COURSE CRAM ECON 110B

1. Market Failure and Government

Government: restore efficiency or achieve broader social goals

Market failure: When marginal cost and marginal benefit do not equal
- Prices of goods and services do not reflect true costs of producing
and consuming them

3 Types of Market Failures

1. Public Goods (ie. National Defence)

Characteristics
- Non-Rivalries (marginal cost very low)
- Non-Excludable (no one can be excluded)
- Non-Collectible (difficult to design payment system)
Free-Rider Problem: consumes a good without paying for it (not
profit maximizing – government has to pay for it)

Efficient when there is the biggest

gap between Total Cost and Total
Benefit

Common Goods

Rival Non-Rival
Excludable Private Goods Natural
(charge (pizza, dvd) Monopolies
price) (cable tv)
Non- Common Property Public Goods
Excludable (air, fish) (National security,
(congestion - Property rights, licenses, lighting)
goods) quotas
 2. Externalities (effects on parties not directly involved)

Negative Externalities (external costs)

- Higher social cost than private cost (ie. Driving car – we pay for
pollution)
-

At every point SMC is lower

quantity than PMC. SMC is higher
cost than PMC.

Choose to produce at Q1 (PMC =

MB)
Optimal is SMC = MB at Q0

Private Cost to Firm: Labour, Raw Materials, Capital

Social Cost to Community: Toxic Water, death of wildlife

Government: limit production of goods (taxes, permits, regulation)

Assigning Property Rights

- Pay for the compensation – costs are now internalized pushing PMC
until it equal to SMC (Costs are higher for private firm)

Coase Theorem: with property rights no transaction costs 

negotiating the purchase and sale of the right

TAXES: Should push MPC to

MSC

TAX

Tradable Emission Permits: government permits that firms can

buy and sell to each other
(Marginal Cost of Reduction exceeds price of permit)
MC=P(permit) – firms efficient level of pollution
 Positive Externalities (external benefits)
- Higher social benefit than private benefit (ie. Good health care
system – less sick days – higher national income)

Social Benefit is to have more quantity

Firm will choose PMB=MC at Q0
Social Planner will try to get the firm
to choose SMC=MC at Q1

Private Benefits: Money

Social Benefits: Thriving local businesses, bigger taxpayer base

1. MARGINAL PRIVATE COST (PMC)

MARGINAL PRIVATE BENEFIT (PMB)
(only think about how much it costs them to produce one more unit)

2. MARGINAL SOCIAL COST (SMC) – social cost of producing

additional unit
MARGINAL SOCIAL BENEFIT (SMB)- benefit gain by the whole
society

Government (goods usually under produced)

Regulation: require by law undertaken by firms at social level

Subsidy: increase private marginal benefit –

INCREASE Private Marginal

Benefit
 Below-Cost Provision: setting price where MSB = MSC (even if its not
profit maximizing) (ie. Public schools)
Patents and Copyrights: don’t want free-rider problem between firms
– intellectual property rights

3. Asymmetric Information (perfect competition only works if all

firms have full knowledge of all relevant information)

- Moral Hazard: incentives by individuals with insurance to commit

arson – encourage riskier behavior
- Adverse Selection: firm set rates equivalent to the average (but
could set higher for dangerous driver, smoker)

Taxation and Redistribution of Income

- Government correct inequality in income distribution
- Income Maintenance Programs: direct payments to households in
need of finance programs (social security employment insurance,
welfare programs)
- Subsidized services: provision of goods and services at prices below
the cost of production (healthcare, education)

1. Tax System: raise money for the government

- Proportional Taxation (flat rate on income/consumption) – does

not change (Marginal Tax Rate is equal Average Tax Rate)
- Progressive Taxation (higher rate on higher income) – Marginal
tax rate is higher than Average Tax Rate (ie. Canadian Income Tax)
- Regressive Taxation (lower rate on higher income) – Marginal tax
rate is lower than Average Tax Rate (ie. Canadian Consumption)

Just because of higher taxes doesn’t mean higher revenue for the
government (Laffer Curve) – higher tax = higher leisure
 2. Equity vs. Efficiency
Disparity between the rich and the poor is not too great
- Government: redistributes wealth
- In order to become a more equitable society we may have to give up
some efficiency

Direct Burden: total tax revenue collected by the government

Excess Burden: lost surplus (DWL) created by the tax

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2. Introduction to Macroeconomics
Different individual economic variables to obtain entire economy

1. Gross Domestic Product (GDP) – Measures a country’s economic

performance
- Market Value of all goods and services (at given period of time)
- Tend: Higher GDP is better - may generate more negative externalities
- Only measures things with a dollar value

GDP is the market value

- Adding many goods and services into one measure output
- Measures at market price
of all
- Tries to include every good and service produced
Goods and services
- Tangible goods (TV, pizzas) and intangible services (haircuts)
- Does not include financial assets (bonds, stocks)
- Does not include – hidden markets (underground, illegal economic
activity – not counted, miss taxes) externalities, quality of life
factors
Newly produced
- Only includes goods/services produced within the current time
period (not include used or recycled goods)
- Ie. House built = included, House resold = not included
Within a country
- Domestically produced goods and services
- Goods produced by Canadian-owned factory in US add to US GDP
In a given period of time
- Usually over a year period
At base year prices
- Nominal GDP: valued at current prices ($10,000 to $20,000 car -
could be same level of production)
- Real GDP: valued at constant base year prices (measured at current
prices – face value of todays dollar)
o Base Year: gives us a reference point we can compared with
years
- Makes it difficult to compare GDP from one year to another

Real GDP = Nominal GDP / Price Level

Change in GDP = Difference in GDP/Base year GDP x 100
2. Measuring GDP
Total Output = Total Expenditure = Total Income
Value added = Expenditure = Income Generated
1. Value added Approach (adds up extra value contributed at each step
of production)
- Views economy as a giant assembly line (adds up these values)
- Value added to GDP: Value of good (end product) – Value of the
intermediate goods (inputs)

$3.00 – Price that consumers pay – Cost of Goods $2.00 = $1.00 to GDP
Total Value-Added: $3.00 (equal to price consumers pay)
- Final Goods (end products) not used to produce another
good/service [ie. Grocer – retail]
- Intermediate Good (inputs): goods used to produce another good [ie.
Wheat, Flour, Bread]
- Final Goods method is better, don’t double count Intermediary Goods

2. Expenditure Approach (adds up spending on domestic goods and

services)
- Adding up spending up four groups of buyers: consumers, firms,
governments and foreign sector
o Types of Spending: Consumption, Investment, Government
expenditure, net exports (exports – imports)

