Econ 102 Final Chapters

Appreciation

increase in the value of currency as measured by the amount of foreign currency it can buy ( stronger) - exchange rate changes so that a dollar buys more foreign currency

Suppose that velocity is constant and the economy's output of goods and services rises by 5 percent each year. If the Bank of Canada wants to keep the price level stable instead, it should ___________ next year.

increase the money supply by 5%

If the central bank wants to expand aggregate demand, it can ________ the money supply, which would ________ the interest rate.

increase, decrease

Inflation-induced tax distortions

the income tax that is not completely indexed for inflation; an increase in nominal income created by inflation results in higher real tax rates that discourage savings.

If nominal GDP is $400, real GDP is $200, and the money supply is $100, then what is price level? what is velocity?

the price level is 2, and velocity is 4

Shoe Leather Costs

the resources wasted when inflation induces people to reduce their money holdings

A change in the expected price level shifts which curve.. Longterm or short term

the short-run aggregate-supply curve. If people expect lower prices in the future, they will accept lower wages (that is, supply more labour for any given price level) and set lower prices (or produce more output at any given price level). This would be reflected in a rightward shift of the short-run aggregate-supply curve

Interest Rate Parity

theory of interest rate determinism where the real interest rate on comparable financial assets should be the same in all economies with full access to world financial markets

According to the classical dichotomy, which of the following is influenced by monetary factors?

unemployment

At what level of inflation is wealth distributed from borrowers to lenders?

unexpectedly low

What happens when the money supply increases?

value of money decreases

According to the quantity theory of money, which variable in the quantity equation is most stable over long periods of time?

velocity

Inflation Tax

when the government creates money to raise revenue

Holding other things constant, an increase in a nation's interest rate reduces

domestic investment and the net capital outflow.

Negative NCO

domestic residents are buying less foreign assets than foreigners are buying domestic - capital flowing into the country (inflow)

Positive NCO

domestic residents are buying more foreign assets than foreigners are buying domestic - capital flowing out of economy

What best describes the relationship of the money-demand curve to the value of money?

downward slope

Which category of consumer spending is most volatile?

durable goods, such as furniture and car purchase

Suppose that Parliament is considering an investment tax credit, which subsidizes domestic investment. real interest rate would...

increase

natural level of output (long run)

production of G/S that an economy achieves in the long run when unemployment is at its normal rate

Monetary neutrality

proposition that changes in the money supply do not affect real variables.

Costs of High Inflation

(1) Shoe leather costs (2) Menu costs (3) Relative-price variability (4) Inflation-induced tax distortions (5) Confusion and inconvenience (6) Unexpected inflation

when the nation is running a trade deficit...

(NX < 0) - buying more goods and services from foreigners - capital is flowing into the country (NCO < 0)

when the nation is running a trade surplus...

(NX > 0) - selling more G/S to foreigners - capital is flowing out of the country (NCO > 0)

Real Exchange Rate: Supply and Demand in Market for Foreign exchange

- balances S and D - when Canada's rer appreciates -> Canadian goods become more expensive relative to foreign = Canadian goods are less attractive to consumers at home and abroad =NX decreases = real exchange rate decreases quantity of dollars demanded NCO does not depend on exchange rate

Determinants of NX

- consumer taste for domestic and foreign goods - prices of goods @ home and abroad - exchange rate between domestic and foreign currencies - income level of consumers @ home and abroad - cost of transporting goods - gov. policies toward international trade

Liquidity Reference Theory

- interest rates will always adjust to bring supply of money and demand for money into equilibrium - used to explain the short run theory/fluctuations in interest rates

Sticky Wage Theory

- nominal wages slow to adjust to changing economic conditions

Aggregate Supply

- quantity of G/S firms produce and sell at each price level

Interest Rate Determination in Small Open Economy with Perfect Capital Mobility

- when predicting if Canada's interest rates will increase or decrease look at United States -

Wealth Effect

decreased price level makes consumers wealthier - encourages them to spend more = increased spending = increased G/S

Open Economy 2 uses for Saving

1. Domestic Investment 2. Net capital Outflow

Limitations to Interest Rate Parity

1. Financial assets carry the possibility of default 2. Financial assets in diff. countries are not perfect subtitutes

What are 2 Implications of PPP

1. Goods are not easily tradable ex. haircuts 2. Even if they are tradable -> not always a perfect substitution ex. Canadian car vs. German car - beer -sausage

Suppose that a country's inflation rate increases sharply.

