econ 1022 mid 2 Flashcards
1
Q
Money
A
A commodity or token that is generally acceptable as a means of payment.
2
Q
Means of payment
A
is a method of settling a debt.
3
Q
Money performs three other functions:
A
Medium of exchange
Unit of account
Store of value
4
Q
A medium of exchange
A
is any object that is generally acceptable in exchange for goods and
services.
5
Q
barter
A
Without money, it would be necessary to exchange goods and services directly for other goods
and services
6
Q
A unit of account
A
is an agreed measure for stating the prices of goods and services.
* In the absence of a standardized unit of account, keeping track of prices and comparing prices
would be difficult.
7
Q
A store of value
A
is any commodity or token that can be held and exchanged later for goods and
services.
* The more stable the value of a commodity or token, the better it can act as a store of value and
the more useful it is as money.
8
Q
Money in Canada consists of
A
Currency
▪Deposits at banks and other depository institutions
9
Q
Currency
A
The notes and coins held by businesses and individuals
Notes and coins inside of banks are money but they are not counted as currency because they are not held by individuals and businesses
Currency is convenient for settling small debts and buying low-priced items
10
Q
Deposits at banks and other depositary institutions
A
Deposits count as money because the owners of them can use them to make payments
Deposits owned by the Government of Canada are not counted as money because they are not held by individuals or businesses
11
Q
The two main measures of money are called
A
o M1
o M2
All of the aspects of M1 and M2 are counted as money.
Both cheques, credit, and debit cards are NOT counted as money
12
Q
M1
A
consists of currency held outside the banks and chequable deposits of individuals and
businesses.
M1 does not include currency held by banks, and it does not include currency and bank
deposits owned by the government of Canada.
13
Q
Liquidity
A
The property of being easily convertible into a means of payment without a loss in value
13
Q
M2
A
consists of M1 plus all other deposits.
* Deposits are money but cheques are not money.
* A cheque transfers a deposit from one account to another.
* Credit cards and debit cards are not money.
14
Q
A depository institution
A
is a private firm that takes deposits from households and firms and
makes loans to other households and firms.
15
Q
The deposits of three types of depository institutions make up the nation’s money:
A
Chartered banks
o Credit unions and caisses populaires
o Trust and mortgage companies
16
Q
Chartered banks
A
Private firms chartered under the Bank Act of 1991 to receive deposits and make loans
These are the largest institutions in the banking system and conduct all types of banking and financial business
17
Q
A bank has four types of assets:
A
overnight loans, liquid assets, securities, and loans.
17
Q
Credit unions and caisses populaires
A
A credit union is a cooperative organization that operates under the Cooperative Credit Associations Act of 1991 and that receives deposits from and makes loans to its members
A caisse populaire is a similar institution that operates in Quebec
18
Q
Trust and mortgage loan companies
A
Privately owned depository institutions that operate under the Trust and Loan Companies Act of 1991
These institutions receive deposits, make loans, and act as a trustee for pension funds and for estates
Because they all provide the same economic function, we will refer to all of these institutions as banks.
19
Q
But the banks must balance profit and prudence
A
Loans generate profit.
▪ Depositors must be able to obtain their funds when they
want them.
20
Q
Reserves
A
Notes and coins in its vault or its deposit account at the Bank of Canada
These funds are used to meet depositors’ currency withdrawals and to make payments to other banks
In normal times, the bank keeps about half of 1 percent of deposits as reserves
21
Q
Liquid assets
A
Government of Canada treasury bills and commercial bills
These are a bank’s first line of defence if they need reserves
They can be sold and converted into reserves with virtually no risk of loss
Since they are low risk, they also earn a low interest rate
22
Q
Securities
A
Government of Canada bonds and other bonds such as mortgage backed securities
These assets can be converted into reserves but at prices that fluctuate
Since their prices fluctuate they are riskier than liquid assets but they earn a higher interest rate
23
Loans
A commitment of funds for an agreed upon period of time
Banks make loans to corporations to finance the purchase of capital
They also make mortgage loans to finance the purchase of homes, and personal loans to finance consumer durable goods, such as cars or boats
These are the riskiest assets of a bank because they cannot be converted into reserves until they are due to be repaid
Some borrowers default and never repay
They earn the highest interest rate because of this
24
Banks provide four services for which people are willing to pay:
Create liquidity
▪ Pool risk
▪ Lower the cost of borrowing
▪ Lower the cost of monitoring borrowers
25
Depository institutions are regulated to lessen financial
risk, which has two dimensions
Insolvency
Illiquidity
26
Insolvency
if the value of its liabilities exceeds the value of its assets
has negative net worth(negative owners’ capital)
27
Financial Innovation
the development of new
financial products—is to lower the cost of deposits or to
increase the return from lending.