GDP (expenditure) = Y = C + I + G + NX(or X-M)

Consumption Spending (C): sum of spending by households on goods and

services (produced in Canada and imported)
Ie. Durable goods (cars, fridge), non-durable (food, movies), services
(haircuts)

Gross Investment (I): sum on spending on capital goods, inventories and

structures. Items to produce more goods in the future (ie. Buying a new
house)
 - Net Investment: Gross Investment – Depreciation
- Gross Investment: investment over a period of time

Government Expenditure (G): sum of spending by all levels of government

on goods and services
- Including wages, spending on public works
- Does not include transfer payments – pension payments

Net Exports (NX): spending on Canadian goods by foreigners (exports)

minus spending on foreign goods by Canadians (imports)
- Imports aren’t produced in Canada (not included)
3. Income Approach (adds up income claims generated by production
of goods and services)
- Measures GDP by adding up incomes that firms pay households (ie.
Wages, interest for capital, rent land, profits)

GDP (Income) = Y = Factor Payments + Indirect Taxes + Depreciation

Factor Payments (Sum = net domestic income at factor cost)

1. Wages, salaries, supplementary labor income (+ benefits)
2. Profits of corporations and government enterprises (interest on capital,
dividends/retained earnings)
3. Interest and investment income (from assets (stocks, bonds), physical
capital (machinery, trucks) minus debt payments (credit cards, bank
loans)
4. Farmer’s income and income from non-farm unincorporated business

Gross National Product and Disposable Income

- Measures total income received by Canadians (regardless of geographic
source of income)
Disposal Personal Income
- portion of GDP that is available to households to spend or to save
- Performance disposal Income = Personal Income – Net Taxes
- Net Taxes = taxes paid – benefits received (or transfer payments)

Money (nominal) value of a nation’s output can increase in three ways

1. Rising Prices
2. Growing Labour force
3. Greater productivity (output per worker)

Standard of Living – The real GDP per

capita (per person), reflects goods and
services individuals consume on average
Business Cycle: periodic contractions (declines) and expansions
(increases) in overall output
- Recession: downturn that lasts for two or more quarters (trough)
- Depression: really severe recession
- Boom: really strong expansion (peak)
 
 
 
 
Real GDP and Potential GDP
- Real GDP (Y) value of output an economy actually produces
- Potential GDP (Y*) value of output an economy could produce if all
of its resources are used at full capacity (possible: 24hours a day)
 
 
 
Output Gap: Difference
between potential GDP and
real GDP

Recessionary Gap: actual

output is less than potential
output

Inflationary Gap: actual output

is more than potential output

- Economic Growth: increase in potential GDP (why potential: more

stable)

Stagflation: both inflation and unemployment are high (rare happened in

1970s)
Growth Recession: If real GDP growth falls below potential growth

3. Unemployment
- Working age population: includes everyone aged 15 and older
- Labor force: Employed and unemployed (even if you aren’t working)
- Unemployed: wants to work but unable to find work (have to look
for work)
- When stop looking for work: you are not unemployed anymore
- Unemployment rate: measures % of people in labour force
unemployed
Unemployment Rate = (Total number of unemployed / Total
labour force) x100

Participation Rate = (Labour force/Working age population)

x100

Types of Unemployment

Frictional unemployment: natural turnover in the labour markets

(moving from one job to another – including new entrants)
Cyclical unemployment: Recession hits, plant shuts down – laying off
workers (plant workers are cyclical unemployed)
Structural unemployment: mismatch between structures of labour supply
and demand (ie. Seasonal demand)
Full employment: does not mean there is zero unemployment, no cyclical
unemployment – constant level of unemployment

Natural Rate of Employment = Frictional unemployment + structural

unemployment (at full employment)

5. Inflation
- Increase in the overall price level and inflation rate

Inflation = ((Price level 2 - Price level 1) / Price Level 2) x 100

- Is Inflation Bad? = Erodes the value of fixed income holdings (wages,

savings, accounts)

Ways of Measuring Inflation

1. Consumer Price Index (CPI) – fixed basket of goods at base year then
measuring how price changes over time

CPI = (fixed basket at current prices / fixed basket at base year prices)
x100

- Problems with CPI

1. Substitution Bias: Prices of some goods will rise more than prices of
other goods. Customers substitute away from more expensive goods
[CPI : Fixed basket of goods]
2. New Goods: Goods not account for price changes in new goods after
basket was determined
3. Quality Change: Prices of goods increase due to quality not inflation

2. GDP Deflator

GDP Deflator = (NomGDP / RealGDP) x 100 = (Current output at

current prices/ Current output at base year prices) x 100

- More Accurate
- More Difficult and takes longer

Standard of Living: average amount of goods and services that people

consume
Cost of Living: level of income needed to maintain a standard of living
Inflation = Rising Cost of Living
Predictable Inflation: factored into economic decisions
Unpredictable Inflation: redistributes income and wealth if long-term
doesn’t account for inflation
Cost of Living Adjustments: wages automatically rise with the price level
Borrowers Gain and Leaders lose (dollars used to pay back are worth less)
Reprising Cost: Price lists need to be updated to keep up with rising prices
– administrative burden

6. Interest Rates
- When bank lends money, it charges interest
Interest Rate: Cost of borrowing money for a certain period of time
Nominal Interest Rate: Annual amount paid per dollar borrowed
Real Interest Rate: Nominal Interest corrected for inflation
(nominal interest rate – rate of inflation)
(ie. 7% - 8% = Real Interest Rate = -1%, lender loses money)

- Interest Rates affect the standard of living of savers and borrowers

- Savers & Lenders: between off with high interest rates
- Borrowers: lower interest rates

Equilibrium in Financial Capital Markets

Investment Curve = Savings Curve = Equilibrium Interest Rate
SAVINGS = Supply the money (supply curve for how much money there is)
INVESTEMENT = Borrowing the money (demand curve for borrowing)

6. Government Policies
- To control, not eliminate the business cycle
- Macroeconomic policies to influence the performance of the economy as a
whole (ie. Stabilization policies)

Monetary Policy
Approach the central bank (bank of Canada) takes to controlling interest
rates (price of borrowing money) and the money supply (amount of money
in the economy)
- RECESSIONS: Bank lower interest rates or put more money into the
economy (stimulate economic activity)
- EXPANSIONS: Raise interest rates to slow down the economy and
reduce inflationary pressures (contractionary monetary policy)

