economics lessons

Exchange Rates and the BOP

2011-06-20T01:49:00.001-06:00

FINALLY: EXCHANGE RATES AND THE BALANCE OF PAYMENTS!!!!!!!!!!!!!!

Okay- final bit, and then we can all write our exams and promptly forget everything we ever needed to know about economics! =D

What is a balance of payments? It's a summary account of all the receipts and payments in and out of Canada (or any other country) in relation to the rest of the world (including payments made for both goods and investments). It clocks Canadian money moving back and forth across the border. Receipts are money going into Canada, and payments are money going out of Canada.

The balance of payments includes both current and capital accounts. Because these two accounts always balance out, the balance of payments will always be 0. You'll see why in a little bit.

SOME TERMS

A SURPLUS

-There is more money going in than out

-This is favorable

-We also call this "credit"

-More receipts than payments

A DEFICIT

-There is more money leaving than entering the country

-This is unfavorable

-We also call this a debit

-More payments than receipts

When foreign consumers buy Canadian exports, this creates a receipt (money enters Canada from the outside)

When domestic consumers buy foreign imports, this creates a payment (money leaves Canada)

OFFICIAL RESERVES

-These are holdings held by the BoC

-It includes gold, foreign exchange, and SDRs

-SDRs are special drawing rights, and they are the IMFs substitute for gold

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SO WHAT COMPOSES THE BALANCE OF PAYMENTS?

Basically, a bunch of different sub-accounts which measure trade flows

1: The Current Account (The BOP for goods)

-This encompasses exports, imports, and investment incomes

-The Trade Account is a subcategory of the current account, and it includes an account for merchandise, and an account for services. This account stacks up exports and imports and measures the difference difference

-The Capital Service Account measures the net investment income and unilateral money transfers. This measures the difference between Canadian interest and dividends on foreign bonds and investments, and Foreign interest and dividents on Canadian bonds and investments

2: The Capital Account

-This encompasses money spend on long and short term capital investments, including stocks, bonds, realty, factories and other investment devices

-Financial capital imports are A CREDIT (this may be confusing)! This is when foreigners bring money into Canada in order to purchase Canadian assets. Subsequently, financial capital exports are capital outflows: when Canadians bring money out of Canada in order to purchase foreign assets.

-Finally, the Capital account also includes the official financial account, which measures receipts and payments of Canadian dollars due to the selling and buying of foreign exchange. Selling foreign exchange constitutes a receipt of Canadian dollars, and thus counts as a receipt on the balance of payments. Essentially, the official financial account balances out the other two accounts: when Canadians buy a whole lot of foreign goods and investments, for instance, the BoC accommodates this by selling off foreign exchange for Canadian dollars (which thus counteracts the account deficit caused by other categories)

-An increase in official receipts means that the Bank of Canada is selling Canadian dollars in order to buy foreign exchange. This creates a negative balance effect (it counts as a debit on the balance sheet)

-An decrease in official receipts means that the BoC is selling foreign exchange in order to buy Canadian dollars. This creates a positive balance effect (it counts as a credit on the balance sheet)

IN SUMMARY

Current accounts = X - M + Returns to Investments

Capital Accounts = Capital in - Capital out, + Official Financing Account (which is Can$ in - Can$ out)

As you can see, the OFA always balances out all other payments and receipts, so the Balance of Payments is always 0! Sometimes, news media will talk about exchange deficits or credits, and when they are doing this, they are usually omitting the OFA.

So... if there are more exports than imports, foreigners are short of Canadian dollars, so the BoC will sell Canadian currency to foreigners (and in doing so, increase its holdings of foreign currency). This counts as a negative entry in the OFA: in this way, the BoC provides the excess Canadian money that foreigners require to buy Canadian exports.

Okay?

-The BOP always balances

-BOP balances or deficits are balanced out by the OFA

-There is nothing inherently good or bad about balances. A deficit is not necessarily bad, and a surplus is not necessarily good!

THE FLOATING EXCHANGE RATE ACTS AS AN ECONOMIC SHOCK ABSORBER!

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Okay- foreign exchange can be seen as a marketable good, just like anything else. As such, we have the FOREIGN EXCHANGE MARKET

External Value is how much domestic currency is worth in foreign terms (the foreign price of domestic currency)

Exchange Rate is how much foreign currency is worth in domestic terms (the domestic price of foreign currency)

ER = 1/EV & EV = 1/ER

Depreciation means that the external value is going down

Appreciation means that the external value is going up

What determines external value (and by association, exchange rates)???

SUPPLY AND DEMAND!!!

Remember: People supply currency in order to purchase imports or to facilitate capital exports (domestic investiture into foreign markets) and people demand currency in order to purchase domestic exports, or to facilitate capital imports (foreign investiture into domestic markets)...

Basically, supply of any currency increases as that currency becomes valued more (because high valued currencies can buy more imports, and translate into larger foreign investments), while demand for any currency shrinks as that currency appreciates (because this makes exports from that country more expensive, and capital in-flows less effective)

As such, currency prices tend to settle at an equilibrium value!

Remember, however, that demand and supply can shift here to affect the equilibrium price level!

Supply of currency will increase if

-There is heightened demand for imports

-There is heightened domestic demand for investment in foreign markets

-Domestic prices are higher than foreign prices

Demand for currency will increase if

-There is a heightened demand for exports

-There is a heightened foreign demand for investment in domestic markets

-Foreign prices are higher than domestic prices

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Surpluses, Deficits, and the EV

For surpluses, exports are higher, imports are low, demand for domestic currency is high, supply of it is low, and thus the currency appreciations

For deficits, exports are lower, imports are high, demand for domestic currency is low, supply of it is high, and this the currency depreciates

You can verify this by moving the supply and demand curves around!

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PRICES AND EXCHANGE RATES: Exchange rates facilitate the rule of one world price!

Domestic Prices = the exchange rate * Foreign Prices

And this translates into a stabilization mechanism- I'll show you!

When external value is higher, domestic prices become cheaper for international goods (due to the above formula), and as such, exports decrease, imports increase, and we are left with a BOT deficit (which brings the EV back down again)

The reverse is true for when the domestic value is lowered.

As such, the balance of trades and the exchange rate are interdependent and cyclical!

YOU SHOULD UNDERSTAND HOW THIS CYCLE WORKS

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Trade Policy

2011-06-18T13:24:00.001-06:00

This chapter looks at the policies which either facilitate or impede free trade in the world!

As economists, we usually are in favor of free trade. We recognize that free trade offers many benefits to different countries!

Why is free trade a good idea?

-The law of comparative advantage

-When there is regional specialization and trade, the world production of all products rises

-This maximizes the world's average standard of living (world GDP per capita)

On the other hand, some countries may attempt to instill protectionist policies (policies which counteract free trade in order to protect domestic firms from international competition). These can include both TARIFFS and NON TARIFF BARRIERS (NTBs, such as quotas, customs procedures, anti-dumping duties and countervailing duties).

Why might nation choose certain degrees of protectionism?

REASONS WHICH RELATE TO MAXIMIZING NATIONAL INCOME

1: To improve the terms of trade! If a country is large enough, it can force the world price downward for goods it imports by imposing a Tariff

2: Infant Industry Protection. Some countries may set up trade barriers in order to protect domestic firms from international competition, with the hopes that these industries will grow to the point where they can realize economies of scale. The idea here is that under protection, infant industries will eventually "grow up" to the point where they will be able to compete on the international market without need of protectionism. A problem with this is that not all industries develop to this level of competency while under protection. Canada's national policy of 1876 was an example of infant industry protection directed at improving Canadian manufacturing.

3: Learning by doing. This sort of goes along with infant industry protection, but along with protecting developing industries from international competitors, protectionism can also simply give those industries time to operate, which gives personnel time to gain mastery over certain procedures. In this way, countries can turn comparative disadvantages into comparative advantages.

PROBLEM! Not every industry which gets chosen for protection will ultimately grow up to be an international "winner", so each time the government placed an industry under protection, they are effectively gambling (as protectionism exacts economic costs) on their choice. If governments do this frequently, statistically, they are likely to choose more losers than winners, which would be quite costly.

4: Protectionism can allow certain key industries to earn economic profits and thus innovate more. As such, Canada has strategic trade policy in place with regards to Bombardier (if you remember, they're the company which made the olympic torches)

OTHER REASONS

1: There are advantages from diversification. Countries which are only specialized in a narrow range of products may use protectionism in order to diversify their economies (which gives local firms a "safe space" to expand into new industries, thus increasing the range of products produced domestically). This can be useful in that it buffers the volatility and risk posed by price changes and new technologies by spreading production to several different sectors. The idea here is not to "put all of your eggs in one basket" (although, often, this is more of a political argument than an economic argument)

2: Protectionism lets governments protect favored groups! In Canada, competitive advantage favors skilled labour over unskilled labour, and as a result, free trade may lower the wages of unskilled laborers (who are now competing with wage slaves from overseas). Here, protectionism can redistribute income to certain productive groups, but at the expense of the collective standard of GDP. There is a deadweight loss!

USUALLY, HOWEVER, PROTECTIONISM IS FOR POLITICAL OR FALLACIOUS ECONOMIC REASONS!!!!!!!!! >=(

HERE ARE SOME FAULTY ARGUMENTS WHICH PEOPLE WILL OFTEN POSE IN ORDER TO SUPPORT PROTECTIONISM!

1: "We've got to keep our money at home"

The Premise: If I buy a domestic good, by country will have both the good AND the money used to buy that good

Why it's incorrect: Domestic money is only useful for buying domestic goods. If you are buying foreign products, the money you spend on those products eventually gets used to buy Canadian products- it flows between the two trading countries

2: "We've got to protect ourselves from low-cost foreign labour"

The Premise: Low wage foreign goods will eliminate domestic goods from the market, and thus lower the domestic standard of living.

Why it's incorrect: This goes against the law of comparative advantage. Even if a foreign country can produce all goods at a lower cost than Canada, it would still be advantageous to trade, as trade will lower the opportunity cost of having certain products.

3: "Exports are good, and imports are bad"

The Premise: Exports add to domestic GDP, while imports take away from domestic GDP

Why it's incorrect: Standard of living is dependent on consumption, not production. If a country exports a lot of goods, but derives its comparative advantage by paying its workers very low salaries, then those workers will not be able to consume very many products, on average, and thus that country's standard of living will probably be quite low.

4: "Protectionism creates local jobs"

The Premise: Protecting the domestic market can help save local jobs, and thus combat unemployment

Why it's incorrect: Protectionism reduces employment in other sectors which may have local comparative advantages, and thus, while it may increase employment in one sector, the overall economic effect is inefficient.

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METHODS OF PROTECTIONISM

TARIFFS: Import Duties- these are a tax on imports. They increase costs for domestic consumers, but benefit domestic producers (who can sell at higher than the world price) and the government (who receives tax revenue). Tariffs create a deadweight social loss for the economy as a whole.

Originally, at the world price, Canada will import 1500 units of this product, and domestic producers will supply the other 500 units needed to satisfy demand.

Once the tariff raises the prices, Canada only imports 500 units of the product, and domestic producers supply the other 1000 units needed to satisfy domestic demand (as you can see, demand has decreased due to the higher price).

Consumer lose surplus represented by sections C, D, E, & F due to the Tariff

Producers gain surplus represented by section C due to the Tariff (the increase in price times the increase in production, minus the costs incurred by increasing production)

The government gains section E due to the Tariff (the quantity of foreign imports at the Tariff price, multiplied by the amount of the Tariff)

SECTIONS D & F REPRESENT A DEADWEIGHT SOCIAL LOSS, HOWEVER! (tragic, isn't it!?)

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QUOTAS AND VOLUNTARY EXPORT RESTRICTIONS (VERs)

An import quota is like a quantity ceiling- it restricts the quantity of products which a country will import

With a voluntary export restriction, the exporter agrees to limit the amount of exports it will send to any one country.

This incurs costs for domestic consumers, but benefits domestic producers

The net result is a deadweight social loss which is greater than that which results from a Tariff!

At the world price, Canada will import Q4 - Q1, and domestic producers will supply Q1

Let's say that a quota restricts domestic imports to Q3 - Q2. If this happens, then the domestic price must rise to P1, where the quota exactly satisfies the excess demand which domestic producers cannot meet.

Consumers lose surplus equal to E, F, G, H, & I due to the quota,

Producers gain surplus equal to E due to the quota

Since there is no taxation here, the higher price on the quota goods causes foreign producers to gain surplus equal to G & H

THERE IS A DEADWEIGHT LOSS EQUAL TO SECTIONS F & I due to the quota! >=(

Usually, in trade barrier situations, exporters prefer a quota (so they can gain the extra revenue section) while importing governments prefer a tariff (so they can gain the extra revenue section).

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NON-TARIFF BARRIERS

1: Antidumping Duties

-Dumping is the practice of selling a good in a foreign country at a price below domestic prices at a reason other than costs

-This is like price discrimination (remember from micro) but on an international level

-Usually, it is only temporary, in order to sell off excess supply, or to weaken local industries and force reliance on foreign imports

-It is seen as anti-competitive, and many people believe that it is an unfair form of competition

-Antidumping duties (taxes to bring "dumped" imports back up to the domestic price level) are often used to compensate for this

-Recently, however, these have been abused and used as a non-trade barrier

-When Antidumping Duties are used, the domestic price becomes the price floor, regardless of the foreign price (which can lead to an inflexibility in domestic prices compared to the world price)

-As such, if the world price falls below the average costs for domestic producers, they are protected

-Often, the system requires foreign accusers to prove that dumping is occurring in order for antidumping duties to be instated

2: Countervailing duties: a tariff imposed as a trade remedy to counteract foreign governments subsidizing their industries

-Governments wishing to impose countervailing duties must prove that there is a foreign subsidy being used to bolster a certain foreign industry, and that it is significantly harming the prospects of domestic producers

-The U.S. is currently placing countervailing duties on Canadian softwood lumber.

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IMPORTANT ORGANIZATIONS AND TERMS

GATT- The general agreement on trades and tariffs: an effort to reduce international protectionism

The Uruguay Round- reduced tariffs by 40%, but failed to deal with European and Canadian agricultural subsidies (eventually, they ended quotas, but replaced them with Tariffs in a process called Tariffication)

WTO- World trade organization- it has 148 members, it is a global organization which deals with the rules of trade, and it endeavors to lower trade and non-trade barriers. It also includes a formal dispute settlement mechanism

Doha Round- tried to reduce agricultural subsidies

The Battle for Seattle- People protested that human, labour, and environmental rights were not being addressed by the WTO. Interestingly, 3rd world countries often argue against considering these in trade deals

MAI- Multilateral agreement on investment: similar to WTO, but for investments

Free trade Area- Goods and services may move freely among member countries, but each member nation still sets barriers against foreign imports on an individual basis (like NAFTA) PROBLEM: Certain Tariffs have grandfather clauses, and thus persist despite agreements.

Customs Union- A free trade area, but with a common set of barriers against foreign imports (like Mercosur: Brazil, Uruguay, Paraguay, and Argentina)

Common Market- A customs union in which factors of production (i.e., workers) may move freely among member nations (like the EU)

THAT'S ALMOST ALL!!!

Gains from International Trade

2011-05-17T17:26:00.000-06:00

OKAY! Let's talk turkey about international trade.

Over time, while world GDP had been increasing at a fairly constant rate, world trade has increased exponentially!

Canada is, itself, involved in quite a bit of international trade (we export and import quite a lot of goods)

David Rciardo was an economist of lore (1772-1823), and he was a major proponent of international trade. He wrote "Current comparative advantage is a major determinant of trade under free-market conditions."

Economists who advocated world trade often promoted teachings which led to real changes, such as England repealing its corn laws and moving towards a more open economy (an open economy is one which engages in international free trade, and realizes certain advantages from this, known as the gains from trade).

