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Ch 11 Assumptions with the Multiplier
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1. Producers are willing to supply extra output at a fixed price.
2. ∆ in aggregate expenditure translates into changes in aggregate output
3. We take interest rate as given
4. No government spending, no taxes
5. Exports & Imports = 0
2. ∆ in aggregate expenditure translates into changes in aggregate output
3. We take interest rate as given
4. No government spending, no taxes
5. Exports & Imports = 0
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Marginal Propensity to Consume (MPC)
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the increase in consumer spending when disposable income rises by $1; MPC is a positive fraction less than 1; 0 < MPC < 1
MPC = change in C/change in Yd
MPC = change in C/change in Yd
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Marginal Propensity to Save (MPS)
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the increase in household savings when disposable income rises by $1
MPS = 1 - MPC
MPS = 1 - MPC
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autonomous change in aggregate expenditure
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an initial change in the desired level of spending by firms, households, or government at a given level of real GDP
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multiplier
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the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change
- Multiplier = ∆Y/∆AAS = 1/1-MPC
- Higher if there's higher MPC
- Weaker with foreign trade
- Multiplier = ∆Y/∆AAS = 1/1-MPC
- Higher if there's higher MPC
- Weaker with foreign trade
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individual consumption function
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c = ac + MPC x yd
An equation that shows how an individual household's C varies with yd
An equation that shows how an individual household's C varies with yd
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aggregate consumption function
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C = AC + MPC x YD
Relationship for economy as a whole between aggregate disposable income & aggregate consumer spending
Relationship for economy as a whole between aggregate disposable income & aggregate consumer spending
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What Shifts the Aggregate Consumption Function?
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1. Changes in Expected Future Disposable Income
2. Changes in Aggregate Wealth
2. Changes in Aggregate Wealth
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planned investment spending
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the investment spending that businesses intend to undertake during a given period
- Represented by Ip
- Represented by Ip
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What drives (planned) investment spending?
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1. Interest Rate
2. Expected future real GDP - higher expectations = higher I
3. Current level of production capacity - higher production capacity means lower I
2. Expected future real GDP - higher expectations = higher I
3. Current level of production capacity - higher production capacity means lower I
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accelerator principle
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Higher growth rate of real GDP leads to higher planned I (vice versa)
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inventories
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stocks of goods held to satisfy future sales
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inventory investment
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value of change in total inventories held in economy during given period
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unplanned inventory investment
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unplanned changes in inventories that occur when actual sales are more or less than businesses expected
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actual investment spending
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Sum of planned I & unplanned I
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income-expenditure equilibrium
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when aggregate output, measured by real GDP, is equal to planned aggregate spending
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planned aggregate expenditure
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total amount of planned expenditure in the economy
PAE = C + Ip
- Assume Ip is fixed
PAE = C + Ip
- Assume Ip is fixed
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income-expenditure equilibrium GDP
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the level of real GDP at which real GDP equals planned aggregate spending
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Keynesian Cross
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a diagram that identifies income-expenditure equilibrium as the point where the planned aggregate spending line crosses the 45-degree line.
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life-cycle hypothesis
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consumers plan their spending over a lifetime, not just in response to their current disposable income
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Exports
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Treated as an increase to autonomous spending.
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economic interdependence
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Trade links between economies are one reason why business cycles are often international in scope.
Many countries have recessions & recoveries at the same time.
Many countries have recessions & recoveries at the same time.