Financial innovation has changed the composition of
money
27
Bank of Canada
Canada’s central bank
A public authority that supervises other banks and financial institutions, markets, and the payment system
Conducts monetary policy
Banker to the banks and government
Lender of last resort
Sole issuer of bank notes
28
Illiquidity
if it is solvent but it has used borrowed funds to make loans and is faced with a sudden demand to repay more of what it has borrowed than its available cash.
To avoid illiquidity, the Bank of Canada ensures that the
banks and other depository institutions have adequate
reserves.
29
Banker to banks and governments
These include the institutions that make up the banking system as well as the Government of Canada, and the central banks of other countries
They accept deposits from these customers
The deposits of depository institutions are a part of their reserves
30
Lender of last resort
It stands ready to make loans when the banking system is short on reserves
If some banks are short on reserves while others have a surplus, the overnight loan market moves funds from one bank to another
31
Sole issuer of bank notes
The central bank has a monopoly on this
Places like Ireland and Scotland also let private banks issue bank notes
32
The Bank of Canada has two main assets
Government securities
Loans to depository institutions
33
The Bank of Canada has two liabilities
Bank of Canada notes – The dollar bills that we use in our daily transactions
Depository institution deposits
34
The Bank of Canada’s Balance Sheet
The Bank of Canada’s assets are government securities
and last-resort loans to banks.
Its liabilities are Bank of Canada notes and deposits of
banks and the government.
35
Monetary base
The sum of Bank of Canada notes, coins, and depository institutions deposits at the Bank of Canada.
It is named in this way because it is the base that supports the nation’s money
36
Open market operation
What the bank does to change the monetary base
Defined as the purchase and sale of government securities by the Bank of Canada in the loanable funds market
When the Bank of Canada buys securities in the open market, it creates bank reserves
37
Bank rate
The interest rate that the Bank of Canada charges on short, one-day loans to major depository institutions when the banking system is temporarily short on reserves.
The bank rate acts as an anchor for other short-term interest rates
37
The quantity of deposits that banks can create is limited by
three factors
The monetary base
▪ Desired reserves
▪ Desired currency holding
38
Creating Deposits by Making Loans
Banks create deposits when they make loans and the new
deposits created are new money
39
The monetary base
The size of the monetary base limits the total quantity of money the banking system can create
Banks have desired reserves Households and firms have desired currency holdings
And both these desired holdings of monetary base depend
on the quantity of money
40
Desired reserves
Desired reserves – The reserves a bank plans to hold
Required reserves – The reserves a bank must hold
Desired reserve ratio – The ratio of reserves to deposits that the banks plan to hold
41
Desired currency holding
The ratio of desired currency to deposits changes slowly
Currency drain – The leakage of bank reserves into currency
Currency drain ratio – The ratio of currency to deposits
42
Excess reserves
A bank’s actual reserves – desired reserves
When the entire banking system has excess reserves, total loans and deposits increase and the quantity of money increases
43
Extra deposits lower excess reserves for two reasons
An increase in deposits increases desired reserves
A currency drain decreases total reserves
BUT, excess reserves still do not totally disappear, so the process of lending more repeats.
