ECN 204 Chapter 11

Marginal Propensity to Consume/Save

The marginal propensity to consume, or MPC, is the increase in consumer

spending when disposable income rises by $1.

The marginal propensity to save, or MPS, is the increase in household savings

when disposable income rises by $1.

When one earns a dollarthe part of the dollar you spend C/YD

MPS = change in savings/YD

MPC + MPS = 1

The Multiplier

Increase in investment spending = $10 billion

+ Second-round increase in consumer spending =

MPC $10 billion

+ Third-round increase in consumer spending =

MPC2 $10 billion

+ Fourth-round increase in consumer spending =

MPC3 $10 billion

Total increase in real GDP = (1 + MPC + MPC2 + MPC3 + . . .) $10 billion

The multiplier is the ratio of the total change in real GDP caused by an
autonomous change in aggregate spending to the size of that autonomous
change.

An autonomous change in aggregate spending is an initial change in the

desired level of spending by firms, households, or government at a given
level of real GDP.

The change in real GDP equals the multiplier times the autonomous
expenditure

Individual Consumption Function

An equation showing how an individual households consumer spending

varies with the households current disposable income.

Its linear
Linear function-upward sloping an increase in disposable income causes
an increase in consumption
Slope is the MPC
Aggregate Consumption Function

The relationship for the economy as a whole between aggregate current

disposable income and aggregate consumer spending.
Planned Investment Spending

The investment spending that businesses plan to undertake during a

given period.
It depends negatively on:

interest rate
existing production capacity
And positively on:

Expected future real GDP.

In other wordshow much firms choose to invest
Accelerator Principle: A higher rate of growth in real GDP leads to higher
planned investment spending.

Inventories

Inventories: stocks of goods held for future sales

If inventories goes up you sell less, if inventory goes down you sell more
Unplanned inventory investment: occurs when actual sales are more or
less than businesses expected, leading to unplanned changes in
inventories.
Actual investment spending: the sum of planned investment spending and
unplanned inventory investment
Actual Spending Formula:

Income Expenditure
Assumptions underlying the multiplier process:

The interest rate is fixed.

Taxes, transfers, and government purchases are all zero.
Exports and imports are both zero. There is no foreign trade.
Price level is fixed, real channels not nominal channels

Planned Aggregate Expenditure

Total amount of money planned to be spent in the economy

Note: the AE slope does not always equal CF

Income Expenditure Equilibrium

Incomeexpenditure equilibrium GDP: the level of real GDP at which

real GDP equals planned aggregate spending.

New definition of equilibrium

Real GDP greater than Y is bigger than Y* the economy is exceeding
expectations inventories are reduced, negative increase production
Actual GDP falls below the target Y is lower than Y* - inventories are
positive and build up reduce production

It tells us when planned aggregate expenditure equals real GDP

Planned = Unplanned
45 degree line is the equilibrium line
Aggregate expenditure = c + I planned + I unplanned -curve intersects 45
degree line real GDP equilibrium Y = Y*

Paradox of Thrift

Households and producers cut their spending in anticipation of future

tough economic times.
These actions depress the economy, leaving households and producers
worse off than if they hadnt acted virtuously to prepare for tough times.
not everything aggregates well together
whats good for one person might not be good for the economy as a whole

ECN 204 Chapter 12 Lecture 7

Aggregate Demand
Aggregate demand curve: shows the relationship between the aggregate
price level and the quantity of aggregate output demanded by households,
businesses, the government, and the rest of the world.
The curve is downward-sloping because
1. Wealth Effect: higher aggregate price level reduces the purchasing power of
households wealth and reduces consumer spending.
2. Interest Rate: higher aggregate price level reduces the purchasing power of
households money holdings, leading to a rise in interest rates and a fall in
investment spending and consumer spending.
Substitution and wealth effect wealth= Income / price level
Interest rateReal balance = money in your wallet / price level
Price goes up purchasing power goes down and interest rates goes up
They both say different things
Shifts caused by
The aggregate demand curve shifts because of:

changes in expectations
If consumers and firms become more optimistic, aggregate
demand increases and vice versa