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unplanned investment - positive and negative numbers
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- positive unplanned investment; when expected sales exceed actual sales (real GDP > PAE), leading to an increase in inventory
- negative unplanned investment; when PAE is greater than real GDP, leading to unintended drops in inventories
- negative unplanned investment; when PAE is greater than real GDP, leading to unintended drops in inventories
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savers
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people with funds to invest or lend
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borrowers
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those who need money to finance investment spending projects
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public savings (government budget balance
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the tax revenue that the government has left from net tax revenue (T-TR) after paying for its spending on goods and services (T-TR-G)
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savings-investment spending identity
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a fact of accounting, savings and investment spending are always equal for the economy as a whole
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budget balance
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the difference between tax revenue and government spending; can be positive or negative
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budget surplus
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a budget balance in which revenues are greater than expenditures, the difference between tax revenue and government spending when tax revenue exceed government spending
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budget deficit
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a budget balance in which revenues are less than expenditures, the difference between tax revenue and government spending when government spending exceeds tax revenue; government is dissaving
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government borrowing
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the total amount of funds borrowed by federal, provincial, and municipal governments in the financial markets
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net capital inflow (NCI)
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The total outflows of funds out of a country minus the total inflows of funds into that country; the difference between the amount of foreign investment undertaken by the country and the amount of domestic investment undertaken by foreigners
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national savings
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the sum of private savings and the budget balance, is the total amount of savings generated within the economy
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balanced budget
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a budget balance of zero, in which revenues are equal to spending
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loanable funds market
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a hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders
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interest rate (r)
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price determined in the loanable funds market; nominal/unadjusted for inflation
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present value of X
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is the amount of money needed today in order to receive X at a future date given the interest rate
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equilibrium interest rate
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the interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded
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crowding out
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occurs when a government deficit drives up the interest rate and leads to reduced investment spending
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A global loanable funds market arises when
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international capital flows are so large that they equalize interest rates across countries
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Fisher effect
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an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged
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financial markets
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where households invest their current savings and their accumulated savings by purchasing financial assets; a household's wealth is the value of its accumulated savings
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wealth
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value of accumulated savings
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financial asset
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a paper claim that entitles the buyer to future income from the seller (ex: loan, stocks, bond, and bank deposits)
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physical asset
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a tangible object that can be used to generate future income
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engaging in investment spending
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spending funds that add to the stock of physical capital in the economy (purchasing a newly manufactured item or loan)
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liability
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a requirement to pay income in the future
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balance sheet
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a list of an economic unit's assets and liabilities on a specific date
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flow
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a measure that is defined per unit of time (saving)
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financial system
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the collection of markets and institutions that facilitate the flow of funds from lenders to borrowers
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capital gains
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increases in the value of existing assets
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capital losses
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decreases in the value of existing assets
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transactional costs
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the expenses of negotiating and executing a deal
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financial risk
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uncertainty about future outcomes that involve financial losses and gains
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risk-averse
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a person who is more sensitive to a loss than to a gain of an equal dollar amount
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diversification
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investing in several different assets so that the possible losses are independent events
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liquid
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can be quickly converted intro cash with relatively little loss of value
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illiquid
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cannot be quickly converted intro cash with relatively little loss of value
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loan
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a lending agreement between an individual lender and an individual borrower
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bond
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borrowing in the form of an IOU that pays interest
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IOU
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"I owe you" - a signed document acknowledging a debt
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default
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when a borrower fails to make payments as specified by the loan or bond contract
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stocks
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a share in the ownership of a company held by a shareholder OR a measure that is defined at a point in time
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loan-backed securities
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assets created by pooling individual loans and selling shares in that pool
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financial intermediary
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an institution that transforms the funds it gathers from many individuals into financial assets (ex: mutual funds, pension funds, life insurance companies, and banks)
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diversified portfolio
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a group of stocks in which risks are unrelated to, or offset by, one another
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mutual fund
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a financial intermediary that creates a stock portfolio and then resells shares of this portfolio to individual investors
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pension funds
