Macroeconomics, Ninth Canadian Edition, 9E Andrew B Abel Solution Manual by Ace Test Banks

INSTRUCTOR’S MANUAL Andrew Wong University of Alberta

Macroeconomics Ninth Canadian Edition Andrew B. Abel The Wharton School of the University of Pennsylvania

Ben S. Bernanke Brookings Institution

Dean Croushore Robins School of Business, University of Richmond

Ronald D. Kneebone The School of Public Policy, University of Calgary

Contents Chapter 1: Introduction to Macroeconomics ..................................................................................... 1 Learning Objectives ................................................................................................ 1 Teaching Notes ....................................................................................................... 1 Additional Issues for Classroom Discussion .......................................................... 5 Answers to Textbook Problems .............................................................................. 7 Review Questions ....................................................................................... 7 Numerical Problems.................................................................................... 9 Analytical Problems .................................................................................. 10 Chapter 2: The Measurement and Structure of the Canadian Economy.......................................... 12 Learning Objectives .............................................................................................. 12 Teaching Notes ..................................................................................................... 12 Additional Issues for Classroom Discussion ........................................................ 20 Answers to Textbook Problems ............................................................................ 22 Review Questions ..................................................................................... 22 Numerical Problems.................................................................................. 24 Analytical Problems .................................................................................. 29 Chapter 3: Productivity, Output, and Employment ......................................................................... 30 Learning Objectives .............................................................................................. 30 Teaching Notes ..................................................................................................... 30 Additional Issues for Classroom Discussion ........................................................ 38 Answers to Textbook Problems ............................................................................ 41 Review Questions ..................................................................................... 41 Numerical Problems.................................................................................. 43 Analytical Problems .................................................................................. 48 Chapter 4: Consumption, Saving, and Investment .......................................................................... 51 Learning Objectives .............................................................................................. 51 Teaching Notes ..................................................................................................... 51 Additional Issues for Classroom Discussions ....................................................... 59 Answers to Textbook Problems ............................................................................ 62 Review Questions ..................................................................................... 62 Numerical Problems.................................................................................. 64 Analytical Problems .................................................................................. 68 Chapter 5: Saving and Investment in the Open Economy ............................................................... 74 Learning Objectives ................................................................................................. 74 Teaching Notes ........................................................................................................ 74 Additional Issues for Classroom Discussion ........................................................... 81 Answers to Textbook Problems............................................................................... 83 Review Questions ........................................................................................ 83 Numerical Problems .................................................................................... 85 Analytical Problems .................................................................................... 89 . ii

Chapter 6: Long-Run Economic Growth......................................................................................... 94 Learning Objectives ................................................................................................. 94 Teaching Notes ........................................................................................................ 94 Additional Issues for Classroom Discussion ......................................................... 101 Answers to Textbook Problems............................................................................. 103 Review Questions ...................................................................................... 103 Numerical Problems .................................................................................. 105 Analytical Problems .................................................................................. 108 Chapter 7: The Asset Market, Money, and Prices ......................................................................... 112 Learning Objectives ............................................................................................... 112 Teaching Notes ...................................................................................................... 112 Additional Issues for Classroom Discussion ......................................................... 121 Answers to Textbook Problems............................................................................. 123 Review Questions ...................................................................................... 123 Numerical Problems .................................................................................. 124 Analytical Problems .................................................................................. 126 Chapter 8: Business Cycles ........................................................................................................... 128 Learning Objectives ............................................................................................... 128 Teaching Notes ...................................................................................................... 128 Additional Issues for Classroom Discussion ......................................................... 133 Answers to Textbook Problems............................................................................. 134 Review Questions ...................................................................................... 134 Analytical Problems .................................................................................. 135 Chapter 9: The IS-LM-FE Model: A General Framework for Macroeconomic Analysis ............. 136 Learning Objectives ............................................................................................... 136 Teaching Notes ...................................................................................................... 136 Additional Issues for Classroom Discussion ......................................................... 150 Answers to Textbook Problems............................................................................. 151 Review Questions ...................................................................................... 151 Numerical Problems .................................................................................. 154 Analytical Problems .................................................................................. 158 Chapter 10: Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy .................................................................................................... 161 Learning Objectives ............................................................................................... 161 Teaching Notes ...................................................................................................... 161 Additional Issues for Classroom Discussion ......................................................... 181 Answers to Textbook Problems............................................................................. 182 Review Questions ...................................................................................... 182 Numerical Problems .................................................................................. 184 Analytical Problems .................................................................................. 186

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Chapter 11: Classical Business Cycle Analysis: Market-Clearing Macroeconomics .................... 188 Learning Objectives ............................................................................................... 188 Teaching Notes ...................................................................................................... 188 Additional Issues for Classroom Discussion ......................................................... 200 Answers to Textbook Problems............................................................................. 201 Review Questions ...................................................................................... 201 Numerical Problems .................................................................................. 203 Analytical Problems .................................................................................. 207 Chapter 12: Keynesian Business Cycle Analysis: Non-Market-Clearing Macroeconomics ......... 211 Learning Objectives ............................................................................................... 211 Teaching Notes ...................................................................................................... 211 Additional Issues for Classroom Discussion ......................................................... 227 Answers to Textbook Problems............................................................................. 229 Review Questions ...................................................................................... 229 Numerical Problems .................................................................................. 232 Analytical Problems .................................................................................. 237 Chapter 13: Unemployment and Inflation ..................................................................................... 246 Learning Objectives ............................................................................................... 246 Teaching Notes ...................................................................................................... 246 Additional Issues for Classroom Discussion ......................................................... 258 Answers to Textbook Problems............................................................................. 259 Review Questions ...................................................................................... 259 Numerical Problems .................................................................................. 261 Analytical Problems .................................................................................. 263 Chapter 14: Monetary Policy and the Bank of Canada ................................................................. 265 Learning Objectives ............................................................................................... 265 Teaching Notes ...................................................................................................... 265 Additional Issues for Classroom Discussion ......................................................... 275 Answers to Textbook Problems............................................................................. 277 Review Questions ...................................................................................... 277 Numerical Problems .................................................................................. 279 Analytical Problems .................................................................................. 281 Chapter 15: Government Spending and Its Financing................................................................... 284 Learning Objectives ............................................................................................... 284 Teaching Notes ...................................................................................................... 284 Additional Issues for Classroom Discussion ......................................................... 296 Answers to Textbook Problems............................................................................. 297 Review Questions ...................................................................................... 297 Numerical Problems .................................................................................. 299 Analytical Problems .................................................................................. 302

CHAPTER 1: INTRODUCTION TO MACROECONOMICS LEARNING OBJECTIVES I. Goals of Part I: Introduction A. B.

Introduce students to the main concepts in macroeconomics (Ch. 1) Introduce national income accounting and major economic magnitudes (Ch. 2)

II.

Goals of Chapter 1 A. Major economic issues—growth, business cycles, unemployment, inflation, the international economy, macroeconomic policy, aggregation (Sec. 1.1) B. What macroeconomists do—forecasting, analysis, research, data development (Sec. 1.2) C. Why macroeconomists disagree—Classicals vs. Keynesians, the text’s approach (Sec. 1.3)

III.

Notes to Eighth Edition Users A. Sections on economic theory and data development are combined into the section titled macroeconomic research. B. Answer for numerical question #2 was updated.

TEACHING NOTES I.

What Macroeconomics Is About (Sec. 1.1) 1. Long-run economic growth 1. Growth of real output in Canada over time 2. Sources of growth—rising population, increase in the average labour productivity

This may be a good place to introduce students to the calculation of a growth-rate, which is used throughout the textbook. You can write it first in general terms, as %∆X = [(Xt+1 – Xt)/Xt] × 100% = [(Xt+1/Xt) – 1] x 100%. Then you might use an example with something you’re talking about, such as real GDP growth over the past year, or the inflation rate. We also recommend explaining how the growth rate of a ratio is approximately the growth rate of the numerator minus that of the denominator. Throughout the text, students may come across mathematical calculations that are unfamiliar to them. The Appendix at the end of the textbook contains some helpful basic guidance to mathematical topics, including discussions of functions and graphs, slopes of functions, elasticities, functions of several variables, shifts of a curve, exponents, and growth rate formulas. 2. 3.

Business cycles Unemployment and Price Instability

Analytical Problem 1 asks students to think about average labour productivity and unemployment and their relationship to output.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Analytical Problem 2 asks students to think about the welfare consequences of having a higher price level. You may wish to note here that the inflation rate is just the growth rate of the price level, so that π = [(Pt + 1/Pt) - 1 × 100%. Numerical Problem 1 gives students practice calculating growth rates, including the growth rate of average labour productivity, unemployment rate, and the inflation rate. 4.

The international economy 1. Open vs. closed economies 2. Trade imbalances; the trade deficit and the trade surplus 3. The exchange rate Macroeconomic policy 1. Fiscal policy a. Effects of large federal deficits b. Canadian experience c. Relation to decline in productivity growth

Numerical Problem 2 serves two purposes: (1) to get students to look at some real data on the economy; and (2) to give them some idea how large are the trade deficit and government budget deficit or surplus. 6. II.

2. Monetary policy; the Bank of Canada Aggregation; from microeconomics to macroeconomics

What Macroeconomists Do (Sec. 1.2) 1. Macroeconomic forecasting 1. Relatively few economists make forecasts

Data Application There are many firms that provide forecasts for macroeconomic variables in Canada, such as the Conference Board of Canada, DRI Canada, and most private banks. In addition, the Federal Department of Finance and the Bank of Canada make projections for the economy based on large scale macroeconometric models. Finally, international agencies such as the Organization for Economic Cooperation and Development (OECD) provide annual surveys of the Canadian economy which make forecasts for the economy. 2.

Forecasting is very difficult

Data Application Francis X. Diebold presents a comprehensive survey of the development of structural and non-structural forecasting in his article, “The Past, Present, and Future of Macroeconomic Forecasting,” Journal of Economic Perspectives, Spring 1998, vol. 12, pp. 175-92. Despite the difficulties in macroeconomic forecasting, he is optimistic about its future with the rapid advances in numerical and simulation techniques. 2.

Macroeconomic analysis 1. Private and public sector economists—analyze current conditions .

Chapter 1: Introduction to Macroeconomics

Data Application The Canadian financial sector hires a large number of economists, most of whom are engaged in data analysis on a daily basis. Their job is to tell traders what the current data means in terms of their effect on the financial markets in general, as well as on the prices of individual assets. Many of them also make their own detailed forecasts of the economy. 2.

Does having lots of economists ensure good macroeconomic policies? No, since politicians, not economists, make major decisions Macroeconomic research 1. Goal: to make general statements about how the economy works 2. Theoretical and empirical research are necessary for forecasting and economic analysis 3. Economic theory: a set of ideas about the economy, organized in a logical framework 4. Economic model: a simplified description of some aspect of the economy

This is a good point for you to talk about your own research interests. It has been found that students are very interested in learning about the kind of research their instructors do. You may want to talk about your research later, if and when you come to a section of the textbook that discusses the topic on which you do your research. 5.

Usefulness of economic theory or models depend on reasonableness of assumptions, possibility of being applied to real problems, empirically testable implications, and theoretical results consistent with real-world data

Theoretical Application The classic discussion of research issues by Milton Friedman is, “The Methodology of Positive Economics,” Essays in Positive Economics, Chicago: University of Chicago Press, 1953. Analytical Problem 3 is an exercise in how to formulate and test a theory. 6. Ill.

Data development—very important for making data more useful

Why Macroeconomists Disagree (Sec. 1.3) A. Positive vs. normative analysis

Analytical Problem 4 gives students practice in distinguishing positive from normative analysis. B.

Classicals vs. Keynesians 1. The classical approach a. The economy works well on its own; the “invisible hand” leads people, acting in their own best interests, to maximize the general welfare b. Wages and prices adjust rapidly to get to equilibrium c. Result: Government should have only a limited role in the economy

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Theoretical Application At this point in the discussion, you may want to talk about philosophies of economics. Students are often fascinated by how philosophical differences arise and what they mean, especially for policy. This helps to reinforce the idea that the Keynesian and classical models are very different in their implications. You might suggest the idea that economists who are skeptical of government’s role in the economy are more likely to believe in a classical model, while those who believe the government can do good are more likely to become Keynesians. You can point out, however, that things are changing; some New Keynesians seem skeptical of government intervention. 2.

The Keynesian approach a. The Great Depression: Classical theory didn’t appear to work b. Keynes: Persistent unemployment occurs because wages and prices adjust slowly, so markets remain out of equilibrium for long periods c. Result: Government should intervene to restore full employment

Analytical Problem 5 asks students to distinguish between how a classical economist and a Keynesian economist would think about the same issue.

Theoretical Application You may wish to add a discussion of the recent progression of research. You could start by a brief discussion of how the failure of Keynesian models in the stagflation of the 1970s led to the growth of rational-expectations modeling, with its focus on the importance of microfoundations. Then you could discuss New Keynesian macroeconomics (discussed in greater detail in Chapter 13) and its attempts to provide some microfoundations for wage and price stickiness in Keynesian models. Although the textbook presents just a few versions of classical models and Keynesian models, it is difficult to find a prototypical classical or Keynesian economist who believes fully in that particular model. The lack of convincing evidence on which model is correct has led macroeconomists to be eclectic, so that they often hedge their bets. As a result, a one-armed macroeconomist is hard to find; analysis tends to be of the “on the one hand, and on the other hand” variety. And, of course, that means that if you laid all the macroeconomists on the earth end to end, they still wouldn’t reach a conclusion! C.

A unified approach to macroeconomics 1. Textbook uses a single model to present both Classical and Keynesian ideas 2. Three markets: goods and services, assets, labour 3. Model starts with microfoundations: individual behaviour 4. Long run: wages and prices are perfectly flexible 5. Short run: Classical case—flexible wages and prices; Keynesian case—wages and prices are slow to adjust

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Chapter 1: Introduction to Macroeconomics

ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1. How Has Increasing Productivity Changed Life in Canada? Increases in labour productivity allow people to consume more goods and services. How have rising consumption levels affected daily life—and people’s expectations— over the last few generations? Even over relatively short periods of time, such as 30 years, living standards for Canadians have changed dramatically. In the 1986-2016 period, average labour productivity has risen tremendously, (although it slowed in the 1980s and recently), as did the quantity of consumer goods people owned. In 1986 the population of Canada was 26.2 million people. It had risen to almost 36.4 million by 2016. Thus, the population increased by almost 39 percent in that time. But the value of consumer durables owned by households increased by 315 percent (from 153.4 billion to 637.1 billion). Do additional goods make people happier? Are Canadians’ lives better today because they now own more cars and appliances than they did in the early 1960s? Note: Data from CANSIM Table 378-0121and 378-0049. 2. Are Canadians Better Off Today? Canadians have more material goods today than they had in the 1950s. Does this mean that life in the 2010s is better than it was in the 1950s and 1960s? Do more goods and services compensate adequately for the environmental problems and rapid changes of life today? Although the average house has more square feet and more appliances than it had 50 years ago, does that outweigh the fear that causes us to keep our doors locked? Does being able to buy many fruits and vegetables year-round improve lives enough to make up for the additional pollution, which causes increased respiratory problems? Is it more important to be able to drive two hours to work that is interesting and challenging than to breathe clean air? Does having several cars in the garage compensate for urban congestion? Does the exhilaration of new products and services outweigh the disruption in our lives caused by rapid and extensive change? Robert, Frank. Luxury Fever. New York: Free Press, 1999. 3. Is Economics a Science? What is a science? Does the term science apply to economics? If economists cannot predict accurately what will happen in the future, can we claim that economics is a science? If one defines as a body of knowledge gained by investigation that will allow one to predict future outcomes, can economics be considered a science? Although economists argue that they follow scientific methods to learn about economic interactions, can they claim true scientific rigor? In economics it is difficult to carry out controlled experiments such as those undertaken by physicists, biologists, and chemists; and, in most cases, we can’t even repeat experiments for verification. The economy is influenced by a myriad of factors; sorting out what is cause and what is effect is quite difficult. With so many factors changing at once, together with shocks such as weather, earthquakes, riots, and changes in people’s preferences, it’s tough to figure out the effects of changes in policy. However, economic theory does allow us to predict the direction of change if not its exact magnitude.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Is Macroeconomics Linked to the Modern Industrial Society?

Many topics in macroeconomics are closely linked to our urban money-based economy. Inflation, unemployment, business cycles, growth, and the balance of trade have all been the concerns of leaders for long periods of time, yet they tended to have limited impact on the common person until the end of the nineteenth century. You may ask your students to think about why this is true. In the middle of the nineteenth century, a large percentage of the Canadian population lived in farms. Much of their commerce was based on barter—trading the products of their fields and forests for flour, cloth, powder, and shot. In a society in which many produced their own food and clothing, questions of inflation, unemployment, and balance of trade had little effect on the common person. Such questions applied mostly to those who lived in the cities or those involved in international trade. Inflation and unemployment became concerns as people moved from mostly subsistence farming to either cash crops or urban wage employment. Because today’s workers specialize in the production of a particular good in exchange for money income, they are more subject to the vagaries of inflation and unemployment. 5. Do Economic Conditions Change the Outcome of Elections? Many commentators believe that the condition of the economy with respect to unemployment and growth influence the outcome of general elections. For instance, if the economy is sluggish or undergoing a recession during an election, the incumbent party may be defeated. The poor state of the Canadian economy in the early 1990s was clearly an important factor in the Conservative government’s dramatic defeat in November 1993. Although economic conditions are not the only factor that influences voters, they may play a major role. Is this good or bad? Economic policies often take effect only after long delays. Quick-fix changes may lead to more problems later on. While no one argues that bad economic policy should be encouraged, are there problems with politicians being concerned with short-run results that improve their electoral chances, rather than long-run solutions?

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Chapter 1: Introduction to Macroeconomics

ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1. Both total output and output per worker have risen strongly over time in Canada. Output itself has grown by a factor of 80 in the last 125 years. Output per worker is now five times as great as it was in 1921. These changes have led to a much higher standard of living today. 2. The business cycle refers to the short-run movements (expansions and recessions) of economic activity. The unemployment rate rises in recessions and declines in expansions. The unemployment rate never reaches zero, even at the peak of an expansion. 3. A period of inflation is one in which prices (on average) are rising over time. Deflation occurs when average prices are falling over time. 4.

Aggregation refers to the process of adding together individual economic variables to obtain economy-wide totals. Aggregation distinguishes microeconomics from macroeconomics. It allows us to study the economy as a whole, rather than looking at its individual parts. Macroeconomists engage in macroeconomic forecasting, macroeconomic analysis, basic research, and data development. Macroeconomic research can be useful in investigating forecasting models to improve forecasts, in providing more information on how the economy works to help macroeconomic analysts, and in telling data developers what types of data should be collected. Research provides the basis (results and ideas) for forecasting, analysis, and data development. The steps in developing and testing an economic model or theory are: (1) State the research question; (2) make provisional assumptions that describe the economic setting and the behaviour of the economic actors; (3) work out the implications of the theory; (4) conduct an empirical analysis to compare the implications of the theory with the data; (5) if the theory fits the data well, use the theory to predict what would happen if the economic setting or economic policies change; (6) if the theory fits the data poorly, start from scratch with a new model; (7) if the theory fits the data moderately well, either make do with a partly successful theory or complicate the model with additional assumptions. The criteria for a useful theory or model are that (1) it has reasonable and realistic assumptions; (2) it is understandable and manageable enough for studying real problems; (3) its implications can be tested empirically using real-world data; and (4) its implications are consistent with the data. Yes, it is possible for economists to agree about the effects of a policy (that is, to agree on the positive analysis of the policy), but to disagree about the policy’s desirability (normative analysis). For example, suppose economists agreed that reducing inflation to zero within the next year would cause a recession (positive analysis). Some economists might argue that inflation should be reduced, because they prefer low inflation even at the cost of higher unemployment. Others would argue that inflation isn’t as harmful to people as unemployment is, and would oppose such a policy. This is normative analysis, as it involves a value judgment about what policy should be.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Classicals see wage and price adjustment occurring rapidly, while Keynesians think that wages and prices adjust only slowly to shocks. The classical theory implies that unemployment will not persist, since wages and prices adjust to bring the economy rapidly back to its full-employment equilibrium in response to a shock. But if Keynesian theory is correct, then the slow response of wages and prices means that unemployment may persist for long periods of time unless the government intervenes.

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Chapter 1: Introduction to Macroeconomics

Numerical Problems 1. a. Average labour productivity is output divided by employment: 2011: 12 000 tonnes of potatoes per 1000 workers = 12 tonnes of potatoes per worker 2012: 14 300 tonnes of potatoes per 1100 workers = 13 tonnes of potatoes per worker b. The growth rate of average labour productivity is [(13/12) – 1] × 100% = 8.33%. c. The unemployment rate is: 2011: 2012: 2.

100/1100 = 9.1% 50/1150 = 4.3%

d. The inflation rate is [(2.5/2) – 1] × 100% = 25%. The answers to this problem will vary depending on the current date. Numbers are at annual rates in billions of current dollars. 2015 1,986.2 627.2 674.7 586.8 (2014)

2016 2,027.5 628.7 676.7 573.2 (2015)

Exports/GDP Imports/GDP Trade imbalance/GDP

31.6% 34.0% -2.39%

31.0% 33.4% -2.37%

b. Federal Net Financial Debt/GDP

29.6% (2014)

28.9% (2015)

GDP Exports Imports Federal Net Financial Debt a.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Analytical Problems 1. Yes, average labour productivity can fall even when total output is rising. Average labour productivity is total output divided by employment (of workers sixteen years old and over). So average labour productivity can fall if output and employment are both rising but employment is rising faster. Yes, the unemployment rate can also rise even though total output is rising. This can occur through a number of channels. For example, average labour productivity might be rising with employment constant, so that output is rising; but the labour force may be increasing as well, so that unemployment is rising. Or average labour productivity might be constant, and both employment and unemployment could rise at the same time due to an increase in the labour force. 2. Just because prices were lower in 1914 than they were in 2013 does not mean that people were better off back then. People’s incomes have risen much faster than prices have risen over the last 99 years, so they are better off today in terms of real income. 3. There are many possible theories. One possibility is that people whose last names begin with the letters A through M vote Liberal while those whose names begin with the letters N through Z vote Conservatives You could test this theory by taking exit polls or checking the lists of registered voters by party. However, this theory fails the criterion of being reasonable, since there is no good reason to expect the first letter of people’s last names to matter for their political preferences. A better theory might be one based on income. For example, you might make the assumption that the Conservatives party promotes business interests, while the Liberal party is more interested in redistributing income. Then you might expect people with higher incomes to vote Conservatives and people with lower incomes to vote Liberal. This could be tested by taking a survey of people as they left the polls. In this case the assumptions of the theory seem reasonable and realistic, and the model is simple enough to understand and to apply. So it is potentially a useful model. 4. a. Positive. This statement tells what will happen, not what should happen. b. Positive. Even though it is about income-distribution issues, it is a statement of fact, not opinion. If the statement said “The payroll tax should be reduced because it . . . “ then it would be a normative statement. c. Normative. Saying they are too high suggests that they should be lower. d. Positive. Says what will happen as a consequence of an action, not what should be done. 5.

e. Normative. This is a statement of preference about policies. A classical economist might argue that the economy would work more efficiently with NAFTA because it reduces trade barriers, making the invisible hand work even better. Workers could specialize even more than before, so that more total output would be produced by all three countries. Though the industrial mix might change in each country, wages and prices across industries would adjust quickly, and people in industries that closed down in a particular country would quickly find new jobs. A Keynesian economist might be more sympathetic to concerns about NAFTA because of the belief that adjustment to the changes will not occur quickly. As a result, people in particular industries in a country may become unemployed. . 10

Chapter 1: Introduction to Macroeconomics

Wages won’t adjust quickly to restore full employment, so some government action (like retraining programs to give displaced workers new skills) may be desirable. 6.

Keynes was responding to the suggestion of classical economists that there was no need for a response to the Great Depression from government policymakers because in the long run the economy always adjusts back to full employment equilibrium. Keynes argued that this adjustment might take a long time and that it might be better for policymakers to take action to speed up the process of adjustment and so relieve the suffering of those suffering unemployment.

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CHAPTER 2: THE MEASUREMENT AND STRUCTURE OF THE CANADIAN ECONOMY LEARNING OBJECTIVES I.

Goals of Chapter 2 A. National income accounts; relationships between key macroeconomic variables (Sec. 2.1) B. Gross domestic product—the main measure of output (Sec. 2.2) C. Saving and wealth—private and government (Sec. 2.3) D. Real GDP, Price indexes, and inflation—macroeconomic variables not in the national income accounts (Sec. 2.4) E. Interest rates – real versus nominal interest rates (Sec. 2.5)

II.

Notes to Eighth Edition Users A. Figures, tables and their corresponding text have been updated.

TEACHING NOTES I.

National Income Accounting: The Measurement of Production, Income, and Expenditure (Sec. 2.1) A. Three alternative approaches give the same measurements 1. Product approach: the amount of output produced 2. Income approach: the incomes generated by production 3. Expenditure approach: the amount of spending by purchasers B. Juice business example shows that all three approaches are equal 1. Important concept in product approach: value added = value of output minus value of intermediate inputs C. Why are the three approaches equivalent? 1. They must be, by definition 2. Any output produced (product approach) is purchased by someone (expenditure approach) and results in income to someone (income approach) 3. The fundamental identity of national income accounting: total production = total income = total expenditure (Note in Chapter 5 an open economy is considered in which a country’s spending need not equal its production in every period.)

II.

Gross Domestic Product (Sec. 2.2) A. The product approach to measuring GDP 1. GDP is the market value of final goods and services newly produced within a national boundary during a fixed period of time

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Chapter 2: The Measurement and Structure of the Canadian Economy

Data Application The period referred to here is either a quarter or a year. You may want to show your students what some of the tables from the National Income and Expenditure Accounts look like, or send them to the library to find the accounts in the Canadian Economic Observer. Alternatively, you could direct your students to www.statscan.gc.ca (the homepage for Statistics Canada) or CANSIM I (for historical data) and II (for current data) if your institution subscribes to it. Students may also be interested in seeing what happens in the financial markets and to public opinion on the day a new national income and expenditure accounts release (especially the advance release) comes out. 2.

3. 4.

Market value: allows adding together unlike items by valuing them at their market prices a. Problem: misses nonmarket items such as homemaking, the value of environmental quality, and natural resource depletion Analytical Problems 1 and 4 both discuss difficulties in counting nonmarket items for GDP, including the important idea that GDP is not the same as welfare. b. There is some adjustment to reflect the underground economy c. Government services (that aren’t sold in markets) are valued at their cost of production Newly produced goods and services: counts only things produced in the given period; excludes things produced earlier Final goods and services a. Don’t count intermediate goods and services b. Capital goods (goods used to produce other goods) are final goods since they aren’t used up in the same period that they are produced c. Inventory investment (the amount that inventories of unsold finished goods, goods in process, and raw materials have changed during the period) is also treated as a final good

Data Application People are often surprised to see how large inventory swings may be from quarter to quarter. For example, in the second quarter of 2009 real inventories fell by over $7.8 billion (2007 dollars), over half the total decline in real GDP of about $14 billion in that recession quarter. d. 5.

Adding up value works well, since it automatically excludes intermediate goods GNP vs. GDP a. GNP = output produced by domestically owned factors of production GDP = output produced within a nation b. GDP = GNP – NFP (net factor payments from abroad) c. NFP = payments to domestically owned factors located abroad minus payments to foreign factors located domestically

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Analytical Problem 2 has students see the relationship between GDP and GNP. Data Application While the use of GDP as a measure of production has been conventional in Canada and Europe, prior to December 1991, the United States used GNP as its main measure of production; after that time GDP became the main concept. The main reasons for the switch were that GDP is more relevant to production in an open economy (though GNP is more relevant for income), and GDP is more precise than GNP in the advance estimate, since net factor payments are difficult to measure quickly. d.

Example: Engineering revenues for a road built by a Canadian company in Saudi Arabia is part of Canadian GNP (built by a Canadian factor of production), not Canadian GDP, and is part of Saudi GDP (built in Saudi Arabia), not Saudi GNP e. Difference between GNP and GDP is less than 2% for Canada. A Closer Look 2.1: Natural resources, the environment, and the national income accounts a. A good deal of Canada’s economic well-being is due to its substantial stocks of natural resources b. The exploitation of natural resources produces costs that are difficult to measure accurately c. In the early 1990s, Statistics Canada developed a system of environmental and resource accounts – it provides inflation on the stock of natural resources, the use of those resources and the pollutants produced by their exploitation d. The accounts also report the production of pollutants by industry and by sector of the economy – these help policy makers to focus attention on environmental issues and to design effective mechanisms to price natural resources appropriately

Data Application The timeline for national income and product amount releases is generally: Advance release Last week of month following end of quarter Preliminary release Last week of second following month Final release Last week of third following month Revisions occur every July for the following three years, then every fifth year for a new benchmark release. Each new release contains either additional new data that was not available before, or a change in seasonal factors, or a correction of errors made previously. B.

The expenditure approach to measuring GDP 1. Measures total spending on final goods and services produced within a nation during a specified period of time 2. Four main categories of spending: consumption (C), investment (I), government purchases of goods and services (G), and net exports (NX) 3. Y = C + I + G + NX, the income-expenditure identity .

Chapter 2: The Measurement and Structure of the Canadian Economy

Consumption: spending by domestic households on final goods and services (including those produced abroad) a. About 60% of Canadian GDP b. Four categories (1) Consumer durables (examples: motor vehicles, furniture, major appliances) (2) Semi-durables (examples: clothing) (3) Nondurable goods (examples: food, utilities, fuel) (4) Services (examples: health care, financial services, rent, and restaurant meals) Investment spending for new capital goods (fixed investment) plus inventory investment a. About 1/6 of Canadian GDP b. Business (or non-residential) fixed investment, spending by businesses on structures and equipment

Data Application Note that the consumption category in the national income and expenditure accounts does not correspond to economists’ concept of consumption, because it includes the full value of durable goods. When economists study consumption behaviour, they must account for this; one way to do so is to assume that durable goods provide services that are proportional to their existing stock. Total consumption is this fraction of the stock of consumer durables, plus nondurables and services. c.

Residential fixed investment: spending on the construction of houses and apartment buildings d. Machinery and equipment investment: spending on machines, tools and vehicles Government purchases of goods and services: spending by the government on goods or services a. About 1/5 of Canadian GDP b. Most by provincial and local governments, not federal government c. Not all government expenditures are purchases of goods and services (1) Some are payments that are not made in exchange for current goods and services

Data Application People often don’t realize how large transfer programs are relative to federal government purchases. For example, in 2009 government purchases were $337.7 billion out of total government expenditures (including the Canadian Pension Plan) of $631.3 billion. Federal government expenditures included $72.0 billion of transfers payments to individuals and businesses, $29.2 billion in grants to provincial and local governments, and $28.98 billion in interest payments.

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(2)

One type is transfers, including public pension payments, welfare, and unemployment benefits. (3) Another type is interest payments on the government debt 7. Net exports: exports minus imports a. Exports: goods produced in the country that are purchased by foreigners b. Imports: goods produced abroad that are purchased by residents in the country c. Imports are subtracted from GDP, as they represent goods produced abroad, and were included in consumption, investment, and government purchases The income approach to measuring GDP 1. Adds up income generated by production (including profits and taxes paid to the government) a. Net National income = labour income + corporate profits + interest and investment income + unincorporated business income b. Net National income + indirect taxes-subsidies = net domestic product c. Net domestic product + depreciation = gross domestic product (GDP) d. GDP + net foreign income (NFP) = GNP 2. Private sector and government sector income a. Private disposable income = income of the private sector = private sector income earned at home (Y or GDP) and abroad (NFP) + payments from the government sector (transfers TR, and interest on government debt, INT) – taxes paid to government (T) = Y + NFP + TR + INT – T (2.4) b. Net government income = taxes – transfers – interest payments = T – TR – INT (2.5) c. Private disposable income + net government income = GDP + NFP = GNP

Numerical Problems 1,2, 3, and 4 give practice in working with the national income and product accounts. III.

