long Run
Since workers will now be able to negotiate higher wages due to the higher prices in the economy and the
low rate of unemployment, firms will begin to decrease their supply as it is too costly for them at their
current level of output given the costs of their business. This will shift the short-run aggregate supply to
the left, resulting in a new macroeconomic equilibrium with a higher price than before the expansion.
Supply Shock
The Short-Run Effect of a Supply Shock
Consider that oil prices sky rocket. This will decrease the short-run aggregate supply as firms adjust their
output based on the given increase for their production costs.

Adjustment Back to Potential GDP in the Long Run

The recession caused by the supply shock will lead to lower prices and wages, which will allow firms to
increase their short-run supply again, resulting in the economy moving back to the position it was in
before.
A Dynamic Aggregate Demand and Aggregate Supply Model
Three main changes to the regular model to make up the dynamic model.
Potential GDP increases continually, shifting the long-run aggregate supply curve to the right
During most years, the aggregate demand curve shifts to the right.
Except during periods when workers and firms expect high rates of inflation, the short-run aggregate
supply curve shifts to the right.
Typically speaking, the aggregate demand will shift to the right further than the short-run aggregate supply,
which will result in inflation from year to year.
What is the usual cause of inflation?
Normally, there is a faster growth rate of total spending then total production in the economy, which is the
reason for typical inflation from year to year.
The Functions of Money
Medium of Exchange - When a store accepts your $5 bill as payment for the shirt you are buying, the $5 bill
is acting as a medium of exchange of value. Economies work most efficiently when a single good is recognized
as a medium of exchange.
Unit of Account - In a barter system, each good has many prices based off of what is being traded. (An
iPhone could be worth two iPads or half a MacBook.) When a single good is used for money (I.E. the Canadian
dollar), everything has one price based on the given set standard of money.
Store Value - Money is used as a store of value. While other things like bonds and houses can be used to
store value, and are arguably better ways to store the value you have, money is a store of value, and in dollar
form, is high in liquidity value.
Standard of Deferred Payment - When firms make contracts with each other to buy goods, and pay later,
they need a standard deferred payment option in order to make sure that when they do receive their payment,
they are receiving it in a form that still holds value a week, month, or year after the sale when they actually
receive full payment.
What Can Serve as Money?
Five Criteria to make a good suitable for use as a medium of exchange
The good must be acceptable to (I.E. useable by) most people.
It should be of standardized quality so that any two units are identical.
It should be durable so that value is not lost by spoilage.
It should be valuable relative to its weight so that amounts large enough to be useful in trade can be
easily transported.
The medium of exchange should be divisible because different goods are valued differently.
Fiat Money
It can be inefficient for an economy to rely on precious medals for its money supply. Having to transport bars of
gold to a store is annoying in order to purchase something. Instead, banks offered paper currency that was
exchangeable for gold, which made it easier for people to carry their stored value around. (No longer in effect
anywhere.)
Legal Tender - The federal government requires that a given form of money (i.e. Canadian dollar) to be
accepted as payments of debts and requires that cash or cheques dominated in dollars be used in payment of
taxes.
How is Money Measured in Canada Today?
There are 6 different definitions of the money supply in Canada
M1+ - The narrowest definition of the money supply: It includes currency and other assets that have
cheque-writing features - all chequable deposits at chartered banks, TMLs, and CUCPs.
M1++ - Includes everything that the M1+ includes, plus non-chequable deposits at chartered banks,
TMLs, and CUCPs.
M2 - A monetary aggregate that includes currency outside banks and person deposits at chartered
banks, non-personal demand and notice deposits at chartered banks, and fixed-term deposits.
M2+ - A broad monetary aggregate that includes everything that is in the M2 plus deposits at TMLs,
deposits at CUCPs, life insurance company individuals annuities, personal deposits at government-owned
saving institutions, and money market mutual funds.
M2++ - The broadest definition of the money supply: It includes everything that is in the M2+ as well as
Canada Savings Bonds and other retail instruments, and non-money market mutual funds.
M3 - A category within the money supply that includes everything that is in the M2 plus non-personal
term deposits at chartered banks and foreign currency deposits of residents at chartered banks.
TML - Trust and Mortgage Loan Companies
CUCP - Credit Unions & Caisses Populaires

