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Market Failure and Government
Intervention
Chapter 16
 Market Failure
•  Market Failure
–  When market fails to reach socially optimal
outcome
–  Negative Externality
• The benefit to society is less than the benefit to the
companies involved.
• We want market to produce less of a good
–  Positive Externality
• The benefit to society is more than the benefit to
the companies involved.
• We want market to produce more of a good
 Market Failure
•  Solutions:
–  Social norms
–  Merger of firms linked by an externality
–  Coase Theorem: “costless negotiation”
• People have lots of trouble with this one
 Coase Theorem
•  Coase Theorem
–  In one bay
• Coral Reef Adventure Tour (T)
• Oil Rig (R)
–  Oil rig pollutes, while the adventure tour is the
bearer of pollution.
–  We want to come to the equilibrium where the
benefit to society of making and using oil equals
the cost to society of oil pollution.
• Coral Tour is society in this example
 Coase Theorem
•  In Coase Theorem, one of the two parties
has all the rights to the bay
–  This is unrealistic, but we assume it’s true.
•  If Oil rig had all the rights, it would choose
to produce where its marginal private costs
equal its marginal private benefits, with
loads of pollution
•  If Coral Tours had the rights, it would
choose no production at all, with no
pollution.
 Coase Theorem

•  Oil Rig would pick point b at Qm of oil

•  Coral Tours would pick 0 oil
•  But the Coral Tours choice is too little oil,
and the Oil Rig choice is too much pollution.
 Coase Theorem
•  We want production in the middle at Q*
•  Where Marginal Social Cost = Marginal Social
Benefit
–  Produce until the next jar of oil costs more to
society in pollution than would benefit society
in oil.
 Coase Theorem
•  Coral Reef controls the Bay
–  It wants no production of oil
–  Oil Rig obviously unhappy
–  Oil Rig will pay Coral Reef anywhere between
area D and areas C+D to produce at Q*
 Coase Theorem
•  Oil Rig Controls the Bay
–  It wants to produce at Qm
–  The pollution is hurting Coral Reef
–  Coral Reef will pay Oil Rig anywhere between
area B and areas A+B to produce at Q*
 Coase Theorem
•  In each of case, to produce the party
without the power would pay
–  At least the profits the other would lose
–  At most the profits it would gain
•  Ex. When the Coral Tour owned the bay, the
Oil Rig would pay
–  At least the profits Coral Tour would lose from
pollution
–  At most the profits Oil Rig would make from
production
 Market Failure
•  Different types of goods can lead to market
failure
•  Rivalrous Consumption
–  One person’s consumption leaves it unavailable
to others e.g. pretzel
•  Excludable Consumption
–  People can be prevented from consuming a
good e.g. expensive hockey ticket
 Market Failure

•  Private Goods
–  Rival and Excludable
–  Typical consumption goods and services
–  Banana
 Market Failure

•  Local Public Goods

–  Non-rival and excludable
–  E.g. TV
 Market Failure

•  Common Property Resources

–  Rival and Non-Excludable
–  E.g. Congested Roads
–  “tragedy of the commons”
• Overused by the market
 Market Failure

•  Pure Public Goods

–  Non-Rival and Non-Excludable
–  E.g. Radio
–  “free rider” problem
• Can’t stop people from free riding on purchases of
others
 Government Failure
•  Public Choice Theory
–  Voting system can lead to government pursuing
wrong policies
• Intensity Problem
• Cycle Problem
 Government Failure
•  Intensity Problem:
–  Voting doesn’t count intensity

–  Project 1
• A and B gain $10
• C loses $50
• Total loss of -$30, but A and B vote it through
–  Project 2 similar problem
 Government Failure
•  Cycle Problem
–  Three voters, three policies (X, Y, Z)
–  Voters choose different policies depending on
the match-up
–  X>Y, Y>Z, Z>X
–  Cycle through policies
•  More in notes
Economics of Pollution Control

Chapter 17
 Pollution
•  There is a negative externality associated
with pollution
–  Companies will choose to pollute more than is
good for society
•  Government policies can reduce how much
they pollute
•  Note that we don’t want 0 pollution.
–  while there is a social cost to pollution, there is
also the social benefit of the goods produced.
 Pollution

•  We like to look at this in terms of how much

companies it costs companies to abate
(reduce) their pollution.
•  Want to produce where the MC of abating to
firms is equal to the MB of abating to
society
 Government Policy
•  Three ways to get to where MC = MB
–  Direct Controls
–  Emissions Taxes
–  Tradable Pollution Permits
 Government Policy
•  Direct Controls
–  Set a single target for all companies
–  But different companies will have different MC
of abatement!
–  Inefficient for individual
firms
 Government Policy
•  Emissions Taxes
–  If you set a tax on each unit of pollution,
companies will pollute until abatement is
cheaper than paying the tax.