Saving and Wealth (Sec. 2.3) A. Wealth 1. Household wealth = a household’s assets minus its liabilities 2. National wealth = sum of all households’, firms’, and governments’ wealth within the nation 3. Saving by individuals, businesses, and government determine wealth B. Measures of aggregate saving 1. Saving = current income – current spending 2. Saving rate = saving / current income 3. Private saving = private disposable income – consumption Spvt = (Y + NFP – T+ TR + INT) – C (2.6) 4. Government saving = net government income – government purchases of goods and services

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Sgovt = (T – TR – INT) – G (2.7) a. Government saving = government budget surplus = government receipts – government outlays b. Government receipts = tax revenue (T) c. Government outlays = government purchases of goods and services (G) + transfers (TR) + interest payments on government debt (INT) d. Government budget deficit = –Sgovt 5. National saving a. National saving = private saving + government saving b. S = Spvt + Sgovt = [Y + NFP – T+ TR + INT – C] + [T – TR – INT – G] = Y + NFP – C – G = GNP – C – G (2.8) The uses of private saving 1. S = I+ (NX + NFP) = I + CA (2.9 and 2.10) Derived from S = Y+ NFP – C – G and Y= C + I+ G + NX CA = NX + NFP = current account balance 2. Spvt = I+ (–Sgovt) + CA (using S = Spvt + Sgovt) The uses-of-saving identity—saving is used in three ways: a. investment (I) b. government budget deficit (–Sgovt) c. current account balance (CA)

Analytical Problem 3 has students consider the effect of a price change on spending. Numerical Problem 5 provides practice in calculating consumption, net exports, GDP, net factor payments from abroad, private saving, government saving, and national saving. D.

Relating saving and wealth 1. Stocks and flows a. Flow variables: measured per unit of time (GDP, income, saving, investment) b. Stock variables: measured at a point in time (quantity of money, value of houses, capital stock) c. Flow variables often equal rates of change of stock variables 2. Wealth and saving as stock and flow (wealth is a stock, saving is a flow) 3. National wealth a. Country’s domestic physical assets (capital goods and land) b. Country’s net foreign assets = foreign assets (foreign stocks, bonds, and capital goods owned by domestic residents) minus foreign liabilities (domestic stocks, bonds, and capital goods owned by foreigners) c. Changes in national wealth (1) Changes in value of existing assets and liabilities (change in price of financial assets, or depreciation of capital goods) (2) National saving (S = I + CA) raises wealth .

Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

IV.

Real GDP, Price Indexes, and Inflation (Sec. 2.4) A. Real GDP 1. Nominal variables (in dollar terms) 2. Problem: Do changes in nominal values reflect changes in prices or quantities? 3. Real variables: adjust for price changes; reflect only quantity changes 4. Example Table 2.4 5. Alternative price indexes 6. Real vs. nominal GDP

Data Application The distinction between nominal and real GDP can be very important in practice. Between 1981 and 1982 nominal GDP rose by 5.2%, but real GDP fell by 3.2%. Numerical Problem 6 provides practice in calculating real and nominal GDP and price indexes given several goods with different prices and quantities in two years. B.

Price indexes 1. GDP deflator = nominal GDP/real GDP, where real GDP is calculated by deflating each component of GDP separately; variable-weight index 2. Variable-weight index P = value of current output at current prices/value of current output at base-year prices; example: GDP deflator 3. Fixed-weight price index P = value of fixed basket at current prices/value of fixed basket at base-year prices; example: CPI

Data Application There are two price indexes available for consumption expenditures: the implicit price deflator’ for personal expenditures, and the consumer price index (CPI). The first is available only quarterly, while the CPI is available monthly. 4. 5.

Note that base year P = 1 or P = 100 Some problems with both types of indexes a. Variable-weight index: Current output may include goods that didn’t exist or were of different quality than in base year b. Fixed-weight index: reflects basket of goods purchased in base year instead of current year

A Closer Look 2.2: Does CPI inflation overstate increases in the cost of living? a. One reason is the difficulty that government statisticians face in trying to measure change in the quality of goods b. Another problem is that CPI based on the assumption that consumers purchase a basket of goods and services that is fixed over time

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Data Application The fact that it is difficult to handle new goods or goods whose quality has changed makes it especially difficult to compute price indexes. If you use a recent year as the base year, for example, it gives a large weight to the prices of computers; yet it would have cost a fortune 30 years ago to get the same computing power that is now available on a desktop PC costing $1000 today. This fact can lead to distortions in price indexes that use a particular base year. Because of this problem, Statistics Canada uses indexes that do not rely on a fixed base year. One is a chain-weighted index, in which the weights change each benchmark: year (about once every five years). These indexes are especially valuable when studying the economy over long periods of time, when there have been substantial changes in relative prices (so that the fixed-base-year index is misleading). C.

Inflation 1. Calculate inflation rate: πt+1 = (Pt+1 - Pt)/Pt = ΔPt+1/Pt Text Fig. 2.1 shows the Canadian inflation rate for 1945–2012.

Data Application There are many problems with price indexes; they are imperfect measures of price changes. What do the indexes do when new goods are introduced? What happens as more efficient stores replaces stores that had higher intermediate costs? How do We account for the fact that people substitute cheaper goods for higher-priced goods? Inadequate treatment of these questions means the measures of prices give an overestimate of the inflation rate of perhaps 0.5%. So a measured inflation rate of 0.5% might really mean that the true average price level is constant. See A Closer Look 2.4 Numerical Problems 6, and 7 give practice in calculating inflation rates. V.

Interest rates (Sec. 2.5) 1. Real vs. nominal interest rates a. Real interest rate: real return to an asset b. Nominal interest rate: nominal return to an asset c. Real interest rate = i - π (2.12) Figure 2.2 plots nominal and real interest rates for Canada from 1951 to 2012. 2. The expected real interest rate a. r = i - πe (2.13) b. If π = πe, real interest rate = expected interest rate

Numerical Problem 8 provides practice in calculating nominal and real interest rates.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1. How Much Do GDP Comparisons Tell Us? National income accounting data are used to compare production and prices between very different countries and within the same country over long periods of time. What problems does this involve? Are there any alternatives? Making comparisons of prices or GDP over long periods of time or from county to country is difficult because the underlying economies vary. For example, if you compare GDP in the 2000s with estimate of GDP in the 1950s, you will find that the increase in output per capita may not give a good indication of a change in welfare of the population. For example, in 1950 few convenience foods were available in the grocery store. One purchases chicken or peas or potatoes. There were no frozen french fries or microwave fried chicken. The productive activity that takes place in the individual kitchen is not counted in GDP. If you make your own french fries, GDP is lower than if you pay to have them made. Similar difficulties occur when you attempt to compare figures across countries, especially when the countries have very different expectations or productive situations. For example, the GDP of many developing countries will tend to be low, in part because those who live on the land raise their own food and its value is imperfectly included in GDP. In a country like Canada, farmers specialize, growing wheat or raising pigs for market, and buying flour and bacon at the supermarket. Although the amount of food consumed by the average citizen may or may not be similar, the amount included in GDP is larger in the second case. What other ways can we use to compare well-being that are not subject to these problems? There are many other statistics that can give us a view of economic welfare across different societies. Figures on life expectancy, caloric intake, hours of work per week, energy consumption, availability of education, and infant mortality are among those that have been used to see how people in various societies fare. Students can discuss how effective they think these measures would be in determining the welfare of those living in different societies, e.g. the well-publicized UN comparisons. 2. Does It Make a Difference Which Type of Price Index One Chooses? Price indexes generally move together. As long as the basket of goods that people consume doesn’t change too much, then fixed-weight and variable-weight price indexes give similar measures of inflation. Different methods of calculation usually give answers that vary by only small amounts. For example, let’s assume that we have an economy producing only three commodities: jeans, haircuts, and textbooks. The quantities and prices of each good produced in year 1 and year 2 are given below. Year 1 Year 2 Number Price Number Price Jeans 1000 $25 1200 $30 Haircuts 5000 5 4000 5 Textbooks 3000 50 3000 55 If we use a fixed-weight price (like the CPI), and year 1 is the base year, the total cost of the goods in year 1 is 1000 × $25 = $25 000 (market value of jeans in year 1) + 5000 x $5 =$25,000 (market value of haircuts in year 1) + 3000 x $50 = $150 000 (market value of textbooks in year 1) for a total of $200 000. In year 2, the same market basket will cost$220,000 calculated as follows: 1000 x $30 = $30 000 (year 1 sales of jeans at year 2 prices) + 5000 × $5 = $25 000) year 1 sales of haircuts at year 2 prices) + 3000 x $55= $165,000 (year 1 sales of textbooks at year 2 prices). Our price index for

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year 2 is the cost of the year 1 quantities in year 2 divided by the cost of year 1 quantities in year 1 = $220 000/$200 000 − 1.1. On average, prices rose 10%. Note that the price of jeans rose 20%, that of haircuts was unchanged, and that of textbooks rose 10%. Not all prices must rise for the price index to rise. Also, the average price increase for the economy is close to the rise in the price of textbooks, the largest part of the economy. A variable-weight index (like the GDP deflator) is calculated by dividing the value of current outl3ut at current prices by the value of current output at base-year prices. In our example in year 2 the value of current output at current prices is 1200 x $30 = $36 000 (market value of jeans in year 2) + 4000 × $5 = $20 000 (market value of haircuts in year 2) + 3000 × $55 = $165 000 (market value of textbooks in year 2) for a total of $221 000. The value of current output at base-year prices is 1200 × $25 = $30 000 (value of quantity of jeans bought in year 2 in year 1 prices) + 4000 × $5 = $20 000 (value of quantity of haircuts bought in year 2 in year 1 prices) + 3000 × $50 = $150 000 (value of quantity of textbooks bought in year 2 in year 1 prices) for a total of $200 000. The index is calculated as $221 000/$200 000, or 1.105. On average, prices rose 10.5%. However, if the basket changes radically between periods, the answers can be quite different, the fixed-weight basket weights the most-consumed goods in the base year most heavily. A variable-weight emphasizes changes in prices of the most-consumed goods in the current year. 3. Does Greater GDP Always Mean Greater Human Welfare? Most nations wish to improve the well-being of their populations. Although economists often articulate the need for a steady increase in economic output, low unemployment, and minimal inflation, people also have a variety of other goals. Students can be asked to think about the importance of such environmental issues as clean air, safe water, and the survival of wild rivers. People desire an adequate supply of goods and services, employment for all, and stable prices. They also want to live in an area that is safe, pleasant, and in which they can freely follow the activities that appeal to them. These goals are interrelated, but not always in positive ways. An increase in output is likely to result in additional employment. However, the need for additional raw materials to produce that output may interfere with the enjoyment of nature and outdoor sports. Additional logging may reduce the availability of forests and other wilderness areas for recreation, or threaten wildlife. Extraction of minerals may result in unsightly holes in the countryside and mine tailings that pollute rivers, but on the positive side may provide many opportunities for work at good wages. Though factories provide jobs, they may be undesirable neighbours in residential areas. Thus, economic goals must be considered along with environmental ones.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1. The three approaches to national income accounting are the product approach, the income approach, and the expenditure approach. They all give the same answer because they are designed that way; any entry based on one approach has an entry in the other approaches with the same value. Whenever output is produced and sold, its production is counted in the product approach, its sale is counted in the expenditure approach, and the funds received by the seller are counted in the income approach. 2. Goods are measured at market value in GDP accounting so that different types of goods and services can be added together. Using market prices allows us to count up the total dollar value of all the economy’s output. The problem with this approach is that not all goods and services are sold in markets, so we may not be able to count everything. Important examples are homemaking and environmental quality. 3. Intermediate goods and services are used up in producing other goods in the same period (year) in which they were produced, while final goods and services are those that are purchased by consumers or are capital goods that are used to produce future output. The distinction is important, because we want to count only the value of final goods produced in the economy, not the value of goods produced each step along the way. 4. The four components of spending are consumption, investment, government purchases, and net exports. Imports must be subtracted, because they are produced abroad and we want GDP to count only those goods and services produced within the country. For example, suppose a car built in Japan is imported into Canada. The car counts as consumption spending in Canadian GDP, but is subtracted as an import as well, so on net it does not affect Canadian GDP. However, it is counted in Japan’s GDP as an export. 5. Private saving is private disposable income minus consumption. Private disposable income is total output minus taxes paid plus transfers and interest received from the government. Private saving is used to finance investment spending, the government budget deficit, and the current account. National saving is private saving plus government saving. 6. National wealth is the total wealth of the residents of a country, and consists of its domestic physical assets and net foreign assets. Wealth is important because the long-run economic well-being of a country depends on it. National wealth is related to national saving because national saving is the flow of additions to the stock of national wealth. 7. Real GDP is the useful concept of figuring out a country’s growth performance. Increases in nominal GDP may be due simply to increase in prices rather than growth in output. 8. The GDP deflator is a variable-weight index. It takes the value of current output at current prices divided by the value of current output at base-year prices to arrive at an index value. The CPI is a fixed-weight index, using the value of a fixed set of consumer goods and services at current prices divided by the value of the fixed set at base-year prices. The GDP deflator covers all the output of the economy, while the CPI uses only a fixed set of consumer goods and services, including imported as well as domestically produced goods and services.

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The nominal interest rate is the rate at which the nominal (or dollar) value of an asset increases over time. The real interest rate is the rate at which the real value or purchasing power of an asset increases over time, and is equal to the nominal interest rate minus the inflation rate. The expected real interest rate is the rate at which the real value of an asset is expected to increase over time. It is equal to the nominal interest rate minus the expected inflation rate. The concept that is most important to borrowers and lenders is the expected real interest rate, because it affects their decisions to borrow or lend.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Numerical Problems 1.

GDP is the value of all final goods and services produced during the year. The final output of coconuts is 1000, which is worth 500 fish, because two coconuts are worth one fish. Of the 500 fish caught during the year, the 100 fish used as fertilizer are an intermediate good, so the final output is 400 fish. So in terms of fish, GDP consists of 500 fish worth of coconuts plus 400 fish, with a total value of 900 fish. To find consumption and investment, we must find out what happens to all the coconuts and fish. Gilligan consumes all his 200 coconuts (worth 100 fish) and 100 fish, so his consumption is worth 200 fish. The Professor stores 100 coconuts with a value of 50 fish. In an ideal accounting system, these stored coconuts would be treated as investment. However, in the national income accounts, because it is so difficult to tell when durable goods are consumed and when they are saved, they are counted as consumption. So the Professor’s consumption consists of 800 coconuts (value 400 fish) and 300 fish, for a total of 700 fish. Thus, the economy’s total consumption is valued at 900 fish and investment is zero. In terms of income, Gilligan’s income is clearly worth 200 fish (100 fish plus 200 coconuts worth 100 fish). The Professor’s income is less easily calculated, because he uses 100 fish to fertilize the coconut trees. These 100 fish are therefore not income to him. Thus, the Professor’s income is 800 coconuts (1000 coconuts minus the 200 coconuts paid to Gilligan) plus 300 fish (500 fish minus 100 fish paid to Gilligan and minus 100 fish used as fertilizer). In terms of fish, the Professor’s income is 700 fish. This question illustrates some of the nuances of national income accounting. Many difficult choices and measurement issues are involved in constructing the accounts. Here, for example, it is clear that what we call consumption really isn’t just the volume of goods consumers use up during the year, but also includes consumption goods that are purchased but saved for the future. Since there is no way to measure when goods are used after they are purchased, the accounts are unable to distinguish consumption from storage of goods. Another subtlety is the treatment of the fish used as fertilizer. If the fertilizer increases future output rather than current output, then the fertilizer is not used up during the year and represents investment of 100 fish. In this case, GDP would equal 1000 fish, consumption is 900 fish, investment is 100 fish, the Professor’s income is 800 fish, and Gilligan’s income is 200 fish. a. Furniture made in Quebec that is bought by consumers counts as consumption, so consumption increases by $600 million, investment is unchanged, government purchases are unchanged, net exports are unchanged, and GDP increases by $600 million. b. Furniture made in Sweden that is bought by consumers counts as consumption and imports, so consumption increases by $600 million, investment is unchanged, government purchases are unchanged, net exports fall by $600 million, and GDP is unchanged. c. Furniture made in Quebec that is bought by businesses counts as investment, so consumption is unchanged, investment increases by $600 million, government purchases are unchanged, net exports are unchanged, and GDP increases by $600 million. d. Furniture made in Sweden that is bought by businesses counts as investment and imports, so consumption is unchanged, investment increases by $600 million, government purchases are unchanged, net exports decline by $600 million, and GDP is unchanged. . 24

Chapter 2: The Measurement and Structure of the Canadian Economy

a. ABC produces output valued at $2 million and has total expenses of $1.3 million ($1 million for labour, $0.1 million interest, $0.2 million taxes). So its profits are $0.7 million. XYZ produces output valued at $3.8 million ($3 million for the three computers that were sold, plus $0.8 million for the unsold computer in inventory) and has expenses of $3.2 million ($2 million for components, $0.8 million for labour, and $0.4 million for taxes). So its profits are $0.6 million. According to the product approach, the GDP contributions of these companies are $3.8 million, the value of the final product of XYZ. ABC’s production is of an intermediate good, used completely by XYZ, and so is not counted in GDP. According to the expenditure approach, the GDP contribution is also $ 3.8 million, with $3 million (of sold computers) adding to the capital stock (as investment spending), and $0.8 million (the unsold computer) as inventory investment. The income approach yields the same GDP total contribution. The amounts are: ABC $1.0 million Labour Profit $0.7 million Taxes $0.2 million Interest $0.1 million Total of all incomes = $3.8 million

XYZ $0.8 million $0.6 million $0.4 million $0.0 million

Total $1.8 million $1.3 million $0.6 million $0.1 million

b. If ABC pays an additional $.5 million for computer chips from abroad, the results change slightly. The correct answer is easiest to see using the expenditure approach. As in part a, there is $3.8 million expenditure on final goods, but not there are also net exports of –$5 million. So the total expenditure on domestically produced goods is only $3.3 million. The product approach gets the same answer if it is realized that the $.5 million is a contribution to GDP of the country in which the chips were made, and so must be deducted from the GDP of Canada. The value added in Canada is only $3.3 million. Finally, the income approach gives the same answer as in part a, except that the cost of importing the chips reduces ABC’s profits by $.5 million, so the sum of the incomes is only $3.3 million. a. Product approach: $50 = lumber store’s value added = $200 product minus $150 value of product produced in the previous year. Expenditure approach: $200 consumption spending plus inventory investment of –$150. Income approach: $50 paid to the factors of production at the lumber store (wages of employees, interest, taxes, profits).

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

b. Product approach: $60 000 broker’s fee for providing brokerage services. Expenditure approach: $60 000 counts as residential investment made by the home buyer. The important point here is that the transfer of an existing good, even at a higher value than that at which it was originally sold, does not add to GDP. Income approach: $60 000 income to the broker for wages, profits, etc. c. Product approach: $20 000 salary plus $8000 child care equals $28 000. Note that there is a sense in which the child care is an intermediate service and should not be counted, because without it the homemaker would not be able to work. But in practice there is no way to separate such intermediate services from final services, so they are all added to GDP Expenditure approach: $28 000 ($8000 consumption spending on child care services plus $20 000 in categories that depend on what job the homemaker has). Income approach: $28 000 ($20 000 compensation of homemaker plus $8000 income to the factors producing the child care: employees’ wages, interest, taxes, profits). d. Product approach: $100 million of a capital good. Since it is produced with local labour and materials, and assuming no payments go to Japanese factors of production, this is all added to Canadian GDP. Expenditure approach: $100 million net exports, since the plant is owned by the Japanese. (It is not part of gross domestic investment because the plant is not a capital good owned by Canadian residents.) Income approach: $100 million paid to Canadian factors of production. e. Product approach: $0 because nothing is produced. Expenditure approach: $0 because this is a transfer, not a government purchase of goods or services. Income approach: $0, because this is not a payment to a factor of production, just a transfer. f. Product approach: $5000 worth of advertising services. Expenditure approach: $5000 of government purchases. Income approach: $5000 compensation of employees. g. Product approach: $120 million composed of $100 million of new cars produced plus $20 million of sales services provided by the consortium ($60 million sales price minus $40 million cost). Expenditure approach: $100 million by Discount Car Rentals as investment plus $60 million by the public for consumption of the used cars minus $40 million of investment goods sold by Discount Car Rentals, for a total of $120 million. Income approach: $100 million to the factors of production of GM plus $20 million in payments to the factors of production and profits for the consortium. 5.

Given data: I = 40, G = 30, GNP = 200, CA = −20 = NX + NFP, T = 60, TR = 25, INT = 15, NFP = 7 − 9 = −2. Since GDP = GNP−NFP, GDP = 200 −(−2) = 202 = Y. Since NX + NFP = CA, NX = CA − NFP = −20 − (−2) = −18. Since Y = C + I + G + NX, C = Y − (I + G + NX) = 202 − (40 + 30 + (−18)) = 150.v Spvt = (Y + NFP − T + TR + INT) − C = (202 + (−2) − 60 + 25 + 15) − 150 = 30. Sgovt = (T − TR − INT) − G = (60 − 25 − 15) −30 = −10. S = Spvt + Sgovt = 30 + (−10) =20. a. b. c.

Consumption = 150 Net exports = −18 GDP = 202

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Chapter 2: The Measurement and Structure of the Canadian Economy

Private saving = 30

Government saving = −10

National saving = 20

Base-year quantities at current-year prices: Apples 3 000 x $3 = $ 9 000 Bananas 6 000 x $2 = $12 000 Oranges 8 000 x $5 = $40 000 Total $61 000

at base-year prices: 3000 x $2 = $ 6 000 6000 x $3 = $18 000 8000 x $4 = $32 000 $56 000

Current-year quantities at current-year prices:

at base-year prices:

Apples Bananas Oranges Total a.

4 000 x $3 = $ 12 000 14 000 x $2 = $ 28 000 32 000 x $5 = $160 000 $200 000

4 000 x $2 = $ 8 000 14 000 x $3 =$ 42 000 32 000 x $4 =$128 000 $178 000

Nominal GDP is just the dollar value of production in a year at prices in that year. Nominal GDP is $56 000 in the base year and $200 000 in the current year. Nominal GDP grew 257% between the base year and the current year: [($200 000 /$56 000) − 1] x 100% = 257%.

Real GDP is calculated by finding the value of production in each year at base-year prices. Thus, from the table above, real GDP is $56 000 in the base year and $178,000 in the current year. In percentage terms, real GDP increases from the base year to the current year by [($178 000 / $56 000) − 1] x 100% = 218%.

The GDP deflator is the ratio of nominal GDP to real GDP. In the base year, nominal GDP equals real GDP, so the GDP deflator is 1. In the current year, the GDP deflator is $200 000 / $178 000 = 1.124. Thus, the GDP deflator changes by [(1.124 / 1) −1] x 100% = 12.4% from the base year to the current year.

Nominal GDP rose 257%, prices rose 12.4%, and real GDP rose 218%, so most of the increase in nominal GDP is because of the increase in real output, not prices. Notice that the quantity of oranges quadrupled and the quantity of bananas more than doubled.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Calculating inflation rates: 1929–30: [(14.0 / 14.2) – 1] x 100% = –1.4% 1930–31: [(12.7 / 14.0) – 1] x 100% = –9.3% 1931–32: [(11.5 / 12.7) – 1] x 100% = –9.4% 1932–33: [(10.9 / 11.5) – 1] x 100% = –5.2% These all show deflation (prices are declining over time), whereas recently we have had nothing but inflation (prices rising over time).

The nominal interest rate is [(545 / 500) – 1] × 100% = 9%. The inflation rate is [(214 / 200) – 1] x 100% = 7%. So the real interest rate is 2% (9% nominal rate – 7% inflation rate). Expected inflation was only [(210 / 200) – 1] × 100% = 5%, so the expected real interest rate was 4% (9% nominal rate – 5% expected inflation rate). a. The annual rate of inflation from January 1, 2010 to January 1, 2012, is 10%. This can be found by calculating the constant rate of inflation that would raise the deflator from 200 to 242 in two years. This gives the equation (1 + π) x (1 + π) = 242 / 200), which has the solution π = 10%· An easy way to think about this question is this. A constant inflation rate of π raises the deflator from 200 on January 1, 2010, to 200 x (1 + π) on January 1, 2011, and to 200 × (1 + π) x (1 + π) = 242 on January 1, 2012. So we need to solve the expression (1 + π)² = 242 / 200. b. By similar reasoning, the inflation rate over the three-year period is (1 + π)³ = 266.2 / 200, or π = 10%. c. We can derive a general expression in the same way: 1 + π= P1 / P0 1 + π = P2 / P1 ... ... ... 1 +π = Pn / Pn-1 Multiplying all these lines together, we get: (1 + π)ⁿ = (P1 / P0) x (P2 / P1) x … x (Pn / Pn−1) = Pn / P0

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Analytical Problems 1.

To be included in GDP work must be paid employment. If Paula provides care to her child herself, the value of that work is not included in GDP. If, however, Paula pays someone else to mind her child, then the value of that work is included in GDP.

Canada’s GNP is the market value of final goods and services newly produced by factors of production owned by Canadians. Since ABC Inc. is a Canadian firm, the market value of goods it produces, regardless of where it is produced, is included in Canada’s GNP. Canada’s GDP, on the other hand, is the market value of final goods and services newly produced within the geographic boundaries of Canada. Since the widgets are produced in Mexico, the value of this production is not included in Canada’s GDP. National saving does not rise because of the switch to CheapCall because although consumption spending declines by $2 million, so have total expenditures (GDP), which equal total income. Since income and spending both declined by the same amount, national saving is unchanged. a. The problem in a planned economy is that prices do not measure market value. When the price of an item is too low, then goods are really more expensive than their listed price suggests—we should include in their market value the value of time spent by consumers waiting to make purchases. Because the item’s value exceeds its cost, measured GDP is too low. When the price of an item is too high, goods stocked on the shelves may be valued too highly. This results in an overvaluation of firms’ inventories, so that measured GDP is too high. A possible strategy for dealing with this problem is to have GDP analysts estimate what the market price should be (perhaps by looking at prices of the same goods in market economies) and use this “shadow” price in the GDP calculations.

b. “Homework” is not calculated in the GDP accounts because it is not sold on the market, making it difficult to measure. One way to do it might be to look at the standard of living relative to a market economy, and estimate what income it would take in a market economy to support that standard of living.

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CHAPTER 3: PRODUCTIVITY, OUTPUT, AND EMPLOYMENT LEARNING OBJECTIVES I.

Goals of Part 2: Long-Run Economic Performance A. Analyze factors that affect the longer-term performance of the economy B. Develop a theoretical model of the macroeconomy 1. Three markets a. Labour market (this chapter) b. Goods market (Ch. 4) c. Asset market (Ch. 7)

II. Goals of Chapter 3 A. Introduce the production function as the main determinant of output 1. Discuss the marginal productivity of labour and capital 2. Analyze supply shocks B. Discuss the determinants of labour demand and supply C. Equilibrium in the classical model of the labour market 1. Full-employment output 2. Factors that change equilibrium D. Unemployment 1. Definitions of employment status 2. Frictional, structural, cyclical unemployment III. Notes to Eighth Edition Users A. Figures, tables and their corresponding text have been updated. TEACHING NOTES I. How Much Does the Economy Produce? The Production Function (Sec. 3.1) A. Factors of production 1. Capital 2. Labour 3. Others (raw materials, land, energy) 4. Productivity of factors depends on technology and management B. The production function 1. Y = AF(K,N) (3.1) 2. Parameter A is a measure of overall productivity C. Application: The production function and productivity growth in Canadian 1. Cobb-Douglas production function works well for Canadian economy: Y = AK0.3N0.7 (3.2) 2. Data for Canadian economy—Table 3.1 Numerical Problem 1 gives students practice working with a production function

3. Productivity growth calculated using production function a. Productivity moves sharply from year to year b. Productivity growth relatively slow since 1980 c. Productivity normally falls in recession as in 2008-2009 and rises in recoveries. The shape of the production function 1. Two main properties of production functions

Chapter 3: Productivity, Output, and Employment

Data Application Productivity in the Canadian economy can be very volatile. It tends to go down in a recession and up during a recovery. For data on Canadian productivity (and comparisons with the United States and between Canadian provinces) see the Centre for the Study of Living Standards web site at www.csls.ca and search under “projects” and “data base.” a. Slopes upward: more of any input produces more output b. Slope becomes flatter as input rises: diminishing marginal product as input increases 2. Graph production function (Y vs. one input; hold other input and A fixed) a. Marginal product of capital, MPK = ΔY/ΔK (Fig. 3.1; Key Diagram 1) (1) Equal to slope of production function graph (Y vs. K) (2) MPK always positive (3) Diminishing marginal Figure 3.1 productivity of capital b. Marginal product of labour, MPN = ΔY/ΔN (Fig. 3.2) (1) Equal to slope of production function graph (Y vs. N) (2) MPN always positive (3) Diminishing marginal productivity of labour Figure 3.2

Numerical Problem 2 gives students practice calculating the MPK and MPN. E.

Supply shocks 1. Supply shocks affect the amount of output that can be produced for a given amount of inputs 2. Shocks may be positive (increasing output) or negative (decreasing output) 3. Examples: weather, inventions and innovations, government regulations, changes in the supplies of factors of production other than capital and labour, access to financial capital

Data Application Why haven’t computers increased productivity? We’re living in the information age, in which many chores that used to take hours of labour can be done in seconds, such as typesetting a textbook. Computers have made many tasks much simpler. But if we look at measured productivity, we see that it is growing much more slowly than it did 30 years ago. Economists generally believe that it is not so much that computers aren’t worthwhile, but that their contributions to productivity are difficult to measure, especially in service industries.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

4. Supply shocks shift the graph of the production function (Fig. 3.3; like text Fig. 3.3) a. Negative (adverse) shock: Usually slope of production function decreases at each level of input (for example, if shock causes parameter A to decline) b. Positive shock: Usually slope of production function increases at each level of output (for example if parameter A increases)

Figure 3.3

Analytical Problem 1 asks students to draw production functions and show how they change when there are supply shocks. Theoretical Application At this point the instructor may wish to introduce the idea of real business cycle analysis (discussed in greater detail in Chapter 11. The basic point to get across is that many business cycle fluctuations may be caused by outside events (supply shocks) over which policy has no control. II. The Demand for Labour (Sec. 3.2) A. How much labour do firms want to use? 1. Assumptions a. Hold capital stock fixed—short-run analysis b. Workers are all alike c. Labour market is competitive d. Firms maximize profits 2. Analysis at the margin: costs and benefits of hiring one extra worker (Fig. 3.4; like text Fig. 3.4) a. If real wage (w) > marginal product of labour (MPN), the firm is paying the marginal worker more than the worker produces, so the firm should reduce the number of workers to increase profits b. If w < MPN, the marginal Figure 3.4 worker produces more than he or she is being paid, so the firm should increase the number of workers to increase profits c. Firms’ profits are highest when w = MPN Numerical Problem 3 sets up an example in which students calculate MPN and see what happens when the wage rate or price of the product change.

Chapter 3: Productivity, Output, and Employment

Data Application We generally assume that when we speak of labour or employment we could be referring to either the number of people employed or total hours worked. Generally, both employed workers and hours worked change in a similar way. But sometimes, as in the recovery from the 1990–92 recession, employed workers grow at a very different rate than hours worked. Between 1991 and 1993, average weekly hours grew more rapidly than employment which prompted fears of a jobless recovery. Economists speculated that the rise in costs of providing benefits, especially medical care benefits, caused employers to prefer paying workers overtime, even at time-and-a-half wages, rather than hiring new employees. Ask your students to look at Table 5.2 (Labour income statistics) in the most recent Canadian Economic Observer and compare changes in total employment to changes in total hours worked. B.