43
Steps on how the banking system creates money
Banks have excess reserves
Banks lend excess reserves
The quantity of money increases
New money is used to make payments
Some of the new money remains on deposit
Some of the new money is a currency drain
Desired reserves increase because deposits have increased
Excess reserves decrease
44
negative excess reserves
If the Bank of Canada sells securities in an open market operation, – they are short of reserves.
45
When these banks are short of reserves
the above process happens in a downward direction where loans and deposits decrease and desired reserves plus desired currency holding have decreased by an amount equal to the decrease in the monetary base.
46
The price level
Nominal money – The quantity of money measured in dollars
The quantity of nominal money demanded is proportional to the price level
Real money – The quantity of money measured in constant dollars (2007 for example)
Equation = Nominal money/Price level
46
Money multiplier
Determines the change in the quantity of money that results in a change in the monetary base.
The ratio in the change of the quantity of money to the change in the monetary base
The smaller the banks’ desired reserve ratio and the smaller the currency drain ratio, the larger is the money multiplier
47
The quantity of money that people plan to hold depends
on four main factors
▪ The price level
▪ The nominal interest rate
▪ Real GDP
▪ Financial innovation
48
The nominal interest rate
Nominal interest rate on other assets - Nominal interest rate on money (Opportunity cost of holding money)
The interest rate that you earn on currency and chequable deposits is zero
By holding money you forgo the interest rate you would have received
The inflation rate also devalues money, so, the higher the expected inflation rate, the higher is the nominal interest rate
49
Real GDP
If this figure increases you buy more and keep a larger amount of money on hand to finance the expenditure
50
Financial innovation – Examples of financial innovation
Daily interest chequable deposits
Automatic transfers between chequable and savings deposits
Automatic teller machines
Credit cards and debit cards
Internet banking and bill paying
51
Demand for money
Relationship between the quantity of real money demanded and the nominal interest rate.
52
Money Market Equilibrium
Money market equilibrium occurs when the quantity of
money demanded equals the quantity of money supplied.
Adjustments that occur to bring about money market
equilibrium are fundamentally different in the short run and
the long run.
53
A change in real GDP or financial innovation changes the demand for money and shifts the demand for money curve
A decrease in real GDP decreases the demand for money
In increase in real GDP increases the demand for money
Generally increases in financial innovation decreases the demand for money
54
The Short-Run Effect of a Change in the Quantity of Money
If the Bank increases the quantity of money, people
will be holding more money than the quantity demanded.
So they buy some bonds. The increased demand for bonds raises the bond price and lowers the interest rat
55
The quantity of money supplied is dependent on the actions of banks and the Bank of Canada.
As the Bank of Canada adjusts the quantity of money, the interest rate changes
56
Characteristics for long-run equilibrium
When the inflation rate equals the forecasted inflation rate
When real GDP equals potential GDP
Then the money market, the loanable funds market, the goods market, and the labour market are in long-run equilibrium (and so is the economy)
57
In the long run, an increase in the quantity of money returns all real variables to their original levels, but changes the price level
The price level changes by the same percentage as the quantity of money
The only free variable that is able to respond to a change in the supply of the quantity of money in the long run is the price level
The level adjusts to make the quantity of real money supplied equal to the quantity of real money demanded
Price level changes by the percentage change in the quantity of nominal money
58
In long-run equilibrium, the Government of Canada increases the quantity of money supplied by 10 percent. The steps that follow are
The nominal and real interest rates fall
People borrow and spend more and firms want to do the same
This increases the demand for loanable funds
The increase in demand cannot be met by an increase in supply because the economy is at full employment
Thus there is a general shortage of various goods and services
This forces the price level to rise
This then decreases the real quantity of money
This then raises both the nominal and real interest rates
This then decreases demand and the equilibrium is restored
Thus, the price level has increased by 10 percent but nothing else has changed
59
Quantity theory of money
Holds that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.
60
Velocity of circulation
The average number of times a dollar of money is used to annually buy the goods and services that make up GDP.
V= PY/M
61
In this case, PY is GDP (not real GDP) and M is the quantity of money.
