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Economics Final Sheet: Eqn = equation, G&S = goods and services, EC = economic, FM = financial markets, UNE = unemployment, EQ=equilibrium, D=demand, S=supply, IR=interest rates, =increase Chapter 1 What is economics? Economic agents firms, govt, household Economic problemhow societies deal w/ providing for the economic well-being of citizens. Society needs to decide on: what G&S to produce, how many, methods to produce G&S, who gets produced G&S. Scarcityinsufficient resources to produce all desired G&S. Opportunity cost (OC)value of best alternative forgone-- not value of all choices. People are rational-make best possible choice given available info. Econ agents act only if MB (extra benefit from action) > MC (extra cost from action, an OC). Types: 1) money OC expressed in money ($80 for textbook), but true OC=best alternative w/ money (8 CDs), 2) Time costOC includes value of time to achieve activity, 3) external cost OCs of decisions borne by other people (person beside didn't shower, you bear part of cost). OC in actionvalue of uni degree (student's time). Basic resources for production: labour, land (natural resources), capital (roads). Limited resourceslimit to G&S produced, choose which G&S to produce. Trade allows individuals/countries to specialize in production of G&S they are good at. Trade w/ others for G&S they produce more cheaply. Don't need to produce all needs/wants to consume. Total economic output will be higher if individuals stick to their specialties. 3 basic ways of social coordination: tradition, command, and the market. Net benefits=total benefits-total costs. Ppl respond to incentives. Chapter 2 Economic markets -Market power dependent on market size of buyers/sellers/available substitutes for good produced. muffin. utility from eating ittotal benefit(monetary equivalent). Total benefit is willingness to pay for so many units of the muffin. Willingness to pay for one more unit = marginal benefit (MB). Individuals compare MB to price of good, and buy it only if MB > price. At low price, MB > P for lots of people, so total D is high. Result: downward-sloping D curve as price of a good rises, the total quantity demanded for the good falls. Bottom line: As price of a good rises, most individual consumers buy less, and some consumers exit the market. As a result of each effect, as the price rises, the quantity demanded (per day/week/year) falls. in relevant vars beside own-price affect D. Substitute-good that can be used instead of another good. Bun price risesD should fallD for muffins risesD curve shifts right. At price P, original demand was Q0, but after some bun buyers shifted to muffins, at P0 a quantity demand of buns of Q1 > Q0. If price of substitute good rises, D for other related good will . Complementgood consumed in conjunction w/ another good (muffins & coffee). If price of complement good , D for other related good will fall. Income change- types of goods: normal goods (D rises if your income rises, like muffins), or inferior goods (D falls if your income rises, like less McDonalds). At each price of McDonalds, the quantity demanded would fall. Shift left in D curve, own-price held constant. Other related variables expected future price, population, quality. Ceteris paribus-hold constant all other factors. Change in own-price on demand for good: there are no other changes in the other factors that affect Dchange in quantity demanded shift ALONG curve. Else change in D. (if price held constant, and population increases, D will shift to the right). Firm supply. In market model, supply by firms. Operate to make profits=revenues-costs. 2 crucial variables: price of good and cost of production. Firms will supply extra unit only if they receive a profit (P MC). MC extra cost to produce 1 more unit (OC). Some firms produce G&S cheaper. As firm produces more goods and adds extra staff, MC rises. As prices rise, more and more firms enter market. S curve relationship between quantity supplied of a good (by firm per time period) and its price, cet par.Other factors affect S curve other factors can change MC. A) Input prices if price of inputs in production process rise, MC rises, firm supplies less at each market price curve shifts left/up, reflecting higher price to produce same amount of output. B)Technology. Better techMC fallsmore supplied at each market price. S curve shifts down/right. C) If price of substitute in production rises, supply of current good shifts left. D) If number of firm increases, supply of product increases. Market EQ: S&D. Price plays important role in signalling to buyers and sellers to whether buy/sell. Urge to make profits/surplus is incentive to follow those signals. D&S curves show quantities demanded/supplied at various prices. EQ-at trading prices, all buyers can find sellers, vice versa. At EQ, quantity demanded=quantity supplied (intersection of S&D). When not at EQ, you have excess supply (disequilibrium).

Chapter 3 Macroeconomic cycles and growth (house=investment, not consumption!!)

