Review

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Review

• Part III Chapters 26 to 31

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Chapter 26
Overview
Benefits and Costs of Economic Growth Sources of
Growth Savings, Investment and Growth Neoclassical
Growth Theory New Growth Theory
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Benefits and Costs of Economic Growth
Benefits Rising average living standards Poverty
Alleviation Investment in Environmental
Preservation
Costs Sacrificing current consumption Job
Destruction and Structural Unemployment Environmen
tal Degradation
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Sources of Growth
Labour Force Human Capital Physical
Capital Technological Innovation
National Saving
National saving is the sum of private saving and
public saving National Saving Y - C - G
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Savings, Investment and Growth
National savings represents the supply of funds
available for investment. National savings is
increasing in the real interest rate as the real
interest rate represents the opportunity cost of
current consumption.
Investment demand is negatively related to the
real interest rate because the real interest rate
represents the cost of borrowing and most
investment takes place with borrowed funds.
The equilibrium real interest rate equates
desired national savings with desired investment.
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The real interest rate, i, is determined in the
market for loanable funds.
Real Interest Rate
NS Y-C-G
Excess Supply


i1
Desired savings, public and private, represents
the supply of loanable funds.

i
E


i2
I
Excess Demand
Desired investment, represents the demand for
loanable funds.
Loanable Funds
INS
The higher the rate of saving (and thus
investment), the higher growth rate of potential
output. The flow of investment determines the
growth rate of the capital stock (physical and
human).
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Neoclassical Growth Theory
GDP FT(L,K,H)
where L is the total amount of labour, K is the
stock of physical capital, H is the quality of
labours human capital, and T is the state of
technology. FT represents the fact that changes
in technology will change the production function
The neoclassical aggregate production function
displays diminishing marginal product of both K
and L.
It also displays constant returns to scale (when
both K and L are changed in equal proportions).
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Aggregate Production Functions
The first production function exhibits constant
returns to scale in K and L, and diminishing
marginal product of both K and L
The second production function exhibits
decreasing returns to scale in K and L, and
diminishing marginal product of both K and L
The third production function exhibits increasing
returns to scale in K and L, and constant
marginal product of both K and L
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Average and Marginal Product
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Predictions of Neoclassical Theory
The growth rate of the capital stock will depend
on the savings rate. Saving rate only affects
level of output and not long run growth rate.
If the labour force, L, grows faster than the
capital stock, GDP will rise but at a diminishing
rate. GDP per capita will fall.
If the labour force, L, and the capital stock, K,
both grow at the same rate, GDP will increase at
the same constant rate. GDP per capita will
remain constant.
Technological change is necessary in order to
have sustained growth in living standards.
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Capital accumulation leads to smaller and smaller
increases in per capita GDP.
The neoclassical model predicts that eventually
all nations will converge to the same level of
per capita GDP
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New Growth Theories

• Endogenous Technological Change
• Learning by doing
• Knowledge transfer
• Market structure and innovation
• Shocks and innovation

• Increasing Returns to Scale
• Fixed Costs
• Knowledge
• Positive Externalities

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Key Differences to Neoclassical Theory

• Constant or increasing marginal productivity of
  capital
• The savings rate or flow of investment affects
  the long run growth rate through its impact on
  the rate of technological change.
• Emphasize human capital formation and RD.
• Provide a better explanation of income
  disparities between countries.

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Chapter 27 Money and Banking
Overview

• Barter vs. Money
• Functions of Money
• Monetary Standards
• Canadian Banking System
• Reserves
• Money Creation by the Banking System
• Measuring Money Supply

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Barter vs. Money
Barter involved the direct exchange of goods and
services for other goods and services. Barter is
time-consuming.
Money is an improvement over barter because it
reduces the number of transactions, simplifies
trade and removes the need for a double
coincidence of wants.
Empirical evidence shows links between money in
circulation and many important macroeconomic
variables (e.g. inflation, interest rates, real
GDP).
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Functions of Money

• Medium of Exchange
• Store of Value
• Unit of Account

An item does not have to be legal tender in order
to be considered as money and thus as a medium of
exchange.
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Monetary Standards

• Commodity Standards (e.g. gold standard)
• Fractionally-backed Paper Money
• Fiat Money (current monetary standard in Canada)

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Canadian Banking Systems

• The Bank of Canada
• As the central bank of Canada, the Bank of
  Canada
• acts as a banker to commercial banks
• acts as a banker to the federal government
• regulate the money supply
• regulate, support and monitor the financial
  system

• Joint Responsibility
• The Bank of Canada and the Ministry of Finance

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• Commercial Banks
• Other Financial Institutions
• Trust companies, mortgage loan companies, credit
  unions and caisse populaires, insurance
  companies, investment dealers.
• Canadian Payments Association
• Operates an automated cheque-clearing system for
  all financial institutions.