1. Holders of savings accounts are hurt by the increase in the inflation rate because they are taxed on their nominal interest income 2. The inflation tax on holders of money increases.

In which of the following circumstances is expansionary fiscal policy more likely to lead to a short-run increase in investment?

1. When the investment accelerator is large = means that the increase in demand caused by expansionary fiscal policy will induce a large increase in investment. Without a large accelerator, investment might decline because expansionary fiscal policy raises the interest rate. 2. When the interest rate sensitivity of investment is small -the greater the sensitivity of investment to the interest rate, the greater the decline in investment will be, offsetting the positive accelerator effect

Effects of Capital Flight: Market of Loanable Funds

1. decreases supply of loanable funds 2. savers ask for risk premium 3. borrowers pay the higher interest rate 4. without capital flight NCO = AB with capital flight NCO = XY, XY > AB NCO shifts right

Facts About Aggregate Demand and Supply

1. economic fluctuations are irregular and unpredictable 2. most macroeconomic quantities fluctuate together - real GDP -> value of final G/S and total income in economy - when it changes so does everything else 3. as output decreases, unemployment increases - real GDP decreases = increased unemployment

Short Run Economics 2 Variables

1. economy's output of G/S (real GDP) 2. overall price level (CPI and/or GDP Deflator)

Factors That Affect NCO

1. real interest rates being paid on - foreign assets - domestic assets 2. perceived economic and political climate -> risks of holding assets abroad 3. Government policies that affect foreign ownership of domestic assets

f a cup of coffee costs 2 euros in Paris and $6 in Toronto and purchasing-power parity holds, what is the exchange rate?

1/3 of a euro

can of soda costs $0.75 in Canada and 12 pesos in Mexico. Assume purchasing-power parity holds. The peso - Canadian exchange rate is....

16 pesos per dollar

If the nominal interest rate is 8 percent and the inflation rate is 3 percent, what is the real interest rate?

5% real = nominal - inflation

Current Account Balance Equation

= NX + Net inflow of dividends and interest payments

Which of the following is likely responsible for this?

A high Japanese saving rate relative to Japanese investment

If an economy always has inflation of 10 percent per year, which of the following costs of inflation will it not suffer?

Arbitrary redistributions between debtors and creditors that expected inflation does not cause arbitrary redistributions between debtors and creditors. That is, expected inflation can be built into loan and wage contracts and therefore does not arbitrarily benefit or harm one party when inflation increases or decreases the value of loans or wages.

Holding national saving constant, an increase in net capital outflow __________ a country's accumulation of domestic capital.

decreases

Why is investment more variable over the business cycle than consumer spending?

Because firms can curtail investment spending more easily than households can curtail consumption spending

If the money supply is increased, what effect does this have on the price level and the quantity of money demanded in the long run?

Both the price level and the quantity of money demanded increase.

Hyperinflations occur when the government runs a large budget ________, which the central bank finances with a substantial monetary ________

deficit, expansion

how inflation discourages savings

Capital gains are the profits made by selling an asset for more than the purchase price. Taxes on capital gains, if they do not consider the effects of inflation, will exaggerate the size of a capital gain and inadvertently increase the tax burden on this type of income. Taxes on interest income are levied as income on nominal interest earned on savings, even though part of the nominal interest rate merely compensates for inflation. Thus, inflation will exaggerate the taxes paid on interest income.

Equation for nominal GDP

PY

Relative-price variability

Higher inflation causes relative prices to vary more since prices change infrequently. Decisions based on relative prices are then distorted.

Unexpected Inflation

Inflation decreases the real value of debt, thereby transferring wealth from creditors to debtors.

Confusion and Inconvenience

Inflation decreases the reliability of the unit of account, making it more complicated to differentiate successful and unsuccessful firms and thereby impeding the efficient allocation of funds to alternative investments.