Gross Domestic Product (GDP)measure of economic well being=total econ output of country over a year=a measure of total market value of all final G&S produced in a country. Nominal GDP monetary or current market value of total output at current year prices. Real GDP = (nominalGDP/price level) controls inflation impact by measuring using prices of a single "base" year (2002). Real GDP measures actual quantity of G&S consumed in economy0 better estimate of economic well-being of avg person, good for comparisons of economic well-being over time. Problems with real GDP omits G&S not sold on markets (leisure), hidden from govt (illegal), so not true economic well-being. Real GDP uses market prices, better to use purchasing power parity to compare b/w countries. Circular flow of income and expenditure Stylized view; G&S sector (product markets), financial sector (financial markets), resources sector (resource markets). Simplified view of 4 economic agents: households, governments, firms, world, showing both real flows & monetary flows to and from agents. Householdsown factors of productionlabour, capital, land, entrepreneurial abilityand rent/sell these to firms in resource markets. Receive domestic income (Y) from firms. Use part of income for consumption G&S (C) from firms. Save (S) part of income for future expenditure/retirement by putting money in banks, stock market. May receive transfer payments from govt (old-age pension/EI/welfare). net taxes (T) = taxes transfer payments, flow from households to govt.Firms pay factor payments (wages&salaries/rent/interest payments/dividends) to households for factors of production in resource markets. Receive revenue from sale of C goods from households. Pay taxes to govt, receive govt subsidies (pretend these flows only go from households to govt for simplicity). Borrow from financial markets to finance purchases of investment goods (I) like factories/trucks/computers. Govts all levels of govt. Tax revenues from households and firms. Pay subsidies to firms and transfer payments (EI) to individuals, yielding net taxes (T). Govt buy G&S from firms (govt expenditure (G)), leads to flow of funds to firms. If G > taxes, then budget deficit, and must borrow money from financial markets. If budget surplus, pay off some of their outstanding debt eventually, results in flow of funds from govt back into financial markets. Foreign sector buy our G&S (exports (X)), so they pay us money. Sell us G&S (imports (M)), so we pay them. Net exports (X-M) = exports imports. If imbalance b/w X and M, then one side or the other must borrow. Circular flow figureX-M is positive. Foreigners need to borrow from financial markets to pay for extra X they cannot finance from selling us imports. Aggregate markets goods market (ch 5), financial markets (ch 9), resource markets under unemployment (ch 4). Formulas-production occurs in firms, who pay income to factors of production (Y) to produce G&S to sell to C, I, G, X-M. Firms' sales must = total expenditure on G&S, since they are two sides of the same transactions: household buys good (expenditure), firm receives the money (sales). This total expenditure is called aggregate expenditure (AE). Total domestic income (Y) must = firms' revenues. (5.3) Y = AE = C + I + G + X M. How StatsCan measures GDP. 1) Expenditure. Nominal GDP measures value of production in given year in prices of that year. Circular flow: what's produced is purchased by households, firms, govts and rest of world. (5.4)value of production=expenditure=C+I+G+X-M. 1 way of measuring nominal GDP is to measure value of all G&S purchased: personal expenditure on G&S+business investment(new capital+new inventories+new homes)+govt expenditure on G&S(not transfer payments)+net exports(need to net out imports b/c not domestic production). 2) Income. Circular flow: earnings from productionpay for factors of production (value of production=factor incomes). income: wages, salaries, supp labour income+corporate profits+interest and misc. investment income+farmers income+income from non-farm unincorporated businesses. 2 sets of adjustments: add value of indirect taxes (subsidies) and add value of depreciation. This yields GDP values for income approach. Nominal and real GDP. above calcs give value of nominal GDP. Nominal GDP can rise from year to year b/c price of goods rise or quantity produced rises. StatsCan control price levels between years with chained-dollar methodcaptures only changes in real quantity of G&S produced. Thus, real GDP measures real value of production. Compare real GDP b/w 2 yearsknow change in production.Using GDP to measure economic growth/cycles-upward trend in GDP=long-term econ growth, fluctuations=changes in business cycle. Long-term growth. Upward trend reflects growth in potential GDP. potential GDP value of real GDP when all the economy's labour, capital, land and entrepreneurial ability are fully employed. Growth in potential GDP=growth in labour, etc. Part of it is from population growth. Business cycleChapter 4 Unemployment and inflation measure economic well-being, like real GDP. If high, low levels of well-being. Hurts society b/c lost real GDP and higher crime rates. Inflation erodes spending power of families, especially those on fixed incomes. Unemployed = frictional + seasonal + structural + cyclical. To be officially unemployed, must be actively seeking work in the last 4 weeks, expecting to be recalled from a layoff, or waiting to start a new job within 4 weeks.(4.1) unemployment rate = (unemployed / labour force) x 100, not seasonally adjusted. Involuntarily unemployed people working part-time who would prefer full-time work. Discouraged workers have quit looking. Recessions have delayed but powerful impact on unemployment. Job recovery lags behind economy. Unemployment differs b/w regions. Unemployment & full employment. Employment determined by labour S and labour D, and minimum wage and labour unions. Determined when labour demand = labour supply in market EQ. Labour D from employers who hire labour to produce G&S (labour demand = derived demand). Price of produced good goes up or workers are more productive (more output/hour)firms supply more goodsdemand more labour. Wage rate (incl benefits) goes uplabour cost goes upfirms want less labour. Real wage rate=nominal wage rate (W) / price level (P). Labour S from households; compare entering workforce to best alternative (OC). If working-age population rises, usually labour S will too (shift right in curve). If real wage rate rises, some of those who are working will work more hours, some of those out of labour force will enter labour force and give up next best alternative (schooling, family business). Net result of these 2 factors is that labour supply will as real wage rate . Labour market flows. When labour D=labour S, still natural unemployment--always flows of workers in/out of jobs/labour force, even in boom times. Most flows of people in/out of jobs are job changersnot unemployed for any serious amount of time. Some people in/out of labour force who lose their jobs for some time b/c they haven't found a job yet create natural unemployment. Types of natural unemployment: frictional, seasonal and structural. Frictionalnormal labour market turnover (temp unemployed, find better job). Seasonalnormal part of economy. Seasonal peaks in unemployment rate so natural rate rises in winter, as derived demand for construction workers, etc falls off. In dynamic economy, SOME seasonal&frictional is economically beneficial. Society benefits b/c workers find jobs in which they are more productive. Market cures for frictional and seasonal private job search, advertising by firms and job-seekers, private employment centers like Workopolis. Govt cures for frictional and seasonal govt job centres, EI benefit. Structural permanent job losses in industries/regions that have permanently declining demand for labour due to structural change in economy (shift in export/import/automation) (need to retrain yourself, relocate yourself, or retire). Market cure private incentives to retrain workers. Govt cures subsidized retraining, helping to pay for regional relocation. Cyclical-sharp spikes during recession. 0 in boom times, positive in recessions b/c layoffs. Initiated in fall of labour D, from fall in total production in econ, from fall in D for G&S. Increased by fact that wages are sticky-adjust downwards too slowly. Real wages are too high in recessions. Market: lower wages, govt cure: G spending Inflation and price index. Price level-avg level of prices. Price level is measured by price index-weighted avg of prices in Cdn econ. Most commonConsumer Price Index (CPI)- measure cost of buying basket of goods that avg Cdn household would buy, compared to buying same basket in base year of 2002. Oct 2010 CPI=117.4, means it costs 17.4% more to buy avg basket of goods than it did in 2002. We'll use CPI to measure cost of living for households, and GDP deflator as price level for aggregate economy. GDP deflator is key alternative measure of price level, which measures avg prices of goods produced by GDP. (4.2) GDP deflator = (nominal GDP / real GDP) x 100 (4.3) real GDP = (nominal GDP / GDP deflator) x 100. Inflation-measures rate of change in price index. Rate of change of CPI is positiveinflationincrease in cost of living. Rate is negativedeflation. (4.4) inflation rate normally calculated as rate of change of CPI= ((current year's price level last year's price level) / (last year's price level)) x 100. 2.2million% inflation= $1 at beginning of year is $2.2 million at end of year. Costs of inflation. Inflation is bad b/c causes unpredictable changes in money value. Value of money=quantity of G&S that can be bought for given amt of money. When econ experiences inflation, value of money falls-can't buy as many goods with $ this year as last year. Changes are especially bad if unpredictable & vary from year to year. Fluctuation creates random gains and losses to people. Pensioners lose from such occurrences. Randomness forces people to try and protect themselves from inflation-diversion of resources like labour and capital away from production towards forecasting inflation. Deflation-rare. Still cause random fluctuations in value of money, problematic like unpredictable inflation. But value of money is rising over time. Inflations damage savers, deflations tend to hurt borrowers. Borrowers need to pay debt in more valuable currency. Deflation also affects consumer behaviour. Avg prices decline, so consumers get G&S cheaper if they wait to buy. Deferred buying creates "vicious cycle"-deflation creates lower spendinglayoffslower spendinglower prices(more deflation).