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a type of mutual fund that holds assets in order to provide retirement income to its members
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life insurance companies
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sells policies that guarantee a payment to a policyholder's beneficiaries when the policyholder dies
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bank deposit
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a claim on a bank that obliges the bank to give the depositor his or her cash when demanded
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bank
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a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investment spending needs of borrowers
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imputed rent
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an estimate of what homeowners would pay to themselves to rent the housing they own
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fundamentals
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intrinsic value of an asset
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future expectation
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the expectation about the increase/decrease in price of an asset
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Efficient Market Hypothesis
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asset prices embody all publicly available information
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random walk
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the movement over time of an unpredictable variable
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behavioural economic
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the study of how people make (predictable) mistakes in their decisions) (ex: overconfidence, loss aversion, and herd mentality)
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Securitization
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a pool of loans is assembled and shares of that pool are sold to investors
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money
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any asset that can easily be used to purchase goods and services
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currency in circulation
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cash held by the public
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Chequable Deposits
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Bank accounts on which people can write cheques
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money supply
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the total value of financial assets in the economy that are considered money
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medium of exchange
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an asset that individuals acquire for the purpose of trading goods and services rather than for their own consumption
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store of value
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a means of holding purchasing power over time
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unit of account
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a measure used to set prices and make economic calculations
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commodity money
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a good used as a medium of exchange that has intrinsic value in other uses (ex: gold)
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commodity-back money
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a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods
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fiat money
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a medium of exchange whose value derives entirely from its official status as a means of payment
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monetary aggregate
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an overall measure of the money supply
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near-moneys
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financial assets that can't be directly used as a medium of exchange but can be readily converted into cash or checkable bank deposits
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bank deposit function
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bank reserves / reserve ratio
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money supply function
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currency + bank deposits
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T-chart of a commercial bank
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Assets: reserves, loans
Liabilities: deposits
Liabilities: deposits
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T-chart of the central bank
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Assets: treasury bills
Liabilities: monetary base (currency and bank reserves)
Liabilities: monetary base (currency and bank reserves)
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bank reserves
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the currency banks hold in their vaults plus their deposits at the Bank of Canada (not part of currency in circulation)
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T-account
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a tool for analyzing a business's financial position by showing, in a single table, the business's assets (on the left) and liabilities (on the right)
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Equity
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the difference between total assets and total liabilities
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reserve ratio
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the fraction of bank deposits that a bank holds as reserves
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bank run
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a phenomenon in which many of a bank's depositors try to withdraw their funds due to fears of a bank failure
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deposit insurance
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guarantees that a bank's depositors will be paid even if the bank can't come up with the funds, up to a maximum amount per account
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capital requirements
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ensures the bank holds more assets than the value of its deposits
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bank's capital/equity of the bank
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excess of bank's assets over liabilities;
Tier 1: shareholders' equity and retained earnings
Tier 2: supplementary capital (riskier)
Tier 1: shareholders' equity and retained earnings
Tier 2: supplementary capital (riskier)
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reserve requirements
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regulations on the minimum amount of assets as noninterest-bearing reserves that banks must hold against deposits; influences how much money the banking system can create with each dollar of reserves
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discount window
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an arrangement in which the Bank of Canada stands ready to lend money to banks in trouble
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desired (or voluntary) reserve ratio
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the faction of deposits that the banks want to hold as reserves
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money multiplier
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the ratio of the money supply to the monetary base
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multiplier process
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an initial increase in real GDP leads to a rise in consumer spending, which leads to a further rise in real GDP, which leads to a further rise in consumer spending, and so on
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"chequable-deposits-only" monetary system
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where funds are always deposited in bank accounts and none are held in wallets as currency
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excess reserves
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a bank's reserves over and above its desired reserves
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monetary base
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the sum of currency in circulation and bank reserves
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central bank
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an institution designed to oversee the banking system and regulate the quantity of money in the economy
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functions of a central bank
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bankers for commercial banks, banker for federal government, issues currency, conducts monetary policy
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central bank tools to control money supply
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reserve requirements, the bank rate,openmarketoperations,depositswitiching
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overnight funds market
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A financial market in which financial institutions, such as banks that are short of reserves can borrow funds from banks with excess reserves
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overnight rate
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The interest rate set in the overnight market.