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Reserves
Banks only hold a fraction of their deposit
liabilities in reserves (fractional-reserve
system). Reserves are made up of vault cash or
deposits with the Bank of Canada.
A banks reserve ratio is the fraction of its
deposit liabilities it actually holds as reserves.
The target reserve ratio is the fraction of the
deposit liabilities it would like to hold as
reserves.
Any reserves held beyond target reserves are
called excess reserves.
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Money Creation
Let v denote the target reserve ratio of
commercial banks. If households keep a fixed
fraction of their deposits in cash there is cash
drain. Let c denote the ratio of cash to deposits
that people would like to maintain.
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Practice Question
v 0.10 and c 0.10 and 5000 is deposited.
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(No Transcript)
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Measuring Money Supply

• Currency in circulation currency outside the
  banking system.
• M1 currency in circulation plus current accounts
  and personal chequable accounts. This definition
  most closely specifies money as it fulfils its
  medium of exchange function.
• M2 M1 plus notice deposits of firms and personal
  savings deposits at chartered banks.
• M2 M2 plus notice and term deposits at
  near-banks. Significantly larger than M2,
  signaling the increasing importance of financial
  institutions other than banks.
• M3 M2 plus non-personal fixed term deposits and
  the Canadian dollar value of chartered bank
  deposits denominated in foreign currencies but
  owned by Canadian residents.

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Chapter 28 Money, Interest Rates and Economic
Activity
Overview

• Bonds
• Demand for Money
• Monetary Transmission Mechanism
• Strength of Monetary Forces

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Bonds
PV R1 R2 ... RT (1i)
(1i)2 (1i)T
The present value of the stream of payments from
a bond is decreasing in the interest rate.
The equilibrium market price of an asset will be
the present value of the income stream that the
asset produces. Therefore the interest rate is
negatively related to bond prices and positively
related to bond yields.
The riskiness of a bond is negatively related to
its price and positively related to its yield.
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Demand for Money

• Reasons for holding money
• Transactions demand
• Precautionary demand
• Speculative demand

i
i1

MD
M0
M1
Quantity of Money

• Determinants of Money Demand
• The interest rate ( - )
• The level of real GDP ( )
• The price level ( )

Changes in real GDP and the price level shift the
MD curve.
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Monetary Equilibrium
Interest Rate
MS
i0

MD
M0
M2
Quantity of Money
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An increase in the supply of money
A decrease in the demand for money
or
Excess supply of money
A fall in interest rates
An increase in desired investment expenditure
Capital outflow and currency depreciation
Increase in net exports
An upward shift in the AE curve
A rightward shift in the AD curve
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Strength of Monetary Forces
Long-Run Neutrality of Money Changes in the money
supply do not have long-run effects on the level
of real GDP because in the long run, real GDP
returns to potential following a shock. Changes
in the money supply only affect the price level
not real variables.
Keynesians argued that MD was relatively flat and
ID was relatively steep. As a result, they argued
that monetary policy was not very effective.
Monetarists argued that MD was relatively steep
and that ID was relatively flat. As a result,
monetary policy was quite effective.
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Monetarist View
The effectiveness of monetary policy will depend
on the slopes of the money demand (MD) and
investment demand (ID) curves.
i
i
Investment
Quantity of Money
Changes in money supply are effective
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Keynesian View
If money demand is fairly flat or investment
demand is fairly steep, changes in money supply
will not stimulate significant changes in
investment.
i
i
Investment
Quantity of Money
Changes in money supply are not effective
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Chapter 29 Monetary Policy in Canada
Overview

• Monetary Policy Tools
• Monetary Policy Targets
• Complications to Monetary Policy
• Bank of Canada Price Stability Policy

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Monetary Policy Tools
Open Market Operations the sale and purchase of
government securities, changing the reserves of
commercial banks.
Cash Management the shifting of government
deposits between the central bank and commercial
banks, changing the reserves of commercial banks.
The central bank cannot set the interest rate and
the money supply independently.
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The Bank of Canada announces its target operating
band for the overnight interest rate and then
uses its monetary tools so that the overnight
rate falls within the target range.
The overnight interest rate is the interest rate
that commercial banks charge each other for very
short-term loans. It is market-determined.
The upper limit of the operating band is the bank
rate. The bank rate is the rate at which the Bank
of Canada, in its role as lender of last resort,
makes loans to commercial banks.
The lower limit of the operating band is the
interest rate offered to commercial banks who
keep positive balances at the Bank of Canada.
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Monetary Policy Targets

• Price Level
• Inflation
• Real GDP
• Exchange Rates

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Complications to Monetary Policy

• Volatile Food and Energy Prices
• Core inflation

• Exchange rate changes
• The cause and impact of exchange rate changes
  must be determined before the appropriate
  monetary policy is taken.