Chapter 5 Expenditure and Production Keynesian AE model. Macroeconomy EQ when supply=demand for ALL markets. Supply of G&S (production/GDP/Y)=demand for G&S (desired expenditure/AE). EQ when Y=AE or Y=C+I+G+X-M.. AE total spending on all G&S, holding constant price level. (assume prices of G&S don't changefirms adjust level of production to meet level of D and won't change prices). C is largest component of AE (60%) and fairly stable in size. I is 17%, somewhat variable. Govt spending is similar in size to I, and stable. Exports and imports are fairly high (40%) of AE, but net exports are close to 0%, quite variable in size. Why is consumption so stable, but others less so? Determinants of C & S. Consumption demand for G&S for C purposes (pizza/clothing). Include new housing as part of investment decision. Factors affecting consumption interest rates, wealth, household composition, expected future income but disposable income is most important. Household income allocated b/w Y = C+S+T. YD = Y T, allocated b/w consumption and saving (YD = C + S) (assume taxes as outside household control)

C function relationship b/w C and YD. C+S=YD, so S=YD-C. If C<YD, then S>0 households save today. If C=YD, then S=0 neither save nor borrow. If C>YD, then S<0 households consume more than income. C+ S= YD. Households consume more than income by using existing assets (dissave) (retirees), or borrow against future income (students can borrow from /parents or use parents' savings). If we have 0 income, we still want to consume minimum amount by borrowing/dissaving$80 billion=autonomous consumption indep of current YD=intercept of C function. Consumption graph-45 degree line is C=YD. Gap b/w C and C=YD is S. C function. As income rises, so does our desired C. In graph, change in C is $60 per every $100 in extra YD=slope of C function. Slope=rise/run= / YD=+60/+100=+0.6. Equation of this specific C function (in billions) of (5.1) C=80+0.6YD. C function in algebraic form as C=a+bYD, where a>0, 0<b<1. (a=intercept,b=slope) S function. S=YD-C. Substitute C. (5.3)SD=YD-(80+0.6YD)= -80+0.4YD. (5.4) S=YD-(a+bYD)= -a+(1-b)YD, where a>0, 0<(1-b)<1. a=intercept, (1-b)=slope. MPS/MPC. Last $ of YD that is earned is divided into extra C and extra S. Marginal propensity to consume (MPC)= C/ YD=C function slope. In example, MPC=0.6. Slope is constantMPC is constant. MPS = S/ YD. In example, MPS=0.4=(1-b). Constant. Shock to econ change YDchange C/Sfurther income changes. Key role played by size of impact of YD on Cand we measure this size by MPC. C, T and real GDP. real GDP YD C. Need to understand how change in real GDP changes YD. Link =taxes. (5.5)T=t0+tY. t0=autonomous taxes-taxes that don't vary w/ real GDP. t=marginal tax rate= T/ Y, and this is induced taxes-part of taxes that varies with income, and 0<t<1. If substitute (5.5) into YD definition, we get (5.6)YD=Y-T=(1-t)Y t0. If substitute (5.6) into (5.2), C function out of real GDP: (5.7) C=a+bYD=a-bt0+b(1-t)Y. We see our linkage from real GDP(Y) to C as defined by marginal propensity to consume out of real GDP (=slope of C function). (5.8) C/ Y = b(1-t). Impact of other vars on C and S. Households borrow and save, so factors other than current income affect C. 1) expected future income 2) current wealth holdingsif mutual funds/house rise in value, C increase. 3) Age of household head older households save for retirement. 4) rate of interest if high IR, people will borrow less and save more, shrinking C. each change=intercept shift up/down in C function Other components of AE. Investment spending. Firms buy capital goods (assembly lines/comps) to increase future sales. Aggregate planned expenditure (APE). Basic model of aggregate spending/AE, and what factors affect ASp, and how changes in ASp lead to changes in level of production Y. Initially assume no changes in aggregate price level.We now wish to find point of EQ expenditure when APE=real GDP. When planned spending=actual production, EQ b/c all buyers can find G&S to buy, sellers can find buyers. (5.9) AEP= (P=planned). Planned C expenditure. (5.10) Cp =(a-bt0)+bY. Assume autonomous taxes, no income taxes. This gives us the relationship of Cp to Y. Changes in wealth/expected future incomechanges in parameter a. (5.11) I = I0, G = G0, NX = NX0. (5.12) AEp = (a bt0) + bY + I0 + G0 + NX0. Equilibrium expenditure. Y*=(1/(1-b))*(a-bt0+I0+G0+NX0) Chapter 6-The Multiplier. Multiplier initial in spending will result in a multiplied or larger overall effect on total income. Multiplier (k) = real GDP / initial spending ) Shocks to autonomous expenditure. 2 parts to AE: 1) Autonomous expenditurenot affected by real GDP, but may be affected by other variables. A = ( . 2) Induced expenditure(bY)-affected by real GDP level-here that is solely part of consumption expenditure. Shock-originates as change in one of the variables that underlies autonomous expenditure. (eg. Fall in saving rate due to rise in I/G/change in X/M). Fall in saving creates rise in autonomous consumption, increasing a in consumption function (C = a bt0 + bY). Changes in autonomous expenditurechange in total expenditurechange in production(Y)increase in production crates 2nd round changeincrease in induced expenditurefurther increase in productionfurther increase in real GDP. 2nd and 3rd round effects amplify original shock. Multiplier effect final change in real GDP > initial autonomous shock. Multiplier spinoff jobs created by projects. In reality, initial change causes some neg effects that often offset initial good effects. Large-scale govt spending can drive up prices, reducing private spending, or crowd out private spending. Formula. K= Y/ I=1/(1-b)=1/(1-MPC) Multiplier process. Starts whenever change in some component of total spending (shock to consumer confidence/I/recession/G). Change in autonomous expenditure initiates multiplier. Happens indirectly by change in related variable (shock). Shockincrease in