GAINS FROM TRADE: These are increases in total economic output due to efficiency advantages resulting from local economies engaging in specialization and trade of goods in which they have a comparative advantage.

COMPARATIVE ADVANTAGE: A situation where one local economy can produce a certain good at a lower opportunity cost than other economies (i.e., if it is less expensive for Canada to grow wheat than it is for Haiti to grow wheat, then we would state that Canada has a comparative advantage in wheat)

WHAT IS THE LOGIC BEHIND INTERNATIONAL TRADE? It's the same logic which states that interpersonal trade will be beneficial!
-When there is no trade on an interpersonal level, each individual has to be self-sufficient: they must provide for all of their own needs
-Trade allows individuals to specialize in providing goods and services which they can produce or provide efficiently, and then trade those for goods and services which they are less proficient at providing.

For an example, if I am a Doctor, I could be very very good at fixing coronary blockages, but terrible at fixing pipes. Trade means that I can simply make money by acting as a doctor, and then trade this money to "borrow" a trained plumber, thus saving me hours of frustration and reading complicated instructions. In this situation, both me and the plumber are providing the services which we are most efficient in, and because I don't have to waste time learning how to fix pipe and he doesn't have to waste time memorizing human anatomy, the overall economic output between the two of us is higher! We are more efficient when we can divide and conquer! =D

Well... interregional and international trade follows the same logic!

There are two different sources of gains from international trade:

1- The fact that different local economies have different resource endowments (and therefore can benefit from specializing in producing products which fit well with regional endowments, both natural and acquired)

2- The fact that international trade leads to a larger market for products means that local firms can realize reductions in production costs due to increased production (they are able to achieve economies of scale)

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ABSOLUTE ADVANTAGE: This is when one country (or economy), compared to another, can produce more of a good from the same inputs

So, lets say that given the same inputs...

Canada can produce 10 bushels of wheat or 6 lengths of cloth
England can produce 5 bushels of wheat or 10 lengths of cloth

Canada has an absolute advantage over England in terms of wheat, and England has an absolute advantage of Canada in terms of cloth. Here, we have a situation of reciprocal advantage (each country is more adept at producing a different good), and thus it will be advantageous for England and Canada to trade!

WHY?!

Because each unit of input which Canada switched from cloth production to wheat production leads to 6 fewer cloths, but 10 more wheat. Similarly, each unit of input which England switched from wheat production to cloth production leads to 5 fewer wheat and 10 more cloth. The net effect of this is that the world production of both wheat and cloth has increased if both the countries specialize in what they are best at producing: there are worldwide gains from specialization.

But English and Canadian consumers want to purchase both goods... so unless these countries are able to trade, this specialization would not be practical.

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THE LAW OF COMPARATIVE ADVANTAGE

Lets say that using one unit of input...

Canada can produce 100 bushels of wheat or 60 lengths of cloth
England can produce 5 units of wheat or 10 length of cloth

Here, Canada has can absolute advantage in both wheat and cloth (so Canada is more efficient at producing either of these products). Some people might think that Canada should thus not engage in trade... but they would be WRONG! Dead WRONG!

Canada can produce 20 times as much wheat at England, but only 6 times as much cloth using one unit of input. From this, we can surmise that Canada has a COMPARATIVE ADVANTAGE in wheat, while England has a comparative advantage in cloth.

Each country should trade goods in which it has a comparative advantage. Trade, in this case, increases the world's per-capita GDP. Comparative advantage is a necessary and sufficient condition for trade. Absolute advantages (in the absence of comparative advantages) do no lead to gains from trade.

How do we figure out which product a country has a comparative advantage in?

Easy! You just calculate the opportunity cost of producing any one good. Given the previous example, the OC of producing 100 bushels of wheat in Canada is 60 lengths of cloth, so the opportunity cost of each bushel of wheat is 0.6 lengths of cloth. Similarly, the OC of producing is length of cloth is 1.67 bushels of wheat for Canada. The opportunity cost for England of producing 1 length of cloth is 0.50 bushels of wheat, and the opportunity cost for England of producing 1 bushel of wheat is 2 lengths of cloth!

The opportunity cost of wheat is lower in Canada than in England, so Canada has a comparative advantage in wheat
The opportunity cost of cloth is lower in England than in Canada, so England has a comparative advantage in cloth

The point: opportunity cost depends on relative costs, no absolute costs!

WHENEVER OPPORTUNITY COSTS DIFFER, SPECIALIZATION AND TRADE CAN INCREASE THE WORLD PRODUCTION OF BOTH COMMODITIES, WHICH LEADS TO INCREASED CONSUMPTION POSSIBILITIES

*to note: increased production does not necessarily lead to increased consumption, and standard of living depends on consumption rather than production (so a country could produce a whole lot of products, but if its workers make very low factor incomes, and are hence unable to consume many goods, that country's standard of living may still be extremely low.)

ABSOLUTE ADVANTAGE DOES NOT LEAD TO GAINS FROM TRADE!

If Canada can produce 100 wheats or 60 cloths given one unit of input
and England can produce 10 wheats or 6 cloths given one unit of input

Canada has the same absolute advantage of England in terms of both products, but each country has the same opportunity costs in terms of producing each good. Because of this, specialization and trade will NOT lead to any gains for either country, nor will it increase world output of either product.

There are other reasons in addition to comparative advantage that can make it beneficial to engage in specialization and trade

Basically, whenever OC's differ for the same products between different countries, specialization (and subsequent trade) leads to an increase in net production of goods, and as a result, a decrease in costs, because of...

1: Economies of Scale- Trade creates a larger market for domestic producers (who, after international trade, provide products for consumers around the world instead of just domestically)

2: Product Differentiation- A large international market for any type of product leads to further specialization, or product differentiation. For an example, in Europe, each country specializes in intra-industry trade. Between Canada and the U.S., each country specializes in a different type of car.

3: Learning by doing- Larger international markets lead to specialization, which leads to "accumulated experience". For an example, the silicon valley area of the United States has gained a reputation for computerized innovation, and as a result of that specialization, people from that area gain experience over time, and become better-equiped to compete in that industry.

Economies of Scale = Production moves to the bottom of the LRAC
Learning by Doing = The entire LRAC shifts downward, so any level of production costs less

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SOURCES OF COMPARATIVE ADVANTAGE:

1: Natural Factor Endowments
-This is how traditional economists explained comparative advantages
-What each country is "born with"
-This includes both natural resources and climates, as well as social patterns and institutional set-ups
-This natural resource advantage translates into cost advantages (i.e., a very fertile country will not incur as many costs growing food as an arid country)

2: Acquired Comparative Advantages
-This is a newer idea: what each country DEVELOPS can lead to a comparative advantage in certain products
-For an example, social fixtures such as education, healthcare, and social services can create more productive workers
-Research and development can also lead to innovations and localized experience which gives certain nations comparative advantages in certain sectors (like Canada and aerospace engineering, or Korea and shipbuilding)

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PATTERNS OF INTERNATIONAL TRADE:

We know that countries should specialize and then trade in goods in which they have a comparative advantage.

So... do countries actually export those goods in which they have a comparative advantage? The answer is YESSSSSSS!

THE LAW OF ONE WORLD PRICE: Internationally traded goods sell at the same price, regardless of which country they are sold in, assuming
-zero transport costs
-it is actually the same good
-competitive markets
-the good is tradable

World price simply equates global supply and demand for any product to determine the equilibrium price

So.........

If one country has a comparative advantage in a certain product which would potentially lead to a lower domestic price for this product than the world price level, instead of simply selling the product at the domestic price level, that country will sell that product on the world market at the (higher) world price level: the domestic excess supply will get sold off on the international market.

THE THEORY OF COMPARATIVE ADVANTAGE IS STILL RELEVANT~!! Sources of those competitive advantages may have changed over the years, but the basic premise of this theory still holds true!

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TERMS OF TRADE: These determine how the gains from trade are shared- in other words, how will the gains in world per-capita GDP be shared among the trading nations.

The Terms of Trade = the ratio of (the price of exports / the price of imports)
OR
The relative international price of imports (how many imports can be purchased per unit of export)

If the terms of trade increase, this is favorable for the nation in question, because they are able to get more imports per export. The reverse is true if the terms of trade decrease.

Unfavorable terms of trade will not be conducive to trade! Basically, if the terms of trade make it so that the OC of obtaining imports is equal to or greater than the OC of producing a product domestically, the country in question will not trade for that product! There needs to be a win-win situation (terms of trade which allow for both countries to enjoy lowered OCs) in order to trade to occur.

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International Trade and the PPC:

When there is trade, consumption can differ from production! This means that trade can facilitate changes in production which allow for patterns of consumption which lie outside the PPC!

The slope of the dotted line = the terms of trade (tt)

Basically, given any point on the original PPC, international trade allows that country to trade products with another country at a rate which differs from that given on the PPC (which is usually convex). As you can see, if the country in the diagram specializes and trades, it can reach point B!

By specializing (changing production), countries can optimize their production in order to best take advantage of good terms of trade!

NOTE: Which country wins depends on the terms of trade (the slope of the line). Also, the consumption pattern (the point on the CPC) which each country settles into will depend on their preferences between the two products being compared.
Also, most countries have increasing OCs with increased specialization, and thus they have convex PPCs

That's all for now!

Unemployment

2011-05-14T22:55:00.000-06:00

Okay- I'm really behind in these online notes, but I'm going to catch up as much as I possibly can tonight.

Unemployment is scary stuff! Here we go!

CHANGES IN UNEMPLOYMENT:

-In the long run, increases in the labor force should be matched by changes in employment (so as the population grows, more people should get hired for more jobs)

-In the short run, changes in the labor force may not match population growth

In Canada, the supply of labour has increased because of increases in the population (probably due to immigration), an increased rate of labor force participation, and an increase in education. Demand for labor has also increased due to new technology and economic growth. In most years, new jobs are created to replace old jobs and provide new jobs for the growing labor force.

In a typical year in Canada, employment increases by 1/4 million jobs.

CHANGES IN UNEMPLOYMENT

-In Canada U was 12% in 1980, and 8% in 2008

-During booms, unemployment falls, and during recessions, unemployment rises. Doh

-In Canada, employment is rising, BUT the labor force is growing at a FASTER RATE, so in Canada, the unemployment rate has increased

-The proportion of employment in the service sector has increased (it is now about 75%)

-The proportion of employment in the goods sector has decreased

RECENT DEVELOPMENTS

-According to Naomi Klein, North America produces "brands, no products"

-A lot of labour is outsourced these days

-There is a rise in the amount of low-skill service labor these days (i.e., McJobs)

-There is greater transience in the workforce: people move from job to job more

-Schedules are crappier, and employees receive fewer benefits

-There is less company loyalty, so quality suffers (the Wal-mart greeter makes about $11,000 working full time, so you can bet your ass she's not really that happy to see you)

-The best way to operate here is to see yourself as a movable asset: "Me Inc." sell yourself and you will be happy- attach yourself to any one company and you will not be happy

What are some reasons for these negative changes?

-Low ability levels

-The entry level for better jobs has significantly increased

-Flexible hours are now the norm

-Part-time workers have less legal protection (and are thus preferred)

LABOR FLOWS

-The labor market can be seen in terms of flows in about of unemployment, rather than as a simple unemployment rate

-We should examine gross rather than net flows (because this gives us more information about the nature of the labor market)

THE EFFECTS OF UNEMPLOYMENT

-Voluntary vs. Involuntary: Technically, voluntary unemployment does not exist, as that individual has technically left the workforce.

-Not all unemployment is bad!

Unemployment: All individuals who are willing and able to work at the going rate, but are unable to find a job

When there is a great deal of involuntary unemployment, we end up with something like the great depression:

-On a small scale, this causes personal hardship and psychological suffering for those who lose their jobs

-On a large scale, this decreases national output per capita, and by association, the standard of living- there is a loss in potential output

GAP UNEMPLOYMENT

Why does it happen? It happens because there is a recessionary gap! (doh)

If Y = Y*, U =0

If Y < Y*, U > U*

Cyclical Unemployment is unemployment in exess of frictional and structural unemployment!

We could see the labour market as any other market where there is supply and demand for labour at different prices.

Demand = the willingness of firms to hire at any given wage rate

Supply = willingness of workers to work at any given wage rate

The price of labor is the real wage rate (w)

As the graph should demonstrate, labor markets are pretty flexible, because wages can shift upward and downward. With wage flexibility, real wages and employment change with economic cycles.

This graph shows that eventually, employment reaches an equilibrium! In other words, there should be no involuntary or cyclical unemployment in the long run...

There are two theories which examine gap unemployment

1: THE NEO-CLASSICAL THEORY OF LABOR MARKETS

2: THE NEO-KEYNESIAN THEORY OF LABOR MARKETS

NEO CLASSICAL LABOR MARKETS:

-We assume here that markets are flexible and that they will eventually clear

-This theory predicts that there will be no cyclical unemployment (but they're wrong! There is cyclical unemployment!)

Here's the logic: since wages are flexible, the labor market will always reach an equilibrium where the amount of labour supplied equals the labor demanded at the going wage rate. Here, no one is involuntarily unemployed, and thus, there is no cyclical unemployment. There are only people who are voluntarily unemployed (i.e., frictional and structural unemployment)

NAIRU, here, can occur due to

Exogenous demand shocks

-Changes in technology or tastes

-Changes in the demand for labour

Exogenous supply shocks

-Changes in the willingness to work

-Changes in the supply of labour

In this model, it is the NAIRU which fluctuates, since the unemployment rate is alwats the NAIRU

NOTE* Real wages ARE flexible and markets DO eventually clear, so this model isn't entirely wrong...

But there are PROBLEMS:

-According to this theory, real wages should change rapidly with the business cycle. This does not happen. Real wages remain relatively constant even as the economy fluctuates

-An unemployed person would be shocked to learn that economists veiw him or her as "voluntarily" unemployed

-This model seems to show that there is no need for stabilization policy, but in reality, we know that there IS!

thankfully, we have...

NEO-KEYNESIAN LABOUR MARKETS (aka, how they actually work)

-Here, labour markets are inflexible and do not clear... at least not in the short run

-This is because of STICKY WAGES! The wage rate does not change fast enough to equate the supply and demand of labour (because wages are not perfectly flexible), as a result, we get unemployment in slumps, and labour shortages in booms.

-Only when the supply and demand of labour are equal is there no involuntary unemployment: it is here that the market clears!

IN A SLUMP:

-Demand for labor decreases

-Wages want to fall to their new equilibrium level

-But wages stick at a higher level than the equilibrium

-So there is excess supply of labour, and thus unemployment

IN A BOOM:

-Demand for labor increases

-Wages want to rise to a new equilibrium level

-But wages will not immediately increase to that new equilibrium level: it takes time for that to happen

-In the meantime, there will be excess demand, and therefore a labor shortage

We know that wages are much more likely to be "sticky downward" (they take longer to fall than to rise). Why is this?

-Long-term employment contracts: workers and employers respond to other factors like job security by creating long term contracts: here, wages are planned over the long-term and are thus insulated from short term fluctuations. The fringe benefits of these contractual agreements can be mutually beneficial, as they give employees long term stability, and ensure employers that they will have trained employees invested in the company over a longer period of time

-Menu costs: Changing wages in any way invokes administrative costs

-Efficiency wages: this is when employers pay employees higher wages than the equilibrium wage necessary to hire them, because they believe that the higher wages will act as a motivator, and cause workers to become more efficient

-Unions: unions negotiate on behalf of workers who are already embedded in the workforce, and thus often make it difficult to negotiate for higher wages

-Psychological factors: people find it psychologically difficult to give up wages (even if the price level is dropping, so real wages are effectively still the same)

OKAY!

In summary, Neo-Keynesians assume that markets may not clear, and thus there CAN be involuntary unemployment

NOW LET'S BRING THESE TWO THEORIES TOGETHER!