Wealth
If the real value of household assets rises, aggregate demand
increases and vice versa

the stock of physical capital

If the existing stock of physical capital is relatively small,
aggregate demand increases and vice versa

government policies
fiscal policy

If the government increases spending or cuts taxes,

aggregate demand increases and vice versa

monetary policy

Aggregate Supply Curve

If the central bank increases the quantity of money,

aggregate demand increases and vice versa

 Shows the relationship between the aggregate price level and the quantity of
aggregate output in the economy.
Upward-sloping because nominal wages are sticky in the short run:
o A higher aggregate price level leads to higher profits and increased
aggregate output in the short run.
o they dont adjust easily
Nominal wage: the dollar amount of the wage paid.
Sticky Wages: nominal wages that are slow to fall even in the face of high
unemployment and slow to rise even in the face of labour shortages.
Note: In the short run wages are fixed
Shifts of the Short-Run Aggregate Supply Curve
Changes in
commodity prices
o If commodity prices fall, short-run aggregate supply increases
and vice versa
nominal wages
o If nominal wages fall, short-run aggregate supply increases and
vice versa
Productivity
o If workers become more productive, short-run aggregate supply
increases and vice versa
. lead to changes in producers profits and shift the short-run aggregate supply
curve.
Long-Run Aggregate Supply Curve
Shows the relationship between the aggregate price level and the quantity of
aggregate output supplied that would exist if all prices, including nominal
wages, were fully flexible.
RW wont change over time
P goes up wages goes up
The AD AS Model
Uses the aggregate supply curve and the aggregate demand curve together
to analyze economic fluctuations.
Short-run macroeconomic equilibrium: when the quantity of aggregate
output supplied in the short run is equal to the quantity demanded.
Short-run equilibrium aggregate price level: the aggregate price level in the
short-run macroeconomic equilibrium.
Short-run equilibrium aggregate output: the quantity of aggregate output
produced in the short-run macroeconomic equilibrium.
Long Run Macroeconomic Equilibrium
When the point of short-run macroeconomic equilibrium is on the long-run
aggregate supply curve.
Triple intersection

Gap Recap
Recessionary Gap: when aggregate output is below potential output
o When short run equilibrium is to the left LRE
Inflationary Gap: when aggregate output is above potential output
o When SRE is to the right LRE
Output Gap: the percentage difference between actual aggregate output and
potential output

SRAS = AD > SRE Actual GDP

SRAS=AD=LRAS=LRE Potential GDP
Essentially the formulas is (SRAS= AD LRAS) / LRAS
Self-Correcting: when shocks to aggregate demand affect aggregate output in
the short run, but not the long run.
o Economy will self-adjust

Recessionary gap E1 to E1 prices fallSRAS goes up from SRAS 1 to SRAS2,

move from E2 to E3
Price level going to fallpotential GDP stays same

demand goes up move from AD1 to AD2

At E2 SRAS=AD2 to right of LRAS
Prices goes up, inflationary gap cause wages goes up
Price goes up, Y stays the same

Macro Policy
Active stabilization policy: using fiscal or monetary policy to offset shocks.
Policy in the face of supply shocks:
o There are no easy policies to shift the short-run aggregate supply
curve.
o Policy dilemma: a policy that counteracts the fall in aggregate output
by increasing aggregate demand will lead to higher inflation, but a
policy that counteracts inflation by reducing aggregate demand will
deepen the output slump.

ECN 204 Lecture 8 Chapter 13 & 14

Fiscal Policy
Government Budget and Total Spending
Fiscal Policy: the use of taxes, government transfers or government
purchases of goods and services to shift the aggregated demand curve
Expansionary and Contractionary Fiscal Policy

Expansionary fiscal policy-increase in government purchases of goods and

services, a reduction in taxes, or an increase in government transfersshifts
the aggregate demand curve rightward.
Also, it leads to an increase in real GDP
It can close the recessionary gap by shifting AD1 to AD2, moving the economy
to a new short-run macroeconomic equilibrium, E2, which is also a long-run
macroeconomic equilibrium.
A contractionary fiscal policyreduced government purchases of goods and
services, an increase in taxes, or a reduction in government transfersshifts
the aggregate demand curve leftward.
Also, it leads to a fall in real GDP
Lags in Fiscal Policy
Realize the recessionary/inflationary gap by collecting and analyzing
economic data takes time
Government develops a spending plan takes time
Implementation of the action plan (spending the money takes time

Fiscal Policy and the Multiplier

Theres a multiplier effect with fiscal policy
Depends on the type of fiscal policy
The multiplier on changes in government purchases,
1/(1 MPC), is larger than the multiplier on changes in taxes or transfers,
MPC/(1 MPC),
o Because part of any change in taxes or transfers is absorbed by
savings.
How Taxes Affect the Multiplier
Taxes and some transfers act as Automatic Stabilizers
o Reduce the size of the multiplier, reducing size of fluctuations in
business cycle
Discretionary Fiscal Policy arises from deliberate actions by policy makers
rather than from the business cycle
Budget Balance