The marginal product of labour and labour demand 1. Example: The Clip Joint—setting the nominal wage equal to the marginal revenue product of labour (MRPN = P x MPN) 2. W = MRPN is the same condition as w = MPN, since W = P × w and MRPN = P × MPN (3.3) 3. A change in the wage a. Begin at equilibrium where W = MRPN b. A rise in the wage rate means W > MRPN, unless N is reduced so the MRPN rises c. A decline in the wage rate means W < MRPN, unless N rises so the MRPN falls The marginal product of labour and the labour demand curve 1. Labour demand curve shows relationship between the real wage rate and the quantity of labour demanded 2. It is the same as the MPN curve, since w = MPN at equilibrium 3. So the labour demand curve is downward sloping; firms want to hire less labour, the higher the real wage Factors that shift the labour demand curve 1. Note: A change in the wage causes a movement along the labour demand curve, not a shift of the curve 2. Supply shocks: Beneficial supply shock raises MPN, so shifts labour demand curve to the right; opposite for adverse supply shock 3. Size of capital stock: Higher capital stock raises MPN, so shifts labour demand curve to the right; opposite for lower capital stock Aggregate labour demand (Fig. 3.5) 1. Aggregate labour demand is the sum of all firms’ labour demand 2. Same factors (supply shocks, size of capital stock) that shift firms’ labour demand cause shifts in aggregate labour demand

III. The Supply of Labour (Sec. 3.3) A. Supply of labour is determined by individuals 1. Aggregate supply of labour is sum of individuals’ labour supply 2. Labour supply of individuals depends on labour–leisure choice

Figure 3.5

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

3. Real wages and labour supply a. A pure substitutioneffect: A one day rise in the real wage. b. A pure income effect: Winning the lottery. c. The substitution effect and the income effect together: A long-term increase in the real wage d. Empirical evidence on real wages and labour supply Figure 3.6

The labour supply curve (Fig. 3.6; like text Fig. 3.6) 1. Increase in the current real wage should raise quantity of labour supplied 2. Labour supply curve relates quantity of labour supplied to real wage

Theoretical Application The field of labour economics studies the determinants of labour supply. One of the major issues since the 1970s had to do with the increased participation rates of women in the labour force. Research on both the causes and consequences of this change occupied many economists and yielded many interesting research results, such as explaining why there is a negative relationship between family income and labour force participation across families, but over time there is a positive relationship.

3. Labour supply curve slopes upward because a higher wage encourages people to work more Factors that shift the labour supply curve 1. Wealth: Higher wealth reduces labour supply (shifts labour supply curve to the left) 2. Expected future real wage: Higher expected future real wage is like an increase in wealth, so reduces labour supply (shifts labour supply curve to the left)

Analytical Problem 4 asks students to think about factors that shift an individual’s labour supply curve. D.

Aggregate labour supply 1. Aggregate labour supply rises when current real wage rises a. Some people work more hours b. Other people enter labour force c. Result: Aggregate labour supply curve slopes upward 2. Factors increasing labour supply a. Decrease in wealth b. Decrease in expected future real wage c. Increase in working-age population (higher birth rate, immigration) d. Increase in labour force participation (increased female labour participation, elimination of mandatory retirement)

Chapter 3: Productivity, Output, and Employment

Data Application A broad characterization of labour force participation rates (LFPR) is that men’s LFPR has declined fairly steadily over the past 60 years, while the LFPR of women has been rising. But since 1990s, women’s LFPR growth slowed. Most of this slowdown has been concentrated in the prairies and BC, aggravating the shortage of labour in these areas. Probable reasons may include less use of daycare, higher proportion of immigrants in the west due to economic expansion, women in the west are moving in growing numbers into older age groups and the concentration of job growth in areas less suited to women, who prefer white collar jobs and those with fewer hours. IV. Labour Market Equilibrium (Sec. 3.4) A. Equilibrium: Labour supply equals labour demand (Fig. 3.7; Key Diagram 2; like text Fig. 3.8)

Figure 3.7

1. Classical model of the labour market—real wage adjusts quickly 2. Determines full-employment level of employment N and market-clearing real wage w . 3. Factors that shift labour supply or labour demand affect N and 4. Problem with classical model: cannot study unemployment Data Application There are, of course, many different wages in the economy; our model with just one wage is a simplification. When economists look at real data to see how wages are changing over time, they control for the fact that the mix of jobs changes over time. Statistics Canada publishes monthly statistics on average hourly and average weekly earnings for an industrial aggregate, which takes this change into account. Numerical Problems 4, 5, and 6 are exercises in which students are given algebraic labour demand and supply curves and are asked to find the equilibrium. Analytical Problems 3 (dealing with wage rigidity) and 5 (dealing with tax on labour demand) are comparative static exercises dealing with labour market equilibrium. Analytical Problem 2 asks students to show how different shocks to the economy affect full-employment output.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Full-employment output 1. Y = AF(K, N ) 2. Y affected by changes in N or production function (example: supply shock)

Data Application What is full-employment output? For many of our theories about macroeconomics, we need a measure of full-employment output, but it is not obvious where to get such a measure. In practice, economists make some assumptions about the structure of the economy, including the production function, apply these assumptions to the data, and thus estimate what they think is the full-employment level of output. C.

Application: Output, employment, and the real wage during oil price shocks 1. Sharp oil price increases in 1973–74, 1979–80, 1990, 2008 2. Adverse supply shock—lowers labour demand, employment, the real wage, and the full-employment level of output 3. Following 1979–80 and 1990, the Canadian economy entered a recession. This scenario now seems less likely in 2008 as recent increases in oil prices have prompted a dramatic expansion of oil production in Canada which may have a beneficial effect on employment and output. Application: Technical change and wage inequality 1. Two important features of Canadian real wages since 1970 a. real wage growth has slowed b. real wage has become more unequal 2. Wage inequality between the sexes has declined: while an increase in labour supply tends to lower the real wage, increased full time job experience tends to raise the real wage by raising productivity. 3. Women have benefited from changes that reward skill-based technological change than men. 4. Skill-based technological change (such as computerization) has increased real wages of highly educated workers, but limited real wage growth for unskilled workers

V. Unemployment (Sec. 3.5) A. Measuring unemployment 1. Categories: employed, unemployed, not in the labour force 2. Labour Force = Employed + Unemployed 3. Unemployment Rate = Unemployed / Labour Force 4. Participation Rate = Labour Force / Working-Age Population 5. Employment Ratio = Employed / Working-Age Population Analytical Problem 6 tests students’ ability to use these different measures. B.

Changes in employment status 1. Flows between categories

Numerical Problem 7 is a quantitative exercise using the unemployment and employment concepts. Data Application For an in-depth look at job creation and destruction, see John R. Baldwin, Timothy Dunne, and John Haltiwanger, “A Comparison of Gross Job Creation and Destruction in Canada and the U.S.”, Review of Economics and Statistics, August 1998, pp. 347–356. Copyright © 2016 Pearson Canada Inc. 36

Chapter 3: Productivity, Output, and Employment

How long are people unemployed? 1. Most unemployment spells are of short duration a. Unemployment spell = period of time an individual is continuously unemployed b. Duration = length of unemployment spell 2. Most unemployed people on a given date are experiencing unemployment spells of long duration 3. Reconciling 1 and 2—numerical example: a. Labour force = 100; on the first day of every month, two workers become unemployed for one month each; on the first day of every year, four workers become unemployed for one year each b. Result: 28 spells of unemployment during year; 24 short (one month), four long (one year); so most spells are short c. At any date, unemployment = six; four have long spells (one year), two have short spells (one month); so most unemployed people on a given date have long spells Why there are always unemployed people 1. Frictional unemployment a. Search activity of firms and workers due to heterogeneity b. Matching process takes time 2. Structural unemployment a. Long-term, chronic unemployment b. One cause: Lack of skills prevents some workers from finding long-term employment c. Another cause: Reallocation of workers out of shrinking industries or depressed regions; matching takes a long time 3. The natural rate of unemployment a. ū = natural rate of unemployment; when output and employment are at full-employment levels b. ū = frictional + structural unemployment c. Cyclical unemployment: difference between actual unemployment rate and natural rate of unemployment (u − ū)

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1.

What Causes Productivity to Rise or Fall?

The production function treats total factor productivity as a “black box.” What are some real-world factors that may cause one individual, firm, or country to be more economically productive than another, given the same capital and labour inputs? Asking the class to discuss factors affecting work or study effectiveness will allow students to relate the abstract concept to their own experiences. Productivity depends on such things as (1) morale; (2) easy access to the tools, equipment, and information needed to get a job done; (3) education; and (4) training. To illustrate morale, offices where workers are happy with their jobs and like their working conditions frequently outperform those in which the opposite is true. Happy workers are not concerned with complaining about their working conditions. Similarly, when layoffs are imminent, workers spend large amounts of time trying to find out who is going to be laid off and when. They have little time for their work and do not concentrate on the tasks at hand, leading to decreases in the amount and quality of their output. If workers cannot easily acquire the tools and information they need, they may spend much of their time on the job hunting for these items, rather than actually doing productive tasks. For example, if company policy allows a travelling employee to check out a company car for only one business trip at a time, an individual needing to make several trips in a short period will waste considerable time in signing out the car and returning it. The issue is not the amount of capital available, but rather whether it is available for use when it is needed. Students who have worked should be able to contribute examples of such problems. 2.

Another Production Function Example

Below is an example that is generally similar to Numerical Problem 3 at the end of the chapter. Music, Music Number of Workers Compact Disks Marginal Product Marginal Revenue Per Day Per Day of Labour Product (units per day) (CD price $12) 0 0 — — 1 20 20 240 2 35 15 180 3 48 13 156 4 59 11 132 5 68 9 108 6 75 7 84 7 81 6 72 8 86 5 60 9 90 4 48 10 93 3 36 11 95 2 24 If the wage rate is $40 per day ($5 per hour), Music, Music will hire nine workers. Hiring eight workers would cost $320; selling the output at $12 per CD would result in revenues of $1032, leaving $712 for fixed costs and profits. Hiring nine workers would cost $360; selling the output at $12 per CD would result in revenues of $1080, leaving $720 for fixed costs and profits. Hiring ten workers would cost $400; selling the output at $12 per CD would result in revenues of $1116, leaving $716 for fixed costs and Copyright © 2016 Pearson Canada Inc. 38

Chapter 3: Productivity, Output, and Employment

profits. So profits are maximized when nine workers are hired. The analysis of the totals complements the marginal analysis and may help convince the skeptics in class that marginal analysis works. By varying the price of labour you can create a demand for labour curve for Music, Music. For example, by determining that at a wage of $70 per day you will hire seven workers, for $50 per day you will hire eight, and for $30 per day you will hire ten, you can easily draw a labour demand curve. Assigning each student a different price for CDs, having each derive a labour demand curve for his or her price, and then asking them to graph these on the same paper, with each student contributing a curve based on a different CD price, may help them to see how changes in prices of the output move the demand for labour curve. 3.

How Do Society’s Expectations Affect Labour Supply?

The labour force participation rate varies substantially over time and across countries. Other than the level of real wages, what factors contribute to this variation? Besides real wages, a major determinant of labour supply is the needs and expectations of the individuals in a society. During World War II many women worked to aid the war effort. In the 1950s and early 1960s, women were expected to leave the labour force when they had their first child, if they had not left upon marriage. Today many women expect to return to their jobs a few weeks after a child is born. Families differ as to how much work is expected from college or university students. In some families each student is expected to pay for his or her education with little assistance from the parents. In other households most college expenses are paid by the parents. Another change in work patterns has occurred in the labour force participation rates of older men and women. For example, due to retirement benefits that allow for comfortable living, many individuals choose to retire before they are 65. In fact, labour force participation rates for men over 50 have moved downward since 1960, in contrast to participation rates for the economy as a whole. Another influence on labour force participation is the level of taxation. In Sweden marginal rates of taxation for those with high incomes are over 50%, reducing the desire of such workers to supply labour. In assigning Numerical Problem 5 you may wish to briefly discuss such taxes and their effect on the supply of labour. 4.

Additional Costs and Benefits of Unemployment

What costs does unemployment impose on individuals and society? Are there any potential benefits? Unemployment has a negative impact on individuals and the economy beyond loss of output and the financial hardships of those who are unemployed. The job skills and knowledge of those who are out of work for long periods of time may deteriorate unless they are involved in retraining or other skill development activities. Not only do workers’ skills deteriorate due to lack of practice, but the day-to-day learning of new information stops. A second difficulty is that unemployment is sometimes associated with breakdown of family life.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Extensive unemployment may spawn political unrest. The rise of AdoIf Hitler and the Nazis in the 1930s was built, in part, on the dissatisfaction of the unemployed with the previous German government. Many observers wonder how long the states of the former Soviet Union and Eastern Europe will be able to maintain stable governments if many people remain unemployed. Unemployment does provide some long-term benefits to the economy and individuals despite the short-run hardships. In order to look for a new job, individuals frequently assess their interests, skills, and experience. If they feel that their skills need updating, workers may go to school to retrain and increase their skills and their chances of finding a job. For example, white collar business workers who get laid off may decide to return to school to do an MBA program to increase their employment chances. This will eventually result in a better trained and more productive workforce. Some workers may move from a region of low demand to a region in which the need for new workers is great. In the mid-2000s many oil industry workers moved to Alberta, following the expansion in the oil sand market, from other provinces, where manufacturing was declining. Some people who lose their jobs decide to strike out on their own. Many entrepreneurs who later built successful businesses started when they were laid off. 5.

Is Technological Change Good for Workers?

Workers are often adamantly opposed to technological change; they see it as a threat to their jobs. But technological change can make work easier and the higher productivity allows higher wages to be paid. Workers frequently oppose the introduction of new ways of producing goods and services. From the Luddites in the 1800s, who smashed machines, to the 1990s workers who fear computers, job holders have seen technology as a threat to their jobs and their way of life. New machines and methods of production have reduced the marginal product of some workers, especially those with limited skills. There is little demand for unskilled labourers such as ditchdiggers. Fewer and fewer production line jobs in manufacturing exist. On the other hand, technological innovation opens up new, highly productive and thus high-paying positions in such fields as computer information systems and electrical or mechanical repair. The transition from the old, less productive to the new, more productive jobs is a hard one for many. Those in unskilled jobs find it difficult to acquire the skills necessary for the new high-paying positions. Often they are older workers whose learning skills are rusty. They lack the background in science and mathematics necessary to easily acquire the necessary new knowledge and abilities. In addition, the new jobs may be in different places. For example, workers laid off from the fishing industry in Newfoundland find it difficult to move to the Ontario or the West where industry has been adding jobs. Older workers own homes, have established family patterns, and do not want to move.

Chapter 3: Productivity, Output, and Employment

ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1.

A production function shows how much output can be produced with a given amount of capital and labour. The production function can shift due to supply shocks, which affect overall productivity. Examples include changes in energy supplies, technological breakthroughs, and management practices. Besides knowing the production function, you must also know the quantities of capital and labour the economy has.

The upward slope of the production function means that any additional inputs of capital or labour produce more output. The fact that the slope declines as we move from left to right illustrates the idea of diminishing marginal productivity. For a fixed amount of capital, additional workers each add less additional output as the number of workers increases. For a fixed number of workers, additional capital acids less additional output as the amount of capital increases.

The marginal product of capital (MPK) is the output produced per unit of additional capital. The MPK can be shown graphically using the production function. For a fixed level of labour, plot the output provided by different levels of capital; this is the production function. The MPK is just the slope of the production function.

The marginal revenue product of labour represents the benefit to a firm of hiring an additional worker, while the nominal wage is the cost. Comparing the benefit to the cost, the firm will hire additional workers as long as the marginal revenue product of labour exceeds the nominal wage, since doing so increases profits. Profits will be at their highest when the marginal revenue product of labour just equals the nominal wage.

The same condition can be expressed in real terms by dividing through by the price of the good. The marginal revenue product of labour equals the marginal product of labour times the price of the good. The nominal wage equals the real wage times the price of the good. Dividing each of these through by the price of the good means that an equivalent profit-maximizing condition is the marginal product of labour equals the real wage. The MPN curve shows the marginal product of labour at each level of employment. It is related to the production function because the marginal product of labour is equal to the slope of the production function (where output is plotted against employment). The MPN curve is related to labour demand, because firms hire workers up to the point at which the real wage equals the marginal product of labour. So the labour demand curve is identical to the MPN wage curve, except that the vertical axis is the real wage instead of the marginal product of labour. A temporary increase in the real wage increases the amount of labour supplied because the substitution effect is larger than the income effect. The substitution effect arises because a higher real wage raises the benefit of additional work for a worker. The income effect is small because the increase in the real wage is temporary, so it doesn't change the worker's income very much, thus the worker won't reduce time spent working very much. A permanent increase in the real wage, however, has a much larger income effect, since a worker's lifetime income is changed significantly. The income effect may be so large that it exceeds the substitution effect, causing the worker to reduce time spent working.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

The aggregate labour supply curve relates labour supply and the real wage. The principal factors shifting the aggregate labour supply curve are wealth, the expected future real wage, the country's working-age population, or changes in the social or legal environment that lead to changes in labour force participation. Increases in wealth or the expected future real wage shift the aggregate labour supply curve to the left. Increases in the working-age population or in labour-force participation shift the aggregate labour supply curve to the right.

Full-employment output is the level of output that firms supply when wages and prices in the economy have fully adjusted; in the classical model of the labour market, this occurs when the labour market is in equilibrium. When labour supply increases, full-employment output increases, as there is now more labour available to produce output. When a beneficial supply shock occurs, then the same quantities of labour and capital produce more output, so full-employment output rises. Furthermore, a beneficial supply shock increases the demand for labour at each real wage and leads to an increase in the equilibrium level of employment, which also increases output.

The classical model of the labour market assumes that any worker who wants to work at the equilibrium real wage can find a job, so it is not very useful for studying unemployment.

10. The labour force consists of all employed and unemployed workers. The unemployment rate is the fraction of the labour force that is unemployed. The participation rate is the fraction of the adult population that is in the labour force. The employment ratio is the fraction of the adult population that is employed. 11. An unemployment spell is a period of time that a person is continuously unemployed. Duration is the length of time of an unemployment spell. Two seemingly contradictory facts are that most unemployment spells have a short duration and that most people who are unemployed at a particular time are experiencing spells with long durations. These can be reconciled by realizing that there may be a lot of people with short spells and a few people with long spells. On any given date, a survey finds a fairly long average duration for the unemployed, because of the people with bong spells. For example, suppose that each week one person becomes unemployed for one week, so there are fifty-two such short unemployment spells during the year. And suppose that there are four people who are unemployed all year, so there are four long unemployment spells during the year. In any given week five people are unemployed: one unemployed person has a spell of one week, while four have spells of a year. So most spells have a short duration (fifty-two short spells compared to four long spells), but most people who are unemployed at a given time are experiencing spells with long duration (one short spell compared to four long spells). 12. Frictional unemployment arises as workers and firms search to find matches. A certain amount of frictional unemployment is necessary, because it is not always possible to find the right match right away. For example, an unemployed banker may not want to take a job flipping hamburgers if he or she cannot find another banking job right away, because the match would be very poor. By remaining unemployed and continuing to search for a more suitable job, the banker is likely to make a better match. That will be better both for the banker (since the salary is likely to be higher) and for society as a whole (since the better match means greater productivity in the economy).

Chapter 3: Productivity, Output, and Employment

13. Structural unemployment occurs when people suffer long spells of unemployment or are chronically unemployed (with many spells of unemployment). Structural unemployment arises when the number of potential workers with low skill levels exceeds the number of jobs requiring low skill levels, or when the economy undergoes structural change, when workers who lose their jobs in shrinking industries may have difficulty finding new jobs. 14. The natural rate of unemployment is the rate of unemployment that prevails when output and employment are at their full-employment levels. The natural rate of unemployment is equal to the amount of frictional unemployment plus structural unemployment. Cyclical unemployment is the difference between the actual rate of unemployment and the natural rate of unemployment. When cyclical unemployment is negative, output and employment exceed their full-employment levels. Numerical Problems 1.

To find the growth of total productivity, you must first calculate the value of A in the production function. This is given by A = Y/ (K.3N.7). The growth rate of A can then be calculated as Ayear2/Ayear1 − 1. The result is: 1960

A 12.68

% increase in A —

1970

14.91

17.6%

1980

16.61

11.3%

1990

18.17

9.4%

Calculate the marginal product of labour by seeing what happens to output when you add 1.0 to N; call this Y2, and the original level of output Y1. [A more precise method is to take the derivative of output with respect to N; dY/dN = 0.7A(K/N)3. The result is the same (rounded).] Y1

MNP

1960

223

248

25.8

1990

768

808

40.5

The MPK is 0.2, because for each additional unit of capital, output increases by 0.2 units. The slope of the production function line is 0.2. There is no diminishing marginal productivity of capital in this case, because the MPK is the same regardless of the level of K. This can be seen in Fig. 3.8 because the production function is a straight line.

Figure 3.8

When N is 100, output is Y = 0.2(100 + 100.5) = 22. When N is 110, Y is 22.0976. So the MPN for raising N from 100 to 110 is (22.0976 − 22) / 10 = 0.00976. When N is 120, Y is 22.1909. So the MPN for raising N from 110 to 120 is (22.1909 − 22.0976) / 10 = 0.00933. This shows diminishing marginal productivity of labour because the MPN is falling as N increases. In Fig. 3.9 this is shown as a decline in the slope of the production function as N . 43

Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

increases.

Figure 3.9

1 2 3 4 5 6

8 15 21 26 30 33

P = $5.

(1)

W = $38. Hire one worker, since MRPN ($40) is greater than W ($38) at N = 1. Do not hire two workers, since MRPN ($35) is less than W ($38) at N = 2.

(2)

W = $27. Hire three workers, since MRPN ($30) is greater than W ($27) at N = 3. Do not hire four workers, since MRPN ($25) is less than W ($27) at N = 4.

MPN MRPN MRPN (P=5) (P=10) 8 40 80 7 35 70 6 30 60 5 25 50 4 20 40 3 15 30

(3)

W = $22. Hire four workers, since MRPN ($25) is greater than W ($22) at N = 4. Do not hire five workers, since MRPN ($20) is less than W ($22) at N = 5. Figure 3.10 plots the relationship between labour demand and the nominal wage. This graph is different from a labour demand curve because a labour demand curve shows the relationship between labour demand and the real wage. Figure 3.11 shows the labour demand curve.

Chapter 3: Productivity, Output, and Employment

Figure 3.11

Figure 3.10

d. P = $10. The table in part a. shows the MRPN for each N. At W = $38, the firm should hire five workers. MRPN ($40) is greater than W ($38) at N = 5. The firm shouldn't hire six workers, since MRPN ($30) is less than W ($38) at N = 6. With five workers, output is 30 widgets, compared to 8 widgets in part a when the firm hired only one worker. So the increase in the price of the product increases the firm's labour demand and output. e. If output doubles, MPN doubles, so MPRN doubles. The MPRN is the same as it was in part d when the price doubled. So labour demand is the same as it was in part d. But the output produced by five workers now doubles to 60 widgets. f.

Since MRPN = P x MPN, then a doubling of either P or MPN leads to a doubling of MRPN. Since labour demand is chosen by setting MRPN equal to W, the choice is the same, whether P doubles or MPN doubles.

MPN = A (100 – N) a. A = 1. MPN = 100 – N. (1) W = $10, w = W/P = $10/52 = 5. Setting w = MPN, 5 = 100 – N, so N = 95. (2) W = $20. w = W/P = $20/$2 = 10. Setting w = MPN, 10 = 100 – N, so N = 90. These two points are plotted as line NDa in Fig. 3.12. If labour supply = 95, then the equilibrium real wage is 5.

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Figure 3.12

b. A = 2. MPN = 2(100 – N). (1) W = $10. w = W/P = $10/$2 = 5. Setting w = MPN, 5 = 2(100 − N), so 2N = 195, so N = 97.5. (2) W = $20. w = W/P = $20 / $2 = 10. Setting w = MPN, 10 = 2(100 − N), so 2N = 190, so N = 95. These two points are plotted as line NDb in Fig. 3.12. If labour supply = 95, then the equilibrium real wage is 10. 5.

a. If the lump-sum tax is increased, there is an income effect on labour supply, not a substitution effect (since the real wage is not changed). An increase in the lump sum tax reduces a worker's wealth, so labour supply increases. b. If T = 35, then NS = 22 + 12w + (2 x 35) = 92 + 12 w. Labour demand is given by w = MPN = 309 − 2N, or 2N = 309 − w, so N = 154.5 − w/2. Setting labour supply equal to labour demand gives 154.5 − w/2 = 92 + 12w, so 62.5 = 12.5w, thus w = 62.5/12.5 = 5. With w = 5, N = 92 + (12 x 5) = 152. c. Since the equilibrium real wage is below the minimum wage, the minimum wage is binding. With w = 7, N = 154.5 − 7/2 = 151.0. Note that NS = 92 + (12 x 7) = 176, so NS > N and there is unemployment.

Since w = 4.5 K0.5 N−0.5, N−0.5 = 4.5 K0.5/w, so N = 20.25 K/w2. When K = 25, N = 506.25/w2.

a. If t = 0.0, then NS = 100w2. Setting labour demand equal to labour supply gives 506.25/w2 = 100w2, so w4 = 5.0625, or w = 1.5. Then NS = 100 (1.5)2 = 225. [Check: N = 506.25/1.52 = 225] Y = 45N0.5 = 45(225)0.5 = 675. The total after-tax wage income of workers is (1−t) w NS = 1.5 x 225 = 337.5.

Chapter 3: Productivity, Output, and Employment

b. If t = 0.6, then NS = 100 [(1 − 0.6) w]2 = 16w2. The marginal product of labour is MPN = 22.5 / N0.5, so N = 100 [(1 − 0.6) x 22.5 / N0.5]2, so N2 = 8100, so N = 90. Then Y = 45 N0.5 = 45(90)0.5 = 426.91. Then w = 22.5 / 900.5 = 2.37. The total after-tax wage income of workers is (1−t) w NS = 0.4 x 2.37 x 90 = 85.38. Note that there is a big decline in output and income, although the wage is higher. c. A minimum wage of 2 is binding if the tax rate is zero. Then N = 506.25/22 = 126.6, NS = 100 x 22 = 400. Unemployment is 273.4. Income of workers is wN = 2 x 126.6 = 253.2, which is lower than without a minimum wage, because employment has declined so much. 7.

a. At any date, 25 people are unemployed: 5 who have lost their jobs at the start of the month and 20 who have lost their jobs either on January 1 or July 1. The unemployment rate is 25 / 500 = 5%. b. Each month, 5 people have one-month spells. Every six months, 20 people have six-month spells. The total number of spells during the year is (5 × 12) + (20 × 2) = 100. Sixty of the spells (60% of all spells) last one month, while 40 of the spells (40% of all spells) last six months. c. The average duration of a spell is (0.60 × 1 month) + (0.40 × 6 months) = 3 months. d. On any given date, there are 25 people unemployed. Twenty of them (80%) have long spells of unemployment, while 5 of them (20%) have short spells.

( Y – Y)/ Y = 2(u – u ), this can be rewritten as Y – Y = 2(u – u ) or Y = [1 – Y 2(u – u )] Y , or Y =/Y/[1 – 2(u – u )]. a. Using the formula above, this table shows the value of Y , given values for u and Y. Year 1 2 3 4

u 0.08 0.06 0.07 0.05

Y 950 1030 1033.5 1127.5

Y 989.6 1030.0 1054.6 1105.4

b. The first calculation of Δ Y / Y comes from calculating the percent change in Y from part a. The second calculation of Δ Y / Y comes from using Eq. (3.7): ΔY/Y = Δ Y / Y – 2 Δu, so Δ Y / Y = ΔY/Y + 2 Δu. Year Δ ΔY/Y Δu Δ 1 989.6 — — — — 2 1030.0 0.041 0.084 –0.02 0.044 3 1054.6 0.024 0.003 -0.01 0.023 4 1105.4 0.048 0.091 –0.02 0.051 The two methods give fairly close answers.

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(a) Total hours worked per week = 1900 workers × 40 hours per worker = 76 000 hours per week. Total output per week = 76 000 total hours per week × 10 units of output per hour = 760 000 units of output. The unemployment rate is 100 unemployed/2000 labour supply = 0.05, or 5%. (b) Employment falls 4% from 1900 to: (1 – 0.04) × 1900 = 1824. The labour force falls 0.2% from 2000 to: (1 – 0.002) × 2000 = 1996. With a labour force of 1996 and employment of 1824, unemployment is 1996 – 1824 = 172. The unemployment rate is 172/1996 = 0.086, or 8.6%. Hours worked per employed worker falls 2.5% from 40 to: (1 – 0.025) × 40 = 39. Total hours per week = 39 hours per worker × 1824 workers = 71 136. So, total hours per week falls by (76 000 – 71 136)/76 000 = 0.064 = 6.4%. Total output per week falls 1.4% for every 1% drop in hours, so output falls by 6.4% × 1.4 = 8.96%. Since output was 760 000, it now falls to 760 000 × (1 – 0.0896) = 691 904.

Analytical Problems 1.

See Figs. 3.13 and 3.14.

Figure 3.13

Figure 3.14

In the initial situation, capital K1 and labour N1 produce output Y1; when productivity rises they produce output 1.1 Y1. Suppose that a small increase in capital to K2 with labour left at N1 produces output Y2 in the initial situation. Then it produces 1.1 Y2 when productivity rises by 10%. The marginal product of capital (MPK) in the initial situation is (Y2 − Y1) / (K2 – K1); when productivity rises the new MPK is (1.1 Y2 − 1.1 Y1) / (K2 − K1) = 1.1 (Y2 − Y1) / (K2 − K1). So the new MPK is 10% higher than the old MPK. This argument is completely symmetric, so it holds for MPN as well. If you substitute N for K everywhere and follow the same steps, you will show that the new MPN is 10% higher than the old MPN.

Chapter 3: Productivity, Output, and Employment

Yes, it is possible for a beneficial productivity shock to leave the MPK and MPN unchanged. This could happen only if the shock was additive that is, if it shifted the whole production function upward, but did not affect its slope at any point. In Figs. 3.15 and 3.16 this is shown as a shift up in the production function, leaving the slope unchanged.

Figure 3.16

Figure 3.15

An increase in the number of immigrants increases the labour force, increasing employment and increasing full-employment output.

If energy supplies become depleted, this is likely to reduce productivity, because energy is a factor of production. So the reduction in energy supplies reduces full-employment output.

Better education raises future productivity and output, but has no effect on current full-employment output.

This reduction in the capital stock reduces full-employment output (although it may very well increase welfare).

As shown in Fig. 3.17, when the real wage (w) is above its market-clearing level, labour supply (NS) exceeds labour demand (ND). The difference is the amount of unemployment (U).

Figure 3.17

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Output is lower because of the real wage rigidity. With the real wage higher than the wage that clears the market at full employment, labour demand must be lower than it is at full employment, so employment and output are lower as well.

The increased value of Helena's home increases her wealth. The rise in wealth leads to an income effect that leads Helena to reduce her labour supply.

The permanent rise in Helena's real wage gives rise to offsetting income and substitution effects. The income effect of the higher wage reduces Helena's labour supply, but the substitution effect increases it. So the result is theoretically ambiguous. Empirically, women tend to increase labour supply in response to a permanent increase in the real wage, and men tend to reduce labour supply in response to a permanent increase in the real wage.

The temporary income tax surcharge is equivalent to a temporary reduction in the real wage, which reduces current labour supply, assuming that the income effect is smaller than the substitution effect.

The tax reduces the marginal product of labour by 6%, since that portion of output goes to the government rather than to the firm. Thus, labour demand is reduced. With labour supply unchanged, the downward shift in labour demand reduces the real wage and employment, as shown in Fig. 3.18.

Figure 3.18

Yes, it is possible for the unemployment rate and the employment ratio to rise during the same month. For example, suppose the population falls, the labour force is constant, the number of unemployed rises, and the number of employed falls (but by less than the decline in population). Then the unemployment rate rises, since there are more unemployed but the same labour force, but the employment ratio rises, since population declines more than employment does. Yes, it is possible for the participation rate to fall at the same time that the employment ratio is rising. For example, suppose that population is constant, the labour force declines, employment rises, and unemployment falls. The participation rate falls, since there are fewer people in the labour force from the same population. The employment ratio is rising, since employment rises while population is constant.

CHAPTER 4: CONSUMPTION, SAVING, AND INVESTMENT LEARNING OBJECTIVES I.

Goals of Chapter 4 A. Examine the factors that underlie economy wide demand for goods and services B. Assumes closed economy (for now, dropped in Chapter 5) C. Focuses on consumption and investment D. Equivalent to studying saving and capital formation E. Examines trade-off present vs. future F. Goods market equilibrium when desired saving equals desired investment G. Real interest rate plays key role in bringing goods market to equilibrium

II.

Notes to Eighth Edition Users A. All figures and tables have been updated.

TEACHING NOTES I.

