Midterm 2 (Chapters 23-27, no 25) Flashcards
Aggregate Demand (AD) curve
combinations of real GDP and the price level that make desired aggregate expenditure equal to actual national income; a set of stable equilibriums
Negative slope of AD curve
Inverse relationship between P and Ye
Relationship between price and wealth held in money
When price increases, purchasing power of money decreases, so wealth decreases
Relationship between price and wealth held in bonds
When price increases, value of the loan repayment decreases, so the wealth of the lender decreases while the wealth of the borrower increases
Relationship between wealth and consumption
Direct relationship
Trade effect
When domestic price increases, X decreases and M increases, NX decreases, and AE decreases
Relationship between P and AE
Inverse relationship: economy doesn’t have to make as much to satisfy lower desired spending
Fallacy of Composition
Individual micro demand curves cannot be added to get the aggregate demand curve
Movement along AD curve
A change in the price level causes a shift of the AE curve and a movement along the AD curve
Aggregate Demand Shock
Increase in autonomous AE shifts AE curve upward and AD curve to the right, vice versa
Simple multiplier of AD curve
Measures the horizontal shift in AD curve in response to a change in autonomous desired expenditure
Size of the horizontal shift of AD curve
simple multiplier x increase in autonomous expenditure
Aggregate supply (AS) curve
relationship between the price level and the quantity of aggregate output supplied for given technology and factor prices
Aggregate Supply Shock
Due to exogenous changes in costs: factors prices (increase, leftward) or technology/productivity (increase, rightward)
Macro equilibrium
AD=AS; Ya (points on SRAS)=Ye=Y (points on AD)
Keynesian SRAS
constant unit costs, P is constant while Y increases, k=simple multiplier
Intermediate SRAS
increasing unit costs, P and Y increase, k= multiplier
Classical SRAS
escalating unit costs, P increases while Y is constant, k=0 (very inflationary)
Key assumptions in the short run
factor prices are exogenous, technology and factor supplies are constant, thus Y* is constant, means that Real GDP is determine by AD=AS
Key assumptions in the adjustment process
factor prices are flexible/endogenous and adjust in response to output gaps, technology and factor supplies are constant, thus Y* is constant, real GDP=Y*
Key assumptions in the long run
factor prices are fully adjusted/endogenous, technology and factor supplies are changing, thus Y* is changing, meaning economic growth
Adjustment asymmetry
Booms cause wages to rise quickly, Recessions cause wages to fall slowly
3 ways to eliminate an output gap
(1) Do nothing, inventory adjustment forces Y back to Y* (2) Demand shock through fiscal policy (3) Supply side economics
Phillip’s curve
rate of change of wages are inversely related to unemployment rate
Potential output as “anchor” and SRAS as “chain”
SRAS reacts to AD/AS shocks using wage adjustments to pull Y back to Y* automatically
Long run equilibrium
Y is no longer adjusting to output gaps, AD intersects SRAS at Y*
LRAS or Classical AS
relationship between P and Y after all input costs have adjusted; a vertical line at Y* (Y*=LRAS)
What causes economic growth (changes in long run EQ)?
Only changes in Y* create economic growth due to increase in technology and factor supplies. Increase in AD only causes inflation in the long run (unless expenditure is on technology).
Paradox of thrift
In a recession, there’s a natural tendency for individuals to increase savings but this decreases C, AE, AD, Ye for the group and exacerbates a recessionary gap
Automatic fiscal stabilizers
built-in tax-and-transfer system that automatically stabilizes business cycle
Automatic stabilization vs. discretionary stabilization
If GDP is relatively low, the government automatically runs a deficit, and vice versa; Shift of budget function due to intentional change in budget
Limitations of discretionary fiscal policy
(1) Decision and Execution lags (2) Temporary v. Permanent changes - H may not trust change, long-run expectations (3) Fine v. Coarse tuning - fiscal may be too broad for fine-tuning but useful for gross-tuning
Real sector
allocation of resources among alternative uses depends on relative prices (Px/Py) i.e. shape of P distribution
Money sector
change in the money supply would change the absolute price level (Px in terms of dollars or the common denominator) i.e. mean of P distribution
Classical dichotomy
divide the economy (fictitiously) into real and monetary sectors
Exchange identity
amount of money/value that you give up = what you get; MV=Py
Neutrality of Money
Change in M leads to a change in P if you assume velocity (V) is constant since technology is constant and Y is constant since it’s at/near Y*
Modern view of money
In the SR, change in M can lead to a change in P or Y. In the LR, change in M leads to a change in P.
What is money?
