Final Study Guide - Summary Macroeconomics PDF

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Study guide for FINAL EXAM, covers chapters 5-11 (briefly) and chapters 12-14 (in depth)...

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MACROECONOMICS 2200 Study Guide for Final Exam, Spring 2015 Covers chapters 5 – 11 (briefly) and chapters 12 – 14 (in depth) All information from Macroeconomics (Third Edition) by Colander, Rockerbie and Richter

Matthew Kwong May 15, 2015

TABLE OF CONTENTS CHAPTER 5: ECONOMIC GROWTH, BUSINESS CYCLES, UNEMPLOYMENT, AND INFLATION .................................... 2 BUSINESS CYCLES ........................................................................................................................................................... 2 UNEMPLOYMENT ...........................................................................................................................................................2 NOMINAL AND REAL GDP ...............................................................................................................................................3 CHAPTER 9 AND 10: THE AGGREGATE DEMAND – AGGREGATE SUPPLY (AD-AS) MODEL AND FISCAL POLICY ....... 5 AGGREGATE DEMAND.....................................................................................................................................................5 AGGREGATE SUPPLY .......................................................................................................................................................5 AS – AD MODEL ...........................................................................................................................................................6 CHAPTER 11: POLITICS, SURPLUSES, DEFICITS, AND DEBT ...................................................................................... 7 DEFICITS AND THE BUSINESS CYCLE ....................................................................................................................................7 BUDGET BALANCE ..........................................................................................................................................................7 IMPORTANCE .................................................................................................................................................................8 CHAPTER 12: THE MONEY MARKET AND AD-AS MODEL ...................................................................................... 10 FUNCTIONS OF MONEY .................................................................................................................................................10 DEMAND FOR MONEY ...................................................................................................................................................11 QUANTITY THEORY .......................................................................................................................................................11 KEYNESIAN APPROACH ..................................................................................................................................................11 COMBINING THE THREE DEMANDS FOR MONEY .................................................................................................................13 FROM THE MONEY MARKET TO AD-AS ...........................................................................................................................13 CHAPTER 13: MONEY, BANKING AND THE FINANCIAL SECTOR ............................................................................ 15 THE IMPORTANCE OF THE FINANCIAL SECTOR TO MACROECONOMICS ....................................................................................15 THE DEFINITION OF MONEY ...........................................................................................................................................16 MEASURE OF MONEY IN CANADA ...................................................................................................................................16 BANKS AND THE CREATION OF MONEY .............................................................................................................................17 REGULATION OF BANKS AND THE FINANCIAL SECTOR...........................................................................................................19 CHAPTER 14: THE AD-AS MODEL AND MONETARY POLICY .................................................................................. 21 DUTIES AND STRUCTURES OF THE BANK OF CANADA ...........................................................................................................21 TOOLS OF MONETARY POLICY .........................................................................................................................................22 MONETARY POLICY IN THE AD-AS MODEL .......................................................................................................................23 PROBLEMS IN THE CONDUCT OF MONETARY POLICY ...........................................................................................................24 INFLATION TARGETING ..................................................................................................................................................26 APPENDIX A: CHAPTER 5 ...................................................................................................................................... 27 APPENDIX B: CHAPTER 9 - 10 ............................................................................................................................... 28 APPENDIX C: CHAPTER 11 .................................................................................................................................... 33 APPENDIX D: CHAPTER 14.................................................................................................................................... 35

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Chapter 5: Economic Growth, Business Cycles, Unemployment, and Inflation Business Cycles Recurrent, but irregular ups and downs in real economic activity  2 to 15 years ago, or more  Measured as movements away from trend GDP o 2% or less is generally considered less than optimal Each business cycle is different:  Length – how long to complete cycle?  Amplitude – how strong is economic expansion/contraction Business cycles are usually measured from peak to peak