Seigniorage - The profit the government makes from printing fiat money. (It costs Canada 4 cents to print a
$20 bill, so the Seigniorage is $19.96.)
What about Credit Cards and Debit Cards?
Credit Cards - The money spent on a credit card is not included in the money supply because you are
essentially taking out a loan. Therefore, this is only included once you pay the loan off.
Debit Cards - The money spent on a debit card is also not included in the money supply, because you are
taking money directly out of your own pocket (I.E. bank) so that money is included in the supply.
Both debit cards and credit cards themselves actually hold no money. They are just an access point to a loan or
your own funds.
How do Banks Create Money
Bank Balance Sheets
On a balance sheet, a firms assets are on the left and liabilities are on the right.
Reserves - Deposits that a bank keeps as cash in its vault or on deposit with the Bank of Canada.
Desired Reserves - Reserves that a bank desires to hold, based on its chequing account deposits.
Desired Reserve Ratio - The minimum fraction of deposits banks desire to keep as reserves.
Excess Reserves - Reserves that banks hold over and above the desired amount.
When you deposit $1000 into the bank, the bank pay loan out 90% of everything you deposit. Therefore, by
increasing its assets (accounts receivable by $900.) The other $100 goes to reserves. This increases the money
supply by $900.
Once this money makes it to another bank, they get $900, and then loan out another 90. This process
continues, until we get the total value of the initial $1000 loan.
Simple Deposit Multiplier - The ratio of the amount of deposits created by banks to the amount of new
reserves.
Multiplier = 1/1-amount of new reserves (percentage).
The Simple Deposit Multiplier versus the Real-World Deposit Multiplier
When banks gain reserves, they make new loans, and the money supply expands.
When banks loose reserves, they reduce their loans, and the money supply contracts.
The Bank of Canada Opened in 1933
Fractional Reserve Banking System - A banking system in which banks keep less than 100 percent of
deposits as reserves.
Bank Run - A situation in which many depositors simultaneously decide to withdraw money from a bank.
Bank Panic - A situation in which many banks experience runs at the same time.
The central bank can often handle a bank run by lending out loans to other banks so that they can pay off
their loans and get money out to depositors who are requesting withdraws.
The Bank of Canada's Operating Band for the Overnight Interest Rate
Overnight Interest Rate - The interest rate banks charge each other for overnight loans.
Key Policy Rate - The Bank of Canada's target for the overnight interest rate.
Collateralized Transactions - Transactions that involve properly being pledged to the lender to guarantee
payment in the event that the borrower is unable to make debt payments.
Operating Band - The Bank of Canada's 50-basis-point range for the overnight interest rate (For example,
they could set an objective between 1.25% & 1.75%.)
Bank Rate - The interest rate the Bank of Canada charges on loans (advances) to banks. (THIS IS ALWAYS THE
TOP OF THE OPERATING BAND (I.E. 1.75% based on the example above.))
Settlement Balances - Deposits held by banks in their accounts at the Bank of Canada.
Advances to Banks - Loans the Bank of Canada makes to banks.
Standing Liquidity Facilities - The Bank of Canada's readiness to lend to or borrow from a bank.
How the Bank of Canada Implements Monetary Policy
Two Main Monetary Policy Tools
Open Market Buyback Operations - Agreements in which the Bank of Canada, or another party,
purchase securities with the understanding that the seller will repurchase them in a short period of time,
usually less than a week.
Open Market Operations - The buying and selling of government securities by the Bank of
Canada in order to control the money supply.
Monetary Base - The sum of the Bank of Canada's monetary liabilities (I.E. paper money in
circulation and bank settlement balances) and the Canadian Mint's coins outstanding (I.E. Coins in
circulation.)
Purchase and Resale Agreements (PRAs) - The Bank of Canada's purchase of government
securities to primary dealers (I.E. banks or security brokers/dealers), with an agreement to
repurchase them later. (Use this to reduce pressure on the overnight interest rate)
Sale and Repurchase Agreements (SRAs) - The Bank of Canada's sale of government securities
to primary dealers (I.E., banks or security broker/dealers) with an agreement to repurchase them
later.

Purchase to lower overnight rate, sell to increase overnight rate.

Read page 309
Lending to Financial Institutions - Banks borrow money from the bank of Canada at a high interest
rate, but since they make loans off of all the money they typically borrow from the bank of Canada, they
are able to make money even though they have to pay it back at a high rate.
When there is a decrease in target for the overnight interest rate.. The dollar and interest rate
go down.. So there is an increase in demand and an increase in the rate of inflation.
When there is an increase in the target for the overnight interest rate.. The dollar and the
interest rate go down. So there is a decrease in the demand and a decrease in the inflation rate.
Bank of Canada's target range is 1-3%. With 2% being the ideal rate.
Security - A financial asset - such as a stock or bond - that can be bought and sold in a financial market.
Securitization - The process of transforming loans or other financial assets into securities.
Connecting Money and Prices: The Quantity Equation
MxV=PxY
M = Money Supply
V = Velocity
P = Price level
Y = Real Output
Velocity of Money - The average number of times per year each dollar in the money supply is used to
purchase goods and services included in GDP
Quantity Theory of Money - A theory about the connection between money and prices that assumes that
the velocity of money is constant.
Growth Rate of Money Supply + Growth Rate of Velocity of money = growth rate of the price level
+ growth rate of real output.
Inflation Rate = Growth rate of money supply + growth rate of velocity - growth rate of real output
Inflation Rate = Growth rate of money supply - growth rate of real output
This leads to the following predictions
If the money supply grows faster than the real GDP, there will be inflation
If the money supply grows slower than the real GDP, there will be deflation
If the money supply grows equal to that of the real GDP, there will be no inflation or deflation (I.E stable
prices)
CIBC insures deposits up to $250,000
The Simple Deposit Multiplier = 1/RR
Monetary Policy - The actions the Bank of Canada takes to manage the money supply and interest rates to
pursue macroeconomic policy goals.
The Goals of the Monetary Policy (Price stability, low unemployment, stable markets, economic
growth.)
Price Stability - Rising prices, especially with the high inflations rates in the 70's, can cause money to
lose value as a medium of exchange.
The goal of the Bank of Canada is to keep inflation in a target range of 1 to 3 percent, with the
ultimate goal being 2%. ---------- The Bank of Canada is equally worried about the inflation rate
rising too high as it is the inflation rate falling too low.
Inflation Targeting - Conducting monetary policy so as to commit the central bank to achieving a
publicly announced level of inflation.
Symmetric Inflation Targeting - Conducting monetary policy based on equal concern about
inflation rising above its target as about inflation falling below its target.
Flexible Inflation Targeting - Conducting monetary policy that does not rely on mechanical rules
to achieve its inflation target, but tries to meet the inflation target over a time horizon (typically a
two-year horizon.)
Monetary Policy Targets - The Bank of Canada cannot directly tell firms how many people to hire, or how
much to produce, in order to result in the perfect inflation rate. The two main things it can control in order to
vary the inflation rate are the money supply and the interest rate.
The Demand for Money - The interest rate and quantity of money demanded are explicitly linked.
A decrease in the interest rates causes the quantity of money demanded to increase.
An increase in the interest rates causes the quantity of money demanded to decrease.
An increase in the quantity of money demanded causes the interest rate to fall.
A decrease in the quantity of money demanded causes in the interest rate to rise.