–  If tax at MB, polluters will abate where the MC

of abatement is less the MB until MC = MB.
 Government Policy
•  Tradable Pollution Permits
–  Government grants certain amount of permits
so total abatement is at ideal level (MB = MC)
–  Companies trade amongst each other, so firms
where abatement is too expensive will buy
permits off of other firms
–  Eventually price of a permit settles at p = MB
Taxation and Public
Expenditure
Chapter 18
 Tax Systems
•  Tax systems evaluated on
–  Equity
–  Efficiency
 Tax Systems
•  Equity
–  Horizontal Equity: similar taxpayers should pay
similar amounts
–  Vertical Equity: people with greater ability to
pay taxes should pay more
–  Measure Vertical Equity through average tax
rate (atr): taxes per income
• Progressive system: rich pay higher atr
• Proportional system: everyone pays equal atr
• Regressive system: rich pay lower atr
 Tax Systems
•  Efficiency
–  Minimize Direct Burden and Excess Burden
• Direct Burden: actual revenue that goes to the gov’t
• Excess Burden: DWL in the economy, and other
indirect costs
 Tax Systems
–  A tax of t shifts supply curve up by t

–  Direct Burden: t × Q
–  Direct Burden affected by the atr
–  Excess Burden affected by the mtr (the slope)
 Tax Systems
•  Lump Sum Taxes
–  Regressive: pay same amount regardless of
income
–  No Excess Burden: mtr = 0
•  Fiscal Federalism
–  Flow of cash through different levels of
government (province to municipality)
–  Intergovernmental transfer
 Intro to Macroeconomics
Will go over in other sections
when applicable
Chapter 19
Measurement of National
Income
Chapter 20
 GDP
•  Gross Domestic Product (GDP) is a measure
of everything produced in an economy
–  Also called National Output
•  Equivalent to National Income (Y)
–  Because production of output generates income
• Firm produces a $5 shoe
• If the price of shoe is $5, firm makes income of $5
 Measuring GDP
•  Two ways to measure GDP
–  Expenditure Approach
• Adds up all money spent purchasing output of
domestic producers
–  Income Approach
• Adds up all income generated by domestic
production
 Measuring GDP
•  Both ways, must measure through “value-
added” approach
–  How much value is added by each firm
•  VA = Revenues – Cost of Intermediate Goods
–  Farm sells Milk to store for $1, Store sells Milk
for $2
–  VA of store = $2 - $1
 Expenditure Approach
•  Expenditure Approach:
•  GDP = C + I + G + (X – IM)
•  Consumption (C)
–  spending by households
•  Government Purchases (G)
–  Spending by government
 Expenditure Approach
•  GDP = C + I + G + (X – IM)
•  Investment (I)
–  Spending by firms on capital, inventories and
structures
–  Capital = goods that provide a flow of services
(e.g. calculator)
–  I is considered gross investment, which is
• Net Investment: new additions to capital stock
• Depreciation: replacement of worn out capital
 Expenditure Approach
•  GDP = C + I + G + (X – IM)
•  Exports (X)
–  Spending by foreigners on domestic goods and
services
•  Imports (IM)
–  Domestic spending on foreign goods and
services
–  Subtracted because it’s an addition to foreign
output, not our national output
•  Net Exports (NX) = X - IM
 Income Approach
•  Income Approach: (don’t need so much)
•  GDP = Factor Incomes + Indirect Taxes –
Subsidies + Depreciation
•  Factor Incomes – all wages, interest earned
on assets, and business profits
•  Indirect Taxes, Subsidies & Depreciation:
–  All have to be accounted for when simply
measuring income
 GNP
•  Gross National Product (GNP) is total value
of income earned by domestic residents
•  GNP = GDP + payments from foreign sources
– payments made to foreigners
•  Ex. if RIM opens up a factory in India,
profits are added as payments from foreign
sources
•  Ex. if Toyota opens up a plant here, profits
are subtracted as payments to foreigners.
 Real GDP
•  Nominal GDP: this year’s output at this
year’s prices
•  Real GDP: this year’s output at base year’s
prices
–  Easy to compare changes in output year to year
•  GDP Price Deflator
= Nom GDP / Real GDP × 100
–  Good way to compare GDPs
 Issues with GDP
•  GDP misses a variety of outputs
–  Illegal Transactions
–  Underground Economy: legal, but not reported
to avoid taxes
–  Home Production: things done for no pay e.g.
making dinner
–  Economic Bads: pollution should ‘apparently’ be
subtracted from GDP
• Green GDP = GDP – Depreciation of Environment
Simplest Short Run Macro
Model
Chapter 21/22
 Aggregate Expenditure
•  Aggregate Expenditure (AE) is the amount of
spending that occurs in an economy.
–  Does not always equal national income (Y)
–  Consumers borrow or save to spend more or less
than their individual incomes
 Aggregate Expenditure
•  This can be represented in an equation
•  AE = A +zY
•  As national income (Y) rises, AE rises too
–  AE rises slower than Y, because only a portion
of income is actually spent
• z = marginal propensity to spend
–  There is also some spending done without
regards to income
• A = autonomous expenditure
 Aggregate Expenditure
•  AE0 = A + zY

