EC140 Final Exam Review

Chapter 29: Fiscal Policy

-Federal Budget: Annual statement of the federal governments outlays

and revenues
Finances the activities of federal government
Achieves macroeconomic objectives
-Fiscal Policy: Use of federal budget to achieve macroeconomic objectives
maintain full employment, economic growth, and price level stability
-Budget Making:
Federal gov. and Parliament makes fiscal policy Minister of Finance
presents budget plan to Parliament Parliament debates plan and
enacts laws necessary to implement it budgets may politically driven
(not be interests of economy)
-Revenues come from: Personal income taxes (largest revenue source),
Corporate income taxes, Indirect taxes (HST), investment income
-Outlays are: Transfer payments (largest outlay expenditure; for
Unemployment, Welfare payments, Farm subsidies), Expenditure on g/s, Debt
interest
-Budget Balance:
Revenues > Outlays = Budget Surplus
Revenues < Outlays = Budget Deficit
Revenues = Outlays = Balanced Budget
-Government Debt: Total amount that gov. borrows; Sum of past deficits
past surpluses
-Supply-Side Effects of Fiscal Policy: Effects of fiscal policy on
employment, potential GDP, and aggregate supply
Income tax changes full employment and potential GDP introduces
tax wedge reduces take home pay of each individual reduces
incentive to work = supply of labour decreases (since tax decreases
take home pay)
o Tax Wedge: Gap between before and after tax wage rates
o When quantity of labour employed decreases, potential GDP
decreases
o Full employment quantity of labour decreases = Potential GDP
decreases = AS decreases
Taxes on consumption (HST) adds to tax wedge taxes raises prices
paid
Taxes on capital income (interest income) lowers quantity of saving
and investment slows growth rate of real GDP
o Real After-Tax Interest Rate: Interest rate influencing saving
and investment
o Real Interest Rate = Nominal Rate Inflation Rate

o Real after-tax Interest Rate = (1 Tax Rate) x Nominal Rate Inflation Rate
o Taxes depend on nominal interest rate true tax on interest
income depends on inflation rate
o Inflation: Raises nominal interest rates but not real interest
rates, Increases savers tax burdens, Lowers after-tax real
interest rate
Tax on capital income: Decreases supply of loanable funds
o Tax wedge driven between real interest rate and real after tax
interest rate
o Investment and saving decrease
Laffer Curve: Relationship between tax rate and amount of tax
revenue collected
o Higher tax rate doesnt always bring higher revenue
o Higher tax rate brings in more revenue per $ earned
o Higher tax rate decreases # of $ earned = 2 forces operate in
opposite directions
o At T*, revenue if maximized
o Tax rate < T*, rise in tax rate increases tax revenue
o Tax rate > T*, rise in tax rate decreases tax revenue
-Fiscal Stimulus: use of fiscal policy to increase production and
employment
Discretionary Fiscal Policy: Policy action initiated by act of
Parliament
Automatic Fiscal Policy: Fiscal policy action triggered by state of
economy with no gov. action occurs automatically given the
structure of gov. programs
-Increase in gov. outlays/decrease in gov. revenues = production and jobs
-Increase in expenditure on g/s directly increases aggregate expenditure
-Increase in transfer payments/decrease in tax revenues = increases
disposable income increase consumption expenditure
-Low taxes provide incentives to work and invest
-Automatic Fiscal Policy: Changes automatically in response to state of
economy
Tax Revenue: depends on tax rates and incomes tax rates people pay
are set by Parliament
o Incomes vary with real GDP = tax revenues depend on real GDP
when real GDP increases in expansion, tax revenues increases,
and vice versa
Transfer Payments: Gov. creates programs that pay benefits to
qualified people and businesses depending on economic state
o Expansion = unemployment falls = unemployment benefits
decrease

