econ 1022 final Flashcards

Question

The government budget balance =

Answer 1

Revenues – Outlays

Answer 2

Transfer payments – largest outlay (by a large margin) Expenditure on goods and services – appears as government expenditure in the circular flow chart Debt interest

Answer 3

During the 1960s, outlays and revenues increased. During the late 1970s and through the 1980s, outlays continued to rise but revenues fell and then remained steady. A large budget deficit arose. During the 1990s, expenditure cuts eliminated the budget deficit, and after 1997, the budget returned to surplus. A deficit re-emerged during the 2008–2009 recession, but since 2014 the budget has been close to balanced.

Answer 4

The main source in the fluctuations in revenues was personal income taxes Transfer payments swelled drastically in the 1980’s and then were cut by a large amount in the 1990’s

Answer 5

Government debt is the total amount that the government borrowing. It is the sum of past deficits minus past surpluses.

Answer 6

Debt enables the holder to buy assets that will earn a return that exceeds the interest paid on the debt. Some government expenditure is investment—the purchase of public capital (highways, universities, national defence, etc.) that yields a social return that probably far exceeds the interest rate the government pays on its debt. But Canadian government debt, which is $709 billion, is much larger than the value of the public capital stock. This fact means that some government debt has been incurred to finance public consumption expenditure

Answer 7

Economists who believe that the effects of taxes on personal and corporate income are large.

Answer 8

Income taxes change full employment and potential GDP. The supply of labour decreases because the tax lowers the after-tax real wage rate. An income tax reduces the incentive to work and thus reduces the supply of labour, then reducing labour hours, raising the wage rate, and reducing real GDP. The vertical distance between the LS curve and the LS + tax curve determines the amount of income tax. Tax wedge – The gap created between the before tax and after tax wage rate.

Answer 9

A tax on interest income reduces the incentive to save and drives a wedge between the after-tax interest rate earned by savers and the interest rate paid by firms. Taxes on consumption expenditure add to the wedge. A tax on capital income lowers the quantity of saving and investment and slows the growth rate of real GDP.

Answer 10

A tax on capital income lowers the quantity of saving and investment and slows the growth rate of real GDP. The interest rate that influence saving and investment is the real after-tax interest rate. The real after-tax interest rate subtracts the income tax paid on interest income from the real interest. Taxes depend on the nominal interest rate. So the true tax on interest income depends on the inflation rate

Answer 11

A tax on interest income decreases the incentive to save and lend and thus decreases the supply of loanable funds (SLF). In this case, the amount of tax payable is measured by the vertical distance between the SLF curve and the SLF + tax curve A higher tax rate does not always bring greater tax revenue. It brings in more revenue per dollar earned Since a higher tax rate decreases the amount of dollars earned, two forces act in opposite directions on government revenues

Answer 12

The relationship between the tax rate and the amount of tax revenue collected is called the Laffer curve. At the tax rate T*, tax revenue is maximized. If the current tax rate is less than T*, then a rise in the tax rate will increase tax revenue. If the current tax rate exceeds T*, then a rise in the tax rate will decrease tax revenue. Supply-siders emerged through Ronald Reagan’s cabinet, specifically Arthur B. Laffer. They correctly argued that tax cuts would increase employment and increase output They incorrectly argued that tax cuts would increase tax revenues and decrease the budget deficit

Answer 13

A fiscal stimulus is the use of fiscal policy to increase production and employment. Fiscal stimulus can be either ▪ Automatic or ▪ Discretionary. Automatic fiscal policy is a fiscal policy action triggered by the state of the economy with no government action. Discretionary fiscal policy is a policy action that is initiated by an act of Parliament.

Answer 14

Two items in the government budget change automatically in response to the state of the economy. ▪ Tax revenues ▪ Outlays

Answer 15

Parliament sets the tax rates that people must pay. The tax dollars people pay depend on tax rates and incomes. But incomes vary with real GDP, so tax revenues depend on real GDP. When the real GDP increases in an expansion, tax revenues increase. When real GDP decreases in a recession, tax revenues decrease.

Answer 16

The government creates programs that pay benefits to qualified people and businesses. These transfer payments depend on the economic state of the economy. When the economy is in an expansion, unemployment falls, so unemployment benefits decrease. When the economy is in a recession, unemployment rises, so unemployment benefits increase.

Answer 17

In a recession, tax revenues decrease and outlays increase. So the budget provides an automatic stimulus that helps shrink the recessionary gap. In a boom, tax revenues increase and outlays decrease. So the budget provides automatic restraint that helps shrink the inflationary gap.