Consumption and Saving (Sec. 4.1) People think about the present vs. the future in choosing saving and consumption 1. Increase in current income: both consumption and saving increase (vice versa for decrease in current income) 2. Desired consumption: consumption amount desired by households 3. Desired national saving: level of national saving when consumption is at its desired level Sd = Y – Cd – G (4.1) A. The consumption and saving decision of an individual. 1. The rate a person trades off current and future consumption depends on the real interest rate prevailing in the economy. 2. The real interest rate, r, determines the relative price of current consumption and future consumption. B. Effects of changes in current income. 1. When current income (Y) rises, Cd rises, but not by as much as Y, so Sd rises 2. The fraction of additional current income that one consumes in the current period is the marginal propensity to consume (MPC)

Theoretical Application The classic discussions of consumption are the permanent-income hypothesis of Milton Friedman (A Theory of the Consumption Function, Princeton: Princeton University Press, 1957) and the life-cycle hypothesis of Franco Modigliani and Richard Brumberg (“Utility Analysis and the Consumption Function: An Interpretation of Cross-Section Data,” in Ken Kurihara, ed., Post-Keynesian Economics, New Brunswick, N.J.: Rutgers University Press, 1954). The permanent income hypothesis focuses on what consumers do with random income receipts; the life-cycle hypothesis is concerned with predictable changes in income over the life cycle. C.

Effects of changes in expected future income. 1. Higher expected future income leads to more consumption today, so current saving falls 2. Application: consumer attitudes and recessions; sharp contraction in consumer sentiment in 1981-82 recession but also recovered rapidly. Decline in consumer attitudes was more gradual during the early . 51

Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

1990’s while its recovery was more erratic reflecting consumers pessimism and uncertainty. The same close relationship was illustrated after the recent recession of 2008-2009. Effects of changes in wealth 1. Increase in wealth raises current consumption, so lowers current saving 2. Application: The 1987 stock market crash and consumer spending. When the stock market crashed in 1987, wealth declined by about $100 billion. Consumption fell somewhat less than might be expected, and it wasn’t enough to cause a recession. There was a temporary decline in confidence about the future, but it was quickly reversed. The small response may have been because there had been a large run-up in stock prices between January and August 1987, so the crash mostly erased this run-up. Housing wealth and consumer spending: Consumers increase spending more due to increase in housing wealth than by increase in stock market wealth. The three reasons are 2/3 of households own their homes; stock prices are far more volatile than are housing prices; and increases in wealth arising from increases in housing prices are exempt from capital gain taxation. Effect of changes in the real interest rate 1. Increased expected real interest rate has two opposing effects a. The income effect of the real interest rate reflects a positive effect on saving, since rate of return is higher; greater reward for saving elicits more saving b. The substitute effect of the real interest rate on saving reflects the negative effect on saving, since it takes less saving to obtain a given amount in the future (target saving) c. Empirical studies have mixed results; probably a slight increase in saving 2. Taxes and the real return to saving a. Expected after-tax real interest rate: rә-t = (1- t)i – πe (4.2) b. Simple examples: i = 5%, πe = 2%; if t = 30%, ra-t = 1.5%; if t = 20%, ra-t = 2%

Data Application Eytan Sheshinski, in “Treatment of Capital income in Recent Tax Reforms and the Cost of Capital in Industrialized Countries,” in Larry Summers, ed., Tax Policy and the Economy 4, Cambridge, Mass.: MIT Press, 1990, pp. 25-42, finds that real after-tax interest rates were negative for Canada and many other countries in the 1970s. Even with fairly low inflation, because nominal returns, rather than real returns, are taxed, the real after-tax interest rate (for taxpayers in the top bracket) is fairly low relative to the pretax real interest rate. For example, in Canada in 1985, the pretax real interest rate was 6.6%; the after-tax real interest rate was 1.1% (π = 3.98%, t = 52%). In 1987 the pretax real rate was 5.4%; the after-tax real interest rate was 0.7% (π = 4.35%, t = 49%).

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A Closer Look 4.2: interest rates Discusses different interest rates, default risk, term structure, tax status

Numerical Problem 1 explores how changes in income, future income, wealth, and interest rates affect consumption. F.

Fiscal policy 1. Affects desired consumption through changes in current and expected future income 2. Directly affects desired national saving, Sd = Y – Cd – G 3. Government purchases (temporary increase) a. Higher G financed by current taxes reduces after-tax income, lowering desired consumption b. Even true if financed by higher future taxes, if people realize how future incomes are affected c. Since Cd declines less than G rises, national saving (Sd = Y = Cd = G) declines d. So government purchases reduce both desired consumption and desired national saving 4. Taxes a. Lump-sum tax cut today, financed by higher future taxes b. Decline in future income offsets increase in current income c. Ricardian equivalence proposition

Data Application This theory is confirmed by empirical data. Shaghil Ahmed, in “Temporary and Permanent Government Spending in an Open Economy: Some Evidence for the United Kingdom,” Journal of Monetary Economics, March 1986, pp. 197-224, finds, using a long-time series of British data, that temporary government purchases indeed crowd out consumption spending, even though the expenditures are useful in increasing the marginal productivity of private capital and providing a substitute for consumption goods. (1) If future income loss exactly offset current income gain, no change in consumption (2) Tax change affects only the timing of taxes, not their ultimate amount (present value) (3) In practice, people may not see that future taxes will rise if taxes are cut today; then a tax cut leads to increased desired consumption and reduced desired national saving

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Theoretical Application There are a number of reasons why Ricardian equivalence may not hold. The text notes that if people don’t see that future taxes are equal (in present value) to a current tax cut, then Ricardian equivalence may not hold. An additional reason for the failure of Ricardian equivalence, liquidity constraints, is covered in Chapter 8. It may also be possible for people to avoid future taxes, even if they foresee them, by moving or dying; however, in the latter case, if those people planned to leave bequests to future generations, they would increase their bequests by the increased tax liability (Robert Barro, “Are Government Bonds Net Wealth?” Journal of Political Economy, Nov./Dec. 1974, pp. 109-1117.) Other reasons for the failure of Ricardian equivalence include: (1) If the current tax cut is given to a different set of people than must pay the future taxes, and those people have differing marginal propensities to consume; (2) if taxes are distortionary, rather than lump sum; and (3) if future tax rates or future income aren’t known with certainty. For a useful overview and further details, see Andrew B. Abel, “Ricardian Equivalence Theorem,” in John Eatwell et al., eds., The New Palgrave: A Dictionary of Economics, London: Macmillan Press, 1987. Empirically, the evidence on Ricardian equivalence is mixed; for a review, see B. Douglas Bernhelm, “Ricardian Equivalence: An Evaluation of Theory and Evidence,” in Stanley Fischer, ed., NBER Macroeconomics Annual, Cambridge, Mass.: MIT Press, 1987, pp. 263-304. For the Canadian evidence, see David R. Johnson “Ricardian Equivalence: Assessing the Evidence for Canada” in William B.P. Robson and William M. Scarth eds. Deficit Reduction: What Pain, What Gain? Toronto, C.D. Howe Institute, 1994 pp. 81-118. II.

Investment (Sec. 4.2) A. Why is investment important? 1. Investment fluctuates sharply over the business cycle, so we need to understand investment to understand the business cycle 2. Investment plays a crucial role in economic growth B The desired capital stock 1. Desired capital stock is the amount of capital that allows firms to earn the largest expected profit 2. Desired capital stock depends on costs and benefits of additional capital 3. Since investment becomes capital stock with a lag, the benefit of investment is the future marginal product of capital (MPKf) 4. The user cost of capital a. Example of Tony’s Bakery: cost of capital, depreciation Figure 4.1 rate, and expected real interest rate b. User cost of capital = real cost of using a Figure 4.1 unit of capital for a specified period of time c. uc = rpK + dpK = (r + d)pK (4.3)

Chapter 4: Consumption, Saving, and Investment

Determining the desired capital stock (Fig. 4.1; like text Fig. 4.2) a. Desired capital stock is the level of capital stock at which MPKf = uc b. MPKf falls as K rises due to diminishing marginal productivity c. uc doesn’t vary with K, so is a horizontal line d. If MPKf > uc, profits rise as K is added (marginal benefits > marginal costs) e. If MPKf < uc, profits rise as K is reduced (marginal benefits < marginal costs) f. Profits are maximized where MPKf = uc

See A Closer Look 4.3, “Investment and the Stock Market,” for an alternative method of determining the desired stock of capital. C. Changes in the desired capital stock 1. Factors that shift the MPKf curve or change the user cost of capital cause the desired capital stock to change 2. These factors are changed in the real interest rate, depreciation rate, price of capital, or technological changes that affect the MPKf (text Fig. 4.3 shows effect of change in uc) 3. Taxes and the desired capital stock a. With taxes, the return to capital is only (1 – τ) MPKf b. Setting the return equal to the user cost gives MPKf = uc/(1 – τ) = (r + d)pk/(1 – τ) c. Tax-adjusted user cost of capital is uc/(1 – τ) d. An increase in τ raises the tax-adjusted user cost and reduces the desired capital stock Theoretical Application The first general use of the user cost of capital concept was by Dale Jorgenson. “Capital Theory and Investment Behavior,” American Economic Review Papers and Proceedings, May 1963, pp. 247-259. Numerical Problems 2 and 4 give students practice in working with the marginal product of capital and the user cost of capital. e.

In reality, there are complications to the tax-adjusted user cost (1) We assumed that firm revenues were taxed (a) In reality, profits, not revenues, are taxed (b) So depreciation allowances reduce the tax paid by firms, because they reduce profits (2) Investment tax credits reduce taxes when firms make new investments (3) Summary measure: the effective tax rate the tax rate on firm revenue that would have the same effect on the desired capital stock as do the actual provisions of the tax code (4) Table 4.2 shows effective tax rates for G7 countries;

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Data Application Another simplification that is used in this chapter is the assumption that taxes are based on a firm’s real revenue. In reality, taxes on nominal revenue combine with inflation to create a large distortion to investment. See Robin Boadway, Nell Bruce, and Jack Mintz “Taxation, Inflation, and the Effective Marginal Tax Rate on Capital in Canada”, Canadian Journal of Economics, 1984, 17.

Theoretical Application For a detailed discussion about the effects of tax policy on investment, see Chapter 24 in Rosen, Boothe, Dahlby, and Smith, Public Finance in Canada, Toronto: McGraw-Hill Ryerson, 1999. D.

From the desired capital stock to investment 1. The capital stock changes from two opposing channels a. New capital increases the capital stock; this is gross investment b. The capital stock depreciates, which reduces the capital stock c. Gross investment minus depreciation = net investment (4.5) Kt+1 – Kt = It – dKt, where I is gross investment and net investment equals the change in the capital stock d. Text Fig. 4.5 shows gross and net investment for the Canada from 1926–2012 2. Rewriting (4.5) gives It = Kt+1 – Kt + dKt a. If firms can change their capital stocks in one period, then the desired capital stock (K*) = Kt+1 b. So It = K* – Kt + dKt (4.6) c. Thus, investment has two parts (1) Desired net increase in capital stock over the year (K*–Kt ) (2) Investment needed to replace depreciated capital (dKt) 3. Lags and investment a. Some capital can be constructed easily, but other capital may take years to put in place

Theoretical Application Acknowledging that it may take time to get capital in place may be crucial to modeling the business cycle. See Finn E. Kydland and Edward C. Prescott, “Time to Build and Aggregate Fluctuations,” Econometrica, November 1982, pp. 1345–1370. b.

So investment needed to reach the desired capital stock may be spread out over several years Investment in inventories and housing 1. Marginal product of capital and user cost also apply, as with equipment and structures

Numerical Problem 3 applies the user-cost concept to the purchase or rental of a home. III.

Goods Market Equilibrium (Sec. 4.3) A. The real interest rate adjusts to bring the goods market into equilibrium 1. Y = Cd + Id + G (4.7) goods market equilibrium condition

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Differs from income-expenditure identity, as good market equilibrium condition need not hold; undesired goods may be produced, so goods market won’t be in equilibrium 3. Alternative representation: since Sd = Y – Cd – G, Sd = /d (4.8) The saving-investment diagram 1. Plot Sd vs. Id (Fig. 4.2; Key Diagram 3; like text Fig. 4.6 2. Equilibrium where Sd = /d 3. How to reach equilibrium? Adjustment of r 4. Shifts of the saving curve a. Saving curve shifts right due to a rise in current output, a fall in expected future output, a fall in wealth, a fall in government purchases, a rise in taxes (unless Ricardian equivalence Figure 4.2 holds, in which case tax changes have no effect) b. Example: Temporary increase in government purchases shifts S left (text Figure 4.7) c. Result of lower savings: higher r, causing crowding out of l

Numerical Problems 5 and 6 and Analytical Problem 5 examine what happens when government spending changes. Theoretical Application What happens to the economy if government taxes change? Under Ricardian equivalence a tax cut today that is financed by higher future taxes has no effect on national saving, because private saving rises by the amount of the tax cut, just offsetting the decline in government saving. Since there’s no shift in national saving, there’s no change in the equilibrium real interest rate. Suppose, however, that people don’t foresee the future tax change, or for some other reason national saving declines. Then the shift to the left of the desired saving curve leads to a new equilibrium at a higher real interest rate and lower level of investment. The true burden of the government debt comes about because the lower investment rate means a lower capital stock, so that the economy is less productive in the future. Thus, future generations bear the burden of today’s government debt. 5.

Shifts of the investment curve a. Investment curve shifts right due to a fall in the effective tax rate or a rise in expected future marginal productivity of capital (text Figure 4.8) b. Result of increased investment: higher r, higher S and /

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Policy Application Should tax policy be used to promote savings or investment? Many policymakers and economists have argued that obtaining the correct amount of future economic growth requires us to have a higher capital stock, so that we need more investment than we have. They suggest tax policies like RRSPs to encourage saving and tax breaks for businesses to encourage investment. As we’ve seen in this chapter, such policies could indeed affect people’s decisions to save (by affecting the after-tax real rate of interest) and to invest (by reducing the after-tax cost of capital). But what isn’t so clear is whether or not investment really is too low. After all, to save today requires reducing consumption today; people may prefer not to save any more than they are already saving. Also, if the government goes too far in encouraging investment, we may end up with an inefficiently large capital stock; as an example, in the early 1980s there was a large overbuilding of commercial real estate in big cities, due partly to tax incentives. In summary, it isn’t perfectly clear that government policies that encourage saving and investment are appropriate; we first need to show clearly that some externality creates a need for such government intervention. Analytical Problems 1, 2, 3, and 4 all look at shocks to the economy and changes in variables needed to restore equilibrium.

For a useful summary of recent research on consumption and investment, see Andrew B. Abel, “Consumption and Investment,” in B. Friedman and F. Hahn, eds., Handbook of Monetary Economics, vol. 2, Netherlands: Elsevier Science Publishers, 1990, pp. 725– 778.

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSIONS 1.

Saving, Investment, and the Baby Boomers

Recently, saving has been relatively low in Canada compared to other countries and other times. Is this because a large portion of the adult population was born in the late 1940s and the 1950s and these people are in the phase of life when they spend heavily? Probably not. Relatively few children were born during the Great Depression of the 1930s and World War II in the first half of the 1940s. Shortly after the war ended, the birth rate rose and stayed high for over 10 years. The children born during this period are called the “baby boomers.” The presence of a larger-than-normal percentage of the population in a certain age category has a considerable effect on society. During the 1950s and 1960s, while the baby boomers were in elementary and high school, the country built thousands of schools. In the 1960s and 1970s, as they reached college age, many institutions of higher education were created or enlarged. When the bulk of the baby boom generation had passed the age of school attendance, schools found they had extra classrooms, and colleges had to scramble to fill their courses. On the other hand, the need for investment in housing, roads, and electricity increased as the baby boomers married, bought houses, automobiles, and the other items typical of adult life. It is natural for people in their late 20s and early 30s to spend more than they earn as they acquire durable goods like housing and appliances. Since a larger-than-normal percentage of the population has been in this age group, it’s not surprising that the economy’s saving rate went down. The baby boomers are now approaching the heavy saving years—those in which they consume less than they earn and thus contribute to savings. Several factors are at work. People in their 50s have higher incomes during these years than they will at any other time in their lives. They frequently have raised their families. Their children are now financially independent, reducing the parents’ expenditures. At this point, too, people see retirement approaching and become interested in preparing for it. Thus, savings increase. If the baby boomer generation follows this pattern, the savings rate should increase appreciably in the next decade. This has the potential to fuel increased investment and faster growth in the Canadian economy. 2.

Concern About the Level of Saving

While Canadian saving is not low by OECD standards, it is much lower than that of the fast-growing Asian economies. On average high savings countries tend to be high growth countries. Several explanations for the relatively lower rate of private savings in Canada have been advanced. One suggestion is that consumers are myopic, they do not value goods in future periods highly and thus are unwilling to give up current consumption for future goods. A second is that the transfer system discourages saving for retirement since it provides income to many individuals of retirement age. Can the saving rate be raised? During World War II, saving was relatively high. This was in part clue to the difficulty of buying appliances, automobiles, and other consumer goods, since most productive capacity had been converted to war needs. However, because so many extra people were working, and those in the military were not producing any salable goods or services, there was still a need to encourage saving. So massive campaigns were mounted to encourage both the military and civilians to invest in war bonds. Canadians were told that it was their patriotic duty to invest in bonds to provide the military with the supplies it needed and hasten the end of the war. . 59

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A more recent example of an attempt to promote saving was the development of RRSPs (Registered Retirement Saving Plans). An RRSP allows the saver to take money before taxes and place it in an account in which both the principal and interest are tax-deferred until the money is withdrawn from the account when a person reaches retirement age. This raises the after-tax return on saving since no tax is paid immediately. And future taxes may be lower for those who are in a lower tax bracket when they retire. However, saving is relatively insensitive to interest rates, so the establishment of RRSPs did not lead to a flood of new saving. 3.

What Should Be Included in Investment?

Investment is the sum of business fixed investment (structures and equipment), residential investment, and the change in inventories. But if investment is the purchase of goods and services that will increase productive capacity in the long run, then several important categories, such as education, are left out. Spending on education, infrastructure, and health and nutrition programs should be included in investment. People are frequently the crucial factor in determining whether an enterprise is successful or not. When businesses, individuals, and government spend money on education, they are helping to increase human productivity and thus investing in the future productive capacity. The knowledge gained does not apply only to the current period, but will enhance output far into the future. Hiring individuals with limited knowledge may be cheaper, but it frequently leads to lower-quality products and services that have trouble competing with those of other producers. Health and nutrition programs have similar beneficial effects. A healthier population can do more both in the current and in future periods. Good health and nutrition in childhood may result in a healthier, longer, and more productive adult life. The provision of roads, railroads, airports, communication facilities, and power plants to an area should also be included in investment. The availability of transportation, communication, and electricity are crucial to the success of most businesses. In addition, such facilities provide services for a long period of time. However, if they are built by government, they are included in the government purchases category of the national income accounts, not the investment category Only if a private firm constructs them, as in the case of a hydroelectric dam built by a private utility, would they be included in the investment component of GDP (as nonresidential structures). 4.

Housing as an Investment Good

Residential construction, which is just investment in housing (including apartment buildings) represents a large component of total fixed investment in Canada. For instance, in Table 2.1 of the text, it is shown that for 2015 residential construction represented 31% of total investment. This is a particularly volatile component of investment. One way to obtain information on this is to Look at new housing starts. Data on Housing starts is released monthly by the Canada Mortgage and Housing Corporation.

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What particular aspects of the investment decision are specific to housing investment? One is that housing investment is exceptionally sensitive to movements in interest rates. One reason for this is that depreciation in housing in very low at annual rates. This make the user-cost of capital very sensitive to the interest rate. Generally, we see that episodes of increasing interest rate increases are followed by a sharp decline in housing starts. This happened in 1981-82, 1990-91, and again in 1994-95. A second important aspect of housing investment is the potential for capital gains and losses through price changes. While in the text it is assumed that the price of the capital good remains unchanged, in reality an expected rise in the price will reduce the usercost of capital. In the late 1980’s many people in Canada were willing to purchase houses at historically very high prices and at high mortgage rates because of their expectation that house prices would continue to rise, thus conferring capital gains on them. By the mid 1990s house prices stabilized or fell in most parts of the country. This raises the user cost of capital and makes people more reluctant to invest in housing even at the same interest rates.

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1.

Saving is current income minus consumption. For given income, any increase in consumption means an equal decrease in saving, so consumption and saving are inversely related. The basic motivation for saving is to provide for future consumption.

When a consumer gets an increase in current income, both current consumption and future consumption increase. Since current consumption rises, but by less than the increase in current income, saving increases. When the consumer gets an increase in expected future income, again both current and future consumption increase. Since current income does not increase, but current consumption does, saving decreases. When the consumer gets an increase in wealth, both current and future consumption again rise. Again, there has been no increase in current income, so saving decreases. At the aggregate level, these changes in consumption and saving made by individuals are decisions that change the aggregate level of desired consumption and saving. When the expected real interest rate increases, there are two opposing effects. The same amount of saving today leads to a higher payoff in the future, due to the higher real interest rate. The greater reward for saving encourages people to save more. On the other hand, a consumer needn’t save as much to obtain a future savings target. Thus, saving may be discouraged. Thus, for any individual, the response of saving to an increase in the real interest rate is ambiguous; at the aggregate level, the response of desired saving is also ambiguous.

The effect on desired saving of an increase in the expected real interest rate is potentially ambiguous. An increase in the real interest rate has two effects on desired saving: (1) the substitution effect increases saving, because the amount of future consumption that can be obtained in exchange for giving up a unit of current consumption rises; and (2) the income effect may increase or reduce saving. The income effect reduces saving for a lender, because a person who saves is better off as a result of having a higher real interest rate, so he or she increases current consumption. However, for a borrower, the income effect increases saving, because the borrower is worse off having to face a higher real interest rate, and so reduces current consumption. So the income effects work in different directions depending on whether a person is a lender or a borrower. For a borrower, then, both the income and substitution effects work in the same direction, and saving definitely increases. For a lender, however, the income and substitution effects work in opposite directions, so the result on desired saving is ambiguous.

When government purchases increase temporarily, consumers see that higher taxes will be required in the future to pay off the deficit. They reduce both current consumption and future consumption, but current consumption declined by less than the amount of the government purchases. Since national saving is output minus desired consumption minus government purchases, and government purchases have increased more than current desired consumption has decreased, national saving declines at a given real interest rate.

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In the case of a lump-sum tax increase, consumers have higher taxes today, but lower taxes in the future. If consumers take this into account, current desired consumption is unchanged, and since output and government purchases didn’t change, desired national saving is unchanged as well. This is the case of Ricardian equivalence, and is controversial because consumers may not understand that higher taxes today imply lower future taxes. As a result, they may reduce desired consumption today, increasing desired national saving. 5.

The two components of the user cost of capital are the interest cost and the depreciation cost. The depreciation cost is the value lost as the capital wears out during the period. The interest cost represents the opportunity cost of not using the funds that purchased the capital in some other way; an example would be if the money was invested in bonds rather than buying capital goods.

The desired capital stock is the amount of capital that allows the firm to earn the largest possible profit. The higher the expected future marginal product of capital, the higher the desired capital stock, since any given amount of capital will be more productive in the future. The higher the user cost of capital, the lower the desired capital stock, since a higher user cost yields lower profits on each unit of capital. The higher the effective tax rate, the lower the desired capital stock, again because the firm gets lower profits on each unit of capital.

Gross investment represents the total purchase or construction of new capital goods that takes place during a period. Net investment is gross investment minus the depreciation on existing capital. Thus, net investment is the overall increase in the capital stock. Yes, it is possible for gross investment to be positive when net investment is negative. This occurs whenever gross investment is less than the amount of depreciation.

Equilibrium in the goods market occurs when the aggregate supply of goods (Y) equals the aggregate demand for goods (Cd + Id + G). Since desired national saving (Sd) is Y – Cd – G, an equivalent condition is Sd = Id. Equilibrium is achieved by the adjustment of the real interest rate to make the desired level of saving equal to the desired level of investment, as shown in text Fig. 4.7.

The saving curve slopes upward because saving is assumed to increase with an increase in the expected real interest rate. The investment curve slopes downward because investment is lower the higher is the expected real interest rate. The saving curve would be shifted to the right by an increase in current output, a decrease in expected future output, a decrease in wealth, a decrease in government purchases, and possibly by a rise in taxes. The investment curve would shift to the right by a decline in the effective tax rate or a rise in expected future marginal productivity of capital.

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NUMERICAL PROBLEMS 1.

First, a general formulation of the problem is useful. With income of Y1 in the first year and Y2 in the second year, the consumer saves Y2 – C in the first year and Y2 – C in the second year, where C is the consumption amount, which is the same in both years. Saving in the first year earns interest at rate r, where r is the real interest rate. And the consumer needs to accumulate just enough after two years to pay for college tuition, in the amount T. So the key equation is (Y1 – C)(1 + r) + (Y2 – C) = T. a.

Y1 = Y2 = $25 000, r = 10%, T = $6300. The key equation gives ($25 000 – C) 1.1 + ($25 000 – C) = $6300. This can be simplified to $25 000 – C = $6300/2.1 = $3000, which can be solved to get C = $22 000. Then S = Y – C = $25 000 – $22 000 = $3000.

Y1 = $27 100. The key equation is now ($27 100 – C)1.1 + ($25 000 – C) = $6300. This can be simplified to ($27 100 x 1.1) + $25 000 – $6300 = 2.1 C, or $48 510 × 2.1 C, so C = $23,100. Then S = Y1 – C = $27 100 – $23 100 = $4000. This illustrates that a rise in current income increases savings.

Y2 × $27,100. The key equation is now ($25 000 – C)1.1 + ($27 100 – C) = $6,300. This can be simplified to ($25 000 × 1.1) + $27 100 – $6300 = 2.1 C, or $48 300 = 2.1 C, so C = $23 000. Then S = Y1 – C = $25 000 – $23 000 = $2000. This illustrates that a rise in future income decreases savings.

With the increase in wealth of W, the total amount invested for the second period is W + Y1 – C, so the key equation becomes ($525 + $25 000 – C)1.1 + ($25 000 – C) = $6300. This can be simplified to ($25 525 × 1.1) + $25 000 – $6300 = 2.1 C, or $46 777.5 = 2.1 C, so C = $22 275. Then S = Y1 – C = $25 000 – $22 275 = $2725. This illustrates that a rise in wealth decreases savings.

T = $7350. The key equation is now ($25 000 – C) 1.1 + ($25 000 – C) = $7350. This can be simplified to $25 000 – C = $7350/2.1 = $3500, which can be solved to get C = $21 500. Then S = Y – C = $25 000 – $21 500 = $3500. The rise in targeted wealth needed in the future raises current saving.

r = 25%. The key equation is now ($25 000 – C) 1.25 + (25 000 – C) = $6300. This can be simplified to $25 000 – C = $6300 / 2.25 = $2800, which can be solved to get C = $22 200. Then S = Y – C = $25 000 – $22 200 = $2800. The rise in the real interest rate, with a given wealth target, reduces current saving.

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This chart shows the MPKf as the increase in output from adding another fabricator. # Fabricators Output 0 1 2 3 4 5 6

0 100 150 180 195 205 210

MPKf

— 10 0 50 30 15 10 5

uc = (r + d)pK = (0.12 + 0.20)$100 = $32. HHHHC should buy two fabricators, since at two fabricators MPKf = 50 > 32 = uc. But at three fabricators, MPKf = 30 < 32 = uc. You want to add fabricators only if the future marginal product of capital exceeds the user cost of capital. The MPKf of the third fabricator is less than its user cost, so it should not be added.

When r = 0.08, uc = (0.08 + 0.20)$100 = $28. Now they should buy three fabricators, since MPKf = 30 > 28 = uc for the third fabricator and MPKf = 15 < 28 = uc for the fourth fabricator.

With taxes, they should add additional fabricators as long as (1 – τ)MPKf > uc. Since τ = 0.4, 1 – τ = 0.6. They should buy just one fabricator, since (1 – τ)MPKf = 0.6 × 100 = 60 > 32 = uc. They shouldn’t buy two, since then (1 – τ)MPKf = 0.6 × 50 = 30 < 32 = uc.

When output doubles, the MPKf doubles as well. At r = 0.12, they should buy three fabricators, since then MPKf = 60 > 32 = uc; they should not buy four, since then MPKf = 30 < 32 = uc. At r = 0.08, they should buy four fabricators, since then MPKf = 30 > 28 = uc; they should not buy five, since then MPKf = 20 < 28 = uc.

The expected after-tax real interest rate is r = i(1 – τ) – πe = 0.10 (1 – 0.30) – 0.05 = 0.07 – 0.05 = 0.02.

The maintenance and miscellaneous expenses can be treated just like depreciation. So the annual user cost of capital is uc = (r + d)pK = (0.02 + 0.06)$200 000 = $16 000.

You should be indifferent between buying and renting if the rent is $16 000 per year.

uc = (r + d)pK = (0.10 + 0.15)$1000 = $250.

The desired capital stock is such that MPKf = uc, so 1000 – 2K = 250, or 2K = 750, so K = 375.

The tax-adjusted user cost of capital is uc/(1 – τ), so with τ = .5, the condition for the desired capital stock is 1000 – 2K = 250/0.5; the solution is K = 250. Thus, taxation decreases the firm’s desired capital stock.

The investment tax credit basically lowers the price of capital from $1000 .

Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

to (1 – 0.2)$1000 = $800. So the tax-adjusted user cost of capital is only (0.25 × $800)/0.5 = $400. Then the equation for setting the desired capital stock is 1000 – 2K = 400: the solution is K = 300. Thus, the investment tax credit increases the firm’s desired capital stock. 5.

Desired consumption declines as the real interest rate rises because the higher return to saving encourages higher saving; desired investment declines as the real interest rate rises because the user cost of capital is higher, reducing the desired capital stock, and thus investment. Use the following table, where Sd = Y – Cd – G r Cd Id Sd Cd + Id + G 2 3 4 5 6

610 600 590 580 570

150 140 130 120 110

90 100 110 120 130

960 940 920 900 880

Equation (4.7) says that Y = Cd + Id + G at equilibrium. Looking at the last column of the table, with Y = 900, this is true only at r = 5%. At this point, Sd = Id = 120. Equation (4.8) says that Sd = Id at equilibrium. From the table, this occurs at r = 5%.

When government purchases fall by 40 to 160, each Sd entry in the table is higher by 40, and each Cd + Id + G entry is lower by 40. Then Y = Cd + Id + G occurs at r = 3%, as does Sd = Id = 140.

Sd = Y – C – G = Y – (360 = 200r + 0.1 Y) = 120 = –480 + 200r + 0.9Y

(1) Using Eq. (4.7): Y = Cd + /d + G Y = (360 + 200r + 0.1 Y) + (120 – 400r) +120 = 600 – 600r+ 0.1Y So 0.9Y = 600 – 600r At full employment, Y = 600. Solving 0.9 × 600 = 600 – 600r, we get r = 0.10. (2) Using Eq. (4.8): Sd = /d –480 + 200r + 0.9Y = 120 – 400r 0.9Y = 600 – 600r When Y = 600, r = 0.10. So we can use either Eq. (4.7) or (4.8) to get to the same result.

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When G = 144, desired saving becomes Sd = Y – Cd – G = Y – (360 – 200r + 0.1 Y) – 144 = –504 + 200r + 0.9Y. Sd is now 24 less for any given r and Y; this shows up as a shift in the Sd line from S1 to S2 in Fig. 4.3. Setting Sd = /d, we get: –504 + 200r+ 0.9Y = 120 – 400r 600r + 0.9Y = 624 At Y = 600, this is 600r = 624 – (0.9 x 600) = 84, so r = 0.14. The market-clearing real interest rate increases from 10% to 14%.

r = 0.10 uc/(1 − τ) = (r + d)pK /(1 − τ) = [(0.1 + 0.2) x 1] / (1 − 0.5) = 0.6. MPK f = uc/(1 − τ), so 20 − 0.02K f = 0.6; solving this gives K f = 970.