AE(intercept now higher)GDP rise2nd round of induced expenditures (C)multiplier. Chapter 7 AD-AS: price level (avg price in economy) is key variable, and how AD and AS react to price level. AD= relationship b/w real GDP demanded (includes AE, so C+I+G+X-M) and the price level = total quantity of real goods and services (Y) people wish to buy at an aggregate price level. Real GDP demanded depends on all factors underlying AE components, like changes in consumer spending/economies of trading partners/fiscal policy/investor spending, etc. Underlying factors of real GDP demanded: 1) price level, 2) expectations (about future values of variables), 3) fiscal and monetary policy, 4) world economy Start off by examining effects of changes in the price level on the AD curve, assuming all else constant. Slope of AD curve. AD curve shows us graph of how levels of AD vary with price level, cet par. Fig 7.1: AD slopes down-higher price level=less real GDP demanded. A higher price level lowers total demand for G&S b/c: -As price level rises, tends to lower value of monetary assets (eg bank accts), lowering our real wealth holdings, leading to increase in saving (to fix lost wealth). Lowers C, shifting AE curve down. Causs movement up and to left on AD curve. -As price level rises, Cdn goods > world goods in price. Our exports fall, imports rise, and econ agents substitute towards foreign goods, causing domestic spending to fall. Shifts AE curve down, creating movement up and to left on AD curve. -As price level rises, interest rate rises, which lowers C and investment spending econ agents substituting towards more future consumption. Shifts in AD curve. Fig 7.2: Rise in ADmore real GDP demanded at each price level. AD might shift because: 1) expectations of future (consumer confidencehigher C, business confidence in future saleshigher I), 2) monetary and fiscal policy (lower interest ratesmore borrowing more spending), 3) changes in world economy (higher US incomehigher X, lower ERhigher X, lower Mhigher YD). AS=total supply of G&S (YS) producers want to sell at avg price level. AS curve shows relationship b/w P and YS. Labour is most flexible factor of production b/c labour hired can be quickly changed, but capital used can't be changed as quickly. Full employment: real GDP supplied=potential GDP. SAS-assume input prices (wages) are fixed, so they don't adjust to price level-big adjustments in AS to price level changes. LASwages adjust completely to price level, leading to no change in AS in response to price level changes, although other factors like capital can affect AS. LAS-relationship b/w total supply of real GDP and price level when all factor prices have adjusted in step with changes in price level so that real factor prices are unchanged. (real wages are unchanged). If price level goes up, factor prices go up by the same.SAS-relationship between total supply of real G&S and price level when we hold constant factor prices (wages don't adjust). Factor prices don't adjust at all. In short run, sticky wages mean if price level goes up, factor prices are assumed to be unchanging. As P rises, real wage rate falls. As P rises, so does AS b/c increase in real production of G&S. simultaneous shifts. Anything that shifts LAS will shift SAS. LAS/SAS shift to right if a) supply of inputs (labour, capital) grows, b) tech improves, c) other factors change (taxes fall, incentives improve). SAS shifts. If we change factor price like wage rate, only affects SAS, not LAS. If wage rises, but revenue is same, then production will fall and SAS will shift horizontally left. If wage rises, they will supply same real GDP only if price of output rises by same amount, so that the rise in costs is offset by rise in revenues (SAS shifts up). SAS shifts right if factor prices fall. When input prices shift, no shift in LASno shift in real resources of society/potential GDP. if initiating shock is change in price level, movement along AD/AS curves. If initiating shock is any other variable, shift along AD/AS curve. Chapter 8 Understanding Growth, Unemployment, Inflation and Cycles Macroeconomic EQ when AD = AS. Short-run macroeconomic EQ real GDP demanded = real GDP supplied (AD=SAS). Long run EQ when AD=LAS=SAS. Short-run macroEQ is not automatically a long-run EQ on the LAS. Figure: aggregate price level does the adjusting to get us to EQ. If AD>SAS at current price level (P2), then firms find excess demand for their goods. Prices are pushed up, getting rid of excess demand, pushing the economy towards EQ at PE, YE. If AD < SAS at current price level (P1), then firms have excess supply (can't sell all goods), so they lower prices to get rid of excess supply, pushing the economy towards EQ at PE, YE. Full-employment (long-run) macroecon EQ (left). If SAS=AD on LAS, then real GDP=potential GDP, unemployment=natural rate, so full employment EQ. Economy is in long-run EQ, and will stay here as long if no shocks. Unemployment/below full employment EQ (center). If SAS=AD is left of LAS, then output is below potential GDP by recessionary gap. Unemployment > natural rate, so positive cyclical unemployment (eg. Current recession) Above full-employment EQ(right). If SAS=AD to right of LAS, then output above natural rate, revealing an inflationary gap. Unemployment < natural rate (shortage of labour, negative cyclical unemployment). (eg. Canada in late 1980s or in 2007) Real GDP and price level? Short-run macroecon EQ determined by AD and SAS curve positions. Long run by AD, SAS and LAS curves. EQ is influenced by factors that underlie these curves (factors that underlie G&S/financial/labour markets). To understand macroEQs, discuss what underlies AD and AS curves. AD curve discussed in chapters 5-7, factors underlying SAS and LAS curves discussed briefly in Ch 4 (labour market) and in part of Ch 7. LAS curve creates the permanent, long-run growth. Essential cause of inflation is strong shifts in AD.