The Policy Question Does the market economy have effective mechanisms to move the economy towards a fullemployment equilibrium level of employment?  Or is government intervention required to move economy to equilibrium  Market mechanisms may not be effective, or too slow

Role for government policies 1. Expectations: what do consumers expect of the economy 2. Uncertain market forces 3. Confidence: consumer confidence Active government policies may be required to assist market forces in returning an economy to its full-employment equilibrium  Does not dominate or control market forces Discretionary policies

Unemployment  

Percentage of people who don’t have a job and are looking for work o The data needs to be managed, sometimes they act and sometimes not Associated with business cycles, negative relationship o Unemployment lags behind the business cycle – firing people takes time to happen o Confidence in recovery required before hiring new employees

Different types of unemployment pose different problems for policy makers

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Frictional Unemployment Occurs because it takes time to find a new job  Information  Geographic considerations  Demanded skills match possessed skills Solution: information to better match job seekers with employers

Structural Unemployment Represents mismatch between job seekers and available jobs  As economy changes, some jobs become unavailable  Indicate change in nature of production in the economy  Employees must retrain or relocate to be employed, can be long term problem Solution: training program to update skills

Cyclical Unemployment Occurs in accordance with business cycle Solution: Stimulate economy

Natural Rate of Unemployment (Target Rate of Unemployment) The rate of unemployment producing at a natural rate in the economy Full employment:  Does not mean everyone has a job  People roughly have a job  Long-run equilibrium  Full-employment unemployment rate Everyone working who wants to work; also no one working who does not want to work  Occurs when the business cycle is exactly at its long-run trend growth rate  Includes frictional and some structural unemployment o People always moving between jobs o Economy always adjusting

Nominal and Real GDP Nominal GDP: measures the current market value of all final goods and services produced during the year Real GDP  measure of a country’s annual production which factors out the effects of inflation  makes it possible to compare different year’s production Page 3

Calculating Nominal and Real GDP Calculate nominal GDP for each year by multiplying the quantity of units produced by the price of each unit – add the totals for all types of products produced to get nominal GDP.

Shirts VCR Sofa Machines Computers Nominal GDP Shirts VCR Sofa Machines Computers Real GDP

Quantity 10000 400 100 250 60

1981 Price per unit $ 12.00 $ 600.00 $ 600.00 $ 900.00 $ 4,000.00

Total $ 120,000.00 $ 240,000.00 $ 60,000.00 $ 225,000.00 $ 240,000.00 $ 885,000.00

Quantity 11000 600 120 275 125 11000 600 120 275 125

1991 Price per unit $ 20.00 $ 500.00 $ 950.00 $ 1,125.00 $ 2,600.00 $ $ $ $ $

12.00 600.00 600.00 900.00 4,000.00

Total $ 220,000.00 $ 300,000.00 $ 114,000.00 $ 309,375.00 $ 325,000.00 $ 1,268,375.00 $ 132,000.00 $ 360,000.00 $ 72,000.00 $ 247,500.00 $ 500,000.00 $ 1,311,500.00

Real GDP is calculated using the GDP deflator method to factor out the effects of inflation. Take the number of units produced in the current year multiplied by the prices of the base year to obtain real GDP. Compare the real GDP of 1991 to the nominal GDP of 1981 – there is definitely growth in real terms (real as in adjusting for inflation).

Inflation To calculate inflation over the period from 1981 to 1991: Π = inflation 𝜋 = 𝜋=

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑓𝑜𝑟 1991 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 𝑓𝑜𝑟 1991

−1

1268375 − 1 = 0.9671 1311500

Inflation is less than 1, therefore deflation!