The idea that economic downturns result from an inadequate aggregate demand for goods and services is derived from the work of which economist?

John Maynard Keynes believed that recessions and depressions can occur because of inadequate aggregate demand for goods and services. Because of this, he advocated policies to increase aggregate demand during times of recession. This is in contrast to the classical approach of allowing the economy to correct itself in the long run.

What is the quantity equation

M x V = P x Y M= quantity of money V= velocity of money or rate at which money changes hands P= price of output Y= amount of output (real)

Net Capital Outflow

NCO = Purchase of foreign assets by domestic residents - purchase of domestic assets by foreigners ex. if Canada buys stock in a Mexican Company= increase in NCO

when S < I

NCO is negative - foreigners are financing some of this investment by purchasing domestic assets

when S > I

NCO is positive - nation is using some of its saving to buy assets abroad

Trade Balance Equation

NX = Value of Exports (X) - Value of Imports (M)

Suppose that the money supply in a particular country is $80 billion, the real GDP is $960 billion, and the price level is 3.0. What is the value of the nominal GDP? What is the velocity of money?

Nominal GDP = $2880 Velocity= 36

Suppose the Bank of Canada expands the money supply, but because the public expects this action, it simultaneously raises the public's expectation of the price level. What will happen to output and the price level in the short run?

Output will not change, price level will rise

Price level equation using GDPs

Price Level = Nominal / Real

Aggregate Demand

Quantity of G/S that firms, households and government want to buy at each price level

Saving, Investment and Their Relationship to The International Flow

S = I + NX S = I + NCO * when people save a dollar of their income for the future it can be used to finance accumulation of domestic capital or used to finance the purchase of capital abroad

Trade Policy

Tariff: tax on imports Import Quota: limit on quantity of goods produced abroad and sold domestically

In fiscal year 2009-10, the Government of Canada incurred a budget deficit of $56 billion, an increase of about $50 billion from the year before. What effect should we expect this increase in the government's deficit to have had on Canada's net exports?

The dollar appreciates, and net exports decrease.

Economists often lament the low level of national saving. Low saving impedes capital growth, productivity, and living standards. For this reason, economists tend to favour policies designed to increase saving. Suppose that all Canadians choose to increase their saving. What would be the effect of increased saving on the value of the dollar and on net exports?

The dollar would depreciate, and net exports would rise

If the value of a nation's imports exceeds the value of its exports, which of the following is not true?

The nation is experiencing a net outflow of capital.

Which statement best describes the outcome when a government prints money to finance its expenditures?

This imposes an "inflation tax" on everyone who holds money.

redistribution effects of unexpected inflation

Unexpected inflation redistributes income because many loans in the economy are specified in terms of the unit of account, that is, money. Unexpected changes in prices redistribute wealth from creditors to debtors because they diminish the real value of the debt. The debtor repays the debt in less valuable dollars than anticipated.

Trade Deficit

X < M NX < 0 Y < C + I + G S < I NCO < 0

Balanced Trade

X = M NX = 0 Y = C + I + G S = I NCO = 0

Trade Surplus

X > M NX > 0 Y > C + I + G S > I NCO > 0

What is the primary result of inflation?

a decline in the value of money

Stagflation is caused by

a leftward shift in the aggregate-supply curve. Stagflation is a period of time where output is falling and prices are rising. When firms experience an increase in the costs of production, selling goods becomes less profitable, and firms supply less output at any given price level. This causes the aggregate-supply curve to shift to the left, resulting in lower output and a higher price level

What would be the primary effect of an increase in the money supply?

a proportional increase in prices

Purchasing Power Parity

a theory of exchange rates where a unit of any given currency should be able to buy the same quantity of goods in all countries

A sudden crash in the stock market shifts which curve...

aggregate demand curve causes consumers to cut back in spending and firms to cut back in their investments, reduces aggregate demand at any given price level (that is, causes a shift in the aggregate-demand curve).

