Econ Final Study Notes.docx

Econ Final Study Notes

9.1 Three Macroeconomic States (LO 1)

• Short Run:
  • In the short run, factor prices (e.g., wages, raw material costs) are exogenous, meaning they are fixed and do not adjust in response to changes in output.
  • Technology and factor supplies (labor, capital, land) are assumed to remain constant.
  • Output is determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves.
• Adjustment Process:
  • In the short run, the economy is not at full employment, meaning real GDP may differ from potential output.
  • Factor prices adjust over time in response to the output gap (the difference between actual output and potential output). This adjustment process will gradually bring the economy back to potential output.
• Long Run:
  • In the long run, factor prices have fully adjusted to any output gaps (i.e., wages and prices have moved to a level where no incentive exists to change the supply of labor or capital).
  • In the long run, technology and factor supplies are assumed to change. For example, technological advances and increases in the labor force can affect the economy’s potential output.
  • The economy returns to potential output (Yᵖ), and the economy reaches a state of long-run equilibrium.

9.2 The Adjustment Process (LO 2, 3)

• Potential Output (Yᵖ):
  • Potential output (Yᵖ) is the level of real GDP that the economy can produce when all factors of production (labor, capital, land) are fully employed. It represents the economy’s capacity to produce goods and services without creating inflationary pressure.
  • Potential output is not directly observed but is estimated based on the economy’s productive capacity.
• Output Gap:
  • The output gap refers to the difference between actual real GDP (Y) and potential output (Yᵖ).
    • Positive output gap (inflationary gap): When actual GDP is greater than potential output (Y > Yᵖ), there is excess demand in the economy, which leads to upward pressure on wages and prices.
    • Negative output gap (recessionary gap): When actual GDP is less than potential output (Y < Yᵖ), there is excess supply in the economy, leading to downward pressure on wages and prices.
• Inflationary Gap (Y > Yᵖ):
  • In an inflationary gap, actual output exceeds potential output. This creates excess demand in factor markets (e.g., labor and capital), causing wages and other factor prices to rise.
  • As firms face higher unit costs, the aggregate supply (AS) curve shifts upward, leading to higher prices and a higher price level (inflation).
  • The adjustment process moves the economy back to potential output, where wages and factor prices have fully adjusted.
• Recessionary Gap (Y < Yᵖ):
  • In a recessionary gap, actual output is less than potential output. This creates excess supply in factor markets.
  • Wages and other factor prices tend to fall, but the adjustment process is often slow due to downward price rigidity (factor prices are sticky downward).
  • As firms’ unit costs fall, the AS curve shifts downward, leading to lower prices and an increase in output, gradually bringing the economy back to potential output (Yᵖ).
• Adjustment Mechanism:
  • The economy’s AS curve adjusts to close the output gap, bringing the economy back to potential output (Yᵖ). The price level is also adjusted as part of this process.
  • The economy returns to long-run equilibrium when Y = Yᵖ.

9.3 Aggregate Demand and Supply Shocks (LO 4)

• Demand Shocks:
  • Positive Demand Shock: A positive shock to aggregate demand (e.g., an increase in government spending, consumer confidence, or exports) increases real GDP beyond potential output, leading to an inflationary gap.
    • The AS curve shifts upward due to higher wages and unit costs, causing a rise in the price level.
    • Over time, the economy adjusts, and the output returns to potential output (Yᵖ), with a higher price level.
  • Negative Demand Shock: A negative shock to aggregate demand (e.g., a decrease in consumer spending or investment) decreases real GDP, leading to a recessionary gap.
    • The economy adjusts slowly because factor prices are sticky downward. Wages and other factor prices decrease, gradually shifting the AS curve downward.
    • The economy moves back toward potential output (Yᵖ), but this process may take time.
• Supply Shocks:
  • Aggregate Supply Shocks: A change in the costs of production (e.g., a rise in input prices like oil or wages) shifts the AS curve.
    • Positive AS Shock: If input prices fall (e.g., lower oil prices), the AS curve shifts downward, leading to higher output and lower prices.
    • Negative AS Shock: If input prices rise (e.g., higher oil prices), the AS curve shifts upward, leading to lower output and higher prices (stagflation).
  • Adjustment Process for Supply Shocks:
    • In the short run, shocks to the AD or AS curves lead to temporary changes in real GDP and the price level.
    • In the long run, the economy will return to potential output (Yᵖ) after the factor-price adjustment process, unless the shock changes the underlying factors of production or technology.
• Short-Run vs. Long-Run Equilibrium:
  • Short-run equilibrium occurs at the intersection of the AD and AS curves.
  • Long-run equilibrium occurs when real GDP equals potential output (Yᵖ), and the economy is at full employment.

