ECON102 Final EXAM AID Tutor: Ming Zhou

1. ECON102 Final EXAM AIDTutor: Ming Zhou

2. Agenda Chapter 11 - Money Growth and Inflation Chapter 12 - Open Economics: Basic Concepts Chapter 14 - Aggregate Demand and Aggregate Supply Chapter 15 - Monetary and Fiscal Policies Q&A regarding previous chapters!

3. Chapter 11 Money Growth and Inflation

4. Value of Money Let P = the price level (CPI or GDP deflator) 1/P = the value of $1 in terms of goods Ex. If the goods basket contains 10 cups of Tim Horton’s • If P = $5, value of $1 is 2 cups of Tim Horton’s • If P = $10, value of $1 is 1 cup of Tim Horton’s *As prices increase, value of money decreases

5. Money Supply and Money Demand MS is controlled by the Bank of Canada - vertical (unaffected by P) MD is determined by various factors that affect how much money people want to hold (interest rate, price levels) - downward sloping Money Equilibrium when MS = MD

6. Quantity Theory of Money • Explains long-run price level and inflation rate • Quantity of money determines value of money • MS increases creates increase in demand for g&s • Supply for g&s remains constant, P increases • Value of money decreases and new equilibrium is reached

7. Classical Dichotomy • Separation of real and nominal variables Real variables – measured in terms of output (relative price, real wage) Nominal variables – measured in terms of $ (nominal price, nominal wage) Money Neutrality - Monetary shifts affect nominal variables but not real variables

8. Velocity of Money Velocity (V) = Nominal GDP (P x Y) Money Supply (M) • Average number of transactions a dollar goes through *Fairly stable in the long run

9. Quantity Equation M x V = P x Y • V is assumed to be constant • Change in M does not affect Y (money neutrality) • P changes in proportion to change in M

10. Practice Problem One good: Rebecca Black CDs. The economy currently produces 100 CDs. V is constant. In 2011, MS = $100, P = $10/CD. a. What is the nominal GDP and velocity in 2011? For 2012, the BoC increases MS by 100%, to $200. b. What is the 2012 values of nominal GDP and P? What is the inflation rate for 2011-2012? c. Suppose tech. progress causes Y to increase to 150 in 2012. What is the 2011-2012 inflation rate? 10

11. Fisher Effect Nominal IR = Real IR + Inflation Rate Real IR is unaffected by inflation -> Nominal IR adjusts directly with inflation rate *Increase in MS leads to increase in Nominal IR

12. Inflation Tax • Inflation caused by the government printing more money (increase in MS) • Affects the holding of money (nominal IR), not wealth (real IR) After-tax Real IR = Nominal IR(1 – tax rate) - Inflation • Higher tax lowers real IR

13. Practice Problem You deposit $100 in the bank for one year. Case 1: inflation = 0%, nom. interest rate = 10% Case 2: inflation = 5%, nom. interest rate = 15% a.How much does the actual value of the deposit grow in each case? Assume the tax rate is 10%. b.How much taxes are you paying in each case? c.Calculate the after-tax real interest rate for both cases.

14. Cost of Inflation • Inflation fallacy – belief that inflation lowers real income (prices increase, but nominal wage increases as well) • Shoeleather cost – cost of using the bank more frequently (time, transaction fee) • Menu cost – cost of changing prices (menus, price tags, etc.)

15. Cost of Inflation • Misallocation of resources from relative-price variability – relative prices vary due to time lag in price changes • Confusion & inconvenience – complicates long-term planning due to change in unit of account • Tax distortions – paying more taxes at the same real income

16. Cost of Inflation Arbitrary Redistributions of Wealth • Nominal IR is fixed by contract If actual inflation > estimated inflation: • Real IR is less, borrowers are better off, lenders are worse off If actual inflation < estimated inflation: • Real IR is more, borrowers are worse off, lenders are better off

17. Chapter 12 Open Economy Macroeconomics: Basic Concepts

18. Flow of Goods & Services Net Exports (NX) = Exports – Imports Exports – produced domestically, sold abroad Imports – produced abroad, sold domestically Trade Deficit - Imports > Exports Trade Surplus - Exports > Imports Balanced Trade – Imports = Exports

19. Flow of Financial Capital Net Capital Outflow (NCO) = Domestic purchase of foreign assets – Foreign purchase of domestic assets Foreign Direct Investment (capital) Foreign Portfolio Investment (loanable funds) Capital Outflow – NCO > 0 Capital Inflow – NCO < 0

20. International Flow of G&Sand Capital S = I + NX since S = Y – C – G S = I + NCO since NX = NCO • If S > I, then NCO > 0, the excess loanable funds flow abroad • When S < I, NCO< 0, some of the country’s investments are financed by foreigners