In the short run, the Neo-Keynesian are correct: sticky wages can create excess supply or demand of labour... HOWEVER, all of the factors which contribute to sticky wages will not persist in the long run, so eventually, the labour market DOES clear, and wage flexibility eliminates involuntary unemployment. Thus, in the long run, both Classical and Keynesian theories predict that unemployment will be at U*

(The only differences is that for classical economists, there is no short run- that time frame is not taken into account)

LET'S COMPARE THESE TWO THEORIES ONE LAST TIME

NEO-CLASSICAL:

-Wages are flexible, so the labour market will always clear

-U is always at U* and there is no gap unemployment (no involuntary unemployment)

-Aggregate demand shocks will have no effect on unemployment, because aggregate supply reacts

NEO-KEYNESIAN:

-Wages are sticky, and markets will not clear immediately

-U is not always at U*, so there can be gap unemployment (involuntary unemployment)

-Aggregate supply and demand shocks cause gaps

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The Non-Accelerating-Inflationary-Rate of Unemployment (NAIRU)

There are 2 components to NAIRU: Frictional and Structural Unemployment

FRICTIONAL UNEMPLOYMENT (Job turnover, or search unemployment)

-This refers to the length of time it takes someone to either find their first job or a new job

STRUCTURAL UNEMPLOYMENT (Mismatching of supply and demand of labour)

-It can be supply-side (ie: a worker's skills are needed in an economy, but in a different city, persay)

-It can be demand-side (ie: there are jobs available, but they require more training than the current workforce has accumulated)

WHAT'S THE DIFFERENCE BETWEEN THE TWO?

-Structural Unemployment may just be long run frictional unemployment

-Both are similar in that the number of unfilled jobs is equal to the number of people looking for work

NAIRU = The Non-Accelerating-Inflationary-Rate of Unemployment

-This is the rate on unemployment when inflation does not accelerate

-In other words, this is the normal, or natural rate of unemployment

-Here, we only have frictional and structural unemployment

-There is no cyclical unemployment at U*

-But "there is always some unemployment at full employment"

-This is the rate of unemployment when the supply and demand of labour are equal

-This is the rate of unemployment at Y*, or Yfe

NEWSFLASH: NAIRU can change over time! How does this happen???

1: Demographic Changes

-Baby boomers and shadow baby boomers, for example, entered the labour market and created a larger flow of voluntary unemployment, thus increasing NAIRU

-Historically, increased female participation in the workforce (where females historically have had a higher unemployment rate than men) will increase NAIRU

-Immigration may affect this as well

2: Labour Market Flexibility

-The speed at which wages adjust to supply and demand changes is slowing down over time

-It is more costly for firms to hire new workers these days, and due to unions and legal issues, it often takes them a longer amount of time to commit to hiring or laying off workers

-Unions and the psychology of concessions also play a role here

3: Government Policy

-Any government policy that reduces labour market flexibility will increase the NAIRU

-EI decreases search costs (the opportunity cost of searching for a new job) and will therefore increase average job search times, thus contributing more to NAIRU

-Severance Pay increases the cost of firing a worker, but at the same time, also makes companies less willing to hire new workers in the first place (its a higher risk, so firms must be more discerning)

4: Globalization and Technological Changes

-Rightsizing, restructuring, retooling, and rationalizing, global competition, and freer trade have increased structural unemployment, many would argue (mature industrial nations such as Canada are expected to provide high level services and technology, while countries with cheaper labour are expected to provide lower level manufacturing and production, but this can often lead to a mismatch between available worker skills and desired potential employee assets)

5: Hysteresis (A lagged effect)

-This theory suggests that the future NAIRU is a function of the current actual rate of unemployment

-This is seen more in European countries with an insider-outsider model to the workforce: in these countries, people who are already employed use their insider power to keep outsiders out

-Recessions prevent on-the-job training and thus reduce the amount of "learning by doing" which can occur, and as a result, when a recession is over, the group of people who would otherwise have gained skills due to simply being employed are left without employable skills, and may thus continue to struggle to find employment

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MEASURING NAIRU

OKUN's LAW!!!!!!!!!!!!!!!!!!!!!!!!!!

A 1% Change in the cyclical unemployment rate is associated with a 2% change in the recessionary gap!

So... if the economy goes into a recession and is producing output at 12% below its potential level, than we know that cyclical unemployment has risen by 6%. Similarly, if cyclical unemployment were in increase by 3%, we could predict that output would decrease to 6% below Y*

HOW TO ESTIMATE NAIRU: You need to know Y*, the current output level, and the actual unemployment rate

1: Find Y* (potential output level)

2: Calculate the recessionary gap as a percentage of Y*: (Y-Y*)/Y* multiplied by 100

3: Take 1/2 of the recessionary gap you just calculated. This is the cyclical unemployment rate

4: Subtract the cyclical unemployment rate from the actual unemployment rate. The difference is the normal U-rate, or NAIRU!

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WHAT ARE SOME WAYS THAT WE COULD REDUCE UNEMPLOYMENT?

Reducing Frictional Unemployment:

-Here, the goal is to decrease turnover time

-Governments could create giant posting boards to match potential employers with potential workers (i.e., Canada Manpower, workopolis, craigslist)

Reducing Structural Unemployment

-The goal here is to make the supply and demand of labour match

-Government initiatives to retrain and relocate workers can help here

-Eliminating resistance to change (i.e., tariffs and subsidies) can help, as these instruments perpetuate the status quo, and may deter people from getting the skills needed to operate in the new global labor market (i.e., if a tariff is supporting a failing industry, then that tariff is also going to deter people employed in that industry from getting the retraining they require to become employed once that industry inevitably topples)

-Aiding change is key here

Reducing Cyclical Unemployment

-The goal here is to bring Y back to Y* by increasing aggregate demand

-This accomplished using fiscal and monetary policy

-YAY! Gap-busting! =D =D

That's all for unemployment. I hope all of you who read this are successful at avoiding summer employment....

More Irritating Details About Inflation

2011-04-29T16:57:00.000-06:00

The Phillips Curve & Accelerating Inflation

-We know what the Phillips curve is. I'm not explaining it again.

-At Y* and U*, there is no gap inflation

-When the economy is in an inflationary gap, the BoC must validate for wage inflation

-In the 1960s, the level of wage and price adjustment began to rise for any level of output (the whole phillips curve shifted to the right)

-Why? Because the original phillips curve included only gap inflation and ignored expectation inflation (which impacts wage changes, obviously)

-This newly-shifted phillips curve is called the expectations-augmented phillips curve. There is still an inverse relation between the unemployment rate and the rate of changes of nominal wages, but with the effect of expectation inflation built into the model.

-Expectation inflation is graphically represented by the height of the phillips curve above the X axis at U*

Using this new phillips curve, we can see than when there is gap inflation, and when there are expectations adding to inflation, the curve shifts up at Y*: expected inflation increases for all levels of inflation, and thus, inflation can accelerate.

THERE IS NOT A STABLE TRADEOFF BETWEEN INFLATION AND OUTPUT. TO MAINTAIN Y @ LEVELS GREATER THAN Y*, INFLATION MUST ACCELERATE.

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Is inflation a monetary phenomenon? Was Milton Friedman correct when he said "Inflation is everywhere, and always a monetary problem"?

Does inflation have purely monetary consequences? What about its consequences- are they purely monetary?

Well... inflation on its own can be caused by either an increase in AD or a decrease in A. However, unless monetary validation is continuous, inflation will only be temporary. As such inflation is not necessarily caused by monetary issues, but continuous inflation IS.

The consequences of inflation:

1: Short run gap inflation caused by output being higher than Y*

2: Short run supply inflation caused by Y being less than Y*

3: In the long run, output will always eventually return to Y*, so inflation will only cause a change in the price level.

so... SUSTAINED inflation is everywhere, and is always a monetary problem.

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REDUCING INFLATION: The process of disinflation

Accelerating Inflation is inflation. There is a positive change in the price level.

Constant Inflation is inflation. There is a positive change in the price level.

Decelerating Inflation is disinflation. There is a positive change in the price level, but at a decreasing rate.

Stopped Inflation is zero inflation. There is no change in the price level.

Reverse Inflation is deflation. There is a negative change in the price level.

How do we reduce constant inflation from occurring at Y*??? by STOPPING EXPECTATIONS

How do we reduce accelerating inflation? By NO LONGER VALIDATING CHANGES IN THE ECONOMY

both of these measures may cause short-term economic pain (recessionary gaps cause unemployment, which is both depressing for individuals, and unproductive for economies in general). However, this will eliminate sustained accelerating inflation.

But is this a good thing?

There is often questions over whether the benefits of reducing inflation outweigh the costs.

How it works:

1: remove monetary validation to eliminate the inflationary gap (which allow the SRAS to return GDP to Y*)

2: stagflation: the SRAS decreases to the point where it actually overshoots Y* due to the intensity of wage momentum. As a result, there will be a period of rising unemployment accompanied by inflation

3: recovery: wage adjustments can bring SRAS back to Y* the slow way, or the BoC can use expansionary monetary policy to bring it there faster (at the cost in inflation)

The cost of disinflation:

-Disinflation is caused by a recessionary gap

-The cost of disinflation is equal to the loss of output caused by the required recessionary gap.

The SACRIFICE RATIO is the cumulative loss of output as a percentage of potential output divided by the percentage reduction in the inflation rate.

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THE COSTS OF INFLATION: Why is this bad, again?

1: Unanticipated Inflation

-Affected the distribution of income (redistributes income from creditors to debtors)

-Wage contracts: redistributes income from employers to employees if inflation is less than expected, and vice versa if inflation is higher than expected

-Pension contracts: redistributes income away from pensioners (although this can be solved by indexing pensions for inflation)

1970s: Trudeau indexed public pensions, and they have remained indexed as thus until..

1980s: Mulroney de-indexed tax brackets

2000: Chretian fully indexed tax brackets

Low versus Moderate Inflation: BC advocates low inflation

-The price signal distortion hypothesis suggests that inflation interferes with the information conveyed by price changes. As a result, market participants can have a difficult time distinguishing absolute prices from relative prices. This extra confusions created by inflation reduces market efficiency

-In PLANNING DISRUPTION, inflation interferes with retirement plans and long term contracts

With moderate inflation...

-The downward nominal wage rigidity hypothesis claims that low levels if inflation reduce economic efficiency, because real wage cuts will require nominal wage cuts, which will be resisted. Basically, if inflation is zero, a 2% cut in real wages required a 2% cut in nominal wages: workers will resist a drop in their nominal wages. However, if inflation were high enough, nominal wages could simply be maintained to the effect of reducing real wages, and this is met with much less resistance. In this way, this theory suggests that high inflation facilitates more efficient economies, because it makes it easier for employers to "trick" their employees into accepting real wage cuts.

The zero bound on nominal interest rates hypothesis claims that the BoC cannot run expansionary money policy.

AS A GENERAL RULE, healthy economies have moderate inflation (this is caused naturally by economic growth and increases in aggregate demand).

High and accelerating inflation leads to prediction problems, and arbitrary redistribution of income. It may also lead to hyperinflation. Politics, however, is usually the entity to blame for these problems.

HYPERINFLATION: This is associated with low economic growth. Why? Because hyperinflation increases transaction costs (ie: menus must be changed constantly, and holding money for transactions is risky, because that money's purchasing power can rapidly decrease)

DISINFLATION: Governments can try to use wage or price controls, but usually this doesn't work.

-Two recessions in Canada have been caused by the government of Canada attempting to slow the rate of disinflation. As such, the costs of disinflation probably outweigh the benefits unless inflation is getting seriously out of control.

DEFLATION: Like disinflation, is not a good idea.

THAT'S ALL

Demand Shocks and Accelerating Inflation

2011-04-27T15:27:00.000-06:00

INFLATIONARY DEMAND SHOCKS AND INFLATION

-An increase in consumption, investment, government expenditures, and net exports causes an increase in aggregate expenditure, a rightward shift in aggregate demand, and an increase in the equilibrium price level.

IF THE GOVERNMENT DOES NOT VALIDATE INFLATION CAUSED BY AN ISOLATED DEMAND SHOCK

Aggregate demand will shift to the right as a result of this demand shock. Y is now greater than Y*, and thus we have an inflationary gap. however, wages adjust: excess demand for labour increases wages, which in turn increases firm costs. As a result, short run aggregate supply shifts to the left, and output returns to its original level, but at a higher price level. This is one-shot inflation. The price level is now at a higher equilibrium level, but since the demand shock is isolated, inflation will not be sustained.

IF THE GOVERNMENT DOES VALIDATE INFLATION CAUSED BY ISOLATED DEMAND SHOCKS

Aggregate demand will shift to the right as a result of this supply shock. In response to this, SRAS shifts to the left due to wage adjustment. However, if the government tries to validate this change in supply by increasing the money supply (which lowers interest rates, and ultimately shifts AD to the right), this puts NEW INFLATIONARY PRESSURES on an economy: basically, the natural chain and anchor mechanism is fighting against government policy here, and the result is sustained inflation within an inflationary gap. The SRAS want to return output to Y*, but the government continues to artificially increase AD through monetary policy. As both AD and SRAS continue to shift right and left, respectively, the price level will continuously climb. =(

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WHAT ABOUT ACCELERATING INFLATION?

-We know that in most cases, demand shocks cause wage adjustment, and that if governments are not crafty, they may follow this up with monetary validation. If we look at this graphically, we can say that the inflation rate (the change in the price level divided by the original price level) could be graphically represented by the vertical distance between the original price point and the new price point.

-When AD and AS both shift up, the inflationary gap will persist.

-Graphically, we know that inflation is accelerating if the arrow between the price points gets longer and longer.

SO... two questions we need to answer are:

1) What creates persistent inflation (what causes inflation to hang around, instead of being a one-off)?

The answer: Validation

and

2) When is the inflation at a constant rate, and when is it at an accelerating rate (what causes inflation to get worse and worse)?

The answer: Expectations

ACCELERATION HYPOTHESIS

-If the economy is running an inflationary gap caused by either increased aggregate demand (for an example, demand resulting from China's increased demand for raw materials) or increased aggregate supply (for an example, increase supply due to lower world prices of raw materials)...

-AND if the central bank wants to maintain the "good time" (aka: it uses monetary policy to validate this inflationary gap, and tries to keep the gap from being closed)...

-THEN, inflation will persist, and be accelerating.

In summary, if the BoC maintains a constant inflationary gap, then the actual inflation rate will persist and accelerate (the economy will continue to inflate at progressively larger rates over time).

WHY?

1) EXPECTATION EFFECTS (remember, actual inflation is a combined result of gap inflation, expectation inflation, and supply shock inflation)

-An increase in aggregate demand causes an inflationary gap, and as we know, this ultimately causes prices to rise due to the wage change mechanism

-As a result, expectations are formed: workers demand that their wages rise at a similar rate over the next year to account for predicted inflation (for an example, let's say that they expect inflation to be 2%, then they will demand a 2% wage increase).

-If the BoC adds inflationary pressures by maintaining the gap, then this will create extra gap inflation of 2%, which stacks on top of the expectation inflation for a combined actual 4% rate of inflation.

-This overall 4% rate of inflation informs new expectations for the next year: workers will demand 4% wage increases, and those new expectation pressures stack onto persistent gap inflation for a total of 6% total inflation over the next year

-This continues on for quite a while, generating an inflationary spiral.

AS LONG AS THE BoC VALIDATES THE GAP, EXPECTATIONS ARE ALWAYS BEING REVISED UPWARDS (worker expect higher and higher inflation, and demand higher and higher wage increases). People come to expect this inflation, and build it into their wage demands.

2) MORE RAPID MONETARY VALIDATION IS REQUIRED

-If the BoC wants to maintain output above Y*, it has to increase the rate of growth in the money supply.