•  z is the slope of AE0

•  A is where AE0 starts, along the vertical axis
–  Because A is a constant amount regardless of Y
 Equilibrium
•  AE will always end up equal to Y

–  If AE was larger than Y, firms will increase output

to take advantage of the extra spending
•   Y back to AE = Y
–  If AE was smaller than Y, firms will decrease output
in response to less spending
•   Y back to AE = Y
 Equilibrium
•  So we can say in general Y = AE
•  To find where Y = AE on a given AE line, use
this formula
–  Y0 = A / (1-z)
•  VERY IMPORTANT. Tells us how Y moves
when we change A or z
 Equilibrium
•  An increase in z to z’ will pivot AE0 up

•  To find Y, recalculate using z’

–  Y0 = A / (1-z’)
 Equilibrium
•  An increase in A by •  Multiply that ΔA by
ΔA the “simple
–  shift AE0 up by ΔA multiplier” to see
how much Y
increases
–  mult’ = 1/(1-z)
 Aggregate Expenditure
•  AE = Y = C + I + G + NX
–  Consumption (C)
• C = a + bYD
• a = autonomous consumption
• b = marginal propensity to consume
–  A = a
–  z = b
 Aggregate Expenditure
•  AE = Y = C + I + G + NX
–  Investment (I)
• I is autonomous
–  A = a + I
–  z = b
 Aggregate Expenditure
•  AE = Y = C + I + G + NX
–  Government
• Government Spending (G) is autonomous
• To spend, government has to tax (T) at a percentage
of income tY
–  t is between 0 and 1
–  A = a + I + G
–  z = b(1-t)
 Aggregate Expenditure
•  AE = Y = C + I + G + NX
–  Net Exports (NX) = Exports (X) – Imports (IM)
• Exports (X) are an autonomous amount
• Imports (IM) are a percentage of our income mY
–  (because with more income we buy more imports)
–  m = marginal propensity to import
–  A = a + I + G + X
–  z = b(1-t) – m
 Aggregate Expenditure
•  In summation:
•  AE = A+zY
= [a+I+G+X]+[b(1-t)–m]Y
•  Y0 = A/[1-z]
= [a+I+G+X]/[1–(b(1-t)–m)]
•  Mult’ = 1/[1-z]
= 1/[1–(b(1-t)–m)]
 Aggregate Expenditure
•  I thought this chart would be helpful
•  Think about the equation for Y0 and how
changes in variables affect Y0
•  Remember
–  changes in z (b, t, m) lead to pivots,
–  changes in A (a, I, G, X) lead to shifts
 More on Consumption
•  Everything you don’t consume you save (S)
•  S = YD – C
–  YD is disposable income: income after taxes
–  YD = tY
 More on Government
•  Fiscal Policy
–  Can change G or T to simulate Y in a recession
• When Y < Y*… we’ll get to that
–  Increasing G will
• Shift up AE, Y rises
–  Decreasing T will
• Pivot up AE, Y rises
 More on Government
•  The government’s Budget Balance is just
taxes (T) minus spending (G)
–  BB = T – G = tY – G
–  BB > 0: Budget Surplus
• (+) government saving
–  BB = 0: Balanced Budget
• 0 government saving
–  BB < 0: Budget Deficit
• (-) government saving (borrowing)
 More on Government
•  Taxes are an “automatic stabilizer”
–  Decrease the size of the multiplier
–  Changes in A result in smaller changes in output
–  So rises and falls of the business cycle have less
harsh effect on Y
Output and Prices in the SR

Chapter 23
 Adding Price Level
•  When we add price level (P) to economy
–  When things are more expensive, people buy
less
–  Increase in P leads to decrease in AE
–  Decrease in P leads to increase in AE
 AD Curve

•  This can be
translated into an
economy-wide
aggregate demand
(AD) curve
•  Looks at how much
people spend at
different prices
 AD Curve
•  AD curve shifts up or down when AE changes
for anything other than P
–  Aggregate Demand Shock
 SRAS Curve
•  Also an Aggregate Supply curve
•  We will look at the short-run curve (SRAS)
–  Looks different in the Long-Run
 SRAS Curve
•  Change in P:
–  Movement along SRAS
•  Change in input prices (wages..):
–  Shift in SRAS
Movement Shift