Medium of exchange, store of wealth, unit of account
Medium of exchange
facilitates trade, “double coincidence of wants” i.e. A wants what B has, vice versa
Characteristics of medium of exchange
generally acceptable, high value relative to its weight, divisible and durable, cannot counterfeit
Store of wealth or store of purchasing power
earning and spending are not synchronized so it must have a stable value e.g. deferred payments
Unit of account
a means for comparing values of G&S (relative or absolute)
Commodity money
high intrinsic value that’s recognizable, durable, divisible, and stable e.g. precious metals and gold
Paper money
token money that had value because it was generally accepted, not intrinsic, by custom or mandated/legislated by the state, fully convertible to gold on demand (goldsmith receipt)
Fractionally backed paper money
Banks issue more notes convertible to gold (loans) than gold in their vaults as reserves and charge interest; banks have discovered there are less withdrawals than deposits
Fiat money
declared by law as legal tender i.e. if you pay off debt, you’ve discharged your debt, not convertible to gold
The gold standard
Domestically, the economic unit of account is fully convertible to gold at a fixed rate
Chequing account or demand deposits
interest rates are relatively low, withdrawn on demand with no prior notice needed
Savings accounts
needs a notice prior to withdrawal, higher interest rates
Term deposits
Makes higher interests for a specific period of time but penalized if withdrawn early (interest reduced)
Central bank
government Crown corporation (solely owned by the government) whose primary function is to implement monetary policy
Financial intermediaries or “the banks”
privately owned profit-maximizing corporations that transform assets (deposits) to liabilities (loans)
Functions of BOC
(1) Banker’s bank- holds reserves, lender of last resort at bank rate, settles accounts (bank transfer funds), (2) Government’s bank- short-term T-bills or long-term G bonds (3) Regulates money supply (4) Regulates financial markets- prevents panic and bank failures
Functions of commercial banks
(1) To provide credit (lend) and accept deposits (borrow) (2) Interbank activity- pooled loans to large companies (3) Clearing cheques by chartered banks through “clearing house”
Main asset and liability of commercial banks
Asset: securities and loans; Liability: deposits
Reserves
Profit that isn’t loaned out to meet demands on deposits and avoid a run on the banks (withdrawals>reserves)
Methods to avoid run on banks
(1) BOC can induce an increase in reserves by loaning money directly to banks on overnight market or through open market operations- banks buy securities (2) Canada Deposit Insurance Corporation- govt. can insure deposits (3) Narrow banking- banks restricted to make safe loans
Reserve ratio
% of deposits that are not loaned out either in cash or BOC deposits; RR= Reserves/total deposits
Target reserves
what banks wish to hold
Actual reserves
what banks actually hold
Excess reserves
amount of reserves held above target
Secondary reserves
liquid assets convertible to cash e.g. T-bills and govt. bonds
Fractional reserve system
BOC can bail the banks out if reserves are low by changing the bank rate (cost of borrowing from BOC), which is inextricably linked to the overnight market and determines level of reserves
What happens when BOC changes the bank rate?
If BOC increases the bank rate, banks are induced to hold more reserves. If BOC decreases the bank rate, banks are induced to decrease level of reserves and loan out more.
Simplifying assumptions for the creation of money
(1) Fixed reserve ratio- money creation only works if banks loan excess reserves or grant credit (2) No leakage in the banking system=no cash drain; money creation is not automatic but depends on both public and bank behavior (trust)
Money Supply
currency in circulation (cash) + deposits (many types)
Multiple expansion of money supply
A portion of a new deposit into a bank (RR) is kept as reserves while the rest are loaned out, which is deposited into other banks etc. Total change in M= Change in new deposit/RR
M1
Cash + demand deposits in banks (not used anymore0
M2
M1 + savings deposits (used by BOC)
M2+
M2 + deposits at other financial intermediaries
M2++
M2+ plus all other mutual funds
M3
M2 + all other deposits (foreign currency deposits)
Near money
not a very good medium of exchange, but a good store of wealth e.g. T-bills and trust company deposits
Money substitutes
good medium of exchange but not a very good store of wealth e.g. credit and debit card
Division of wealth in financial portfolio
Money are non-interest bearing assets (no risk, no return) and bonds are interest-bearing assets
Bond
financial contract to pay fixed payment (interest) at future specified date(s) and repay the principal at the end of maturity
Debtor vs. Creditor
Debtor=borrower=sells bond and creditor=lender=buys bond
Clipping
shaving the edges of coins, collecting the shavings, then minting new coins
Milling
placing rough edges on coins to prevent clipping and counterfeits
Debasement
adding cheap metal when reminting coins, thus lowering their intrinsic value; causes inflation (classical theory of inflation: more money chasing the same goods)
Gresham’s law
“bad money drives out good” people hoard money with high intrinsic value (i.e. keep them out of circulation) while using ones made of cheaper metal for payment
4 pillars of the financial system
commercial banks, insurance companies, security companies, trust companies
Wealth in a financial portfolio
accumulated purchasing power divided into non-interest bearing assets or money and interest-bearing assets or bonds
Face value of a bond
initial price of the bond or the original loan value
Coupon
dollar value of future return; constant
Coupon yield
coupon/face value; constant; market yield when the bond was originally sold in the primary market
Price of the bond (Pb)
originally the face value but its present value (PV) can change once it’s sold in the secondary bond market
Bond yield or rate
the yield to maturity or effective yield, which is determined by coupon + capital gain, and moves in tandem with the market yield
Market yield (i-rate)
the average interest rate on all interest-bearing assets currently in the market or the minimum you would accept in order to loan money
Primary market and secondary market of bonds
primary market is where you buy new bonds (Pb=face value) and secondary market is where you buy used bonds (Pb=Pv, can go up or down)
Present value approach
varies inversely with the i-rate or market yield; the discounted value of all expected future returns using the market yield
What happens when market yield increases and decreases?
When the market yield increases, the demand for existing bonds (in the primary market) decreases, the Pb or PV of those old bonds decreases (in the secondary market) and the bond yield increases to match the current higher market yield i.e. the bond gets sold “at a discount” (PVFV).
Liquidity preference function (L)
the demand for money or the willingness to hold money (real cash balances) instead of bonds
Bond rate (nominal)
directly related with OC of holding money and inversely related with Ls (speculative demand for money)
Why do households and firms hold money?
Transactions demand (Lt), precautionary demand (Lp), speculative demand (Ls)
Marginal Efficiency Investment (MEI) curve
real interest rate in the nominal sector and willingness to invest in the real sector (PEI’R) are inversely related; decreasing i-rate = decreasing OC of borrowing for investment
What are hysteresis effects?
Argues that a change in M can affect Y*
