Professor: Mokhles, HOSSAIN Weiting Xu | York University

Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

Chapter: 1 Purpose: Readings Date: Tues. January 8
th
, 2013
WHAT IS ECONOMICS?
Definition of Economics
Scarcity: inability to get everything we want (therefore we must make choices)
- What society can get is limited by productive resources available from nature, human labour and tools/equipment
- My choices must be consistent with choices of others (e.g. if I want to buy an iPad, someone must sell it)
incentives reconcile choices
Incentive: reward that encourages an action or penalty that discourages one (e.g. ssPrice)

Economics: social science that studies choices that individuals, businesses, governments, and entire societies make as
they cope with scarcity and the incentives that influence and reconcile those choi ces
Microeconomics: study of choices that individuals and businesses make, the way these choices interact in markets,
and the influence of governments.
Macroeconomics: study of performance of national economy and global economy.

Two Big Economic Questions
1. How do choices end up determining WHAT, HOW, and FOR WHOM goods and services are produced?
2. Can the choices that people make in pursuit of their own self-interest also promote broader social interest?

What, How, and For Whom?
- Goods and Services: objects that people value and produce to satisfy human wants.
Goods physical objects (e.g. cellphones or cars) Services tasks performed for people (auto-repair)

WHAT What we produce varies across countries and changes over periods of time.
- So what determines patterns of production? How do we make choices on QTY? etc.
HOW Factors of Production: what goods and services are produced of
Land Natural resource (so is minerals, oil, gas, coal, water, air, fish, etc.)
- Land and water = renewable
- Energy resources = non-renewable
Labour Time and effort people devote to producing goods and services
- Includes both physical and mental efforts put into work
- Quality of labour depends on human capital
Human Capital: knowledge and skill that people obtain from education,
training, and work experience
Capital Physical Capital: Tools, instruments, machines, buildings, and etc. used to
produce goods and services
- Financial capital: money, stocks, bonds; used to borrow funds in order
to buy physical capital
Entrepreneurship Human resource that organizes labour, land, and capital
FOR WHOM Dependent on the incomes that people earn
- Land earns rent, labour earns wages, capital earns interest, entrepreneurship earns profit
- The disparity of incomes between rich and poor is insanely large
Example: women and minorities earn less than white males; but why?

Can the Pursuit of Self-Interest Promote the Social Interest?

Self-Interest If you think choice is best one available for you
e.g. Im hungry so I order pizza (Im doing it for my benefit) but the delivery guy does it for an income
and is just hoping for a good tip (not for my benefit)
Social Interest If it leads to an outcome that is best for society as a whole
Efficiency Achieved when available resources are used to produce goods and services at
lowest possible cost and quantity that gives greatest possible value/benefit
Equity Fairness.

The Big Question : can choices made in pursuit of self-interest promote social-interest too?
- e.g. Can trading in free markets or international cooperation achieve social interest?
Globalization Expansion of international trade, borrowing and lending, and investment
e.g. people working in third world countries for Nike to make shoes
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

- Self: I get lower cost shoes, how about for workers?; Is it of Social-interest?
The information-age
economy
Information revolution
e.g. Windows, Apple, and Intel executives benefited a lot but so have I (internet, cellphones,
laptops, etc.) but would social interest been better served if these firms had more
competition?
Climate change Huge political issue
e.g. when I make decision to use electricity and gasoline, I contribute to carbon emissions.
Not everyone will make decisions to contribute to the social interest (welfare) of reducing
Earths carbon-dioxide accumulation
Economic instability Great Moderation
e.g. banks were borrowing and lending way too much that they had to get bailouts loans from
governments and central banks. Similarly, GM received govt bailouts but did it serve social
interest?

The Economic Way of Thinking
A Choice is a Tradeoff Tradeoff: an exchange giving up one thing to get something else
- This is because we are given alternatives and we cant choose both
Making a Rational Choice Rational Choice: one that compares costs and benefits and achieves the greatest
benefit over cost for person making choice
- Provides answer to What goods and services will be produced and in what
quantities? well, obviously its those that people rationally choose to buy!
Benefit: What you gain Benefits: gain or pleasure that it brings and determined by Preferences: what a
person likes and dislikes and intensity of those feelings
- Economist will measure benefit as the most that a person is willing to give up
to get something else
Cost: What you must give up Opportunity cost: highest-valued alternative that must be given up to get it
- Most situations dont involve all or nothing costs
How Much? Choosing at the
Margin
Marginal Benefit: benefit that arises from an increase in an activity
Marginal Cost: opportunity cost of an increase in an activity
- If MB > MC, it is good and you would choose that
Choices Respond to
Incentives
Everyone will pursue their self-interest (not necessarily selfish actions)
e.g. macro teacher gives us problem set to solve and tells us it will be on the test; I
will want to solve these questions to prepare for test; lots of MB!
e.g. math teacher gives us problem set to solve but it wont be on test. I will not want
to solve it because it offers little marginal benefit

Economics as Social Science and Policy Tool
Positive Statements Normative Statements
What is What is ought to be
Many questions arise. (e.g. are computers cheaper because people are buying them in greater quantities? Or are people
buying computers in greater quantities because they are getting cheaper? In order to test this, we use economic models!
Economic Model: description of some aspect of the economic world that includes only those features that are needed for
the purpose at hand

Chapter: 2 Purpose: Readings Date:








Chapter: 3 Purpose: Readings Date:



Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)





Chapter: 20 Purpose: Readings Date: January 9
th
, 2013
MEASURING GDP AND ECONOMIC GROWTH

Gross Domestic Product : market value of final G/S produced within a country in a given time period (4)
Market Value - Total production is calculated by valuing items at their market values (price at which
items are traded in markets)
Final Goods and
Services
- GDP is calculated by valuing final G/S produced
Final G/S: item that is bought by its final (end) user during specified time period
Intermediate G/S: item that is produced by one firm, bought by another firm, and used as
a component of final G/S
- Adding value of intermediate G/S produced to value of final G/S would be double
counting (adding it more than once)
- Some items are neither final goods nor intermediate goods and are not part of GDP
(e.g. financial assets, stocks/bonds)
Secondhand good: part of GDP in year in which it was produced, but not in GDP this year
Produced Within a
Country
- Only G/S produced within a country count as part of the countrys GDP
In a Given Time Period - GDP measures value of production in a given time period (e.g. Quarterly GDP data:
quarter of a year. Annual GDP data: yearly)
- GDP also measures total income and total expenditure
- Standard of living rises when our incomes rise
- Rising incomes and rising value of production go together (increasing productivity)

GDP and the Circular Flow of expenditure and income
Households and Firms - Households make Consumption Expenditures: total payment for G/S
- Firms buy services of labour, capital, and land in factor markets
- Firms pay income to households, wages for labour services, interest for use of
capital, and rent for use of land; entrepreneurship receives profit
Retained earnings: profits that are not distributed to households
Aggregate income: received by households, including retained earnings
- Firms make investments
Investment: purchase of new plant, equipment, and buildings and the additions to
inventories
Governments - Govts buy G/S from firms
Govt Expenditure: their expenditure on G/S
- Govt finance expenditure with taxes.
- Financial transfers (e.g. taxes are not part of circular flow of expenditure and
income
- Pays subsidies to firms, unemployment benefits, social security benefits
Rest of the World Exports: G/S sold to the rest of the world
Imports: G/S bought from the rest of the world
- Rest of the world buys net exports (value of X-M); net flow is dependent on the (-)
or (+) of that value
GDP Equals Expenditure
Equals Income
- GDP measured by;