Fiscal Policy
Spending and taxation decisions made by federal and provincial
government
- RECESSIONS: governments may cut taxes or increase spending (ie.
Expansionary fiscal policy)
 - EXPANSIONS: governments may hike taxes or reduce spending to
slow down the economy + reduce inflationary pressures

Budget Balances: Measure the difference between what government takes

in from taxes and what it spends on goods + transfer payments
Budget Surplus: Revenue exceeds spending
Balanced Budget: revenue equals spending
Budget Deficit: spending exceeds revenues (government borrowing
money)

7. Global Economy
- Variables: exchange rates and net exports

1. Exchange Rate: how many Canadian dollars it takes to buy one unit of
foreign currency
- Rise in exchange rate: takes more Canadian dollars to buy one unit of
foreign currency
- Depreciation: Canadian dollar loses value relative to a foreign
currency (rise in exchange rate)
- Drop in exchange rate: takes fewer Canadian dollars to buy one unit of
foreign currency
- Appreciation: Canadian dollar gains value relative to a foreign
currency (decrease in exchange rate)

2. Trade
- Exchange of goods and services between countries
Imports: Buy goods, services from other countries
Exports: Sells goods and services to other countries
Trade Balance: Difference between exports and imports (net exports)
- Positive Trade Balance (Trade Surplus) – Canada exports more than
imports
- Negative Trade Balance (Trade Deficit) – Canada exports less than
imports

 
 
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
3. Income – Expenditure Analysis
and the Multiplier
- Equilibrium level of real GDP is totally demand determined
(i.e – firms will produce how every many quantities people want to
buy)

1. Keynesian Cross Model

- examines the equilibrium quantity of real GDP demanded at any given
price level

National Income Accounts

- measures GDP using actual expenditures
- Aggregate Expenditure: AE= C+ I + G + Z+ (X-M)

Aggregate Expenditure Function

- relates the level of desired AE to the level of real income or output
- Desired AE – total expenditure on goods and services that
households, firms, government and foreign sector wish to make at
each level of income
- Equilibrium level of income or output and desired aggregate
expenditure (AE = Y)

If AE > Y – desire is greater than what can be produced

- inventories pile up above target levels and firm cut production to meet
inventory targets
If Y > AE – production /output is more than desired amount

AE will always be positive even if income is zero (you will still want to
spend)
AE Curve is upward sloping (total output increases, AE rise)
AE Curve slope is less than one
Aggregate expenditure is divided into….
Induced expenditure – portion of aggregate expenditure that responds to
changes in real GDP
(Induced  endogenous , determined within the model)
Autonomous expenditure - portion of aggregate expenditure that doesn’t
respond to changes in real GDP
(Autonomous  independent of  exogenous, determines by factors
outside)

Y* = C + I + G + (X – M)

1. Consumption
- assume how much money households choose to spend on consumption
(C) or put into savings depend on disposable income (YD)
- Real Disposable income: amount of income households have left over after
paying taxes (Total Income – Net Taxes)

Consumption (C) - Disposable Income spent on goods and services

Savings (S) – Amount of money not spend on goods and services

Disposal Income = Consumption + Saving (C + S = YD)

Marginal Propensity to Consume (MPC) – fraction of a change in

disposable income that is spent on consumption
- Change in C / Change in YD
ie. MPC of 0.7 means household will spend $o.70 on each additional dollar of disposable income (NOT INCOME)
Marginal Propensity to Save (MPS) – fraction of a change in disposable
income that is saved
- Change in S / Change in YD

MPS + MPC = 1

Average Propensity to consume (APC) – proportion of disposable income

that households choose to spend
- C / YD
Average Propensity to save (APS) – proportion of disposable income that
households choose to save
- S / YD
APC + APS = 1

Autonomous Consumption (a)

- Fraction of planned consumption that doesn’t depend on disposable
income
- Level of consumption that consumers would like to spend even if
disposable income was zero

Induced Consumption
- fraction of planned consumption that depends on disposable income
- MPC x YD

Consumption Expenditure = Autonomous Consumption + Induced

Consumption

C = a + MPC * YD
Consumption Function
- Relationship between desired consumption expenditure (C) and
disposable income (YD)
- Shows how much households plan to spend at different levels of
disposable income
- Slope = Marginal Propensity to consume

Consumption change = Shift in C

1. Wealth (less worries about saving for the future) - increase C
2. Higher Interest Rate (opportunity cost of consuming to increase –
earn more by saving ) – decrease C
3. Positive Expectations about the future (increase in desired
consumption – optimistic)
Movement along C = change in disposable income
Break-Even Level of Disposable Income: (C = YD) – desired savings is
zero

C > YD – saving is negative = dissaving (ie. Borrowing money)

C < YD – saving is positive (ie. Pay down debt or accumulate savings)

We can assume at AE = C
Aggregate expenditure = desired consumption expenditure = total output

Y = a + MPC (1-t)Y
Y* = a / (1-MPC (1-t)

2. Investment
Determinants of desired investment by firms
1. Real Interest Rate
2. Changes in Sales
3. Expectations about the future

- Higher real interest rates = lower desired investment expenditure in

capital goods, inventories and housing
o More expensive to borrow money
o Spending more on interest earning financial assets
o More buy new homes (ie. Investment) with borrowed money,
price of mortgages have gone up – so investment in housing
goes down

AE = C + I = (a + MPC * YD) + i
- only effects the intercept of the curve not the slope
3. Government
- Changes the amount of disposable income households have to spend on
consumption or save
- Taxes aggregate expenditure indirectly
- Taxes reduce household disposable income (YD)

YD = Y – T

Marginal Propensity to Tax – increase in net tax revenue when national

income increases by $1
- When tax rate increases, vertical intercept of the AE curve remains
unchanged
o Slope becomes flatter (steeper)
National Saving: sum of private saving and public saving
- Private saving: difference between disposable income and
consumption expenditure (pushes economy into a disequilibrium
(AE > Y))
- Public Saving: difference between government tax revenue (T) and
government expenditure (G) = Budget balance
Budget Balance: Net tax revenue – government spending (T-G)
- T > G : government has a budget surplus (public saving is positive)
- T < G : government has a budget deficit and public saving is negative
- T = G : government has a balanced budget and public saving is zero

AE = C + I + G = (a + MPC * YD) + i + g
4. Exports and Imports
Net Exports are (X – M ) (Exports – Imports)
- Exports dependent on income of other countries
- Import depend on the level of income in our economy

Marginal Propensity to Import (MPM) – amount that imports rise when

national income increases by $1
M = MPM * YD
Marginal Propensity to Spend (MPS) – how much desired spending
changes when disposable income changed by one extra dollar