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Chapter 9 and 10: The Aggregate Demand – Aggregate Supply (AD-AS) Model and Fiscal Policy Aggregate Demand Relationship between real GDP and price level Ceteris Paribus conditions (all things held equal): what if underlying conditions change? 1. Interest rates i. Interest increases  borrowing decreases spending (C,I) decreases  AD decreases (shift left) 2. Expected inflation i. Expected inflation increases future purchasing power decreases spending increases AD increases (shift right) 3. Foreign exchange rate i. Canadian dollar depreciation  Canadian goods relatively cheaper than foreign goods  spending increases (X increases, M decreases)  AD increases (shift right)

Aggregate Supply Two time frames  Long run  Short run Long-run Aggregate Supply Occurs at the point where economy producing at its natural capacity  “comfortable maximum production” o Potential output level, full employment, natural rate of output  Given current stock of productive capital resources and a fully-employed labour force Short-run aggregate supply o Actual production in the economy may vary from its potential  Sometimes below capacity – unemployment exists  Sometimes beyond current production capacity – overtime, nightshift, weekend shift Ceteris Paribus Conditions: Long Run Factors affecting the economy’s production potential  Size of labor force  Capital stock  Human capital o Education o Training o Experience Page 5

  

Raw materials Technology Climate

Factors which affect (shift) only the SAS, and which do not affect the potential production capacity (LAS)  Wages  Raw material costs  Capital costs  Energy Costs LAS and SAS converge at production absolute limit – cannot produce more, even in short term At equilibrium, economy in potential output – no need to adjust or work harder Unemployment equilibrium means not performing at potential output Recessionary Gap: SAS equilibrium with AD less than LAS Inflationary Gap: SAS equilibrium with AD higher than LAS

AS – AD Model Assume economy is in recession, output well below potential To rectify the problem associated with low production, the government embarks on a program of expansionary fiscal policy. More government spending pushes the AD curve to equilibrium point – intersection of LAS and SAS Suppose, instead of raising government spending, the government decides to stimulate the economy by offering consumers a tax cut. Taxes decrease  consumer spending increases However because consumers will also save money rather than spend, tax cuts are not as effective as direct government spending – AD curve may not reach equilibrium Suppose government enacts a classical policy – do nothing Wages will begin to fall  affects cost of production  SAS shifts down until it reaches equilibrium due to lower prices charged

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Chapter 11: Politics, Surpluses, Deficits, and Debt Debts: accumulated deficits Deficit: shortfall per year Budget deficit = revenue – expenditure < 0 Revenue  Earnings from crown corporations  Taxes  Tariff’s and duties Expenditure  Government spending on goods/services  Transfer payments  Interest payments on the debt *For a given year Debt: total of all years

Deficits and the Business Cycle Peak  Contraction  Trough  Expansion  Peak Peak    

High employment High revenue Low transfer Budget surplus

Trough  High unemployment  Increased transfers  Low income – pay low income tax receipts  Budget deficit

Budget Balance Government spending = G Tax = T Tax Rate = t Y = income Total tax = T + t * Y Budget = T – G G < T then T – G > 0  Budget Surplus Page 7

G > T then T – G < 0  Budget Deficit Structural deficit or surplus  Government budget at potential output  Deficit  Surplus  Balance Cyclical deficit or passive deficit  Passive because not caused by the government  Depends on stage of the business cycle

Importance Long-run vs. short-run view of economic growth Long-run view  Surpluses are source of saving to fund investment o Infrastructure o Education o Training o Roads and bridges o Technology projects Short-run view  Deficit spending to stimulate production o Economy in recession o Encourage AD  Shift right  Output rises  Income tax (t * Y) rises Burden of the debt  Debt gets bigger and bigger – interest rate increase to make people buy bonds  Danger of going to monetization o Switch from debt financing to money financing – print money  Especially if debt is large  Lasting a long time  Leads to depreciation  Higher future debt burden o Pay interest on the debt o Consume today  Next generation pays for it  Unless a generation has to pay for themselves Income redistribution from Canadian taxpayers to debt holders (rich Canadians and foreigners)

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Crowding out investment  Government borrowing raises interest rate  Current investment decreases  Future generations inherit less capital stock Ricardian Equivalence  People anticipate future higher taxes  Reduce consumer spending today, save in order to pay future taxes  Same as paying higher taxes today

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Chapter 12: The Money Market and AD-AS Model Money Market: broadly defined as the exchange of financial assets with a maturity date of one year or less – e.g. cash, cheque, some bonds, etc. This chapter includes the trade of aforementioned financial assets into the AD-AS model explained in previous chapters. Money is a unit of exchange, an asset which can be quickly traded for another good, service or asset. This is not necessarily currency – bills and coins – which will be discussed later.