9.4 Fiscal Stabilization Policy (LO 5)

• Fiscal Policy for Stabilization:
  • Recessionary Gap: To eliminate a recessionary gap, the government can shift AD to the right by either increasing government spending or cutting taxes. Both actions stimulate demand, increasing output and employment.
  • Inflationary Gap: To eliminate an inflationary gap, the government can reduce aggregate demand by either increasing taxes or decreasing government spending.
  • Fiscal policy aims to stabilize the economy by adjusting demand-side factors like government spending and taxes.
• The Paradox of Thrift:
  • The paradox of thrift refers to the situation where, in the short run, an increase in saving (by households, firms, or the government) leads to a reduction in aggregate demand and, consequently, a decrease in real GDP.
  • In the long run, the paradox does not apply because increased saving leads to higher investment and economic growth, which will eventually lead to higher potential output.
• Automatic Stabilizers:
  • Automatic stabilizers (e.g., unemployment insurance, progressive taxes) automatically adjust to fluctuations in economic activity without the need for new government action.
  • These programs reduce the size of the fiscal multiplier and help smooth the effects of economic shocks, offering a level of economic stability without discretionary policy changes.
• Discretionary Fiscal Policy:
  • Discretionary fiscal policy involves deliberate changes in government spending and taxation to stabilize the economy.
  • However, discretionary fiscal policy faces decision lags (the time it takes for policymakers to recognize the need for action and decide on a policy) and execution lags (the time between policy enactment and its effect on the economy).
• Fiscal Policy in the Short and Long Run:
  • In the short run, an increase in government purchases (G) raises real GDP by directly increasing aggregate demand.
  • A tax cut increases disposable income, leading to higher consumption, thus raising real GDP in the short run.
  • Long-run effects of fiscal policy:
    • Government Spending (G): The long-run effect of increased government spending depends on the type of spending. If the government invests in infrastructure (e.g., roads, bridges), it can increase the economy’s potential output by improving productivity and efficiency.
    • Tax Cuts: If tax cuts lead to more investment or an increase in labor force participation, the economy’s potential output (Yᵖ) could rise. However, in the absence of such effects, tax cuts may not have long-term benefits for potential output.

