Final 28-32 (no 31) Flashcards
What two options does BOC have in monetary policy?
Either target M-supply (increase M, i-rates fall) or target i-rate (drop i-rates, BOC accommodates the increase in demand for money by jacking up M)
What are the problems with targeting the M-supply?
(1) Although BOC can control reserves through OMO, it has no control over deposit expansion; no guarantee that dropping the bank rate will make banks increase loans (2) BOC is unsure about the position and slope of L
Which of the two approaches does BOC use?
Sets i-rates the accommodates by changing M-supply through OMO (buying/selling bonds), resulting in a change in L
What are the five buttons or policy instruments used to implement monetary policy?
overnight rate and bank rate, open market operations, buyback operations (fine-tuning), shifting government money between BOC and chartered banks, announcement effect
What are the operational or intermediate targets?
exchange rate, money supply, or interest rate to target inflation rate
What are the policy or ultimate targets?
Y: stable economic growth, U: low unemployment, P: low inflation
Yield curve/distribution of i-rates (moves in tandem)
term structure of i-rates; i-rates on borrowing increase as maturity increases; the longer the loan, the quality of borrower falls, risk increases
Overnight rate
1-day i-rate for banks to borrow either from each other or investment dealers if they have insufficient funds to clear cheques; cheapest and shortest maturity to the safest borrower; start of the yield curve
Prime rate
banks loan to reputable corporations
Mortgage rates
rate of interest charged in exchange for taking title of the debtor’s (borrower’s) property; banks can seize the home if borrower defaults on the loan
Overnight rate target
BOC’s desired ONR target announced 8x a year on fixed announcement dates
Overnight rate operational band
Within the operating band, which ranges 50 basis points (1 basis point= 0.01%) below the bank rate, ONR will hover around BOC’s target ONR
Bank rate
upper limit of the ONR operating band; rate that BOC charges to lend to banks
Deposit rate
lower limit of ONR operating band; rate that BOC pays to borrow from banks or i-rate paid on deposits at the Bank
What is the Canadian approach with the ONR?
BOC lowers the ONR by setting the bank rate instantly, ONR sets the distribution all i-rates and yield curve shifts down, demand for money increases along the L curve, BOC accomodates L by increasing M (a passive accomodation/endogenous)
What is the Canadian approach with OMO?
(1) Easy M-policy: As L increases, BOC buys bonds to increase excess reserves in banks, which may increase M-supply when banks loan out, and i-rates fall (2) Tight M-policy: the opposite
Quantitative easing
another form of OMO where BOC buys long term bonds e.g. G-bonds
Credit easing
another form of OMO where BOC buys long-term commercial bonds e.g. collateralized debt obligations or a loan with collateral if it goes into default
What are buyback operations?
BOC uses specials and reverses to stabilize ONR within 1 basis point of its ONR target; fine-tuning
Specials
special purchase and resale agreement; a transaction where BOC offers to purchase government securities from major financial players with an agreement to sell them back at a predetermined price the next business day; BOC puts cash into the system for a day to offset upward pressure on ONR
Reverses
sale and repurchase agreement; BOC offers to sell bonds and takes cash out of the system to offset downward pressure on ONR
What is shifting?
cash management when BOC shifts Govt’s deposits (e.g. tax revenue) between BOC and banks; a day-to-day instrument to reinforce ONR (specials and reverses)
How does shifting occur?
To chartered bank: increased reserves and M; From chartered bank: decreased reserved and M
Announcement effect (fixed announcement dates)
BOC announces ONR on 8 predetermined dates in the year (every 6 weeks); sends signal to the economy on BOC’s intentions with monetary policy (forward guidance)
Macro-prudential regulation
BOC announces that they want to be careful: flag asset bubbles (out of control inflationary increases in P of an asset) in advance, cooly command banks to pull back e.g. regulations, required reserves etc.
Taylor rule
Central banks link their i-rates to their inflation rates to their output gaps: i=i* + a(π-π) + b(y-y); if inflation and output are above their targets, BOC raises i-rates
What are the complications in inflation targeting?
Food and energy prices are volatile, inflation rate and exchange rate are inextricably linked (changes in ER affect inflation and output gap), regional differences in Canada (M-policy is a national lever)
Operational guide or Core CPI
CPI excluding food, energy, indirect taxes because P changes unrelated to GDP and output gaps
What can’t monetary policy do?
identify and correct asset price misalignments (e.g. asset bubbles), stabilize ER and inflation rate at the same time, mitigate regional or sectoral differences in growth rates
Recession
two quarters of negative economic growth; according to NBER: low output, high U, low personal, low sales; assess the duration, depth, and dispersion
What are the costs of unanticipated inflation?
reduction in purchasing power, arbitrary redistribution of income (e.g. money from creditors to debtors, employees to employers), creates uncertainty that lowers I, distorts P mechanism and allocation of resources
Price signal distortion hypothesis
inflation interferes with information conveyed by price changes
How do prices increase?