How changes in AD affect real GDP and price level. Eg) Negative AD shock, like Canada in 2008-2009. Economy starts out at EQ at P0, YPOT. AD shifts left due to shock. At original price level P0, AS is still at YPOT, while AD is now at YA, leaving excess supply of YPOT-YA. Figure beside it shows situation after shock (without AD0 curve). After the shock, excess supply means firms can't sell all their goods. Their inventories rise, so they cut back on production and lower prices, lowering avg price level. Falling price level, signals to producers to produce less (leading to less SAS as outlined in Ch 7.3.2) and signals to consumers/investors to buy more domestic goods. Thus, this leads to more AD as outlined in Ch 7.2.1. Changes are represented by red arrows. Increasing AD and decreasing AS leads to new EQ where AD1=SAS0. Since SAS0=AD1 to the left of LAS, we have unemployment EQ output < potential GDP, unemployment > natural rate. Econ adjusts to full-employment EQ. Econ in below-full employment EQ. 1) No government intervention, automatic adjustment. Government does nothing, allows economy to adjust on its own. Unemployed workers will work for lower wages, and firms demand lower wages from workers. Lower wages lower labour cost to firmshire more labourproduce more output. SAS shifts right to SAS1, new EQ at full employment at P2 and YPOT. His adjustment by private sector may be slow due to labour market rigidities like long-term contracts. If it's too slow, govt will step in and speed up adjustment. 2) Government intervention. If auto adjustment too slow, it may stimulate AD by countercyclical monetary/fiscal policy. This policy pulls AD back to AD0, getting economy back to full employment at P0 and YPOT. How AS changes affect real GDP and price level. Positive shock to SAS (like oil fell). Economy starts at full employment. Fall in commodities cause shift right in SAS to SAS1 (inflationary gap). Increase in quantity suppliedexcess Sdrive down prices to new level P1increase quantity demanded(movement right along AD) increase output level to Y1. If no govt intervention, economy will adjust to YPOT on its own. Here, shortage of labour (output above potential), wages are too low, so wages would go up. Raises costs of production, and production falls. SAS shifts left back towards SAS0, converge to YPOT with some inflation. Macroeconomic schools of thought. New Keynesian-wages slow to adjust b/c labour market rigidities (sticky prices) so need for govt intervention. Monetarist theory focuses on role of monetary policy. Argues that economy adjusts to full employment quickly on its own, no need for govt intervention. New classical theorists (incl real business cycle theorists) focus on AS shocks, argue econ adjusts quickly. No need for govt intervention b/c shock is readjustment. Chapter 9 Finance, Saving and Investment (see red on circular flow) Basic financial market actions: 1) Saving/lending by households coupled w/ borrowing by firms, 2) this saving & borrowing PLUS borrowing & repaying debt by govts, 3) Households, firms, govts AND intl borrowing and lending by countries Moneywhat we use to pay for goods in economy. Financeactivity of raising financial capital. Financial capital-funds that firms use to buy physical capital (tools/instruments/buildings used in production to make G&S). Can be raised by firms by 1) borrowing from themselves with past profits (retained earnings), 2) issuing & selling new stock to share-holders, 3) selling bonds, 4) borrowing from banks. Last 3 actions done in 3 types of financial markets: stock, bond and loan markets. Buyers&sellers deal with variety of financial institutions that help them buy/sell these items, including banks, pension funds. Financial institutions simultaneously borrow and lendbank borrow from depositors and lend to households (mortgages/car loans) and to firms to buy physical capital. Financial institution net worth=market value of its lending-market value of its borrowing=value of its assets-value of liabilities. If net worth < 0, firm is insolvent (broke). Firm can be illiquid if unable to raise enough cash to pay current requirements. If illiquid firm is still solvent, it can sell off assets/borrow to meet its cash shortage and stay in business. Financial assets trade for market price in various markets (eg price of stock share in stock market). Some of these assets pay explicit interest rates (loans, bonds), others pay implicit rates of return. These interest rates are inversely related to price of asset by (9.1/9.2), holds approx. for all assets.(9.1) Price of asset = income payment / interest rate. (9.2) interest rate = income payment / price of asset. The income payment is usually set in advance by issuer of financial assets. Price set either by D&S, OR interest rate is set by D&S-not both, since one implies the other. If increase in SLFlowers interest ratesmovement down D curve (higher DLF=borrowing) (9.7) I = S + (T G) + (M X). Investment by firms in financed by 3 sources: Household saving (S). The government budget surplus (T G). Borrowing from the rest of the world (M X). Chapter 10 Money and the Financial System What's money? Not currency/wealth. If meets functions of money = money). Money acceptable as a means of payment; used to settle debts. (eg. Modern currency, gold, cattle, etc.) 3 Functions of money. 1) Medium of exchange barter: people exchange goods. Double coincidence of wants (Hungry tailor searching for shivering farmer). Monetary economy=indirect exchange. Tailor sells clothes, use money to buy food. Extra exchange compared to barter, but total costs of buying/selling are much lower b/c don't need to match double coincidence of wants. Lower transaction costs make specialization and exchange of sophisticated decentralized economy possible. 2) Store of value indirect exchange delayed purchasing power over time sell today, buy later. This function is seriously eroded by inflation, b/c money resale value declines. High inflation=people hold land, gold instead, reducing money's acceptability as medium of exchange b/c not usable as a store of value medium of exchange based on acceptable store of value function. 