Who appoints people to which role in the Bank of Canada? (2)

After inflation was high during the 1970s and early to mid 1980s, what did the Bank of Canada do to lower the rate?

What is the operating band?

What are on the two ends?

 1) Minister of finance chooses 12 directors

2) 12 directors choose the governor and deputy governor

They started to target the actual inflation rate and control it with the overnight interest rates (target overnight rate)

It is the band that determines the interest rates set for overnight rate.

On the higher end is the bank rate, in the middle is the overnight rate.

Who controls monetary policy?

Who controls fiscal policy?

How has fiscal policy changed over the years?

How is monetary policy viewed with regards to fiscal policy?

The Bank of Canada.

The Ministry of Finance.

Since the 1990s, Canada has reduced G in order to lower the debt/GDP ratio. Before then there were large deficits.

Today, most people believe monetary policy is better for stabilization since fiscal policy has long lags.

What are some key characteristics of an economy in a liquidity trap? (2)

Best way to stop liquidity trap?

1) Nominal interest rate is low and fixed, with low inflation it means real interest rates are high and investment is low.

2) For IS-LM, L_i is extremely large which makes the slope close to 0.

Use fiscal policy.

What does the central bank do in a financial crisis? (2)

What are some negative effects of the central bank's actions?

1) Lenders of last resort

2) Providing deposit insurance

A negative effect would be the moral hazard, where firms have incentives to act risky since they have insurance.

How do the budget deficit and IS curve interact?

Give an equation that represents their interactions.

Increase in G or decrease in T shifts IS and AD curves out.

deficit: d = G - T

What are some methods of measuring the budget balance (BB)? (4)

Write out equations for each method.

1) Actual BB (most used)

Actual BB = (Tax revenue) - (Gov. purch.) - (Transfer PMT)

2) Cyclically or FE adjusted BB (better index)

Same as Actual but adjusted for fluctuations in taxes and payments during the business cycles

3) Inflation adjusted BB

 BB = Actual BB + πD  (Debt affected by inflation)

4) Primary BB

BB = Actual BB + iD  (Debt affected by int. rates)

How do we know the Debt to GDP ratio is heading for steady-state?

Based on this, what is the growth rate of debt?

What is the steady-state level equation?

Both Y and D are growing at the rate of n + g

(n = growth of labour, g = growth of labour efficiency)

ΔD = -π + δ * (Y/D)

(δ = deficit as a share of GDP)

D/Y = δ / (n + g + π)

1) Political consequences - increases in G results in increases in future T, must be transparent

2) Short-run consequences - stimulates investment, output and employment rise = expansion

(controlled with monetary policy)

3) Open economy consequences - increases in deficit means exchange rates decrease and productivity falls

4) Long run consequences - lowers national savings and investment, means less productivity and capital growth

(Also, more debt)

What is the main idea behind Ricardian Equivalence (RE)?

What are the conditions for RE to fail? (3)

Consumption changes based on what the government intends to change with regards to taxation.

1) Myopia - not far-sighted to see what'll happen in future

2) Liquidity constraints - not everyone can borrow and lend

3) Beneficiaries and Payers differ - burden of tax not shared

(immigrants come in = they gotta pay a portion)

What are some important features of the Two-period model? (2)

What is savings equal to?

1) Ricardian equivalence theory holds

2) Consumption smoothing exists

(no fluctuations in consumption, save some money)

s = y - t - c

In terms of the two period model...

What is the consumer's lifetime budget constraint?

What is lifetime wealth?

How do we figure out what to put as the budget constraint?

c + c'/(1+r) = y + y'/(1+r) - t - t'/(1+r)

Lifetime wealth (we) = right side of constraint equation

[we = y + y'/(1+r) - t - t'/(1+r)]

For each axis, solve for c or c' by substituting in (we) and simplifying.

In terms of the two period model...

What is the endowment point?

What happens when current income increases?

What happens when future income increases?

It is the point of consumption where the person uses all disposable income. (c = y - t, c' = y' - t')

Lifetime wealth increases, resulting in c, c' and s to increase as well.

Wealth increases, resulting in c and c' to increase.

s decreases to save more in the current period.

In terms of the two period model...

What are some reasons as to why consumption may not be as smooth? (2)

What changes if there is a perfect complements case?

1) Imperfect credit mkt, not everyone can borrow & lend

2) If everyone is trying to smooth consumption, market prices will change (changes aggregate output)

There is a new variable, (a = positive constant)

This variable changes 1 + r into, 1 + r + a

In terms of the two period model...