21. Nominal Exchange Rate Nominal Exchange Rate • Rate of trading the currency of one country for the currency of another Appreciation – increase in value of currency (can buy more foreign currency) Depreciation – decrease in value of currency (can buy less foreign currency)

22. Real Exchange Rate Nominal e x Domestic P Foreign P* Real Exchange Rate • Rate of trading the g&s of one country for the g&s of another Real e =

23. Purchasing-Power Parity • Real exchange rate should be 1 • Nominal exchange rate adjusts based on a country’s inflation rate • Law of one price • A good should be sold at the same price in all markets in order to avoid arbitrage Nominal e x Domestic P = Foreign P*

24. Purchasing-Power Parity Foreign P* Domestic P Nominal e = • Inflation on P* > inflation on P, nominal e increases, dollar appreciates • Inflation on P > inflation on P*, nominal e decreases, dollar depreciates

25. Chapter 14 Aggregate Demand and Aggregate Supply

26. Economic Fluctuations • Irregular and unpredictable due to the business cycle • Most macroeconomic variables fluctuate together, except price level (output, income, profit) • Unemployment and output are inversely related

27. Aggregate Demand Y = C + I + G + NX • Represents the total amount of purchases planned by each group of spenders • Downward sloping shows an inverse relationship between P and Y

28. Downward Sloping AD • Wealth Effect (P and C) • Purchasing power increases when prices decrease (consumption will go up) • Interest Rate Effect (P and I) • Lower interest rates promote investment spending • Exchange-rate Effect (P and NX) • Lower price levels make Canadian goods relatively cheaper

29. Aggregate Supply Long-Run AS • Vertical • Affected by factors of production, not P • Y is equal to potential output Short-Run AS • Upward sloping • Increase in P causes increase in G&S supplied

30. Upward Sloping AS • Sticky-Wage Theory • Nominal wages are slow to adjust, which affects employment and output • Sticky-Price Theory • Prices for some goods do not change immediately, affecting their sales • Misperceptions Theory • Firms are unsure whether it is an overall price level increase, or market-related

31. Upward Sloping AS Short run output is equal to the long run output adjusted for the difference between the actual and expected price levels *a is a number that represents the output’s sensitivity to price level changes

32. Shifts in AS • In the long run, expectedP = P • Change in factors of production • If expected P changes in the short run • Increases, then output decreases • Decreases, then output increases • The greater the difference in price expectation, the greater short run output differs from long run output

33. Economic Fluctuations • Contraction in AD • Leftward shift of AD • Short run recession • No change in output, lower P for long run • Adverse shift in AS • Leftward shift of AS • Short run stagflation (inflation + recession) • No change in output, higher P for long run

34. Chapter 15 The Influence of Monetary and Fiscal Policy on Aggregate Demand

35. Theory of Liquidity Preference r (interest rate), is the opportunity cost of holding money in liquid form • If r increases, then the opportunity cost for holding money increases, quantity of money demanded decreases (vice versa) *No inflation in short-run due to sticky prices At higher P, MD and IR increases, quantity of g&s demanded falls due to lower investment

36. Monetary Policy Closed Economy – Increase in MS increases AD by decreasing interest rate Open Economy: Flexible Exchange Rate -Increase in MS eventually decreases exchange rate and shifts AD right  Fixed Exchange Rate -Exchange rate must be held constant by decreasing MS 

37. Fiscal Policy • Change in government spending/taxation Expansionary – increase in G and/or decrease in T to shift AD right Contractionary – decrease in G and/or increase in T to shift AD left • Multiplier Effect • Crowding-Out Effect

38. Multiplier Effect Increase in C caused by an increase in income from G Marginal Propensity to Consume (MPC) C / Y Closed-economy Multiplier = 1 / (1-MPC) Marginal Propensity to Import (MPI) I / Y Open-economy Multiplier = 1 / (1-MPC+MPI)

39. Crowding-Out Effect Shift in AD increases the interest rate, which decreases Investment *Opposite direction of multiplier effect Y can be greater or less than G depending on the effect of multiplier effect and crowding-out effect

40. Open Economy Considerations *Domestic interest rate = World interest rate due to perfect capital mobility Flexible Exchange Rate - AD shifts right from government spending, but shifts left from lower net exports  Fixed Exchange Rate -MS must shifts right to keep exchange rate constant, cancels crowding out 

41. Automatic Stabilizers • The Tax System • Less taxes are collected during a recession and transfer payments increase, C increases • Government Spending • Welfare payments, EI benefits, and etc. naturally increase using recession, G increases • Flexible Exchange Rate • When exports go down from one country, exchange rate goes down, NX increases

42. GOOD LUCK ON YOUR FINALS! 