-This is because the inflation rate is accelerating, and therefore, to accommodate for increase transaction demands due to higher prices, the BoC must accelerate the growth of money (basically, it must print a larger and larger quantity of money each year)

-This validation becomes more and more dramatic as time goes on

Let's summarize what we know!

We have an isolated shock ---> There will be no gap in the long run

We have have a repeated AS shock ---> There will be a persistent gap

We have a repeated AD shock ---> There will be a persistent gap

At Y*, persistent inflation will consist of only expectation inflation

With a Gap, there will be accelerating inflation, due to the gap inflation on top of expectation inflation

Cost push inflation from Y* lead to a recessionary gap

Demand pull inflation from Y* leads to an inflationary gap

AGAIN: Is monetary validation a good idea?

Yes, because monetary validation can eliminate recessions more quickly than simply letting "nature take its course"

No, because it causes inflation

Additionally, as we now know, monetary validation can create expected inflation to increase over time, creating a wage-price spiral. Some economists argue that the disadvantages of these increased expectations could be avoided if the BoC never validated gaps in the first place!

Inflation and Supply Shocks

2011-04-20T15:26:00.000-06:00

FROM WAGE CHANGES TO PRICE CHANGES

-If a change in money wages is positive (wages increase), short run aggregate supply will decrease (it shifts to the left due to increased costs). This causes prices to rise, and the overall effect is inflationary

-If an change in money wages is negative (wages decrease), short run aggregate supply will increase (it shifts to the right due to lowered costs). This causes prices to fall, and the overall effect is deflationary.

Wages up --> Costs up ---> SRAS shifts left --> Equilibrium price level rises

Okay... so so far, we've talked about two causes of inflation: gap effects and worker expectations. There is, however, a third cause of inflationary pressures: AN EXOGENOUS SUPPLY SHOCK (for an example, a change in the price of raw materials, such as oil, can increase the general price level, which is why vegetables can start to cost more when the price of oil goes up).

SOOO

ACTUAL INFLATION IS A COMBINATION OF:

1: GAP INFLATION

2: EXPECTATION INFLATION

3: SUPPLY SHCOK INFLATION (even though that's a bit of an afterthought)

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Next, we're going to talk about the difference between sustained/constant inflation and accelerating inflation.

CONSTANT/SUSTAINED INFLATION

-Here, we assume that there is no supply shock, and no output gaps

-As such, the ONLY cause for inflation when there is sustained inflation, is expectations

-This kind of inflation occurs when Y is equal to Y*

Let's summarize: constant inflation occurs when...

-There is no gap inflation

-There is no supply shock inflation

-Monetary growth is equal to the rate that wages increase at

-Actual inflation is equal to expected inflation

HOW IT WORKS:

1: Worker expectations trigger constant inflation (expectations cause workers to demand higher wages, which then causes SRAS to shift to the left)

2: The BoC validates the price increase by increase the money supply

SO.... let's say that we start off with expectation inflation at 2%. Workers anticipate future increases of 2% in the price level, so they demand higher wages, which causes SRAS to shift to the left as money wages rise. When the government validates this increase, they increase the money supply, which shifts SRAD to the right. Because of the way that this mechanism works, the price level will rise at the exact same rate as is predicted (because expectations are what catalyze the change). Actual inflation is equal to expected inflation, and output remains at Y*. THIS IS CONTINUOUS INFLATION AT A CONSTANT RATE.

NOTE* This isn't expansionary monetary policy- the BoC is not reducing the overnight target rate here- interest rates aren't affect by this. The BoC is merely accommodating for the growing demand for money by steadily increasing the nominal money supply. As such, the real money supply remains constant (so the ratio of money in the economy and the average price of products remains the same).

INFLATIONARY SUPPLY SHOCKS (negative supply shocks which temporarily inflate prices)

-Remember, in all cases of inflation, the price level rises to a new equilibrium level. In temporary inflationary situations, the price will simply remain at the new level, whereas in cases of persistent inflation, the equilibrium price level will continue to rise.

Inflationary supply shocks are caused by increased cost of productive inputs (for an example, an increase in the price of oil). This, in turn, causes costs to rise, which shifts SRAS to the left, and increases the price level while decreasing output.

BUT... as we know from previous chapters, this change is NOT permanent. Eventually, the higher unemployment which accompanies the supply-shock-recession puts downward pressures on wages, eventually causing them to fall. As a result of these wage-related cost savings to firms, the short run aggregate supply will shift back to its original level: costs will be the same as they once were, even though workers are being paid less. As SRAS shifts to the right, the price level and output level both shift back to what they were originally. SO, WE CAN CONCLUDE THAT INFLATIONARY SUPPLY SHOCKS ONLY CAUSE INFLATION IN THE SHORT RUN, AND THAT THERE IS NO SUSTAINED INFLATION HERE.

OKAY.. BUT WHAT HAPPENS WHEN WE HAVE AN ISOLATED SUPPLY SHOCK WHICH IS MONETARILY VALIDATED BY THE BoC?

Well, we start out at macroeconomic equilibrium, and then we shift SRAS to the left. This increases the price level and decreases the output level. After this, if the government tries to correct this recessionary gap by increasing the money supply (the money supply increases, which lowers interest rates, which increases investment and net exports, which drives aggregate expenditure up and shifts aggregate demand to the right), aggregate demand will shift to the right, which will bring output back to its equilibrium level, but at a higher general price level. As such, there will be more inflation than if the government does not intervene, but prices will still settle at the new equilibrium level, and inflation will not be persistant.

OKAY... BUT WHAT HAPPENS WHEN WE HAVE REPEATED SUPPLY SHOCKS WITHOUT MONETARY VALIDATION?

For an example, lets say we have cost push inflation, which occurs due to repeated increases in firms' costs. What happens then? Well, either the economy will stabilize at a higher price level and a smaller output level, OR persistent unemployment will erode the power of unions, causing monetary wages to fall, and bringing short run aggregate supply back to its original levels.

OKAY... BUT WHAT HAPPENS WHEN WE HAVE REPEATED SUPPLY SHOCKS WHICH ARE VALIDATED BY THE GOVERNMENT?

Well, then economies can enter into an inflationary spiral. For an example, if unions consistently negotiate to increase their monetary wages, and the government consistently validates this decrease in SRAS by printing more money, then an economy will experience consistent inflation (albeit, often the wage increases are very small, so inflation persists at a small but constant level). Basically, monetary validation reinforces price increases and offsets the natural tendency of Ye to return to Y* on its own, hence sustained inflation.

So.... is monetary validation of supply shocks desirable or undesirable? Yes and No!

No, because the BoC should allow for unemployment, which will eventually eliminate the output gap through the natural chain and anchor process.

Yes, because nations can avoid severe (albeit temporary) recessions by using monetary validation (although this comes at the cost of creating higher prices)

So its sort of a dilemma: governments must choose between long stretches of unemployment (no validating) or inflation (validating).

What is STAGFLATION? Stagflation is when supply shocks and monetary validating occur simultaneously, which leads to a NEGATIVE COMBINATION OF INFLATION AND UNEMPLOYMENT

Persistent Recessionary Gaps + Persistent Inflation: Continous SRAS shocks continue to push SRAS to the left, while continuous validation continues to push AD to the right. The overall effect on the output level is neutral, so the original recessionary gap is never closed. At the same time, both supply shocks and monetary validation continuously push up the price level, so the equilibrium price level will continuously rise while the economy remains in a recession. =(

The Gap Effect, and the Expectation Effect

2011-03-27T15:25:00.000-06:00

THE WONDERFUL WORLD OF INFLATION:

People talk about inflation a LOT, so its probably a good idea know what it is. If you've survived macroeconomics without knowing what inflation is up until this point, congratulations, you live a seriously charmed life.

For the rest of us, lets reiterate:

Inflation is any rise in the general price level (P)

Inflation can be temporary/transitory (the price level increases to a new equilibrium price level, where it stays put for a while) or it can be sustained/persistant (the price level rises continuously over time)

In classical economics, aggregate demand shocks and aggregate supply shocks cause TEMPORARY inflation (one-time jumps in the price level) as a side effect of gap inflation. In this chapter, we are more concerned with exploring the causes of sustained inflation (which, as we will learn, is affected by people's expectations). We're also going to look at what causes accelerating inflation.

On a very basic level, prices can rise for two different reasons

1) There is a decrease in supply (this is called cost-push inflation)

2) There is an increase in demand (this is called demand-pull inflation)

HERE IS A LIST OF TERRIBLY IMPORTANT DEFINITIONS WHICH WE SHOULD ALL PROBABLY LEARN IF WE WANT TO DO WELL IN MACROECONOMICS:

Inflation - A rise in the consumer price index

Inflation Rate - The percentage change in the consumer price index

Zero Inflation - A situation where there is no percentage change in the consumer price index

Stable Inflation - A situation where the inflation rate remains relatively constant over time (ie: inflation is 2% for seven years in a row)

Accelerating Inflation - The inflation rate increases over time (ie: inflation is 2% in 1991, 4% in 1992, 8% in 1993, and 13% in 1994)

Disinflation - The inflation rate decrease over time (ie: inflation is 16% in 1991, 9% in 1992, 5% in 1993, and 3% in 1994)

Deflation - A negative rate of inflation: the consumer price index goes down (so goods end up costing less)

Low inflation: 1-3%

Medium inflation: 3-6%

High inflation: Over 6%

Hyperinflation: Over 20%

Why are we concerned with inflation? Because too much inflation inflicts a bunch of costs on society. Here are some of them:

-It decreases the purchasing power of people who are on fixed incomes (both contractually and in terms of pensionary incomes)

-It can arbitrarily redistribute income

-It undermines the efficiency of the price system by distorting relative prices (so its harder for consumers to tell if they are getting a good deal or if they are getting ripped off if the general price level is continuously in flux)

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One last important concept is NAIRU, which is the non-accelerating inflationary rate of unemployment. Basically, this is the rate of unemployment present in an economy when there are no inflationary or recessionary gaps (when Y is at Y*). This does not mean that there is no unemployment- only that there is no GAP unemployment (there can still be frictional and structural unemployment). NAIRU is also sometimes called "full employment," or U*.

We're going to look at why NAIRU is called NAIRU in this chapter

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INFLATION AND WAGE CHANGES:

Okay... why do people's wages change?

There are two factors which can explain why people's wages change

1) The gap effect

2) The expectation effect

THE GAP EFFECT

-Basically, this is demand-pull inflation caused by excess demand in the labour market.

-In an inflationary gap, we get GAP INFLATION. Y is larger than Y*, U is smaller than U*, and there is an excess demand for labour. As a result, firms are forced to raise wages in order to keep employees. The result of this rise in wages is that average costs rise (which, in turn, causes the short run aggregate supply to shift to the left, correcting the inflationary gap).

-In a recessionary gap, we get GAP DEFLATION. Y is smaller than Y*, U is greater than U*, and there is an excess supply of labour. As a result, firms can safely lower employee wages without the risk of losing employees (its better to have a low-paying job than no job at all). This, in turn, causes average costs to fall, which shifts short run aggregate supply to the right, correcting the inflationary gap.

-When there is no gap, there is NO INFLATION. Y equals Y*, U equal U*, demand and supply of labour are equal, wages remain constant, average costs remain constant, and the short run aggregate supply remains constant (as do prices).

The Phillips Curve shows the inverse relation between the unemployment rate and the rate of changes in nominal wages.

Basically, as unemployment gets higher, wage increases get smaller and smaller, and eventually, turn into wage decreases (salary cuts).

Classical economists ONLY considered the gap effect to be a source of inflation, and believed that gaps would only create a temporary period of inflation. They also believed that if there was no gap, that there would be no increase in wages...

They were entirely correct... there is also...

THE EXPECTATION EFFECT

-Here, expected inflation is taken into account when employees are negotiating wage demands with their employers

-Here, inflation is like a "self fulfilling prophecy". If employees believe that there will be inflation of a certain level over the next year, they will negotiate for higher wages to account for that inflation. This, in turn, increases firms' average costs, which shifts the SRAD curve to the left, effecting CAUSING an increase in prices in-step with what employees predicted. In other words, preemptively adjusting wages for expected inflation can MANUFACTURE real inflation!

Causes of expectation inflation:

-Expectation inflation can be caused by backward-looking, where people assume that past rates in inflation will continue into the future (people believe that history repeats itself)

-At the same time, if an economy has an extremely volatile inflation rate, it may take time for people to develop a psychological trend to respond to inflation- it takes a while to figure out how the pattern works and predict accurately for the future.

-Expectation inflation can also be forward-looking. Workers could look at governments' macroeconomic policies to predict what future changes may be in store (they can prognosticate).

-The main thing to remember is that in economics, we assume that people are RATIONAL BEINGS with their own best interests at heart. People try to use all available information to the best of their ability, and for the most part, they are correct. People can adjust rapidly to changes.

The TOTAL EFFECT: Changes in money wages are a combination of the gap effect and the expectation effect

-In this way, we can decompose an increase in the rate of wage changes into the gap effect (excess demand for labour) and the expectation effect (psychology)

-We can think of the expectation effect as the "cake" and the gap effect as the "icing", which causes increased wages changes on top of expected changes

-The total effect can be either positive or negative.

The Transmission Mechanism

2011-03-15T19:11:00.000-06:00

So... what happens when the money supply changes? How does this affect things? That's what we're going to figure out today!

Remember the marginal efficiency of investment function?

There are two reasons why interest rates and desire for investment are negatively related

-lower interest rates mean that there is a lower opportunity cost for investing (it costs less to borrow money)

-when interest rates are lower, investing in capital becomes more attractive than keeping money in bonds (so if buying a new mixmaster will have a 4% yield, my friend the baker is much more likely to buy one when an equivalently-priced bond would only give him a 2% yield)

-Investment is determined by the REAL interest rate: for simplicity's sake, just assume that there is no inflation in this model for now

SO: There is an investment transmission mechanism

Let's do this in steps

1: The government changes the money supply (we'll learn how in the next little while)

2: The change in the money supply, thanks to the way the money market works, causes interest rates to fall (this is liquidity preference theory)

3: Lower interest rates cause investment to increase (this is marginal efficiency of investment theory)

4: Increased investment causes the family of aggregate expenditure curves for this economy to shift up

5: A shift up in aggregate expenditure causes aggregate demand to shift to the right, indicating an increasing in GDP, a decrease in unemployment, and an increase in the price level

BE SURE THAT YOU CAN REPRESENT EACH OF THESE STEPS GRAPHICALLY! If you have any questions about that, just send me an email and I will spell it out for you! =D

------------------------------

THERE IS ALSO AN EXCHANGE RATE TRANSMISSION EFFECT:

In open economies, consumers are not restricted to buying domestic bonds- they can also buy bonds sold by foreign governments. Thus, when the interest rate falls for one country in comparison with other countries, this makes that particular country's bonds less attractive for investors (if China's interest rate is 25% and Canada's is 4%, why the hell would you put your money in Canadian bonds [assuming the Chinese bonds were relative risk-free]). As a result, when domestic interest rates fall, investors tend to pull money OUT of the domestic economy and into foreign economies. This DEVALUES domestic currencies.

We know that when domestic currencies are devalued, this makes it more attractive for foreign economies to import domestic goods, and less attractive for local consumers to import foreign goods (for price-related reasons). Thus, net exports increases. This leads to an increase in aggregate expenditure, and subsequently, an rightward shift in the aggregate demand curve!