1
total expenditure on G/S or by
2
total income earned producing G/S
Aggregate Expenditure (total expenditure): equals consumption expenditure
plus investment plus govt expenditure plus net exports
(Y = C + I + G + X M)
- Aggregate income = total amount paid for services of factors of production used to
produce final G/S (wages, interest, rent, profit)

[GDP = Aggregate expenditure = Aggregate income]

Why is Domestic Product Gross?
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

Depreciation: decrease in value of firms capital that result from wear and tear and obsolescence.
Gross investment: total amount spent both buying new capital and replacing depreciated capital
Net investment: amount by which value of capital increases

[Net investment = Gross investment Depreciation]

Gross investment: one of the expenditures included in expenditure approach to measuring GDP
Gross profit: firms profit before subtracting depreciation, included in income approach

Measuring Canadas GDP
Expenditure Approach Income Approach
- Measures GDP as the sum of:
Consumption
expenditure (C)
Expenditure by Canadian
households on G/S produced in
Canada and in rest of the world
- Includes consumer
durable goods
(computers/ovens) but not
purchases of new homes
Investment (I) Expenditure on capital equipment
and buildings by firms and
additions to business inventories
- Includes purchases of
new homes by
households
Govt expenditure
on G/S (G)
Expenditure by all levels of govt
on G/S
- Includes national defence
and garbage collection but
not transfer payments
(unemployment benefits)
[overlap]
Net exports of
goods and
services (X-M)
Value of exports minutes value of
imports
- Includes DVD players
made in China but sold
here

- Measures sum of incomes that firms pay
households for factors of production hired
Wages, salaries,
supplementary
labour income
Payment for labour services
- Includes gross wages plus
benefits (pension
contributions)
Other Factor
incomes
A mixture of interest, rent, and
profit, and some labour income from
self-employment
- Corporate profits, farmers
income. etc.
Indirect Tax: tax paid by consumers when G/S are
bought; makes market price exceed factor cost
Direct Tax: tax on income
Subsidy: payment by govt to a producer. Makes factor
cost exceed market price

Net domestic income at market prices: make factor cost to
market price by adding indirect taxes and subtract
subsidies
- Total expenditure is a gross number because it
includes gross investment
- Net domestic income at MP is a net income
measure bc corporate profits are measured after
deducting depreciation
- - to get from net income to gross income, we add
depreciation

Statistical Discrepancy: gap between expenditure
approach and income approach (small #)
(GDP expenditure total GDP income total)

Nominal GDP Real GDP
Value of final G/S produced in a given year when valued
at prices of that year.
- More precise name for GDP
Value of final G/S produced in a given year when valued
at prices of a reference base year
- Reveals change in production
Calculating Real GDP:

USES AND LIMITATIONS OF REAL GDP
Economists use estimates of real GDP for two main purposes:
Compare standard of
living over time
The Standard of Living Over Time
Real GDP per Person: real GDP divided by population; tells us value of G/S avrg
person can enjoy. By using Real GDP, we avoid influence of rising prices and rising
cost of living
Long-Term
Trend

- Good because it expresses it as a ratio of some reference year
Growth of potential GDP: maximum level of real GDP that can be
produced while avoiding shortages of L
and
,C
apital
,L
abour
,E
ntreprenural ability
that
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)





Graph p.
474
would bring rising inflation
- It does not grow at a constant pace
Fluctuations of Real GDP: sometimes real GDP per person will shrink
Productivity
Growth
Slowdown
Graph p.
475
Lucas wedge (Nobel Laureate Robert E. Lucas Jr): dollar value of
accumulated gap b/w what real GDP per person would have been if growth
rate of 1960s had persisted and what real GDP per person turned out to be
Real GDP
Fluctuations
Business
Cycle




Graph
p.475
- B.C. is not as predictable as the moon but it has two phases
1. Expansion: period during which real GDP increases
(Early stage: real GDP =potential GDP
Later stage: real exceeds potential)
2. Recession: real GDP decreases (growth rate is negative for at least
2 successive quarters)
Turn points:
1. Peak: highest level that real GDP has attained up to that point
2. Trough: real GDP reaches temporary low point and next expansion
begins


Compare standard of
living across
countries
1. Real GDP of one country must be converted into same currency units as real GDP of
other country
2. G/S in both countries must be valued at same prices

Example of China compared to U.S
China and
the US in
U.S. $
2010
Real GDP per person in US = $43,800
China = 23,400 yuan = US$2,850
- Market exchange rate was 8.2 per US$1
- Real GDP/person in US was 15 times that in China
China and
the United
States at
PPP
- Estimation of Chinas real GDP/person by assessing Chinas
production on same terms as U.S. production
- Purchasing Power Parity (PPP): same prices for both countries
2010
Chicago Big Mac = $3.75
Shanghai Big Mac = 13.25 yuan = US$1.62
- In terms of Chinas real GDP, a Big Mac gets less than half the weight
that it gets in U.S. real GDP
- U.S was 6.5 times that of China (not 15)

Limitations of Real GDP (7)
- These are not part of GDP but influence standard of living
Household Production Production that takes place at home (e.g. preparing meals, cleaning, changing light
bulb, cutting grass, etc.)
- GDP understates total production and overestimates growth rate of total production
- Growth rate of market production (in GDP) is a replacement for home production
- Increase in GDP arises from decrease in home production
- Real GDP grows more rapidly than does REAL GDP + home production
Underground economy
activity
Part of the economy that is purposely hidden from the view of the govt to avoid taxes
and regulations or bc G/S being produced are illegal
- Omitted from GDP because it is unprotected
(e.g. illegal drugs, labour less than minimum wage, jobs done for cash)
(e.g. tips earned by cab drivers, hairdressers, hotel/restaurant workers)
- Estimate of Canadas underground accounts for 5-15% of GDP

Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

- Production shifts from underground to rest of the economy (or vice versa)
-
Health and life
expectancy
- Life expectancy has lengthened since WWII
- When taking negative influences (e.g. drug abuse), real GDP growth overstates
improvements in standard of living
Leisure time - Economic good that adds to our economic well-being and standard of living
- More we have of leisure time, obviously, the better we are!
- Leisure time must be at least as valuable as wage workedotherwise, we would all
work!
- Improvements in economic well-being are not reflect in real GDP
Security - We value security thats in jobs, local police services, and national defence
Environmental quality - Although resources used to protect environment is valued part of GDP, pollution of
atmosphere, deteriorating air we breathe is not counted as a (-) part of GDP
- Economic activity influences quality of environment
Political freedom and
social justice
- Value political freedoms provided by Canadian Constitution, social justice (equality),
and social security safety nets (protection from misfortunes)
- A country might have very large real GDP/person but limited political freedom and
social justice!

The Bottom Line we get the wrong message about level and growth in economic well-being and standard of living by
only looking at level and growth of real GDP
- A broader indicator of economic well-being can be expressed by the United Nations measure of Human
Development Index (HDI)
- Despite all alternatives, real GDP/person remains most widely used indicator of economic well -being and
standard of living

Real GDP Forecasts in the Uncertain Economy of 2011
ARE WE READY FOR THAT DOUBLE DIP?