Determinants of Net Exports

1. Foreign Income
2. Relative International Prices
3. Exchange Rate (Influences X and M)
 - Rise in Canadian Prices relative to foreign prices reduces Canadian
net exports
o Makes our goods more expensive and foreigners will by fewer
– imports rise
- Rise in the exchange value of the Canadian Dollar, decreases net
exports
o Depreciation of Canadian dollar means foreign goods become
more expensive) – imports fall

AE = C + I + G + (X – M)
AE = (a + i + g + x) + (mpc – mpm)((1-t)(Y))

Equilibrium condition: Aggregate expenditure = actual national income

(output)

Y* = [a + i + g + x] / ((1- (mpc – mpm) * (1-t))

5. Multiplier
- Increase in equilibrium income the results from a $1 increase in the
autonomous component of aggregate expenditure
- IDEA: once components of the AE increases by a certain amount, the
equilibrium of Y will increase by even greater amount

m = 1/ (1-MPC)(1-t)

To build one object, you need to spend money on the object and many other
things (example)
- This will continue as long as people in the economy buy more goods
and services in the economy

Effect of Taxes on the Multiplier

- Taxes Increases : consumption, investment or exports will have a smaller
effect on output

Leakages: Taxes, savings and spending on imports

Savings and Taxes make multiplier go down

  
 

4. Aggregate Demand and

Aggregate Supply
Relationship between real GDP and the Price Level
o Growth of potential GDP, inflation and business cycle
fluctuations

1. Aggregate Demand
- Total quantity of goods and services demanded in an
economy at different price levels
- AD curve relates the aggregate quantity of output
demanded to the general price level (even if relative prices
are the same)

• Price level falls = Aggregate Demand increases *

• Price Level increases
o Exports more expensive, cut back on consumption
expenditure, decrease investment (higher interest
rates) = lower consumption
 SHIFT DOWN IN THE AE CURVE

Price Change = Move along the Aggregate Demand Curve

Any other change = Shifts the Aggregate Demand Curve

Shifts in Aggregate Demand

- Consumption, Investment,
Government purchases, net exports shift

The World Economy

- Affects aggregate demand through
changes in exchange rates & foreign
national income
o Ie. Drop in exchange rate makes
Canadian dollar worth more (goods more
expensive = exports goes down, imports
increase = reduces demand)
Expectations
Influence aggregate demand because they plan consumption
and investment about expectations for future
(ie. Higher profits: increase investment expenditure)

Fiscal Policy
Government influencing the economy through expenditure on
goods and services, taxation and transfer payments
- Fiscal Policy: increase AD: expansionary
- Fiscal Policy: decrease AD: contractionary

2. Aggregate Supply
Total quantity of goods and services supplied at different price
levels.
- Depends on three inputs: Labour (L), Capital (K), and
Technology (T)
o Increase in any increases real GDP
o Total Output Y = F (L, K, T)

Short-run Aggregate Supply and Long-Run aggregate Supply

- Prices are fixed in the short-run
- Prices are variable in the long-run (factor prices adjust to
changes in the economy in the longrun)

Short-run Aggregate Supply curve [SRAS]

- Shows relationship between price level and quantity of
aggregate output supplied holding technology and wages
o Firms will react to change in the price level in
economy by changing levels of employment for
higher profits – because they are fixed (or vice versa)

Flat at start because firms

have unused capacity at low
levels of output.

At one point firms need more

Long Run Aggregate Supply Curve [LRAS]
- Wages adjust to changes in prices and firm’s profitability
doesn’t depend on the price level
o Implies that total production (Real GDP) is constant
o Level of real GDP that an economy produces in the
long run: Potential GDP (not maximum possible level
– all of its resources are used at normal rates)

Rise in price level = rise

in wages

You will always produce

the same amount of
output

Shifts of SRAS and LRAS

- Changes in Price Levels causes movements along the SRAS and
LRAS Curves

LRAS CURVE
- Change in the economy
- Level of labor, Capital and technology available
- Shift right: size of labour force/capital stock increases
- Shift left: size of the labour force or the capital stock
decreases

SRAS CURVE
- Changes in the prices of factor inputs labour, capital and
technology
- Prices of factors of production increase: SRAS Curve
Decrease
- Prices of factor of production decrease: SRAS Curve
Increases
Macroeconomic Equilibrium
 - Occurs at the intersection of A and SRAS
- Long-run Equilibrium: SRAS intersects AS where real GDP
equals potential GDP

Short-Run Macroeconomic Equilibrium

Occurs when SRAS Curve and

AS curve intersect at a level of
real GDP – higher or lower
than potential GDP

Long-Run Macroeconomic Equilibrium

- Occurs when all three

Curves (SRAS, AD, LRAS)
intersect
FIGURE A
- Short-Run Equilibrium where real GDP at point A (Yo) is
greater than potential GDP at point B (Y*) : Inflationary
Gap
o Means firms are using factors of production at a rate
higher than normal (ie. Add an extra night shift) –
not sustainable in the long-run
o High production cost will lead SRAS to decrease and
left (until inflationary gap is eliminated) – long-run
equilibrium is reached

FIGURE B
- Short run equilibrium where real GDP at Point A (Y1) is
smaller than potential GDP (Y*) : Recessionary Gap
o Means firms are not using factors of production at
full capacity (ie. Normal utilization rates) – not
sustainable in the long run
o Excess supply of labor pushes wages down and firms
unit costs decrease – lower production costs lead
SRAS to increase and shift right (until recessionary
gap is eliminated) – Long-run equilibrium is reached

Demand Shocks and Supply Shocks

- Economic expansions and contractions are precipitated by
economic shocks
o Hit the Economy either on the demand side or on the
supply side (unexpected)
- Adjustment mechanisms lead the economy back to
equilibrium

Expansionary AD Shocks

Initial equilibrium point is at Eo

-Experiences a expansionary
shock – AD shifts right (ie.
Lower taxes, higher government
spending, investment or net exports)
- E1 new equilibrium point = difference is the inflammatory gap

- High demand for labour by firms trying to produce higher-

than-potential output
o Upward pressure on wages and firms (unit cost rises)
o THIS SHIFTS THE SRAS curve ASWELL
- Equilibrium point for Quantity is re-stored at Y* but with
higher prices at P2