SO! There are 2 different pathways through which changes in the money supply can affect aggregate demand in an economy (and by association, Y, U, and P)

-----------------------

THE LONG RUN NEUTRALITY OF MONEY

Classical economists divided the economy into real and monetary sectors: they believed that changes in the money supply only affected the price level, but would not impact GDP in the long run

MV = PY where V and Y are constant (money has a constant velocity, and GDP tends to return to its potential leve in the long run)

Modern economist now understand that in the short run, changes in the money supply CAN impact GDP through the monetary transmission mechanism. At the same time, they state that in the long run, the "anchor and chain" mechanism will bring GDP back to its potential level (through wage adjustment)

Pretend this graph indicated that the increase in AD was due to an increase in the money supply. In the long run, inflationary pressures cause wages to increase, which effectively raises costs for firms. This shifts aggregate supply to the left until the real GDP is back at Y*, but at a higher price level

Hysteresis: some economists debate that Y* can be affected by short run trends in Y, not just factors and productivity (for an example, a long-lasting recessionary gap may cause worker skills to depreciate, thus bringing productivity down, and consequently lowering potential GDP as well)

---------------------------

SOME OTHER COOL THINGS

-Changes in the money supply cause larger changes in the interest rate when the money-demand curve is STEEP

-Changes in the interest rate cause larger changes in investment when the MEI curve is very FLAT

MONETARISTS: believe that the LPF is steep and the MEI is flat- they think that monetary changes can cause LARGE changes in GDP and price levels

KEYNESIANS: believe that the LPF is very flat and that the MEI is very steep- they think that monetary changes are much less effective than fiscal changes in affecting GDP and the price level

That's all for now. Only one more bit to cover for the midterm! =D

The Demand & Supply for Money

2011-03-10T18:26:00.000-07:00

The Liquidity Preference Function: This shows people's preference to hold money (cash balances) rather than bonds (interest bearing assets)
-People have a choice between holding their wealth in one of two ways: bonds or money
-Money pays no returns, and bonds do pay a return
-The opportunity cost of holding money is the interest rate one earns on a bond
-People only want to hold money when it provides benefits which at least equal the cost of forgoing bond interest

3 REASONS WHY PEOPLE HOLD MONEY

1: TRANSACTION DEMANDS FOR MONEY

-People hold money so that they can make transactions

2: PRECAUTIONARY DEMAND FOR MONEY:

-People hold money in case they experience an emergency where money would is required

-There is uncertainty sometimes about the timing of receipts and payments, so it can be strategic to have a buffer of cash savings to "tide yourself over"

3: SPECULATIVE DEMAND FOR MONEY:

-People hold money because they believe it will be more strategic to buy bonds in the near future than in the immediate present (if the interest rate is really low, for interest, waiting for the interest raise to rise before buying bonds will be more financially strategic)

The transaction and precautionary demands for money account for the distance between the money demand curve and the Y-axis. When the demand for money shifts to the left or right, this is usually due to a change in transaction demands (for an example, if GDP increases or prices increase, consumers will have higher transaction demands)

The speculative demand for money explains why the liquidity preference curve is downward sloping: the opportunity cost of holding money increases as interest rates increase, so the higher the interest rates, the lower the demand for money (this is dependent on nominal interest rates, rather than real interest rates, as this is a PSYCHOLOGICAL, rather than an accounting effect)

Income, Prices, and The Nominal Interest Rate Affect Demand for Money!

The higher income is, the more transactions there are within an economy, so the higher demand for money will be

+ Positive Relation

The higher the nominal interest rate, the lower the demand for money will be, for reasons related to opportunity cost

- Negative Relation

The higher the price level is, the higher demand for money will be (this is called inflationary demand for money), because a greater monetary value of transaction will be required to facilitate the same amount of real spending: households need more money to carry out their transactions.

+ Positive Relation

Note* when interest rates are very very very high, the only demand for money is transaction demands (so this is the space between the liquidity preference function's asymptote and the Y axis)

THE SUPPLY OF MONEY

-The money multiplier is relatively constant

-The currency ration and and reserve ratio only change during times of uncertainty (usually, they both increase when the future is murky)

-The money supply is independent from the interest rate (although it affects the interest rate)

-In our model, we say that the money supply is a constant, and that it is perfectly inelastic: it is represented by a straight line on our graph

-The real money supply is M/P: this describes money's purchasing power in terms of goods and services

PUTTING SUPPLY AND DEMAND TOGETHER: MONETARY EQUILIBRIUM

(This is also called liquidity preference theory of interest, or the portfolio balance theory)

-This is a short run analysis of how interest rates are affected by the money supply- it is very different than the long run analysis we talked about earlier

Okay: So..

-The supply of money is perfectly inelastic (a vertical line)

-The demand for money varies inversely with the interest rate (it is a downward sloping curve)

Equilibrium occurs when demand and supply for money intersect: M = L

Notice that because the demand for money is downward sloping, the money supply affects equilibrium interest rates: a higher money supply renders lower interest rates, while a lower money supply renders higher interest rates

Monetary equilibrium is a stable equilibrium: if there is higher demand for money than money supplied, then a large number of people will begin to sell-off their bonds to generate some extra money. Because of an excess influx of bonds being sold on the market, the price of bonds will fall, while their relative yields will increase. This, in turn, causes the interest rate to rise, and it will rise until the money market is in equilibrium. A similar mechanism returns interest rates to an equilibrium level when there is an excess supply of money.

That's all for now!

Bonds!

2011-03-06T12:09:00.000-07:00

TODAY: WE ARE GOING TO LEARNING ABOUT THE MONEY MARKET: This basically let's us understand how the money supply determines the interest rate

BONDS: What are bonds...

Well... Wealth is accumulated purchasing power, and wealth can be held in assets, or "things which you own" -This includes both money and "interest bearing assets"

Any household's financial portfolio includes a combination of money and interest bearing assets- choosing a different investment plan is just a matter of deciding how much of your wealth you wish to hold as money, and how much of it you wish to hold as an asset

Money has no risk of lost value (other than inflation), but also does not give you any returns as an investment

Interest bearing assets include bonds (IOUs from companies or the government), stocks (shares of control of a company) and other things (like real estate). They contain an element of risk, in that they can decrease in value over time and cause you to lose money, but on the other hand, they can generate returns (so you can profit off of investing of interest bearing assets if they increase in value)

TO SIMPLIFY OUR MODEL (for now) WE'RE GOING TO ASSUME THAT THERE ARE ONLY TWO KINDS OF ASSETS: MONEY & BONDS!

So.... Here's a chart

Money: Cash in circulation, as well as deposits held in checking accounts: it has no risk, and generates no returns

Bonds: All other forms of interest bearing assets: it has risk, but can also generate returns

Debt: An interest-earning financial asset: this is a synonym for a bond: when you are a creditor, loaning money to a company, you are effectively buying a debt. There is some risk involved (because there is a chance that the company will go bankrupt and be unable to pay back the loan), but there is also a guaranteed rate of return, as determined by the bond agreement.

Equity: Claims on real capital: This describes stocks, which are a "gift" to companies. Companies may pay dividends to stockholders, but there is no guarantee of this.

BOND TERMINOLOGY: This is dense, awful stuff, so get ready

A BOND: A financial contract to pay fixed amounts at future specified dates, and to repay the principal (a loan agreement or a debt are both synonyms for bonds)

A DEBTOR: A borrower, or someone who sells bonds

A CREDITOR: A lender, or someone who buys bonds

THE INTIAL PRICE OF THE BOND: The original loan value or face value of the bond (ie: the principal)

A COUPON: The dollar value of the fixed returns on the bond

THE COUPON YIELD: Coupon / Initial Price (so, if the bond was valued at $100, and the coupon was $10 for a one-year loan, the coupon yield would be 10%, because 10/100 = 0.10

Initial Price * Coupon Yield = Coupon

100 * 10% = $10 Coupon!

PRICE OF THE BOND (Pb): Originally, this is the face value, or principal of the bond, BUT once the bond is sold, it is the present value of the bond in the market (so the price of the bond can change depending on market conditions)

PRESENT VALUE (PV): A discounted value of all future expected income streams using the MARKET RATE OF INTEREST (the discount rate). The price of the bond which a buyer is willing to pay to receive a future income stream provided by a bond

BOND YIELD: How much money you will make off of the bond- this is determined by a combination of the coupon, plus capital gain (as bonds are a form of asset, and can gain value depending on market conditions)

MARKET YIELD (i): The 'average' interest rate in all money-bearing assets currently in a market: the time-sensative value of money (in other words, the minimum rate on interest which you would impose on debtors to loan them money)

TERM (t): The time it takes to completely pay off a bond (principal and coupons)

JUNK BOND: A riskier, high-yield bond (BBB)

Basic ideas:

-The Present Value is equal to the Price of the Bond, which is equal to the face value of the bond at the time of issuance if the market rate of interest is equal to the coupon yield (which it usually is), because the present value, if you use the market rate, will be the face value

-The Present Value is equal to the Price of the Bond, which is equal to Face Value of the bond at maturity, because the bond has no return at that point: just principal

-As a lender, returns higher than those for the market rate are desirable

Note*

There are 3 yields (or rates of return, or interest rates)

-The coupon yield (which is guaranteed, according to the bond agreement)

-The bond yield (which can change depending on market conditions)

The market yield (which is the interest rate of money-bearing assets currently in a market): generally, coupon yields for bonds are set at the market rate for the time when they are issued

demand for money is a function of the NOMINAL rate of interest

Three cases where bonds are sold

Case 1: The bond is price "at par"

Case 2: The bond is sold at a discount (it is worth less in the market than it's face value, so it is sold for less than its face value

Case 3: The bond is sold at a premium (it is worth more in the market than it's face value, so it is sold for more than its face value)

Interest rates affect the present market value of bonds.

The price of bonds varies inversely with interest rates!

R = return one year hence

i = annual market rate of interest (sometimes called the discount rate)

PV = Present value

PV = R/(1 + i)

PV = R/(1 + i)-exponent t (where t is the number of years in the future)

So if the return on a bond one year hence is $110, and the interest rate is 3%, then

PV = 110/(1.03)

PV = $106.80

If the return on a bond is $120 in two years and the interest rate is 10%, then

PV = 120/(1.10)^2

PV = $99.17

The price of a bond is the present value of that future income stream

-The buyer will not pay more than PV for the bond, and the seller will not sell it for less than PV

-The higher the interest rate, the lower the present value of the bond, and vice versa, in order to keep the coupon yield equal to the market interest rate. Basically, we just always fiddle with the present value to make the bond yield equal to the market interest rate (or simply "the" interest rate)

Pb * Bond Yield = Coupon

On most bonds, only the coupon yield is constant.

So, with a given face value, or original bond price of $100, and an original market interest rate of 10%, the issuer of the bond (the borrower) will offer a coupon of $10, or a coupon rate of 10% to compete in the market. This means that the coupon will be $10

Coupon yield = Coupon/Face Value

10/100 = 0.10 = 10%

Bond Yield = The market rate of interest, so there is no capital gain initially...

BUT

let's say that the market interest rate jumps to 20%

The present value of the bond falls to around $60

The price of the bond falls to around $60

-The bond yield (including the present value of future payments + capital gain as the bond approaches maturity) rises to market interest rates of 20%

That's all for today!

MONEY MONEY MONEY

2011-03-04T15:57:00.000-07:00

Money Money Money!

THE NATURE OF MONEY

-Classical economists arbitrarily divided economies into the real sector, and the monetary sector.

-The REAL SECTOR describes the allocation of resources to produce different goods

-Resource allocation (use of factors) is dependent on relative prices

-Relative prices affect output (so if wood is cheaper than brick, an economy will produce more wood houses than brick houses

-The MONETARY SECTOR encompasses changes in the money supply (how much money is circulating in an economy)

-Most economists believe that a change in the money supply would just change the absolute price level in the long run

-If relative prices do not change (ie: the price of both wood and brick rises proportionately), then this will not change the allocation resources

-This shows the NEUTRALITY OF MONEY (A change in the money supply can change the macroeconomic price level, but it will not change relative prices, or GDP)

-The amount of money circulating in an economy affects ABSOLUTE prices, but not relative prices (so while the price of wood will go up, so will the price of bricks, and consequently, the price of houses)

-In modern economic theories, money supply has no long run effect on GDP (it only affects the price level)

-In the short run, however, money supply can affect both price level and GDP

This is the exchange identity: MV = PY : The velocity of money (the size of the money supply multiplied by the amount of times money is used in an economy) is equal to the general price level multiplied by real output. In other words, what you give up (the amount of many people spend to get things) is equal to what you get (the value of the real goods produced by an economy)

THE DEFINITION OF MONEY: 3 ESSENTIAL CHARACTERISTICS

1: Money is a medium of exchange

-Barter requires the "double coincidence of wants" (you have to want what I have, and I have to want what you have)

-Because such situations rarely occur, money is an excellent "in-between" medium-of-exchange for facilitating trade

There are stipulations, however!

1: Money only works as a medium of exchange if people expect that others will accept their money as a legitimate form of payment

2: Money should have a generally high value relative to its weight (or else it will be awkward to exchange: can you imagine if sand or dirt were money, for instance!)

3: It must be divisible (you can divide a dollar in half. You cannot divide a live cow in half)

4: It must not be counterfeit-able (which explains the elaborate construction of dollar-bills)

2: Money is a method of storing wealth

-Earning and spending are not synchronized (ie: you may work on a Monday, but not wish to buy anything until a Saturday)

-Money has stable value which does not diminish over time

-It is a method of deferred payment (this is sometimes cited as the 4th role of money)

3: Money is a unit of account, or financial measurement

-We use money as a unit of measurement: we measure different transactions using dollars, thus it is a sort of accounting unit which facilitates accounting.

NOTE* Demand deposits (aka: deposits into an easily-accessible checking account) count as money, as they satisfy all of these conditions!

THE ORIGINS OF MONEY

1: Commodity Money

-Money was originally precious metals, such as gold

-These were generally recognized as valuable and accepted as payment in most places- they did not wear away or lose value over time, and they had a stable value

Problems:

-Originally, these metals were carried in bulk, so they would have to be weighed, and then stamped by a ruler, guaranteeing the weight of "face value"

-Clipping and shaving

-debasement led to inflation and Quantity Theory of Money

Gresham's Law:

-Bad money forces good money out of the system

-People will hang on to money with high intrinsic value (because it is a very good method for storing wealth)

2: Token Money

-To overcome the problems associated with commodity money, would was deposited at a goldsmith's vault for safekeeping. The goldsmith would give owners a receipt, and this receipt of ownership of the gold was exchanged, rather than the gold itself. Eventually, banks replaced goldsmiths, performing a similar function

-Bank notes were paper money, which were FULLY BACKED by gold (ie: convertible on demand)

-A country whose money is fully backed by gold is on the gold standard

3: Fractionally Backed Money

-Banks discovered that while some customers withdraw gold, and some customers deposit gold, most of their customers are simply trading indirectly using bank notes

-Thus, banks could issue more notes convertible to gold than they actually have gold in their vaults as reserves, and then charge interest on this lent money to generate profits.

-The fraction of money held in reserve affects the money supply: the higher the amount held in reserve, the lower the money supply (because money held in banks cannot be in circulation)

4: Fiat Money: Legal Tender

-Here, the state promises that a certain form of paper or coin currency is legally money, so it becomes money

-Over time, central banks took control of the note issuance: while it was originally backed by gold, it is now only fractionally backed

-Ultimately most of the money we deal with on a day to day basis is not backed by gold at all (for instance, if we went to the neighborhood bank, deposited a cheque, and asked for gold, the teller would probably think we were very strange)

-Most countries abandoned the gold standard by 1940 (WW2)

Legal Tender: The law requires that this be accepted to repay debts- refusal discharges debt.

-Fiat money is backed by the productive capacity of an economy

-Fiat money is valuable because it can purchase goods and pay debts (today's money is fiat money)

5: Bank Deposits (Modern Money)

-Money held by the public in the form of deposits withdrawn on demand from banks (no notice is required)

-(Checks and debit cards, however, are not considered money)

-Bank deposits function on a fractional reserve system: banks create money by granting more loans than deposits to cover them (so if a run on the banks were to occur, the banks would not actually have enough money on hand to pay everyone back.