The equation of exchange= MV=PY
Price level in the long-run=M(V/Y)
62
The equation of exchange can also be expressed as growth rates
Money growth rate + Rate of velocity change =Inflation rate + Real GDP growth rate
In the long run, the rate of velocity change is assumed to be zero, so:
Inflation rate= Money growth rate - Real GDP growth rate
In the long-run, the real GDP growth rate equals the potential GDP growth rate.
63
The size of the money multiplier depends on
The currency drain ratio (C/D)
The desired reserve ratio (R/D)
Money multiplier = (1 + C/D) ÷ (C/D + R/D)
In our example, C/D is 0.5 and R/D is 0.1, so
Money multiplier = (1 + 0.5) ÷ (0.1 + 0.5)
= (1.5) ÷ (0.6)
= 2.5
64
Foreign currency
The money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits.
65
Foreign exchange market
is the market in which the currency of one country is exchanged
for the currency of another.
66
The foreign exchange rate
is the price at which one currency trades for another.
66
Currency depreciation
is a fall in the value of one currency in terms of another currency.
67
Currency appreciation
is the rise in the value of one currency in terms of another currency.
68
About the Canadian Dollar Exchange Rate
The exchange rate is determined by demand and supply in the foreign exchange market.
The quantity of Canadian dollars demanded in the foreign exchange market is the amount that
traders plan to buy during a given time period at a given exchange rate.
69
The exchange rate influences the quantity of dollars demanded for two reasons
Exports effect
Expected profit effect
70
The quantity depends on many factors but the main ones are
The exchange rate
World demand for Canadian exports
Interest rates in Canada and other countries
The expected future exchange rate
The law of demand for foreign exchange states that other things remaining the same, the higher the exchange rate, the smaller is the quantity of Canadian dollars demanded on the foreign exchange market.
71
Exports effect
The lower the exchange rate, the cheaper are Canadian-produced goods to foreigners,
and the greater the level of exports, the greater the quantity of Canadian dollars
demanded on the foreign exchange market.
72
Expected profit effect
The lower the exchange rate, the larger the expected profit from buying Canadian
dollars, and the greater the quantity of dollars demanded on the foreign exchange
market
73
Supply in the Foreign Exchange Market
The quantity of Canadian dollars supplied in the foreign exchange market is the amount that
traders plan to sell during a given time period at a given exchange rate.
74
The quantity depends on many factors but the main ones are:
The exchange rate
o Canadian demand for imports
o Interest rates in Canada and other countries
o The expected future exchange rate
* The law of supply of foreign exchange states that other things remaining the same, the higher
the exchange rate, the greater is the quantity of Canadian dollars supplied in the foreign
exchange market.
75
The exchange rate influences the quantity of dollars supplied for two reasons
Imports effect
Expected profit effect
76
Imports effect
The higher the exchange rate, the cheaper are foreign-produced goods to Canadians,
and the greater the level of imports, the greater the quantity of Canadian dollars
supplied on the foreign exchange market.
77
Expected profit effect
The higher the exchange rate, the larger the expected profit from selling Canadian
dollars, and the greater the quantity of dollars supplied on the foreign exchange market.
78
Exchange Rate Fluctuations
A change in any influence other than the exchange rate on the quantity of Canadian dollars that
people plan to buy brings a change in the demand for dollars and a shift in the demand curve for
dollars.
79
(Exchange Rate Fluctuations)These other influences are
Interest rates in Canada and other countries.
o World demand for Canadian exports.
o The expected future exchange rate.
80
Changes in the demand for Canadian dollars
World demand for Canadian exports (A RISE IN ALL OF THESE BRINGS A RISE IN DEMAND)
An increase in demand for Canadian exports increases the demand for Canadian dollars
81
Canadian interest rate relative to the foreign interest rate
Canadian interest rate – the foreign interest rate = Canadian interest rate differential
The larger the Canadian interest rate differential, the larger the demand for Canadian dollars
82
The expected future exchange rate
A rise in the expected future exchange rate increases the profit that people expect to make by holding Canadian dollars, so the demand for Canadian dollars increases today
83
Changes in the Exchange Rate
If demand for Canadian dollars increases and
supply does not change, the exchange rate rises.