Automatic Stimulus: Recession tax revenues decrease, outlays

increase = budget provides automatic stimulus that helps shrink
recessionary gap
o Boom: Tax revenues increase, outlays decrease = budget
provides automatic restraint that helps shrink inflationary gap
-Structural Surplus/Deficit: Budget balance that would occur if economys
at full employment and real GDP = potential GDP
Considered permanent
-Cyclical Surplus/Deficit: Actual surplus/deficit Structural surplus/deficit
Occurs because real GDP does NOT equal potential GDP
Temporary disappears when economy returns to full employment
-Fiscal Stimulus and Aggregate Demand: Changes in gov. expenditure
and tax change AD and have multiplier effects
Government Expenditure Multiplier: Effect on real GDP from
change in gov. expenditure
o Increase in gov. expenditure = increases autonomous component
of AE, shifts AD to right
o If gov. finances by borrowing = crowding out effect
Investment falls b/c increase in real interest rates
Investment decreases and offsets increase in gov. spending
= smaller increase in autonomous AE
Small right shift in AD
Tax Multiplier: Effect on real GDP from change in taxes
o Decrease in autonomous taxes = increase in disposable income,
increase in autonomous component of AE, shifts AD to right
o Change in Y = Change in A / (1-Slope of AE)
o Effects of tax cut are likely to be smaller than an equivalent
increase in gov. expenditure
Investment falls due to increase in real interest rate
Investment decreases and partly offsets tax cut smaller
increase in autonomous AE, smaller rightward shift of AD
-Limitations and Discretionary Fiscal Policy
Recognition Lag: Time it takes to figure out that fiscal policy action is
needed
Law-Making Lag: Time it takes Parliament to pass laws needed to
change taxes or spending
Impact Lag: Time it takes from passing a tax or spending change to
its effect on real GDP being felt

Chapter 30: Monetary Policy

-Monetary Policy Objectives:

Control quantity of money and interest rates in order to avoid inflation
Prevent excessive swings in real GDP growth and unemployment

-Bank of Canada operates inflation rate targeting policy: alters interest

rates and money supply to keep inflation within specified range
Inflation is kept within a band between 1-3% per year targeted at
2% midpoint
-Inflation target uses CPI as measure of inflation
BoC pays close attention to core inflation its operational guide
BoC believes core inflation is better measure of underlying inflation
trend and better predicts future CPI inflation
-Rationale for Inflation-Control Target:
Fewer surprises and mistakes on the part of savers and investors
Anchors expectations about future inflation
-Controversy about Inflation-Control Target
By focusing on inflation, Bank of Canada might permit unemployment
rate to rise or real GDP growth to slow but keeping inflation low and
stable = best way to achieve full employment an sustained economic
growth
Bank of Canada might permit the value of $ rise on foreign exchange
market and make exports suffer Bank of Canada has a good record
(last time recession was 90s)
-Monetary Policy Instrument: Variable that Bank of Canada can directly
control/closely target; Only 1 of 3 possible instruments can be set at a time
others need to adjust
Quantity of Money (Monetary base), Exchange Rate, Short-Term
Interest Rate (Opportunity cost of holding money)
-Bank decreases quantity of money = interest rate and exchange rate rises
-Bank raises interest rate = quantity of money decreases, exchange rate
rises
-Bank lowers exchange rate = quantity of money increases = interest rate
falls
-Short-Term Interest Rate (Overnight Rate)
Exchange rate and quantity of money find their own equilibrium values
Overnight Loans Rate: specific interest rate that Bank of Canada
targets
o Interest rate on overnight loans that chartered banks make to
each other
When bank wants to slow inflation, it raises overnight loans rate
When inflation is low, Bank wants to avoid recession, and lowers
overnight loans rate
-The Banks Interest Rate Decision
Gather data about economy (way it responds to shocks, and policies)
process data and find best level for policy instrument announce
interest rate decision and explain
Inflation Report: published twice a year, describes forces operating
on economy, outlook on inflation and real GDP growth