The lower interest rates are, the less incentive there is for households to invest their money into treasuries and
bonds, and therefore the demand of money increases. Vise-versa occurs when the interest rates on bonds and
treasuries are high.
Shifts in the Money Demand Curve - Anything that causes a change in the demand for money other than
the interest rate.
An increase in real GDP causes a shift to the right. (Amount of buying and selling increases, more funds
are needed.)
A decrease in real GDP causes a shift to the left. (Amount of buying and selling decreases, less funds are
needed.)
Higher price levels require more money to buy the same amount of goods and services, shifting the curve
to the right.
Lower price levels require less money to buy the same amount of goods and services, shifting the curve
to the left.
How the Bank of Canada Manages the Money Supply: A quick Review
If the bank of Canada wants to increase the money supply, they purchase government of Canada

securities. The sellers of these securities deposit this money into banks as additional reserves, the bank's
loan out the money, and the money supply is increased.
If the bank of Canada wants to decrease the money supply, they sell government of Canada securities.

The buyers of these securities withdraw the money used to purchase these securities from their bank,
reducing the bank's reserves, and decreasing the amount of money they can lend out therefore reducing
the money supply.
Equilibrium in the Money Market
Through the supply of money, the Bank of Canada can effect both the demand of money and the interest rate.
When the supply of money increases, the demand for money increases and interest rates fall.
When the bank of Canada increases the money supply, the interest rate must fall until it reaches a level
at which households and firms are willing to hold the additional money.
When the supply of money decreases, the demand for money decreases and interest rates rise.
When the bank of Canada decreases the money supply, the interest rate must rise until it reaches a point
at which households and firms are willing to leave their money in the bank still.
The Tale of Two Interest Rates
Long-Term Real Rate of Interest - Loanable funds model is concerned with this kind of interest rate investors are concerned about this rate who are going to be borrowing for the long-run.
Short-Term Real Rate of Interest - Money market model is concerned with this kind of interest rate - This is
more important when it comes to the money market because it is directly related to the interest rate that
increases and decreases the money supply
Choosing a Monetary Policy Target
The Bank of Canada typically focuses on interest rates as opposed to the money supply in order to control the
rate of inflation.
The Importance of the Overnight Interest Rate
Overnight Fund Market - When banks need additional reserves, they lend it from here and typically pay it
back in the next few days.
Overnight Interest Rate - The interest rate banks charge each other for overnight loans.
Operating Band - The Bank of Canada's 50 basis point range for the overnight interest rate.
Monetary Policy and Economic Activity
Open Market Buyback Operations - Agreements in which the Bank of Canada, or another party. Purchases
securities with the understanding that the buyer will repurchase them in a short period of time, usually less
than a week.
How Interest Rate Effects Aggregate Demand
Changes in real interest rates will not affect government purchases, but they will affect the following three
components of aggregate demand.
Consumption - Many consumer purchases such as cars or furniture are purchased through financing.
Lower interest rates lead to higher consumption, and higher interest rates lead to lower levels of
consumption.
Investment - Lower interest rates mean firms will take on more investment projects and activities,
raising investment. High interest rates increase the cost of borrowing, so firms will take on less investing
activities, lowering overall investment.
Net Exports - If interest rates fall, the value of the dollar will fall, increasing exports as our goods will
now be cheaper compared to those of other countries. If interest rates rise, the value of the dollar will
rise, decreasing exports as our goods will now be more expensive than those from other countries.
The Effect of Monetary Policy on Real GDP and the Price Level
Expansionary Monetary Policy - The Bank of Canada's decreasing interest rates to increase real GDP.