Key Points of Chapter 9: Aggregate Demand and Aggregate Supply

1. Short Run vs Long Run:
   • Short Run: Factor prices are assumed to be fixed, and technology and factor supplies are constant.
   • Long Run: Factor prices adjust to output gaps, and technology and factor supplies can change, leading the economy to return to potential output.
2. Potential Output:
   • Potential output (Y*) is the level of real GDP where all resources are fully employed.
   • Output Gap: The difference between actual real GDP and potential output.
     • Inflationary Gap: When actual GDP is greater than potential, leading to rising wages and prices.
     • Recessionary Gap: When actual GDP is less than potential, leading to falling wages and prices.
3. Adjustment Process:
   • The economy adjusts to return to potential output:
     • Inflationary Gap: Excess demand raises factor prices, shifting the Aggregate Supply (AS) curve upward, reducing real GDP.
     • Recessionary Gap: Excess supply causes factor prices to fall, shifting the AS curve downward, eventually increasing real GDP.
   • Factor prices adjust over time, leading to a long-run return to potential output.
4. Shocks to Aggregate Demand and Supply:
   • Demand Shocks:
     • Positive Shock: Shifts the Aggregate Demand (AD) curve right, creating an inflationary gap. Wages and prices rise, pushing the economy back to potential output.
     • Negative Shock: Shifts the AD curve left, creating a recessionary gap. The adjustment process is slow, and the economy may remain below potential output for a while.
   • Supply Shocks:
     • These shocks (e.g., changes in input prices) shift the AS curve, affecting both real GDP and the price level. The economy adjusts to return to initial output and price levels.
5. Fiscal Policy and Stabilization:
   • Fiscal Policy: Government actions like changes in taxes or spending can shift AD to stabilize output.
     • Recessionary Gap: Governments can increase spending or cut taxes to boost AD and return output to potential.
     • Inflationary Gap: Governments can reduce spending or raise taxes to decrease AD and reduce inflation.
   • Paradox of Thrift: In the short run, increased saving reduces demand and GDP, but in the long run, more saving leads to higher investment and growth.
   • Automatic Stabilizers: Tax and transfer systems automatically adjust to stabilize the economy without new policy actions.
   • Discretionary Fiscal Policy: While discretionary fiscal policies are used to stabilize the economy, they face delays due to decision-making and execution lags, limiting their immediate effectiveness.
6. Short vs Long Run Effects of Fiscal Policy:
   • Short Run: Fiscal expansions (increased government spending or tax cuts) increase real GDP.
   • Long Run: The long-term impact depends on the type of spending (e.g., infrastructure investments) and tax policies (e.g., investment incentives from corporate tax cuts).
     • Infrastructure spending can increase potential output by improving productive capacity.
     • Tax cuts, especially for corporations, may lead to more investment, increasing long-term potential output.

Chapter 12: Money, Monetary Policy, and Inflation

12.1 Understanding Bonds

Key Concepts:

• Relationship Between Bond Prices and Interest Rates:
  • There is an inverse relationship between bond prices and interest rates. When market interest rates rise, the price of bonds falls, and when market interest rates fall, the price of bonds rises.
  • The present value of a bond is calculated by discounting the future payments (coupon payments and principal repayment) at the market interest rate.
• Bond Yield:
  • The yield of a bond refers to the rate of return a bondholder receives. The yield is inversely related to the bond’s purchase price: the lower the purchase price, the higher the yield.
• Risk and Bond Prices:
  • When the perceived riskiness of bonds increases (e.g., economic uncertainty or changes in credit ratings), bond prices fall, leading to higher yields.

12.2 The Theory of Money Demand

Key Concepts:

• Money vs. Bonds:
  • In the macro model, households and firms divide their wealth between bonds (which earn interest) and money (which does not). Money is held for transaction purposes, while bonds provide a return.
• Opportunity Cost of Holding Money:
  • The opportunity cost of holding money is the interest income foregone by not holding bonds.
• Determinants of Money Demand:
  • Interest Rates (i):
    • Higher interest rates reduce the demand for money since individuals and firms prefer earning interest on bonds.
  • Real GDP (Y):
    • Higher GDP increases the demand for money as more transactions are made in the economy (increased spending activity).
  • Price Level (P):
    • Higher prices lead to an increased demand for money, as more is needed to carry out the same level of transactions at higher prices.
• Money Demand Curve:
  • The Money Demand Curve is negatively sloped, indicating that as interest rates increase, the demand for money decreases.
  • Shifts in the Money Demand Curve: An increase in real GDP (Y) or the price level (P) causes the money demand curve to shift to the right.