Contractionary AD Shocks

- Initial Equilibrium Eo
- Experiences a contractionary
AS Shock – AD shirts left
- Higher taxes, lower
government spending,
investment or net exports
New short-run macroeconomic
equilibrium (E1)
- Real GDP is below
potential GDP difference creates
a recessionary gap
- - Firms will lower demand for labour putting downward
pressure on wages and firms unit costs fall
o SHIFT THE SRAS right and down
- Equilibrium point restored at Y* prices are drived down

Supply Shocks
Negative supply shocks or positive supply shocks (curve to left
or right)

- Positive AS Shock
SRAS shift from SRAS0  SRAS 1
Reasons: decrease in wage levels, or other factor prices
(improved technology)

Intersection of SRAS and AD curve: short-run macroeconomic

equilibrium. Output is Y1 , P1
- Real GDP now above potential GDP (Inflationary gap)
o Pushes wages up and SRAS curve shirts up and left
Long run equilibrium: E2
- LRAS curve remains unchanged so Price level goes back to P0
Automatic Stabilizers
- Buffers that lessen the extent which actual GDP deviates
from potential GDP without any deliberate intervention by
the government or centeral bank

- Ie. Progressive Taxes (ie. Income tax) and transfer

payments (ie. Unemployment benefits)

o They have a counter-cyclical effect on the economy

EXAMPLES
1. Recessionary Gap
- Income assistance (ie. Employment insurance) to
unemployed workers.
o These increase the disposable income and hence
consumption expenditure of households and diminish
the magnitude of the recessionary gap
2. Inflationary Gap
- Taxes
- When economy expands and income rises, income taxes
collected go up long with rising incomes  disposable income
doesn’t increase
- Taxes decrease disposable incomes and hence consumption
expenditure of households diminish the magnitude of the
inflationary gap
Sticky (Rigid) Wages
- Sometime adjustment mechanisms that steer the economy
back to long run equilibrium don’t work as well
- Sticky (Rigid) Wages: recessionary gaps may persist in the
short-run: because the nominal wages are slow to adjust to
market forces
o Nominal Wages: Sticky (slow to change)
 Due to Union Wages, Government Regulation,
Efficiency Wages, Implicit and Explicit
contracts (fixed wages)
- Union Contracts: negotiate the highest possible wages for
employed union members
- Government Regulations (ie. Minimum wage laws) – prop
up wage levels (above equilibrium) and prevent wage
decreases
- Implicit Contracts and Explicit contracts: firms and
workers predetermine wage and prevent any adjustment
in wages for contract
o Government may intervene for wage changes
because they take too long to move or not move.

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

5. Government Budgets and Fiscal

Policy
Budget Balance and Government Debt
- Federal Government Plan for spending and taxing each year is outlined in
the annual federal budget
- Spending by Government: expenditure
- Tax collected by government: revenue

GOVERNMENT REVENUE
Sum of Net Tax Revenue(Tax – Payments) + Borrowing
1. Personal Income Taxes
2. Corporate Income Taxes
3. Indirect Taxes (Ie. Sales Tax)
4. Investment Income (ie. Profits of crown corporations)

GOVERNMENT EXPENDITURE
Sum of Government Spending + Interest Payments
1. Spending on goods & services (ie. Highways)
2. Transfer payments (ie. Pension cheques)
3. Interest payments on debt (debt service payments)

Budget Constraint G + (i x D) = T + Borrowing

Budget Deficit Change in Debt = G + (i x D)
Discretionary Expenditure: G and T (program spending
Primary Budget Deficit (G – T) – shows tax revenues are sufficient to pay for
discretionary expenditure

Budget Balance: different government revenue and government expenditure in a

fiscal year

Budget Balance = government revenues - government expenditures

Revenue = Expenditure  Budget Balance

Revenue > Expenditure  Budget surplus
Revenue < Expenditure  Budget Deficit

Government Debt: Sum of all past budget deficits – surpluses

HOW TO COVER A DEFICIT?

1. Raise Taxes or cut Spending
- Contractionary effect on economy
- Lower GDP and higher unemployment in short-run
2. Borrow (selling bonds to private investors)
- Increases government debt
- Greater portion of revenue go to interest payments
3. Money Financing (selling bonds to Bank of Canada)
- Bank of Canada pays by creating more money
- Inflationary effect on economy

Recessions
Budget Deficits to rise in recessions and fall in expansions
- Net taxes typically decrease as tax receipts go down
 - More unemployment equals less income tax revenue
- Transfer payments go up (more unemployment equals more welfare
payments)

Debt-to-GDP-Ratio
- Measures size of the debt in relation to the country’s gross domestic
product
- Indicates a government’s ability to pay back creditors (solvency)
o HIGH Debt Ratio: lenders more risk (default on payment)
 Demand higher interest rates
o Negative implications for conduct of monetary policy and fiscal
policy
 Inflationary expectations & makes it harder to control
inflation

Crowding out effects of Budget Deficits

- Deficits put upward pressure on interest rates
- Diminish both private sector investment and net exports
o Reduces National Saving = pushes up interest rates (excess demand
for loanable funds)
o Less investment slows the growth rate of potential GDP
- Raises the value of the dollar and makes Canadian goods more expensive

Discretionary Fiscal Policy: government actively adjusts spending and taxing

policies to change aggregate demand in the economy.

Expansionary Fiscal Policy and Contractionary Fiscal Policy

- If there is a Recessionary Gap, real GDP is below potential GDP
- GOAL: Increase AD through more government spending or lower taxes

Eo  E1 with government
Eo  E2 naturally
- Would take too long for the wages to eventually fall
- If wages are sticky, they might not even go back
down to E2

- If there is a Inflationary Gap, government may use contractionary fiscal

policy to slow down the economy
- GOAL: Decrease AD through lower government spending or higher taxes

- Economy Fixing itself = rise in wages

o SRAS 0  SRAS 1
- Government reduce AD by decrease G or
Increase T
o AD0  AD1
Crowding Out: government borrows to finance increased expenditure
- Tax cuts in excess of revenue
o Upward pressure on interest rates
 Crowds out private sector investment
- Full Crowding Out: if decrease in private investment equals the increase in
government spending
o Otherwise: partial crowding out
- Crowding in : More government spending on infrastructure or other
productive factors will lead to increased returns on investments by firms
o Leads to higher private investment

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  

6. Monetary System and Monetary

Policy
Money
- Anything generally accepted as a representation of value that serves
o Medium of Exchange
o Unit of Account
o Store of value
- Main Function: Medium of exchange for goods and services
o Recognized
o Accepted
o Durable
o Visible
o Portable
- Second Function: unit of account
o Compare the relative value of goods/services
- Third Function: store of value
o It can be held and used in exchange for goods or services at
some later time
- Inflation: diminished the purchasing power of money & weakens its
effectiveness
- Barter System: goods and services directly traded for goods and
services
o Double Coincidence of wants: transactions don’t occur unless
both parties have something to exchange