Increased gov. spending, increased gov. transfers or lower taxes reduce

budget balance for that year
Expansionary fiscal policies make a budget surplus smaller or a budget deficit
bigger
Contractionary fiscal policies smaller gov. spending, smaller gov. transfers or
higher taxes increase the budget balance for that year making a budget
surplus bigger or a budget deficit smaller
Some fluctuations are caused by the business cycle
Cyclical Adjustment Budget Balance an estimate of the budget balance if
the economy were at potential output
Long Run Implications of Fiscal Policy
Persistent budget deficits lead to public debt
Problems with Rising Gov. Debt
Public debt may crowd out investment spending reduce long run economic
growth
Rising debt may lead gov. into default( economic and financial turmoil
Printing more money causes inflation
CHAPTER 14

Money: any asset that can easily be used to purchase goods and services
Currency in circulation: money that is held by the public

Chequeable deposits: bank deposits on accounts which people can write

cheques
Money Supply: total value of financial assets in the economy that are
considered money
Medium of exchange: an asset that individuals acquire for the purpose of
trading rather than for their own consumption
Store of Value: means of holding purchasing power over time
Unit of account: a measure used to set prices and make economic
calculations
Commodity money: a good used as a medium of exchange that has intrinsic
value in other uses
Commodity-Backed Money: a medium of change with no intrinsic value whose
ultimate value is guaranteed by a promise that it can be converted into
valuable goods
Fiat Money: medium of exchange whose value derives entirely from its official
status as a means of payment
Monetary aggregate: overall measure of the money supply
Near-Moneys: financial assets that cant be directly used as a medium of
exchange but can be readily converted into cash or chequeable bank deposits
A bank is a financial intermediary that uses liquid assets in the form of bank
deposits to finance the illiquid investments of borrowers.

Bank reserves: the currency banks hold in their vaults plus their deposits at
the Bank of Canada.

A T-account: a tool for analyzing a businesss financial position by showing, in

a single table, the businesss assets (on the left) and liabilities (on the right)
o Summarizes a businesss financial position
o If assets are more than liabilities the equity is positive and vice versa

Reserve ratio: the fraction of bank deposits that a bank holds as reserves.
Reserve requirements: rules set by the central bank that determine the
minimum reserve ratio banks.

The desired (or voluntary) reserve ratio: the fraction of deposits that banks
want to hold as reserves.

Determining the Money Supply

The effect of before a bank makes a new loan:

The effect of when a bank makes a new loan:

Effect of turning cash into a deposit:

Excess reserves: bank reserves over and above the banks required reserves
o Ex. Increase in bank deposits from $1,000 in excess reserves =
$1,000/rr
Money Multiplier
Monetary base: the sum of currency in circulation and bank reserves.
Money multiplier: the ratio of the money supply to the monetary base.
Central Banks
Central bank: an institution that oversees and regulates the banking system
and controls the monetary base.
Ex. Bank of Canada
o Banker for commercial banks the BOC will normally act as a lender
of last resort for a commercial bank with sound investments that is in
urgent need of cash and cannot find a lender.
o Banker for the federal government the BOC not only manages federal
government bank accounts, but it also occasionally lends money to the
federal government through buying some of the securities that the
government issues.
o Issues currency ensures the supply of banknotes meets public
demand and prevent counterfeiting.
o Conducts monetary policy controls interest rates, the quantity of
money, the exchange rate, or some combination of these actions.

 Banks in Canada are not required to hold a fraction of deposits as reserves

Overnight Funds Market: a financial market in which banks can borrow funds
from banks with excess reserves
Overnight rate: the interest rate determined by the overnight funds market
Target for the overnight rate: the bank of Canadas official key policy interest
rate also known as the discount rate in some countries

Open Market
Open Market Operation: is the purchase or sale of assets by a central bank.
Bank of Canadas assets and Liabilities:

Deposit switching: the shifting of government deposits between the Bank of

Canada and the commercial banks. It is a major tool used by the Bank of
Canada in its day-to-day operations.
Bank of Canadas policy has been to set a key interest rate rather than set
the money supply.
The BOC can only influence the money supply, but not control it.
It is not clear what the money supply is. Monetary aggregates M1, M2, and
M2+ differ not only in their annual growth rates, but may also move in
different directions.
It is more easily explained to and understood by the public.