According to the principle of monetary neutrality, what is the most likely effect of an increase in the money supply?

an increase in the price level but not in real GDP

If business leaders in Great Britain become more confident in their economy, their optimism will induce them to increase investment, causing the British pound to ________ and pushing the British trade balance toward ________.

appreciate, deficit An increase in investment means increased demand for loanable funds, which increases the interest rate. A higher interest rate will decrease net capital outflow and increase demand for the British pound, causing it to appreciate. As the currency appreciates, imports become cheaper and British exports become more expensive to foreigners, so the trade balance moves toward deficit

The nation of Ectenia has long banned the export of its highly prized puka shells. A newly elected president, however, removes the export ban. this change in policy will cause the nation's currency to ________, making the goods Ectenia imports ________ expensive.

appreciate, less

If a nation's currency doubles in value on foreign exchange markets, the currency is said to ________, reflecting a change in the ________ exchange rate.

appreciate, nominal

Automatic Stabilizer

are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action

A ________ is more likely to engage in foreign direct investment, and ________ is more likely to engage in foreign portfolio investment.

corporation, individual investor

The theory of purchasing-power parity says that higher inflation in a nation causes the nation's currency to ________, leaving the ________ exchange rate unchanged.

depreciate, real

What happens to the real exchange rate when: Canada's nominal exchange rate declines, and prices are unchanged in Canada and abroad.

decrease

What happens to the real exchange rate when: Canada's nominal exchange rate declines, and prices rise faster abroad than in Canada.

decrease

What happens to the real exchange rate when: Canada's nominal exchange rate is unchanged, but prices rise faster abroad than in Canada.

decrease

Depreciation

decrease in value of currency as measured by the amount of foreign currency it can buy (weaker) - exchange rate changes so that a dollar buys less foreign currency

If the government wants to contract aggregate demand, it can ________ government purchases or ________ taxes.

decrease, increase

Interest Rate Effect

decreased interest rate = increased demand G/S

Aggregate Demand Curve

decreased price level = increased quantity of G/S demanded

Small Open Economy

economy that trades goods and services with other economies and has a negligible (small) effect on world prices and interest rates

Which of the following is the most likely effect of a change in the price level?

either inflation or deflation exists

When the Bank of Canada increases the bank rate, commercial banks are ______ reserves and this in turn causes the money supply to ________ .

encouraged to borrow, expand

NCO = NX

every transaction on one side affects the other by the same amount

Real Exchange Rate Effect

exchange rate depreciates = increased demand for net exports

The demand for net exports is stimulated by expansionary monetary policy through the ___________. The decline in the interest rate _______________ net capital outflow and causes the exchange rate to ___________ , thus increasing net exports.

exchange rate effect, increases, depreciate

If the supply of money increases, which of the following occurs?

expenditures increase (spending increases)

Holding other things constant, an appreciation of a nation's currency causes

exports to fall and imports to rise

Suppose that velocity is constant and the economy's output of goods and services rises by 5 percent each year. If the Bank of Canada keeps the money supply constant, the price level will_______ , and nominal GDP will ________

fall by 5%, stay the same

The government in an open economy cuts spending to reduce the budget deficit. As a result, the interest rate ________, leading to a capital ________ and a real exchange rate ________.

falls, outflow, depreciation ***reduction in government spending increases national saving, which, in turn, causes the interest rate to fall. Lower interest rates decrease the incentive to buy domestic assets (relative to foreign assets), which leads to a capital outflow. This increases the amount of currency a country supplies in foreign currency markets, causing a real exchange rate depreciation.

When the economy goes into a recession, real GDP ________, and unemployment ________.

falls, rises

Would the effect on aggregate demand be larger if the Bank of Canada held the money supply constant in response, or if the Bank of Canada were committed to maintaining a fixed interest rate?

fixed interest rate

Macroeconomist

focus on overall prices rather than prices of individual items - to measure real -> use CPI

perfect capital mobility

full access to world markets R = RW ex. r= 5% rw=8% -cannot persist -savers would prefer to buy foreign assets that pay on interest rate of 8% than just 5%

Arbitrage Opportunities

good bought in one country at a low price and sold in another at a high price

what determines the quantity of money that individuals and businesses want to hold?

how much they rely on credit

Hyperinflations are extremely rare in countries whose central banks are independent of the rest of the government. This is because

hyperinflations usually arise when governments finance their expenditures by printing money.