AD Price change AE change

SRAS Price change Input change

–  Note: We haven’t seen a price change that

makes a movement along SRAS.
 AD-SRAS Equilibrium
•  Short Run Equilibrium
–  Where SRAS and AD meet
 Comparative Statics
•  In the short run, we see fluctuations in
different elements of the economy,
consumption, investment, exports, etc.
•  Using the AD and SRAS curves, we can
determine the effects of these fluctuations
on Y and the price level.
 AD Shock
1.  C, AE shifts up,
Y
2.  AD shifts right
3.  Movement back to
AD-SRAS Equilibrium
at:
1.  P
2.  Slightly Y
4.  AE curve shifts
partway back down
due to higher price
 SRAS Shock
1.   in factor price
like oil
2.  SRAS shifts up and
left
3.  Y decreases to Y1
4.  AE accordingly shifts
down
–  “stagflation”
•  output falling
(stagnating)
•  prices (inflation)
 Short Run to Long Run:
Adjustment of Factor Prices
Chapter 24
 Natural Output Y*
•  Every economy has a natural output level
–  “potential output” Y*
•  This is where unemployment is at its natural
level u*
•  In the short-run, the economy can fluctuate
around that level
•  In the long-run, it will always end up back
at Y*
 Short Run Gaps
•  In the Short Run
–  Inflationary Gap
• Y > Y*
• u < u*
–  Recessionary Gap
• Y < Y*
• u > u*
 Returning to Long Run
•  Inflationary Gap 4.  Decreases Y back to
1.  AD shock pushes Y* at a higher price
curve to right, and
increases Y
2.  Unemployment low
 hard to find
workers  wages
rise
3.  Pushes the SRAS to
the left
 Returning to Long Run
•  Recessionary Gap
–  AD shock pushes AD left and decreases Y
–  Unemployment rises  easy to find workers 
wages rise
–  Pushes SRAS to the right
–  Increase Y back to Y* at a lower price
 Unemployment and Wages
•  In the adjustment process, as
unemployment goes down, wages go up, and
vice versa
•  This is reflected in the “Phillips Curve”
 Returning to Long Run
•  In summation, the SRAS shifts to get us back
to Y*
•  Y* is thus considered the “Long Run
Aggregate Supply Curve”, or the LRAS
 Government Policies
•  Many economists claim the adjustment
process is very slow
–  “sticky wages” keep the SRAS from shifting back
to LRAS
–  Wages change too slowly to shift the SRAS
•  Fiscal Policy can speed up the process
–  Recessionary Gap
–  G shifts AE up  AD to the right  Y* rises
–  T pivots AE up  AD to the right  Y* rises
 Government Policies
•  Gov’t must also react to “paradox of thrift”
–  In bad times, people save rather than consume
–  Can reduce Y even more
–  Gov’t should counteract
 Government Policies
•  Issues with Fiscal Policy
1.  Hard to time fiscal boost
• Could push Y past Y*
• Gov’t not recommended to “fine-tune” economy
• Unless severe recession, let natural wage
adjustments do the job.
2.  Temporary tax decreases don’t work
• People just save the extra money
• They know lifetime earnings aren’t affected much
Difference between SR and LR
Economic Growth
Chapter 25/26
 Differentiate SR and LR
•  If we look at GDP in terms of factors, we
can see the difference between SR and LR
–  Factors = labour (L) and capital (K)
•  GDP = F x (FE/F) x (GDP/FE)
–  F – the amount of factors
–  FE – factor employment
–  FE/F – factor employment rate
–  GDP/FE – factor productivity
•  Short Run
–  Fluctuations in FE/F cause fluctuations in Y
•  Long Run
–  Growth in F and GDP/FE cause growth in Y*
•  For example, in terms of labour
•  GDP = (L) x (E/L) x (GDP/E)
–  L is size of workforce
–  E is the # employed
–  E/L is the employment ratio
–  GDP/E is their productivity
•  During a recession (in the SR)
–  # employed drops
–  L and GDP/E remains the same
 Neoclassical Growth Theory
•  Building upon the concept of LR growth
•  Long Run GDP described by this function:
–  Y* = FTH(L,K)
–  T: level of technology (quality of capital)
• Affect function itself
–  H: level of human capital (skills and education)
• Affect function itself
–  L: Labour Force
–  K: Capital Stock
 Neoclassical Growth Theory
•  Drawn in terms of labour
–  As labour force grows, so does our long-run
potential GDP
 Neoclassical Growth Theory
•  2 characteristics
1.  Diminishing Marginal Product
•  The increase in output by attaching an additional
unit of L/K is less than the last unit added

2.  Constant Returns to Scale

•  Double both L and K = double Y
 Neoclassical Growth Theory
•  So in essence, four things contribute to LR
economic growth
–  Growth in Human Capital
–  Growth in Technology
–  Growth in the Labour Force
–  Growth in Physical Capital
 Capital Growth
•  To grow capital, we need businesses to
invest (I) in new capital
•  The amount of savings helps determine the
amount of investment
 Savings and Investment
•  Y* = C + I + G (No foreign sector)
•  Y – C – G = I
–  If national income (Y) is not consumed (C and G)
it is saved
–  Y – C – G = National Savings
–  National Savings (NS) = Investment (I)
 Savings and Investment
•  Breakdown NS with Taxes
–  Private Saving (SP) = Y – T - C
–  Government Saving (SG) = T – G
•  NS = SG + SP = I
–  Savings/Investment Identity
–  Sources and Uses of Funds Identity
•  Reflects the market for loanable funds
•  Savings are used to fund investment
 Savings and Investment
•  The amount of savings and investment in
the economy is determined by the interest
rate (r)
 Savings and Investment
•  NS: Supply of loanable funds
•  I: Demand for loanable funds
•  r: price of loanable funds
–  r
• More people save to take advantage of high “price”
for their funds
• Fewer people borrow to invest, because funds too
expensive
• Oversupply leads to “price” decrease back to r *
–  r
• Undersupply, “price” goes back up to r*
 Changes in S and D
•   in SG (government savings)