• Lags and Destabilizing Policy

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Bank of Canada Price Stability Policy
Inflation targeting is a stabilizing policy as
positive shocks are met with contractionary
monetary policy and negative shocks are met with
expansionary monetary policy.
Since the mid-90s the Bank of Canada has held
inflation within the 1 to 3 percent target band.
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Practice Question
A depreciation of the Canadian dollar due to a
fall in demand for Canadian goods and services.
This depreciation will be accompanied by a shift
to the left of aggregate demand a recessionary
gap will open up.
The appropriate monetary policy would be
expansionary increasing money supply growth.
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A depreciation of the Canadian dollar due to a
reduction in the demand for Canadian financial
assets.
This depreciation would make Canadian products
relatively cheaper to foreign products, leading
to an increase in net exports. This would shift
aggregate demand to the right an inflationary
gap would open.
The appropriate monetary policy would be
contractionary reduction in money supply growth.
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Chapter 30 Inflation
Overview

• Wages, Excess Demand and Expected Inflation
• Constant Inflation
• Shocks and Monetary Validation
• Process of Disinflation

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Wages, Excess Demand and Expected Inflation
Changes in wages shift the aggregate supply curve.
Wages respond to supply and demand forces in the
labour market. If there is excess demand for
labour, wages increase. If there is excess supply
of labour, wages decrease.
Wages also respond to expectations about
inflation. This allows for wages increase even
when there is no excess demand/supply.
The response to expectations will depend on the
type of expectations people hold (backward,
forward, rational).
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Constant Inflation
In the case of constant inflation, peoples
expectations about inflation are being met. That
is, actual inflation equals expected inflation.
This means that there is no excess demand
inflation, so that real GDP is at potential.
Aggregate demand and aggregate supply are
shifting up by the same percentage.
The increase in AD comes from the constant
increases in the money supply. The shift in AS is
driven by inflation expectations.
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Shocks and Monetary Validation
Demand and supply shocks that are not validated
by an increase in the money supply will lead to
temporary inflation.
A recessionary gap caused by a negative supply
shock that is validated with monetary expansion
will be shorter but will result in a higher price
level.
An inflationary gap caused by a positive demand
shock that is validated with monetary expansion
will last longer as AD shifts further upward.
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A positive demand shock that is continually
validated by monetary expansion in order to
maintain real GDP above potential will require
successively larger increases in the money supply
and inflation will accelerate. Hence the natural
rate of unemployment is also known as the
non-accelerating inflation rate of unemployment
(NAIRU).
Sustained inflation requires continual monetary
expansion otherwise increases in the price level
must come to a halt.
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Process of Disinflation

• Removing monetary validation in response to
  positive demand shocks
• Stagflation inflation with declining output
• Recovery through the adjustment process or
  monetary expansion.

Sacrifice Ratio The cost of disinflation is the
recession that is created in order to reduce
inflation. The sacrifice ratio is the cumulative
loss in real GDP expressed as a percentage of
potential GDP, divided by the percentage-point
reduction in the rate of inflation.
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Chapter 31 Unemployment
Overview

• Friction and Structural Unemployment
• Theories of Cyclical Unemployment
• NAIRU

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Frictional and Structural Unemployment
The NAIRU is composed of frictional and
structural unemployment.
Frictional unemployment is caused by the time
that is taken for labour to move from one job to
another. The normal turnover of labour causes
frictional unemployment.
Structural unemployment is due to a mismatch
between the characteristics desired by employers
and the characteristics possessed by the
unemployed (geographical, skills, occupational,
industrial).
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Theories of Cyclical Unemployment
Cyclical unemployment is the difference between
the actual level of unemployment and the amount
that exists at full employment when YY.
Unemployment is involuntary if the unemployed
worker is willing to work at the prevailing wage
but cannot find work.
The New Classical Theory assumes that labour
markets clear quickly and that the only
unemployment is voluntary unemployment.
New Keynesian theory proposes that wages are
sticky and labour markets do not clear, leading
to involuntary unemployment.
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NAIRU, u

• Non-Accelerating Inflation Rate of Unemployment
• This is the level of unemployment that exists at
  full employment when YY.
• When the actual level of employment is greater
  than the NAIRU, the economy is experiencing a
  recessionary gap.
• When the actual level of employment is less than
  the NAIRU, the economy is experiencing a
  inflationary gap.