ECN 204 Lecture 9 Chapter 15 and 16

Non-monetary assets: assets that are not made up of money nor function as
money
Short-term interest rate: the interest rates on financial assets that mature
within six months or less
Long term interest rate: interest rates on financial assets that mature a
number of years in the future.
The motivation is to hold ones money however no interest
Hold wealth in the form of money or bonds
Money demand curve: shows the relationship between the interest rate and
the (nominal) quantity of money demanded.
o Downward sloping, negative
o inverse relationship interest rate goes up quantity of money goes
down and vice versa
o Along the curve shift due to change in interest rate
Shifts of Money Demand Curve:
o Changes in aggregate price level
Increase price level creates shift to right and vice versa
o Changes in real GDP
Increase in real GDP creates shift to right and vice versa
o Changes in credit markets and banking technology
Increase credit markets and banking technology creates shift to
right and vice versa
o Changes in institutions
Liquidity preference model of the interest rate: the interest rate is
determined by the supply and demand for money.
The money supply curve shows how the nominal quantity of money supplied
varies with the interest rate.
o Money supply curve, upward sloping, positive
o Two assumptions

o
o

1: An increasing function of the interest rate

2: The money supply curve is invariant to the interest rate (BOC sets it)

Lower than equilibrium interest rate, money demand is greater than money
supply and prices go up
Higher than equilibrium interest rate, money demand is lower than money

supply and prices fall

Increased money supply which causes excess supply of money which pushes
down the prices of money, which pushes down the interest rate

 Shrinks the money supply, interest rate goes up

Monetary Policy
Expansionary monetary policy is monetary policy that increases aggregate
demand.
To increase the money supply
Contractionary monetary policy is monetary policy that reduces aggregate
demand.
To shrink the money supply

Effects

I (investment spending) and C (Consumer spending) are a function of the

interest rate
GDP goes down with contractionary and vice versa with expansionary

Monetary Policy in Reality

Inflation Targeting
Occurs when the central bank sets an explicit target for the inflation rate and
sets monetary policy to hit that target.
More or less, a zone rather than target
Advantages of inflation targeting:
Economic uncertainty is reduced because the central banks plan is
transparent.
The central banks success can be judged by the gap between the
actual inflation and the inflation target, making central bankers
accountable.
Note: One disadvantage of inflation targeting is that its too restrictive when
there are other concerns, such as financial system stability, that may require
more attention.
Zero Bound and QE

Zero lower bound for interest rate: interest rates cannot fall below zero, which
sets limits to the power of monetary policy.

Quantitative Easing (QE): a monetary policy in which a government tries to

drive down interest rates, thus exerting an expansionary effect on the
economy, by buying longer-term government bonds, instead of the shorterterm bonds it would buy usually.

Essentially, flooding money supply

Money Neutrality

 Money has inflationary (Price level) effects

No change in real GDP
Monetary neutrality: changes in the money supply have no real effect on the
economy. So, monetary policy is ineffectual in the long run.
If it isnt neutral it isnt vertical

Increased money supply MS1 to MS2 , Equilibrium drops, interest rates are
lowered , creates demand for money and all this in the long run raise interest
rate and alters equilibrium again
Money doesnt affect GDP
Chapter 16
Inflation
Classical Model of the price level: real quantity of money is always at its longrun equilibrium
Aka its neutral
Inflation Tax: the reduction in the value of money held by the public caused
by inflation
Seigniorage: the revenue generated by the governments right to print
money
Print more money it creates inflation which lowers purchasing power
and value of money

Formuala: Seigniorage= M

Nominal because it is the change in M( Money Supply)

Real Seigniorage: the real purchasing power that the government takes away
from money holders when it generates revenue by printing money, which can
be written as rate of growth of the money supply multiplied by real money
supply

Real seigniorage=

M M
=
P
M

( )( MP )

Output Gap & Unemployment

When actual aggregate output is equal to potential output, the actual

unemployment rate is equal to the natural rate of unemployment.

When the output gap is positive (an inflationary gap), the unemployment rate
is below the natural rate.

Unemployment is too low

When the output gap is negative (a recessionary gap), the unemployment

rate is above the natural rate.