Answer 18

The structural surplus or deficit is the budget balance that would occur if the economy were at full employment and real GDP were equal to potential GDP. The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit. That is, a cyclical surplus or deficit is the surplus or deficit that occurs purely because real GDP does not equal potential GDP

Answer 19

Most discretionary fiscal stimulus focuses on its effects on aggregate demand.

Answer 20

Changes in government expenditure and taxes change aggregate demand and have multiplier effects. Two main fiscal multipliers are ▪ Government expenditure multiplier ▪ Tax multiplier

Answer 21

The quantitative effect of a change in government expenditure on real GDP. The consensus is that the crowding-out effect that government deficits can have makes the government expenditure multiplier less than one If this were the only consequence of the increase in government expenditure, the multiplier would be >1. If this were the only consequence of the increase in government expenditure, the multiplier would be < 1. Which effect is stronger? The consensus is that the crowding-out effect dominates and the multiplier is <1.

Answer 22

he quantitative effect of a change in taxes on real GDP. Generally seen as less than one because the saving in disposable income will not always go towards aggregate demand, some will be saved Also decreases investment because of the crowding-out effect

Answer 23

An increase in government expenditure or a tax cut increases aggregate expenditure. The multiplier process increases aggregate demand.

Answer 24

Taxes drive a wedge between the cost of labour and the take-home pay and between the cost of borrowing and the return on lending. Taxes decrease employment, saving, and investment and decrease real GDP and its growth rate. A tax cut decreases these negative effects and increases real GDP and its growth rate. The supply-side effects of a tax cut probably dominate the demand-side effects and make the overall tax multiplier larger than the government expenditure multiplier.

Answer 25

The use of discretionary fiscal policy is seriously hampered by three time lags: ▪ Recognition lag—the time it takes to figure out that fiscal policy action is needed. ▪ Law-making lag—the time it takes Parliament to pass the laws needed to change taxes or spending. ▪ Impact lag—the time it takes from passing a tax or spending change to its effect on real GDP being felt.

Answer 26

Objective of monetary policy is ultimately political, and it stems from the mandate of the Bank, which is set out by the Bank of Canada Act. Objective of monetary policy is set out in the preamble of the 1935 Bank of Canada Act, and it is as follows: To regulate credit and currency To mitigate the fluctuation of production, trade, prices, and employment In simple terms this means it is the bank’s job is to control the quantity of money and the interest rates to control inflation and where possible prevent excessive swings in real GDP growth and unemployment.

Answer 27

The agreement of 2016 is 1. The target is defined in terms of the 12-month rate of change in the total CPI. 2. The inflation target is the 2 percent midpoint of the 1 to 3 percent inflation-control range. 3. The agreement will run until December 31, 2021. Such a monetary policy strategy is called inflation rate targeting.

Answer 28

A monetary policy where the central bank commits to an explicit inflation target. Uses the CPI as the measure of inflation The core inflation rate is said to better predict future inflation rates and a consistent trend Over the past 20 years, the core trend and CPI trends were very similar The average of the three core inflation rates (CPI-common, CPI-median, and CPI-trim) has never left the target range.

Answer 29

Two main benefits flow from adopting an inflation-control target: 1. Fewer surprises and mistakes on the part of savers and investors. 2. Anchors expectations about future inflation.

Answer 30

Policy actions are more clearly understood by financial market traders, which leads to fewer miscalculations by savers and investors The target provides an anchor for future expectations about inflation

Answer 31

Critics of inflation targeting fear that 1. By focusing on inflation, the Bank might permit the unemployment rate to rise or real GDP growth to slow. 2. The Bank might permit the value of the dollar rise on the foreign exchange market and make exports suffer.

Answer 32

. Keeping inflation low and stable is the best way to achieve full employment and sustained economic growth. 2. The Bank’s record is good. The last time the Bank created a recession was at the beginning of the 1990s when it was faced with double-digit inflation.

Answer 33

The Bank of Canada’s Governing Council is responsible for the conduct of monetary policy. The Governor and the Minister of Finance must consult regularly. If the Governor and the Minister disagree in a profound way, the Minister may direct the Bank in writing to follow a specified course and the Bank would be obliged to accept the directive.

Answer 34

The monetary policy instrument is a variable that the Bank of Canada can directly control or closely target. The Bank of Canada has three possible instruments: 1. The quantity of money (the monetary base) 2. The price of Canadian money on the foreign exchange market (the exchange rate) 3. The opportunity cost of holding money (the short-term interest rate)

Answer 35

The Bank of Canada can set any one of these three variables, but it cannot set all three. The values of two of them are the consequence of the value at which the third one is set. 1. If the Bank decreased the quantity of money, both the interest rate and the exchange rate would rise. 2. If the Bank raised the interest rate, the quantity of money would decrease and the exchange rate would rise. 3. If the Bank lowered the exchange rate, the quantity of money would increase and the interest rate would fall.