•   in NS  Shift Supply of loanable funds to

right
•   in Investment,  r*
 Changes in S and D
•  Increase in payoffs to investment projects

•   in investment demand  shifts demand

right
•   in Investment,  r*
Money and Banking

Chapter 27
 Money
•  Money:
1.  Medium of Exchange
2.  Store of Value
3.  Unit of Account
 Money
•  History
–  Used to have intrinsic value: gold
–  Now we use “fiat” money
• No intrinsic value
• People must take it by law
–  Most money today in bank deposits
• Because it is “liquid”
• Easy to turn deposits into physical currency
 Canadian Banking System
•  Commercial Banks:
–  For-profit businesses
–  Functions:
• Keep deposits
• Make loans using those deposits
–  Profits by charging higher interest rate on loans
than interest rate it pays on deposits
 Canadian Banking System
•  Commercial Banks:
–  Keep portion of deposits as reserves, so
depositors can make withdrawals
• Small reserve = more loans
• But may run short if depositors want a lot of money
–  Reserve Ratio (v)
• Desired level of reserves as percentage of total
deposits
• Reserve Ratio (v) = Total Reserves / Total Deposits
 Canadian Banking System
•  Central Bank: The Bank of Canada (BOC)
1.  Issue Physical Currency
2.  Regulator of commercial banks
3.  Banker to government
4.  Using above three, controls amount of money
in the economy
 Money Supply
•  Many ways to count Money Supply
–  M1 = currency in circulation + demand deposits
at chartered banks
–  M2 = M1 + savings deposits and non-personal
notice deposits at chartered banks.
–  M2+ = M2 + deposits at non-chartered financial
institutions.
–  M3 = M2 + near money
• Near money are financial assets that can be easily
converted without any loss into currency
•  We usually use M2 (deposits and currency)
 Money Creation
•  Money Creation by the Banking System
–  Commercial banks increase money supply

–  Let’s look at an individual commercial bank

–  Its target reserve ratio is v = 0.10 (10%).
• So out of $100 in deposits, it may only lend out $90
and must keep $10
–  Assume everyone keeps all their money as
deposits
• Money Supply = Deposits
 Money Creation
•  Take a look at the bank’s balance sheet

•  Assets = Liabilities always

•  Someone finds $10, makes a deposit

•  Adds 10 to Reserves (physical cash it owns)

•  Adds 10 to Deposits (owed to depositors)
 Money Creation
•  Reserve ratio (v) now 20/110 = 0.18
•  Aiming for v = 0.10
•  Can lend out more money

•  Now v = 11/110 = 0.10

 Money Creation
•  New loans are spent on something
•  Money deposited right back in

•  Once again, the reserve ratio has risen

–  v = 20/119 = 0.168
•  Again, excess money lent out
 Money Creation
•  Cycle ends when:

•  Money Supply = Deposits

•  Money Supply has grown from $100 to $200
 Money Creation
•  Money Multiplier
–  Summarizes whole process into one equation
•  Δ Reserves / v = Δ Deposits
–  In this case, where 10 new dollars were added
–  $10/0.10 = $100
–  At a reserve ratio of 0.10, 10 new dollars leads
to a 100 dollar increase in the money supply
 Money Creation
•  Leakages
–  Keep money supply from growing as fast
–  Excess Reserves
• Bank decides to keep more than target ratio
• Fewer loans in each cycle
–  Cash Drain
• In each round, people choose to keep some money
outside the banks instead of returning them as
deposits
• Decreases amount of reserves  fewer loans
 Money Creation
•  BOC can fix money supply by:
–  Adding or subtracting from reserves
–  Influencing reserve ratio
–  Will go over in Chapter 29: Monetary Policy
Money, Interest Rates and
Economic Activity
Chapter 28
 Bonds
•  Bond:
–  Supplied by governments/businesses to increase
cash supply now
–  Financial asset that promises to make certain
cash payments in the future
–  Interest Payments:
• Paid over the lifetime of the bond
–  Maturity Value:
• What has been paid when the contract ends
 Bonds
•  Bond A promises a 10% interest rate, and it
costs you $90.91, it will pay off $100 in a
year.
–  Interest rate (i) = 0.10
–  Present Value and Bond Price = $90.91
–  Maturity Value = $100
–  Yield = Maturity – Present = 100-90.91 = $9.09
 Bonds
•  In many problems you will be given the
maturity value of the bond (usually $1000)
and the interest rate (i)
•  Need to determine the present value (PV)
•  Use this equation
–  PV = 1000/(1+i)T
–  i =yearly interest rate
–  T = years until maturity
 Bonds
•  PV = 1000/(1+i)T
•  Note: inverse relationship between PV and i
–  As i falls, PV rises
–  As i rises, PV falls
•  Also note that as i rises, yield rises as well
 Interest Rates
•  We’ve talked about generally determining
interest rates through the savings-
investment relationship
•  In addition, riskier individual bonds demand
a higher yield
•  Two types of risk:
–  Default Risk
–  Exchange Rate Risk
 Money Market
•  There is a second reason for the general
movement of interest rates
•  The Money Market:
–  The equilibrium between Money Supply (MS) and
Money Demand (MD)
 Money Market
•  MS: Fixed by BOC
•  MD: determined by
–  i
•  Increase in i decreases MD
•  Would rather take advantage of i by investing in bonds
instead of just holding cash
-  Y
-  Increase in Y increases MD
-  Need currency to facilitate more daily transactions
-  P
-  Increase in P increases MD
-  More currency needed to carry out daily transactions
 Money Market
•  In summation:
 Money Market