This occurs when the economy is producing below potential. By raising the money supply and decreasing
the interest rates, the government will increase the aggregate demand in the economy. This shifts the AD
curve to the right, increasing real GDP as well as the price level in the economy, in order to reach market
potential. (Refer to page 335 in the textbook to see a graph - graph a)
Contractionary Monetary Policy - The Bank of Canada increases interest rates to reduce inflation.
By decreasing the money supply and increasing the interest rate, the government will decrease the
aggregate demand in the economy. In doing so, this decreases real GDP in the economy and decreases
the price level in the economy. The market was producing over-potential before, and now it will produce
at potential.
If the bank of Canada implements an expansionary policy when a recession has actually just ended, they will
increase real gdp too much resulting in inflation.
REFER TO TABLE 11.1 ON PAGE 338
Monetary Policy in the Dynamic Aggregate Demand and Aggregate Supply Model
These include continued inflation, as well as long-run growth with the LRAS.
The Effects of Monetary Policy on Real GDP and the price level: A More Complete Account
To see graphs, look at page 340/341 of the textbook.
Using Monetary Policy to fight inflation - All the bank of Canada has to do is increase interest rates, as it
will induce saving and reduce spending.
Monetary Growth Rule - A plan for increasing the quantity of money at a fixed rate that does not require
changes in economic conditions. Milton Friedman wants the bank of Canada to use the money supply for the
monetary policy and not the inflation rate.
The bank of Canada cannot use both the interest rate and the money supply in setting a monetary policy.
They must choose one or the other.
Taylor Rule - A rule developed by John Taylor that links the central bank's target for the overnight interest rate
to economic variables.
Overnight Interest Rate Target = Current Inflation Rate + Real Equilibrium Overnight Interest Rate
+ ((1/2) x Inflation Gap) x ((1/2) x Output Gap)
Fiscal Policy - Changes in federal taxes and purchases that are intended to achieve macroeconomic policy
objectives.
Automatic Stabilizers - Government spending and taxes that automatically increase or decrease along with
the business cycle. (These are used in order to counter the business cycle.)
This is automatic because things like employment insurance will be paid out less in an expansion when
more people have jobs, than in a recession when people are losing jobs and more people rely on
employment insurance.)
Additionally, in an expansion when people are making more and paying more taxes, the government
receives more tax money and therefore spends more. Vice versa when an economy is in a recession.
Discretionary Fiscal Policy - This is when the government takes actions in order to change spending or
taxes, instead of letting it happen "automatically."
Fiscal Government Spending as a percentage of total government spending - Has been declining
over the last 50 years.
This is mainly due to the federal government passing some responsibilities off to provincial and territorial
governments. Examples of this include the regulation of motor ways and management of forestry and
natural resources.)
Additionally, a greater percentage of the government's budget has been going to healthcare, especially
over the last 20 years.
While healthcare is mainly a provincial responsibility, the government of Canada helps them out
through Health Transfers.
Where Does the Money Come From?
The government earns roughly 49% of its income from personal income taxes. (Taxes people pay on every
dollar they make.)
How will the government (federal, provincial, and territorial) afford the new-coming wave of
seniors?
Cut spending in other areas (probably the best solution.)
Run a budget deficit by borrowing from investors (future tax payers will have to pay for this plus the
interest it costs the government.)
Increase tax rates (This can have a negative impact on the economy and make people unhappy in
general and with the government.)
The Effects of Fiscal Policy on Real GDP and the Price Level
The government can use fiscal policy (I.E. government spending) in order to influence the economy.
Decreasing government spending will decrease aggregate demand, while increasing government
spending will increase aggregate demand. This can have an effect on real GDP, employment levels, and
the price level .