3) Unit of account-accounting unit, base of all transactions/bookkeeping. Money is what sales, purchases,etc are measured. Barter n(n-1)/2 prices for n goods, good priced in all other goods. Monetaryn-1 prices, denominated in money (less). Eroded by inflation, as prices change unpredictably.Money in Canada. Econ acceptable money = currency & bank deposits. Currency has no intrinsic worth (fiat money). Fiat money intrinsic worth b/c it's legal tender- accepted as payment for debts, pay taxes. Banks can't issue money, but they create bank deposit money. People deposit currency in banks for safekeeping,etc. Cash often just moves b/w accts, not totally redeemed. Banks can lend out some surplus reserves to make new money (money multiplier). This money is underpinned by confidence in bank issuing money (and in govt deposit insurance behind your acct), and b/c it is exchangeable for currency. What isn't money. Enhance transfer of money, but fail functions of money: Electronic funds transfers, debit card, Paypal (online payments), credit cards. Measures of money. Many measures of money, incl currency in circulation+various measures of deposits. How money is used for spending - liquidityhow easy to spend money on G&S. Cash is easiest > accts that use debit cards/cheques/electronic transfers > various other non-chequable accts ( notice of withdrawal (like term deposits)). Textbook's basic defn of money:-currency in circulation M1=currency in circulation+all chequable deposits at banks and near-banks M2=M1+personal and nonpersonal non-chequable deposits (eg savings accts)+fixed-term deposits (M2 includes forms of wealth not really held for immediate spending purposes, so potentially too broad a defn of money at times.) Banking System. Depository institutions, BoC, and payments system that allows banks to make inter-bank settlements. Depository institutions. Financial markets unite lenders and borrowers. Funds flow from lendersborrowers through markets. Primary sources of lenders are households, primary borrowers are firms. Firms can move directly from household to firm via stock. However, more usual for households and firms to use financial intermediaries (mutual funds/pensions/banks) to match w/ each other. Depository institutions-subset of financial intermediaries-take deposits and give our loans=banks & near banks. -Both lender&borrower gain from intermediary services. 1) help lenders & borrowers find each other cheaply. 2) Pool together funds of many small lenders, lowering avg cost/lender (check/monitor borrowers cheaply) 3) offer lower risk to individual savers (diversified loan portfolio). 4) Offer liquidity to savers (easily take money out of bank/mutual fund, hard if invested in business)-Sources of funds to banks: deposits by households/firms/govt(main source), raise money from stock issuances, sell bonds to public. BoC lends to banks if short of funds. How banks create money. Assets: reserves, securities, loans, other assets (physical capital). Liabilities: demand deposits, time deposits, BoC bonds, equity capital. Banks create money when they create new deposits loan out excess reserves. Bank sources of funds are liabilities (deposits). Money market EQ. When money D=money S. Money S determined in short run by banking system and M policy of BoC, so in short run MS curve is vertical. In short run the nominal rate of interest is determined by BoC and monetary policy. Change in MS by BoC will change nominal rate. How is it related to LF market? In short run, nominal determined by MD&MS. In long run, LF market determines real rate of interest from S&D (and influence of global market). In long run, (10.1) nominal interest rate=real interest rate+expected inflation rate. In long run, real rate of interest=independent of quantity of money.Quantity theory of money: real GDP in long-run is fairly stable. Primary cause of inflation=excessive monetary growth. (MG rate rises by 2%, inflation rises by 2%)
Chapter 11 Exchange rates and international finance CAD is too strongdeters growth. Exchange rate value of CAD measured in foreign currency, often USD. Most of our exports/imports go to US. ER=USD per CAD. 1/ER = CAD per USD. If 1/ER = 1.0919, cost 1.092 CAD to buy 1 USD. ER is most quoted in press. To buy most Cdn goods/assets, foreigners must use CAD, so they desire to buy CAD with foreign currency, and vice versa. Actual value of ER determined by S&D in market for CAD (floating or flexible ER). Value of ER can change significantly as S&D fluctuate, even on a daily basis.Forex is foreign monetary claims, including demand deposits denominated in foreign currencies. Forex market is where 2 sides get together to make exchanges, highly developed, high turnover. If CAD becomes more valuable, it appreciates and ER rises in value (USD in turn becomes less valuable). Arbitrage (buying/selling by profit-seeking speculators) guarantees ER and 1/ER are mutually consistent, and that any 3 rates (USD, CAD, Euro) are mutually consistent. 2 types of relevant ER markets: spot market (market for current transactions, w/ delivery in 1-2 days) and forward market (market for delivery sometime in future not discussed). 3 types of spot markets: 1) fixed ER, rate is set by BoC. Rarely changes. 2) managed or dirty float, ER is technically determined by S&D, but BoC occasionally intervenes to slow/stop big movements, or to try and change rate. 3) floating or flexible ER, entirely set by S&D for CAD. S&D of CAD on forex markets. Demand for forex by Cdns and demand for CAD by forex are derived demand (like demand for labour). Cdns demand forex (supply is CAD) to buy foreign G&S (imports) and foreign-currency assets (foreign companies), vice versa for foreigners. S&Dglobal markets in G&S, global asset markets. Global market for G&S. D for Cdn exports by foreigners higher when: world demand for specific Cdn G&S is higher (commodity market boom caused by China's industrial expansion), world income is higher, Cdn goods are relatively cheaper (our prices are lower relative to world prices, or our ER is lower in value, so it takes less foreign currency to buy a CAD and thus less foreign currency to buy Cdn G&S). Demand for imports by Cdns will be higher when: Cdn demand for specific foreign G&S is higher (more winter vacation due to cold winter in Canada), Cdn income is higher (marginal propensity to import), world goods are relatively cheaper (our prices are higher relative to world prices, our ER is higher in value, so it takes less CAD to buy foreign currency and thus less CAD to buy foreign G&S).

Global asset markets. In short run, forex market dominated by asset flows- the short-term flows of money seeking to make profits from interest rate differentials. Low transaction costs make arbitrage quick and efficient billions instantly moved to get tiny % return. These flows strongly influence the market for forex in the short-run they are many times larger than the flows for sales of G&S. Eg) someone deciding to invest financially in one country or another.