•  Graph: MD and MS in relation to i

•  Changes in Y or P  Shift in MD
 Money Market
•  Equilibrium at i0 where MD=MS
–  If MD > MS
• people sell bonds to get cash
• To make their bonds more attractive, bid up i back
to i0
–  If MD < MS
• People buy bonds to get rid of cash
• Bond sellers don’t need to attract them with high
interest rates, bid i down to i0
 Monetary Transmission
•  Monetary Equilibrium
 Investment
 National Income!
1.  Changes in MD or MS lead to changes in i0
2.  Investment (I) changes in response to new
interest rate
3.  Change in I induces a change in AE
4.  Causes appropriate effect on the AD curve
 Monetary Transmission
•  Example 1: Increased MS

1.  The BOC increases MS, decreasing interest

rate
2.  Decreased interest rate leads to lower cost
of borrowing  increased investment
 Monetary Transmission
•  Example 1: Increased
MS
3.  Increased I shifts AE
upwards to more Y
4.  Shifts AD to right

Note that  Y will

 MD, but will not
raise i very much
 Monetary Transmission
•  Example 2: Increased MD through P

1.  Increase in P pushes MD to the right,

increasing i
2.  Increased i means higher cost of borrowing
 decreased investment
 Monetary Transmission
3. Decreased I shifts
AE downwards to
less Y
4. Movement along AD
to the left, to lower
price P1
 Monetary Transmission
•  In an open economy, monetary equilibrium
affects Y through NX
–  We’ll learn about exchange rates near the end
1.  BOC increases MS, decreasing i0
2.  People holding Candadian bonds sell them, to get
higher interest rates elsewhere.
3.  To do so, people must exchange CAD for foreign
currency. This increases the supply of CAD, and
causes it to lose value relative to foreign currency
4.  This means that the price of Canadian exports falls,
increasing net exports
5.  An increase in NX increases AE, Y, and AD
 Monetary Transmission
•  Monetary Forces most effective when:
–  MD is inelastic
• Shift in MS = Larger change in interest rates

• “Liquidity Trap”: when MD too elastic to change

interest rates
•  Monetary Forces most effective when:
–  I is elastic
• Change in i = larger change in Investment
 Monetary Transmission
•  Monetary Forces most effective when:
–  In the Short Run
• “Long Run Neutrality of Money”
• As prices change, Y will return to Y*
• As we remember, when AD shifts right (due to
interest rate changes), SRAS will shift back up to Y*
at a higher price
• As P rises, MD will rise as well to original interest
rate
Monetary Policy in Canada

Chapter 29
 BOC and MS
•  We learnt that the commercial banks play a
big part in the money creation process
•  We also learnt that the BOC fixes the money
supply
•  It does this by controlling commercial
banks’ money creation process
 BOC and MS
•  BOC controls the “overnight interest rate”
–  Rate at which banks lend to each other when
short of cash
–  A higher rate leads banks to increase reserve
ratio, because they don’t want to be short of
cash
–  The increased reserve ratio decreases MS
• As we learnt through the money creation process
 BOC and MS
•  When banks want to adjust their reserves,
BOC accommodates by buying/selling
government bonds
–  By selling their gov’t bonds to BOC, banks get
cash with which they increase their reserves
 Monetary Policy
•  Expansionary Policy
–  When BOC increase MS to increase AD & Y
• Reduces overnight interest rate
• Banks don’t want as many reserves
• Loan out more money, increase MS
•  Contractionary Policy
–  When BOC reduces MS to decrease AD & Y
• Increases overnight interest rate
• Banks want more reserves
• Loan out less money, reduce MS
 Monetary Policy
•  Goal of BOC: Inflation Targeting
–  Inflation is persistent increase in prices
–  Deflation is persistent decrease in prices
–  Occurs during the long run adjustment process
• As SRAS shifts to adjust for new AD at a higher/lower
Y, prices rise or fall
 Monetary Policy
•  Quick review of adjustment process:
–  AD shifts right  Higher Y  low unemployment
 wages rise  SRAS shifts up  return to Y*
at higher price
–  AD shifts left  Lower Y  high unemployment
 wages fall  SRAS shifts down  return to Y*
at a lower price
 Monetary Policy
•  When a shock shifts AD up and to the right,
contractionary policy can shift it back down
to original spot
–  Avoid the SRAS adjustment process that causes
inflation
•  When a shock shifts AD down and to the
left, expansionary policy can shift it back
up to original spot
–  Avoid the SRAS adjustment process that causes
deflation
 Monetary Policy
•  Issue: Not very quick
–  Significant lag (9-12 months) before we see any
effect
–  Therefore should only be used in severe
recessions/booms
–  No “fine-tuning”
Inflation & Disinflation