Answer 36

The Bank of Canada’s choice of policy instrument (the same choice made by most other major central banks) is a short-term interest rate. Given this choice, the exchange rate and the quantity of money to find their own equilibrium values. The Bank of Canada targets is the overnight loans rate, which is the interest rate on overnight loans that chartered banks make to each other. When the Bank wants to slow inflation, it raises the overnight loans rate. When inflation is low and the Bank wants to avoid recession, it lowers the overnight loans rate.

Answer 37

To make its interest rate decision, the Bank of Canada gathers data about the economy, the way it responds to shocks, and the way it responds to policy. The Bank must then process the data and come to a judgement about the best level for the policy instrument. After announcing an interest rate decision, the Bank engages in a public communication to explain the reasons for its decision.

Answer 38

Once an interest rate decision is made, the Bank of Canada achieves its target by using two tools:  Operating band  Open market operations

Answer 39

The operating band is the target overnight loans rate plus or minus 0.25 percentage points. So the operating band is 0.5 percentage points wide. The Bank creates the operating band by setting: 1. Bank rate, the interest rate that the Bank charges big banks on loans, is set at the target overnight loans rate plus 0.25 percentage points. 2. Settlement balances rate, the interest rate the Bank pays on reserves, is set at the target overnight loans rate minus 0.25 percentage point.

Answer 40

If the overnight loans rate is above target, the Bank buys securities to increase reserves Other short-term interest rates and the exchange rate also fall The quantity of money and supply of loanable funds increases The long-term interest rate falls In the end, real GDP growth and inflation both speed up If the overnight loans rate is below target, the Bank sells securities to decrease reserves Same but opposite effects occur here with the process illustrated above

Answer 41

1.The Bank buys securities in an open market operation. 2. Other short-term interest rates and the exchange rate fall. 3. The quantity of money and the supply of loanable funds increase. 4. The long-term real interest rate falls. 5. Consumption expenditure, investment, and net exports increase. 6. Aggregate demand increases. 7. Real GDP growth and the inflation rate increase. When the Bank of Canada raises the overnight loans rate, the ripple effects go in the opposite direction.

Answer 42

Short-term rates move closely together and follow the overnight loans rate. Long-term rates move in the same direction as the overnight loans rate but are only loosely connected to the overnight loans rate.

Answer 43

The interest rate and exchange rate effects are immediate Effects on money and bank loans follow in a few weeks and run for a few months Real long-term interest rates change quickly and often in anticipation of the short-term interest rate changes Spending plans change and real GDP growth changes after about a year The inflation rate changes about one or two years after the change in the overnight loans rate

Answer 44

The interest rate paid by the Government of Canada on 3-month debt. Identical to the overnight loans rate – a powerful substitution effect keeps the two rates close to each other When they are close together like this there is no incentive for banks to choose one or the other – they are in equilibrium

Answer 45

The interest rate paid on bonds issued by large corporations. The interest rates are higher on these because they are riskier When the Bank of Canada raises the overnight loans rate, the Canadian interest rate differential rises and the Canadian dollar appreciates. The overnight loans rate also changes the quantity of money demanded and the quantity of loans and deposits created in the banking system.

Answer 46

The exchange rate responds to changes in the interest rate in Canada relative to the interest rates in other countries—the Canadian interest rate differential. But other factors are also at work, which make the exchange rate hard to predict.

Answer 47

The ripple effects that follow a change in the overnight rate change three components of aggregate expenditure: ▪ Consumption expenditure ▪ Investment ▪ Net exports A change in the overnight loans rate changes in aggregate expenditure plans, which in turn changes aggregate demand, real GDP, and the price level. So the Bank influences the inflation rate and output gap

Answer 48

Money and Bank Loans When the Bank lowers the overnight loans rate, the quantity of money and the quantity of bank loans increase. Consumption and investment plans change. Long-Term Real Interest Rate Equilibrium in the market for loanable funds determines the long-term real interest rate, which equals the nominal interest rate minus the expected inflation rate. The long-term real interest rate influences expenditure plans.

Answer 49

If inflation is low and the output gap is negative, the Bank lowers the overnight loans rate target. The Bank conducts an open market purchase to increase reserves … and hit the new overnight loans rate target. An increase in reserves increases the supply of money. The short-term interest rate falls, and the quantity of money demanded increases. The increase in the supply of money increases the supply of loanable funds. The long-term real interest rate falls and investment increases The fall in the real interest rate increases aggregate planned expenditure. The multiplier increases aggregate demand.