12.3 How Money Affects Aggregate Demand

Key Concepts:

• Monetary Equilibrium:
  • The interest rate is determined by the intersection of money supply and money demand. At this equilibrium point, the quantity of money supplied equals the quantity of money demanded.
• Monetary Transmission Mechanism:
  • Stage 1: Changes in Interest Rates:
    • A change in the money supply (from central bank actions or commercial banking changes) or a change in the demand for money (due to shifts in GDP or price level) causes a change in the equilibrium interest rate.
  • Stage 2: Impact on Investment and Consumption:
    • A change in the interest rate affects both investment and consumption decisions. Lower interest rates make borrowing cheaper, encouraging investment and consumption.
    • In an open economy, changes in the interest rate affect capital flows, exchange rates, and net exports (exports minus imports).
  • Stage 3: Changes in Aggregate Demand (AD):
    • Changes in investment, consumption, or net exports cause shifts in the Aggregate Demand (AD) curve, impacting real GDP and the price level.
    • A higher money supply can lead to increased aggregate demand, raising output and prices in the short run.

12.4 The Strength of Monetary Forces

Key Concepts:

• Short-Run vs. Long-Run Effects of Money:
  • Neutrality of Money: In the long run, changes in the money supply do not affect real variables like real GDP. This concept is known as the neutrality of money.
    • In the long run, wages and factor prices adjust, and real GDP returns to its potential level.
    • Changes in the money supply only affect the price level (inflation) in the long run, not real output.
• Short-Run Effects:
  • In the short run, changes in the money supply can affect real GDP and employment. The effectiveness of these changes depends on:
    • Steepness of the Money Demand Curve (MD): A steeper curve means that money supply changes have a more significant impact on interest rates.
    • Flatness of the Aggregate Supply Curve (AS): A flatter AS curve means that changes in aggregate demand will have a larger effect on real GDP and employment.
• Money Growth and Inflation:
  • Over the long run, there is a strong positive correlation between the growth rate of the money supply and the rate of inflation across countries.

Key Takeaways:

1. Bond Market:
   • There is a negative relationship between bond prices and interest rates. A rise in interest rates leads to a decrease in bond prices.
2. Money Demand:
   • Money demand depends on interest rates, GDP, and price levels. Higher interest rates reduce demand for money, while higher GDP and prices increase it.
3. Monetary Transmission Mechanism:
   • Changes in money supply lead to changes in interest rates, affecting investment, consumption, net exports, and ultimately shifting the Aggregate Demand (AD) curve.
4. Monetary Forces:
   • In the short run, changes in money supply can significantly affect real GDP and employment, depending on the shapes of the money demand and aggregate supply curves.
   • Long-run neutrality of money means that in the long run, money supply only affects the price level, not real GDP.

13.1 How the Bank of Canada Implements Monetary Policy (LO 1)

• Monetary Policy Objectives:
  The Bank of Canada aims to influence the economy by controlling inflation and supporting economic growth through monetary policy.
• Money Supply vs. Interest Rate Targeting:
  • Money Supply Targeting: Involves controlling the total amount of money in circulation. However, because the Bank has incomplete control over the money supply and cannot always predict the relationship between money supply and inflation, this method is difficult to apply.
  • Interest Rate Targeting: The Bank of Canada primarily targets the overnight interest rate. This is a more reliable way to control the economy because interest rates influence spending, investment, and inflation.
• The Bank's Target for Overnight Rate:
  • The Bank sets a target for the overnight interest rate (the rate at which major financial institutions lend to each other).
  • The Bank uses two key rates to influence this target:
    1. The Bank Rate (lending rate): Set 25 basis points (bps) above the target rate.
    2. The Deposit Rate: Set 25 bps below the target rate.
  • These rates help the Bank control the actual overnight rate by setting a floor and a ceiling for the rate at which financial institutions can lend or borrow from the Bank.
• Monetary Policy Actions:
  • Expansionary Policy: When the Bank lowers the overnight interest rate, it aims to stimulate aggregate demand and economic activity.
  • Contractionary Policy: By raising the overnight interest rate, the Bank attempts to slow down inflation and cool off an overheated economy.