2008 United States went into a recession
9 months later (Fall of 2008), Canada followed suit
Within less than 10 months, Canada recovered and was on the way to growth/expansion
It took the US 18 months to get back into stable conditions

Mid-2011, Canadian economy was performing well but risk of a double-dip recession in us hung over Canada and the
world
- Drop of 5% in US demand could translate into 1% hit to real growth here; Canada is dependent on the US like
many countries are! (1/5 of Canadas production is sold in the US)


Chapter: 21 Purpose: Readings Date: January 21
st
, 2013
MONITORING JOBS AND INFLATION
Employment and Unemployment
- During the Great Depression, 1/5 was unemployed!

Why Unemployment is a Problem? (2)
Lost Incomes and
Production
- Unemployment benefits create a safety net but dont full replace lost earnings!
Lost Human Capital - Damages persons job prospects by destroying their ability to move forth with their
learning (e.g. new MBA graduates are better off than a manager who has been
unemployed for the last 6 months! Manager lost valuable knowledge)

Labour Force Survey
- Asks about age and job market status of members of each household
- Divides individuals intoworking-age and too young/institutionalized (unable to work)
Working Age population: total number of people 15+
(1) Labour Force: sum of employed and unemployed (2) Non-Labour Force
(a) part-time or (b) full time
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

(i) voluntary part-time or (ii) involuntary part-time[want full-time]
- To be counted as unemployed, an individual must be 1/3:
(1) without work but has made specific efforts to find a job within previous four weeks
(2) laid off from a job and waiting to be called back to work
(3) waiting to start a new job within four weeks

Labour Market Indicators (4)
The Unemployment Rate % of people in labour force who are unemployed
Unemployment Rate =



Labour Force = # of people employed + # of people unemployed
The Involuntary Part-Time Rate % of people in labour force who are part-time workers but want full-time
work
Involuntary Part-time Rate =



Labour Force Participation Rate % of working-age popn who are members of labour force
Labour Force Participation Rate =




The Employment-to-Population Ratio % of people working age who have jobs
Employt to Popn =



- fluctuates with business cycle; falls in recession and rises in expansion

Other Definitions of Unemployment
- Unemployment doesnt count underutilized labour of people with PT who wants FT jobs
Marginally Attached Worker: person who currently is neither working nor looking for work but indicated he/she
wants a job and is available and has looked for work sometime in the recent past
- May become a Discouraged Worker: marginally attached worker who has stopped looking for a job bc of
repeated failure to find one
- Measure of unemployment does not count MAWs because they havent made efforts to find a job within the last
FOUR weeks.

Most Costly Unemployment
Is LONG TERM unemployment (lasting longer than 14 weeks)
- Short term (lasts for 1-13 weeks)

Unemployment and Full Employment (4)
Frictional
Unemployment
from people entering and leaving the labour force and ongoing creation/destruction of jobs; its
healthy and normal in a growing economy
- There are new businesses every day and they need time to look for employees whereas
others are going out of business
Structural
Unemployment
arise when changes in technology or international competition change skills needed to perform
jobs or change locations of jobs
- Lasts longer than frictional bc workers must retrain and relocate; painful!
Cyclical
Unemployment
higher than normal unempt at business cycle trough and lower than normal unempt at business
cycle peak
- e.g. worker getting laid off in recession but rehired during expansion stage
Natural
Unemployment
arise from frictions and structural change when there is no cyclical unemployment
N.U. Rate: % of labour force in natural unemployment
Age distribution of
population
Young popn lots of new job seekers, high frictional unempt
Aging pop fewer job seekers, low frictional unempt
Scale of structural
change
Technological upheaval lots of lost jobs, man-skill lost
Same then nothing changes, most likely
Real wage rate

(level of wage rate)
Minimum wage price flooring set by govt
Efficiency wage set above market wage to attract most productive
workers (no shirking), discourage them from quitting
Unemployment
benefits
- lowers opport. Cost of job search
Extending unempt benefits increase natural unempt rate

Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

Real GDP and Unemployment Over the Cycle
- quantity of real GDP at full employment is at POTENTIAL GDP
- Output Gap: difference between real and potential GDP; as it changes over B.C., unempt rate changes around
natural unempt rate
- @ Full Empt
Unempt rate = natural unempt rate & real GDP = potential GDP output gap = 0
- @ Unempt rate < natural Unempt rate
Real GDP > potential GDP output gap is (+)
- @ Unempt rate > natural unempt rate
Real GDP < potential GDP output gap is (-)

The Price Level, Inflation, and Deflation
- Measure annual % change of price level and find money values and real values of economic variables
Price Level: average level of prices and value of money
Inflation: persistently rising price level
Deflation: persistently falling price level

Why inflation and deflation are problems (the unpredicted situations)
Redistributes Income Inflation raises price but not wages; employers are better off due to higher profits but
employees wages cant buy as much now
Deflation wages dont full but price falls; workers fixed wages buy more than they
bargained for but employees receive lower profits
Redistribute Wealth Inflation - $ borrowed buys less than originally loaned; interest paid on loan doesnt
compensate lender
Deflation $ borrow repays buys more than money originally loaned
Lowers Real GDP and
Employment
Inflation raises firms profits brings rise in investment and boom in production and empt;
- real GDP > potential GDP, unempt rate falls below natural rate;
- only TEMPORARY because investment dries up, spending falls,
real < GDP, unempt rate rises
Deflation those in debt will cut their spending; fall in total spending brings recession and
rising unempt
Diverts Resources From
Production
- wasting of resources is a cost of inflation
- it is more profitable to forecast their rates than to invent new products
Hyperinflation: inflation rate of 50%+/month grinds economy to half and causes society
to collapse

The Consumer Price Index (CPI): measurement of price level by measuring avrg prices paid by urban consumers for
fixed basket of consumer G/S

Reading the CPI Numbers
- reference base period = 100 (in 2002)
e.g. in 2011 CPI = 120 therefore, it is 20% higher than 2002

Constructing the CPI
1. Selecting CPI Basket
2. Monthly Price Survey
3. Calculating CPI
(1) find cost of CPI basket at base-period prices
(2) find cost of CPI basket at current-period prices
(3) find CPI for base period and current period

CPI =




Measuring Inflation Rate
- Measures annual % change in CPI
Inflation Rate =




Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

Distinguishing High Inflation from a High Price Level
(a) Price level rises rapidly, inflation rate = HIGH
(b) Price level rises slowly, inflation rate = LOW
(c) Price level falls, inflation rate would be (-) = DEFLATION
- Changes in CPI overstate inflation rate!!!!!!!

The Biased CPI its main sources of bia
New Goods Bias - We would have to compare new items with old items but they dont have the same
value! Gives upward bias into CPI and inflation rate
e.g. type writer versus PC today
Quality Change Bias - Each year, items are better QUALITY but not exactly inflation! CPI counts entire
$ rise as inflation; overstates
e.g. newer generations of iPods
Commodity Substitution
Bias
- Change in relative $ lead consumers to change items they buy; although it might
be the same but CPI ignores substitution and says $ increased
e.g. chicken $ unchanged so people buy more chicken than beef bc beef $ increased
Outlet Substitution Bias - When theres higher $, people will want to go to discount stores more rather than
convenience stores; CPI does not monitor outlet substitutions

The Magnitude of the Bias James Rossiter said its about 0.6% per year

Some Consequences of the Bias
- Distorts contracts and increases govt outlays

Alternative Price Indexes
GDP Deflator index of prices of all items included in GDP and is ratio of nominal GDP to real GDP
GDP Deflator =



- Real GDP includes all the investment, govt expenditure, net exports, etc.
- Weights attached to each item are components of GDP in both current and preceding
year
Chained Price Index
for Consumption
index of prices of all items included in consumption expenditure in GDP and is ratio of
nominal consumption expenditure to real consumption expenditure
CPIC =



- Overcomes source of bias because it uses current and previous period quantities
rather than fixed quantities from earlier period (has sub effect & new goods)

Core Inflation
Core Inflation Rate: inflation rate excluding volatile elements (e.g. food and fuel)
- It gives misleading view of true underlying inflation rate: bias because food and fuel could be rising!