If demand for Canadian dollars decreases and
supply does not change, the exchange rate falls.
If supply of Canadian dollars increases and
demand does not change, the exchange rate falls.
If supply of Canadian dollars decreases and
demand does not change, the exchange rate rises.
84
World Demand for Canadian Exports
At a given exchange rate, if world demand for Canadian
exports increases, the demand for Canadian dollars
increases.
85
Arbitrage
is the practice of seeking to profit by buying in
one market and selling for a higher price in another related
market.
86
Arbitrage in the foreign exchange market and international
loans and goods markets achieves four outcomes
The law of one price
▪ No round-trip profit
▪ Interest rate parity
▪ Purchasing power parity
87
Canadian demand for imports
An increase in the demand for Canadian imports increases the supply of Canadian dollars in the foreign exchange market (SAME)
88
Canadian interest rate relative to the foreign interest rate
Inverted interest rate differential effect for the supply of Canadian dollars
89
The expected future exchange rate
A fall in the expected future exchange rate decreases the profit that can be made holding Canadian dollars and decreases the quantity of Canadian dollars that people want to hold and the supply of Canadian dollars increases because people want to get rid of them (INVERTED FROM DEMAND)
89
The law of one price
If an item is traded in more than one place, the prices will be the same in all places
90
No round-trip profit
A round-trip is using currency A to buy currency B and then using currency B to buy currency A
This may involve more stages (using B to buy C and then C to buy A
91
Interest rate parity
States that in risk-free transactions, there is no gain from choosing one currency over another
92
Purchasing power parity
Means the equal value of money
This is an example of the law of one price
If goods and services are said to cost more in one country than another, the currency of the first country is said to be overvalued
Arbitrage is said to stop this
93
Speculation
Trading on the expectation of making a profit.
It differs from arbitrage because that is trading with the certainty of making a profit
94
Exchange rate forecasting differs from weather forecasting in three ways
Exchange rate forecasts are hedged with a lot of uncertainty
There are many divergent forecasts
The forecasts influence the outcome
The reliance on exchange rate forecasts can give rise to exchange volatility in the short run
The market fundamentals that influence the exchange rate are world demand for Canadian exports, Canadian demand for imports, and the Canadian interest rate differential.
95
Three possible exchange rate policies are
Flexible exchange rate
▪ Fixed exchange rate
▪ Crawling peg
95
Real exchange rate
The relative price of Canadian-produced goods and services to foreign-produced goods and services.
RER= (E × P) ÷ PJ
Where E is the exchange rate, P is the Canadian price level, and PJ is the Japanese price level.
The real exchange rate is not 1 and it changes over time.
The exchange rate is: E = (RER × PJ) ÷ P
RER = (E x P)/P*.
E = RER x (P*/P).
96
flexible exchange rate
policy is one that permits the exchange rate to be determined by
demand and supply with no direct intervention in the foreign exchange market by the central
bank.
97
A fixed exchange rate
policy is one that pegs the exchange rate at a value decided by the
government or central bank and that blocks the unregulated forces of demand and supply by
direct intervention in the foreign exchange market.
98
Market fundamentals that determine the exchange rate in the long run
The real exchange rate
The quantities of money in each economy
98
A crawling peg
exchange rate policy is one that selects a target path for the exchange rate with
intervention in the foreign exchange market to achieve that path.
99
balance of payments accounts
A country’s balance of payments accounts records its
international trading, borrowing, and lending.
100
There are three balance of payments accounts
Current account
2. Capital and financial account
3. Official settlements account
101
The current account
records payments for imports of goods and services from abroad, receipts
from exports of goods and services sold abroad, net interest paid abroad, and net transfers
(such as foreign aid payments).