13.2 Inflation Targeting (LO 2, 3)

• Why Inflation Control is Crucial:
  High inflation leads to economic instability, erodes purchasing power, and creates uncertainty. Therefore, controlling inflation is essential for maintaining economic stability.
• Monetary Policy and Inflation:
  • Long-term Inflation Target: The Bank of Canada aims to keep the annual inflation rate close to 2% (CPI inflation).
  • Inflation Targeting Strategy: By focusing on inflation, the Bank works to stabilize prices and reduce uncertainty in the economy.
• Output Gap and Inflation Control:
  • The Bank of Canada uses the output gap as a key indicator.
    • Inflationary Gap: If actual output exceeds potential output, inflationary pressures build, and the Bank responds by tightening monetary policy.
    • Recessionary Gap: If actual output is below potential output, the Bank loosens monetary policy to stimulate economic activity and close the gap.
• Policy Responses to Shocks:
  • The Bank responds to both positive and negative shocks by adjusting its interest rates.
    • Positive Shocks (e.g., strong economic growth) lead to contractionary policies to prevent overheating.
    • Negative Shocks (e.g., economic downturns or global events) lead to expansionary policies to stimulate growth.
• Challenges to Inflation Targeting:
  • Volatile Prices: Fluctuations in food and energy prices can lead to short-term deviations from the 2% inflation target.
  • Exchange Rate Movements: Changes in the value of the Canadian dollar affect import prices and can influence inflation.

13.3 Long and Variable Lags (LO 4)

• Delay in Monetary Policy Effects:
  • The Bank can adjust interest rates quickly, but it takes time for businesses and households to change their spending behavior in response.
  • The economic impact of these changes takes time as well, due to the multiplier effect (the cascading effect of changes in demand and output through the economy).
• Policy Lag:
  • The effects of monetary policy are not immediate. It can take months, or even years, for a change in interest rates to significantly influence GDP and inflation.
  • Because of this delay, the Bank of Canada focuses on persistent and significant shocks rather than trying to fine-tune the economy.

13.4 Four Decades of Canadian Monetary Policy (LO 5)

• Early 1980s: Tight Money to Control Inflation:
  • The Bank of Canada focused on reducing inflation by tightening the money supply.
  • This led to high unemployment and a deep recession in the early 1980s, but it helped reduce inflation in the long term.
• 1983-1987: Recovery and Liquidity:
  • As the economy recovered, the Bank faced the challenge of providing enough liquidity to accommodate growth without triggering inflation.
  • By 1988, inflation was between 4-5%, and the Bank set a new goal: price stability.
• 1992: Success in Reducing Inflation:
  • The Bank’s tight monetary policies successfully reduced inflation to below 2% by 1992.
  • However, there was debate over whether the cost of higher unemployment was justified by the benefits of lower inflation.
• 1994: Change in Bank Leadership:
  • A leadership change occurred when John Crow was replaced by Gordon Thiessen as the Bank's governor.
  • Despite the change, the policy focus on price stability continued.
• 2000-2007: Economic Stability:
  • By 2000, inflation had remained near 2% for several years.
  • The Bank of Canada faced challenges like the appreciation of the Canadian dollar, which made Canadian exports less competitive.
• 2008-2009: Global Financial Crisis:
  • The financial crisis led the Bank of Canada to reduce interest rates and provide liquidity to stabilize the financial system.
• 2011-2019: Gradual Recovery and Monetary Tightening:
  • The economy slowly recovered from the global financial crisis.
  • Inflation was under control, and by 2019, the Bank’s target overnight rate was raised to 1.75% as the economy approached full capacity.
• COVID-19 and Post-Pandemic Recovery:
  • In response to the COVID-19 pandemic, the Bank slashed interest rates to 0.25% and implemented quantitative easing (QE) to stimulate the economy.
  • QE involved purchasing large amounts of government bonds to inject liquidity into the financial system.
  • The Bank’s total assets increased by 400% during 2020, marking a dramatic shift in its monetary policy.
  • As inflation surged post-pandemic, the Bank began increasing interest rates in early 2022 to combat rising prices while supporting economic recovery.