Real Variables in Macroeconomics
- Distinguish between Real from nominal we want to see what is really happening to variables that influence
standard living

Jobs Growth Labs Recovery
Can Canada Keep its Jobs Pace as U.S. Stumbles?

- 2011: Unemployment in US increased to 9.2%
- Canadas unemployment rate was steady at 7.4%
- Canadian jobs were mostly PT; our success is limited by U.S.s weak economy
- OUR goods: Timber, oil, metals, other commodities
Chapter: 22 Purpose: Readings Date: Friday, January 18
th
, 2013
ECONOMIC GROWTH
The Basis of Economic Growth
- Sustained expansion of production possibilities measured as the increase in real GDP over a given period
- Slow economic growth or absence of growth can hat a nation to devastating poverty (e.g. Sierra Leone)
Calculating Growth Economic Growth Rate: annual % change of real GDP
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

Rates
Real GDP growth rate =



- Growth rate of real GDP tells us how rapidly total economy is expanding
- It measures usefulness of potential changes in balance of power among nations but
not changes in standard living
Real GDP per person (per capital RGDP): real GDP divided by the population
(all we do is replace whats in current formula with RGDP per person)

Example:
RGDP of current year = $1,650 billion RGDP of previous year = $1,500 billion
RGDP per person =



= $54,455
RGDP per person =



= $50,000
Real GDP growth rate =

= 8.9%
- Real GDP per person grows only if real GDP grows FASTER than popn grows
- If growth of popn exceeds growth of real GDP; real GDP per person falls
Magic of Sustained
Growth
Compound Interest
e.g. you put $100 principle and earn 5% interest in first year. This means you get
$105 at end of year 1. Second year, you earn interest on the principle AND previous
interestyou want to get to $200
But after how many years?
Rule of 70: formula which states number of years it takes for level of any variable to
double is approx. 70 divided by annual % growth rate of variable
(e.g. for $100 to get to $200, 70 5 = 14 years)
Applying Rule of 70
p.519, Figure 22.1
Putting in perspective CHINA and their Rule of 70 usage.


Economic Growth Trends
Growth in Canadian Economy

p.520, Figure 22.2
- During the 84 years from 1926 to 2010, real GDP per person in
Canada grew by 2%/year, on avrg.
- Growth was most rapid during 1960s and slowest during 1980s
Real GDP Growth in World Economy




p.521, Figure 22.3
- Canada had the second-highest real GDP per person, ahead of
Japan,
1
France,
2
Germany,
3
Italy, and the
4
UK (Europe Big 4)
- Japan was really good, caught up to Canada but then they
stagnated
- Some countries cannot catch up to Canada; drifting farther behind
- Labour productivity growth is key to rising living standards

How Potential GDP Grows
- Economic growth occurs when real GDP increases; it is a sustained, year-after-year increase in potential GDP

What determines Potential GDP? (2)
- Labour, capital, land, entrepreneurship produce real GDP, and the productivity of the factors of production
determines quantity of real GDP that can be produced
- Potential GDP is the level of real GDP when QTY of labour employed is the full-employment quantity
Aggregate Production Function - Production possibilities frontier: boundary between combo of goods and
services that can be produced and those that cannot be
e.g. more hours that are worked, less and less productive hours are used.
Each additional hour of leisure forgone, real GDP increases out by
successively smaller amount.
Aggregate Production Function: relationship that tells us how real GDP
changes as QTY of labour changes when all other influences on production
remain same
Aggregate Labour Market (3) - Pretending there is one large labour market that determines QTY of labour
employed and QTY of real GDP produced
Demand
for Labour
Relationship b/w QTY of labour demanded (hours of
labour demanded by all firms in economy in a given
period) and is dependent on real wage rate (QTY of G/S
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

that an hour of labour earns)
[


]
- Money wage rate: # of $ an hour of labour earns
- Real wage rate influences qty of labour demanded bc
what matters to firms is not number of dollars they pay,
but how much output they must sell to earn those dollars
Law of diminishing returns:
Qty of labour demanded Real wage rate


By successively small amounts
Firms will only hire more if RWR = fall in extra output
produced by that labour
Supply of
Labour
Relationship b/w QTY of labour supplied and RWR
Qty of labour supplied: # of hours all households in economy
plan to work during given period; RWR dependant
- RWR influences it bc its not how much is earned but
what they can actually buy with that $
- If one can earn more per hour, then obv. they will choose
to work longer hours
Labour
Market
Equilibrium
- $ of labour = RWR
- Forces of S/D in labour market is the same with G/S
- Shortage or surplus of labour brings only gradual change
in RWR
- During shortage of labour: RWR rises to eliminate it
- Neither: labour market is in EQ (full emplt)

Potential GDP - RGDP increases as qty of labour increases but at EQ of qty of labour (full
employment) it becomes PGDP

What Makes Potential GDP Grow?
Growth of
Supply of
Labour
- When S
L
grows, curve shifts rightward = qty of labour at given RWR increases
QTY of labour = # of workers avrg hours per worker
- QTY of labour changes as a result of:
1) Avrg hours per worker
2) Emplt to popn ratio
3) Working-age popn
In long run, working age popn grows at same rate as total popn

Effects of Population Growth
- Brings growth in S
L
Does not change D
L
nor production function
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

- PGDP increases when theres increased QTY of Labour
- Increase in popn increases the full-emplt QTY of labour, increases PGDP, and lowers RWR.
BUTdecreases PGDP per hour of labour (cause of diminishing returns)
Growth of
Labour
Productivity
Labour Productivity: QTY of real GDP produced by an hour of labour
Labour Productivity = RGDP / Aggregate Labour hours
- When productivity grows, RGDP per person grows = rising standard of living

Effects of an Increase in Labour Productivity
- When labour productivity increases, production possibilities expand
- If labour = more productive = increase in willingness for firms to pay higher
- Increase in labour produc. increases D
L
and it shifts rightward
- Aggregate labour hours increase as a CONSEQUENCE (not cause) of growth of PGDP

Why Labour Productivity Grows (3)
- Fundamental precondition for labour productivity growth is incentive system created by firms, markets, property
rights (Industrial Revolution, Britain, middle 1700s), and money
Physical Capital Growth - Amount of capital per worker increases = increase in labour productivity
- Production by hand may create beautiful products but large amounts of capital
per worker are much more productive
Human Capital Growth - Human capital: accumulated skills and knowledge of human beings; fundamental
source of labour productivity growth
- It grows when new discoveries are made and when people learn from past
- It would be so hard if way to do things were only in memorieshow would other
people know about it?!
- Sometimes physical capital stays constant, but repetitive work makes individuals
more productive because the more you do it, easier it becomes
e.g. education and training, job experience
Technological Advances - Technological change: Discovery and application of new technologies
- Things are more productive than they were before because we can use
technological aspects that didnt exist back then!