i^C=nominal interest rate in Canada. i^f=nominal interest rate in foreign country. Since we're talking about investing in foreign country, we need to talk about expected rate of change of the ER. ER=(foreign currency/CAD) is the value of the ER today, define ER^e as expected Cdn ER in 1 year. Expected % change in this ER=(ER^e ER)/ER^e = % ER^e. Eg) suppose foreign speculator considering buying Cdn bonds. Risk factors are identical b/w both countries, all you care about is the return in your currency. You'll earn i^C in CAD after 1 year, but need to convert back to foreign currency, so approx interest rate you expect to make in foreign currency would be i^C + % ER^e. Ignoring transaction costs, you'd buy Cdn bonds (and thus CAD) if: i^C + % ER^e > i^f (interest in foreign currency), or if i^C > i^f - % ER^e, or if i^C > i^f expected appreciation of CAD. Invest in Canada only if you make as much as the interest rate in foreign market, including adjustment to make up for the expected appreciation of CAD. - 2) If CAD is expected to appreciate in value in the future, the demand for Cdn assets will , and thus D for CAD. The 2nd effect reflects speculation of foreign investor on what will happen to the CAD in the future. Speculation in currencies may depend on speculation about political factors, economic change, etc. (above arguments=version of interest rate parity argument). D&S curves for CAD. Figure shows market for CAD on forex markets. "price" is exchange in terms of foreign currency per CAD. D curves slope downwards, S curves slope upwards. Market equilibrium when demand=supply, and ER adjusts to get to EQ. ER fluctuations. CAD can vary strongly (S&D). Cdn exports and imports are large % of our econ, so CAD trends If, then D and S react Demand for C$ Supply of C$ can have strong impacts on firms that export/import and the workers in those firms. (Movement (Movement Canadian ER Balance of payments and intl borrowing/lending. up/left D Curve) up/right S Curve) Chapter 12 Government Budgets and Fiscal Policy World D for Cdn Exports Fiscal policy federal/provincial govt encourage economic growth/reduce unemployment and inflation. intentional World Income attempts to vary govt expenditure and/or taxes to try and stabilize the economy. countercyclical policy - counter Cdn D for World Goods the swings of the business cycle. Expansionary anti-recessionary policies meant to real GDP (raise govt Canadian Income spending or cut taxes). Contractionary anti-inflationary policies meant to decrease inflation (cutting spending or Canadian Prices raising taxes). Budget annual statement of projected revenues and spending of govt over next fiscal year, Foreign Prices usually announces fiscal policy. Based on assumptions, actual amounts may change. Govt will have microeconomic Cdn Interest Rates relative goals (help farmers) and macroeconomic goals (encourage econ growth). Federal budget developed after to World Interest Rates consultation process with business/consumer groups, other levels of govt. Prov & local budgets. Feds transfer money to provinces. Provinces raise own taxes and spend own money (mostly health care/education). Transfers to Expected Future Cdn ER local govt, who collect own taxes (property) and spend. Cities not focused as much on explicit fiscal policy. Provincial govt interested in some countercyclical policy, but not the same as feds. Govt surplus/deficit. Govt budget balance=govt revenue-govt outlays (expenditures)=taxes(+other revenues)-govt purchases-transfer payments-interest on debt If revenues>outlay, then budget balance>0, budget surplus. Otherwise budget deficit. Deficits are financed by bondfinancing-sell bonds to public so increase in govt bonds on market. Govt debt=amount of outstanding bonds increases. If surplus, govt can reduce outstanding debt by paying off some of this debt. Current govt debt=sum of all past deficits-sum of all past surpluses. A large govt deficit/debt can cause problems for economy. Stabilizing the business cycle. 1) Changes in G will affect overall spending (AE). If govt wants to increase domestic income and employment, increase G. Multiplier effect have a larger impact on real GDP. 2) Changes in taxes indirectly affect overall spending. Tax cutincrease YDgenerally increase C and Smultiplier effect of higher GDP and employment. Types of fiscal policy. Automatic stabilization-occurs in recession/boom situation w/o conscious changes by govt. Recessionless tax revenuesEI and welfare payments go upincreasing YD and Coffsets slowdown. Discretionary fiscal policy-conscious changes in tax and spending program structure to raise or lower aggregate spending (eg stimulusgovt spending to counter recession). Sometimes hard to separate the 2. Fiscal policy and AD. Basic theory of how fiscal policy would workshocks to autonomous expenditure on AE and therefore AD, eventually on price level, real GDP, unemployment. Fiscal policy=planned shock to AE. (figure for desired impactsee countercyclical figure from ch7). Expansionary policy designed to move AD back to level that will move us from below fullemployment EQ at Y1 to potential GDP at YPOThigher real GDP, less unemployment, higher price level. Fiscal policy multipliers. Actual size of fiscal policy impact on AE. Govt expenditures multiplier: Y/G = 1/(1 b(1 t) + m). An increase in G of $1 shifts AD curve rightward by G multiplier amount. Autonomous tax multiplier (only taxes like GST are changing, t0): Y/t0 = -b/(1 b(1 t) + m). Increase in autonomous taxes of $1 shifts AD curve leftware by this amount. Increase in transfer payments (negative taxes) would shift AD curve right by b/(1 b(1 t) + m).Limitations. 3 lags: time to recognize problem, pass laws, tax cuts and extra G to be rolled out. Delayed expansion may exacerbate business cycle swing. Contractionary impacts of higher deficits and higher interest rates expansionary=tax reductions, increases in spending=budget deficit. Govt deficitincrease in D for LF. May push up D for LFs enough to push up national and global interest rates. Higher interest ratesborrowing for C and I more expensive, so it would crowd-out private spending. If debt grows faster than revenue, snowball effect. Contractionary impacts of higher prices due to higher spending. Expansionaryaffect price level. If economy starts in recession (left), expansionary would shift AD right, increase price leveldecreases AD somewhat. If expansionary happens in full employment (right), then increased spending drives up prices, in the long-run has no effect on real GDP. Figures: expansionary fiscal policy and price level. Expansionary policy has strongest effect, when unemployed labour is available for hire without driving up wages and prices too much.