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target for the overnight rate
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The Bank of Canada's official key policy interest rate
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bank rate/discount rate
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the interest rate charged by the Bank of Canada on loans to the commercial banks
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open-market operation
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The purchase or sale of assets by a central bank. For the Bank of Canada, normally these assets are Government of Canada bonds, but they may also be foreign exchange. (ex: Treasury bills)
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deposit switching
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The shifting of government deposits between the Bank Of Canada and the commercial banks. It is a major tool used by the bank of Canada in its day to day operations
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shadow banking
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bank-like activities undertaken by non-depository financial firms such as investment banks and hedge funds, but without regulatory oversight and protection
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subprime lending
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lending to home buyers who don't meet the usual criteria for being able to afford their payments
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investment bank
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trades in financial assets and is not covered by deposit insurance
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self-regulating economy
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an economy in which problems such as unemployment are resolved without government intervention, through the working of the invisible hand
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Keynesian economics
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economic slumps are caused by inadequate spending, and they can be mitigated by government intervention
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monetary policy
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changes in the quantity of money to alter interest rates and affect overall spending
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fiscal policy
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changes in government spending and taxes to affect overall spending
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recession/contraction
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period of economic downturn when output and employment are falling
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expansion/recoveries
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period of economic upturn when output and employment are rising
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business cycle
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the short-run alternation between recessions and expansions
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busines-cycle peak
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the point at which the economy turns from expansion to recession
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busines-cycle trough
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the point at which the economy turns from recession to expansion
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long-run economic growth
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the sustained upward trend in the economy's output over time
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inflation
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a rising overall price level
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deflation
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a falling overall price level
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price stability
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when the overall level of prices changes slowly or not at all
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open economy
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an economy that trades goods and services with other countries
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trade deficit
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when the value of goods and services bought from foreigners is more than the value of goods and services it sells to them
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trade surplus
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when the value of goods and services bought from foreigners is less than the value of goods and services it sells to them
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national income and product accounts (national accounts)
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numbers calculated by Statistic Canada, keeps track of the spending of consumers, sales of producers, business investment spending, government purchases, and a variety of other flows of money between different sectors of the economy
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government purchases of goods and services
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total expenditures on goods and services by federal, provincial, and municipal governments
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consumer spending
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household spending on goods and services
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investment spending
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spending on productive physical capital, such as machinery and construction of structures, and on changes to inventories
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exports
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Goods and Services sold to other countries
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imports
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goods and services purchased from other countries
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final goods and services
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goods and services sold to the final, or end, user
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intermediate goods and services
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goods and services bought from one firm by another firm to be used as inputs into the production of final goods and services
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Gross Domestic Product (GDP)
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the total value of all final goods and services produced in a country in a given year
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aggregate expenditure
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the sum of consumer spending, investment spending, government purchases of goods and services, and exports minus imports, is the total spending on domestically produced final goods and services in the economy
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value added
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of a producer is the value of its sales minus the value of its purchases of inputs (intermediated goods and services)
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factor incomes
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incomes earned by factors of production which include wages, interest, rent, dividends, and profits
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non-factor payments
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The difference between the prices paid for final goods and services and the amount received by factors of production, which include net indirect taxes and capital depreciation
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net exports
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the difference between the value of exports and the value of imports
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aggregate output
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the economy's total quantity of output of goods and services
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real GDP
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the total value of all final goods and services produced in the economy during a given year, calculated using the prices of a selected base year
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nominal GDP
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the value of final goods and services produced in a given year, calculated using the prices current in the year in which the output is produced
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chained dollars
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the method of calculating changes in real GDP using the average between the growth rate calculated using an early base year and the growth rate calculated using a late base year
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GDP per capita
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GDP divided by the size of the population, equivalent to the average GDP per person
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aggregate price level
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a measure of the overall level of prices in the economy
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market basket
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a hypothetical set of consumer purchases of goods and services
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price index
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the cost of purchasing a given market basket in a given year, where that cost is normalized so that it is equal to 100 in the selected base year
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inflation rate
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the percent change per year in a price index- typically the consumer price index
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consumer price index (CPA)
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measures the cost of the market basket of a typical urban Canadian family
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industrial produce price index (IPPI)
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measures changes in the price of goods purchased by producers
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GDP deflator
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a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100 for a given year
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employment
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total number of people in the economy (aged 15 and older) currently employed, in either a full-time or part-time job
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unemployment
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the number of available people (aged 15 and older) who are actively looking for paid work but aren't currently employed
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labour force
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the sum of the total number of employed people (employment) and the total number of unemployed people (unemployment) - aged 15 and older in all cases
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labour force participation rate
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the percentage of the population aged 15 and older that is in the labour force
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unemployment rate
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the percentage of the labor force that is unemployed
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discouraged workers
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nonworking people who are capable of working but have given up looking for a job due to the state of the job market (they believe no work is available)
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marginally attached workers
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would like to be employed and have looked for a job in the recent past but are not currently looking for work
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underemployment
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when workers have jobs that, in certain ways, fall short of what they want
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visible underemployment
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the number of people who involuntarily work part time because they cannot find full time jobs
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invisible underemployment
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the number of people who have jobs that do not fully use their skills or that have one or more substandard job characteristics, such as low pay.