What are the differences between a change in temporary income versus permanent income? (2)

Explain what happens when real interest rates (r) increases for a lender and borrower.

1) A permanent change shifts the budget constraint curve further outwards.

2) Most variables increase (we, c and c') but savings only increases for a temporary change and Δs is unknown in a permanent change.

In both cases, the lines get steeper.

Lender: c' increases, Δc and Δs is unknown

Borrower: c decreases, s increases and Δc' is unknown

(IE and SE can be measured between points and IC)

In terms of the two period model...

What is the government's PV of budget constraint?

What are the conditions that must hold for the government case? (3)

G + G'/(1+r) = T + T'/(1+r)

1) Consumers choose c and c' given r

2) Gov's PV of BC holds

3) Credit market clears (S^P = B)

In terms of the two period model...

What does S^P = B imply?

In terms of the Ricardian Equivalence theorem, what does it imply in our model? Use an equation to explain.

Does anything change in the our model when we consider RE theorem?

It implies (Y = C + G) and that, (S^P + S^g = 0)

If G and G' are fixed, any change in T and subsequent change in T' doesn't change c and r.

 Essentially it means: Δt' = −Δt(1 + r)

The endowment point will change and savings would increase because you'd want to save to pay future taxes.

How has our macro-economy changed over time, what types of jobs are not popular and which ones are?

How has our economy improved over time, by using what new strategies? (4)

What is the caveat?

Agriculture jobs are not very popular. Other services are extremely popular while manufacturing and education jobs have become slightly less popular.

1) Better financial systems (smooth consumption, lower MPC and multiplier)

2) Deposit insurance (type of stabilizer) - reduces panic

3) Improve labor prod. efficiency

4) Financial automatic stabilizers

The caveat is that business cycles still persist.

In terms of our economy growing...

What are some economic variables that have seen and will see growth from financial flexibility? (4)

1) Consumption - less liquidity constraints mean slightly higher MPC and easier to borrow

2) Globalization - decreases in multiplier means higher demand for foreign goods and less domestic shocks

3) Monetary policy - lower multiplier makes it harder but with more flexibility it will be easier

4) Inventories - better at managing with technology, less fluctuations in inventory

What does a business cycle show?

What are the types of business cycle theories? (4)

What is the main idea behind them?

A diagram with a trend GDP curve and a real GDP curve. It shows the fluctuations in the economy with the curves.

1) Keynesian business cycles - fluctuations in expectations

2) Real business cycles - fluctuations in z (TFP)

3) Austrian business cycles - fluctuations in innovating

K and L and adapting to the changes

4) Policy business cycles - fluctuations based on policy use

How has cyclical volatility worked in the long run?

How has economic policy worked in our economy?

What are the ways economic policy has not worked and for what reasons has it not worked?

Many effects have cancelled each other out leading to little cyclical volatility in the long run.

It has caused less recessions due to shocks in IS and LM and overall there have been only some recessions.

The government focused too much on inflation, this made policy-induced recessions. BC still fluctuate due to these mistakes.

What are the main consequences of the great depression? (3)

What is the key to fighting against harsh situations like the G.D?

1) High real interest rates due to high deflation

2) Much lower real GDP

3) Much higher unemployment

Aggressive monetary policy, it can fight deflation and the increases in the real interest rate.

(Over the years we have gotten better at using policies)

What are the key features out of the rational expectation revolution? (2)

Explain what the inter-temporal substitution of leisure is.

1) Macroeconomic models based off of microeconomics principles

2) Flexible wage/price models can be used to study macroeconomics

Price of leisure in the future = w'/(1 + r)

Therefore, as r increases you'll take

more leisure in the future and

work more in the present since the

price of leisure goes down in the future.

In the RBC model...

What does a shock that increases z do?

Explain what graphs it affects. (4)

It is an increase in TFP

1) Output supply increases (due to more labor demand), output demand increases (due to anticipated high income)

2) Labor demand increases, labor supply decreases but less then the demand. Overall increase in labor.

3) Money demand increases

4) On the production function graph, the average labor productivity increases.

How can you explain that money supply follows business cycles? Give some key features. (2)

What are the variables that aren't pro-cyclical in RBC? (2)

1) Money supply is considered endogenous

2) It increases due to z because monetary policy changes the value in accordance.

1) real interest rates (r) are counter-cyclical

2) price level (P) is a-cyclical

Does the government have a role in RBC?