-Hitting Overnight Loans Rate Target: achieves target- operating band,

open market operations
Open Market Operations: Purchase or sale of gov. securities by Bank
of Canada from/to a chartered bank or general public
o BoC buys securities = pays with newly created reserves
o BoC sells securities = paid for with reserves held by banks
o Influence commercial banks reserves
o Changes in amount of reserves affect overnight loans rate
Operating Band: Target overnight loans rate +/- 0.25% points ~ 0.5%
points wide; creates operating band by getting:
o Bank Rate: Interest rate BoC charges commercial banks on loans
Target overnight loans rate + 0.25%
Cap on overnight loans rate
o Settlements Balances Rate: Interest rate BoC pays commercial
banks on reserves (deposits)
Targets overnight loans rate 0.25%
Lower bound on overnight loans rate
-When Bank of Canada lowers the overnight loans rate:
Other short-term interest rates and exchange rate fall
Quantity of money and supply of loanable funds increase
Long term real interest rate falls
Consumption expenditure, investment, and net exports increase
Aggregate demand increases
Real GDP growth and inflation rate increase
-Exchange Rate Fluctuations: Exchange rate responds to changes in
interest rate in Canada relative to interest rates in other countries
Canadian interest rate differential
Higher interest rates in Canada = foreigners demand Canadian bonds
= CAD purchased = CAD appreciates due to increase in demand
-Interest Rate Changes: Short term bill rate, long term bond rate,
overnight loans rate
Short Term Rates: Move closely together, follow overnight loans rate
Long Term Rates: Move in same direction as overnight loans rate, only
loosely connected to overnight loans rate
-Bank of Canada Fights Recession (Expansionary Monetary Policy):
Low inflation and negative output gap = Bank lowers overnight rate target
-Expenditure Plans: Ripple effects that follow a change in overnight rate,
changes 3 components of aggregate expenditure
Consumption Expenditure: via interest rates
Investment: via interest rates
Net exports: via exchange rates
Changes aggregate demand, real GDP, and price level influences
inflation and output gap

-High inflation and positive output gap, Bank raises overnight loans rate
target

Chapter 25: Exchange Rate and Balance of Payments

-Foreign Currency: Foreign bank notes, coins, and bank deposits
-Foreign Exchange Market: Market in which currency of one country is
exchanged for currency of another
-Foreign Exchange Rate: Price at which one currency exchanges for
another
Currency Depreciation: Fall in value of one currency in terms of
another
Currency Appreciation: Rise in value of one currency in terms of
another
-Factors affecting demand of one currency are the factors affecting supply of
another
-Competitive market (many traders, no restrictions) supply and demand
determine price
-Quantity Demanded: Amount traders plan to buy during given time period
at given exchange rate; depends on:
World exchange rate
World demand for Canadian exports
Interest rates in Canada and other countries
Expected future exchange rate
-Demand curve is downward sloping because:
Exports effect: Exchange rate falls = quantity demanded increases
Expected profit effect: Lower exchange rate today = Greater quantity
demanded
-Shifts in Demand Curve:
Right: World demand for Canadian Exports decrease; Canadian
interest rate differential (Canadian interest rate foreign interest rate)
rises; Expected future exchange rate rises
Left: If above variable declines
-Quantity Supplied: Amount traders plan to sell during given time period
and exchange rate
Exchange rate
Canadian demand for imports
Interest rates in Canada and other countries
Expected future exchange rate
-Supply curve is upward sloping because:
Imports Effect: Higher exchange rate = lowers prices of Canadian
imports = increases volume of Canadian imports = increases quantity
of CAD supplied
Expected Profit Effect: lower the current exchange rate = greater
expected profit = smaller quantity of CAD supplied

-Shifts in Supply Curve:

Right: Canadian demand for imports increases, Canadian interest rates
differential falls, Expected future exchange falls
Left: Canadian demand for imports decreases, Canadian interest rate
differential rises, Expected future exchange rises
-Arbitrage: Buying in one market and selling for more in another
Arbitrage ensures exchange rate is same in all trading centers to remove
profits
-Shifts in Exchange Rate:
If demand for CAD increases and supply does not change, exchange
rate rises
If demand for CAD decreases and supply does not change, exchange
rate falls
If supply of CAD increases and demand does not change, exchange
rate falls
If supply of CAD decreases and demand does not change, exchange
rate rises
-Expectations about Exchange Rate
Interest Rate Parity: Equal rates of returns
o Return on Canadian gov. bonds = interest rate
o Return on US gov. bonds = interest rate + expected rate of
appreciation of USD
Purchasing Power Parity: When 2 quantities of money can buy the
same quantity of g/s; Equal value of money
-Real Exchange Rate (RER): Rate at which g/s of one country trade for g/s
of another
Real Exchange Rate = Nominal exchange rate (E) x Domestic price
level (P) / Foreign price level (P*)
-Short Run Exchange Rate Fluctuations
If nominal exchange rate changes, P and P* dont change, and change
in E brings equivalent change in RER
-Long Run Exchange Rate Fluctuations
RER doesnt change when nominal exchange rate changes
E is determined by RER and price levels (E = RER x P*/P)
Rise in P* = appreciation of CAD in long run
Rise in P = depreciation of CAD in long run
-Exchange Rate Policy:
Flexible exchange rate: Permits exchange rate to be determined by
demand and supply with NO direct intervention in foreign exchange
market by central bank
Fixed exchange rate: Pegs exchange rate at value decided by gov. or
central bank and is achieved by direct intervention in foreign exchange
market to block unregulated forces of demand and supply requires
active intervention (but cant be sustained)

Crawling Peg: Works like a fixed exchange rate except target value
changes (e.g. China operates crawling peg) avoid wild swings in
exchange rate that might happen if expectations become unstable and
avoid problem of running out of reserves
-Balance of Payments Accounts: International trading, borrowing, and
lending; 3 accounts = 0
Current Account: Records receipts from exports of g/s sold abroad,
payments for imports of g/s from abroad, net interest paid abroad, and
net transfers (e.g. foreign aid payments)
o CAB = X M + Net interest income + Net transfers
Capital and Financial Account: Records foreign investment in Canada
Canadian investment abroad
o Foreign investment: Includes both real (firms, factories), and
financial assets (gov. bonds)
Official Settlements Account: Change in gov.s holding of foreign
currency (official reserves)
o When official reserves increase, gov. is buying foreign currencies
= official settlements account will be negative (Canada pays to
obtain official reserves)
-Positive Net foreign investment = Borrowing from rest of world (e.g.
Americans buy Canadian gov. bonds)
-Net Borrower: country that borrows more from rest of world than its
lending has a positive net foreign investment (capital account surplus
Canada!)
-Negative net foreign investment = Lending to rest of world (e.g.
Canadians buy German gov. bonds) negative net foreign investment
(capital account deficit)

Chapter 20: Measuring GDP and Economic Growth

-GDP: Market value of final goods produced in a country in a certain time

frame
Exclude financial assets (stocks, bonds)
-Expenditure Approach: GDP = Aggregate Expenditure = Aggregate
Income = C + I + G + X M
Use gross expenditure
Gov. Expenditure excludes transfer payments (e.g. benefits, EI, taxes,
subsidies)
-Income Approach: Wages, Salaries, and Supplementary Labour Incomes +
Indirect Taxes Subsidies + Other Factor Incomes + Depreciation
Wages, Salaries, and Supplementary Labour Incomes: Payment for
labour services (inc. gross wages and benefits like pension
contributions)