Figure 4.3

Since K f − K = I − dK, I = K f − K + dK = 970 − 900 + (0.2 x 900) = 250. b.

i. Solving for this in general: uc/(1 - τ) = (r + d)pK / (1 − τ) = [(r + 0.2) x 1] / (1 − 0.5) = 0.4 + 2r. MPK f = uc/(1 − τ), so 20 − 0.02K = .4 + 2r; solving this gives K f = 980 − 100r. I = K f − K + dK = 980 − 100r − 900 + (0.2 x 900) = 260 − 100r. ii. Y = C + I + G 1000 = [100 + (0.5 x 1000) − 200r] + (260 − 100r) + 200 1000 = 1060 − 300r, so 300r = 60 r = 0.2 C = 560; I = 240 = S; uc/(1 − τ) = 0.4 + (2 x 0.2) = 0.8; K f = 960

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Analytical Problems 1.

a. As Fig. 4.4 shows, the shift to the right in the saving curve from S1 to S2 causes saving and investment to increase and the real interest rate to decrease. b. This is really just a transfer from the general population to farmers. The effect on saving depends on whether the marginal propensity to consume (MPC) of farmers differs from that of the general population. If there is no difference in MPCs, there will no shift of the saving curve; neither investment nor the real interest rate is affected. If the MPC of farmers is higher than the MPC of the general population, then desired national saving declines and the saving curve shifts to the left; the real interest rate rises and investment declines. If the MPC of farmers is lower than that of the general population, the saving curve shifts to the right; the real interest rate declines and investment rises. c. The investment tax credit encourages investment, shifting the investment curve from I1 to I2 in Fig. 4.5. Saving and investment increase, as does the real interest rate.

Figure 4.4

Figure 4.5

d. The increase in expected future income decreases current desired saving, as people increase desired consumption immediately. The rise of the future marginal productivity of capital shifts the investment curve to the right. The result, as shown in Fig. 4.6, is that the real interest rate rises, with ambiguous effects on saving and investment.

Figure 4.6

a. With a lower capital stock, the marginal product of labour is reduced, so the . 68

Chapter 4: Consumption, Saving, and Investment

labour demand curve shifts to the left from ND1 to ND2 in Fig. 4.7. Then the new equilibrium point is one with lower employment and a lower real wage. With lower employment and a lower capital stock, full-employment output will be lower.

Figure 4.7

b. Because the capital stock is lower, the marginal product of capital will be higher, so desired investment will increase. c. Since current output declines, desired saving declines, because people do not want to reduce their consumption. On the other hand, since future output is also lower, people desire to save more today to make up for the loss of future income. d. The increase in desired investment shows up as a shift to the right in the Id curve, from I1 to /2 in Fig. 4.8. Then the new equilibrium (assuming no change in desired saving) is at a higher level of investment and a higher real interest rate.

Figure 4.8

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a. The temporary increase in the price of oil reduces the marginal product of labour, causing the labour demand curve to shift to the left from ND1 to ND2 in Fig. 4.9. At equilibrium, there is a reduced real wage and lower employment.

Figure 4.9

The productivity shock results in a reduction of output. Because the shock is temporary, the only effect on desired saving or investment is due to the reduction in current output, causing desired national saving to fall. This shifts the saving curve to the left, raising the real interest rate and reducing the level of desired investment, as well as desired national saving, as shown in Fig. 4.10.

Figure 4.10

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b. The permanent increase in the price of oil reduces the marginal product of labour, causing the labour demand curve to shift to the left, again as in Fig. 4.9. At equilibrium, there is a reduced real wage and lower employment. The productivity shock results in a reduction of current output. Because the shock is permanent, it reduces future output as well, and reduces the future marginal product of capital. The desired investment curve shifts to the left, from I1 to /2 in Fig. 4.11, because the future marginal product of capital is lower. The effect on desired saving is ambiguous—the reduction in current income reduces desired saving, but the reduction in expected future income increases desired saving. Let’s assume that the former effect outweighs the latter, so that the desired saving curve shifts to the left from S1 to S2. Then national saving and investment both decline. Figure Again, the effect on the real interest 4.11 rate is ambiguous. (Alternatively, if the effects on desired saving of the reductions in current income and future income offset each other exactly, the desired saving curve does not shift, in this case, the leftward shift of the investment curve along an unchanged saving curve reduces the real interest rate, saving, and investment.) 4.

A temporary increase in government spending reduces national saving. Whether the spending is financed by current taxes or by borrowing (and raising future taxes), consumption falls, but not by the full amount of the spending. Since S = Y – Cd – G, national saving declines. This is shown in Fig. 4.12 as a shift to the left in the saving curve. The real interest rate must increase to get S = /, so / declines as well. It makes no difference whether the temporary increase in spending is funded by taxes or by borrowing.

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In the case of infrastructure spending, MPKf rises, so investment increases. Saving shifts from S1 to S2 and investment shifts from I1 to I2 in Fig. 4.13. With upward shifts in both saving and investment, the new equilibrium is one with a higher real interest rate. However, saving and investment at the new equilibrium may be higher or lower. The effect on consumption is unclear as well. The higher real interest rate reduces consumption, but future income is higher, which increases consumption. If investment actually rises, then the increase in government spending causes private investment to be “crowded in” rather than “crowded out.” In this case consumption is crowded out.

Figure 4.12

Figure 4.13

When there is a temporary increase in government spending, consumers foresee future taxes. As a result, consumption declines, both currently and in the future. Thus, current consumption does not fall by as much as the increase in G, so national saving (Sd = Y – Cd – G) declines at the initial real interest rate, and the saving curve shifts to the left from S1 to S2, as shown in Fig. 4.14. Thus, the real interest rate increases and consumption and investment both fall.

Figure 4.14

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When there is a permanent increase in government spending, consumers foresee future taxes as well, with both current and future consumption declining. But if there is an equal increase in current and future government spending, and consumers try to smooth consumption, they will reduce their current and future consumption by about the same amount, and that amount will be about the same amount as the increase in government spending. So the saving curve in the saving-investment diagram does not shift, and there is no change in the real interest rate. Since the saving curve shifts upward more in the case of a temporary increase in government spending, the real interest rate is higher, so investment declines by more. However, consumption fails by more in the case of a permanent increase in government spending.

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CHAPTER 5: SAVING AND INVESTMENT IN THE OPEN ECONOMY LEARNING OBJECTIVES I.

Goals of Chapter 5 A. Develop the idea that a country’s spending need not equal its production in every period, due to foreign trade B. The fundamental determinants of a country’s trade position are its saving and investment decisions

II.

Notes to Eighth Edition Users A. Figures, tables and their corresponding text have been updated.

TEACHING NOTES I.

Balance of Payments Accounting (Sec. 5.1) A. Balance of payments accounting 1. The record of a country’s international transactions 2. Text Table 5.1 shows recent Canadian data 3. Any transaction that involves a flow of money into Canada is a credit (+) item (enters with a plus sign); for example, exports 4. Any transaction involving a flow of money out of Canada is a debit (–) item (enters with a minus sign); for example, imports 5. In touch with the macroeconomy: the balance of payments accounts Data released quarterly in Canada’s Balance of International Payments B. The current account 1. Net exports of goods and services a. Merchandise trade: Exports minus imports = merchandise trade balance b. Internationally traded services (transportation, tourism, insurance, education, financial services) are also important 2. Investment income from assets abroad a. Investment income received from abroad is a credit item, since it causes funds to flow into Canada b. Payment of investment income to foreigners is a debit item c. Net investment income from assets abroad is part of the current account, and is about equal to NFP, net factor payments (most factor payment flows are investment income, but wages and salaries account for a small part of factor payments) 3. Current transfers a. Payments made from one country to another b. Negative current transfers for Canada, since Canada is a net payer of transfers to other countries

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Students may be helped if you draw the basic balance of payments chart without numbers, but with + and – signs, so they can see more clearly where the different entries go: Debit (–)

Credit (+)

Current Account Net exports Exports of merchandise Exports of services Imports of merchandise Imports of services Net income from assets Income from foreign investments Investment income paid to foreigners Current transfers Transfers from foreigners Transfers to foreigners Capital Account Increase in foreign-owned assets Increase in domestically owned assets abroad 4.

Sum of net exports of goods and services, net investment income from assets abroad, and current transfers is the current account balance a. Positive current account balance implies current account surplus b. Negative current account balance implies current account deficit

Data Application Canada runs a deficit on the merchandise trade balance and has a deficit in services. In addition, Canada’s role as a recipient of foreign direct investment and more recently, as a direct lender in international capital markets, means that net investment income is negative. In 2012, the merchandise trade balance was -$36.2 billion, while the balance on non-merchandise trade (including services and net investment income) was –$47.9 billion. See text Table 5.1. C.

The capital account 1. The capital account records trades in existing assets, either real (for example, houses) or financial (for example, stocks and bonds) a. When home country sells assets to foreign country, that is a capital inflow for the home country and a credit (+) item in the capital account b. When assets are purchased from a foreign country, there is a capital outflow from the home country and a debit (–) item in the capital account 2. Instructors should note the relabelling in 1997. Most of what economists call the capital account is in the capital and financial account.

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The terminology used here is a bit confusing, because we talk about a capital account, capital inflows, capital outflows, and assets that could be capital goods. It is important to emphasize that when we talk about capital inflows and outflows, we mean the direction in which payments (in money) for assets move; for example, a capital inflow into Canada from Japan occurs if someone in Japan buys shares of stock in a Canadian company. If a country has more capital inflows than outflows, it will have a capital account surplus. 3.

The official settlements balance a. Transactions in official reserve assets are conducted by central banks of countries b. Official reserve assets are assets (foreign government securities, bank deposits, and SDRs of the IMF, gold) used in making international payments c. Central banks buy (or sell) official reserve assets with (or to obtain) their own currencies d. Official settlements balance (1) Also called the balance of payments, it equals the net increase in a country’s official reserve assets (2) For Canada, the net increase in official reserve assets is the rise in Canadian government reserve assets minus foreign central bank holdings of Canadian dollar assets e. Having a balance of payments surplus means a country is increasing its official reserve assets; a balance of payments deficit is a reduction in official reserve assets

Analytical Problem 1 gives students practice in making entries into a balance of payments table. D.

The relationship between the current account and the capital account 1. Current account balance (CA) + capital account balance (KA) – 0 (5.1) 2. CA + KA = 0 by accounting; every transaction involves offsetting effects 3. Examples given of offsetting transactions (text Table 5.2)

Analytical Problem 2 gives students practice with offsetting transactions in the balance of payments accounts, while Numerical Problem 1 has them calculating various important balances. 4.

In practice, measurement problems, recorded as a statistical discrepancy, prevent CA + KA = 0 from holding exactly.

Data Application Sometimes the statistical discrepancy can be quite large, as counting cross-border transactions is quite difficult. For example, in 2012 the current account balance was $62.2 billion, and the statistical discrepancy was -$1.5 billion. E.

Net foreign assets and the balance of payments accounts 1. Net foreign assets are a country’s foreign assets minus its foreign liabilities a. Net foreign assets may change in value (example: change in stock prices) b. Net foreign assets may change through acquisition of new assets or liabilities 2. The net increase in foreign assets equals a country’s current account . 76

Chapter 5: Saving and Investment in the Open Economy

3. 4. 5.

surplus A current account surplus implies a capital account deficit, and thus a net increase in holdings of foreign assets (a capital outflow) A current account deficit implies a capital account surplus, and thus a net decline in holdings of foreign assets (a capital inflow) Summary: Equivalent measures of a country’s international trade and lending Current account surplus = capital account deficit = net acquisition of foreign assets = net foreign lending = (if NFP and net transfers are zero) net exports

Numerical Problem 5 looks at the national saving and world interest rate. II.

Goods Market Equilibrium in an Open Economy (Sec. 5.2) A. From Ch. 2, S = I + CA = I + (NX + NFP) (5.2) 1. So national saving has two uses: a. Increase the capital stock by domestic investment b. Increase the stock of net foreign assets by lending to foreigners 2. To get goods market equilibrium, national saving and investment must equal their desired levels: a. Sd = Id + CA = Id + (NX + NFP) (5.3) b. Goods market equilibrium in an open economy c. Assuming net factor payments are zero, then Sd = /d + NX (5.4) 3. Alternative method: a. Y = Cd + Id + G + NX (5.5) b. NX = Y – (Cd + Id + G) (5.6) Net exports equal output (Y) minus absorption (Cd + Id + G)

III.

Saving and Investment in a Small Open Economy (Sec. 5.3) A. Small open economy: an economy too small to affect the world real interest rate 1. World real interest rate (rw): the real interest rate in the international capital market 2. Key assumption: Residents of the small open economy can borrow or lend at the expected world real interest rate (Fig. 5.1; Key diagram 4; like text Figs. 5.2 and 5.3) 3. Result: rw may be such that Sd > Id, Sd = Id, or Sd < Id a. If rw = r1, then Sd > Id, so the excess of desired saving over desired investment is lent internationally (net foreign lending is positive) and CA > 0 b. If rw = r2 then Sd = Id, so there is no net foreign lending and CA = 0 Figure 5.1

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If rw = r3, then Sd < Id, so the excess of desired investment over desired saving is financed by borrowing internationally (net foreign lending is negative) and CA < 0 4. Alternative interpretation: in terms of output and absorption 5. Net exports equals net foreign lending equals the current account balance (assuming net factor payments and net unilateral transfers are zero Application: Domestic and foreign interest rates 1. Text fig. 5.1 show that the interest rate paid on an asset in Canada differs from the interest rate paid on a comparable asset in the US 2. Interest rates will tend to differ on comparable assets if there are considerations other than interest rates that affect the expected rate of return earned on a domestic versus foreign asset 3. Apart from the interest rate, the factors which also affect the expected rate of return on an asset are: transaction costs, tax rates on interest income, exchange rate risk, and political risk c.

Numerical Problems 2 and 3 look at saving and investment in small open economies. C.

The effects of supply shocks in a small open economy 1. Anything that increases desired national saving (Y rises, future output falls, or G falls) relative to desired investment (MPKf falls, t rises) at a given world interest rate increases net foreign lending, and vice versa 2. A temporary adverse supply shock: Temporary drop in income leads to a drop in saving, so net foreign lending declines; shown in text Fig. 5.4 3. An increase in the expected future marginal product of capital: Desired investment rises, so net foreign lending falls; shown in text Fig. 5.5 D. Application: Globalization and the Canadian Economy 1. Globalization has increased quite significantly over the past 20 years 2. The rapid expansion of exports and imports since 1991 reflects the impact of Canada signing free trade agreements. 3. The increase in FDI associated with the increased integration of world financial markets over the past 20 years is often identified as a source of concerns a. Globalization may result in “sell-out of Canada” b. But since 1997, FDI exceeded CDIA by a very considerable margin. 4. Canada clearly benefited from the increased openness of international trade and finance

Data Application Why is the international capital market growing so rapidly? Maurice Obstfeld in his article “The Global Capital Market: Benefactor or Menace?”, Journal of Economic Perspectives, Fall 1998, pp. 9-30, outlines the historical development of the global financial market. To help explain the rapid growth, he describes both the benefits (which include stimulating economic growth by increasing the ability of poorer countries to borrow capital and increasing the efficiency in investment allocation) and the costs (including financial mismanagement and other distortions arising from imperfect information). Do the benefits outweigh the costs? IV.

Saving and Investment in Large Open Economies (Sec. 5.4) A. Large open economy: an economy large enough to affect the world real interest rate

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Suppose there are just two economies in the world a. The home or domestic economy (saving S, investment /) b. The foreign economy, representing the rest of the world (saving SFor, investment IFor) The world real interest rate moves to equilibrate desired international lending by one country with desired international borrowing by the other (Fig. 5.2; Key diagram 5; text Fig. 5.7)

Figure 5.2

3. 4.

Equivalent statement: The equilibrium world real interest rate is determined such that a current account surplus in one country is equal in magnitude to the current account deficit in the other Changes in the equilibrium world real interest rate: Any factor that increases desired international lending of a country relative to desired international borrowing causes the world real interest rate to fall

Note: A key assumption is that the international capital market is integrated, so that there is a free flow of funds across countries. This is not always true; for example, for many years Japan had backward and restrictive financial markets, though they have developed more in recent years. Numerical Problem 4 and Analytical Problems 3, and 5 are all exercises dealing with large open economies. V.

The Twin Deficits (Sec. 5.5) Are government budget deficits necessarily accompanied by current account deficits? That is, are there “twin deficits”? A. The critical factor: the response of national saving 1. An increase in the government budget deficit raises the current account deficit only if the increase in the budget deficit reduces desired national saving 2. In a small open economy, if an increase in the government budget deficit reduces desired national saving, the saving curve shifts left, thus reducing the current account balance

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Analytical Problem 4 asks students to work out the case of a large open economy with an increase in the government budget deficit.

The government budget deficit and national saving 1. A deficit causes by increased government purchases a. No question here: The deficit definitely reduces national saving b. Result: The current account balance declines 2. A deficit resulting from a tax cut a. Sd falls only if Cd rises b. So Sd won’t change if Ricardian equivalence holds, since then a tax cut won’t affect consumption c. But if people don’t foresee the future taxes implied by a tax cut today, they will consume more, desired saving will decline, and so will the current account balance

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1. The Importance of Trade for the Canadian Economy As a small economy located beside the world’s largest economy, Canada is highly dependent on international trade. Exports and imports are about 61% of GDP for Canada (73% of our exports go to the United States). Moreover, with increased communications, transportation, and the impact of ‘globalization’, trade is likely to play an even larger role in the future. It is important therefore to extend our macro model so as to include the impact of international trade. Goods and services involved in international trade are important to the economy as a whole. Many multinational companies use parts from plants in different countries to manufacture their output. Thus, production in Canada may be slowed or jobs lost because the supply of parts from another country is interrupted. In addition, many Canadian workers, particularly during periods of recession in Canada, owe their jobs to the ability of their employers to export. We send not only automobiles, grain, and machinery abroad, but also the output of engineers, architects, and marketing specialists. International trade allows us to consume a much broader selection of goods and services. In the winter, grapes from Chile and strawberries from Mexico enhance our diets. Fresh flowers and pop-up books from Colombia add enjoyment to our lives. We may drive Japanese or German cars and take our vacations in Australia or Kenya as well as in Canada. International trade can be a major cause of growth. In Europe the lowering of trade barriers through what is now the European Union has led to rapid economic growth and a higher standing of living for many citizens. A minority of the population may discover that competition from foreigners lowers their wages or replaces their jobs. However, the numbers affected are generally small compared to the number of people who benefit from imported goods and services. Even people who buy domestic products may benefit, because foreign competition may force domestic producers to improve quality and lower prices. Both the Free Trade Agreement (FTA) with the United States, the North American Free Trade Agreement (NAFTA) with the United States and Mexico, and the completion of the Uruguay Round of negotiations under the General Agreement on Tariffs and Trade (GATT) should enhance growth rates in Canada. Since then, Canada also has signed numerous free trade agreements with Israel (1997), Chile (1997), Costa Rica (2002), Colombia (2008), Peru (2009), Jordan (2009), Panama (2010), Honduras (2013), South Korea (2014), Ukraine (2016), and the European Union (2017). 2. Should Nations Always Avoid Current Account Deficits? There is a strong feeling that nations shouldn’t run deficits in their current accounts. Like individuals, nations are expected to save and thus increase reserves to cope with future difficulties. Is this generally a good idea? Can current account deficits benefit a nation? Canada has run a deficit on its current account for most years between 2009 and 2017. This allowed us to consume and invest more than we produced. A negative current account balance means that we imported more goods and services in dollar terms than we sent abroad. Thus, the total goods and services available to the domestic economy was greater than if there were no international trade. Those extra goods and services may be used to enhance the nation’s productive capacity or for consumption. Expanding the country’s ability to produce is a beneficial use of the additional goods and services available through international trade. As foreigners invest in our farms, factories, and mines, Canada can increase its output without reducing its own

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consumption. If such investment is productive, it will raise output by more than necessary to provide a fair return to its owners and therefore all benefit. The country receiving the investment increases its productive capacity, which will probably add to employment, and those who invest gain a continuing stream of earnings over a long period of time. In addition, being able to run temporary current account deficits or surpluses allows the country to borrow from abroad when income is temporarily low and lend abroad when income is temporarily high. This enables the country to smooth its consumption over time, rather than having consumption vary with economic conditions. Except in periods of national disasters, a sustained deficit on the current account balance, which is used to increase personal consumption expenditures rather than investment, does not bring about long-term benefits, On the contrary, we find ourselves owing other nations for goods and services that have long since been consumed. There is no continuing stream of output to provide the resources with which to repay the debt. As in the domestic economy, borrowing abroad to allow productive investment tends to benefit many, but problems may arise if borrowing is used for current needs.

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1. Credit items in the current account are exports of merchandise and services and income receipts from abroad. Debit items in the current account are imports of merchandise and services, income payments to foreigners, and current transfers. Adding all of the credit items and subtracting all of the debit items gives the current account balance. The current account balance equals net exports plus net factor payments plus current transfers. 2. The current account includes only the trade of currently produced goods and services. Trades of existing assets are counted in the capital account. 3. The sale of books from Canada to Brazil is a credit item in the Canadian current account. Offsetting transactions include anything that is a debit item in either the current account or the capital account. Some examples of offsetting transactions are: (1) A Canadian citizen buys $200 worth of stock in a Brazilian company, so that the offsetting debit item is an increase in Canadian-owned assets abroad, which is a debit in the capital account. (2) A Canadian firm imports $200 worth of tropical fish from Brazil, so the offsetting debit item is an import of merchandise, which is a debit in the current account. 4. In any period the net amount of new foreign assets that a country acquires equals its current account surplus, which in turn must equal its capital account deficit. A country with greater net foreign assets than another is not necessarily better off. What really counts is total national wealth, which consists of both net foreign assets and net domestic assets. For example, Canada has lower net foreign assets than other countries, but has a relatively high level of total national wealth per citizen. 5. In a small open economy, saving does not have to be equal to investment. Saving can be used to finance domestic investment or it can be lent abroad. So saving equals investment plus net exports. Similarly, output need not equal absorption. Absorption is a country’s total spending on consumption, investment, and government purchases. Absorption may be different from output because some new output may be exported. The difference between output and absorption is net exports. 6. A small open economy is likely to run a large current account deficit and to borrow abroad for two main reasons. First, there may be an increase in the expected future marginal product of capital. This shifts the investment curve, reducing the current account balance. The second reason for foreign borrowing is temporary supply shocks that cause absorption to exceed output for a time. 7.

In a world with two large open economies, the world real interest rate is determined such that desired international lending by one country equals desired international borrowing by the other country. When the world real interest rate is at its equilibrium value, the current accounts of the two countries sum to zero. An increase in desired national saving in a large open economy reduces the world real interest rate. The shift to the right in the saving curve increases the country’s account at the current world real interest rate, so the international asset market is out of equilibrium. To restore equilibrium, the world real interest rate must fall. An increase in desired investment has the opposite effect. The increase in investment reduces the domestic country’s current account and leads to an increase in the world real interest rate to restore equilibrium. The reason that changes in desired saving and investment affect the world real interest rate in large open economies but not small open economies is that saving . 83

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and investment in small open economies are so small relative to saving and investment in the world that changes in them simply have no impact. On the other hand, a large open economy may account for a substantial fraction of the world’s saving and investment, so a change there has a significant impact. 9. An increase in the government budget deficit raises the current account deficit of a small open economy if and only if the increase in the budget deficit reduces national saving. Since the current account is the difference between national saving and investment, the current account balance changes by the amount that national saving changes. 10. The twin deficits are the government budget deficit and the current account deficit. They are connected because if an increase in the government budget deficit reduces national saving it leads to an increased current account deficit. So the government budget deficit and the current account deficit move in the same direction.

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NUMERICAL PROBLEMS 1.

The merchandise trade balance equals merchandise exports minus merchandise imports, which equals 100 – 125 = –25. Current Account Credits(+) Debits (–) Merchandise 100 125 Services 90 80 Income from/to foreigners 110 140 Net unilateral transfers 10 Total 300 355 Current account balance (CA) = 300 – 355 = –55. Net exports (NX) = (100 + 90) – (125 + 80) = –15. Capital Account Increase in home country assets abroad Increase in foreign assets in home country Total

Credits(+) 200 200

Debits(–) 160 160

Notice that the increase in home reserve assets is just a subcategory of the increase in home country assets, so it is not included separately. Similarly, the increase in foreign reserve assets is just a subcategory of the increase in foreign assets in the home country. The information about the changes in home and foreign reserve assets is included Jot calculation of the official settlements balance only; it does not affect the capital account. Capital account balance (KA) = 200 – 160 = 40. Statistical discrepancy (SD): CA + KA + SD = 0 –55 + 40 + SD = 0 SD = 15 Official settlements balance = increase in home official reserve assets minus increase in foreign official reserve assets = 30 – 35 = –5. 2.

The following table calculates key variables for this question for different values of the real interest rate. The column for S is calculated by the equation S = Y – (Cd + G). The column headed S – / is foreign lending. Absorption (A) is Cd + ld + G. Net exports (NX) are output (Y) minus absorption (A). Every column except r consists of dollar amounts in billions. r

S–I

5% 4% 3% 2%

12 13 14 15

3 4 5 6

7 6 5 4

4 2 0 –2

21 23 25 27

4 2 0 –2

Net exports and foreign lending are identical.

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All variables but interest rates are in billions of dollars. a.

S = 10 + (100 × 0.03) = 13

I = 15 – (100 x 0.03) = 12 NX = CA = S – / = 13 – 12 = 1 C = Y – (I + G + NX) = 50 – (12 + 10 + 1) = 27 A=C+I+G = 27 + 12 + 10 = 49 S = 13, as before. I = 17 – (100 x 0.03) = 14 NX = CA = S – / = 13 – 14 = –1 C = Y – (1 + G + NX) = 50 – (14 + 10 – 1) = 27 A=C+I+G = 27 + 14 + 10 = 51

To find the equilibrium interest rate (rw), we must first calculate the current account for each country as a function of rw. Then we can find the value of rw that clears the goods market, that is, where CA + CAFor = 0. Home: Cd = 320 + 0.4(1000 – 200) – 200 rw = 320 + 320 – 200 r2 = 640 –200r2 CA = NX = Sd – Id = Y – (Cd + Id – G) = 1000 – (640 – 200 rw + 150 – 200 rw + 275) = –65 + 400 rw Foreign: CdFor = 480 + 0.4(1500 – 300) – 300 rw = 480 + 480 – 300 rw = 960 – 300 rw CAFor = NXFor = SdFor – IdFor = YFor – (CdFor + IdFor + GFor) = 1500 – (960 – 300 rw + 225 – 300 rw + 300) = 15 + 600 rw At equilibrium, CA + CAFor = 0, so: –65 + 400 rw + 15 + 600 rw = 0 –50 + 1000 rw = 0 rw = .05 C = 640 –200 rw = 630 CFor = 960 –300 rw = 945 S = Y – C – G = 1000 – 630 –275 = 95 SFor = YFor – CFor – GFor = 1500 – 945 – 300 = 255 I = 150 – 200 rw = 140 /For = 2325 – 300 rw = 210 . 86

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CA = S – / = 95 – 140 = –45 CAFor = SFor – IFor = 255 – 210 = 45 b.

Cd = 320 + 0.4(1000 – 250) – 200 rw = 320 + 300 – 200 rw = 620 – 200 rw CA = NX = Sd – Id = Y– (Cd + Id + G) = 1000 + (620 + 200 rw + 150 –200 rw + 325) = –95 + 400 rw At equilibrium, CA + CAFor = 0, so: –95 + 400¢ + 15 + 600 rw = 0 –80 + 1000 rw = 0 rw = 0.08 C = 620 – 200rw = 604 CFor = 960 – 300 rw = 936 S = Y – C – G = 1000 – 604 – 325 = 71 SFor = YFor – CFor – GFor = 1500 – 936 – 300 = 264 / = 150 – 200 rw = 134 IFor = 225 – 300 rw = 201 CA = S – / = 71 – 134 = –63 CAFor = SFor – /For = 264 – 201 = 63 So a balanced-budget increase in government spending increases the home Country’s current account deficit.

SH = YH - CH - GH = 1000 − [100 + (0.5 x 1000) − 500r] − 155 = 245 + 500r SF = YF − CF − GF = 1200 − [225 + (0.7 x 1200) − 600r] − 190 = −55 + 600r

NXH = SH - IH = 245 + 500r − (300 − 500r) = −55 + 1000r NXF = SF - IF = -55 + 600r − (250 − 200r) = -305 + 800r In equilibrium, NXH + NXF = 0, so −55 + 1000r + (−305 + 800r) = 0 1800r = 360 r = 0.20

CH = 100 + (0.5 x 1000) − (500 x 0.20) = 500 SH = 245 + (500 x 0.20) = 345 IH = 300 − (500 x 0.20) = 200 CAH = NXH = -55 + (1000 x 0.20) = 145 (assume NFP = 0) absorptionH = CH + IH + GH = 500 + 200 + 155 = 855 CF = 225 + (0.7 x 1200) − (600 x 0.20) = 945 SF = -55 + (600 x 0.20) = 65 . 87

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IF = 250 − (200 x 0.20) = 210 CAF = NXF = −305 + (800 x 0.20) = −145 (assume NFP = 0) absorptionF = CF + IF + GF = 945 + 210 + 190 = 1345 6.

GDP = Y = $1 000 000 = total production of coconuts GDP = $1 025 000 = production of coconuts + net factor income from abroad NFP = $25 000 / = $0 S = Y + NFP – C – G = $1 000 000 + $25 000 – $1 025 000 – $0 = $0 CA = S – / = $0 NX = CA – NFP = $0 – $25 000 = –$25 000 KA = – CA = $0 The $500 000 in foreign bonds provides income of $500 000 × 0.05 = $25 000 per year. Since people consume exactly $1 025 000 they must be using the $25 000 of foreign interest receipts to buy imported consumption goods. So net exports are –$25 000 and the current account balance is zero. Since the current account balance is zero, the capital account balance is also zero.

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Analytical Problems 1. a. Export of merchandise: + entry in current account. b. No entry: just changes the type of foreigner holding Canadian assets. c. Decrease in Canadian official reserve assets + entry in capital account. d. Income receipt from abroad: + entry in current account. e. Import of assets: – entry in capital account. f. Import of services: – entry in current account. g. Increase in foreign ownership of Canadian assets + entry in capital account. 2. There are many possible answers; an example for each is given here. a. Canadian citizens buy cars from the foreign country: – entry in current account. b. c.

No transaction needed. The Bank of Canada sells dollars to, and buys deutsche marks from, the Bundesbank (the central bank of Germany): – entry in capital account.

Brazilian citizens receive interest on Canadian Treasury bonds they own: – entry in current account. e. Revenue Canada sells a bankrupt singer’s home to an Egyptian citizen: – entry in capital account. f. Kuwait pays for the services of a Calgary-based team of oil fire fighters: + entry in current account. g. A Canadian bank buys U.K. government bonds: – entry in capital account. 3. In Fig. 5.3 before the capital controls are imposed the home country has a current account deficit of the amount CA, while the foreign country has a matching current account surplus. The effect of the capital controls is to make saving equal investment in each country. In the home country, the real interest rate rises, investment declines, saving increases, and the current account balance increases to zero. The world real interest rate (the interest rate in the foreign country) declines. d.

Figure 5.3

In Fig. 5.4 suppose initially both countries have a zero current account. A rise in . 89

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the government budget deficit has no effect on desired investment, so it affects the current account only if it affects desired national saving. If desired national saving is affected, the saving curve shifts to the left from S1 to S2. This raises the world real interest rate, reduces investment in both countries, and increases the foreign country’s current account balance.

Figure 5.4

a. The home country’s saving curve shifts to the right, from S1 to S2 in Fig. 5.5 The real world interest rate falls, so that the current account surplus in the home country equals the current account deficit in the foreign country. From Fig. 5.5, S rises, / rises, CA rises, rw falls.

Figure 5.5

The foreign country’s saving curve shifts to the right, from S1For to S2For in Fig. 5.6. The real world interest rate must fall, so the current account surplus in the foreign country equals the current account deficit in the home country. As shown in the figure, S falls, / rises, CA falls, rw falls.

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Figure 5.6

The foreign country’s saving curve shifts to the left, from S1For to S2For in Fig. 5.7. The real world interest rate must rise, so the current account deficit in the foreign country equals the current account surplus in the home country. As shown in the figure, S rises, / falls, CA rises, rw rises.