THE CANADIAN BANKING SYSTEM:

Canada (and many other countries) has a central bank which controls the money supply (the bank of Canada, which a run by a "governor" of the bank of Canada)

-Although the Bank is owned and operated by the government, it operates separately from the cabinet on a day to day basis: it is ultimately held responsible the cabinet, however.

In Canada, our current governor of the Bank of Canada is Mike Carney (Monetary Policy) and our current minister of finance is Jim Flaherty (Fiscal Policy)

THE FUNCTIONS OF THE BANK OF CANDA

1: It is the Bankers' Bank

-It is a lender of last resort to Chartered Banks (they can lend money from the BoC if they have to)

-Chartered Banks have their checking accounts at the Bank of Canada (reserves)

-As of 2002, about $1.2 billion was actually held in asset form at the bank of Canada

2: It is the government's bank

-The government has a chequing account at the BoC

-The government replenishes this account from larger accounts at Chartered Banks

-The BoC's monetary tool is "switching" the location of government accounts (between the BoC and Chartered Banks)

3: It regulates the money supply

-It prints money (this is only done as a reaction in Canada)

4: It regulates financial markets

-It prevents panic and bank failures

-Financial intermediaries (chartered and commercial banks) borrow short term and loan long term from the BoC, so increases in the bank rate squeezes them, and makes the "overnight market" less attractive: basically the higher the BoC sets the bank rate, the higher Chartered Banks will set their prime rate in order to continue to profit, and the more money they will hold in reserve to avoid getting "dinged" with interest for borrowing from the government should a customer seek to withdraw money

-The BoC is concerned about the exchange rate

So, the money supply involves the government, central banks, and chartered banks

The Canadian System

Canada- few banks with many branches (the banking sector is much more like an oligopoly)

USA- many banks with fewer branches (the banking sector is much more like monopolistic competition)

The systems are a bit different, but they essentially function the same way

COMMERCIAL BANKS: Includes chartered banks (formed prior to 1980), smaller banks trusts and credit unions, and foreign banks

A commercial bank is a profit-maximizing private corporation

Chartered Banks

-They hold deposits (trust companies also do this)

-They transfer deposits by cheque (the post office also does this)

-They make loans (credit unions also do this)

-They invest in government securities (insurance companies also do this)

-The government used to require the chartered banks to old money on reserve, but this is no longer required after reforms to the Bank Act (1980)

Interbank Cooperation

-Several Banks can make pooled loans to large companies (which they all benefit from due to the interest paid)

-Charted Banks must now compete against credit card companies

-Debit Cards

-Cheque clearing distinguishes chartered banks (they will turn cheques into money!)

-A clearing house settles interbanks debts: the net difference is accomplished by change in deposits at the bank of Canada

Chartered Banks are Profit-Maximizing Private Corporations:

-Their main asset is securities and loans

-Their main liability is deposits

-They make profits by borrowing money for less than they lend it for

-Competition is strong among different banks, which leads to competitive rates, which is good for consumers

The Big 5:

Royal

Toronto Dominion

Scotia

CIBC

BMO

Note* Our prof usually refers to chartered and commercial banks interchangeably

RESERVES

-Their purpose is to meet demands on deposits for chartered banks

-A RUN ON THE BANKS is when more depositors wish to withdraw more deposits than there are reserves

WAYS TO AVOID A RUN ON THE BANKS:

1: Reserves- the BoC can induce an INCREASE in reserves and avert a run on the banks by

-Loaning money directly to chartered banks

-Open Market Operations: buying securities from Chartered Banks

2: The Canadian Deposit Insurance Coporation

-A Federal Crown Corporation

-Insures deposits in any one account up to $100,000

-A problem is that this insurance is an incentive for banks to pursue riskier investment options "if this investment makes us money, the depositor wins- if it loses us money, then the taxpayer loses"

TYPES OF RESERVES:

1: A Reserve Ratio is the chartered bank's fraction of deposit liability held in Cash of BoC deposits

Actual reserves = reserves the Chartered Bank actually holds

Target reserves = reserves a Chartered Bank wishes to hold

Excess reserves = reserves a Charted Bank holds above target

Secondary reserves = liquid assets convertible to cash (ie: T-bills, and government bonds)

The old bank act required banks to hold reserves for stability and confidence in the system, and to regulate the money supply

Competition from intermediaries and international banks who were not required to hold reserves lead to the elimination of required reserves. Now, the BoC uses the "overnight target rate" (how much interest it charges target rates on overnight loans) to regulate reserves and control the money supply

Presently, actual reserves are about 0.5% of total Chartered Banks liabilities (so we are using a fractional reserve system)

THE FRACTIONAL RESERVE SYSTEM

The reserve ratio is much much less than 1, at about 0.5% of total liabilities. Chartered banks only hold a small portion of deposits on reserve, and the BoC will bail them out if reserves are too low to meet demands on deposits.

The Cost for chartered Banks of borrowing from the BoC (the Bank rate, or the "overnight rate") determines how much reserves banks will hold. An increase in the cost of borrowing will induce the Chartered Banks to hold more reserves

BANK RATE INCREASES ---> BANKS HOLD MORE IN RESERVES

BANK RATE DECREASES ---> BANKS HOLD LESS IN RESERVES

Target reserve ratios are now determined independently by Chartered Banks, but there is incentive for them to still hold some reserves on hand, in order to avoid losing money: the Bank rate determines the opportunity cost of the risk of loaning out more than is on reserve for Chartered Banks.

The Creation of Money!

Assume:

-There is a fixed reserve ratio

-There are no leakages or cash drains (this implies that a change in the money supply will manifest as a change in deposits)

2 Conditions are required for Banks to Make Money

1: The Public must be willing to use bank deposits as money

currency ratio = (public cash holdings/public bank deposits) or C/D

2: banks must be willing to use the fractional reserve system

reserve ratio = (reserve assets/deposit liabilities) or R/D

If the currency ratio is equal to 1, then there is no banking system

If the reserve ratio is equal to 1, there is no creation of money (there is just safety deposit boxes)

The Creation of Deposit Money

Assume:

-cr = 0 (all of the cash is deposited in banks)

-rr = 0.20 (banks loan out 80% of their deposits)

The creation of money is possible due to the fractional reserve system

Changes in the money supply are equal to deposits or withdrawals / The reserve ratio

The currency ratio acts as a cash drain, or leakage. The uncertainty of the banking system increases the currency ratio and decreases the multiple expansion of the money supply (the more cash people hold onto instead of converting into a bank deposit, the smaller the change in the money supply due to banks loaning out money)- we saw this sort of thing happen in 2008 with the US financial meltdown- people lost faith in the banks and wanted their money back, so the money supply in the United States suddenly decreased.

On the other hand, deposits are very convenient (thanks to debit cards), which decreases the currency ratio

High Powered Money (H) is "cash": a combination of cash held on reserve by banks, and cash in circulation within the public.

H = rr * D + cr * D

THE MONEY MULTIPLIER

Money Supply = M

M = D + C (bank deposits + money in circulation)

But, C = cr * D

M = (1 + cr)D

H = R + C

R = rr * D and C = cr * D

Therefore, H = (rr + cr)D

The money multiplier = Changes in M/Changes in H

= (1 + cr)/(rr + cr)

If the currency ratio = 0, then the money multiplier = 1/rr

If banks want to hold more money (the reserve ratio increases) or if the public wants to hold more cash (the currency ratio increases), then the money multiplier gets smaller: basically, the more loanable money which is held in banks, the higher the multiplier effect for money!

AN EXAMPLE OF THE MONEY MULTIPLIER

Assume:

-A constant reserve ration of 0.20

-cr = 0

Person 1 deposits $100 in the bank.

The bank loans out $80 to person 2

Person 2 deposits $80 in another bank

The bank loans out $64 to person 3

Etc...

With each transaction, the money supply increases by a decreasing amount (it works similarly to the expenditure multiplier effect)

So, let's do the math: 100 * the money multiplier = 100 *(1/0.20) = 500!

Monetary Base (H) = C + R - this is the amount of cash in an economy

Money Supply (M) = C + D - This is the amount of money in an economy (because not all money is cash!)

Variable reserve ratios make the the money multiplier equation complicated, but it still works

Cash Drains: Money creation is not automatic- it depends on public and bank behaviors

Public: Uncertainty causes the cr to increase, which makes it harder to create new money

Bank: Uncertainty causes the rr to increase, which makes it harder to create new money

TYPES OF DEPOSITS

Demand Deposit

-Can be withdrawn on demand (no notice required)

-Money can be transfered via cheque

Savings Deposit

-Notice of withdrawal required

-Non-transferable by cheque

Term Deposit

-Chequable savings accounts are now available, so the old distinction isn't as useful

-Today, "term deposit" distinguishes "notice accounts" from other accounts

-A deposit must be left in the account for a term: if withdrawn early, there is a reduced interest rate on that money (so the depositor gets less bang for their buck)

Definitions of the money supply

H = High Powered Money, or cash in public and cash in reserves

M1B = Cash in public + Demand Deposits (this emphasizes the exchange medium function of money)

M2 = M1B + savings deposits at chartered banks (emphasize money's wealth storage function)

M2+ = M2 + Deposits at other intermediaries, including credit unions, trust companies, insurance companies, and MMFs

M2++ = M2+ and all other mutual finds + Canada Savings Bonds

The BoC uses M2's to control inflation.

Near Money and Money Substitutes

There is debate over the definition of the money supply: if a medium of exchange is important, than M1B should define the money supply. If a storage of wealth is important, than deposits that pay higher returns but are not chequable (ie: the M2 series) should count as part of the money supply

Near Money is not a good medium of exchange, but it IS a good store of wealth (like Savings Bongs, Mutual Funds, and Money held in trust accounts)

Money Substitutes are good methods of exchange, but not good methods of storing wealth (like credit cards and debit cards)

Whew. That's all!

2011-02-19T22:42:00.000-07:00

GROWTH ACCOUNTING

It is generally believed that labour accounts for about 2/3 of all income generated, and that capital accounts for approximately 1/3 of national income

as such, percentage-growth in potential national income is = to the percentage change in the level of technology + 2/3 * the percentage change in labour + 1/3 * the percentage change in capital

MEASURING TECHNOLOGICAL CHANGE

-It is impossible to directly measure technological change. Solow tried, and got a Nobel Prize.

-The Solow growth model included only 3 independent varaibles: labour, capital, and "other"

-This "other" is the "Solow Residual" or "Total Factor Productivity" or "A" (in our model). It captures all growth in GDP which is not accounted for by changed in N (L and H) and K.

-BIG PROBLEM HERE: Solow's model included both the quantity and quality of labour and capital, and a great deal of technological change is EMBODIED with labour or capital (so technology factors into labour or capital, and cannot always be separated them from). For instance, if one of my shitty sweat-shop sewing machines breaks down and I decide to replace it with an uber-fast, ultra-modern sewing machine, the capital stock will remain the same for my sweatshop, but the technology level has increased.

-As such, the Solow residual underestimates true technical change (as it can only include disembodied technological changes)

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The Cobb-Douglas Aggregate Production Function is an example of an aggregate production function with 2 characteristics

-The law of diminishing marginal utility

-Constant returns to scale

For this APF, Y = A * N(2/3) * K(1/3)

Here, equal growth rates in labour and capital cause total GDP to grow at the same rate (as it would in a steady state)

y = A * k(1/3)

This is the per-capita APF, where y is per-capita GDP, and k is the capital-labour ratio

Equal growth rates in both labour and capital (ie: a constant k) cause y (per capita GDP) to remain constant

SO: BIG QUESTION: HOW DO WE ALLOW FOR GROWTH?

1: Increase savings (let per capita savings become larger)- in order for growth to occur, the economy requires sufficient savings to increase the capital stock faster than the population growth.

If you are in the Robert Gateman club of not-breeding, choosing NOT to personally contribute to population growth can also help economies grow here...

2: Increase technology: This requires infrastructural developments (health, education, law, physiological needs such as food and water taken care of), and many such developments are difficult for developing nations to set up.

WHY IS TECHNOLOGICAL CHANGE IMPORTANT?

Technological improvements lead to increased productivity, which increases the potential per-capita GDP

Embodied Technical Change = technical change intrinsic to the particular human or unit of physical capital in use: it is a change in the quality of the input (so a higher education, or a computer upgrade would both be examples of embodied technical changes)

Disembodied Technical Change = technical change that is NOT intrinsic to human or physical capital in use. This is a change other than to the quality of the capital (so if my sweat-shop fore-woman comes up with a fantastic new sewing procedure which halves the time it takes her to sew a sneakers, and then she teaches all of her sweat-shop buddies how to sew like this, that new technique would be an example of a disembodied technical change)

Usually, disembodied changes eventually become embodied, so the distinction becomes less important over the long run.

CONVERGENCE HYPOTHESIS: This an interesting theory, and there are 2 different facets of it

1: Absolute Convergence: the tendency for GDP AND Growth Rates in GDP to be equal across nations: each nation will have the same steady state values for y* and k*

-This assumes that different countries have the same marginal propensity to save, the same rate of population growth, and the same rate of technological improvement

-This theory states that if two countries have the same growth model, then even if one starts farther to the left, they will both end up with the same standard of living

2: Conditional Convergence: the tendency for Growth Rates in GDP to be equal across nations: each nation will have the same steady state values.

-This theory assumes different marginal propensities to save for different nations, different population growth rates, and different technological growth rates

-This theory acknowledges that different countries will have different per-capita GDP, but states that they will have THE SAME GROWTH RATES!

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NEW GROWTH MODELS

The Neoclassical Growth Model made growth dependent on exogenous variables such as population growth, the savings rate, and the rate of technological change.

Some new growth theories alter the 2 assumptions of the Neoclassical Model:

-Instead of technology as exogenous, they state that technological changes can be explained within the economic model

-Instead of having diminishing marginal returns, some new growth models suggest that the marginal product of capital is constant, or that there is even increasing marginal product of capital over time!

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ENDOGENOUS TECHNOLOGICAL CHANGE:

Endogenous growth is self-sustaining growth

In this theory, we assume constant marginal product of capital

For an example, if the price of an input rises, firms will develop a new technology rather than just switching to an existing alternative input (so market structures and competition can facilitate technological change)

-Some people believe that competition foster technological change: others believe, especially in the case of health technologies, that only monopolies can risk the large expenditure required to create new drugs

LEARNING BY DOING: In the 1940s, Shumpeter said that innovation was a one-way street- that research caused new developments, which led to new machines and new products. Today, things work different: it is more of a 2-way street. There is a feedback mechanism (ie: the Japanese method of building cars, where the mechanics and workers collaborate with the designer in order to streamline research and production in such a way that is productively efficient).

SHOCKS and INNOVATION:

-Different countries respond to economic shocks in different ways. Some will find different countries to produce goods in where costs are cheaper: others will change production methods and increase technology to make it more cost effective!

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INCREASING MARGINAL RETURNS TO INVESTMENT: Here, each new addition to the capital stock is more productive than the last.

There are 2 sources of increasing marginal returns to investment:

Market-Development Fixed Costs (Paul Romer)

-The original investment into new knowledge or technology has a large fixed cost

-Adopting or adapting this new technology once it has already been established is cheaper

-Also, consumers, wait to use new technologies

-In this way, the costs decrease as more and more people adopt new technologies, so the returns to scale increase with increasing investment

Knowledge

-It is a public good, so it is not subject to the law of diminishing marginal returns

-New ideas are non-excludable and non-rivalrous (as much as copyright laws try to prevent people from accessing them)

-New ideas are pure public goods

-New ideas may not suffer diminishing marginal returns

-SOOOO, because ideas play such a big role in economics, and ideas are practically unlimited, economics doesn't have to the be DISMAL SCIENCE! Yay!