Other Factor Incomes: Corporate profits, interest, farmers income, and

income from non-farm unincorporated businesses (interest, rent, profit,
labour income from self-employment)
-Nominal GDP: GDP valued at the prices of the prevailing year (isnt
corrected for inflation)
-Real GDP: GDP based on a base year (corrected for inflation)
-Uses for Real GDP: Compare standard of living over time, and across
countries
Standard of living over time: GDP per person tells us the value of g/s
that average person can enjoy, and removes influences of inflation and
rising cost of living
o Express real GDP per person as a ratio to a reference year
o Potential Real GDP: Real GDP when economys labour, capital,
land, and entrepreneurial ability are fully employed max. level
of GDP
o Two features of expanding living standard: Growth of potential
GDP per person, Fluctuations of real GDP around potential GDP
o Lucas Wedge: Gap between what real GDP per person would
have been if 60s growth rate persisted and what real GDP
actually was
o Business Cycle
Standard of living across countries: 2 problems:
o Real GDP of one country must be converted into same currency
units as real GDP of other country prices in one country might
be lower/higher in one country than another
o Goods and services in both countries must be valued at same
prices
o Purchasing Power Parity: Using same prices for both countries
-Limitations for Real GDP: Household protection, underground economic
activity, health and life expectancy, leisure time, environmental quality,
political freedom and social justice

Chapter 21: Monitoring Jobs and Inflation

-Number of people unemployed rises during recession, lowers during

expansion
-Why unemployment is a problem: Lost income and production
(unemployment benefits is a safety net but not as much as income), Lost
human capital (permanently damages persons job aspects, and lowers living
standards)
-Why unemployment is important: Measures economic health (provides
info about recession/expansion), People make living through employment
(losing work imposes costs = real consequences), Affect financial market
-Labour Force Survey: Stats Can conducts this monthly to compute
unemployment rate (54 000 households, population divided into 2 groups)

Working age population: Number of people 15 years old and older

who are NOT in institutional care
o People in labour force (employed + unemployed workers),
People NOT in labour force (full time students, retirees,
homemakers)
People too young to work (under 15) or in institutional care
-Employed: Have full time (work 30+ hours/week) or part time (less than 30
hours a week) job
-Involuntary Part Time: People who work less than 30 hours a week but
want full time
-Unemployed: 1 of 3 categories
1. Without work but tried to find a job within the last 4 weeks
2. Waiting to be called back from a job that they have been laid off of
3. Waiting to start a new job within 4 weeks
-Labour Market Indicators:
Unemployment Rate: % of labour force thats unemployed
o Unemployment Rate = (Unemployed/Labour Force) x 100
Involuntary Part Time Rate: % of labour force who have part time jobs
but want full time
o Involuntary Part Time Rate = (Involuntary Part Time
Workers/Labour Force)x100
Labour Force Participation Rate: % of working age population who are
members of the labour force
o Labour Force Participation Rate = (Labour Force/Working Age
Population) x 100
Employment to Population Ratio: % in working age population who
have jobs
o Employment to Population Ratio = (Employment/Working Age
Population) x 100
-Is unemployment rate a perfect measure? Purpose of unemployment
rate is to measure underutilization of labour resources Stats Can believe its
a correct measure, but excludes 2 types of underutilized labour:
Marginally Attached Workers: Person who is neither working nor
looking for work but has indicated they want and are available for a
job, and has looked for work in the past
o Discouraged Worker: Marginally attached worker who stopped
looking for a job because of repeated failure to find one
NOT considered unemployed (havent tried finding a job in
past 4 weeks)
Part time workers who want full time jobs
-Most costly unemployment is long-term unemployment (14+ weeks)
(trends downwards, fluctuates with business cycle)
Short Term Unemployment: 1-3 weeks, about 60% is short term