Key Concepts to Remember:

1. Overnight Interest Rate: The main tool for implementing monetary policy.
2. Inflation Targeting: The Bank of Canada’s goal of maintaining a 2% inflation rate.
3. Monetary Policy Lags: Changes in interest rates take time to affect the economy.
4. Quantitative Easing: A response to the 2020 pandemic crisis, involving the large-scale purchase of government bonds to lower interest rates and stimulate economic activity.

14.1 Adding Inflation to the Model (LO 1, 2)

• Inflation and Aggregate Supply (AS):
  • Inflation typically accompanies growth in wages and other factor prices, which shifts the AS curve upwards.
  • Key Influences on Wages:
    1. Output Gaps:
       • Inflationary Output Gaps: Lead to wage increases.
       • Recessionary Output Gaps: Lead to wage decreases, but at a slower pace.
    2. Expectations of Inflation:
       • Inflation expectations drive wage increases proportional to expected price level increases.
       • Expectations can be backward-looking, forward-looking, or a combination of both.
• Inflation Expectations:
  • When inflation expectations are constant, and there are no supply shocks, expected inflation will eventually match actual inflation.
  • In this scenario, there’s no output-gap effect on inflation.
• Sustaining Constant Inflation:
  • If real GDP remains constant and there’s no change in inflation, the AD and AS curves will shift upward at the same rate.

14.2 Shocks and Policy Responses (LO 3, 4)

• Positive Demand Shock:
  • Initial effects:
    • Price Level Increases.
    • Real GDP Increases.
  • If unvalidated:
    • Output returns to its potential level.
    • Price level continues to rise as the AS curve shifts upwards.
  • Monetary Validation:
    • Allows demand inflation to persist without reducing the inflationary gap.
    • The AD curve continues shifting upward.
• Negative Supply Shock:
  • Initial effects:
    • Price Level Increases.
    • Real GDP Falls.
  • If unvalidated:
    • Output moves slowly back to its potential level.
    • Price level falls gradually as the AS curve shifts downward.
  • Monetary Validation:
    • Allows supply inflation to persist despite a recessionary gap.
    • AD curve shifts upward with monetary validation.
• Bank of Canada’s Response to Inflation:
  • If the Bank of Canada tries to maintain real GDP above potential, the inflation rate will eventually accelerate.
• Effect of Shocks:
  • Aggregate demand and supply shocks have temporary effects on inflation.
  • Sustained inflation is caused by sustained monetary expansion.

14.3 Reducing Inflation (LO 5, 6)

• Phases of Reducing Sustained Inflation:
  • Phase 1:
    • End monetary validation and allow the AS curve to shift upwards to remove the inflationary gap.
  • Phase 2:
    • A recessionary gap develops as expectations of further inflation cause the AS curve to continue shifting upwards.
  • Phase 3:
    • The economy returns to potential output, sometimes with a one-time monetary expansion that raises the AD curve to match potential output.
• Cost of Disinflation:
  • The process of reducing inflation leads to recession.
  • Sacrifice Ratio:
    • The sacrifice ratio measures the cost of disinflation.
    • It is calculated as the cumulative loss in real GDP (as a percentage of potential GDP) divided by the reduction in inflation.

Key Concepts to Remember for the Exam:

• Monetary Validation: The process where central banks allow inflationary or deflationary pressures to persist through monetary expansion.
• Recessionary Gap: A situation where actual GDP is below potential GDP, often associated with lower inflation and higher unemployment.
• Inflationary Gap: A situation where actual GDP exceeds potential GDP, leading to upward pressure on prices.
• Expectations of Inflation: Expectations play a critical role in wage-setting and inflation dynamics.
• Shocks and Policy Responses: Understanding how positive and negative demand and supply shocks affect the economy and inflation, and how monetary policies can validate or counteract those effects.
• Sacrifice Ratio: A key measure for understanding the trade-offs involved in reducing inflation.