(1) decrease in supply = cost push inflation (2) increase in demand = demand pull inflation
Temporary inflation
one time price increase (goes up and stays); Y returns to Y* at higher prices (wage adjustment)
Constant inflation
sustained and constant P increase caused by expectation inflation; a stable rate of change in P
Accelerating inflation
sustained and increasing inflation caused by expectation inflation and gap inflation; a increasing rate of change in P
Disflation
decreasing rate of change in P; still moving forward but slowing down
Deflation
negative rate of inflation
Why do wages (input prices) change?
due to an “effect” or the effect of expectations or gap on nominal wages
Expectation effect- money wages can rise without an inflationary gap!
expected inflation gets built into wage demands; a self-fulfilling prophecy: if employees expect a 2% inflation, employees will negotiate wage contracts with a 2% increase in nominal wages (W), shifting SRAS vertically by 2%, keeping real wages constant
Real wages
w= W/P
What causes expectation inflation?
(1) Backward looking: history repeats itself, though may take a long time to develop psychological trend (2) Forward looking: workers look to govt. macroeconomic policy and make rational expectations (best possible use of all relevant info)
Gap effect or labour market effect
(1) Excess supply of labour causes W to fall: recessionary (2) Excess demand for labour causes W to rise: inflationary (3) When D=S for labour, Y=Y*=Y at FE, natural or normal U or NAIRU (frictional and structural)
Total effect on money wages
increase in the rate of change in W (due to increase in Pe or decrease in U) decomposed into expectation effect (psychological) topped up by the gap effect (excess DN)
Why does an increase in W cause an increase in P (output prices)?
Price setting model: businesses markup their prices; P=(1+m)W
Actual inflation
expectation inflation + gap inflation + exogenous supply shock inflation; all 3 cause SRAS to shift up to the left
Constant inflation
monetary validation by BOC where M is increased at a rate to guarantee actual inflation=expected inflation; Y returns to Y* at a higher price
Depression
long, protracted recessions
Is monetary validation desirable?
it reinforces an inflationary spiral; if SRAS shocks and M validation are continuous and simultaneous, we could get stuck in stagflation (inflation + unemployment, a persistent recessionary gap with inflation
Accelerating inflation
As long as BOC maintains the inflationary gap by validating it to maintain the good times, expectations will always be revised upward and inflation accelerates
Phillips curve
inverse relationship between rate of change of W (W’) and unemployment rate (u) or real GDP; As Y approaches Y*, pressure on P to rise increases; As u increases, pressure on P to rise falls
Expectations-augmented Phillips curve
includes the effects of expectation inflation
Is inflation a monetary phenomenon?
Sustained inflation is everywhere and always a monetary phenomenon because the causes and consequences are monetary
Is moderate inflation desirable?
(1) Downward nominal wage rigidity: if inflation is 0, real w cuts are difficult (2) Zero lower bound on nominal 0-rates: if inflation is 0, real i-rate cuts are difficult (3) Healthy and growing economies tend to have moderate inflation
Unemployment and GDP in a recession
u > u* and y < y*
Unemployment and GDP in an inflation
u < u* and y > y*
What is the change in employment in the LR?
Growth in the labour force is matched by growth in employment (new jobs are created and old jobs are replaced)
What is the change in employment in the SR?
Fluctuations in the unemployment rate
Why has the supply of labour increased?
increase in population, participation, immigration, greying work force (older people still working), collaboration, “gig” or “precarious” work e.g. part-time jobs
Has the demand for labour increased?
In some sectors where new technology is developed and due to economic growth
Labour force
employed + unemployed
Employed
15 years old and over who are willing and able to work, who have ANY kind of job (part-time, temporary, contract work, etc.)
Unemployed
15 years old and over who are willing and able to work, who have NO job
Full-time
working 30 hours or more per week
Part-time
working less than 30 hours per week
Unemployment rate
unemployed/labour force
Employment rate
employed/population
Participation rate
labour force/population
Underemployment
includes discouraged workers (not willing and able to work), part-time, temporary workers, contract work; around 17% of Canadian population
What happens to unemployment during booms and busts?
normally U falls during booms and U rises during busts
Labour market
flows in and out of unemployment, rather than the simple U-rate
Discouraged workers
workers not “actively seeking work,” thus not included in the labour force
Labour force survey (LFS)
asks if you have a job, can include under-employed, temporary, and part-time
What can cause a rise in the u-rate?
discouraged workers leaving the labour force
Unemployment
all those who are willing and able to work, at the going wage rate, but are unable to find a job
What are the effects of unemployment?