Chapter 13 Bank of Canada (BoC=central bank) monetary policy Monetary policycarried out by BoC and feds (together), arm of fed govt w/ some independence. Functions of BoC. 1) Lender of last resort to private banks (interest rate=Bank Rate) 2) Acceptable medium of exchangemaintain stable currency (BoC needs to avoid creating high inflation/hyperinflation, and avoid creating runs on currency in forex markets). 3) Gov fiscal agent (operate bank accts, sell bonds) 4) Promote econ welfare of country (carry out monetary policy. Primary items: 1) countercyclical policy to minimize business cycle fluctuations. 2) keep inflation rates in target band of 1-3% to minimize neg impacts of inflation) Monetary transmission mechanism complex path by which monetary policy changes work their way through modern financial system & economy. 2 policy instruments: change overnight interest rate (rate financial institutions charge each other for lending b/w close of business on 1 day and the opening of business on next day) and OMO (buying/selling govt securities on open market, usually from or to larger financial instruments). Financial institutions = private banks/credit unions/trust companies -Manipulating overnight rates in Ch 10, financial institutions profit by borrowing at low interest rates, combine these borrowings, buy various assets and/or lend out their funds at higher interest rates, so cost of sources of funds matters. At very short-term end of market (immediate funds w/ short repayment periods) are 2 sources: borrowing from BoC at Bank Rate, borrowing from other institutions in overnight market at overnight rate. BoC influences overnight rate and therefore other interest rates & private lending/borrowing by changing Bank Rate and settlement balances rate. Private banks maintain reserves in asset sheets for withdrawals of cash/interbank transfers, including holding some of those reserves as deposits with BoC. Interest rate they earn on these deposits=settlement balances rate. However if short of reserves at BoC, must borrow from BoC/private overnight market. Borrow at BoC at Bank Rate = settlement balances rate + 0.5%. BoC charges Bank Rate and settlement balances rate simultaneously when they want to affect economy, creating "target" range for overnight rate. -Private overnight market involves banks w/ too many reserves lending overnight to banks w/ too few reserves. Rate in this market is overnight rate, influenced by BoC's rates that are charged. BoC lowers its rates when it wants to lower overnight rate. Impact of changes in target range on prime rate. If BoC lowers Bank Rate and settlement balances rate, private banks can borrow cheaper from BoC than from each other. By competition, drags down overnight rate, and for each bank, source of funds is now cheaper. They want to maintain lower reserves, and loan out more money. Loan out more money by lowering interest rates like Prime Rate (short-term rate for best customer). Results in money multiplie, with strong in amount of loans and new deposits that is larger than the initial . Expansion causes shift right in supply of loanable funds (SLF). The ultimate result: lower interest rates = more lending. Figure shows fairly strong link b/w Bank Rate to Prime Rate, but not perfect link. When lowering the overnight target range is not enough, Open market operations (OMO). Overnight rate=primary policy of BoC until 2008; bank needed to use quantitative easing (OMO) to have stronger effect on money supply and bank loans. Quantitative easing-use of OMO when interest rates are 0/near 0; can't be lowered anymore. BoC enters OM for govt securities and buys securities from financial institutions. BoC pays for securities by crediting bank's settlement balances held at BoC. By pushing extra money into system, BoC creates excess reserves for private banks; now have more reserves (earning 0 interest) than they wish to hold. Private banks will be motivated to lend out these reserves, creating deposit creation. W/ money multiplier, we get multiplied increase in deposits, loans and money supply. As SLF/DLF graph shows, this results in increase in SLF & lower interest rates. To encourage customers to borrow more, private banks will lower Prime Rate and other rates they charge best customers. BoC buys up govt securities (mostly short-term Treasury Bills)supplying LF to market pushes down T-bill interest rates. Term structure of interest rates. BoC mostly affects short-term interest rates, starting with overnight rate, Prime Rate, short-term T-bill rates. Pushing down short-term rates can occur quickly. B/c long-term rates are partial substitute for short-term rates, they will fall too, but usually not as much. Monetary policy trans mech. Transmit interest rate changes in econ. Fig 13.1. BoC uses control over overnight rate+OMO to alter short-term interest rates, and via the yield curve has some effect on longer-term interest rates. -Lower interest ratelower borrowing costs for consumers and firms increase in C and I. Low interest rate lower Cdn interest rate differential lower ER and higher net exports. Result: higher AE and shift right in AD. In short-run, increased AD new macroeconomic equilibrium with higher price level and higher real GDP, as well as lower unemployment. Lags, Loose linkages and strings. in Bank Rate impact real GDP growth. Higher Bank Rateslower real GDP growth (with lag); lower Bank Rateshigher real GDP growth (with lag). High anti-inflationary Bank Rates of 1981 and 1990 led to recessions in 1982 and 1991. Quickly lowered Bank Rates of recent months have not had immediate effect. 3 factors why monetary policy might not work in reality as well. Lags in M Policy. Occur due to: recognition lags (BoC needs to recognize serious problem), transmission lags (entire process in Fig 13.1 takes time, especially takes time for changes in capital spending projects to have impact companies can't plan and build new manufacturing plant overnight). Like fiscal policy, lag means monetary policy may arrive too early/late (up to 18 months). Loose linkages b/w overnight rate and long-term rates. Firms long-term spending plans on manufacturing plants/new storestypically financed by longer-term bond issuances, and household spending on home mortgages often linked to rate on 5-year mortgages. Fig 13.5: BoC has swift impact on short-term interest rates, but less impact on long-term rates that households and firms are usinglesser impact on spending.Pushing on a string. In some recessions, monetary policy can't stimulate spending. Monetary policy works in theory by lowering borrowing costs and hoping consumers & investors spend more. If consumers&firms are fearful of future, they won't borrow. Banks won't lend if fearful. Monetary policy is ineffective-central bank is pushing on a string. Concern this is happening in Applied Analysis 13.1 in current recession. Fiscal policy may be stronger option.

Monetary Policy Rules. Pages 747-749 of the textbook discuss whether the Bank of Canada should follow policy rules or change their policies is a discretionary manner. Looking forward. Fiscal and monetary policy allow Finance Dept and BoC to theoretically offset business cycle and inflationary pressures.