Growth Theories, Evidence, and Policies (3)
Classical Growth
Theory
View that growth of real GDP per person is temporary and that when it rises above
subsistence level, popn explosion eventually brings it back to subsistence level
- Adam Smith, Thomas Robert Malthus, David Ricardo proposed this theory (often called
Malthusian Theory; sparked Charles Darwins idea of natural selection)

Modern-Day Malthusians
- They believe that if popn growth rate is growing as rapidly as predicted, then there will
not be enough resources, real GDP per person will decline, and we will return to a
primitive standard of living
- Believe that global warming and climate change = RGDP will decrease
Neoclassical Growth
Theory
Proposition that real GDP per person grows because technological change induces
savings and investment that make capital per hour of labour grow
- Robert Solow (MIT, 1950s)

Neoclassical Theory of Popn Growth
- Occurred in 18
th
century Europe when birth rate fell due to opportunity cost for women
to have children (rise in wage)
- Technological advances bring higher incomes and health care to extend lives
- Income increase = birth rate and death rate decrease
- Contradicts the Classical Growth theory

Technological Change and Diminishing Returns
- Pace of technological change influences economic growth rate not vice versa
- Brings new profit opportunities, expanded businesses, investment/savings increase
- Believes that prosperity will last but growth will not last unless technology keeps
advancing (because of diminishing marginal returns)
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

- Capital falls = incentive to keep investing weakens = saving decreases = rate of capital
accumulation slows

Problem with Neoclassical Growth Theory
- RGDP growth rates and income levels per person around world will converge (growth
in countries is slow but others not so imminent)
- New growth theory overcomes shortcoming of neoclassical growth theory
New Growth Theory - RGDP per person grows because of the choices people make in the pursuit of profit
and growth will persist indefinitely
- Paul Romer (Stanford University, 1980s), based on Joseph Schumpeter (193/40s)
- Pace at which new discoveries are made is not determined by chance but depending
on people looking for new technology; how intensively the look is (incentives)
- No growth stopping mechanism

Key in growth theory:
1) Discoveries are a public capital good
Public Good: no one can be excluded from using It when one persons use does not
prevent others from using it (e.g. national defence)
2) Knowledge is capital that is not subject to diminishing marginal returns
- increase of it makes labour and machines more productive (e.g. biotech knowledge,
developing DNA)

Perpetual Motion Economy
- Our wants will always exceed ability to satisfy them
- It is a never ending cycle that just repeats itself (p.533, Figure 22.10)

New Growth Theory Malthusian Theory
- Popn growth is part of solution; people are ultimate economic resource
- Larger popn = more wants = greater scientific discovery and technological advance
- Popn growth generates faster labour productivity growth and rising RGDP per
person
- Resources are limited but human imagination and ability to increase productivity =
endless
- Popn growth is
the problem
- See end of
prosperity as we
know it today

Sorting Out Theories
Classical growth reminds us physical resources are limited and without advances = diminishing returns
Neoclassical growth says the same but due to diminishing returns to capital and reminds us we have to advance
in technology and accumulate human capital
New growth says capacity of human resources to innovate at pace offsets diminishing returns (most relatable but
not most correct)

The Empirical Evidence on Causes of Economic Growth (p.535, Table 22.1)
- Empirical Evidence data generated by history and natural experiments that it performs
- Political and economic systems are hard to change but market distortions, investment, openness to international
trade are features of nations economy that can be influenced by policy

Policies for Achieving Faster Growth (5)
Stimulate Saving - Saving finances investment so stimulating saving increases economic growth
- Tax incentives (e.g. Registered Retirement Savings Plans) can increase
saving
Stimulate Research and
Development
- Govt can direct public funds towards financing basic research
Improve Quality of Education - Free market produces too little education because it brings benefits beyond
those valued by people who receive education
- Basics give basic skills: language, math, science, etc.
- Can be stimulated and improved by using tax incentives to encourage
improved private provision
Provide International Aid to - Just because money is lent to another country for development does not
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

Developing Nations always spur development; sometimes it can even be a bad turn out
Encourage International Trade - Trade, not aid, stimulates economic growth
- Extracting available gains from specialization and trade
- Lowering trade barriers against developing nations
- WTOs efforts to achieve more open trade are resisted by richer nations


Chapter: 23 Purpose: Readings Date: Tuesday, January 29
th
, 2013
FINANCE, SAVING, AND INVESTMENT

Financial Institutions and Financial Markets
Finance and Money - Finance: activity of providing funds that finance expenditures on capital; how
households and firms obtain and use it, and how they cope with risks that arise
- Money: what we use to pay for goods and services and factors of production and to
make financial transactions
- Closely related but very different
Physical Capital and
Financial Capital
- Physical capital: tools, instruments, machines, buildings, and other items that have
been produced in past to be used today to produce G/S (e.g. raw materials,
semifinished goods)
Financial Capital: funds firms use to buy physical capital
- Aggregate production function, quantity of capital is fixed (i.e. increase in QTY of
capital increases production possibilities = shifts aggregate production function
upward)

Differences
Capital Investment
- Quantities of capital changes due to investment
and depreciation
- Increases QTY of capital
- Depreciation decreases capital
Gross Investment: total amount spent on new capital
Net investment: change in value of capital
[NI = gross investment depreciation]
Wealth Savings
Value of all things that people own; related to
what they earn but not same
- Income is amount received during a period =
supplied by resources owned
- Market value of assets rises = wealth Increase
(Capital gains versus Capital losses)
Amount of income that is not paid in taxes or
spend on consumption G/S
- Increases wealth
- Used to finance investments and
supplied/demanded through loan, bond, and stock
markets
National wealth = wealth at start of year plus savings during year = income (after-tax) consumption expenditure
- To make RGDP grow, saving and wealth must be transformed into investment and capital through the following

Financial Capital
Markets
Loan Markets - In order to finance for items firms/households/businesses want/need,
they need to make loans
- e.g. houses, automobiles, appliances, furnishings
Mortgage: legal contract that gives ownership of home to lender in event
that borrower fails to meet agreed loan payments (repayments and
interest)
Bond Markets - govts: all levels, raise finance by issuing bonds
Bond: promise to make specified payments on specified dates
Bond market: bonds issued by firms and govt are traded here
- Treasury Bills: govt of Canada issues the promise of repayment
(Longterm = higher $, Shorterm = lower $; FEDERAL = least default risk)
- Mortgage-backed security: entitles its holder to income from package
of mortgages (i.e. process of many lenders to borrowers to lenders)
- Bondholder does not own part of the firm that issued the bond
Stock Markets Stock: certificate of ownership and claim to firms profits
- Stock market: financial market in which shares of stocks of
corporations are traded (e.g. Toronto Stock Exchange, New York
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

Stock Exchange, London, Tokyo)

Financial Institutions (5)
Commercial Banks - Banks accept deposits; buys govt bonds and other securities to make loans
- Banks makes up 70% of total assets of Canadian financial services sector
Trust and Loan
Companies
- Like banks, largest are actually owned by banks
e.g. estates, trusts, pension plans
Credit Unions and
Caisses Populaires
- Banks that are owned and controlled by their depositors and borrowers
- Large in number but small in size (only within provincial boundaries)
Pension Funds - Receive pension contributions of firms and workers
- To buy diversified portfolio of bonds and stocks that they expect to make an income
that balances risk and return; to pay pension benefits
- Very large and play an active role in firms whose stock they hold
Insurance Companies - Enter into agreement with households/firms to provide compensation in case of
accidents, theft, fire, illness, and other misfortunes
- Receive premiums from customers and make payments against claims
- Corporate insures businesses when they cant pay their bonds, etc.