Functions of Money Three functions:  Medium of exchange (for goods and services)  Unit of account  Store of wealth

Money as Medium of Exchange Money is used to trade for goods and services. It is a common unit with universal value that can be exchanged for whatever was needed. This eliminated the need for bartering – the trading of one good or service directly for another, such as grapes for bread – which was inefficient and difficult. Medium of Exchange: the actual physical good used to trade e.g. paper bills and coins. The medium itself does not have much value; rather it is the belief that money has value which allows it to be used to buy goods and services. The value of money comes from everyone believing it will have value, and will be accepted at some future date for a good. This value can diminish, which is otherwise known as inflation. Increasing the amount of money in the economy lowers the value of money (supply and demand, higher supply means lower price). Thus the government must regulate the money supply.

Money as a Unit of Account Unit of account: the denomination that prices are measured by e.g. the dollar in Canada. Having a unit of account allows prices to be set easily for a wide range of goods ($2 for bread, $1 for cookies). Otherwise, you’d have to remember that 5 grapes is worth one loaf of bread or two cookies. However the value of money is relative (in part because its value comes from belief). $2 buys one loaf of bread: if the value of money declines (e.g. inflation), it may now cost $5 to buy one loaf of bread. The value of money relative to the goods it can buy has decreased.

Money as Store of Wealth Store of wealth: financial asset for holding savings. Having money – a financial asset – allows money to be saved and spent later on. However, while the actual medium of exchange is durable (dollar bills), the value of money can still change even while it is stored. If prices rise, the relative value of money falls – recall PV and FV, where $100 now is worth more than $100 in the future.

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Demand for Money Money demand: the amount of money individuals desire to hold as cash. In Macroeconomics the concern is with how much money the entire economy wishes to hold, rather than individual. Understanding money demand is important for monetary policy such as changing the interest rate.

Quantity Theory A theory of money demand; measures the frequency with which money is exchanged and extends that into an estimate of how much is demanded in the economy.    

T: number of transactions P: price level M: amount of money in the economy V: velocity of money

Transaction velocity of money: the average number of times a dollar will be exchanged between buyers and sellers within a period of time. 𝑚𝑜𝑛𝑒𝑦 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑘 × (𝑃 × 𝑌) P*Y is nominal income, k is a positive number that translates nominal income into money demand Money demand = money supply Therefore: 𝑘 × (𝑃 × 𝑌) = 𝑚𝑜𝑛𝑒𝑦 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑚𝑜𝑛𝑒𝑦 𝑠𝑢𝑝𝑝𝑙𝑦 Rearrange a bit and you get: 𝑀 = 𝑀𝑉 = 𝑃𝑌 𝑘 OR 𝑃𝑌 𝑀 Equation for finding income velocity of money and money demand. The money supply multiplied by velocity gives the total number of transactions made to generate the nominal income level in the economy – this creates the MV = PY equation. 𝑉=

Keynesian Approach Keynes looked at money demand by considering why individuals hold money:  

Transaction demand Precautionary demand Page 11



Speculative demand

Transactions Demand Liquidity: the ease with which a financial asset can be exchanged for another good. Cash is the most liquid, while durable goods such as bicycles are not. Transactions demand means that people demand money because they need it to exchange for goods and services. An increase in nominal income will increase demand for money – you will have more money to spend (this assumes you do not save money and spend all your income). Likewise a reduction in nominal income will reduce the amount of money available to spend.

Precautionary Demand Demand fo...