o Over 25: short term unemployment is 4%, fluctuates slightly over

business cycle
o U25: short term unemployment is high, fluctuates strongly with
business cycle
-Unemployment = Frictional + Structural + Cyclical Unemployment
-Frictional Unemployment: Unemployment from normal labour market
turnover
Increased # of people entering labour force, and increases in
unemployment benefits raise frictional unemployment
Permanent and healthy phenomenon of growing economy
-Structural Unemployment: Unemployment from changes in technology
and foreign competition that change skills needed to perform jobs or
locations of jobs
Lasts longer than frictional unemployment (workers must retrain or
relocate)
-Cyclical Unemployment: Higher than normal unemployment at business
cycle trough, and lower than normal unemployment at business cycle peak
E.g. worker laid off b/c economys in recession, rehired when expansion
begins
-Natural Unemployment: Unemployment arising from frictional and
structural change when theres NO cyclical unemployment (trends
downwards)
Natural Unemployment = Frictional + Structural
-Full Employment: unemployment rate = natural unemployment rate; real
GDP = potential GDP
-Natural unemployment rate changes over time, influenced by:
Age distribution of population: Younger workers are more prone to
frictional
Scale of structural change: Big technical change causes large
change in employment
Real wage rate: Min. wage/efficiency wage set above equilibrium
wage
Unemployment benefits: Generous unemployment benefits lower
incentives to work
-Real GDP and Unemployment Over Cycle
Potential GDP = Real GDP at full employment
o Potential GDP: capacity of economy to product output on
standard basis
Output Gap: Real GDP Potential GDP
Output gap fluctuates around business cycle, unemployment rate
fluctuates around natural unemployment rate
When unemployment rate = natural unemployment rate, real GDP =
potential GDP, output gap is 0

When unemployment rate > natural unemployment rate, real GDP <
potential GDP, output gap is negative
When unemployment rate < natural unemployment rate, real GDP >
potential GDP, output gap is positive
-Price level: average level of prices and value of money
Inflation: rising price level; Deflation: falling price level
Interested in price level b/c: Measure inflation/deflation rate,
Distinguish between money values and real values of economic
variables
-Why inflation and deflation are problems: unpredictable inflation or
deflation is a problem b/c it redistributes income and wealth, diverts
resources from production, lowers real GDP and employment
Unpredictable inflation/deflation rates changes income between
employers/workers
o Unexpected inflation = our wage buys us less, employers benefit
(higher profits)
Unpredictable inflation/deflation rates changes wealth between
borrowers/lenders
o Unexpected inflation = amount borrowed lends buys less =
borrower wins, lender loses
Unpredictable inflation/deflation rate = resources used to monitor it =
divert resources from production
o Hyperinflation: Inflation rate 50%+ that puts economy to a
stop and collapses society
Unpredictable inflation rates = higher profits = increase in investment
= temporary rise in GDP and employment leads to fall in GDP and
employment
-Consumer Price Index (CPI): Averages of prices paid by urban consumers
for a fixed basket of consumer g/s
Reference base period: CPI = 100
-Constructing the CPI: Selecting the CPI basket, Conducting monthly price
survey, Calculating CPI (Find cost of CPI basket at base period prices, find
cost at current period prices, calculate CPI for current period)
CPI = (Cost of basket at current period prices/Cost of basket at base
period prices) x 100
-Measuring inflation rate: [(CPI this year CPI last year) / CPI last year] x
100
-Biased CPI: CPI might overstate true inflation for 4 reasons
New Goods Bias: New goods that werent available in base year are
more expensive than goods they replace = upward bias on CPI
Quality Change Bias: Quality improvements yearly = we pay for
improved quality (not inflation)
Commodity Substitution Bias: CPI is fixed and doesnt take into
account consumers substitutions from goods whose prices increase

Outlet Substitution Bias: People switch to buying from cheaper

sources but CPI doesnt take this into account
-Magnitude of Bias: CPI overstate inflation by 1.1% a year
-Consequences of Bias: Distorts private contracts, Increases gov. outlays
(Old Age Security, CPP 1/3 of federal gov. outlays linked to CPI 1% is
small but over time, it accumulates)
-Alternative Price Indexes:
GDP Deflator = (Nominal GDP/Real GDP) x 100
Chained Price Index for Consumption (CPIC) = (Nominal
consumption/Real consumption) x 100
Both use current period and previous period quantities rather than
fixed quantities from earlier period incorporate elements of current
and past purchases
-Core Inflation Rate: Inflation rate excluding volatile elements (food, fuel)
attempts to reveal underlying inflation trend (up or down)
Misleading view on true underlying inflation rate relative prices of
excluded items changing = core inflation rate will give biased measure
of true underlying inflation rate