Explain how this role comes to fruition. (2)

What is one major criticism of the RBC and how does it fail?

They have no role.

1) Money supply changes are neutral so smoothing business cycles with policy has no effect

2) No inefficiencies because all markets clear

(equilibrium on all graphs)

During recessions there can be labor hoarding which would not properly reflect TFP.

What is the Keynesian co-ordination failure model based on?

What are some key features about the Keynesian co-ordination failure model compared to other models? (3)

How does the labor market graph look in this model?

Based on optimism and pessimism.

1) Has increasing returns to scale

2) Has multiple equilibrium (good or bad)

3) Not all markets clear (don't have to be at equilibrium)

Labor demand is going the same way as labor supply but it is steeper.

Is the Keynesian co-ordination failure model able to explain how the money supply follows business cycles?

What markets does the Keynesian co-ordination failure model affect?

What are some criticisms of the model? (2)

Yes, optimism comes from high money supply and vice versa, this is an appropriate explanation.

The same as RBC,

labor markets, goods market and money market.

1) Increasing returns to scale is debatable

2) Hard to factor in expectations

In the New Keynesian Model...

What is the main fundamental difference about prices in this model compared to the others?

What market does not need to clear in the model and why?

What is the role of government in this model?

Price/wages are not 100% flexible but flexible prices are represented in the model by the natural real interest rate (r_m) otherwise prices are sticky.

The labor market, because...

-> already producing at P* so more workers is inefficient

The role of government is to close output gaps (Y_m - Y*) by using policies and as well, to smooth out business cycles

In the New Keynesian Model...

Is money neutral? Explain how it is or isn't.

How does the model differ or how is it the same then others with regards to how the variables change?

(Compare to RBC)

It is non-neutral, money supply supports the real interest rate achieving target values by using monetary policy.

(If M^s is increased (r decreased), it'll also increase consumption, employment, investment, etc.)

Compared to the RBC model, this model is the same. The only difference is in how the nominal variables change

(P, M^s)

In the New Keynesian Model...

What does a liquidity trap look like? Describe it.

How does the government decide to use fiscal or monetary policy when lowering the output gap?

Starting at Y1, r1, if the credit market has a shock then our output demand and supply shift.

We are now at a lower point, Y2 and r1 (not equilibrium).

The government could close the output gap by lowering r1 to r2 but they can't since nominal interest rates are equal to 0 and the real rate can't be lowered.

Fiscal policy affects G more, monetary policy not so much. Both can change r though.

If the government wants small G then use monetary policy (depends on what gov. wants)

What is the uncovered interest parity condition (UIP)?

What is the absolute PPP?

What is the relative PPP?

What does the relative PPP show?

1) r = r* + [(ε* - ε) / ε]

can substitute in i and e (nominal variables)

P = e * P^f

ε = constant, ε = ε^e

It shows that π - π^f = [(e^e - e) / e]

What constitutes the current account? (3)

What equations does the Mundell-fleming model focus on? (2)

1) Imports/exports of goods

2) Transfer payments

3) Investment income

1) Internal balance: IS and LM at equilibrium

2) External balance: BP at target level (equal to UIP)

In terms of the Mundell-Fleming model...

In which price model (flexible/fixed) is fiscal policy ineffective?

In which price model (flexible/fixed) is monetary policy ineffective?

When the real interest rate is higher then normal, what happens in a flexible price model?

When the real interest rate is higher then normal, what happens in a fixed price model?

Flexible prices, the curve just bounces back due to changes in net exports and exchange rates

Fixed prices, the curve just bounces back due to the government buying/selling currency

Our currency appreciates, net exports decrease and IS shifts left.

People want to buy Canadian assets, the government buys euros so that the demand goes down and LM shifts right.

In terms of the Mundell-Fleming model...

What happens during the LR for a flexible price model when there is a monetary contraction.

Similarly, what happens in a fixed price model during a fiscal contraction?

Our expected exchange rate adjusts and prices force the equilibrium back to where it was before contraction happen.

The UIP curve shifts 3 times in the process.

Prices fall causing IS and LM to shift back to the original point where we started. UIP does not shift.

In terms of the Mundell-Fleming model...

What happens when our currency is de-valued? SR and LR

What happens during a balance of payments crisis?

SR: IS and LM shifts (ΔY > 0 and Δr = 0) -> Y increases

LR: P falls and we adjust to original point

UIP and LM shift resulting in r to increase and Y to decrease