Flat Money and Deposit Money

- Money that can’t be converted into something for intrinsic value:
valuable due to its acceptability in exchange
- Intrinsic Value: something is valuable whether or not its used as
money
- Flat Money: has no intrinsic value: accepted because it is backed by
government & its legal tender (accepted by law as payment)
- Deposit Money: cheques being widely accepted as form of payment –
deposits in commercial banks. (ie. Cheques aren’t technically
money)

Money Supply
- Total stock of money available in economy at any given time
- Measures of Money
o M1
 “Narrow Money” includes all bank notes and coins in
circulation + demand deposits (quickly turned into
money)
o M2
 Includes M1 + deposits requiring notice before
withdrawal (ie. Savings accounts, and term despots)
o M2+
  Includes M2 + deposits at other financial institutions
that are not banks (ie. Trust companies)
o M2++
 Includes M2+ and Canada Savings Bonds and Mutual
Funds
- UNDERSTAND: Size of Money Supply in an Economy is MUCH larger
than the number of banks notes and coins in circulation

Banking System
- Consists of Central Bank (public) and commercial (private) banks
- Central Bank Functions
o 1. Banker for the government
o 2. Banker for the commercial banks
o 3. Regulator of the money supply
o 4. Protector of financial markets

Commercial Banks
- (ie. Chartered Banks, Trust Companies) – private firms act as
financial intermediaries between savers and borrowers
- Attract money from savers by paying interest on deposits
- Make Money
o Charging interest on loans to borrowers (exceeds interest on
deposits paid to savers)
o Buying securities (ie. Bonds) that pay interest or dividends
o Services charges to their customers
- Reserves: Cash holdings not loaned out
o Very small amount compared to total deposits
- Fractional Reserve: only a fraction of deposits are held as reserves
- Target Reserve Ratio: fraction of deposits a bank plans to hold
- Reserve Ratio: fraction of deposits a bank actually holds
o Cash holding > Target: Excess Reserves

How Money is created

- Created by chartered banking system in an economy
- Assets: Loans to private firms, individuals
- Liabilities: deposit accounts that private firms and individuals have

- Total money supply has increase by $200Billion given the initial

deposit shift of $10B
o Whole banking system a change in reserves increases total
deposits by an amount greater than the initial reserve change
o DEPOSIT MULTIPLIER
 DM = 1/r (r: desired serve ratio)
Currency Drain: households do not hold any cash outside the banking
system
- Money outside bank reserves reduces the amount of the reserves
used to create additional money
- Monetary Base: total amount of a currency held by individuals and
firms and bank reserves kept within a bank or on deposit at central
bank
- Money Multiplier: amount by which the change in the monetary
base must be multiplied to find final change in money supply.

Money Multiplier: change in the quantity of money/ change in the

monetary base

Time Value of Money

- Better to have the same amount of money now rather than later
- Money is worth much more than its value tomorrow

Future Value: value of an asset to be received in the future

Present Value: the value that a future asset is worth today

PV = FV/ (1 + i)^n

FV = PV (1 + i)^n

Money Market
Nominal Interest Rate = Price of Money
- Opportunity Cost

Higher Interest Rate = Higher opportunity for

holding money

MS is vertical – unaffected by the nominal interest

rate (controlled by monetary authority)
MD is downward sloping: opportunity cost of holding money
- Nominal interest rates increase: opportunity cost rises (substutue
out of money and into interest bearing assets)

Demand for Money

Influenced by interest rates, the price level and real GDP
- Amount of money that households and firms wish to hold
- Motives to hold money
o Transactions
o Precautionary
o Speculative
- Households and firms hold money to carry out transactions
(transaction motive)
- Firms and households also hold a reserve of money due to
uncertainty (precautionary motive)
- Investors hold more money when expect interest rates to decrease
(speculative motive)

- Movements along the MD represent substitutions between money

and bonds

o Rates decrease: bonds become less attractive and money more

attractive (movement down MD)
o Rates increase: bonds become more attractive and money
becomes less attractive (substitute away from money and
towards bonds) (movement up MC)
- Liquidity Preference Function: money is more liquid than bonds

• When price level goes up, you have a higher demand for money
• When real GDP goes up the money goes up for firms to produce more
services/goods for GDP to go up

- Change in price level (or real GDP) leads

to a shift of the MD Curve
- Demand for money is positively related
to real GDP and to the price level
- (increase  right, decrease  left)
- Increase in Y will generate more transactions
and increase demand for money

- Increase in price levels: increase in the dollars needed to carry out

the same level of transactions

- Changes in interest move along the MD curve

Money Market Equilibrium
- Quantity of money demanded is equal to the quantity of money
supplied
- If not in equilibrium: interest rates adjust until it is in Equilibrium

Liquidity Preference Theory of Interest:

- Interest rate is higher than the equilibrium interest rate (excess money
supply in the market)
demand for money indicates a preference for the more liquid asset (money
instead of buying bonds)

Adjustment Mechanism
- Interest rate is lower than the equilibrium rate: excess demand for
money
- Houses require more money than is currently available
o Sell bonds to get more liquid = bond prices decreases

Money Transmission Mechanism

- Links changes in demand for money (MD) and supply of money
(MS) to changes in aggregate demand

STEP #1 – Changes in equilibrium interest Rate

- Links changes in the supply of money and demand to changes in the
equiblrium interest rate (excess demand or excess supply of money)

• Increase in supply of money, reduces the interest rate (excess

money supply)
• Increase in demand for money increases interest rate (excess
money demand at initial interest rate)
STEP #2: Changes in desired investment and consumption
- Links changes in interest rates to changes in desired investment and
consumption
o Lower interest Rate: boost desired investment expenditure
 Opportunity cost of borrowing or using retained
earnings goes down
 Increase consumption – buy high priced goods (cars)
- Increase in interest rate decreases desired aggregate expenditure
due to lower investment
o Inverse relationship between interest rates and investment
expenditure in the economy
- Decrease in the interest rates leads to higher investments

STEP #3 – Changes in Aggregate Demand

- Links the shift in the aggregate expenditure curve to a shift in the
AD curve
- Higher money supply leaders to lower interest rates  higher
investment expenditure