All financial institutions face these two problems
Insolvency Illiquidity
Net worth = market value of what it has lent market value of what is has borrowed

- (+) means its solvent, (-) means insolvent and must go out of
business and stock holders bears losses
Made long-term loans with borrowed
funds and is faced with a sudden
demand to repay more of what it has
borrowed than its available cash

Interest Rates and Asset Prices
- Financial assets stocks, bonds, short-term securities, and loans
- If asset price rise, while other things remain same, interest rate falls
- If asset price falls, while other things remain same, interest rate rises (harder to pay debts and net worth falls, insolvency)

Example Problem: What is the Return on Investment? It depends on how much you buy for.
Bond promise to pay holder $5/year forever
Buy bond for $50

Interest Rate = ($5 $50) x 100 = 10%
Price of bond increases to $200


Interest Rate = ($5 $200) x 100 = 2.5%

The Loanable Funds in Market
Loanable Funds Market: aggregate of all individual financial markets
Funds that Finance
Investment




p.549, Figure 23.3
Funds that finance investment
1) Household Saving
2) Govt budget surplus
3) Borrowing from rest of the world

Net taxes: taxes paid to govt cash transfers received from govt
Y = C + S + T

Remember
Y = C + I + G + X M I + G + X = M + S + T

Take away G and X from both sides
I = S + (T G) + (M X)

- This tells us that investment (I) is financed by household savings (S), govt budget
surplus (T G), and borrowing from rest of the world (M X)
- Govt budget surplus (T > G) contribute to finance investment but deficit (T < G)
competes with investment for funds
- Export less than import = use rest of world to finance some of our investment, but if
import is less = we lend, our saving finances investment in other countries
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Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

National Saving: private saving & govt saving (T G)

- When loanable funds market is at EQ, it is measured in REAL interest rate
The Real Interest Rate Nominal Interest Rate: # of dollars borrower pays and lender receives in interest in a
year expressed as % of # of dollars borrowed and lent

Real Interest Rate: nominal interest rate adjusted to remove effects of inflation on
buying power of money; pprox.. equal to nominal interest rate inflation rate
- real interest paid on borrowed funds = opp. Cost of borrowing
- real interest rate forgone = funds are used to buy consumption G/S or to invest in
new capital good = opp. Cost of not saving or not lending those funds

How does loanable funds market determine real interest rate? (3)
The Demand for
Loanable Funds
- Qty of loanable funds demanded is total qty of funds demanded to finance investment,
govt budget deficit, and international investment/lending during a given period

What determines investment and demand for loanable funds to finance?
1) The real interest rate
2) Expected profit
- firms would only invest in capital if they will earn profit

Higher RIR = Smaller quantity of loanable funds demanded
Lower RIR = Greater quantity of loanable funds demanded

Demand for Loanable Funds
Curve



LF = loanable funds

Changes in the Demand for
Loanable Funds
- When expected profit changes, demand of LF changes
- Expected profit rise @ expansion of BC, new
technological changes makes new products, growing
popn brings more demand for G/S, and fluctuates with
optimism and pessimism:
Animal Spirits John Maynard Keynes
Irrational exuberance Alan Greenspan
The Supply of
Loanable Funds
- Qty of loanable funds supplied is total funds available from private saving, govt budget
surplus, and international borrowing during given period

How to decide how much of income to save and supply in LF market?
1) Real interest rate
2) Disposable income
3) Expected future income
4) Wealth
5) Default risk

Higher RIR = Greater qty of LF supplied
Lower the RIR = Smaller qty of LF supplied

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Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

Supply for Loanable Funds
Curve

Changes in the Supply for
Loanable Funds
1. Disposable income: income earned net taxes
- greater disposable income = greater savings
2. Expected future income: higher houses expected
future income, smaller its saving today
3. Wealth: Higher households wealth, smaller its savings
4. Default risk: risk that loan will not be repaid
- great risk = higher IR needed to induce person to lend
= smaller supply of loanable funds
Shifts of Supply of Loanable
Funds Curve
- When any of the above 4 changes, supply curve shifts
e.g. increase of supply of loanable funds (increase savings)
1. Increase in disposable income
2. Decrease in expected future income
3. Decrease in wealth
4. Fall in default risk
Equilibrium in the
Loanable Funds
Market
- Basically, when supply and demand are equal
- Despite shortage or surplus at given periods, the curves are always trying to get to
equilibrium

Changes in Demand
and Supply
Increase in Demand - Shift rightwards of demand curve; with no change in SLF,
causes an EQ change of a higher RIR
- Borrowers compete for funds, IR rises and lenders
increase qty of funds supplied
Increase in Supply - Borrowers find bargains and lenders are accepting lower
interest rates (in turn, borrowers find investment projects
very profitable and increase qty of LF borrowed)
Long-Run Growth of
Demand and Supply
- In the long run, both curves trend upward at similar pace
- RIR has no trend, fluctuates around constant avrg level

Government in the Loanable Funds Market (2)
Government Budget Surplus - Increases supply of LF
- RIR falls decrease household saving decrease qty of private funds
supplied
- Lower RIR increases qty of loanable funds demanded & increase investment
Government Budget Deficit - Increases demand for loanable funds
- RIR rises increases household saving and increases qty of private funds
supplied
- Higher RIR decreases investment & qty of LF demanded by firms to finance
investment
Crowding-Out Effect Tendency for govt budget deficit to raise RIR and
decrease investment
- Crowds out investment by competing with
businesses for scarce financial capital
- Effect does NOT decrease WHOLE amount of govt
budget deficit because higher RIR induces increase
in private saving that partly contributes towards
financing deficit
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

Ricardo-Barro Effect Govt budget, whether in surplus or deficit, has no
effect on either RIR or investment
- tax payers can see that budget deficit today =
increase in future taxes & disposable incomes will
be smaller = saving increases today
- Private saving and private supply of loanable funds
increase to match qty of loanable funds demanded
by govt

The Global Loanable Funds Market
International Capital Mobility - Funds flow into country in which interest rate is highest and out of country in
which interest rate is lowest
- To compare real interest rates of countries, we must compare financial assets
of EQUAL RISK
- Interest Rates include Risk Premium; riskier the loan = higher interest rate
- Risk Premium: Interest rate on risky loan that on safe loan
International Borrowing and
Lending
(-) Net Export [X<M] = rest of world supplies funds to country & qty of LF in country is
greater than national saving

(+) Net Export [X>M] = the country is a net supplier of funds to rest of the world & qty of
LF in country is less than national saving
Demand and Supply in the
Global and National Markets
- In global LF market, it only determines WORLD EQ RIR not the nations (that
depends on whether the country itself is a borrower or lender)
Global Loanable Funds
Market
- Sum of both demand and supply from all countries
International Borrower p.558 Figure 23.10 (b)
- If country is integrated into global economy, funds
would flood into it
International Lender p.558 Figure 23.10
- If country is integrated into global economy, funds
would flow out of it
Changes in Demand
and Supply
- Changes within a country depends on the size of
the country itself
- Small country = no effect on global D/S =
unchanged RIR = only change countrys net
exports and international borrowing/lending
- Large country changes world RIR and countrys
net exports and international borrowing/lending


Chapter: 24 Purpose: Readings Date: Sunday, February 25
th
, 2013
MONEY, PRICE LEVEL, AND INFLATION

What is Money?
Money: any commodity or token that is generally acceptable as means of payment
Means of Payment: method of settling a debt (i.e. when a payment has been made, there is no
remaining obligation between parties to a transaction)
Medium of Exchange Any object that is generally accepted in exchange for goods and services