Chapter 30
 Inflation
•  Wages and Prices rise together
–  Wages rise, causing price increases as firms pass
on cost increase
–  Prices rise, leading to workers demanding
higher wages
•  So any sustained inflation is reflected by
both rising prices and rising wages
 Wage Changes
Wage Changes come from two sources
1.  Shortages or Surpluses in labour market
–  At potential GDP Y* we have unemployment u*
–  In an inflationary gap (Y > Y*)
•  Lots of output, excess demand for labour
•  Wages rise because firms compete for workers
–  In a recessionary gap (Y < Y*)
•  Little output, little demand for labour
•  Wages fall as workers compete for jobs
 Wage Changes
Wage Changes come from two sources
2.  Expectations about Future Prices
–  Workers expect a certain inflation rate
–  Negotiate for wage increases at least that high
to compensate for more expensive goods
 Wage Changes
•  Overall:
Change in Money Wages
= Output Gap Effect + Expectational Effect
•  The output gap effect eventually goes away
•  The expectational effect can become self
fulfilling
 Wage Changes
•  SRAS shifts with wage changes
•  SRAS also shifts with other random shocks in
input prices (e.g. oil)
•  Shift of SRAS = inflation. So in summary:

•  Actual Inflation = Output-Gap Inflation +

Expected Inflation + Supply-shock Inflation
 Inflation
•  Constant Inflation
–  No output gap, no shocks
–  Simply actual inflation = expected inflation
• People negotiate for wage increases  increasing
prices  more negotiation
 Inflation

•  As wages rise, SRAS shifts up

•  AD must shift up as well to keep Y at Y*
–  BOC increases MS at same rate as inflation
–  Called “monetary validation”
–  This is the BOC’s job
 Inflation
•  Demand Shock:
–  No Monetary Validation
• SRAS simply shifts up to higher P, return to Y*
 Inflation
•  Demand Shock:
–  Monetary Validation
• Continues pushing AD to the right to keep Y>Y*, even
as SRAS shifts to the left. Must continue indefinitely
 Inflation
•  Demand Shock: Monetary Validation will
lead to accelerating inflation
–  Validating the SRAS shift at a Y > Y* will lead to
prices rising further than they would have
–  This new rate of inflation becomes expected
–  Wages are negotiated to rise faster, SRAS shifts
back up faster
–  Must increase AD even faster to keep up,
accelerating the inflation!!
 Inflation
•  Supply Shock (shifts up & left)
–  No Monetary Validation
• SRAS shifts back down as wages fall to original price
 Inflation
•  Supply Shock (shifts up & left)
–  Monetary Validation
• Monetary stimulus pushes AD up and right
• Reaches Y* at a higher price
 Inflation
•  Danger with monetary validation here:
–  Could lead to increased inflationary
expectations
–  Keeping SRAS rising back up and left
• At low Y < Y*!! Pretty bad
•  Stop the validation!!
–  SRAS might continue to move left
–  Inflation + unemployment  stagflation!
–  Eventually recover
Unemployment Fluctuations &
NAIRU
Chapter 31
 Unemployment Rate
•  Unemployment Rate = unemployed / labour
force
–  Labour force = all unemployed and employed
–  U = U/LF = U/(U+E)
•  Cost of unemployment
–  Self Esteem
–  Lost Output
 NAIRU
•  NAIRU (u*) is unemployment at Y*
•  Composed of:
–  Frictional Unemployment
• People between jobs
–  Structural Unemployment
• Longer term difference between skills firms want and
workers have
–  Both of these are natural to an economy
 Cyclical Unemployment
•  Cyclical Unemployment:
–  Short-run difference between u* and actual u
•  How is it resolved?
–  All theories agree that u ends up moving to u* in
long term
–  Difference is how quickly
 Cyclical Unemployment
•  New Classical Theory
–  Changes in employment come through labour
market
• Demand and Supply of workers
 Cyclical Unemployment
•  New Classical Theory
–  All unemployment is voluntary
• Some people just don’t want to work
–  Labour Market moves to equilibrium quickly
–  HOWEVER; wages don’t seem to adjust fast
enough for this to be true
 Cyclical Unemployment
•  New Keynesian Theory
–  Labour market moves to equilibrium slowly
–  Due to “sticky wages” – don’t move fast enough
–  Results in labour market gaps that last for a
while
•  Why are wages “sticky”
–  Long Term Contracts
–  Menu Costs
–  Efficiency wages
–  Union Bargaining
Government Debt & Deficits