Figure 5.7

If Ricardian equivalence holds, there is no effect. If Ricardian equivalence does not hold, then the result is the same as in part b, as the foreign country’s saving curve shifts to the right.

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Since the bonds are identical, we would expect that the interest rates would adjust until they were equal. Savers would choose to purchase the Canadian bonds because they pay the higher rate of return. By doing so, they will bid up the price of Canadian government bonds and this will cause the interest rate on those bonds to fall. Those savers currently holding US government bonds will sell those bonds. In doing so the price of US government bonds will fall and this will cause the interest rate on those bonds to increase. In this way, the interest rates on the two bonds will adjust until they are equal. The equilibrium interest rate will be somewhere between 6% and 8%.

To see that this must be the case, suppose for a moment that it were not true. Suppose that the Royal Bank (for example) could lend mortgage money at 10% in Toronto but only 6% in Calgary. In this case, the Royal Bank would lend the savings of Calgarians to borrowers in Toronto. In doing so, the supply of mortgage funds would increase in Toronto and fall in Calgary. The increased supply of mortgage funds in Toronto would lower interest rates there while the reduced supply of mortgage funds in Calgary would increase interest rates there. This would continue until the interest rates were identical. 8. A temporary adverse supply shock hitting the foreign economy causes the foreign saving curve to shift up, from S1For to S2For in Fig. 5.7. This raises the equilibrium world real interest rate, increasing home country saving and decreasing home country investment. Since saving rises and investment falls, the home country’s current account balance increases. If the shock is worldwide, then the effect on the current account depends on how big the shift to saving is in the home country relative to the foreign country, as well as on the slope of the investment curve. If the saving curves shift just right, the current account may be unchanged, as shown in Fig. 5.8. In any event, the world real interest rate increases, and saving and investment in both countries decline.

Figure 5.8

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The shock shifts the saving curve to the right, with no change in the investment curve, since the future marginal product of capital is unaffected. Since income rises and saving rises, consumption rises, but less than income. Thus, although imports rise somewhat, the amount is small, so that the current account increases, it doesn’t fall. The statement is false. 10. Note that when the government of Eastland makes this change, it isn’t changing total government purchases, so there is no effect on national saving. Thus, the current account balance is unaffected. How can that be, given that Eastland’s government is now purchasing more goods from Westland? The answer is that the private sector offsets the government’s actions by increasing its net exports to Westland. The point of this exercise is to show that a government can’t affect the current account balance by changing its purchasing decisions if its total purchases of goods and services remain unchanged; it can only do so if it changes national saving or investment, since the current account equals saving minus investment.

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CHAPTER 6: LONG-RUN ECONOMIC GROWTH LEARNING OBJECTIVES I.

Goals of Chapter 6 A. Identify forces that determine the growth rate of an economy 1. Changes in productivity are key 2. Saving and investment decisions are also important B. Examine policies governments may use to influence the rate of growth

II.

Notes to Eighth Edition Users A. Figures, tables, and their corresponding text have been updated. B. Section on neoclassical growth model has been revised to be more concise. C. Answers for Review Questions have been updated.

TEACHING NOTES I.

The Sources of Economic Growth (Sec. 6.1) A. Production function Y = AF(K, N) (6.1) 1. Decompose into growth rate form ΔY/Y = ΔA/A + aKΔK/K + aNΔN/N (6.2) 2. The terms aK and aN are the elasticities of output with respect to the inputs (capital and labour) 3. Interpretation a. A rise of 10% in A raises output by 10% b. A rise of 10% in K raises output by aK times 10% c. A rise of 10% in N raises output by aN times 10% 4. Both aK and aN are less than 1 due to diminishing marginal productivity B. Growth accounting 1. Four steps in breaking output growth into its causes (productivity growth, capital input growth, labour input growth) (Table 6.2) a. Get data on ΔY/Y, ΔK/K and ΔN/N, adjusting for quality changes b. Estimate aK and aN from historical data c. Calculate the contributions of K and N as aKΔK/K and aNΔN/N, respectively d. Calculate productivity growth as the residual: ΔA/A = ΔY/Y - aKΔK/K - aNΔN/N

Numerical Problems 1 and 2 are growth accounting exercises. 2.

Application: Growth accounting and the East Asian “miracle” a. The East Asian “tigers” (Hong Kong, Singapore, South Korea, and Taiwan) have all grown over 7% per year for 25 years b. Alwyn Young’s research found that their rapid growth resulted from capital and labour growth, not productivity growth c. The implication is that their rapid growth may stop soon, since growth in inputs is hard to sustain permanently Growth accounting and the productivity slowdown a. Results for 1891–2015 (text Table 6.3) (1) Highest growth rate between 1962–73 with productivity . 94

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b. c.

growth 1.6%, labour growth 2.2%, and capital growth 1.5%. (2) Pre-1956 growth was less, and post-1987 growth was less (3) Productivity growth has declined (a) 1926–1956: 2.7% (b) 1962–1973: 1.6% (c) 1974–1986: 0.9% (d) 1987–2015: 0.7% Productivity growth slowdown occurred in all major developed countries Plausible explanations of the post-1973 slowdown in productivity growth (1) Measurement problems: inadequate accounting for quality improvements (2) The oil price explanation: Huge increase in oil prices reduced productivity of capital and labour, especially in basic industries (3) The relatively high rate of productivity growth was an anomaly and the slowdown simply reflects the return of a long-term normal rate of productivity growth

Policy Application Paul Krugman, “The Myth of Asia’s Miracle,” Foreign Affairs, Nov/Dec 1994, pp. 62–78, provides a readable summary of Alwyn Young’s work on growth accounting in Asia. He also gives a thought-provoking analysis of how growth accounting in the 1950s would have predicted the subsequent productivity slowdown in Russia despite the tremendous fears in the US at that time of a USSR convergence with the United States. Theoretical Application Growth accounting provides the basis for the real business cycle (RBC) model of the economy, which we will discuss in greater detail in Chapter 11 The RBC model takes movements in total factor productivity to be the primary source of business cycle fluctuations. Data Application Michael Denny et al in “Productivity in Manufacturing industries, Canada, Japan, and the U.S. 1953-86: Was the ‘productivity slowdown’ reversed?” Canadian Journal of Economics, 1992 August pp. 548-603 argue that during the last twelve-year period measured, from 1973-85, productivity growth in the majority of Canadian manufacturing industries was much lower than during the first twelve years, from 1961-75. They suggest that the decline in Canadian manufacturing productivity growth may have been concentrated in the period 1973-80, and there may have been a recovery after 1980. II.

Growth Dynamics: The Neoclassical Growth Model (Sec. 6.2) A. Three basic questions about growth 1. What’s the relationship between the long-run standard of living and the saving rate, population growth rate, and rate of technical progress?

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How does economic growth change over time? Will it speed up, slow down, or stabilize? 3. Are there economic forces that will allow poorer countries to catch up to richer countries? Setup of the model 1. Basic assumptions and variables a. Population and work force grow at same rate n b. Economy is closed and G = 0 c. Ct = Yt – It (6.3) d. Rewrite everything in per-worker terms: yt = Yt /Nt; ct = Ct /Nt; kt = Kt /Nt e. kt is also called the capital–labour ratio 2. The production function a. Yt = AtF(Kt,Nt) (6.4) b. Assume no productivity growth for now (add it later) c. Plot of per-worker production function—text Fig. 6.1 d. Same shape as aggregate production function

Numerical Problem 5, 6, and Analytical Problem 6 work with the per-worker production function. 3.

(3)

Steady states a. Steady state: yt, ct, and kt, are constant over time b. Gross investment must (1) Replace worn out capital, dKt (2) Expand so the capital stock grows as the economy grows, nKt c. yt = Atf(kt) (6.5) d. From Eq. (6.3), Ct = Yt – It = Yt – (n + d)Kt (6.7) e. In per-worker terms, in steady state c = Af(k) – (n + d)k (6.8) f. Plot of c, Af(k), and (n + d)k (Fig. 6.1; identical to text Fig. 6.2) g. Increasing k will increase c up to a point (1) This is kG, in the figure (2) For k beyond this point, c will decline But we assume henceforth that k is less than kG, so c always rises as k rises

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y, (n+d)k

Chapter 6: Long-Run Economic Growth

(n+d)k y=Af(k)

kmax

Figure 6.1

Reaching the steady state a. Suppose saving is proportional to current income: St = sYt (6.9), where s is the saving rate which is between 0 and 1 b. Equating saving to investment gives sYt = (n + d)Kt (6.10) c. Putting this in per-worker terms gives sAf(k) = (n + d)k (6.11) d. Plot of sAf(k) and (n + d)k (Fig. 6.2; identical to text Fig, 6.4) e. The only possible steady-state capital–labour ratio is k* f. Output at that point is y* = Af(k*); consumption is c* = Af(k*) – (n + d) k* g. If k begins at some level other than k*, it will move toward k* (1) For k below k*, saving > the amount of investment needed to keep k constant, so k rises

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sAf(k), (n+d)k, y

y=Af(k) (n+d)k)

sAf(k)

k k* Figure 6.2

(2)

For k above k*, saving < the amount of investment needed to keep k constant, so k falls h. To summarize, with no productivity growth, the economy reaches a steady state, with constant capital–labour ratio, output per worker, and consumption per worker The fundamental determinants of long-run living standards 1. The saving rate a. Higher saving rate means higher capital–labour ratio, higher output per worker, and higher consumption per worker (shown in text Fig. 6.5) b. Should a policy goal be to raise the saving rate? (1) Not necessarily, since the cost is lower consumption in the short run (2) There is a trade-off between present and future consumption 2. Population growth a. Higher population growth means a lower capital–labour ratio, lower output per worker, and lower consumption per worker (shown in text Fig. 6.6) b. Should a policy goal be to reduce population growth? (1) Doing so will raise consumption per worker (2) But it will reduce total output and consumption, affecting a nation’s ability to defend itself or influence world events c. The Solow model also assumes that the proportion of the population of working age is fixed (1) But when population growth changes dramatically this may not be true (2) Changes in cohort sizes may cause problems for social security systems and areas like health care 3. Productivity growth a. The key factor in economic growth is productivity improvement b. Productivity improvement raises output per worker for a given level of the capital–labour ratio

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In equilibrium, productivity improvement increases the capital– labour ratio, output per worker, and consumption per worker (1) Productivity improvement directly improves the amount that can be produced at any capital–labour ratio (2) The increase in output per worker increases the supply of saving, causing the long-run capital–labour ratio to rise Can consumption per worker grow indefinitely? (1) The saving rate can’t rise forever (it peaks at 100%) and the population growth rate can’t fall forever (2) But productivity and innovation can always occur, so living standards can rise continuously Summary: The rate of productivity improvement is the dominant factor determining how quickly living standards rise

Analytical Problems 1,2, 3, and 4 look at how changes in the fundamentals affect an economy’s economic growth. D.

Endogenous growth theory—explaining the sources of productivity growth 1. Human capital a. Knowledge, skills, and training of individuals b. Richer countries invest more in human capital c. Higher human capital increases output per worker d. Empirical studies show a strong relationship between economic growth and education or literacy

Theoretical Application For a readable discussion of the Solow-Swan model and several simple endogenous growth models, see Charles Jones, Introduction to Economic Growth, New York: W.W. Norton, 1998. In addition to presenting current research on economic growth in an accessible fashion, the text also presents and discusses relevant empirical evidence. 2.

Technological innovation a. Research and development programs: formal programs to improve products b. Learning by doing: innovations that arise in the process of making and marketing a good or service 3. Policy lessons a. Government policy to increase the capital–labour ratio (e.g., by increasing the saving rate) can lead to a virtuous circle, raising output per worker continuously b. This occurs because the higher output raises living standards and human capital, leading to even more productivity improvements Economic growth and the environment 1. Economic growth may be limited by available stocks of natural resources or by the environment. 2. Does economic growth lead to deterioration in the environment?

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Policy Application For a provocative prescription for economic growth, see Chapter 1 in Robert Barro, Determinants of Economic Growth: A Cross-Country Empirical Study, Cambridge: MIT Press, 1997. He also discusses the relevant importance of democracy and inflation on growth in Chapters 2 and 3. III.

Government Policies to Raise Long-Run Living Standards (Sec. 6.3) A. Policies to affect the saving rate 1. If the private market is efficient, the government shouldn’t try to change the saving rate a. The private market’s saving rate represents its trade-off of present for future consumption b. But if tax laws or myopia cause an inefficiently low level of saving, government policy to raise the saving rate may be justified 2. How can saving be increased? a. One way is to raise the real interest rate to encourage saving; but the response of saving to changes in the real interest rate seems to be small b. Another way is to increase government saving (1) The government could reduce the deficit or run a surplus (2) But under Ricardian equivalence, tax increases to reduce the deficit won’t affect national saving B. Policies to raise the rate of productivity growth 1. Improving infrastructure a. Infrastructure: highways, bridges, utilities, dams, airports b. Empirical studies suggest a link between infrastructure and productivity c. Canadian infrastructure spending has declined in the last two decades 2. Building human capital a. There’s a strong connection between productivity and human capital b. Government can encourage human capital formation through educational policies, worker training and relocation programs, and health programs c. Another form of human capital is entrepreneurial skill d. Government could help by removing barriers, like red tape 3. Encouraging research and development Government can encourage R and D through direct aid to research

Policy Application Many issues relating to government policy and its effect on growth are discussed in a special issue of the Journal of Monetary Economics, December 1993. The articles were presented z a World Bank Conference on the research project, “How Do National Policies Affect Long-Run Growth?”

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Industrial policy A growth strategy in which government uses taxes, subsidies, or regulation to influence economic development a. Some argue that government should promote high-tech industry b. But others think the free market allocates resources well without government interference c. Why might government interference be desirable? (1) Borrowing constraints on small firms or individuals may prevent them from undertaking research and development (2) Spillovers of one firm’s innovation may help other firms (3) Prestige or military advantage may make it important that a nation have a presence in an industry with few worldwide firms d. But the government may be bad at picking winning ideas to fund; further, politics, not innovation, may determine what firms get government funding e. Empirical evidence: Governments frequently pick losing ideas to fund, though sometimes they pick big winners Market policy Policy stipulating the extent to which government can restrict the free operation of markets a. Market policies include the choice of free versus regulated markets and the choice of free trade versus protectionism b. Why might government interference with the free operation of markets be desirable? (1) Unfettered operation of markets may result in a highly concentrated production and hence, inefficiency (2) Free operation of markets may produce outcomes that a society may deem unattractive (3) Efficient operation of markets involves the dislocation of resources, including human resources, and societies sometimes choose to interfere with the free operation of markets by providing social insurance (4) A system of free markets also produces an unequal distribution of income by rewarding handsomely those whose skills are valued highly in the marketplace Social Insurance a. Advances in productivity are sometimes resisted because of the perception that they must involve costs in terms of equity and fairness b. However, some economists argue that increases in efficiency may actually require increases in social insurance

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1. Is Growth Always Beneficial? A major goal of most countries is to have sustained growth in the level of GDR Is this an appropriate goal for all countries in all periods? What problems can growth bring? Although growth normally leads to more jobs and a greater availability of goods and services, growth can bring difficulties as well as gains. Rapid growth can cause congestion and unhealthy living and working situations. The need for raw materials may despoil pristine natural settings. In the lower mainland of British Columbia, the pressure of economic and population growth has seriously reduced air quality and damaged natural habitats for wildlife. Industrial production may pollute the air, water, and land. At some point one must wonder if the price we pay for more goods and services is worth what we give up in beauty and cleanliness. Does growth benefit everyone? There is an implicit assumption that when the total amount of goods and services available goes up, everyone will receive more. However, sometimes the benefits of growth are very unequally distributed. Workers and business owners may do better, but frequently the unemployed, the retired, and marginal workers receive few benefits. Sometimes one region may gain while other stagnate, causing regional conflict. 2. Noneconomic Factors in Growth Economic models highlight growth that comes about because of changes in the inputs of capital and labour or in productivity. Political and social changes may affect growth and productivity as well. What noneconomic factors are important in growth? Items such as attitudes toward work, the political climate, and the availability of managerial talent and entrepreneurship are important determinants of the rate of economic growth, but are difficult to quantify. Although there are many non-economic factors, we shall confine ourselves to two: entrepreneurial spirit and political stability. In most places where growth has been rapid, each of these has been available. Growth usually requires people to break out of their old ways—to follow new methods or use new materials. If growth came about only through increases in the amounts of land, labour, and capital used, there would be severe limits on our ability to raise production by more than population growth. GDP per capita would grow very slowly. Much of the increase in productivity requires an entrepreneur to seize the opportunity for new products or better production methods and make the necessary changes, in societies that prize conformity, few people are willing to follow new ideas, so growth in output is generally slow. Political stability is almost an absolute requirement for economic advance. The breakup of Yugoslavia and the ensuing war has brought production to a halt. It is difficult to spend much time improving production when daily life requires one to scramble for food, water, shelter, and fuel just to stay alive. Even when a shooting war does not erupt, governmental instability leads to limited or even negative growth. For businesses to be successful they need consistent, even-handed policies. If permits are hard to get or tax policies are not administered fairly, businesses often prefer to produce in other locations where conditions are more favourable. Being an entrepreneur requires risk in the most stable of political situations. An unstable or nonexistent government makes the risks too high for most prospective business owners. 3. How Do Increases in Productivity Come About? An important part of growth comes from increases in productivity. What causes growth in productivity? Some increases in productivity come from new equipment. For example, buying a new, faster copy machine that collates and staples may allow the graphics department to produce more in a given period of time with fewer workers. Fax machines reduce the time necessary to deliver documents from one office to another. . 102

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Other increases in productivity come from eliminating unnecessary or duplicative steps from a procedure. For example, Revenue Canada is beginning a system allowing for tax returns to be filed electronically. While the electronic submission requires the use of technology, the real saving is in the fact that the information need be entered only once. When the filer fills out the return, the data are in a form that is automatically transmitted to the computer. No second input of data by a human would be necessary. Such a procedure also increases productivity by reducing the number of errors. Every time the data must be entered, the chance of error increases. Major enhancements of output result from reassessing, redesigning, and/or reorganizing production. For example, the development of miniature electronic circuits that could be printed on circuit boards replacing hand-wired setups revolutionized the electronics industry. Not only were smaller electronic devices possible, but the amount of labour necessary to assemble them plummeted. In addition, the smaller circuits took fewer materials. 5.

Why Are Democracy and Growth Generally Compatible?

Research shows that democracy and growth frequently go together. Why is this true? Democracy, in most cases, encourages freedom of expression and the exchange of ideas. For businesses to grow and progress, people need to be able to try new ideas and make changes. A totalitarian society, in which deviating from the governmentimposed norms is considered suspicious or even treasonable, is not a fertile ground for growth. Entrepreneurs need a society that allows them to try new ideas and has a tolerance for eccentricity.

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1. The three sources of economic growth are capital growth, labour growth, and productivity growth. The growth accounting approach is derived from the production function. 2. Productivity growth may have declined because of a deterioration in the legal and human environment, reduced rates of technological innovation, and the effects of high oil prices. To some extent the apparent decline in productivity may be due to measurement difficulties. 3. If there is no productivity growth, then output per worker, consumption per worker, and capital per worker will all be constant in the long run. This represents a steady state for the economy. 4. The statement is false. Increases in the capital–labour ratio increase consumption per worker in the steady state only up to a point. If the capital–labour ratio is too high, then consumption per worker may decline due to diminishing marginal returns to capital, and the need to divert much of output to maintaining the capital–labour ratio. 5. a. An increase in the saving rate increases long-run living standards, as higher saving allows for more investment and a larger capital stock. b. An increase in the population growth rate reduces long-run living standards, as more output must be used to equip the larger number of new workers with capital, leaving less output available to increase consumption or capital per worker. c. A one-time increase in productivity increases living standards directly, by increasing output, and indirectly, since by raising incomes it also raises saving and the capital stock. 6. The new growth theory suggests that the main sources of productivity growth are accumulation of human capital (the knowledge, skills, and training of individuals) and technological innovation (research and development, as well as learning by doing). 7. Government policies to promote economic growth include policies to raise the saving rate and policies to increase productivity. One way to increase the saving rate is to increase the real return to saving by providing a tax break, as RRSPs did in Canada. Unfortunately, the response of saving to increases in the real rate of return is small. Another way to increase the saving rate is to reduce the government budget deficit. However, the theory of Ricardian equivalence suggests that this will not do much to increase national saving. Note that an increase in the saving rate will increase the steady-state capital–labour ratio, but will not increase the long-run rate of economic growth. One way that government policy can increase productivity is by spending more on the economy’s infrastructure, which has been neglected over the past two decades in Canada. Another possibility is to support the creation of human capital by spending more on education and training programs, and reducing barriers to entrepreneurial activity. The government can also support commercially oriented research, perhaps going so far as to develop an industrial policy. The issue in all these cases is whether the free market by itself provides an efficient outcome. A one-time increase in productivity will increase the steady-state capital–labour ratio but will not increase the long-run rate of economic growth. To increase the long-run rate of economic growth, the growth rate of productivity must be permanently increased. . 104

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Numerical Problems 1. Hare: $5000 × (1.03)50 = $21,919.50 Tortoise: $5000 × (1.01)50 = $8,223.1 2. Y K N

20 years ago Today 1000 1300 2500 3250 500 575

ΔA/A = akΔK/K - aNΔN/N

Percent change 30% 30% 15%

= 30% – (0.3 × 30%) – 0.7 × 15% = 30% – 9% – 10.5% = 10.5% Capital growth contributed 9% (aKΔK/K), labour growth contributed 10.5% (aNΔN/N), productivity growth was 10.5%. b.

ΔA/A = 30% – (0.5 x 30%) – (0.5 × 15%) = 30% – 15% – 7.5% = 7.5% Capital growth contributed 15% (aKΔK/K), labour growth contributed 7.5% (aNΔN/N), productivity growth was 7.5%.

a. Year K N Y K/N Y/N 1 200 1000 617 0.20 0.617 2 250 1000 660 0.25 0.660 3 250 1250 771 0.20 0.617 4 300 1200 792 0.25 0.660 This production function can be written in per-worker form since Y/N = K·8N·7/N = K S/N·3 = (K/N)·3 Note that K/N is the same in years 1 and 3, and so is Y/N. Also, K/N is the same in years 2 and 4. and so is Y/N. b. Year 1 2 3 4

K 200 250 250 300

N 1000 1000 1250 1200

Y 1231 1316 1574 1609

K/N 0.20 0.25 0.20 0.25

Y/N 1.231 1.316 1.259 1.341

This production function can’t be written in per-worker form since Y/N = K·8N·8/N = K·8/N·2. Note that K/N is the same in years 1 and 3, but Y/N is not the same in these years. The same is true for years 2 and 4. 4. To answer this problem, an approximate solution can be found by finding the ratio GDP (2016)/GDP (1950), taking the natural logarithm of that ratio and dividing by 66 This is the answer given in the table below. [A more exact solution is found by raising GDP ratio to the 1/66 power and subtracting one; this is now shown below.]

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Real GDP per capita 1950 1989 Australia 7,493 20,390 Canada 7,437 20,559 France 5,270 19,558 Germany 3,881 17,799 Japan 1,926 20,084 Sweden 6,738 18,685 United Kingdom 6,907 18,714 United States 9,561 27,331

Ratio 2.72 2.76 3.71 4.59 10.43 2.77 2.71 2.86

Growth rate 2.1% 2.1% 2.8% 3.2% 5.0% 2.1% 2.1% 2.2%

Germany and Japan had the highest growth rates because damage from World War II caused capital per worker to be lower than its steady-state level, and thus output per worker was temporarily low. In turn this points to growth model factors such as technology and capital. In other words, Japan and Germany reaped the benefits of the new technology that came with the new capital goods being constructed after the war. Other countries, not faced with the massive reconstruction, were still using older technology and depreciated capital goods. 5.

sf(k) = (n + a)k 0.3 x 3k5 = (0.05 + 0.1)k 0.9k5 = 0.15k 0.9/0.15 = k/k5 6 = k5 k = 62 = 36 y = 3k5 = 3 x 6 = 18 c = y – (n+ d)k = 18 – (0.15 x 36) = 12.6 b. sf(k) = (n + d)k 0.4 × 3k5 = (0.05 + 0.1)k 1.2k5 = 0.15k 1.2/0.15 = kk5 8 = k5 k = 82 = 64 y = 3k5 = 3x8 = 24 c = y – (n + d)k = 24 – (0.15 x 64) = 14.4

sf(k) = (n + d)k 0.3 x 3k5 = (0.08 + 0.1)k 0.9k5 = 0.18k 0.9/0.18 = k/k5 5 = k5 k = 52 = 25 y = 3k5 = 3x5 = 15 c = y – (n + d)k = 15 + (0.18 x 25) = 10.5 d. sf(k) = (n + d)k 0.3 × 4k5 = (0.05 + 0.1)k . 106

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1.2k5 = 0.15k 1.2/0.15 = k/k5 8 = k5 k = 82 = 64 y = 4k5 = 4 × 8 = 32 c = y – (n+ d)k = 32 – (0.15 x 64) = 22.4 6.

a. In steady state, sf(k) = (n + d)k 0.1 x 6k.5 = (0.01 + 0.14)k 0.6k.5 = 0.15k 0.6 / 0.15 = k / k.5 4 = k.5 k = 42 = 16 = capital per worker y = 6k.5 = 6 x 4 = 24 = output per worker c = .9 y = .9 x 24 = 21.6 = consumption per worker (n + d)k = .15 x 16 = 2.4 = investment per worker b. To get y = 2 x 24 = 48, since y = 6k.5, then 48 = 6k.5, so k.5 = 8, so k = 64. The capital–labour ratio would need to increase from 16 to 64. To get k = 64, since sf(k) = (n + d)k, s x 48 = .15 x 64, so s = .2. Saving per worker would need to double. First, derive saving per worker as sy = y - c - g = [1 – 0.5(1 – t) – t] 8k.5 = 0.5(1 – t)8k.5 = 4 (1 – t)k.5 a.

When t = 0, sy = 4 (1 – 0)k.5 = 4k.5 = national saving per worker Investment per worker = (n + d)k = .1k In steady state, sy = (n + d)k, so 4k.5 = 0.1k, or 40k.5 = k, so 1600k = k2, so k = 1600. Since k = 1600, y = 8 x 1600.5 = 320, c = 0.5 (1 – 0) 320 = 160, and (n + d)k = 0.1 x 1600 = 160 = investment per worker

When t = 0.5, sy = 4 (1 – 0.5)k.5 = 2k.5 = national saving per worker Investment per worker = (n + d)k = 0.1k In steady state, sy = (n + d)k, so 2k.5 = .1k, or 20k.5 = k, so 400k = k2, so k = 400. Since k = 400, y = 8 x 400.5 = 160, c = 0.5 (1 – 0.5) 160 = 40, and (n + d)k = 0.1 x 400 = 40 = investment per worker, g = ty = 0.5 x 160 = 80.

Figure 6.3

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Analytical Problems 1. a. The destruction of some of a country’s capital stock in a war would have no effect on the steady state, because there has been no change in s, f, n, or d. Instead, k is reduced temporarily, but equilibrium forces eventually drive k to the same steady-state value as before. b. Immigration raises n from n1 to n2 in Fig. 6.3. The rise in n lowers steady- state k, leading to a lower steady-state consumption per worker. c. The rise in energy prices reduces the productivity of capital per worker. This causes sf1 (k) to shift down from sf1(k) to sf2(k) in Fig. 6.4. The result is a decline in steady-state k. Steady-state consumption per worker falls for two reasons: (1) Each unit of capital has a lower Figure 6.4 productivity, and (2) steady-state k is reduced. d. A temporary rise in s has no effect on the steady-state equilibrium e. The increase in the size of the labour force does not affect the growth rate of the labour force, so there is no impact on the steady-state capital–labour ratio or on consumption per worker, however, because a larger fraction of the population is working, consumption per person increases. 2. The rise in capital depreciation shifts up the (n + d)k line from (n + d1)k to (n +d2)k, as shown in Fig. 6.5. The equilibrium steady-state capital–labour ratio declines. With a lower capital–labour ratio, output per worker is lower, so consumption per worker is lower (using the assumption that the capital–labour ratio is not so high that an increase in k will reduce consumption per worker). There is no effect on the long-run growth rate of the total capital stock, because in the long run the capital stock must grow at the same rate (n) as the labour force grows, so that the capital–labour ratio is constant.

Figure 6.5

Figure 6.6

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a. With a balanced budget T/N = g. National saving is S = s(Y – T) = sN[(Y/N) – (T/N)] = SN(y – g). Setting saving equal to investment gives S = I, sN(y – g) = (n + d)K, s(y – g) = (n + d)k, s[f(k) – g] = (n + d)k. This equilibrium point k’ is shown in Fig. 6.6. b. If the government permanent increases purchases per worker, the s[f(k) – g] curve shifts down from s[f(k) – g1] to s[f(k) – g2] in Fig. 6.7 In steady-state equilibrium, the capital–labour ratio is lower. Output per worker, capital per worker and consumption per worker are lower in the steady state. The optimal level of government purchases is not zero—it depends on the benefits of the government purchases as well as on the costs of these purchases.

Figure 6.7

Figure 6.8

4. St = sYt – hKt = Nt(syt – hkt). Setting St = It yields Nt( syt – hkt) = (n + d)Kt. Dividing through by Nt and eliminating time subscripts for steady-state variables gives sy – hk = (n + d)k. Rearranging and using the expression y = f(k) gives sf(k) = (n + d+ h)k. The steady-state value of capital per worker, k*, is given by the intersection of the (n + d + h)k line with the sf(k) curve, as shown in Fig. 6.8. Output per worker is f(k*). Since Ct = Yt – St, c = y – (sy – hk) = (1 – x)f(k*) + hk*. This expression gives consumption per worker. A change in the steady-state value of h increases the slope of the (n + d + h)k line, as shown in Fig. 6.9. This reduces the steady-state value of per-worker capital (k*), per-worker output [since y* = f(k*)], and per-worker consumption [since c* = (1 – s)y* + hk* and both y* and k* decline]. Figure 6.9

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5. The initial level of the capital–labour ratio is irrelevant for the steady state. Two economies that are identical except for their initial capital–labour ratios will have exactly the same steady state. Since the two economies must have the same growth rate at the steady state, and since the economy with the higher current capital–labour ratio has higher current output per worker, then the country with the lower current capital–labour ratio must grow faster. The answer holds true regardless of which country is in a steady state. If the country with a higher initial capital–labour ratio is in a steady state at capital–labour ratio k*, then the other country’s capital–labour ratio will rise until it too equals k*. So the country with the lower capital–labour ratio grows faster than the one with the higher capital–labour ratio. If the country with the lower initial capital–labour ratio is in a steady state at capital– labour ratio k*, then the other country’s capital–labour ratio is too high and it will decline until it equals k’. So the country with the higher capital–labour ratio must grow more slowly than the country with the lower capital–labour ratio. If the two countries are allowed to trade with each other, then their convergence to the same capital–labour ratio and output per worker will occur even faster. 6. The growth accounting equation is ΔY/Y = ΔA/A + (aKΔK/K) + (aKΔN/N) We are just increasing the amount of capital and labour, and there is no change in productivity, ΔA/A = 0. If the production function can be written in per-worker terms, then total output must increase in the same proportion as the percentage increase in capital and labour, so ΔK/K = ΔN/N = ΔY/Y = X. Plugging this into the growth accounting equation, ΔY/Y = A/A + (aKΔK/K) + (aKΔN/N), X = 0 + aKX + aNX, X = (aK +an)X, aK + aN = 1 7. Assume there are a constant number of workers, N, so that Ny = Y and Nk = K. Since y = Akah1−a and h = Bk, then y = Aka(Bk)1−a = (AB1−a)k. Then Y = Ny = (AB1−a)K =XK, where X equals AB1−a. This puts the production function in notation used in the chapter. Investment is )K + dK= sY = national saving. Dividing through both sides of that expression by K and using the production function gives )K/K + d= sXK/K = sX, so )K/K = sX − d, which is the long-run growth rate of physical capital. Since output and human capital are proportional to physical capital, they will all grow at the same rate. 8.

a. As explained in the text, a technological advance that increases productivity causes the per capita savings and output functions to pivot upward. Consumption per person increases at every capital–labour ratio. Thus, a productivity enhancement makes the average citizen better off, both immediately after the technological advance and in the long run after the economy adjusts to a new steady-state

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b. They can’t. The diagram can only show how the average citizen benefits from the technological advance. It is useful to remember that there are adjustment costs to be suffered as a result of any technological advance. The croppers were legitimately concerned that their skills had been made redundant with the introduction of the new mechanized textile loom. Until they could retrain and find new employment, the croppers would suffer loss of income. c. The technological advance moves the economy to a steady state at a higher capital–labour ratio. This adjustment means we slide up the per capita production function. This movement involves an increase in output per capita (y). Since y = Y/N, then during the period of adjustment the rate of growth in Y must exceed the rate of growth in N. In steady state, Y grows at the same rate as N. So, in the period of adjustment, output grows faster than in the steady state.