102
The capital and financial account
records foreign investment in Canada minus Canadian
investment abroad.
103
The official settlements account
account records the change in official Canadian reserves.
104
Official reserves
Official reserves are the government’s holdings of foreign currency.
* If Canadian official reserves increase, the official settlements account balance is negative and if
official Canadian reserves decrease, the official settlements account balance is positive.
* The sum of the balances of the three accounts always equals zero.
105
A net lender
is a country that lends more to the rest of the world than it borrows from it.
106
net borrower.
A country that has a current account deficit and that borrows more from the rest of the world
than it lends to
107
A debtor nation
is a country that during its entire history has borrowed more from the rest of the world than is has lent to it.
108
A creditor nation
is a country that has invested more in the rest of the world than other countries have invested in it.
109
Current Account Balance
The current account balance (CAB) is
CAB = NX + Net interest income + Net transfers
The main item in the current account balance is net
exports (NX).
The other two items are much smaller and don’t fluctuate
much.
110
Financing International Trade
he government sector surplus or deficit is equal to net
taxes, T, minus government expenditure on goods and
services G.
The private sector surplus or deficit is saving, S, minus
investment, I.
Net exports is equal to the sum of government sector
balance and private sector balance:
NX = (T – G) + (S – I
111
Net exports
is the value of exports of goods and services minus the value of imports of goods
and services.
112
The private sector balance
is equal to saving minus investment.
* Net exports is equal to the sum of the government sector surplus and the private sector surplus.
113
The government sector balance
The government sector balance is equal to net taxes minus government expenditures on goods
and services.
114
Quantity Supplied and Supply
The quantity of real GDP supplied is the total quantity that
firms plan to produce during a given period.
Aggregate supply is the relationship between the quantity
of real GDP supplied and the price level.
115
We distinguish two time frames associated with different
states of the labour market:
▪ Long-run aggregate supply
▪ Short-run aggregate supply
116
Long-run aggregate supply
is the relationship between
the quantity of real GDP supplied and the price level when
real GDP equals potential GDP
When real GDP equals potential GDP, the long-run aggregate supply curve (LAS) is vertical, meaning potential GDP is independent of the price level.
117
Short-run aggregate supply
When the money wage rate, prices of other resources, and potential GDP remain constant, a rise in the price level increases the quantity of real GDP supplied. This relationship is represented by the upward-sloping short-run aggregate supply curve (SAS).
118
Changes in Aggregate Supply
Aggregate supply changes if an influence on production
plans other than the price level changes.
These influences include
▪ Changes in potential GDP
▪ Changes in money wage rate (and other factor prices)
119
Aggregate Demand
is the relationship between the
quantity of real GDP demanded and the price level.
The quantity of real GDP demanded, Y, is the total amount of goods and services people, businesses, governments, and foreigners plan to buy. It's calculated by summing consumption expenditures (C), investment (I), government expenditure (G), and net exports (X – M). We study the relationship between the quantity demanded of real GDP and the price level by analyzing how it varies when keeping other factors constant. This relationship is depicted by the aggregate demand curve (AD), which shows the quantity of real GDP demanded against the price level.
120
Changes in Potential GDP
When potential GDP increases, both the LAS and SAS
curves shift rightward.
Potential GDP increases if:
The full-employment quantity of labour increases
The quantity of capital (physical or human) increases
An advance in technology occurs
121
Wealth Effect
A rise in the price level reduces the quantity of real wealth, prompting people to save more and spend less to restore it. Consequently, the quantity of real GDP demanded decreases. Conversely, a fall in the price level increases real wealth, encouraging higher spending and boosting the quantity of real GDP demanded.
122
International substitution effect
Rising prices raise the price of domestic goods relative to foreign goods, leading to increased imports and decreased exports, thereby reducing the quantity of real GDP demanded. Conversely, falling prices increase the quantity of real GDP demanded.
123
Changes in Aggregate Demand
A change in any influence on buying plans other than the
price level changes aggregate demand.