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LIMITS TO GROWTH

-1970s, the club of Rome published a book called "Limits to Growth"

-This book predicted that increased growth would eventually destroy the earth's resources...

Here is their usual anti-growth argument: growth will look like more of what we witness today: production of mostly useless, impractical consumer goods with a short lifespan, which end up in the landfills in a couple of years.

This could be countered with the argument that growth can still occur, but under that condition that instead of producer large quantities of shitty goods, we focus on producing higher-quality, cleaner, longer-lasting, more efficient products.

-Growth permits societies to protect the environment and help the poor (if you haven't noticed, environmental protection legislation is more a by-product of mature industrial economies, and less-so of developing nations)

-The thought is that market participants will react to supply shortages, and innovate around them (ie: by the time oil runs out, productive processes will have innovated away from it)

RESOURCE EXHAUSTION

-Limits to growth are based on fixed technology and resources

-BUT, technology leads to more efficient resource use

-AND technology leads to the discovery of new resources

-Problem: THERE ARE TOO MANY PEOPLE: More people on the earth means that we will require more resource expenditure

POLLUTION:

-Economic growth creates pollution. Nuff said

Although many economists believe that growth creates opportunities for humankind to combat resource depletion and pollution through increased technologies, a lot of these beliefs are based on blind faith.

Like... we are basically relying on our ability to innovate away from these problems...

but what if we simply can't do that? Then what..............?

The Neoclassical Growth Model and Steady States

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THE NEOCLASSICAL GROWTH THEORY: This focuses on capital accumulation, and how it is affected by savings

One important function in the neoclassical growth theory is the AGGREGATE PRODUCTION FUNCTION. This function shows the relationship between total real output and total inputs (sort of like a "macro" version of the production function for individual firms we saw in microeconomics)

REMEMBER from the last leccture? There are three main determinants of economic growth: labour, capital, and technology. Well, with the aggregate production function, we say that output is technology times a function of labour and capital

Y = A x F(N,K) where A = total factor productivity (disembodied technology), N = Labour and Human Capital, and K = capital (both quantity and quality)

Now what happens if we divide through by N?

Well, we get

y = A x F(k) where y is the amount of GDP produced per worker, and k is the amount of physical capital available for each worker

Also, potential output is also representable here

Y* = A x F(Nfe, Kfc) where Nfe is full employment, and Kfc is full capacity. In other words, potential output is technology times a function of labour at its full employment level, and physical capital at its full- capacity level

Some important things to remember:

We assume in the long run that income is at its potential level (that there is no output gap)

L is labour quantity, H is labour quality, and N includes both the quality and quantity of labour.

K includes both the quality and quantity of physical capital

We omit land as a factor input for the sake of simplicity in this model

Technology includes entrepreneurship and savviness

PROPERTIES OF THE NEOCLASSICAL AGGREGATE PRODUCTION CURVE

1: In the short run, there are diminishing returns to scale: as more of a variable factor is added to a given amount of fixed factor, the additional output generated by the added factor (the "return") will get increasingly smaller and smaller: they will diminish... ceteris paribus (they will diminish if all other things are held constant) after a certain point (they will not begin to diminish immediately)

But, this is only true of the short run when one factor is increased, and all other factors are held constant!

2: In the long run, there are constant returns to scale: When all factors increase the same amount, output will also increase by that amount (so if I double the amount of workers and also the amount of sewing machines, my sweat shop should double its output of shitty sneakers!)

3: Technology is nuetral: A affects the productivity of K and N equally, so although technology is present, it will not disproportionately impact any one factor.

Image Plz! y = f(k)

4: Steady state equilibrium: Here, the per-capita capital (k) and the per capita output (y) remain constant over time, so /\y = /\k = 0

If the population is growing at n, then income and capital must also grow at the same rate in order to remain in a steady state equilibrium. In other words, in order to be in a stead state equilibrium, the percentage change in output must equal the percentage change in capital, which must = the percentage change in the workforce.

y* and k* are the steady state values (they don't change over time)

Investment required to provide capital for new workers and to replace machines that have worn out (depreciation) is just equal to the national savings in a steady state equilibrium, so New Capital + Replacement Capital = Investment = Savings

If savings is greater than investment, than capital per worker will increase, and thus output per worker will also increase

If savings is just equal to investment, then the capital per worker will be k* and thus output per worker will be y*

When savings is equal to required investment, the economy is in a steady state equilibrium, each worker will have access to k*, and will produce y*

Economic Growth: Savings and Investments

2011-02-17T22:33:00.000-07:00

The Very Long Run: Economic Growth Models

We can measure long run economic as the annual percentage change in per-capita real potential GDP.

Ecoonomic growth causes Y* to move to the right.

The standard of living is measured by the per capita real actual GDP: The average income generated by each individual within an economy

Although a small difference in growth rates may not seem to make a huge difference, compounded over time, smaller changes in growth rates can have a huge impact on economic growth!

-1% growth rate increases GDP by 10% in 10 years

-7% growth rate increases GDP by 100% in 10 years

Even a small change in the growth rate can cause major long term changes in terms of living standards- much more than gap-busting can, anyways...

Malthus thought that output would not be able to grow at a fast enough rate to keep up with population growth

In this unit, we're going to be studying the depressing, Neoclassical growth model, and then we'll be looking at some more optimistic modern growth models.

(As a general note, most asian countries have a much larger growth rate than the rest of the world, currently. This is because they are developing rather rapidly!)

THE PROS AND CONS OF GROWTH

What are some benefits of economic growth?

-Growth may increase the standard of living, as long as the economy is growing more quickly than the population. This means that people are able to buy more crap!

-Economic growth may help governments to alleviate poverty- the more national wealth a country has access to, the greater their ability to redistribute that wealth to those who are worse off.

What are the costs of economic growth?

1: Opportunity Cost: In order to allow for economic growth, individuals need to divert resources away from present consumption and into investment (ie: savings). For an example, a government has the option of spending 100 million dollars on new parks and public spaces now, OR it can spend that money on educating it's citizens, which won't generate any immediate benefit, but will create better workers and a stronger tax base 20 years into the future

2: Personal hardships to those who can't adapt to change (ie: the poor old blacksmith who goes out of business and doesn't want to retrain for a new job more befitting of the information age)

3: NEGATIVE EXTERNALITIES

-Pollution

-Resource Depletion

-Global Warming

-Financial Meltdown

-Congestion

-Stress

-Disease

-Reduced Happiness (if you want to see this sort of thing in action, check out Carl Honore's "In Praise of Slowness"

SOURCES OF ECONOMIC GROWTH

Well, as we learned in the last chapter, in the long run, output is a function of the supply of factors (usually capital and labour, and this includes embodied increases in quality, not just quantity), and productivity (which can also by thought of as technological change)

In this chapter, we flip this idea around and reconfigure it, to state that we have four determinants of growth

1: Supply of labour: the quantity of labour

2: Human capital: the quality of labour (this is acquired through on-the-job training and education)

3: Physical capital: both the quantity and quality of plant, equipment, inventories, and residential construction

4: Technological change: This is sort of a catch-all category for all sorts of different changes, including changes in the productive process, innovation and invention (creative new ideas), new products, new organizations and many other things!

THE NEOCLASSICAL GROWTH MODEL

-Economic growth occurs in the long run, and related to increasing Y*, not output gaps

Long run growth is determined, largely, by investment and savings. In a nutshell, savings allows for more investment, and greater investment in productive capital increases potential output in the long run

In the short run, we assume that the interest rate is constant, so we use the equilibrium condition savings must = investments and use this to determine output

In the long run, we assume that potential GDP is constant, We also see that both savings and investment are a function of the interest rate, so we use the equilibrium condition S = I to determine what the equilibrium interest rate will be.

In this model of savings, we focus on public savings, which is a combination of private savings (Y* - C - T) and public savings (G - T)

NS = (Y* - C - T) + (T - G)

NS = Y* - C - G

When the interest rate increases, we know that consumption will decrease (because the opportunity cost of borrowing money has risen). When consumption decreases while income remains the same, national savings increases. As a result, high interest rates encourage more people to save money, and as a result, this creates a larger "pot" of loanable funds which accumulates in banks. Basically national savings as a function of interest rates is positively sloped.

What about investment????? Well, we use the marginal efficiency of investment curve to measure the degree of investment as a function of interest rates: this curve basically shows the demand for investment at each interest rate

This curve is negatively sloped. As interest rates rise, the opportunity cost of borrowing money to fund new investments also increases, which leads to decreased desired investment.

SO... what happens when we graph both desired national savings and desired investment together? We get two criss-crossing curves! The point where the two curves intersect is where NS = I: this is the equilibrium point- it does not change over time. If there is an excess supply of funds, this will mean that banks do not need to charge as much interest to prospective borrowers, so the interest rates will naturally fall, which drives up investment until it is equal to savings. Likewise, if there is excess demand for loanable funds, banks will know that that loaning out money when there are not many hard assets to cover their asses should the loan go unpaid is RISKY BUSINESS, so they will charge higher interest rates to compensate for this risk. Higher interest rates, likewise, discourages excess investment and encourages national savings until the economy is in equilibrium once again!

An increase in either public savings OR in the marginal efficiency of investment causes the level of equilibrium savings and investment to increase. This increased investment leads to long term increases in potential national income (because investment allows for the accumulation of new capital production factors). As such, although savings can be bad for an economy in the short run (because increased savings puts recessionary pressure on an economy), they are good in the long run, because they create opportunities for new growth! Woooooooooooo!

Macroeconomic Timespans

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Macroeconomic Time Spans: Changes can have different effects over the long run than they do in the short run! This is just going to be a brief comparison exercise between the long run and the short run.

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IN THE SHORT RUN:

-Changes in national income are a function of factor utilization rate: for an example, the rate of employment. When more people are employed, more factors are being utilized, so national income increases

-National income is demand-induced: aggregate demand determines what the national income is going to be. The higher demand is, the higher the factor utilization rate will have to be in order to sate demand.

-Actual GDP, or Y determines national income: this means that there can be recessionary or inflationary output gaps

-Fiscal and monetary policy can affect both aggregate demand and actual national income

-Policies focus on shifting aggregate demand

-Gapbusting is the political objective

-Policies affect utilization rates

-Policies are focused on stabilizing real GDP at it's potential

IN THE LONG RUN

-Changes in national income are a function of both the supply of factors (ie: the size of the labour force), and factor productivity (ie: how productive and useful, on average, each worker is). The larger the workforce, and the more productive that workforce is, the higher national income will be

-National income is supply-induced: even if demand increases, wages will simply adjust and price will change, but producers will still produce the same amount in the long run UNLESS their production capabilities change. The supply and productivity of factors affects supply, and therefore, can change production in the long run.

-Potential GDP (Y* or Yfe) is a better determinant of what the national income will be. While understanding that output gaps do occur thanks to the business cycle, it is long run aggregate supply which basically determines what GDP will be

-Fiscal and monetary policy have a neutral effect (or even a negative effect: if expansionary policies increase consumption at the expense of savings, then there will be a smaller "pot" for investors to borrow from, so investment will be lower in the long run, causing a lower long run GDP)

-Policies are aimed at affecting potential GDP

-Technological change is key

-Policies attempt to affect factor supply and productivity

-Growth is the political goal

Cool?

Cool! =D

Honestly, just read the chapter for this one: it's short, and it makes more sense than the class notes...

Supply and Demand-Side Economics

2011-02-15T22:24:00.000-07:00

Long-run aggregate supply, however, can shift if the potential national income shifts. When potential national income increases, this brings the equilibrium price level down, and the equilibrium level of GDP up in the long run. Neoclassical economists believe that policies which intend to bring real economic growth and betterment should focus on shifting potential national income to the right (increasing it): they believe that policies which only focus on increasing aggregate demand merely cause price-inflation in the long run.

So, for a classical economist, instead of using short term fiscal policy "gap-busting" to correct short term deviations from potential national income (boosting or reducing government expenditures to correct recessionary and inflationary gaps), policies should focus on brining potential national income forward, and closing the gap through increased potential economic growth! We call this SUPPLY-SIDE ECONOMICS

SO... let's say that an economy is in an inflationary state... there are a few things which policy-makers can do to fix this

1: They can do nothing. The chain and anchor system of long term economic adjustment will make wages higher, which shifts AS to the left and brings the economy back to Y*, but with a higher price level

2: The government could engage in some "gap-busting" policies (ie: they could raise taxes and decrease expenditures to kick aggregate demand back to the left, which would bring equilibrium GDP back to its potential levels)

3: The government could focus on increasing long run aggregate supply. This is also called Reaganomics: some policies in with vein include cutting personal income taxes (which increases incentives to work), cutting corporate income taxes (which increases production and investment). This shifts LRAS to the right to close the gap, and arguably, there is no negative effect on overall tax revenues, despite these cuts (because the increased long run equilibrium national income creates a larger tax base, so the government is still able to generate the same amount of revenue, despite taxing at lower rates).

CRITICISMS of SUPPLY SIDE ECONOMICS

Although these sorts of policies may increase LRAS, critics note that decreases in personal income tax also increase disposable income, which drives consumption upward. Also, decreases in corporate income tax are likely to cause corporations to increase their levels of investment. Thus, while LRAS will shift to the right, aggregate demand will also shift to the right, and the inflationary gap will persist, even if the economy's productive potential grows. This means that economies where supply side economic policies are instated will experience EVEN LARGER price inflation.

FISCAL POLICY

There are two different models we use for the economy: the short run model and the long run model. These two models are very different.

Fiscal policies which are based on the long run model is focused on increasing economic growth by increasing either labour, capital, or technology. These are factors which cause the potential national income to shift, and thus, they create long-run changes in economic potential.

The short run model, on the other hand, deals with temporary fluctuations in the economy which causes GDP to fall above or below potential: this is the economy model which is centered around the business cycle. Most policies in this vein are based around gap-busting, or eliminating recessionary and inflationary gaps.

It is not particularly difficult to determine the direction of the shift which must be kickstarted by fiscal policies: rather, it is the mixture and the magnitude which is hard to determine (for an example, if lowering taxes is likely to eliminate a recessionary gap, the question which the government must ask is how much of a tax cut should be given, how long should these cuts persist for, and which taxes should be affected by the cut).

STABILIZATION POLICY

-This is meant to damped the fluctuations caused by the business cycle

-This reduces the amplitude of the fluctuations (so recessionary and inflationary gaps are less extreme)

-This is GAPBUSTING!

While the automatic economic adjustment which occurs thanks to natural wages shifts WILL bring economies back to potential GDP, one problem is that the natural adjustment process can take a very long time, and while the economy is adjusting to reduce a recessionary gap, unemployment will be high, and the economy will remain unproductive for a long while. Government stabilization policies can fix recessionary gaps a lot more quickly by increasing government expenditures and decreasing taxation. This boosts aggregate demand, and shifts equilibrium GDP back to Y* a lot more quickly than the natural AS shift to the right would have.

Contractionary fiscal policy works in a very similar way: if there is an inflationary gap, the government increases taxation and decreases government expenditure to shift aggregate demand to the right, thus bringing equilibrium GDP back to Y* much faster than the natural AS shift to the left would have.

THE PARADOX OF THRIFT!

In a recession, the natural tendency is for individuals to increase savings: while such prudent actions may benefit individuals, on a larger aggregate level, frugality decreases consumption, and therefore, it also reduces aggregate expenditures, aggregate demand, and GDP as a whole. As a result, this psychological tendency towards thriftiness in a recession can exacerbate recessionary gaps. A historical example of this occurred in the great depression when governments actually RASIED taxes as a response to the hard economic times.

Note* this negative economic result of savings only really applies to the short run: in the short run, increased savings means decreased consumption, and therefore decreased aggregate demand. In the long run, however (as we will learn in the next chapter), an increase in savings facilitates an increase in investment, which leads to a higher aggregate demand.