Expansionary and Contractionary Fiscal Policy

Expansionary Fiscal Policy - Involves increasing government purchases or decreasing taxes.
An increase in government purchases will increase aggregate demand directly.
A decrease in the tax rate has an indirect effect on aggregate demand. Households will have more
disposable income the less they are taxed and will therefore spend and invest more, increasing
aggregate demand. This will cause a shift right in the AD curve, increasing real GDP as well as the
price level.
Contractionary Fiscal Policy - Involves decreasing government purchases or increasing tax.
A decrease in government purchases will decrease aggregate demand directly.
An increase in the tax rate has an indirect effect on aggregate demand. Households will have less
disposable income the higher their taxes are, and will therefore spend and invest less, decreasing
aggregate demand. This will cause a shift left in the AD curve, decreasing real GDP as well as the
price level.
Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model
(Dynamic aggregate supply and demand model includes the fact prices rise almost every year, and the LRAS
curve shifts right almost every year.)
Expansionary Fiscal Policy - In the dynamic aggregate supply and demand model, an expansionary
fiscal policy is years when year to year, AD does not increase enough to match the equilibrium of the next
year's LRAS. This causes real GDP to be too low and the price level to also be too low. But using this
policy, the government can bump the AD up to where it should be for the new year at equilibrium. (NOTE,
PAGE 372 OF TEXTBOOK FOR REFERENCE.)
Contractionary Fiscal Policy - Used for the opposite function of expansionary. If AD increases past
equilibrium, this brings it back to normal.
The Government Purchases and Tax Multipliers
Multiplier Effect - The series of induced increases in consumption spending that results from an initial
increase in autonomous expenditures
Government Purchase Multiplier = Change in Equilibrium Real GDP / Changes in Government
Purchases
Tax Multiplier = Changes in Equilibrium Real GDP / Changes in Taxes
The Effects of Changes in Tax Rates
A cut in tax rates increases the size of the multiplier effect.
A rise in tax rates decreases the size of the multiplier effect.
Taking into Account the Effects of Aggregate Supply
Since the SRAS curve is upward sloping, real GDP does not increase as much as the multiplier says it will.
The Multipliers Work in Both Directions (I.E. They can be negative.)
Pretty self-explanatory. They work two ways.
Crowding Out - A decline in private expenditure as a result of an increase in government purchases.
Crowding Out in the Short Run
By increasing government spending will increase income and real GDP. The increase in chequing account
balances will accommodate the new buying and selling. This will cause the demand and supply for
currency to go up. (Notes graph on page 380.)
Crowding out can reduce the effectiveness of an expansionary fiscal policy. (Note graph on page 381.)
Crowding Out in the Long Run
Many economists agree that an increase in government spending in the long run results in complete
crowding out. Think about it as if government spending is 35% of the economy before an expansionary
fiscal policy, that means consumption, net exports, and investment are 65%. If you increase government
spending to 37% through the expansionary policy, then the rest of the economy must fall to 63%.
Deficits, Surpluses, and Federal Government Debt
Budget Deficit - The situation in which the government's current expenditures are greater than its
current tax revenue.
Budget Surplus - The situation in which the government's current expenditures are less than its current
tax revenue.
How the Federal Budget Can Serve as an Automatic Stabilizer
Deficits occur automatically during recessions.
Cyclically adjusted budget deficit or surplus - The deficit or surplus in the federal government's
budget if the economy were at potential GDP.
Expansionary Fiscal Policy results in a cyclically adjusted budget deficit.
Contractionary Fiscal Policy results in a cyclically adjusted budget surplus.
Should the Federal Budget Always be Balanced?
Few economists believe that the government should try to balance the budget for every year.

This is because in a recession, the government is naturally in a deficit, and naturally in a surplus
when the economy is expanding.
It simply wouldnt make sense, as the government would have to cancel all expansionary fiscal
policies just for the end of the year to get a balanced budget, and then restart again.
The Federal Government Debt
The total value of bonds outstanding, which is equal to the sum of pas budget deficits, net of surpluses.
Over the years, the gross federal debt has grown, meaning there are more government bonds available
for purchase.
Is Government Debt a Problem
Same as household debt, as long as the government can afford the payments on the debt, it is okay. If
they can't, they will need to cut back on spending.
While the government cannot default on debt, they may have to raise taxes in order to be able to pay
their debts.
The Effects of the Fiscal Policy in the Long Run
Most of the aggregate demand oriented goals are short-run. Fiscal policy that intends to work towards
long-term macroeconomic objectives is referred to as supply-side economics, and has to do with
increasing the incentives to work, save, invest, or start a business.
The Long-Run Effects of Tax Policy
Tax Wedge - The difference between the pre-tax and posttax return to an economic activity.
The fraction of each additional dollar of income that must be paid in taxes.
(I.E. if you are paid $20 an hour, and the tax rate is 25%, the after-tax wage is $15.)
Effects on Aggregate Supply Cutting Each of the Following Taxes
Individual Income Tax - Reduces the tax wedge workers face, increasing the quantity of labour
supplied. Households are also taxed on interest at the rate by which they are taxed, so reducing this rate
increases the incentive to save.
Corporate Income Tax - Cutting this rate could encourage firms to invest more in their business since
they will have more disposable income. Innovation leads to advancements in technology, so if tax rates
fall it could increase the speed of technological advancement.
Taxes on Dividends and Capital Gains - Reduces the double taxation on the money received by
shareholders as dividends (because the firm already paid tax on the money.)
Tax Simplification
The Canadian tax system is very complex, creating a market for businesses like H&R Block. This could be
considered a waste of resources, because if taxes were simple and people could do them themselves,
then the entire industry used for this could be available in other industries.
The Economic Effect of Tax Reform
Tax reductions can cause LRAS to increase and shift right because there is more money to invest and
spend in the economy.
Tax increases can cause the LRAS to decrease and shift left because there is less money to invest and
spend in the economy.
Monetary Policy can be changed faster than fiscal policy.
The Discovery of the Short-Run Trade-Off Between Unemployment and Inflation
Phillip Curve - A curve showing the short-run relationship between the unemployment rate and the inflation
rate.
Each point on the Phillips curve represents one possible combination of unemployment and inflation that
may be experienced in a given year.
Curve slopes down to the right, with inflation on the X-Axis and the unemployment rate on the YAxis.
Is the Phillips Curve a Policy Menu?
Structural Relationship - A relationship that depends on the basic behavior of consumers and firms and that
remains unchanged over long periods.
Economists in the 60's argued the Phillips Curve represented a structural relationship. This would mean
that economists could use this as a basis for writing economic goals and principals because it represented
a fixed relationship between unemployment and inflation.
This was later discovered to not be true
Is the Short-Run Phillips Curve Stable?
As discovered in the late 60's when there began to be a difference in the unemployment rates and inflation
rates, the Phillips curve was in fact not a representation of a permanent trade-off. In the long-run, there is no
direct correlation between unemployment and inflation. It is only a trade-off that exists in the short-run.
The Long-Run Phillips Curve
Natural Rate of Unemployment - The unemployment rate that exists when the economy is at potential GDP.