An increase in the aggregate demand for goods and services has a larger impact on output ________ and a larger impact on the price level ________. (use long runs or short runs)

in the short run, in the long run

Changes in government deficits are closely related to changes in net exports. In particular, increases in government deficits lead to reductions in net exports, while reductions in government deficits lead to increases in net exports. This is because a reduction in the government deficit leads to a(n)______ in national savings, which causes the supply of loanable funds to________ . As a result, net capital outflow (NCO) ________ , the real exchange rate _________ , and net exports ____________ .

increase, rise, increase, fall, rise

Shifts from change in Capital

increased capital = increased productivity = shift right

Shifts from change in Technological Knowledge

increased knowledge = shift right

Shifts from Change in Labour

increased labour = shift right increased minimum wage = increase natural unemployment = decrease labour= shift left

Shifts from Change in Natural Resources

increased resources = shift right

What happens to the real exchange rate when: Canada's nominal exchange rate is unchanged, but prices rise faster in Canada than abroad.

increases

According to the quantity theory of money and the Fisher effect, if the central bank increases the rate of money growth,

inflation and the nominal interest rate both increase. If inflation rises, the nominal interest will rise by the same amount in the long run, and the two effects will cancel themselves out in the calculation of the real interest rate

What best explains the revenue the government raises by creating money?

inflation tax

capital flight

large sudden reduction in demand for assets located in a country

In a small open economy, the increase in aggregate demand resulting from an increase in government spending is _____ if the exchange rate is ______ than if it is _______ .

larger, fixed, flexible

In a small open economy, the increase in aggregate demand resulting from an increase in the money supply is _____ if the exchange rate is ______ than if it is _______ .

larger, flexible, fixed

A civil war abroad causes foreign investors to seek a safe haven for their funds in Canada, leading to ________ Canadian interest rates and a ________ Canadian dollar.

lower, stronger

Which of the following is an example of an automatic stabilizer? When the economy goes into a recession,

more people become eligible for unemployment insurance benefits.

classical dichotomy

nominal variables are determined primarily by developments in the monetary system such as changes in money demand and supply. Real variables are largely independent of the monetary system and are determined by productivity and real changes in the factor and loanable funds markets.

What is inflation directly proportional to?

nominal wage growth and nominal interest rates

In an open economy, national saving equals domestic investment

plus the net outflow of capital abroad

as value of money increases

price level decreases (opposite on the graph) - draw out graph

If the Bank of Canada maintains a fixed exchange rate, it would need to ___________ the money supply to prevent the appreciation of the Canadian dollar. This would ____________ the Canadian interest rate.

raise, lower

Real Exchange Rate

rate at which a person can trade the G/S of one country for the G/S of another = (nominal exchange rate x Domestic Price) / Foreign Price *key determinant for imports and exports

Nominal Exchange Rate

rate at which a person can trade the currency of one country for the currency of another

The classical principle of monetary neutrality states that changes in the money supply do not influence ________ variables and is thought most applicable in the ________ run.

real, long

Inflation acts like a tax on people who hold money, by ________ its value. The government can finance its expenditures by printing money and using it to buy things, which results in a ________ money supply and inflation. The result is a transfer of wealth from ________ to ___________

reducing, higher, money holders, the government

hen the Europeans develop a strong interest in investing in Canada, there is a _______ in net capital outflow.

reduction An increase in capital inflow causes a demand for Canadian dollars in the foreign-currency market, which leads to an appreciation of the value of the dollar. It would result in a decrease in the demand for loanable funds, causing the real interest rate to decline, reducing Canada's private saving, but increasing Canada's domestic investment. It will increase Canada's capital stock, since Canada's domestic investment rises

Menu Costs

the cost of more frequent price changes at higher inflation rates

misperceptions theory

the economy is in a recession when the price level is below what was expected

It is sometimes suggested that the Bank of Canada should try to achieve zero inflation. Assume that velocity is constant. What must the rate of money growth equal in order to achieve this zero-inflation goal?

the growth of rate output