Chapter 32
 Budget
•  Government:
•  Makes money from taxes (T) and borrowing
–  We ignore the taxes government uses to
transfer back to consumers (TR)
•  Spends money through
–  Spending on goods and services (G)
–  Debt service payments (i ×D)
• i is the interest rate on debt
• D is total debt
 Budget
•  Government’s Budget Constraint is:
–  Spending = Revenue + Borrowing
–  G + i×D = T + Borrowing
•  Budget Deficit refers to the amount
government must borrow to balance the
budget
–  Budget Deficit
= ΔD = Spending – Revenues = G + i×D - T
Where ΔD is addition to total debt
 Budget
•  Budget Deficit Function

•  Graphed as a function of Y
–  More Y, more T, less deficit
–  Once budget deficit falls below 0, considered a
“budget surplus”
 Effect of Gov’t Debt
•  Assumed that an increase in gov’t deficit
reduces national saving
–  “Ricardian Equivalence” does not hold
• People recognize lower taxes means higer taxes in
the future
• increase private saving to counteract decrease in
gov’t saving
 Effect of Gov’t Debt
•  Crowding Out:
–  Increased gov’t debt lowers National Savings
 decrease in supply of loanable funds
 interest rate rises
In Closed Economy
–  Lower investment
In Open Economy
–  Lower NX
•  Economy (Y) suffers when gov’t increases its
debt
 Effect of Gov’t Debt
•  Good indicator of level of debt is “debt-to-
GDP ratio”
–  Debt accounted as a percentage of GDP
–  The higher the debt-to-GDP ratio, the more
crowding out there will be, the less effective
government policy to increase Y can be
Exchange Rates & Balance of
Payments
Chapter 35
 Balance of Payments
•  Balance of Payments (BOP) record a
summary of a country’s transactions with
the world
•  2 important accounts
 Balance of Payments
•  Current Account (CA)
•  Trade Account Balance + Capital Service
Account Balance
–  Trade Account Balance (NX = X – IM)
• Receipts from exports minus payments for imports
–  Capital Service Account Balance (R)
• investment income and transfers paid to Canadians
by foreigners – investment income and transfers paid
to foreigners by Canadians
• Money transfers coming in – Money transfers leaving
•  CA = X – IM + R
 Balance of Payments
•  Capital Account (KA)
–  Net change in foreign owned Canadian assets –
Net change in Canadian owned foreign assets
• Direct investment: alters legal control of real assets
• Portfolio investment: financial investment like bonds
–  Capital inflow – capital outflow
 Balance of Payments
•  BOP = CA + KA = 0
–  BOP must always balance to 0
•  Example:
–  You sell $100 to a foreigner for his currency
• Transfer to foreigner by Canadian so CA = -$100
–  Foreigner can do two things with his $100
• Buy a Canadian Export: add $100 back to CA. CA = 0
• Buy a Canadian Asset (Bond): adds $100 to KA
• BOP = CA + KA = -$100 + $100 = 0
 Exchange Market
•  Exchange Rate
–  Simply the price for a foreign currency
–  e = domestic $/foreign $
–  Ex. e = $1.25CAN/$US
–  An increase in e is a depreciation of the
Canadian dollar
• CAD is less valuable. Costs more to buy foreign $
–  A decrease in e is an appreciation of the
Canadian dollar
• CAD is more valuable. Costs less to buy foreign $
 Exchange Market

Exchange Rate Value of Canadian $

%  Depreciates
%  Appreciates

•  The higher the e, the lower the value of the

Canadian dollar
 Exchange Market
•  Like any other market:
–  the supply of foreign currency and the demand
for foreign currency determine the price of
foreign currency (e)
 Exchange Market
•  The supply curve increases as e increases
–  As the price for foreign currency rises, it
becomes cheaper for foreigners to buy Canadian
goods
–  More people demand CAN goods, so more
people supply foreign money (to get $C)
•  The demand curve decreases as e increases
–  As the price for foreign currency rises, the price
for foreign goods rises too
–  Fewer people demand foreign goods, so fewer
people demand foreign money
– 
 Exchange Market
•  Flexible Exchange Rate:
–  Like any goods market, the exchange rate
comes to equilibrium at e*
• When lots of supply and little demand, price for
foreign currency drops, and vice versa
 Exchange Market
•  Fixed Exchange Rate:
–  Country pursues an exchange rate of eF
–  If e > eF
• BOC will sell $for, increasing supply and lowering the
exchange rate
–  If e < eF
• BOC will buy $for, increasing demand and raising the
exchange rate
 Exchange Market
•  Capital Flows affect S and D of foreign
currency
–  If our interest rate is lower than foreign interest
rate (i < iF)
• People want to buy foreign bonds
• Demand more foreign currency, D shifts right
• Exchange rate rises
–  If our interest rate is higher than foreign
interest rate (i > iF)
• People want to buy CAN bonds
• Supply foreign currency on our market, S shifts right
• Exchange rate falls
END! Thanks for listening!