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CHAPTER 7: THE ASSET MARKET, MONEY, AND PRICES LEARNING OBJECTIVES I.

Goals of Chapter 7 A. What money is and why people hold it B. The decision about money demand is part of a broader portfolio decision C. Equilibrium in the asset market occurs when money supply equals money demand D. The price level is related to the level of the money supply

II.

Notes to Eighth Edition Users A. All Figures and tables have been updated to reflect the newly available data. B. Application “The U.S. Housing Crisis and Its Aftermath” has been updated to reflect current issues.

TEACHING NOTES I.

What is Money? (Sec. 7.1) A. The functions of money 1. Medium of exchange a. Barter is inefficient—it requires a double coincidence of wants b. Money allows people to trade their labour for money, then use the money to buy goods and services in separate transactions c. Money thus permits people to trade with less cost in time and effort d. Money also allows specialization, since trading is much easier, so people don’t have to produce their own food, clothing, and shelter 2. Unit of account a. Money is the basic unit for measuring economic value b. This simplifies comparisons of prices, wages, and incomes c. The unit-of-account function is closely linked with the mediumof-exchange function d. But countries with very high inflation may use a different unit of account, so they do not have to constantly change prices

Theoretical Application There have been a number of attempts to supply detailed microfoundations for money. Recently, an explicit theory that shows the superiority of money to barter has been developed by Nobuhiro Kiyotaki and Randall Wright (“On Money as a Medium of Exchange” Journal of Political Economy, August 1989, pp. 927-954). They show how introducing fiat money unambiguously improves society’s welfare.

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Store of value a. Money can be used to hold wealth b. Most people use money only as a store of value for a short period and for small amounts, because it earns less interest than money in the bank

Theoretical Application Money’s usefulness as a store of value declines the higher the inflation rate. In hyperinflations (very high inflations), people try to avoid the use of money; on receiving their wages, they rush to buy things before prices rise. And they tend to use other currencies instead of their own, a phenomenon known as currency substitution. 4.

Footnote #1: Money in a prisoner-of-war camp a. Problem with having a commodity money like cigarettes: can’t smoke them and use them as money at the same time Measuring money—the monetary aggregates 1. Distinguishing what is money from what isn’t money is sometimes difficult a. For example, MMMFs allow for withdrawing funds, but give a higher return than bank chequing accounts: Are they money? b. There’s no single best measure of the money stock 2. The M1+ monetary aggregate a. Consists of currency held by the public, and personal and nonpersonal chequable deposits. b. All components of M1+ are used in making payments, so M1+ is the closest money measure to our theoretical description of money

Data Application One concern about measuring money is that the amount of money that is issued may be significantly higher than that available for use within the country, because of foreign demand. The United States, in particular, has the problem that citizens in other countries, whose own currencies are very poor as stores of value because of high inflation, have chosen to use US dollars. As a result, somewhere from 60% to 80% of all the dollar bills issued by the Federal Reserve are in fact held outside the country. This may create policy concerns. For example, in the early 1990s the M1 measure of the money supply rose faster than 10% per year. But much of the increased demand for dollars came from Eastern Europe, where the demise of communism had created economic and political turmoil and unstable local currencies. By contrast, relatively few Canadian dollars are held outside the country. 3.

The M2 and M3 monetary aggregates a. M2 = M1+ + less money like assets b. Additional assets in M2 include personal and non-personal nonchequable deposits. c. M3 = M2 plus non-personal term deposits held by businesses and foreign currency deposit of residents. d. These assets, while not usable directly for payments, can be sold quickly and cheaply to get money

Analytical Problem 1 looks at portfolio changes and how they affect M1+ and M2.

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Data Application Research and empirical work on weighted monetary aggregates was begun by a group of economists at the Federal Reserve Board in the late 1970s. William Barnett, now at Washington University of St. Louis, was part of that group and is now the main proponent of the use of Divisia indexes as a weighted monetary aggregate. The leading Canadian expert on Divisia indexes is Paul Serletis of the University of Calgary. See William Barnett, Douglas Fisher, and Apostolos Serletis, “Consumer Theory and the Demand for Money,” Journal of Economic Literature, December 1992, pp. 2086–2119. C.

II.

The money supply 1. Money supply = money stock = amount of money available in the economy 2. How does the central bank of a country increase the money supply? a. Use newly printed money to buy financial assets from the public—an open-market purchase b. To reduce the money supply, sell financial assets to the public to remove money from circulation—an open-market sale c. Open-market purchases and sales are called open-market operations d Could also buy newly issued government bonds directly from the government (i.e., the Department of Finance) (1) This is the same as the government financing its expenditures directly by printing money (2) This happens frequently in some countries 3. Throughout the text, use the variable M to represent money supply; this might be M1+, M2, or some other aggregate

Portfolio Allocation and the Demand for Assets (Sec. 7.2) How do people allocate their wealth among various assets? The portfolio allocation decision A. Expected return 1. Rate of return = an asset’s increase in value per unit of time a. Bank account: Rate of return = interest rate b. Corporate stock: Rate of return = dividend yield + percent increase in stock price 2. Investors want assets with the highest expected return (other things equal) 3. Returns aren’t always known in advance (for example, stock prices fluctuate unexpectedly), so people must estimate their expected return B. Risk 1. Risk is the degree of uncertainty in an asset’s return 2. People don’t like risk, so prefer assets with low risk (other things equal)

Theoretical Application Their separate work in developing financial theory brought the 1990 Nobel Prize in Economics to Harry Markowitz, Merton Miller, and William Sharpe. Their main contributions were to recognize the trade-off between risk and expected return (Markowitz), to develop the Capital Asset Pricing Model as a general equilibrium theory for pricing assets (Sharpe), and to examine the corporate financial decision about whether to raise funds via debt or equity (Miller). For an overview of their research, see Hal Varian, “A Portfolio of Nobel Laureates: Markowitz, Miller, and Sharpe,” Journal of Economic Perspectives, Winter 1993, pp. 159-169. . 114

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III.

Liquidity 1. Liquidity is the ease and quickness with which an asset can be traded 2. Money is very liquid 3. Assets like automobiles and houses are very illiquid—it may take a long time and large transaction costs to trade them 4. Stocks and bonds are fairly liquid, some more so than others 5. Investors prefer liquid assets (other things equal) Time to maturity 1. The amount of time until a financial security matures and the security’s owner is repaid his or her principal. 2. Term premium: an interest rate on long-term bonds that is somewhat higher than the expectations theory would suggest. Types of assets and their characteristics 1. Households hold many different assets: money, bonds, stocks, houses, and consumer durable goods. 2. Mix of different assets are determined by household wealth and age. Asset demands 1. Trade-off among expected return, risk, and liquidity 2. Assets with low risk and high liquidity, like chequing accounts, have low expected returns 3. The amount a wealth holder wants of an asset is his or her demand for that asset. The sum of asset demands equals total wealth Application: The US housing crisis and its aftermath 1. Housing prices in the US and Canada increased quickly and for a prolonged period during the late 1990s and most of the 2000s. 2. Both borrowers and lenders thought they were insulated from risk because the price of the house would have increased sufficiently that it could be sold for an amount in excess of the mortgage. 3. As housing prices started to decline, losses extended to financial institutions through MBSs and internationally. 4. Rapid rise in Canadian housing prices since 2008 prompted changes in legislation over mortgage lending standards and the risk inherent in carrying too large a mortgage.

The Demand for Money (Sec. 7.3) A. The demand for money is the quantity of monetary assets people want to hold in their portfolios 1. Money demand depends on expected return, risk, and liquidity 2. Money is the most liquid asset 3. Money pays a low return 4. People’s money-holding decisions depend on how much they value liquidity against the low return on money B. Key macroeconomic variables that affect money demand 1. Price level a. The higher the price level, the more money you need for transactions b. Prices are 10 times as high today as in 1945, so it takes 10 times as much money for equivalent transactions c. Nominal money demand is thus proportional to the price level 2. Real income a. The more transactions you conduct, the more money you need b. Real income is a prime determinant of the number of transactions you conduct c. So money demand rises as real income rises . 115

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But money demand isn’t proportional to real income, since higherincome individuals use money more efficiently, and since a country’s financial sophistication grows as its income rises (use of credit and more sophisticated assets) e. Result: Money demand rises less than 1-to-1 with a rise in real income 3. Interest rates a. An increase in the interest rate or return on nonmonetary assets decreases the demand for money b. An increase in the interest rate on money increases money demand c. This occurs as people trade off liquidity for return d. Though there are many nonmonetary assets with many different interest rates, because they often move together we assume that for nonmonetary assets there’s just one nominal interest rate, i e. The real interest rate, which affects saving and investment decisions f. The nominal interest paid on money is im The money demand function 1. Md = PL( Y, i) (7.1) a. Md is nominal money demand (aggregate) b. P is the price level c. L is the real money demand function d. Y is real income or output e. i is the nominal interest rate on nonmonetary assets 2. As discussed above, nominal money demand is proportional to the price level 3. A rise in Y increases money demand; a rise in i reduces money demand 4. We exclude im from Eq. (7.1) since it doesn’t vary much 5. Alternative expression: Md = PL(Y, r + πe) (7.2) A rise in r or πe reduces money demand 6. Alternative expression: Md/P = L(Y, r + πe) (7.3) Real money demand function Other factors affecting money demand 1. Wealth: A rise in wealth may increase money demand, but not by much 2. Risk a. Increased riskiness in the economy may increase money demand b. Times of erratic inflation bring increased risk to money, so money demand declines 3. Liquidity of alternative assets: Deregulation, competition, and innovation have given other assets more liquidity, reducing the demand for money. 4. Payment technologies: Credit cards, ATMs, and other financial innovations reduce money demand Elasticities of money demand 1. How strong are the various effects on money demand? 2. Statistical studies on the money demand function show results in elasticities 3. Elasticity: The percent change in money demand caused by a one percent change in some factor d.

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Income elasticity of money demand ηY a. Positive: Higher income increases money demand b. Less than one: Higher income increases money demand less than proportionately 5. Interest elasticity of money demand ηi Small and negative: Higher interest rate on nonmonetary assets reduces money demand slightly 6. Price elasticity of money demand is unitary, so money demand is proportional to the price level Velocity and the quantity theory of money 1. Velocity (V) measures how much money “turns over” each period 2. V = nominal GDP / nominal money stock = PY / M (7.4) 4.

Numerical Problem 1 is an empirical exercise calculating velocity from a money-demand equation. 3.

Plot of velocities for M1+ and M2 from 1975–2016 (text Fig. 7.2) shows stable velocity for M2, downward trend in velocity for M1+ beginning in early 1990s and 2000s

Analytical Problem 2 asks for explanations for the upward trend in M1 velocity before the 1990s. 4.

Quantity theory of money: Real money demand is proportional to real income a. If so, Md / P = kY(7.5) b. Assumes constant velocity, where velocity is not affected by income or interest rates c. But velocity of M1+ is not constant; it rose steadily during the late 1970s, then became more volatile in the 1980s, before declining more or less steadily since then. (1) Part of the change in velocity is due to changes in interest rates in the 1980s and 90s (2) Financial innovations also played a role in velocity’s decline in the early 1980s d. M2 velocity is more stable.

Data Application For a good source of information about the recent behaviour of monetary aggregates in Canada, including trends and velocities, see www. bank-banque-canada.ca. Click on Publications and Research, then click on Topic Index and search under Monetary Aggregates. (1) (2) IV.

But even M2 velocity isn’t constant over short periods M2 velocity rose sharply during the late 1990s but took a noticeable fall in 2008 during the financial crisis.

Asset Market Equilibrium (Sec. 7.4) A. Asset market equilibrium—an aggregation assumption 1. Assume that all assets can be grouped into two categories, money and nonmonetary assets a. Money includes currency and chequing accounts (1) Pays interest rate im (2) Nominal supply is fixed at M .

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Nonmonetary assets include stocks, bonds, land, etc. (1) Pays interest rate i = r + πe (2) Nominal supply is fixed at NM 2. Asset market equilibrium occurs when quantity of money supplied equals quantity of money demanded a. md = nmd = total nominal wealth of an individual b. Md + NMd = aggregate nominal wealth (from adding up individual wealth) (7.6) c. M + NM = aggregate nominal wealth (supply of assets) (7.7) d. Subtracting (7.7) from (7.6) gives (Md – M) + (NMd – NM) = 0 (7.8) e. So the excess demand for money (Md – M) plus the excess demand for nonmonetary assets (NMd – NM) equals 0. f. So if money supply equals money demand, nonmonetary asset supply must equal nonmonetary asset demand; then the entire asset market is in equilibrium The asset market equilibrium condition 1. M / P = L(Y, r + πe) (7.9) real money supply = real money demand a. M is determined by the central bank b. πe is fixed (for now) c. The labour market determines the level of employment; using employment in the production function determines Y d. Given Y, the goods market equilibrium condition determines r

Numerical Problem 2 is an exercise in calculating the equilibrium real interest rate. 2.

With all other variables in Eq. (7.9) determined, the asset market equilibrium condition determines the price level a. P = M / L (Y, r + πe) (7.10) b. The price level is the ratio of nominal money supply to real money demand c. For example, doubling the money supply would double the price level

For exercises dealing with price level determination, see Numerical Problems 3 and 5 and Analytical Problem 4. V.

Money Growth and Inflation (Sec. 7.5) A. The inflation rate is closely related to the growth rate of the money supply 1. Rewrite Eq. (7.10) in growth-rate terms: ΔP/P = ΔM/M − ΔL(Y, r + πe)/L(Y, r + π e) (7.11) 2. 3.

If the asset market is in equilibrium, the inflation rate equals the growth rate of the nominal money supply minus the growth rate of real money demand To predict inflation we must forecast both money supply growth and money demand growth a. In long-run equilibrium, we will have i constant, so let’s look just growth in Y b. Let ηY be the elasticity of money demand with respect to income .

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c. d.

Then from Eq.(7.11), π = ΔM/M - ηYΔY/Y (7.12) Example: If output grows 3% per year, the income elasticity of money demand is 2/3. and the money supply is growing at a 10% rate, then the inflation rate will be 8%

Numerical Problem 4 gives practice in using elasticities to predict inflation. Data Application For a review of the causes of inflation in the short run and long run in countries throughout the world, see Larry Bali’s article, “What Causes Inflation?” Federal Reserve Bank of Philadelphia Business Review, March / April 1993, pp. 3–12. B.

The expected inflation rate and the nominal interest rate 1. For a given r, expected inflation determines the nominal interest rate 2. What factors determine expected inflation? a. People could use Eq. (7.12), relating inflation to the growth rates of the nominal money supply and real income (1) If people expect an increase in money growth, they would then expect a commensurate increase in the inflation rate (2) The expected inflation rate would equal the current inflation rate if money growth and income growth were stable

Analytical Problem 3 shows how expected inflation depends on the money supply. Expectations can’t be observed directly (1) They can be measured roughly by surveys (2) If real interest rates are stable, expected inflation can be inferred from nominal interest rates (3) Policy actions that cause expected inflation to rise should cause nominal interest rates to rise Text Fig. 7.3 plots Canadian inflation and nominal interest rates from 1960 to 2016 a. Inflation and nominal interest rates have tended to move together b. But the real interest rate is clearly not constant c. The real interest rate was negative in the mid-1970s, then became much higher and positive in the late-1970s to early1980s, and declined somewhat in the 1990s. It turned negative again from early 2010s. b.

Data Application A careful attempt to measure the world real interest rate was undertaken by Robert J. Barro and Xavier Sala-i-Martin, “World Real Interest Rates,” in O. Blanchard and S. Fischer, eds., NBER Macroeconomics Annual, Cambridge, Mass.: MIT Press, 1990, pp. 15–61.

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A Closer Look 7.1: Measuring Inflation Expectations 1. Expected inflation is not measured with any great deal of accuracy 2. Economists at the Bank of Canada have developed a number of methods to gain insights into both inflationary expectations and the expected real interest rate a. Survey from private firms b. Compare the nominal yields on two different types of government bonds c. Figure 7.4 suggests that following a rapid fall of inflation expectations beginning in August 2008 and ending in July 2009, inflation expectations increased quickly back to where they were in 2008.

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1.

Understanding the Demand for Money

In understanding the economy’s transactions demand for money, it might help students to think of their own demand for money. Most of us carry money. How do you determine how much to carry with you and how much to invest or save? The amount of money an individual carries depends on daily expenses, income, the probability of extra expenses, and the difficulty of obtaining extra money when needed. The college student who lives in the campus residence hall and whose meals in the residence hall dining room are part of his room payment has few daily cash expenses. The woman who sits next to him in class may commute to campus and buy her lunch in the local hamburger heaven. She generally will carry more cash so she can pay for her gasoline and luncheon hamburger. Students who are on a tight budget are likely to carry only what they can afford to spend. Those who often join their friends for a snack after class or who need to pick up family groceries on the way home from class need more money than those who don’t. If you use credit cards and most of the places you frequent take them, you’ll need less money than if you must pay cash everywhere you go. What happens if you do not have enough money or money substitutes such as credit cards with you? You forgo purchases or you go to acquire money. The former reduces the sales of the economy at least temporarily. The latter causes you additional trouble and difficulty, whether it is necessary to borrow from your companions or to find a bank or ATM machine that will allow you to obtain means to pay for the goods or services you want. If sources of additional cash are easily accessible, one is less likely to carry a reserve than if they are not. 2. Credit Cards: How Do They Change Our Use of Money? How does the demand for money change over time as the ways we pay for goods change? One major change in the past forty years is the increasing use of credit cards. How does this affect payment patterns and the velocity of money? Credit cards tend to reduce the quantity of money we must hold and increase the velocity of money. Today, credit cards are used to make both large and small purchases. For example, if you pay for gasoline or groceries with credit card, you do not need to carry as much cash or have as much money in your chequing account. Credit cards allow the consumer to spend money that will be received in the future. Credit cards can increase velocity—the rate at which money turns over. Many people find that when their pay cheque comes in, a good portion of it is already spent. The credit card bill has arrived and must be paid from the cheque just received. Thus, instead of a gradual decrease in money held, a large part of it is paid out relatively soon after income is acquired. 3. What Does Rapid Inflation Do to the Demand for Money and to Velocity? While not constant, M2 velocity tends to vary only a little over time in Canada, with its moderate inflation. The demand for money also tends to grow at a roughly predictable rate. How would this change if inflation were very high? How do such enormous changes in prices affect velocity and the demand for money? When a nation undergoes rapid inflation, people must adapt to survive. Money, which under normal conditions serves as a store of value and a unit of account, no longer can be used extensively for these purposes. It serves only as a medium of exchange. Consumers and businesses hold as little money as possible, as it loses value daily, and in some cases, hourly. Any income received needs to be exchanged for goods as quickly as possible in order to preserve its value. In countries undergoing hyperinflation, . 121

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workers rush out to spend their pay as soon as it is received. The delay of an hour or a day will reduce the amount that can be bought. People have no desire to hold any money at all, as its value declines daily. If resources need to be held, people will buy commodities such as cigarettes or food that are in general demand and hold these to trade later. High inflation makes velocity skyrocket. As soon as one receives any money, one tries to use it to buy a needed item immediately. Money held for any length of time loses value. Thus, turnover rates become very high.

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1. Money is the economist’s term for assets that can be used in making payments, such as cash and chequing accounts. In everyday speech, people often use the term “money” to refer to their income or wealth, but in economics money means only those assets that are widely used and accepted as payment 2. The three functions of money are (1) the medium of exchange function, which contributes to a better-functioning economy by allowing people to make trades at a lower cost in time and effort than in a barter economy; (2) the unit of account function, which provides a single, uniform measure of value; and (3) the store of value function, by which money is a way of holding wealth that has high liquidity and little risk. 3. The size of the nation’s money supply is determined by its central bank; in Canada, the central bank is the Bank of Canada. If all money is in the form of currency, the money supply can be expanded if the central bank takes newly minted currency and uses it to buy financial assets from the public or directly from the government itself. To reduce the money supply, the central bank can sell financial assets to the public or the government, taking currency out of circulation. 4. The three characteristics of assets that are most important to wealth holders are (1) expected return, (2) risk, and (3) liquidity. Money has a low expected return compared to other assets, low risk since it always maintains its nominal value, and is the most liquid of all assets. 5. The macroeconomic variables that have the greatest impact on money demand are the price level, real income, and the nominal interest rate on other assets. The higher the price level, the higher the demand for money, since more units of money are needed to carry out transactions. The higher the level of real income, the higher the need for liquidity, and so the higher is money demand. When the nominal interest rate on other assets is high, money demand is low, because the opportunity cost of holding money (that is, the interest you forgo on other assets because you are holding money instead) is high. 6. Velocity is a measure of how often money “turns over” in a period. It is equal to nominal GDP divided by the nominal money supply. The quantity theory of money assumes that velocity is constant, which implies that real money demand is proportional to real income and is unaffected by the real interest rate. 7. Equilibrium in the asset market is described by the condition that real money supply equals real money demand because when supply equals demand for money, demand must also equal supply for nonmonetary assets. The aggregation assumption that is needed for this is that we can lump all wealth into two categories: (1) money and (2) nonmonetary assets. 8.

In equilibrium the price level is proportional to the nominal money supply; in particular it equals the nominal money supply divided by real money demand. Similarly, the inflation rate is equal to the growth rate of the nominal money supply minus the growth rate of real money demand. Factors that could increase the public’s expected rate of inflation include a rise in money growth or a decline in income growth. With no effect on the real interest rate, the increase in expected inflation would increase the nominal interest rate.

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Numerical Problems 1. a. Real money demand is Md / P = 500+0.2Y – 1000i = 500 + (0.2 x 1000) – (1000 x 0.10) = 600. Nominal money demand is Md = (Md / P) × P = 600 × 100 = 60 000. Velocity is V = PY / Md = 100 × 1000 / 60 000 = 1 2/3. b. Real money demand is unchanged, because neither Y nor i has changed. Nominal money demand is

Md = (Md / P) × P = 600 x 200 = 120 000. Velocity is unchanged, because neither Y nor Md / P has changed, and we can write the equation for velocity as V = PY / Md = Y / (Md / P). It is useful to use the last expression for velocity, V = Y / (Md / P) = Y / (500 + 0.2Y – 1000i).

d. (1) Effect of increase in real income: When i = 0.10, V = Y / [500 + 0.2Y – (1000 x 0.10)] = Y / (400+0.2Y) = 1 / [(400 / Y) + 0.2]. When Y increases, 400 / Y decreases, so V increases. For example, if Y = 2000, then V = 2.5, which is an increase over V = 1 2/3 that we got when Y = 1000. (2) Effect of increase in the nominal interest rate: When Y = 1000, V = 1000 / [500 + (0.2 × 1000) – 1000i] = 1000 / (700 – 1000i) = 1 / (0.7 – i). When i increases, 0.7 — i decreases, so V increases. For example, if i = 0.20, then V = 2, which is an increase over V = 1 2/3 that we got when i = 0.10. (3) Effect of increase in the price level: There is no effect on velocity, since we can write velocity as a function just of Y and i. What happens is that nominal money demand changes proportionally with the price level, so that real money demand, and hence velocity, is unchanged. 2.

Md = $100 000 – $50 000 – [$5000 x (i – im) x 100]. (Multiplying by 100 is necessary since i and im are in decimals, not percent.) Simplifying this expression, we get Md = $50 000 – $500 000 (i – im).

Bd = $50 000 + $500 000 (i – im). Adding these together we get Md + Bd = $100 000, which is Mr. Midas’s initial wealth. . 124

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This can be solved either by setting money supply equal to money demand, or by setting bond supply equal to bond demand. Md = Ms $50 000 – $500 000 (i – im) = $20 000 $30 000 = $500 000i [Setting im = 0] i = 0.06 = 6% Bd = Bs $50 000 + $500 000i = $80 000 $500 000i = $30 000 i = 0.6 = 6% From the equation MV = PY, we get M / P = Y / V. At equilibrium, Md = M. so Md / P = Y, V = 10 000 / 5 = 2000. Md = P × (Md / P) = 2 × 2000 = 4000.

From the equation MV = PY, P = MV / Y. When M = 5000, P = (5000 × 5) / 10 000 = 2.5. When M = 6000, P = (6000 x 5) / 10 000 = 3.

π = ηYΔY/Y = –0.5 x: 6% = –3%. The price level will be 3% lower.

π = ηrΔr/r = – (–0.1) × 0.1 = 1%. The price level will be 1% higher.

With changes in both income and the real interest rate, to get an unchanged price level would require ηYΔY/Y + ηrΔr/r = 0, so [0.5 x (Y − 100/100] – [0.1 x 0.1] = 0, so Y = 102 πe = ΔM/M = 10%, i = r + πe = 15%. M/P = L = 0.01 x 150/0.15 = 10. P = 300/10 = 30

a. b.

πe = ΔM/M = 5%, i = r + πe = 10%. M/P = L = 0.01 x 150/0.10 = 15. P = 300/15 = 20 The slowdown in money growth reduces expected inflation, increasing real money demand, thus lowering the price level.

a. With a constant real interest rate and zero expected inflation, inflation is given by the equation π = ΔM / M - ηYΔY / Y. To get inflation equal to zero, the central bank should set money growth so that ΔM / M = ηY ΔY / Y = 2/3 x .045 = .03 = 3%. Note that the interest elasticity isn’t relevant, since interest rates don’t change. b.

Since V = PY / M, ΔV / V = ΔP / P + ΔY / Y - ΔM / M = 0 + 0.045 − 0.03 = 0.015 So velocity should rise 1.5% over the next year.

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Analytical Problems 1. a. People would probably take money out of chequing accounts and put it into money market mutual funds and money market deposit accounts. Money market mutual funds and money market deposit accounts are included in M2 but are not part of M1+. The result is a decrease in M1+, but possibly no change in M2. M2 might not increase because M1+ is part of M2, so the decrease in M1+ offsets the increase in the rest of M2. However, people might also reallocate some assets from M3 or nonmonetary assets to personal savings accounts, which would slightly increase the demand M2, but these changes might not be significant. b. This would increase the nominal interest rate on money. This higher return on money makes people more willingly to hold money, so M1+ increases and M2 will most likely increase or possibly not change (note that M1+ is part of M2). c. If people fear a stock market collapse, they will want great liquidity, so they will hold more money. Also, since stocks are an alternative asset to money, and the expected return to stocks has fallen, money demand will increase. Both effects will lead to people investing less in stocks and more in cash, chequing accounts, and other items that provide liquidity and safety, so M1+ and M2 will both rise. d. People would have less need for money in chequing accounts, and would put more in savings deposits. So M1+ will decrease, while M2 will remain unchanged. (Again, M1+ is part of M2, so reducing the amount that is in M1+, and increasing the amount that is in M2 but not in M1+, has no effect on M2,) e. If currency demand falls, this decreases M1+, thus also decreasing M2. 2. The general rise in velocity before the 1990s is most likely due to changes in income, in interest rates, and in financial institutions. Higher income led to a less than proportional rise in real money demand, so velocity increased. Rising inflation and rising nominal interest rates in this period led people to seek alternatives to non-interest-bearing money, such as DISAS. The result was lower money demand, and thus higher velocity. Financial innovations also reduced the need for money. Examples include the development of cash management accounts and the use of automated teller machines. 3. a. An increase in government purchases reduces national saving, causing the reap interest rate to rise for a fixed level of income. If the real interest rate is higher, then real money demand will be lower. So prices must rise to make money supply equal money demand. The result is that output is unchanged, the real interest rate increases, and the price level increases. b. When expected inflation falls, real money demand increases. With no effect on employment or saving and investment, output and the real interest rate remain unchanged. With higher real money demand and an unchanged nominal money supply, the equilibrium price level must decline. So output and the real interest rate are unchanged and prices decline. c. When labour supply rises, full-employment output increases. Also, with higher output, saving will increase, so the real interest rate will decline. Both higher output and a lower real interest rate increase real money demand. The price level must decline to equate money supply with money demand. The result is an increase in output and a decrease in both the real interest rate and the price level.

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d. When the interest rate paid on money increases, real money demand rises. With no effect on employment or saving and investment, output and the real interest rate remain unchanged. With higher real money demand and an unchanged nominal money supply, the equilibrium price level must decline. So output and the real interest rate are unchanged and prices decline. An individual thus reallocates her wealth portfolio towards liquidity (money) and away from the relatively illiquid non-monetary asset. By this reasoning, an increase in real income causes the demand for non-monetary assets to fall. That is, in order to reallocate a portion of her wealth portfolio toward the monetary asset, she must reallocate the same amount away from the non-monetary asset.

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CHAPTER 8: BUSINESS CYCLES LEARNING OBJECTIVES I.

Goals of Part III: Business Cycles and Macroeconomic Policy A. What causes business cycles? B. How should policymakers respond to cyclical fluctuations? 1. Classical economists see little need for government action 2. Keynesian economists think government intervention can smooth the business cycle C. Coverage of Chapters 8 to 12 1. Business cycle facts and features and introduction to AD-AS (Ch. 8) 2. The basic IS-LM/AD-AS model (Ch. 9) 3. Exchange rates and business cycles (Ch. 10) 4. The classical model of the business cycle (Ch. 11) 5. The Keynesian model of the business cycle (Ch. 12)

II.

Goals of Chapter 8 A. Basic features of the business cycle B. Definition and brief history of Canadian business cycles C. Review of business cycle characteristics

III.

Notes to Eighth Edition Users A. Figures 8.3-8.10 have been updated. B. Section 8.1 and 8.2 have been revised to be much clearer and easier to understand. C. Answers for Review Questions have been updated.

Data Application A major compendium of studies on the business cycle was produced by the NBER in 1986, The American Business Cycle: Continuity and Change, edited by Robert J. Gordon, Chicago: University of Chicago Press. It contains general discussions of the then-current state of knowledge of the business cycle, research on components of expenditure and how they change over the cycle, discussions of the role of fiscal and monetary policies, and research on how the cycle has changed over time. Another NBER volume that is a great resource on business cycle information is Victor Zarnowitz’s book, Business Cycles: Theory, History, Indicators, and Forecasting, Chicago: University of Chicago Press, 1992. Zarnowitz discusses theories and evidence on the business cycle, including the NBER’s research role, research on the cyclical characteristics of cycles, an evaluation of coincident and leading indicators, and a broad discussion of many aspects of business cycle forecasting. TEACHING NOTES I.

What is a Business Cycle? (Sec. 8.1) A. Economists have measured and studied business cycles for more than a century. B. There are several main points about business cycles: 1. Business cycles are fluctuations of aggregate economic activity, not a specific variable 2. There are expansions and contractions a. Aggregate economic activity declines in a . 128

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e. f.

contraction or recession until it reaches a trough (Fig. 8.1) Then activity increases in an expansion or boom until it reaches a peak A particularly severe recession is called a depression The sequence from one peak to the next, or from one trough to Figure 8.1 the next, is a business cycle Peaks and troughs are turning points Turning points are informally designated by Statistics Canada.

Data Application Statistics Canada must wait for some time to pass before they can declare the start or end of a recession. Since they need evidence on the growth in real GDP for at least two consecutive quarters, and since there are lags in compiling quarterly growth figures, it can take up to nine months after a recession has started before it is officially confirmed by the data. 3.

The business cycle is persistent a. Declines are followed by further declines; growth is followed by more growth b. Because of persistence, forecasting turning points is quite important

Theoretical Application Should we even care about the business cycle? Robert Lucas doesn’t think so. In his provocative book, Models of Business Cycles, Oxford: Basil Blackwell, 1987, he suggests that the cost of business cycle instability since World War II is very low; in particular, the cost is one-fifth the cost of having an inflation rate of 10%. So if faced with the choice of eliminating all recessions and having a 105% inflation rate. or having recessions the size we’ve had since 1945 and having no inflation at all, Lucas argues we should take the latter. He suggests that we should move toward a microeconomic view of the business cycle.