The main influences on aggregate demand are
▪ Expectations
▪ Fiscal policy
▪ Monetary policy
▪ The world economy
123
Intertemporal substitution effect
Rising prices reduce the real value of money and raise interest rates, decreasing borrowing and spending, and thus real GDP demanded. Falling prices increase the real value of money and lower interest rates, leading to increased borrowing, spending, and real GDP demanded.
124
Expectations
Expectations about future income, inflation, and profits affect aggregate demand. Higher expected future income boosts current consumption, raising aggregate demand. A rise in expected inflation makes present purchases cheaper, increasing aggregate demand. Similarly, an increase in expected future profits drives up investment, further increasing aggregate demand.
125
Fiscal Policy
Fiscal policy involves government actions like adjusting taxes, transfer payments, and purchasing goods and services to impact the economy. Tax cuts or higher transfer payments raise households' disposable income, which leads to increased consumption expenditure and aggregate demand.
126
Monetary Policy
Monetary policy involves adjusting interest rates and the quantity of money in the economy. Increasing the quantity of money boosts buying power, thereby increasing aggregate demand. Similarly, lowering interest rates stimulates spending, leading to an increase in aggregate demand.
127
The World Economy
The world economy affects aggregate demand in two key ways. Firstly, a decline in the foreign exchange rate reduces the price of domestic goods compared to foreign goods, boosting exports, reducing imports, and thus increasing aggregate demand. Secondly, a rise in foreign income increases the demand for Canadian exports, leading to a rise in aggregate demand.
128
Short-run macroeconomic equilibrium
occurs when the
quantity of real GDP demanded equals the quantity of real
GDP supplied at the point of intersection of the AD curve
and the SAS curve.
129
inflationary gap
The amount by which potential GDP exceeds real GDP
129
The Business Cycle in the AS-AD Model
The business cycle occurs due to fluctuations in aggregate demand and short-run aggregate supply, with slow adjustments in the money wage compared to real GDP and potential GDP. Above full-employment equilibrium means real GDP surpasses potential GDP, full-employment equilibrium denotes real GDP equals potential GDP, and below full-employment equilibrium signifies potential GDP exceeds real GDP.
130
Long-run macroeconomic equilibrium
occurs when real
GDP equals potential GDP—when the economy is on its
LAS curve.
Long-run equilibrium occurs at the intersection of the AD
and LAS curves.
131
recessionary gap
When real GDP is less than potential GDP
132
Fixed Prices and Expenditure Plans
Keynesian model describes the economy in the very short
run when prices are fixed.
Because each firm’s price is fixed, for the economy as a
whole:
1. The price level is fixed.
2. Aggregate demand determines real GDP.
What determines aggregate expenditure plans?
133
Expenditure Plans
Aggregate expenditure components combine to form real GDP, expressed as Y = C + I + G + X - MY=C+I+G+X−M. Among these components, consumption and imports are influenced by real GDP, establishing a two-way relationship between aggregate expenditure and real GDP.
134
Two-Way link Between Aggregate Expenditure and
Real GDP
Other things remaining the same,
An increase in real GDP increases aggregate
expenditure.
An increase in aggregate expenditure increases real
GDP.
135
Disposable income
is aggregate income or real GDP, Y,
minus net taxes, T.
Call disposable income YD.
The equation for disposable income is
YD = Y – T
136
disposable income
disposable income, YD, is either spent on consumption goods, C, or saved, S, forming the equation YD = C + S. The link between consumption expenditure and disposable income, when other factors remain constant, is the consumption function, while the connection between saving and disposable income, under unchanged conditions, is the saving function.
137
Consumption Function
As disposable income rises, consumption expenditure increases. Even when disposable income is zero, consumption expenditure remains positive, known as autonomous consumption. Any consumption expenditure beyond autonomous consumption, resulting from an increase in disposable income, is termed induced consumption.