In reality, in the short run unemployment will fluctuate, but when the economy is at potential GDP, it will
always return to the optimal level. The same thing goes for GDP, an economy can be at potential GDP,
but in the short run GDP will fluctuate.
Therefore, the inflation rate has no effect on the unemployment rate because the unemployment
rate is always equal to the natural rate of unemployment in the long run.
The same goes for a lower price level having no influence on real GDP, because in the long run real
GDP is always in equilibrium regardless of the price level.
The Long-Run Phillips Curve is a vertical line
The Role of Expectations of Future Inflation
Even though during the 1950s and 1960s there seemed to be a long-term trade-off between unemployment
and inflation, Friedman argued that the numbers from the 50's and 60's actually show a short-term
relationship.
The reason for this is when firms expected inflation to be higher or lower than it actually was, the
unemployment rate fluctuated along with their incorrect guesses. Therefore, it made it look like there was
a relationship between the two, when there really wasnt.
Real Wage = Nominal Wage / Price Level x 100
If actual inflation is greater than expected inflation, the actual real wage is less than the expected real wage,
and the unemployment rate falls.
If actual inflation is lower than expected inflation, the actual real wage is more than the expected real wage,
and the unemployment rate rises.
The Short-Run and Long-Run Phillips Curve
Not really sure Need to look into this. What is the relation between the two?
There is a short-run Phillips curve for every level of expected inflation. Each Short-Run Phillips Curve intersects
the long-run Phillips curve at the expected inflation rate.
How Does a Vertical Long-Run Phillips Curve Affects Monetary Policy?
If the Bank of Canada were to use expansionary policies to push the economy to an unemployment rate below
the natural rate, staying at that point on the graph for long enough would raise the long-run expected inflation
rate, increasing the short-run Phillips Curve. (Note page 416)
If the bank of Canada were to use contractionary policies to push the economy to an unemployment rate
above the natural rate, staying at that point on the graph for long enough would lower the long-run
expected inflation rate, decreasing the short0run Phillips Curve. (Note page 416)
Nonaccelerating Inflation Rate of Unemployment (NAIRU) - The unemployment rate at which the
inflation rate has no tendency to increase or decrease.
Expectations of the Inflation Rate and Monetary Policy
How long can an economy remain at a point that is on the short-run Phillips curve but not on the long-run
Phillips Curve? It all depends on how quickly firms and workers adjust their expectations for the economy.
Low Inflation - When the inflation rate is low, workers and firms tend to ignore it, and dont really pay
attention to it. For example, if inflation is low, a restaurant may not want to pay for printing new menus that
would show slightly higher prices.
Moderate But Stable Inflation - When this occurs, firms and workers are expecting that from year to year,
the inflation rate will stay generally the same and therefore they will adapt to what they expect will occur in
the long run based on the current rate of inflation and unemployment.
High and Unstable Inflation - Firms and workers who miscalculate the expected inflation can suffer severe
wage gaps and profits losses - firms and workers would try to adapt to these new inflation rates as fast as
possible in accordance to the other options.
Rational Expectations - Expectations formed by using all available information about an economic variable.
The Effects of Rational Expectations on Monetary Policy
If workers and firms ignore inflation, or if they have adaptive expectations, an expansionary monetary policy
will cause the short-run equilibrium to move to a point where inflation is higher and unemployment is lower.
In the short run, if firms and workers have rational expectations, then the short-run equilibrium will move up
the long-run Philips curve, resulting in increased inflation but no change in the unemployment rate.
Note page 419 for a graph of the above.
Leverage = Total Assets / Total Assets - Liabilities
l=A/A-L