Unemployment too high

Remember: Natural Rate = Long term unemployment

Short Run Phillips Curve: the negative short-run relationship between the
unemployment rate and the inflation rate.
Downward sloping relationship
Short-Run
Unemployment low, inflation high and vice versa
NAIRU (Nonaccelerating Inflation Rate of Unemployment): the unemployment
rate at which inflation does not change over time.
Is there some level of unemployment where inflation is fixed?
Long-Run Phillips Curve: shows the relationship between unemployment and
inflation after expectations of inflation have had time to adjust to experience.
Disinflation: is the process of bringing down inflation that is embedded in
expectations.

 Long run Phillips curve is invariant, an unemployment rate at which inflation

is stable

The natural rate of unemployment is the portion of the unemployment rate

unaffected by the swings of the business cycle.
The NAIRU is another name for the natural rate.
Natural Rate is the long term target rate

ECN 204 Lecture 10 Chapter 18 & 19

Chapter 18
Classical Macroeconomics: believes monetary policy only affects the aggregate
price level, not aggregate output.
Changes in M change P but not Y (GDP)
Classical believes short run was not important
Also believes prices are flexible, making supply curves vertical
The change in M = the change in P
Growth rates The change in growth rate of money supply = change in price
but no change in GDP
Increase in money supply causes inflation

Keynesian Economics
Keynes brought a new economic theory
He believed:
Wages are not flexible, there is stickiness, rigidness in the economy
Wages and prices do not adjust easily
o Explained with unions and how price dont change every day therefore
W/P cant be fixed
As a result, SRAS is upward sloping not vertical
In the long run, we are all dead
Monetarism: believes that GDP will grow if money supply grows steadily
In other words, money matters
Believes the solution is to inject money in the economy

Discretionary Monetary Policy: when the central bank changes interest rates or
money supply based on their assessment of the state of the economy
Basically, when they have to make a change
Monetary policy rule decides the central banks actions
Velocity of money equation: M x V = P x Y
o Where V = velocity
o Classical believes: PY determines MV
o Keynes believes: MV determines PY
o When V is stable. M = PY (aka Nominal GDP)

Fiscal Policy with a fixed money supply

In this casePrice levels increased so Consumption goes down,

investments goes down but interest increases
Crowing out effect that even though fiscal policy can increase GDP, there may
not actually be an increase
If AD only falls a little thats complete crowding out
Fiscal policy becomes less effective when the money supply is held fixed
Inflation & Natural Rate of unemployment
When actual inflation = expected inflation Growth will be constant
Long run believes everything will fix itself
New Classical Macroeconomics
The new classical macroeconomics approach says: Money doesnt matter,
fiscal policy doesnt matter only thing that matters is the business cycle
only can use policy to control it with a target range ( Prevent from getting too
high or low)
Rational Expectations

 Says: you need forward looking expectations, use systematic forecasting,

believes the economy is stable
Real Business Cycles
Real business cycle theory says the market is fundamentally flawed, wages
are sticky and prices are sticky
Debate
Over fiscal policy: monetary policy doesnt work when interest rates are close
to 0
o It doesnt matter how you finance debt, it is bad
Over monetary policy: if you like monetary policy you believe wages and
prices are sticky
o If the interest rate is near zero there is no monetary policy

Chapter 19
Exchange Rates
Currencies are traded in the foreign exchange market
o Aka wherever you can buy foreign currency
When currency becomes stronger, more valuable it appreciates. Vice versa
it will depreciate
Equilibrium Exchange Rate
The exchange rate at which the quantity of a currency demanded in the
foreign exchange market is equal to the quantity supplied
o The equilibrium price at which currency is exchanged
Excess demand pushes the demand curve, leads to an appreciation for the
Canadian dollar
o Thus, Canadian dollars are more valuable
Real Exchange Rates
Mexican pesos per Canadian dollar this would be nominal exchange rate
REAL exchange rate is Mexican pesos per Canadian dollar X (Price of Canadian /
Price of Mexican)
Purchasing Power Parity
If you hold the price level constant then this price should be constant
worldwide
o In reality, doesnt work
Exchange Rate Policy

 A country has the right to fix the exchange against some other currency
Floating exchange rate, is letting the market forces be flexible with the
exchange rate
If you have a flexible exchange rate, then you only have monetary policy and
lose mobility of controlling it
If an exchange rate isnt fixed it would adjust back to equilibrium
Dilemmas
Money only goes so far theres only so many things that the policy can do,
it cant be controlled all at once in the market
A country can set whatever rate it wants
Monetary policy under floating exchange rates
If you expand the money supply, you decrease the interest rate, deprecate
the value of the Canadian dollar, a lot more would be exported, the dollar is
worth less than prior to
Decreasing the exchange rate
Aggregate demand would go up