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jobless recovery
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a period in which the GDP growth rate is positive but the unemployment rate is still rising (or is not falling)
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job search
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a period of time where workers spend time looking for employment
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frictional unemployment
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unemployment due to the time workers spend in job search
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structural unemployment
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unemployment that occurs when workers are unable to fill available jobs because they lack the skills, do not live where jobs are available, or are unwilling to work at the wage rate offered
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efficiency wages
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wages that employers set above the equilibrium wage rate as an incentive for better employee performance
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natural rate of unemployment
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the unemployment rate that arises from the effects of frictional plus structural unemployment
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cyclical unemployment
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the deviation of unemployment from its actual rate due to downturns and upturns caused by the business cycle
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real wage
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the wage rate divided by the price level
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real income
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income divided by the price level
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shoe-leather costs
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the increased costs of transactions caused by inflation
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menu costs
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the real costs of changing listed prices
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unit-of-account costs
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arise from the way inflation makes money a less reliable unit of measurement
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indexing
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a way to correct the effect of inflation on the purchasing power of a unit of currency by adjusting the nominal/dollar value of an item to the inflation rate
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interest rate
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the return a lender receives for allowing borrowers the use of their savings for one year, stated as a percentage of the amount borrowed
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nominal interest rate
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the interest rate expressed in dollar terms
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real interest rate
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the nominal interest rate minus the inflation rate
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unexpected inflation
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the difference between the actual and expected inflation rates
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disinflation
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the process of bringing the inflation rate down
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rule of 70
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the time it takes for a variable the grows gradually over time to double is approximately 70 divided by that variable's annual growth rate
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labour productivity
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output per worker
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physical capital
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human-made resources such as buildings and machines
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human capital
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the improvement in labor created by the education and knowledge embodied in the workforce
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technological progress
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an advance in the technical means of the production of goods and services
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aggregate production function
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relationship that shows how the aggregate real quantity of output is produce using the available factors of production and technology
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total factor productivity
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represented by the parameter A in the aggregate production function Y = A * F(K, L, H), helps account for output that is not a result of the productive input
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positive marginal productivity of physical capital (positive MPk)
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the amount by which productivity is increased as the result of a small increase in physical capital used
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per worker production function
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a hypothetical function that shows how productivity (real GDP per worker) depends on the quantities of physical capital per worker and human capital per worker as well as the state of technology
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diminishing returns to physical capital or diminish marginal productivity of (physical) capital (dim MPk)
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when holding the amount of human capital per worker and the state of technology fixed, each successive increase in the amount of physical capital per worker leaders to a smaller increase in productivity
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growth accounting
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estimates the contribution of each major factor in the aggregate production function to economic growth
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research and development (R&D)
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spending to create and implement new technologies
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infrastructure
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Fundamental facilities and systems like roads, power lines, ports, information networks, and other underpinnings, for economic activity
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convergence hypothesis
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international differences in real GDP per capita tend to narrow over time
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sustainable long-run economic growht
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long-run growth that can continue in the face of the limited supply of natural resources and with less negative impact on the environment
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Paris Agreement
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Most recent global agreement on climate change where 196 countriess agreed to reduce their greenhouse gas emissions in an effort to limit the rise in the earth's temperature to no more than 2 degree centigrade
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aggregate demand curve
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shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world
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the wealth effect (of a change in the aggregate price level)