SUMMARY

STEP #1 – Interest Rates goes down with more money

STEP #2 – Change for more investment consumption

STEP #3 – Higher AE = Higher AD

Monetary Policy
- Tool that the Bank of Canada uses to influence the economy
- Uses interest rates and money supply to achieve low inflation or
price stability to moderate the business cycle

When Increase Money Supply

- Lowers interest Rates to boost the economy (lower unemployment)
o During recession: expansionary monetary policy

When Decreases the money supply or raises interest rates to slow down
economy
- Contractionary monetary policy

KEY TOOLS FOR MONETARY POLICY

1. Open Market Operations (OMO)
- Buying and selling of government securities (treasury bills and
government bonds – by Bank of Canada to Commercial Bank and to
the public)
o Affect interest rates and money supply
o When purchase securities – commercial banks reserves
increases (allowing to increase they lending activity) 
interest rates fall through money creation process
o When Bank of Canada sells securities to the public or to
commercial banks reserves decrease
 Money supply decreases & interest rates rises

2. Bank rates (discount rates)

- Interest rates that central banks charge commercial banks to the
reserves lent to them
- Rate is usually less than the market interest rate: discount rate
o When lower interest rate: commercial banks have an incentive
to borrow and lend at higher interest rate
 Increases their reserves and lending activity, money
supply increases and interest rates falls
o When increase interest rate: commercial banks have less
incentive to borrow – decreasing their reserves and lending
activity – money supply decrease and interest rates rises

3. Government Deposit Shifting

- is the transfer of government funds from a government account in
the Bank of Canada to its account in a commercial bank or vice versa
o When transfers funds the commercial bank reserves increase
 Allows to increase their lending activity (money supply
increases and interest rate falls)
 Or transfer funds to Bank of Canada – decrease in
lending activity & interest rates rises
 4. Required Reserve Ratio

Monetary Policy and Fluctuations in GDP

- can be used to push real GDP back in line with potential GDP during
a boom or recession
- GDP will eventually return to full employments on its own –
monetary policy can be used to accelerate this process (maintains
price stability and low levels of inflation in booms)

Expansionary Monetary Policy

- Aims to increase the size of the economy money supply during a
recession (lowering interest rates, reserve ratio or buying
securities)
(Recessionary Gap)
Government can move AD with more G and less T
- Increase Money Supply
- Decrease Interest Rate
- Increase Investment/Consumption
- Increase Aggregate Demand

Contractionary Monetary Policy

- Aims to reduce the size of the economy’s money supply during a
boom (raising interest rates, raising the reserve ratio, selling
securities)

(inflationary Gap)
Government wants to decrease AD
- Lower Money Supply
- Increase Interest Rates
- Lower Consumption/Investment
- Lower Aggregate Demand

Effectiveness of Monetary Policy

- Measured by its impact on aggregate demand
- Depends on
o 1. Money demand to interest rates
o 2. Investment to Interest Rates
 - Monetary policy is more effective when money demand is less
responsive to interest rates and investment expenditure is less
responsive to interest rates
o Measured by responsiveness of money demand (MD) –
Steepness of the money demand curve (ie. Elasticity)
 Steeper: lower elasticity
 Flatter: smaller effect on interest rates as a result of any
given change in the MS and less effective monetary
policy will be

Liquidity Trap: occurs when interest rates are lowered to nearly 0% - but
there is no change in the economy
- There is so much liquidity in the market that MD is horizontal

Quantity Theory of Money

- Relates the price in the economy with the money supply and the
output

MV – PY

- M: Money supply
- P: price level
- Y: total real output
- V: velocity of money (number of times money changes in economy
over a time period)

Increase in the money supply: will result in either an increase in the price
level, an increase in total output or increase in both

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
7. Inflation and Unemployment
Costs of Inflation
- Anticipated Inflation: situation where people correctly predict the
increase in prices
o Nominal variables (ie. Money wages) change
o Real Variables remain unchanged
- Unanticipated Inflation: situation where people don’t correctly
predict inflation
o Real Variables: also affected because prices and wages do not
rise by same percentage
o Problems of redistribution of income & transfer of wealth
o Inflation is higher than predicted
 Prices rise more than nominal money wages (decrease
in real wages – receive less in real teams, they are worse
off (employers are better off)
• Redistribution of income from workers to
employers
- Transfer of Wealth: from lenders to borrowers when inflation is
higher than predicted
o Better for borrowers when inflation goes up
o Worse for lenders when inflation goes up
- Accelerating Inflation – situations where inflation breeds more
inflation at a rapidly increasing rate

When inflation is high

- Money loses value quickly and ceases to function as a useful store of
value
- Inflation increases the cost of holding money
- “Shoe Leather Costs” – reference to shoes wearing out due to
frequent visits to banks
- Loss of relative price signals – prices become distorted
o One item becomes higher priced than the other – unclear if its
because of quality or because of inflation
- Risk and Uncertainty about the future
o Firms more reluctant to invest and households more hesitant
to buy “big-ticket” items (drag on economic growth)

Causes of Inflation
- Now look at case of sustained inflation
- Major cause: rising wages – shift aggregate supply left and increase
price level

Output Gap: Y>Y* inflationary gap and excess demand for labor: upward
pressure on money wages to close gap naturally
o Y<Y* there is a recessionary gap – excess supply of labor puts
downward pressure on money wages – close the gap naturally
- Y=Y* no pressure on money wages (NAIRU)
 o Non-Accelerating Inflation Rate of Unemployment

Expectations of Future Inflation

- Wage contracts are usually negotiated before observing actual price
changes – bargaining positions of employers and workers strongly
influenced by their expectations

- OUTPUT GAP AND EXPECTATIONS shift the AS curve

o Inflationary output Gaps and Expectations for inflation
 Push up wages, cause AS curve to shift up
 Price level rises
o Recessionary output gaps and expectations of deflation
 Push down wages
 Cause the AS curve to shift down and price level falls

Actual Inflation =
Output Gap Inflation + Expected Inflation +
Supply Shock Inflation

Demand-pull inflation
Demand-pull: rise in the price level causes by an AD shift right
- Causes an inflationary output gap
- (ie. Tax cuts, increase spending by businesses, governments or
consumers, higher net exports, expansionary monetary policy)

Monetary Validation
- Bank of Canada responds by reducing interest rates and expanding
the money supply
- Bout of sustained inflation driven by monetary expansion

Sustained (Constant Inflation) – inflation but at least higher productivity

- Government wants to maintain Y
 Cost-push Inflation:
Cost-push Inflation: rise in the price level caused by AS shift left
- Caused by an increase in production costs that shift the SRAS curve
left
- Ie. Increase in oil prices