Answer 50

If inflation is too high and the output gap is positive, the Bank of Canada raises the overnight loans rate target. The Bank conducts an open market sale to decrease reserves … and hit the new overnight loans rate target. A decrease in reserves decreases the supply of money. The short-term interest rate increases, and the quantity of money demanded decreases. The decrease in the supply of money decreases the supply of loanable funds. The long-term real interest rate rises and investment decreases. The rise in real interest rate decreases aggregate planned expenditure. The multiplier decreases aggregate demand.

Answer 51

Long-term interest rates that influence spending plans are linked loosely to the overnight loans rate. The response of the real long-term interest rate to a change in the nominal rate depends on how inflation expectations change. The response of expenditure plans to changes in the real interest rate depends on many factors that make the response hard to predict. The monetary policy transmission process is long and drawn out and doesn’t always respond in the same way.

Answer 52

The three main events that can put a bank under stress: 1. Widespread fall in asset prices 2. Large currency drain 3. Run on the bank

Answer 53

Widespread fall in asset prices means banks suffer a capital loss. If the fall in asset price is large, the bank’s equity might fall to zero, in which case the bank is insolvent. The bank fails. Large currency drain means that depositors withdraw funds and the bank loses reserves. The bank has a liquidity crisis and is short of cash reserves. Run on the bank occurs when depositors lose confidence and make massive withdrawls. The bank’s equity shrinks.

Answer 54

The three main events that put banks under stress were: 1. Widespread fall in asset prices 2. A significant currency drain 3. A run on the bank

Answer 55

The U.S. Fed’s Policy Actions The Fed’s policy actions dribbled out for more than a year. The Fed conducted massive open market operations to keep the banks supplied with reserves. Congress Crisis Policy Actions ▪ Extended deposit insurance ▪ Authorized the Treasury to buy “troubled” assets. These actions provided U.S. banks with more reserves, more secure depositors, and safe liquid assets in place of troubled assets.

Answer 56

Macroprudential regulation is financial regulation to lower the risk that the financial system will crash. The global financial crisis of 2007–2008 brought this type of regulation to center stage.

Answer 57

Microprudential regulation seeks to lower the risk of failure of individual financial institutions. Macroprudential regulation focuses on the interconnections among individual financial institutions and markets and their shared exposure to common shocks.

Answer 58

involves rules governing banks' balance sheets, such as loan-to-net worth ratios, which adjust according to the macroeconomic climate. For instance, during a recession, minimum ratios might increase, while during an expansion, they might decrease. These regulations aim to stabilize the financial system by considering broader economic conditions, unlike microprudential regulations which focus on specific institutions.

Answer 59

The Minister of Finance is responsible for maintaining Canada’s financial stability, but the front line of Canada’s macroprudential policy is performed by: ▪ The Bank of Canada ▪ The Office of the Superintendent of Financial Institutions ▪ The Canada Deposit Insurance Corporation.

Answer 60

Lender of last resort 2. Management of the payment system 3. Conductor of financial system stress tests The Office of the Superintendent of Financial Institutions regulates and supervises financial institutions. The Canada Deposit Insurance Corporation insures the deposits of banks and other depository institutions.

Answer 61

In the short run, monetary policy creates a tradeoff between inflation and unemployment. But in the long run, monetary policy influences the inflation rate and has no effect on the unemployment rate. In the long run, the unemployment rate is determined by the natural unemployment rate. Inflation targeting is an attractive monetary policy strategy because it manages inflation expectations, which makes the best contribution to attaining full employment and sustained growth.

Answer 62

This rate influences expenditure decisions In the short run, when the price level is not fully flexible, the supply of loanable funds is influenced by the supply of bank loans A fall in the overnight funds rate increases the supply of bank loans and increases the supply of loanable funds A rise in the overnight loans rate decreases the supply of bank loans and decreases the supply of loanable funds

Answer 63

Consumption expenditure The lower the real interest rate the greater the consumption and the smaller the saving Investment The lower the real interest rate the greater the amount of investment Net exports The lower the interest rate, the lower is the exchange rate and the higher are exports and the lower are imports, thus increasing net exports

Answer 64

A formula for setting the overnight loans rate. Formula = 2 + INF + 0.5(INF-2) + 0.5GAP INF = Inflation rate GAP = Output gap The Bank of Canada believes that since they use more information than just the inflation rate and the output gap they can set the overnight loans rate more intelligently than the Taylor Rule.