Open Economy - An economy that has interactions in trade or finance with other countries
Closed Economy - An economy that has no interactions in trade or finance with other countries.
Balance of Payments - The record of a country's trade with other countries in goods, services, and assets.
Balance of Payments Includes three different "accounts."
Current Account - The part of the balance of payments that records a country's net exports, net income on
investments, and net transfers.
Records current or short-term flows of funds into and out of a country.
The Balance of Trade - The difference between the value of the goods a country exports and the
value of goods a country imports.
Net Exports = Balance of Trade + Balance of Services
The Financial Account - The part of the balance of payments that records purchases of assets a country has
made abroad and foreign purchases of assets in the country.
Capital Outflow - When an investor in Canada invests in bonds issued by a foreign government.
Capital Inflow - When an investor outside Canada invests in Canadian Bonds.
Net Foreign Investment - The difference between capital outflows and from a country and capital
inflows, also equal to net foreign direct investment plus net foreign portfolio investment.
Net Capital Flows = Capital Outflows - Capital Inflows.
The Capital Account - The part of the balance of payments that records relatively minor transactions, such
as migrants' transfers and sales and purchases of non-produced, nonfinancial assets. (A non-produced,
nonfinancial asset are things like copyrights, patents, natural resources, etc.
Why is the Balance of Payments Always Zero?
Even if the current account and financial account dont add up to zero, statistics Canada includes an entry
called the statistical discrepancy. They do this because if the accounts dont end up equaling zero, there was
error in the calculations of the capital inflows or capital outflows somewhere.
The proper explanation of this is on page 439 (I'm feeling lazy..)
The Foreign Exchange Market and Exchange Rates
If a company is international, they may receive payments and have to make payments in various difference
currencies and therefore have to deal with exchange rates.
Nominal Exchange Rate - The value of one country's currency in terms of another country's currency.
Page 441 has a whole bunch of info on this stuff, but I understand it so Just for reference.
Three Sources of foreign currency demand for the Canadian Dollar
Foreign firms and households that want to buy goods or services produced in Canada.
Foreign firms and households that want to invest in Canada (through direct investment - I.E. Factories, or
portfolio investment - stocks and bonds.)
Currency traders who believe that the value of the dollar in the future will be greater than it is now.
Equilibrium in the Market for Foreign Exchange
The higher the value of the dollar, the less dollars will be demanded. The lower the value of the dollar, the
more dollars that will be demanded.
You are more likely to buy 20million worth of TV's if the exchange rate is 200 yen to a dollar than 100 yen
to a dollar, because the dollar is worth more so you want to trade it for yen.
Just like any other graph, there is an equilibrium exchange rate. Anything above that rate and there
is a surplus. Anything below the equilibrium and there will be a shortage.
Currency Appreciation - An increase in the market value of one currency relative to another currency.
Currency Depreciation - A decrease in the market value of one currency relative to another currency.
How do Shifts in Demand and Supply Affect he Exchange Rate?
Three main factors can cause the demand and supply curves for foreign exchange to shift.
Changes in the demand for Canadian-produced goods and services and changes in the demand for
foreign-produced goods and services.
Changes in the desire to invest in Canada and changes in the desire to invest in foreign countries.
Changes in the expectations of currency traders about the likely future value of the dollar and the likely
future value of foreign currencies.
Shifts in the Demand for Foreign Exchange

If there is an increase in demand for Canadian goods, there will be an increase in demand for Canadian dollars
at every given possible exchange rate.
If there is an increase in investment in Canada, the demand for currency will increase and the demand
curve will shift to the right.
If there is a predicted increase in the value of the Canadian dollar in the foreseeable future, the
demand curve will shift to the right.
Shifts in the Supply for Foreign Exchange
If there is an increase in demand for foreign goods, Canadians will increase the supply of Canadian currency
available as they convert to foreign currencies to buy products. Therefore an increase in demand for foreign
goods shifts the supply curve of Canadian dollars to the right.
An increase in foreign investment will cause Canadians to exchange their Canadian dollars for foreign
currency, shifting the supply of Canadian dollars to the right. (Occurs when the interest rates in other
countries increase.)
An increase in the foreseeable value of foreign currencies will cause investors to trade their
Canadian dollars for foreign currency, increasing the supply of Canadian dollars and shifting the
supply curve to the right.
Some exchange rates are not determined by the market, as currencies like China's Yuan was fixed to 8.28/USD
for over 10 years.
If it costs more to buy a currency, the dollar has depreciated against it.
If it costs less to buy a currency, the dollar has appreciated against it.
Real Exchange Rate = Nominal Rate x (Domestic price level / Foreign price level)
1.15 = 1.1 x (105/100)
Current Account Balance = (- Financial Account Balance)
Net Exports = Foreign Investment
National Savings = Private Savings + Public Savings
Private Savings = National Income - Consumption - Taxes (S Private = Y - C - T)
Government Savings = Taxes - Government Spending (S Public = T - G)
National Savings = Domestic Investment + Net Foreign Investment (S = I + NFI)
Monetary Policy in an Open Economy
(Expansionary) Lower interest rates in Canada will cause investors to invest elsewhere, and the exchange rate
of the Canadian dollar will decrease.
This will decrease the price of Canadian goods in relation to foreign goods, and therefore increase our net
exports.
(Recessionary) Increased interest rates in Canada will increase the exchange rate of the Canadian Dollar, which
will cause the price of Canadian goods to increase relative to others, and decrease net exports.
Overall, monetary policy has a greater effect in an open economy than a closed economy.
Fiscal Policy in an Open Economy
Higher interest rates lead to an increase in the foreign exchange rate of the dollar, and a decrease in net
exports. Therefore, in a closed economy due to the crowding out effect the fiscal policy can be less useful than
in a closed economy where only C and I are crowded out.
Lower interest rates lead to additional foreign investment, offsetting some of the decreased domestic spending
in the economy. Therefore, this is less effective than in a closed economy.
Floating Currency - The outcome of a country allowing its currency's exchange rate to be determined by
demand and supply.
(Some countries try to keep their currency locked with another country's currency, so this is an alternate
method.)
Exchange Rate System - An agreement among counties about how exchange rates should be determined.
Managed Float Exchange Rate System - The current exchange rate system, under which the value of most
currencies are determined by supply and demand, with occasional government intervention.