- Cost of production is bid up  because of inflationary expectations =

increase in wage
o Even without an inflation gap
o SRAS curve takes a long time to change due to factor prices
(ie. Wages)

SUMMARY
- Anything causes AD curve to shift right: demand-pull inflation
- Anything causes AS curve to shift left: cost-push (supply) inflation

Acceleration Hypothesis: if the Bank does engage in monetary validation:

inflation expectations will rise  inflation rate will pick up
momentum/accelerate

Inflation and Expectations

The only way to keep production more than Y*

or less is to stay above expectations

Sacrifice Ratio: gives the percentage drop in

GDP associated with a 1% drop in inflation rate
 - Measuring the cost of reducing the level of inflation in an economy

Unemployment
- Costs on society as a whole in lost output and on unemployed
individuals
- Lower consumption possibilities and lower self-worth

Working-Age Population: total number of people over 15 years of age

Labour force: members of the working age population who are
employed or unemployed
Employed: people are members of the labour force who have full-time
jobs or part-time jobs
Unemployed People: members of the labour force who don’t have jobs
and are
- Without work and make efforts to find a job
- Waiting to be called back to a job from which they laid off
- Waiting to start a new job within four weeks

Involuntary Part-Time Workers: part-time workers who would prefer

full-time jobs

Type of Unemployment

1. Frictional Unemployment
- Short-term unemployment associated with the natural job turnover in an
economy
- Job turnover: when people quit their jobs, get fired or are just
entering the labor force
- Workers looking jobs can’t be matched instantly
- Frictional unemployment is natural so not a major problem

2. Seasonal Unemployment
- caused by the end of the weather season with certain jobs
(Ie. Summer camps close, summer worker)
- Natural economy – factored out

3. Structural Unemployment
- Ca used by a change in the demand for skills or geographic relocation of
jobs within an economy.
- firms will demand for new skills from workers
- more flexible the labour force means the faster workers can relocate or
retain the less the negative impact on the economy

4. Cyclical Unemployment
- caused by business cycle fluctuations
- cyclical unemployment increases during recessions and decreases during
expansions
- these exist because wages are not perfectly flexible

NAIRU (U*)
- Non-Accelerating Inflation Rate of Unemployment – natural rate of
unemployment or full employment (prevails in long run equilibrium)

NAIRU = Structural Unemployment + Frictional Unemployment + Seasonal

Unemployment

Demographic Changes: to composition of the labour force can influence

NAIRU
- Unemployment higher among younger inexperienced workers than
older and experienced

Hysteresis: current level of unemployment can have an impact on the

future level of unemployment
- People who have jobs (insiders) might keep people who don’t have
jobs (outsiders) unemployed for extended period of time
o Periods of high unemployment, insiders gain valuable
experience but outsiders don’t (leading to a gap)

* Any shock that affects structural unemployment, frictional

unemployment or seasonal unemployment will change NAIRU
8. International Finance
Balance of Payments (BoP)
- record of country’s transactions with the rest of the world
- receiving payment from foreigners (credit)
- when we make payments (debit)

Balance of Payments
BoP = Current Account (CA) + Capital Account (KA) = 0

Current Account (CA)

- Income flows
- Transactions in goods and services and investment income earned
from foreign assets
1. Trade Account: records payments for imported goods and services
as debits and receipts for exported goods and services as credits
2. Capital Services Account: records payments for income on assets
Canadians own in other countries (credits) and receipts for income
on assets that foreigners own in Canada

- Current Account Balance (CAB) is equal to: CAB = Net Exports + Net
Investment Income

Capital Account (KA)

- flows to acquire assets
- ie. Bonds, shares, capital goods, real estate
1. Capital Outflow: purchase of foreign assets by Canadians, leaves
Canada debit (negative)
2. Capital Inflow: sale of Canadian Assets to foreigners, financial capital
enters Canada credit (positive)

Exchange Rate (ER)

- Rate at which one currency can be converted into
- Number of domestic currency needed to purchase one unit of foreign
currency
o Ie. US Exchange Rate = 1.21, costs 1.21 Canadian Dollars to
buy 1 US Dollar
o Fall in exchange rate: rise in external value of Dollar
 Appreciation
o Rise in exchange rate: fall in external value of Dollar
 Depreciation

Foreign Exchange Market

- where foreign exchange is the “product” and exchange rate is the
“price”
- foreigners buying Canadian products or assets supply foreign
exchange and demand Canadian Dollars in Return
Supply of Foreign Exchange
- amount of foreign currency available for Canadians to buy at
different exchange rates
- Arises from receipts of international transactions

Supply Curve: positive slope

Demand Curve: negative slope (amount willing to buy at different rates)

Exchange Rate Policies

- Add the role of the central bank in the foreign exchange market

1. Flexible Exchange Rate Policy

- Central bank to do nothing and let market forces determine the
currency’s exchange rate
2. Fixed (pegged) exchange rate Policy
- Actively intervene in currency markets to keep the currency’s
exchange rate at some particular value
3. Adjustable Peg Policy
- Fixed exchange rate policy where target exchange rate is
occasionally adjusted to respond to new circumstances
4. Managed Float Policy
- Similar to a fixed change rate policy – there is a target range for the
exchange rate

Shocks in Foreign Exchange Markets

- Demand Shock: bank will sell foreign currency reserves in exchange
for Canadian Dollars to decrease demand to E*
- Sell foreign exchange when there is excess demand (when demand
increases or supply decreases)

Changes in Flexible Exchange Rates

- demand right or supply left will push up exchange rate (cause a
depreciation – loss) in Canadian dollar
- demand left or supply right will push down the exchange rate (gain
value of the Canadian Dollar)
Factors that affect the exchange rate
1. Supply side increase in domestic price of exports
a. Shocks that increase production costs (push up prices)
b. Demand for Canadian goods is elastic
c. Elastic: Canadian Dollar Depreciates
d. In Elastic: Canadian dollar Appreciates
2. Demand side increase in foreign price of imports
a. Shocks that increase production costs in other countries and
pushed up prices of foreign goods
b. Demand less foreign currency
c. Elastic: Appreciation of the Canadian Dollar
d. Inelastic: Depreciation of the Canadian Dollar
3. Changes in relative price levels (interest rates)
a. If Interest Rates increase, foreigners will now want fewer
Canadian Dollars (no longer want Canadian Assets)
b. Want more foreign currency in order to buy more foreign
assets
c. Causes Canadian dollar to depreciate
4. Capital Movements
5. Structural Changes