- w/o this, G/S must be exchanged directly for other G/S exchange called
BARTER
Barter requires double coincidence of wants (e.g. in order to sell DVDs to
get ice cream, you have to someone that wants to exchange it and they
must also have ice cream)
- Money acts as medium of exchange because people with something to sell
will always accept money in exchange for it
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Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

- Credit Card (C.C) is not money because money is used to settle C.C debt
Unit of Account Agreed measure for stating prices of G/S
e.g. situation where you exchange ice creams for DVDs, DVDs for Paper, etc.
Store of Value Sense that it can be held and exchanged later for G/S
- If money were not a store of value, it could not serve as means of payment
e.g. house, car, work of art
- no store of value has completely stable value (i.e. always fluctuating)
- inflation lowers value of money & other commodities, and tokens used as
money
- to make money useful = low inflation rate
Money in Canada
Today
Currency notes and coins held by individuals and businesses
- notes and coins INSIDE banks are not counted as
currency because they are not held by individuals and
businesses
- currency = convenient for settling small debts and buying
low-priced items
Deposits - Deposits of individuals and businesses and banks/other
depository inst.
e.g. trust and mortgage companies, credit unions, and
caisses populaires
- Deposits = money bc it can use it to make payments
Official
Measures of
Money
M1: consists currency held by individuals and businesses plus
chequable deposits owned by individuals and businesses
- Does not include notes and coins held by banks, and it
does not include chequable deposits by Government of
Canada
M2: consists of M1 plus all other deposits (i.e. non-chequable
deposits and fixed term deposits)

Are M1 and M2 Really Money?
- Chequable deposits = money bc it can be transferred from one person to
another by writing a cheque or using a debit card
- M1 consists of currency PLUS chequable deposits and each of these =
payment means
- M2 has some savings deposits = not means of payment (liquid assets)
Liquidity: property of being easily convertible into means of payment with
loss in value
* since deposits in M2 are not means of payment AND easily converted into
means of payment they ARE COUNTED AS MONEY

Deposits are money but cheques are not
- Cheques itself is never money because it only instructs bank to transfer
money between parties, there was not $### added into the flow circulation
- In essence: one persons money reduces while another persons increases;
therefore, nothing additional occurred in the stage of transfer

Credit cards are not money
- It is just an ID like your drivers licence
- CC lets you take out a loan at instant you buy something
- To make payment, you need money (which you need to have currency or
chequable deposit to pay CC company
- Although you use CC when you buy something, CC is not means of
payment and it is not money
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)


INSERT GRAPH HERE P.569

The Banking System
Depository Institutions
Private firm
that takes
deposits from
households
and firms, and
makes loans
to other
households
and firms
Charterered Banks Private firm, chartered under Bank Act of 1992 to
receive deposits and make loans
- Largest institutions in banking system and conducts
all types of banking and financial business
Credit Unions and
Caisses Populaires
Credit Union: cooperative organization that operates
under Co0operative Credit Association Act of 1992 and
receives deposits from and makes loans to its members

Caisse populaire: similar type of institution that operates
in Quebec
Trust and Mortgage
Loan Companies
Privately owned depository institution that operates
under Trust and Loan Companies Act of 1992
Receives deposits, make loans, and act as trustee
for pension funds and for estates
All Banks Now - Economic functions of all depository institutions
have grown increasingly similar
- They all perform same essential economic
functions (therefore, well call all BANKS)

What Depository Institutions Do:
- Provide services such as cheque clearing, account management, credit
cards, and Internet banking (income comes from service fees)
- They earn most of income by using funds received from depositors to make
loans, buy securities that earn higher interest rate than paid to depositors
- Must balance act weighting return against risk
Put funds into one of the four of the following:
1. Reserves Notes and coins in its vault or its deposit account at
Bank of Canada
- These funds are used to meet depositors currency
withdrawals and to make payments to other banks
- Normal times: bank keeps about half of 1% here
2. Liquid Assets Government Canada Treasury bills and commercial
bills
- Banks first line of defence if need reserves
- Can be sold and instantly converted into reserves
with almost no risk of loss
But Low risk = low interest rate
3. Securities Government of Canada bonds and other bonds (e.g.
mortgage-backed securities)
- Can be converted into reserves but at prices that
fluctuate
- Prices shift because assets are riskier than liquid
But Risker = higher interest rate
4. Loans Commitments of funds for agreed-upon period of
time
- Banks make loans to corporations to finance
purchase of capital
- Make mortgage loans to finance purchase of homes
and consumer durable goods (e.g. cars/boats)
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

- Cannot be converted into reserves until dues are
repaid (some borrowers default and never pay!)
But riskiest asset = highest interest rate

Economic Benefits Provided by Depository Institutions (DI)
1. Create Liquidity - By borrowing short and lending long
i.e. taking deposits and standing ready to repay on short
notice/demand; making loan commitments that run for
terms of many years
2. Pool Risk - Loan might not be repaid (default!)
i.e. lend to one person that doesnt repay, full amount lost;
but lend to 100 and one person defaults, its not that bad
3. Lower the cost
of borrowing
- Lowers cost of search to borrow funds
i.e. firm that borrows gets money from single institution (DI)
that gets deposits from large number of people but spreads
cost of activity over many borrowers
4. Lower the cost
of monitoring
borrowers
- By monitoring, lender can encourage good
decisions that prevent defaults
i.e. activity is costly if household monitors their $$ lent to
firms; therefore DI does task at lower cost
The Bank of Canada Central Bank: a public authority that supervises other banks and financial
institutions, financial markets, and payments systems, and conducts monetary
policy

Bank of Canada (BoC) is special in 3 important ways:
Banker to Banks and
Government
- BoC has restricted list of customers to
receive deposits
(Chartered banks, credit unions and caisses
populaires, and trust/mortgage loan
companies; Govt of Canada, and central
banks of other countries)
Lender of Last Resort - BoC makes loans to banks
Lender of Last resort: stands ready to make loans
when banking system as whole is short of reserves
- Some banks are short of reserves while
others have surplus reserves; overnight loan
market moves funds from one bank to
another
Sole Issuer of Bank Notes - BoC is the only bank that is allowed to issue
bank notes
- They have a monopoly (actually not natural)

The Bank of Canadas Balance Sheet
- BoC influences economy by changing interest rates
- Bank must change quantity of money in economy (depends on size and
composition of balance sheet items)
Bank of Canadas Assets 1. Government Securities
2. Loans to Depository Institutions
- BoC holds Govt of Canada securities
(treasury bills) that it buys in bills market
- Normal times: this item is small, or zero
(0 in 2011)
Bank of Canadas Liabilities 1. Bank of Canada Notes
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

2. Depository Institution Deposits
- DI deposits at BoC are part of reserves of
these institutions

The Monetary Base
- BoCs liabilities together with coins issued by royal Canadian Mint (coins are
not liabilities of BoC) make up monetary base
Monetary base: sum of Bank of Canada notes, coins, and depository institution
deposists at Bank of Canada; acts as base that supports nations money

Open Market Operation
Purchase of sale of Govt securities by BoC in open market
Open Market Purchase
Open Market Sale

How Banks Create Money
- Money is both currency and bank deposits
- Banks create deposits and do so by making loans