Fixed Exchange Rate System - A system under which countries agree to keep the exchange rates amount
their currencies fixed for long periods of time.
Bretton Woods System - An exchange rate system that lasted from 1944 to 1973, under which countries
pledged to buy and sell their currencies at a fixed rate against the dollar.
The Current Exchange Rate System
The current exchange rate system has three important aspects:
Canada allows the dollar to float against other major currencies.
Seventeen countries in Europe have adopted a single currency, the Euro.
Some countries have attempted to keep their currencies' exchange rates fixed against the US dollar or
another major currency.
What Determines Exchange Rates in the Long Run
Over the short-run, the two most important factors in determining the exchange rate are the interest rates and
the changes in investors' expectations about the future of the currency.
The Theory of Purchasing Power Parity - The theory that in the long run, exchange rates move to equalize
purchasing powers of different currencies.
In theory, this means if one pound buys a chocolate bar, and one Canadian dollar buy a chocolate bar,
these currencies, in respect to chocolate bars, have the same purchasing power.
If a chocolate bar costs 2 pounds but one dollar, the purchasing power between the two currencies is not
equal, and therefore the exchange rate will need to be adjusted in order to make the purchasing power
between the two countries equal.
Three real-world complications that keep purchasing power parity from being a complete
explanation of exchange rates, even in the long run.
Not all products can be traded internationally - Lots of goods produced in different
countries are not available for trade. (Think Nissan Skyline R32, R33, R34)
Products and consumer preferences are different across different countries - Prices
of different products can differ from country to country based on consumer taste and demand.
(Think, each country may have a different supply and demand curve for a given product,
changing the price of it.)
Countries Impose Barriers to Trade - Tariffs or quotas can cause there to be a shift in
demand, supply, and overall price in a different country, therefore validating a difference in
cost from country to country.
The Four Determinants of Exchange Rates in the Long Run
Relative Price Levels - This being the most influential determinant, if the price of goods and services rises
faster in Canada than in the US, the value of the Canadian dollar must decrease in order for the demand for
Canadian goods to stay afloat.
Relative Rates of Productivity Growth - If firms can produce more with less, the cost of production will go
down and therefore so will the price levels. If the price levels in Canada go down compared to the US, the value
of the Canadian dollar must rise in order to keep things level.
Preferences for Domestic and Foreign Goods - If US consumers become more interested in purchasing
Canadian goods, this will increase the demand for Canadian currency and therefore increase the value of the
currency.
Tariffs and Quotas - Increasing the price of foreign goods, there will be a greater demand for Canadian goods
and therefore the Canadian dollar, increasing the value of the dollar.
Pegging Against Another Country
This can have a positive impact when a country has high levels of trade with another country.
For example, if Honda exports cars to Canada and the value of the Japanese (yen?) increases, this may
cause Honda to force prices in Canada up reducing sales. If the exchange rate between the Japanese Yen
and Canadian dollar are fixed, this would not be a problem.
The same can be said for when a company builds a factory in another country; if the exchange rate changes,
this could mess up interest payments and such, which is another reason it is good to have a fixed exchange
rate with some counties.
Pegging - The decision by a country to keep the exchange rate fixed between its currency and another
country's currency.
International Monetary Fund (IMF) - An international organization that provides foreign currency loans to
central banks and oversees the operation of the international monetary system.

The Decline in Pegging - After disastrous events experienced by east Asian countries, the number of
countries pegging exchange rates have fallen. It is now mostly used with small countries who peg a larger
country they do most their trading with.
International Capital Markets
There has been a huge increase in the purchase of foreign bonds/stocks after restrictions were lifted in Europe
in the late 90's.
The greatest amount of portfolio investment occurs in the states, with over 60% of the entire world's
foreign investments going into the states.

Canadian Statistics.
February Total CPI - 1.4%
February Core CPI 1.9%
Overnight Target Rate 0.5%
Bank Rate 0.75%
February Unemployment 7.3%
February Hours Worked All Sectors 600,928.7 Hours
Canadas Real GDP (2007) for 2014 1,747,709 Million
Ontarios Real GDP (2007) for 2014 648,352 Million
Current Account Balance for 2015 (-65.7) Billion
Goods + Services balance for 2015 23,969.3 Million