AUTOMATIC FISCAL STABILIZATION: This refers to built-in tax and expenditure rates which automatically stabilize the business cycle without the government having to specifically set up any policies

-Basically, tax 'n spend systems decrease the simple multiplier, so injections and withdrawals from the economy create smaller shifts in GDP.

-Automatic stabilization can be represented by the slope of the budget function (as GDP increases, there are more withdrawals from the economy)

-Discretionary stabilization (ie: expansionary and contractionary policies) can be represented by a shift in the budget function (so governments are taxing and spending at different rates for the same national income rate)

-Taxes aren't the only automatic stabilizer: other ones include employment insurance and welfare payments (which are forms of withdrawals or expenditures)

ONE FINAL IMPORTANT THOUGHT: WHY ARE ECONOMISTS SO LEERY ABOUT FISCAL STABILIZATION POLICY???

Why not just increase expenditures and lower taxes to fight unemployment???

Wellll....

There can be policy lags- so by the time a budgetary policy gets through the political process and takes effect, it may already be obsolete, or even counter-productive (remember, stabilization policy is extremely time-sensitive)

Also, economists recognize that many households are not "fooled" by short term changes in tax structures. Many households base their spending on what they believe their long term incomes are going to be (as Milton Friedman predicted), so short term changes in taxation which temporarily boosts income may not cause changes in spending habits.

Finally, most economists believe that fiscal policy creates too broad and general a change in the economic environment to fine tune an economy for optimal performance. While stabilization policy may be useful when large, sweeping economic changes are required, many economists believe that it is unnecessary overkill for small economic imbalances which will correct themselves.

THE LONG TERM EFFECTS OF FISCAL POLICY

While increased government purchases lead to increased AE, AD, and GDP in the short run, in the long run, they may "crowd out" private-sector consumption and investment

Similarly, while decreased taxes may increase AE, AD, and GDP in the short run, the long run effect is less clear. On the one hand, some economists believe that decreased taxes may increase investment and incentive to work in the long run, thus drumming up GDP. On the other hand, some economists believe that decreased taxes may crowd out public spending on public goods (case and point, check out Alberta's decaying public infrastructure)

Supply Shocks and Other Important Things!

2011-02-14T18:05:00.000-07:00

SUPPLY SHOCKS: These also correct themselves in the long-run, but unlike demand shocks, these do not cause any net changes in the price level.

NEGATIVE SUPPLY SHOCK

-Let's say that the cost of oil rises: this shifts AS to the left, which decreases overall economic output and increases the price level.

-There is now a recessionary gap in the economy, and this will cause unemployment to rise

-As unemployment rises, firms can get away with paying their workers less, so wages fall

-Because wages are a cost, production costs fall, and this shifts aggregate supply to the right, back to equilibrium

-Ultimately, the economy is right back where it started at: there is NO NET CHANGE

POSITIVE SUPPLY SHOCK

-Let's say that a new technology emerges which lowers the price of electricity: this shifts AS to the right, which increases overall economic output and decreases the price level

-There is now an inflationary gap in the economy, and this will cause unemployment to fall below its natural level

-As unemployment falls wages rise (overtime and worker retention)

-Because wages are a cost, production costs rise, and this shifts aggregate supply to the left, back to equilibrium

-Ultimately, the economy is right back where it started at: there is NO NET CHANGE

BUT, just because the economy is the same, this doesn't mean that wealth doesn't shift. In the event of a negative supply shock wealth tends to shift from the workers to the capital owners (so workers are paid less, and company owners make more money)

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SHOCKS AND THE BUSINESS CYCLE

Positive supply and demand shocks cause GDP to rise above it's potential level for a period of time, and then to fall back to potential (because inflationary gaps cause decreased unemployment, higher wages, and increased factor prices)

THESE SHOCKS ARE RANDOM...

SO:

The economy's adjustment system accounts for these random shocks, and basicaly incorporates them into business cycles (short term fluctuations of the economy)

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LONG RUN AGGREGATE SUPPLY: This is the relationship between price and GDP after changes in input prices have been taken into account. LRAS is the result of automatic adjustments which bring GDP back to its potential level. LRAS is also called classical aggregate supply, because classical economists assumed that the economy has an automatic tendency to return to Y*

LRAS, graphically, is a vertical line at Y*, because the amount of goods produced at the normal utilization rate is Y*

The only thing which this can be used to demonstrate is price changes: as long as factor prices rise by the same proportion as output prices, then Y*remains constant

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SHIFTING Y*

Factor Prices and the Output Gap!

2011-02-12T16:18:00.000-07:00

Oh dear god, am I ever behind schedule for these notes...

Okay, today, we're going to have a look at what happens to our economic model when we allow factor prices (this usually refers to wages) to vary. Up until this point, we've been assuming that factor prices remain constant, but in real life, that isn't necessarily the case.

Here are some things you'll probably need to know about wages and the economy, and how they relate to demand shocks:

If the economy is in a recessionary gap (think post-2008)

-Actual income is lower than potential income

-There is an excess supply of labour (there are a lot more people going around trying to find jobs in a recession than firms are willing to hire)

-This excess supply of labour means that companies can lower wages without having to worry about losing workers

-By lowering wages, producers effectively decrease their average costs

-As a result, the short run aggregate supply curve will shift to the right (remember, decreased costs allow firms to increase production at every output price level)

-IMPORTANT: This adjustment happens relatively slowly, because it takes longer to lower wages than to raise wages (firms have to fight with unions, and it takes a while to agree on a lower wage rate: people don't like to be paid less)

-So... given some time, recessionary gaps will correct themselves, and unemployment will fall back to normal levels. Also, this kind of an adjustment causes the price level to decrease

If the economy is in an inflationary gap (for an example, Alberta circa 2007)

-Actual income is greater than potential income

-There is an excess demand of labour (there are not enough workers to supply firms' increasing demands, which is why you have fifteen year olds working in restaurants and making $12/hour during economic boom-times... it's ridiculous!)

-This excess demand of labour means that firms have to pay higher wages to entice new workers to stay on, or alternately, to reward current workers for working overtime

-This means that average costs increase for firms

-This increase in costs shifts short run aggregate supply to the left (increased costs force firms to decrease production at every output price level)

-IMPORTANT: This is a fast change: wages rise relatively quickly in good times, so this natural return to economic equilibrium is relatively quick.

-So... in the long run, the price level increases, and production decreases, bringing us back to equilibrium... yah!

AS YOU CAN SEE, we have ADJUSTMENT ASYMMETRY:
-Booms cause wages to rise quickly
-Recessions cause wages to fall slowly

ALSO, you should probably know about the Phillips curve!

Basically, the phillips curve shows us that as employment increases, rate of wages become lower. In other words, in times were there is lots of unemployment (read: recessions), the wage rates will fall. Conversely in times when unemployment is high (booms), the wage rates will increase!

Basically, a good way to think about long run economic adjustment is to imagine that Y* (potential GDP) is like an anchor, and that short run aggregate supply is a chain. We have have demand shocks which shift the economy around for a little while, but because these demand shocks affect wage rates, which in turn, affects supplier costs, the short run aggregate supply will always eventually bring the economy back to it's potential level!

We can practice figuring out what happens with supply and demand shocks in the long run, but basically, all you need to know is what I've already told you.

-Inflationary gaps cause increases in prices in the long run

-Recessionary gaps cause decreases in prices in the long run

-Production will eventually shift back to its potential levels

-Also, for economies where wages are "stickier" (less flexible), recessions are likely to last longer, because the wage adjustment does not occur as quickly

-Recessionary and inflationary gaps WILL disappear on their own, but but discretionary fiscal policy can speed up the process a LOT!

MACROECONOMIC EQUILIBRIUM: Putting it all Together

2011-01-30T12:47:00.000-07:00

So, we have the aggregate supply curve and we have the aggregate demand curve.

AD measures levels of production which won't change over time as a function of price

AS measures levels of production which suppliers will actually produce at as a function of price.

SO... what happens when you put both of them together?

Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!

The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level)

GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment

This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium

Aggregate Demand Shocks and Macroeconomic Equilibrium:

These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!

As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)

You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.

The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve.

When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.

When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.

When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.

Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.

We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.

Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.

Okay- that's all you'll need for the test. Good luck!

Aggregate Supply

2011-01-27T02:39:00.000-07:00

In the short run, we're going to assume that factor prices remain constant (but later on, this can change, as we look at the long run)

The short run aggregate supply curve shows the amount which firms are willing to produce at any given price level.

Aggregate Supply is positively sloped!

Why?

Well, as firms increase output and input prices are constant, the law of diminishing marginal returns causes marginal output per factor to fall, and the short run average cost to rise. THUS, in order to retain expected profit margins, the only way for producers to feasibly increase production is to increase the price of goods: as such, as price rises, the actual GDP/output which firms will produce increases- there is a positive relationship here.

What about the slope? Why is it increasing?

Well... at low levels of output, firms have excess capacity, so they are capable of increasing output without making a huge investment, and the law of diminishing marginal returns hasn't really kicked in yet. Production can be increased at a relatively low cost (this corresponds to the flatter part of the curve)

At higher levels of output, however, there is no excess capacity, and great costs must be incurred to increase production.

Aggregate supply can shift (we call this an aggregate supply shock!). Basically, anything which would cause the cost of inputs (wages, intermediate goods, machinery, etc.) to rise OR anything which lowers the productivity of those factor inputs (like a rainy day on a farm) will shift the aggregate supply curve to the left (and consequently, lower input costs shifts AS to the right)

Aggregate Demand

2011-01-25T02:36:00.000-07:00

ECON 101 HELL WEEK BLOG REVIEW:

PART 1: DEMAND SIDE EXPENDITURE
PART 2: SUPPLY SIDE EXPENDITURE
PART 3: EQUILIBRIUM: PUTTING IT TOGETHER

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PART 1: DEMAND SIDE EXPENDITURE

We know that National Income is a function of Aggregate Expenditure. Thus far, we have been assuming that prices remain constant...

Newsflash! In real life, prices change (unless the firms contributing to GDP are monopolies, or they have excess capacity). We need to look at how this affects aggregate expenditure, and subsequently, national income.

We assume that output is demand-determined: that is, GDP will rise if general consumer demand rises, and it will fall with decreases in demand

OKAY: How does price affect aggregate demand? Well, it affects it in an inverse relationship. When the price level increases, aggregate expenditures shift down. When the price level decreases, aggregate expenditures shift up! Why?

2 Reasons:

1: A Decline in Wealth

An increase in price levels causes people's wealth to decrease (unless they have invested into price-variable assets, which most people have not)- inflation decreases the purchasing power of money. Wealth is a ceteris paribus variable for consumption When wealth goes down, peoples' desire to spend (their MPC) also decreases.

2: A Decline in Net Exports

An increase in domestic price levels implies that relatively speaking, foreign products will be cheaper than domestic products. The increases the incentive for domestic consumers to import foreign goods, and it also decreases the incentive for foreign consumers to buy domestic goods. As a result, imports increase (cutting into MPSpend) and exports decrease (lowering autonomous expenditures)

The overall effect is that AE and Prices are negatively related...

SO, what happens when we take the same Aggregate Expenditure curve, and then change the price several times? Well, the equilibrium level of national income will be different for each curve (higher price levels lead to lower expenditures, and therefore lower national income)

When you put together ALL of the different equilibrium income levels for AE, and then graph them in relation to price, you have the Aggregate Demand function!

The Aggregate Demand function is a family of equilibrium national income levels for different price levels! Every point on the AD function is a different equilibrium level.

-The Y-axis is price, and the X-axis is equilibrium national income

-It is downward sloping (As price decreases, equilibrium national income increases)

-Generally speaking, points which are not directly ON the AD function tend to gravitate towards it (because it is a stable equilibrium)

-If income for a certain price level is to the left of the AD curve, it means that for that price level, there is not enough production to satisfy expenditure demands. There are two solutions: firms can make more product (and horizontally move towards the AD curve) or they can raise prices (and vertically move towards the AD curve). More likely, it will be a combination of the two

Shifts in AD are called aggregate demand shocks, and are caused by changes in exogenous, autonomous expenditure (which consequently shifts the whole family of aggregate expenditure curves which we use to derive aggregate demand). If the family of expenditure curves increases, aggregate demand shifts to the right. If the family of expenditure curves decreases, aggregate demand shifts to the left.

The simple multiplier can be used to determine the horizontal shift in AD caused by a demand shock- you just multiply the shock by the simple multiplier, and the AD graph will shift out by that amount for that specific prices level

That's all for this section

Putting it ALL together! Building and fiddling with aggregate expenditures!

2011-01-20T18:44:00.000-07:00

EQUILIBRIUM NATIONAL INCOME AND THE AGGREGATE EXPENDITURE FUNCTION:

REMEMEBER:

Consumption is a function of disposable income (income minus net taxes) and net taxes are taxes minus transfer payments.

So, when you add the government to the economy, you have to substitute (income minus net taxes) into the consumption equation!

As such, consumption is a function of income: C = f(Y) (the disposable part is now implicit with the addition of the government)

Taxes and transfer payments are thus subtly incorporated into the consumption function

DESIRED AGGREGATE EXPENDITURE is a function of actual income! E = f(Y)

AE = C + I + G +NetX

The marginal propensity to spend is the slope of the aggregate expenditure function: This is the portion of each additional added dollar of national income which is spent.

(Don't confuse this with MPS, which is the marginal propensity to save)

THE FORMULA for MPSpend:

MPSpend = z = Marginal Propensity to consume multiplied by (one minus the marginal propensity to tax) minus the marginal propensity to import.

MPSpend = z = MPC(1-MPT) - MPM

C = 10+0.8Yd
I = 25
G = 17
NX = 24-0.1Y
T=0.1Y

Let's put it together to make our formula for aggregate expenditure as a function of national income

AE = (Autonomous C + I + G + X) + MPSpendY
AE = (10+25+17+24) + (0.8(1-0.1) - 0.1)Y
AE = 76 + 0.62Y

Hooray!

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EQUILIBRIUM IN THE GOVERNED (CLOSED) ECONOMY: This involves Households, firms, and governments as economic actors (banks just act as instruments for investments and savings). We assume that the household uses the bank to save money, and that firms loan from banks to fund investments. We also assume that the government taxes and spends.

In the garden hose theory, then, equilibrium happens when National Income is equal to Expenditures (C + I + G). On a graph, this happens when the AE function intersects the 45 degree line. Algebraically, you can find this point by multiplying autonomous expenditures by the simple multiplier (1/(1 - the MPSpend))

In the bathtub theory, equilibrium is when total injections of money into the economy is equal to total withdrawals of money from the economy (S + T = I + G)

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EQUILIBRIUM IN THE OPEN ECONOMY: This involves Households, firms, the government, and the world as economic actors. This is similar to the open economy, but with the world added, domestic consumers can purchase imports, and foreign consumers can purchase exports.

In the garden hose theory, equilibrium happens when National Income is equal to Expenditures (C + I + G + NetX). On a graph, this happens when the AE function intersects the 45 degree line. Algebraically, you can find this point by multiplying autonomous expenditures by the simple multiplier (1/(1 - the MPSpend))

In the bathtub theory, this is when total injections of money into the economy is equal to total withdrawals of money from the economy (S + T + M= I + G + X)

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MORE ON THE SIMPLE MULTIPLIER!

(1/(1 - the MPSpend)) is the simple multiplier!

Taxes and imports reduce the value of the simple multiplier (which makes sense mathematically, because they reduce the value of MPSpend): This is because taxes and imports are directly linked to national income, so as the national income increases, the withdraws or leakages from the economy causes by taxes and imports also increase!

-The simple multiplier causes injections into the economy to lead to an increase in equilibrium expenditure/income which is larger than the injection itself: the value of this equilibrium difference is the sum of the injection multiplied by the simple multiplier

-The simple multiplier in Canada, however, is only 1.2 =(

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