(1) micro level: psychological depression and human suffering (2) macro level: economic depression, decrease in national output per capita, thus a decrease in standard of living
What is the major assumption for market clearing theories?
labour markets are flexible; there is a stable equilibrium
What is unemployment at Y=Y* and U=U*?
only NAIRU (frictional and structural), no gap
What is unemployment at YU*?
gap unemployment, greater than normal
Cyclical/gap unemployment
U in excess of frictional and structural unemployment
Demand for labour (DN)
willingness of firms to hire at a given wage rate
Supply of labour
willingness of worker to work at a given wage rate
Flexible labour market
automatic tendency to move to stable equilibrium when at w, N=N=NFE, Y=Y, U=U; no involuntary/cyclical/gap unemployment; classical or LR view
What is the major assumption for non-market clearing theories?
downward sticky wages
Downward sticky wages
nominal wages are reluctant to fall, leading to cyclical unemployment
What are the causes of downward sticky wages?
long-term employment contracts: creates a disincentive for wages to fall, fringe benefits and job security are part of contract; menu costs: changing wages has an administrative transaction cost; unions: represents interests of the insiders; psychological effect of concessions
Voluntary unemployment
“there is a job but it’s not for me” not willing and able to work so not in the labour force
Efficiency wage
employer pays a wage that is higher than the equilibrium wage to increase efficiency of workers; creates an upward pressure on wages
NAIRU
rate of unemployment that occurs when inflation is not accelerating; when there’s no cyclical unemployment
Fricitional unemployment
turnovers or search unemployment e.g. length of time to find your first job or a new job
Structural unemployment
mismatching S and D of labour e.g. worker supplies skills in logging and lives in Newfoundland (geography) but firm demands high-tech in Vancouver
What’s the difference between structural and frictional unemployment?
Structural U may just be LR frictional U; number of unfilled jobs = number of people looking for work for both
What causes an increasing NAIRU?
demographic changes, hysteresis, globalization and technological changes, government policy
Demographic changes effect on NAIRU
greater participation rates results in higher u-rates, more young people (and women, historically), immigration increased NAIRU
Hysteresis
lagged effect; current actual u-rate affects future normal u-rate (high now, higher tomorrow)
Insider-outsider model
people employed use their power to keep outsiders out, increasing NAIRU
Training model
recession prevents on-the-job training so that when the recession is over, these people are still unemployed, increasing NAIRU
Globalization effect on NAIRU
decrease in transportation and communication costs causing increased competition and trade (rightsizing, restructuring, retooling, rationalizing) increases structural U
Government policy effect on NAIRU
any G policy that reduces labour market flexibility will increase NAIRU e.g. employment insurance decreases search costs and increases search time, mandated job security in EU
Methods of reducing unemployment
(1) frictional: decrease turnover time (2) structural: increase matching of S and D of labour, eliminate resistance to change, aid change e.g. retraining and relocation (3) cyclical: increase AD with fiscal and monetary policy
Why has world trade grown faster than world GDP?
“current comparative advantage is a major determinant of trade under free-market conditions” - Ricardo
Gains from trade
increase in world output due to the law of comparative advantage e.g. getting rid of tariffs
Comparative advantage
lower opportunity cost
What are the reasons for gains from trade?
people must be self-sufficient if there’s no trade, specialization leads to efficiency, efficiency leads to cost savings, which then leads to greater total output (more to go around) so people must trade
Absolute advantage
when one country, compared to another, can produce more of a good from the same inputs
What are the gains from specialization with constant costs?
Whenever opportunity cost differs, specializing on the good that you have a comparative advantage with creates gains from trade by increasing world per capita GDP (population constant).
What are the gains from specialization with variable costs?
Whenever OCs differ, specialization and trading goods in which you have a comparative advantage increases production and decreases costs (cost savings)
What are the reasons for cost savings as production increases?
(1) economies of scale and scope: volume discounts in a larger market, moves down the LRAC (2) learning by doing: gaining accumulated experience, LRAC shifts down
Sources of comparative advantage
(1) natural factor endowments: natural advantage in resources creates cost advantages (2) acquired comparative advantage: what you develop; creates more productive workers (lower costs)
3 safety nets that increase (acquired) comparative advantage
health, education, social services
Law of comparative advantage
countries should specialize, then trade, in those good in which they have a comparative advantage
Law of one world price
internationally traded goods sell at the same price in each country, adjusted for transport costs, tariffs, exchange rates
Domestic price (Pd)
determined by domestic S and D if there is no foreign trade (closed=autarky=self-sufficient)
World price (Pw)
determined by world S and D if there is foreign trade (open economy)
Predictions from the law of one world price
CA exports those goods in which it has a comparative advantage until there is one world price
Terms of trade (real exchange rate)
determine how the gains from trade are shared; how gains in world per capita GDP (standard of living) are shared among trading nations; Px/Pm
Production possibility curve (PPC)
maximum output when using all input; slope is the OC between goods, the domestic price of export, and shows production possibilities inside country
Slope of terms of trade
the international price of export, shows consumption possibilities outside the country