138
Other Influences on Consumption and Saving
The other factors that influence consumption and saving
are
1. The real interest rate
2. Wealth
3. Expected future income
A change in any of these factors changes autonomous
consumption and shifts both the consumption function and
the saving function
139
Marginal Propensities to Consume and Save
The marginal propensity to consume (MPC) represents the fraction of a change in disposable income spent on consumption. It's calculated as the change in consumption expenditure (DC) divided by the change in disposable income (DYD) that caused it: MPC = DC ÷ DYD.
140
marginal propensity to save (MPS)
The marginal propensity to save (MPS) is the fraction of
a change in disposable income that is saved.
It is calculated as the change in saving, DS, divided by the
change in disposable income, DYD, that brought it about.
That is,
MPS =DS ÷ DYD
141
The MPC plus the MPS equals 1
To see why, note that,
DC + DS = DYD.
Divide this equation by DYD to obtain,
DC/DYD + DS/DYD = DYD/DYD
or
MPC + MPS = 1.
142
Consumption as a Function of Real GDP
Disposable income changes when real GDP or net taxes change. If tax rates remain constant, real GDP solely influences disposable income, making consumption expenditure a function of real GDP. We employ this relationship to ascertain real GDP when the price level remains fixed.
143
Import Function
In the short run, Canadian imports are influenced primarily
by Canadian real GDP.
The marginal propensity to import is the fraction of an
increase in real GDP spent on imports.
If an increase in real GDP of $100 billion increases imports
by $25 billion, the marginal propensity to import is 0.25
144
induced expenditure.
Consumption expenditure minus imports, which varies with
real GDP,
145
Aggregate Planned Expenditure
With a fixed price level, aggregate demand relies on aggregate expenditure plans. This encompasses planned consumption, investment, government spending, exports, and imports. Real GDP influences planned consumption and imports, increasing with GDP growth. However, investment, government spending, and exports remain unaffected. This relationship can be shown through an aggregate expenditure schedule or curve, detailing planned expenditure at various GDP levels.
146
autonomous
expenditure.
The sum of investment, government expenditure, and
exports, which does not vary with GDP,
147
Actual Expenditure, Planned Expenditure, and
Real GDP
Actual aggregate expenditure is always equal to real GDP.
Aggregate planned expenditure may differ from actual
aggregate expenditure because firms can have unplanned
changes in inventories.
148
Equilibrium expenditure
is the level of aggregate
expenditure that occurs when aggregate planned
expenditure equals real GDP
149
The Multiplier
Changes in autonomous expenditure lead to shifts in equilibrium expenditure and real GDP, with the adjustment in equilibrium surpassing the initial change in autonomous expenditure. This amplification effect is captured by the multiplier, which magnifies the impact of autonomous expenditure changes on real GDP. An increase in autonomous expenditure, like investment, boosts aggregate expenditure and real GDP, triggering further induced expenditure and resulting in a larger overall increase in real GDP compared to the initial change in autonomous expenditure.
150
Why Is the Multiplier Greater than 1?
An increase in autonomous expenditure induces further
increases in aggregate expenditure.
151
The Size of the Multiplier
The size of the multiplier equals the change in equilibrium
expenditure divided by the change in autonomous
expenditure.
152
Business Cycle Turning Points
Aggregate planned expenditure is influenced by planned consumption, investment, government spending, and net exports. Changes in real GDP affect planned consumption and imports. When real GDP increases, so does planned consumption and imports. However, investment, government spending, and exports remain unaffected by changes in real GDP.
152
Adjusting Quantities and Prices
In the AS-AD model, real firms adjust their prices and production in response to changes in inventories. This adjustment affects both real GDP and the price level, illustrating their simultaneous determination.
153
Aggregate Expenditure and Aggregate Demand
The aggregate expenditure curve shows the relationship between planned expenditure and real GDP, holding other factors constant. Similarly, the aggregate demand curve illustrates the relationship between real GDP demanded and the price level, assuming other factors remain unchanged.
154
Deriving the Aggregate Demand Curve
When the price level changes, a wealth effect and
substitution effects change aggregate planned expenditure
and change the quantity of real GDP demanded.