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the effect on consumer spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers' assets
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the interest rate effect (of a change in the aggregate price level)
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the effect on consumer spending AND investment spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers' AND firms' money holdings
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how does changes in expectations affect aggregate demand
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Consumers base their spending on current and expected future income, so changes in expectations can push consumer spending and planned investment spending up or down
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how does changes in wealth affect aggregate demand
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when real value of household assets changes, purchasing power and aggregate expenditure also changes in accordance
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how does the size of the existing stock of physical capital affect aggregate demand
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The more physical capital a firm has, the less their incentive to engage in planned investment spending
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how does fiscal policy affect aggregate demand
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In response to a recession or inflation, governments can change their spending (direct affect as government purchases are a component of aggregate demand) or affect taxes (indirect effect on disposable income); recessions = increase spending, cut taxes; inflation = decrease spending, increase taxes
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how does monetary policy affect aggregate demand
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Changing the quantity will change purchasing power and interest rates, as well as investment spending and consumer spending; a rise in aggregate price level, reduces purchasing, rise in interest, reduce investment and spending
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aggregate supply curve
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shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy
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nominal wage
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the dollar amount of the wage paid
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sticky wages
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nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages
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short-run aggregate supply curve
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shows the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken as fixed
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how does changes in commodity price affect short-run aggregate supply
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Commodity price affects production costs which will affect how much a firm will want to produce, shifting the curve; increases in commodity prices shifts the curve left
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how does changes in nominal wages affect short-run aggregate supply
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Commodity price affects production costs which will affect how much a firm will want to produce, shifting the curve; increases in nominal wages shift the curve left
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how does changes in productivity affect short-run aggregate supply
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Higher productivity means more units of output can me produce with the same quantity of inputs, decrease production costs and shifting the curve right
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commodity
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standardize input bought and sold in bulk quantities
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long-run aggregate supply curve
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shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible
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potential output
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the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible
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output gap
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actual real (measured) GDP - potential GDP (usually shown as a percentage)
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how does changes in stock of physical capital affect long-run aggregate supply
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An increase leads to lower production costs and shifts curve to the right
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how does size of human capital affect long-run aggregate supply
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An increase leads to lower production costs and shifts curve to the right
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how does changes in size of labour force affect long-run aggregate supply
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An increase leads to lower production costs and shifts curve to the right
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how does changes in total factor productivity affect long-run aggregate supply
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An increase leads to lower production costs and shifts curve to the right
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AD-AS model
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the aggregate supply curve and the aggregate demand curve are used together to analyze economic fluctuations
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short-run macroeconomic equilibrium
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when the quantity of aggregate output supplied is equal to the quantity demanded
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short-run equilibrium aggregate price level
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the aggregate price level in the short-run macroeconomic equilibrium
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short-run equilibrium aggregate output
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the quantity of aggregate output produced in the short-run macroeconomic equilibrium
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demand shock
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an event that shifts the aggregate demand curve; the Great Depression = negative
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supply shock
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an event that shifts the short-run aggregate supply curve; a positive supply shock reduces production costs and increases quantity supplied
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stagflation
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a period of slow economic growth and high unemployment (stagnation) while prices rise (inflation); falling aggregate output leads to higher unemployment while prices rise
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long-run macroeconomic equilibrium
answer
when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve
question
recessionary gap
answer
when aggregate output is below potential output
question
inflationary gap
answer
when aggregate output is above potential output
question
self-correcting
answer
when shocks to aggregate demand affect aggregate output in the short run, but not the long run
question
stabilization policy
answer
the use of government policy to reduce the severity of recessions and rein in excessively strong expansions
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