Creating Deposits by making loans
- Outcome is same when two banks are involved in process of transfer of
money
(e.g. if Shell Gas Stations bank is RBC, then CIBC uses its reserves to pay
RBC. CIBC has increase in loans and decrease in reserves; RBC has
increase in reserves and increase in deposits; banking system as a whole
has increase in loans and deposits but no change in reserves)

Factors limit quantity of loans and deposits that banking system can create:
1. Monetary
Base
Sum of BoC notes, coins, and banks deposits at BoC

- Size of monetary base limits total quantity of money that
banking systems can create
Reason: banks have desired level of reserves, households
and firms have desired holding of currency, and both of
these desired holdings of monetary base depend on
quantity of deposits
2. Desired
Reserves
Reserves that it PLANS to hold

- Different from required reserves (which is minimum
quantity that bank MUST hold)
- What bank plans to hold depends on level of deposits
Desired reserve ratio: ratio of reserves to deposits that
banks plan to hold
- Desired reserve ratio > required reserve ratio by amount
that banks themselves determine
3. Desired
Currency
Holding
Portions of money held as currency and bank deposits

- Ratio of currency to deposits depends on households
and firms choose to make payments
(whether: use currency or debit cards/cheques)

If bank deposists increase = desired currency holding increase
If decrease = decrease too
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)


Thats why when bank makes loans that increase deposits,
some currency leaves banks which leaks reserves
- Currency Drain: leakage of bank reserves into currency
Currency Drain Ratio: ratio of currency to deposits

Money Creation Process (p.576-p.578)
1. Banks have excess reserves
2. Banks lend excess reserves
3. Quantity of money increases
4. New money is used to make payments
5. Some of new money remains on deposit
6. Some new money is a CURRENCY DRAIN
7. Desired reserves increase because deposits have increased
8. Excess reserves decrease
- If BoC sells securities in an open market operation, then banks have
negative excess reserves
(i.e. they are short of reserves)

Money Multiplier: ratio of change in quantity of money to change in monetary base
e.g. if $1 million increase in monetary base increases quantity of money by
$2.5 million, money multiplier is 2.5
Smaller banks desired reserve ratio & currency drain ratio = larger money multiplier

The Money Market
- No limit to amount of money we like to RECEIVE in payment for labour/interest on savings
- IS limit to how big inventory of money we would like to HOLD and neither spend/use to buy assets that
generate income
- Quantity of money demanded: inventory of money that people plan to hold on any given day; in our
wallets and in our deposit accounts at banks
- Quantity of money held must = Quantity supplied

Influences on Money Holding
Price Level - Quantity of money is measured in nominal money dollars
- Quantity of nominal money demanded: proportional to price level,
other things remaining constant
- Real money = nominal money price level
(measured in terms of what it will buy)
Nominal Interest Rate - Higher opportunity cost of holding money, other things remaining
same, smaller quantity of real money demanded
Opportunity cost of holding money Nominal Interest Rate on other
assets nominal interest rate on money
- Holding money, you forgo interest you might otherwise have got
- Money loses value due to inflation; higher expected inflation rate,
higher the nominal interest rate
Real GDP - Quantity of money that households and firms plan to hold depends
on amount they are spending
- Economy as a whole depends on aggregate expenditure (REAL GDP)
Financial Innovation - Technological change and arrival of new financial products
influence quantity of money held

Financial innovations include:
1. Daily interest chequable deposits
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

2. Automatic transfers between chequable and saving deposits
3. Automatic teller machines
4. Credit cards and debit cards
5. Internet banking and bill paying


The Demand for Money

Relationship between quantity of real money demanded and nominal
interest rate when all other influences on amount of money that people
wish to hold remain same

See p.579 for FIGURE 24.3 illustration
Shifts in Demand for
Money Curve

Shifting of demand curve:
1. Change in REAL GDP
- Decrease in real GDP decreases demand for money (shifts leftward)
- increase in real GDP increases demand for money (shifts rightward)
2. Financial innovation Changes in demand for money
- decreases demand for currency, might increase demand for some types
of deposits and decrease demand for others
- generally, innovation decreases demand for money (leftward)

See p.579 for FIGURE 24.4 illustration
Money Market
Equilibrium
Occurs when
demand =
supplied
(long run vs short run)
Short-Run Equilibrium - As BoC adjusts quantity of money, interest
rate changes
` let EQ be at 5%/year
` if it were 4%/year: people will sell bonds, bid down
price, and interest rate would rise
` if it were 6%/year: people will buy bonds, big up
price, and interest rate would fall

See p.580 for FIGURE 24.5 illustration
Short-Run Effect of a
Change in Supply of
Money
If BoC increases quantity of money
- People will hold more money than demanded
- SURPLUS
- People enter loanable funds market and
increase in demand for bonds raises its price;
lowers IR
If BoC decreases qty of money, peoplehold less
money than demanded
- Enter LFM to sell bonds; decrease in demand
for bonds lowers their price; raises IR

See p.580 for FIGURE 24.6 illustration
Long-Run Equilibrium - When inflation rate = expected inflation rate
and when real GDP = potential GDP; money
market, loanable funds market, goods market,
and labour market are in long-run EQ (so is
economy)
If BoC increases qty of money, eventually a new LR
EQ is reached which nothing real has changed
- Real GDP, employment, real qty of money,
and real interest rate all return to original
levels
- Only PRICE LEVEL changes; rises by
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)

same % as rise in qty of money

Why?
- Real GDP and emplt are determined by
demand for labour, supply of labour, and
production function
- Real interest rate determined by demand for
supply of real loanable funds
- Only variable free to change is the long run
price level
Transition from Short
Run to Long Run
Example:

BoC increases qty of money by 10%
1. Nominal interest rate falls; real interest rate
falls too as people try to get rid of excess
money holdings and buy bonds
2. Lower real interest rate, people want to
borrow and spend more; more investment by
firms and want to buy consumer goods
3. Increase in demand for goods cannot be met
by supply because its already at full emplt
(SHORTAGE!)
4. Shortage forces price level to rise
5. Price level rises = real qty of money
decreases
- this decrease raises nominal interest rate
and real interest rate
6. Interest rate rises = spending plans are cut
back, eventually original full-emplt is back
7. At new Long run EQ ,price level rose by 10%
and nothing real changed

The Quantity Theory of Money
Quantity Theory of Money: proposition that in long run, increase in quantity of money brings equal
percentage increase in price level
Velocity of Circulation: average number of times dollar money is used annually to buy G/S that make up
GDP
GDP = price level real GDP
GDP = PY

Velocity of circulation = (Price level x real GDP) / Qty of Money
V=PY/M
Equation of Exchange: tells us how M, V, P, and Y are connected
MV = PY
- It becomes qty theory of money if qty of money does not influence velocity of circulation or real GDP
P = M(V/Y) ; VY is independent of M

Money growth rate + rate of velocity change = inflation rate + real GDP growth rate
Simply rearrange formula to isolate INFLATION RATE
Inflation Rate = Money Growth Rate +Rate of Velocity Change Real GDP growth rate

- In the long run, rate of velocity change is approx. zero and is not influenced by money growth rate
**** Inflation rate = Money Growth Rate Real GDP growth Rate ****
Professor: Mokhles, HOSSAIN Weiting Xu | York University
Textbook: MACROECONOMICS Canada in the Global Environment (PARKIN, BADE)


- At full emplt, real=potential GDP growth rate ; might be influenced by inflation but it is so small
- SO Real GDP growth rate is given, it doesnt change when money growth rate changes
(inflation is correlated with money growth rate)

Money Multiplier (Mathematical Note: p.586-587)