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Data Application New economic theories and statistical techniques may change somewhat the way in which we look at data on the business cycle. The real business cycle (RBC) approach, which will be discussed in more detail in Chapter 11, suggests some new interpretations of business cycle data, as Finn Kydland and Edward C. Prescott show in their article, “Business Cycles: Real Facts and a Monetary Myth,” Federal Reserve Bank of Minneapolis Quarterly Review, Spring 1990, pp. 3-18. They provide a basic set of facts (viewed through the lens of RBC theory) about the movement of economic variables over the business cycle. They also suggest that inflation is not procyclical in the United States since World War II, but seems to be countercyclical. II.

The Canadian Business Cycle: The Historical Record (Sec. 8.2) A. Figure 8.2 gives the real output per capita from 1870-2015. B.

The pre-World War I period 1. Recessions were common from 1867 to 1914, the economy suffered nearly as many months of contractions as it did months of expansion. 2. In contrast, since the end of World War II, the number of months of expansion have outnumbered the number of months of contraction by more than five to one.

The Great Depression and World War II 1. The worst economic contraction was the Great Depression of the 1930s a. Real GDP fell over 30% from the peak in April 1929 to the trough in March 1933 b. The unemployment rate rose from 3% to 20% c. The stock market collapsed, many farmers went bankrupt, and international trade was halted d. There were really two business cycles in the Great Depression (1) A contraction from April 1929 to March 1933, followed by an expansion that peaked in July 1937 (2) A contraction from August 1937 to October 1938 e. By July 1937, output had nearly returned to its 1929 peak, but the unemployment rate was high (12%) f. In 1939 the unemployment rate was over 14% 2.

The Great Depression ended with the start of World War II a. Wartime production brought the unemployment rate below 2% b. Real GDP almost doubled between 1938 and 1944

Post-World War II Canadian business cycles 1. From 1945 to 1974 there were six mild contractions 2. The longest expansion on record was 160 months, from February 1961 to June 1974 3. Some economists thought the business cycle was dead 4. But the OPEC oil shock of 1973 caused a recession, less severe than in the United States, but with the unemployment rate rising to 7%, and inflation rising 5. The 1981-1982 recession was also severe, with the unemployment rate over 12%, but inflation declining from 12% to less than 5% . 130

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6. 7. 8. 9. E.

III.

The 1990-1992 recession was milder, but the recovery was slow and erratic Expansion of economy since 1992, but growth slowed in 2000 and again in 2003 Canadian economy continued its post-1992 expansion up until January 2008. This peak was followed by a sharp recession lasting until May 2009. Over those 18 months the unemployment rate increased from 5.9% to 8.6% and real output per capita fell by 3.8%.

Have business cycles become less severe? 1. Economists believed that business cycles have generally become less severe. 2. Stock and Watson in 2002 dubbed the decline in volatility of macroeconomic variables as “the Great Moderation.” 3. Other recent research, though, suggests that volatility in the economy has fallen a great deal since the early 1980s.

Business Cycle Facts (Sec. 8.3) A. All business cycles have features in common B.

The cyclical behaviour of economic variables—direction and timing 1. What direction does a variable move relative to aggregate economic activity? a. Procyclical: in the same direction b. Countercyclical: in the opposite direction c. Acyclical: with no clear pattern 2. 2. What is the timing of a variable’s movements relative to aggregate economic activity? a. Leading. in advance b. Coincident. at the same time c. Lagging. After

Data Application Economists can gain valuable information about future real economic growth from the bond market. In particular, Campbell Harvey in his article “The Relation between the Term Structure of Interest Rates and Canadian Economic Growth”, Canadian Journal of Economics, February 1997, pp. 169-93, shows that the slope of the term structure of interest rates in Canada can predict Canadian real economic growth. C.

Cyclical behaviour of key macroeconomic variables: direction and timing (text Figs. 8.3–8.10) 1. Procyclical a. Coincident: industrial production, consumption, business fixed investment, employment, import expenditures b. Leading: inventory investment, average labour productivity, money growth, stock prices, trade balance c. Lagging: inflation, nominal interest rates d. Timing not designated: government purchases

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Analytical Problem 2 looks at whether output or total hours worked is more volatile, given that average labour productivity is procyclical. 2. 3. 4.

Countercyclical: unemployment (timing is coincident) Acyclical: real interest rates (timing is not designated) Volatility: durable goods production is more volatile than nondurable goods and services; investment spending is more volatile than consumption

Analytical Problem 1 asks for an explanation of why expenditures on durable goods are more volatile over the business cycle than expenditures on nondurables and services. IV.

Business Cycle Analysis: A Preview (Sec. 8.4) A. What explains business cycle fluctuations? 1. Two major components of business cycle theories a. A description of the shocks b. A model of how the economy responds to shocks 2. Two major business cycle theories a. Classical theory b. Keynesian theory 3. Study both theories in aggregate demand-aggregate supply (AD-AS) framework

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1.

When Real GDP Declines Two Straight Quarters, Does a Recession Occur?

A rule of thumb in the financial markets is that a recession occurs whenever real GDP declines for two quarters in a row. However, this is not a perfect measure. The economists at Statistics Canada who determine whether a peak or a trough has occurred look at many variables in determining the turning points of the business cycle. Why do they look at factors beyond real GDP? Real GDP is an important factor in identifying business cycle turning points. Although in many cases two quarters of negative growth in GDP means the economy has entered a recessionary period, this is not always the case. GDP may decline for other reasons. For example, a drought might reduce GDP growth substantially without generating a recession. Similarly, the date of Easter can make a difference in real GDP growth between the first and second quarters. If Easter is in March, Easter purchases are made in March and thus swell first-quarter GDP figures. If, on the other hand, Easter is in April, more of those sales go into the second quarter. Thus, economists meet to determine whether the changes were due to cyclical problems or if such disturbances are a result of shocks from changing holiday dates or natural catastrophes. 2.

Do Recessions Have Any Positive Economic Effects?

Recessions by their very nature cause hardship. People are laid off. New entrants to the labour force have difficulty finding jobs. Consumers’ disposable income declines. Business failures increase. Do recessions have any positive contributions to make to the economic life of a nation? Recessions often cause consumers and managers to reassess their current practices. When sales and profits drop, companies look carefully at their operations to discover ways to cut costs and improve their products. In periods of expansion, it’s easy to relax one’s vigilance, since profits usually are earned even when a company’s product is not appreciably better than that of its rival or available at a lower cost. Recessions also may give firms a chance to idle their least productive machines and, in some cases, to lay off their least productive people, thus lowering costs. In addition, the shock of losses or lower sales may cause managers to take a hard look at their operations. Reforms and renovations that may increase productivity and lower costs often result. More than one company has discovered ways to cut costs that would never had occurred to them if sales had continued to increase. Companies may use the slow period to retrain their employees, leading to increased output in the future. On a larger scale, a recession may eliminate companies that no longer produce items that are in great demand. By eliminating marginal producers, a recession frees resources for other, more desirable uses. In addition, workers and consumers may reassess their behaviour. Workers, whether on layoff or not, may see the need to work harder or acquire new skills, building a foundation for increased productivity. Some people who lose their jobs start new businesses that will better serve consumer needs. Consumers may reassess their consumption and saving patterns. An actual or prospective loss of income leads shoppers to try different, less expensive products instead of continuing to buy the items they have traditionally purchased. Recessions generally result, for example, in increased purchases of generic goods rather than national brands. If consumers are satisfied, they may permanently change their consumption patterns to the less expensive alternative.

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1. Figure 8.1 illustrates both the recurrence and persistence of the business cycle. The business cycle is recurrent, as there are repeated episodes of contractions and expansions over time. The business cycle also displays persistence, as declines in economic activity tend to be followed by further declines for some time, while growth in economic activity tends to be followed by further growth for some time. Figure 8.1

There is some question as to whether or not the business cycle has become less volatile over time. Originally it was thought that the cycle had been moderated, especially since World War II, but Romer challenged this notion. Further examination of the Canadian and international data by Backers and Kehoe, however, shows that there has been some moderation of the business cycle. Whether the business cycle has become less severe or not is important, especially to economic policymakers. Since World War II, both fiscal policy and monetary policy have been used to try to smooth out business cycles to reduce their severity. If it were found that business cycles are no less severe than they used to be, it would point to the failure of government policy to achieve its objectives.

A variable that moves in the same direction as aggregate economic activity is said to be procyclical, while a variable that moves in the opposite direction is countercyclical. If the peaks and troughs of a variable occur before the peaks and troughs in aggregate economic activity, it is said to be a leading variable. If a variable’s peaks and troughs occur at the same time as the peaks and troughs in aggregate economic activity, it is said to be a coincident variable. If a variable’s peaks and troughs come after the peaks and troughs of aggregate economic activity, it is said to be a lagging variable.

If the economy is entering a recession, you’d expect production, investment, average labour productivity, and the real wage to decline because they are all procyclical, and the unemployment rate to rise because it’s countercyclical.

The fact that some economic variables are known to lead the business cycle is used to develop an index of leading economic indicators. The index is used to forecast economic turning points.

The two components of a theory of business cycles are: (1) A description of the types of factors (called “shocks”) that have major impacts on the economy, such as wars, new inventions, harvest failures, and changes in government policy. (2) A model of how the economy responds to the various shocks. . 134

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Analytical Problems 1. Expenditure on durable goods is more sensitive to the business cycle than expenditure on nondurable goods and services, because people can more easily change the timing of their expenditure on durables. When economic activity is weak, and people face the danger of losing their jobs, they avoid making durable goods purchases. Instead, they may drive their cars a little longer before buying new ones, get the old washing machine repaired instead of buying a new one, and put off buying new furniture until a new expansion indicates greater income security. So in a recession, durable purchases decline a lot, but when an expansion begins, durable purchases pick up substantially. 2.

In symbols, let A = average labour productivity, Y = output, and H = total hours worked. By definition, A = Y / H, so in growth terms, ΔA/A = ΔY/Y - ΔH/H. Since all three are procyclical, they all move in the same direction over the business cycle. If total hours worked varied more than output in an expansion, then ΔH/H would be greater than ΔY/Y, so that ΔA/A would be negative, and average labour productivity would be countercyclical. So it must be the case that output varies more than total hours worked in an expansion. A similar argument holds in a contraction.

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CHAPTER 9: THE IS–LM–FE MODEL: A GENERAL FRAMEWORK FOR MACROECONOMIC ANALYSIS LEARNING OBJECTIVES I.

II.

Goals of Chapter 9 A. Combine the labour market (Chapter 3), the goods market (Chapters 4 and 5), and the asset market (Chapter 7) into a complete macroeconomic model (for a closed economy) B. Although the IS-LM model was originally a Keynesian model because it assumes prices are fixed, by allowing prices to adjust, it’s possible to use the IS-LM framework to discuss the classical approach C. Using one model for both approaches (the classical model in Chapter 11 and the Keynesian model in Chapter 12) avoids the need to learn two different models and helps show clearly both the similarities and the differences of the two approaches Notes to Eighth Edition Users A. All data has been updated.

TEACHING NOTES I.

II.

The FE Line: Equilibrium in the Labour Market (Sec. 9.1) A. In the discussion of the labour market in Chapter 3, we showed how equilibrium in the labour market leads to employment at its full-employment level N and output at Y B. If we plot output against the real interest rate, we get a vertical line at Y= , since labour market equilibrium is unaffected by changes in the real interest rate (Fig. 9.1) C. Factors that shift the FE line 1. Y is determined by the full-employment level of employment and the current levels of capital and productivity; any change in these variables shifts the FE line 2. Summary Table 11 lists the factors that shift the fullemployment line a. The full-employment line shifts right because of (1) a beneficial supply shock (2) an increase in labour supply (3) an increase in the capital stock b. The full-employment line shifts left when the opposite happens to Figure 9.1 the three factors above The IS Curve: Equilibrium in the Goods Market (Sec. 9.2) A. The goods market clears when desired investment equals desired national saving

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1. 2.

Adjustments in the real interest rate bring about equilibrium For any level of output Y, the IS curve shows the real interest rate r for which the goods market is in equilibrium

Figure 9.2

Derivation of the IS curve from the saving-investment diagram (Fig. 9.2; like text Fig. 9.2) a. Key features (1) The saving curve slopes upward because a higher real interest rate increases saving (2) An increase in output shifts the saving curve to the right, because people save more when their income is higher (3) The investment curve slopes downward because a higher real interest rate reduces the desired capital stock, thus reducing investment b. Consider two different levels of output (1) At the higher level of output, the saving curve is shifted to the right compared to the situation at the lower level of output (2) Since the investment curve is downward sloping, equilibrium at the higher level of output has a lower real interest rate (3) Thus, a higher level of output must lead to a lower real interest rate, so the IS curve slopes downward (4) The IS curve shows the relationship between the real interest rate and output for which investment equals saving c. Alternative interpretation in terms of goods market equilibrium (1) Beginning at a point of equilibrium, suppose the real interest rate rises (2) The increased real interest rate causes people to increase saving and thus reduce consumption, and causes firms to reduce investment

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(3) (4)

So the quantity of goods demanded declines To restore equilibrium, the quantity of goods supplied would have to decline (5) So higher real interest rates are associated with lower output, that is, the IS curve slopes downward. Factors that shift the IS curve 1. Any change that reduces desired national saving relative to desired investment shifts the IS curve up a. Intuitively, imagine constant output, so a reduction in saving means more investment relative to saving; the interest rate must rise to reduce investment and increase saving (Fig. 9.3; like text Fig. 9.3)

Figure 9.3

2. 3.

Similarly, a change that increases desired national saving relative to desired investment shifts the IS curve down An alternative way of stating this is that a change that increases aggregate demand for goods shifts the IS curve up a. In this case, the increase in aggregate demand for goods exceeds the supply b. The real interest rate must rise to reduce desired consumption and investment and restore equilibrium Summary Table 12 lists the factors that shift the IS curve a. The IS curve shifts up because of (1) an increase in expected future output (2) an increase in wealth (3) a temporary increase in government purchases (4) a decline in taxes (if Ricardian equivalence doesn’t hold) (5) an increase in the expected future marginal product of capital (6) a decrease in the effective tax rate on capital b. The IS curve shifts down when the opposite happens to the six factors above

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Numerical Problem 1 asks students to find the IS curve, given equations for consumption and investment, and looks at how a change in government purchases shifts the curve. III.

The LM Curve: Asset Market Equilibrium (Sec. 9.3) A. The interest rate and the price of a nonmonetary asset 1. The price of a nonmonetary asset is inversely related to its interest rate or yield a. Example: A bond pays $10,000 in one year; its current price is $9615, and its interest rate is 4%, since ($10 000 – $9615)/$9615 = 0.04 = 4% b. If the price of the bond in the market were to fall to $9524, its yield would rise to 5%, since ($10 000 – $9524)/$9524 = 0.05 = 5% 2. For a given level of expected inflation, the price of a nonmonetary asset is inversely related to the real interest rate B. The equality of money demanded and money supplied 1. Equilibrium in the asset market requires that the real money supply equal the real quantity of money demanded 2. Real money supply is determined by the central bank and isn’t affected by the real interest rate 3. Real money demand falls as the real interest rate rises 4. Real money demand rises as the level of output rises 5. The LM curve (Fig. 9.4; like text Fig. 9.4) is derived by plotting real money demand for different levels of output and looking at the resulting equilibrium

Figure 9.4

By what mechanism is equilibrium restored? a. Starting at equilibrium, suppose output rises, so real money demand increases b. The rise in people’s demand for money makes them sell nonmonetary assets, so the price of those assets falls and the real interest rate rises

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As the interest rate rises, the demand for money declines until equilibrium is reached The LM curve shows the combinations of the real interest rate and output that clear the asset market a. Intuitively, for any given level of output, the LM curve shows the real interest rate necessary to equate real money demand and supply b. Thus, the LM curve slopes upward from left to right

C. Factors that shift the LM curve 1. Any change that reduces real money supply relative to real money demand shifts the LM curve up a. For a given level of output, the reduction in real money supply relative to real money demand causes the equilibrium real interest rate to rise b. The rise in the real interest rate is shown as an upward shift of the LM curve 2. Similarly, a change that increases real money supply relative to real money demand shifts the LM curve down 3. Summary Table 13 lists the factors that shift the LM curve a. The LM curve shifts down because of (1) an increase in the nominal money supply (2) a decrease in the price level (3) an increase in expected inflation (4) a decrease in the nominal interest rate on money (5) a decrease in wealth (6) a decrease in the risk of alternative assets relative to the risk of holding money (7) an increase in the liquidity of alternative assets (8) an increase m the efficiency of payment technologies b. The LM curve shifts up when the opposite happens to the eight factors listed above 4. Changes in the real money supply a. An increase in the real money supply shifts the LM curve down (Fig. 9.5; like text Fig. 9.5) b. Similarly, a drop in real money supply shifts the LM curve up c. The real money supply changes when the nominal money supply changes at a different rate than the price level

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Figure 9.5

Changes in real money demand a. An increase in real money demand shifts the LM curve up (Fig. 9.6; like text Fig. 9.6) b. Similarly, a drop in real money demand shifts the LM curve down

Figure 9.6

Numerical Problem 2 shows the derivation of the LM curve from a money demand equation and looks at how changes in money demand and supply shift the curve. IV.

General Equilibrium in the Complete IS-LM-FE Model (Sec. 9.4) A. When all markets are simultaneously in equilibrium there is a general equilibrium 1. This occurs where the FE, IS, and LM curves intersect (Fig. 9.7; like text Fig. 9.7)

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Applying the IS-LM framework: A temporary adverse supply shock 1. Suppose the productivity parameter in the production function falls temporarily 2. The supply shock reduces the marginal productivity of labour, hence labour demand a. With lower labour demand, the equilibrium real wage and employment fall b. Lower employment and lower productivity both reduce the equilibrium level of output, thus shifting the FE line to the left Figure 9.7 3. There’s no effect of a temporary supply shock on the IS or LM curves 4. Since the FE, IS, and LM curves don’t intersect, the price level adjusts, shifting the LM curve until a general equilibrium is reached

In this case the price level rise to shift the LM curve up to restore equilibrium (Fig. 9.8; like text Fig. 9.8) 5. The inflation rate rises temporarily, not permanently 6. Summary: The real wage, employment, and output decline, while the real interest rate and price level are higher a. There is a temporary burst of inflation as the price level moves to a higher level b. Since the real interest rate is higher and output is lower, consumption and investment must be lower Application: Oil price shocks revisited 1. Does the IS-LM correctly predict the results of an adverse supply shock? 2. The data from the 1973–1974 and 1979–1980 oil price shocks shows the following Figure 9.8 a. As discussed in Chapter 3, output, employment, and the real wage declined b. Consumption fell slightly and investment fell substantially c. Inflation surged temporarily d. All the above results are consistent with the theory e. But the real interest rate did not rise during the 1973–1974 oil price shock (though it did during the 1979–1980 shock) (1) It could be that people expected the 1973–1974 oil price shock to be permanent (2) In that case the real interest rate would not necessarily rise

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(3)

If so, people’s expectations were correct, since the 1973– 1974 shock seems to have been permanent, while the 1979–1980 shock was reversed quickly.

Analytical Problem 2 examines the effect on the real interest rate of a permanent oil price shock compared to a temporary oil price shock. V.

Price Adjustment and the Attainment of General Equilibrium (Sec. 9.5) A. The effects of a monetary expansion 1. An increase in money supply shifts the LM curve down 2. Because financial markets respond most quickly to changes in economic conditions, the asset market responds to the disequilibrium a. The FE line is slow to respond, because job matching and wage renegotiation take time b. The IS curve responds somewhat slowly c. We assume that the labour market is temporarily out of equilibrium, so there’s a short-run equilibrium at the intersection of the IS and LM curves

Analytical Problem 3 looks at this short-run equilibrium. 3.

The increase in the money supply causes people to try to get rid of excess money balances by buying assets, driving the real interest rate down a. The decline in the real interest rate causes consumption and investment to increase temporarily b. Output is assumed to increase temporarily to meet the extra demand The adjustment of the price level a. Since the demand for goods exceeds firms’ desired supply Figure 9.9 of goods, firms raise prices b. The rise in the price level causes the LM curve to shift up c. The price level continues to rise until the LM curve intersects with the FE line and the IS curve at general equilibrium (Fig. 9.9; like text Fig. 9.9b) d. The result is no change in employment, output, or the real interest rate e. The price level is higher by the same proportion as the increase in the money supply f. So all real variables (including the real wage) are unchanged, while nominal wage) have risen proportionately with the change in the money supply

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Numerical Problems 3 and 4 and Analytical Problem 1 look at the complete IS-LM-FE model, including adjustment of the price level to restore equilibrium. 5.

A Closer Look 9.1: Trend money growth and inflation a. This analysis also handles the case in which the money supply is growing continuously b. If both the money supply and price level rise by the same proportion, there is no change in the real money supply, and the LM curve doesn’t shift c. If the money supply grew faster than the price level, the LM curve would shift down d. Often, then, we’ll discuss things in relative terms (1) The examples can often be thought of as a change in M or P relative to the expected or trend growth of money and inflation (2) Thus, when we talk about “an increase in the money supply,” we have in mind an increase in the growth rate relative to the trend (3) Similarly, a result that the price level declines can be interpreted as the price level declining relative to a trend; for example, inflation may fall from 7% to 4% 6. The effects of a fiscal expansion a. The increase in government purchases shifts the IS curve to the right and the economy is no longer in general equilibrium (holding the price level constant and there is no change in the real money supply). b. The adjustment back to equilibrium is a consequence of two influences. c. The first one is the multiplier effect – the increase in G expands the demand for goods and so increases the number of transactions in the economy. The impact of the initial increase in G is multiplied a number of times over. d. The second one is the crowding out effect – the increase in new spending requires that households hold more of their financial wealth in the form of money and the real interest rate will rise. This will cause investment to fall. e. The net influence of the multiplier effect and the crowding out effect is an increase in output. Classical versus Keynesian versions of the IS-LM model 1. There are two key questions in the debate between classical and Keynesian approaches a. How rapidly does the economy reach general equilibrium? b. What are the effects of monetary policy on the economy? 2. Price adjustment and the self-correcting economy a. The economy is brought into general equilibrium by adjustment of the price level b. The speed at which this adjustment occurs is much debated c. Classical economists see rapid adjustment of the price level (1) So the economy returns quickly to full employment after a . 144

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shock (2) If firms change prices instead of output in response to a change in demand, the adjustment process is almost immediate d. Keynesian economists see slow adjustment of the price level (1) It may be several years before prices and wages adjust fully When not in general equilibrium, output is determined by aggregate demand at the intersection of the IS and LM curves, and the labour market is not in equilibrium Monetary neutrality a. Money is neutral if a change in the nominal money supply changes the price level proportionately but has no effect on real variables b. The classical view is that a monetary expansion affects prices quickly with at most a transitory effect on real variables c. Keynesians think the economy may spend a long time in disequilibrium, so a monetary expansion increases output and employment and causes the real interest rate to fall d. Keynesians believe in monetary neutrality in the long run but not the short run, while classicals believe it holds even in the relatively short run

VI. The Aggregate Demand Curve (Sec. 9.6) A. Use the IS-LM-FE model to develop the AD-AS model 1. The two models are equivalent 2. Depending on the issue, one model or the other may prove more useful a. IS-LM-FE relates the real interest rate to output b. AD-AS relates the price level to output B. Deriving the aggregate demand curve 1. The AD curve shows the relationship between the quantity of goods demanded and the price level when the goods market and asset market are in equilibrium a. So the AD curve represents the price level and output level at which the IS and LM curves intersect b. The AD curve is unlike other demand curves, which relate the quantity demanded of a good to its relative price; the AD curve relates the total quantity of goods demanded to the general price level, not a relative price c. The AD curve slopes downward because a higher price level is associated with lower real money supply, shifting the LM curve up, raising the real interest rate, and decreasing output demanded (Fig. 9.10; like text Fig. 9.11; key diagram 7)

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Figure 9.10

Figure 9.11

Factors that shift the AD curve a. Any factor that causes the intersection of the IS and LM curves to shift to the left causes the AD curve to shift to the left; any factor causing the IS-LM intersection to shift to the right causes the AD curve to shift to the fight b. For example, a temporary increase in government purchases shifts the IS curve to the right, so it shifts the AD curve to the right as well (Fig. 9.11; Key Diagram 8; like text Fig. 9.12) c. Summary Table 14: Factors that shift the AD curve (1) Factors that shift the IS curve up and thus the AD curve to the right as well (a) Increases in future output (Yf), wealth, government purchases (G), or the expected future marginal productivity of capital (MPKf) .

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(b) Decreases in taxes (T) if Ricardian equivalence doesn’t hold, or the effective tax rate on capital (MPKf) (2) Factors that shift the LM curve down and thus the AD curve to the right as well (a) Increases in the nominal money supply (M) or in expected inflation (πe) (b) Decreases in the nominal interest rate on money (im) or the real demand for money (3) The effect of a monetary expansion on the position of the AD curve is illustrated in text Fig. 9.12 (a) An increase in the nominal money supply M shifts the LM curve down and the AD curve to the right. (b) Since monetary and fiscal policy both shift the AD curve, they are often referred to as aggregate demand policies. Numerical Problem 5 illustrates the effects of fiscal policy using the model. VII. Appendix 9.A: A Worked-Out Numerical Exercise for Solving the IS-LM Model A. Find the equation of the IS curve 1. Substitute equation (2) to (5) into the goods market equilibrium and solve for r in terms of Y r = 2.05 – 0.0008Y or Y = 2562.5 – 1250r B. Find the equation of the LM curve 1. Substitute equations (6) to (9) into the asset market equilibrium and solve for r in terms of Y r = 0.001Y – 0.05 – 266.4/P or Y = 1000r + 50 + 266 400/P C. Find the AD curve 1. Set the right-hand side of the IS equation with the right-hand side of the LM equation 2.05 – 0.0008Y = 0.001Y – 0.05 – 266.4/P 2. Solve for Y in terms of P Y = 1166.67 + 148000/P This is the AD curve B. Find long run equilibrium values of P, r and i 1. Substitute Y = 2500 in the AD curve will yield P = 111 2. Substitute Y = 2500 in the IS equation will yield r = 0.05 3. Substitute r = 0.05 in the i = r + πe will yield i = 0.10 C. Find the short run equilibrium values of Y, r and i 1. Substitute P = 120 into the AD curve will yield Y = 2400 2. Substitute Y = 2400 into the IS equation will yield r = 0.13 3. Substitute r = 0.13 in the i = r + πe will yield i = 0.18 VIII. Appendix 9.B: An Algebraic Version of the IS-LM-FE Model A. The labour market 1. The production function is Y = A(f1N - ½f2N2) (9.B.1) 2. From the production function, the marginal product of labour is MPN = A(f1 – f2N) (9.B.2) 3. The real wage is the MPN at the amount of labour demanded ND, so W = A(f1 – f2ND) (9.B.3) 4. Labour supply (NS) depends on the after-tax real wage, so NS = n0 + nw(1 – t)w (9.B.4)

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Combining Eqs. (9.B.3) and (9.B.4) gives a solution for the real wage and employment w = A[f1 – f2n0)/[1 – t)Af2nw] = (9.B.5) N = [nc + (1−t)Af1nw]/[1 = (1 − t)Af2nw (9.B.6) 6. Using employment in the production function gives Y = A[f2N − ½f2n2] (9.B.7) B. The goods market 1. Desired consumption depends on after-tax income (Y – T) and the real interest rate Cd = c0 – cY(Y– T) – crr (9.B.8) 2. Taxes are given by T =t0+ tY (9.B.9) 3. Desired investment is Id = i0 – irr (9.B.10) 4. Equilibrium is then given by Y = Cd + Id + G (9.B.11) 5. Substituting Eqs. (9.B.8), (9.B.9), and (9.B.10) into (9.B.11) gives Y = c0 + cY(Y – t0 – tY) – Crr + i0 – irr + G (9.B.12) 6. Rearranging this, collecting terms in Y gives [1 – (1 – f)cY]Y = co – i0 – G – CYt0 – (cr + ir)r (9.B.13) 7. Now rewriting this in terms of r gives the IS curve (9.B.14) r = αIS - βISY αIS = [Co + 1o + G - Cyto]/(Cr + ir) (9.B.15) βIS = 1 - (1 - t)Cy]/( Cr + ir) (9.B.16) C. The asset market 1. The money demand function has the form Md/P = ℓo + ℓYY - ℓr(r + πe) (9.B.17) 2. Equilibrium in the asset market means that M/P = ℓo + ℓYY - ℓr(r + πe) (9.B.18) 3. Rearranging this gives the LM curve r = αLM - (1/ℓr)(M/P) + βLMY (9.B.19) e αLM = ℓo/ℓr - π (9.B.20) βLM = ℓY/ℓr (9.B.21) D. General equilibrium in the IS-LM-FE model 1. The intersection of the IS curve and FE line determines the real interest rate which is found by plugging Y into Eq. (9.B.14) r = αIS - βISY (9.B.22) 2. To find the equilibrium price level, use Y and Eq. (9.B.22) in Eq. (9.B.18) to get P = M/[ℓo + ℓYY - ℓr(αIS - βISY + πe) (9.B.23) Numerical Problem 6 and Analytical Problems 4 and 5 deal with various aspects of the algebraic version of the IS-LM model.

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The AD-AS Model 1. The aggregate demand curve a. Setting the right-hand sides of Eqs. (9.B.14) and (9.B.19) equal and solving for Y gives the AD curve Y = [αIS - αLM + (1/ℓr)(M/P)]/[βIS + βLM] (9.B.24) b. Note that the numerator is the intercept term of the IS curve minus the intercept term of the LM curve (1) So anything that shifts the IS curve up shifts the AD curve to the right (2) Anything that shifts the LM curve down shifts the AD curve to the right

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION Can We Ever Expect to Reach General Equilibrium? General equilibrium occurs when the asset market, the labour market, and the goods market are all in balance. Does this ever happen? Although the economy is constantly moving towards general equilibrium, it may never arrive. New shocks push the economy out of equilibrium on a regular basis. Some shocks are due to natural disasters—storms in the Maritimes, heavy snows that lower production in Ontario, earthquakes in Japan. Others are a result of social and political events—riots in Los Angeles, rebellion in Africa, coup attempts in the countries of the former Soviet Union. Long before the economy adjusts to the effects of one shock, another with its own consequences, arrives. Although a state of general equilibrium almost never exists, the idea of general equilibrium is important. It tells us how the economy will behave over time, since the economy is constantly moving towards that general equilibrium in the absence of new shocks. Our forecasts are dependent on the help of general equilibrium models in predicting the amount and direction of change.

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1. The position of the FE line is determined by the labour market and the production function. Labour supply and demand determine equilibrium employment. Using equilibrium employment in the production function gives the full-employment level of output. The FE line is vertical at that point. The FE line shifts to the right if there is an increase in labour supply or the capital stock or if there is a beneficial supply shock. 2. The IS curve shows combinations of the real interest rate (r) and output (Y) that leave the goods market in equilibrium. Equilibrium in the goods market occurs when the aggregate supply of goods (Y) equals the aggregate demand for goods (Cd + Id + G). Since desired national saving (Sd) is Y – Cd – G, an equivalent condition is Sd =Id. Equilibrium is achieved by the adjustment of the real interest rate to make the desired level of saving equal to the desired level of investment. For different levels of output, there are different desired saving curves, with different equilibrium interest rates. When plotted on a figure showing output and the real interest rate, this forms the IS curve, as shown in Fig. 9.12. The curve slopes downward because as output rises, the saving curve shifts along the investment curve and the real interest rate declines.

Figure 9.12

The IS curve could shift down and to the left if: (1) expected future output falls, because this increases desired saving; (2) government purchases fall, because this increases desired saving; (3) the expected future marginal product of capital falls, because this decreases desired investment; or (4) corporate taxes increase, because this decreases desired investment. The LM curve shows the combinations of output and the real interest rate that maintain equilibrium m the asset market. Equilibrium in the asset market occurs when real money demand equals the real money supply. Figure 9.13 shows the derivation of the LM curve and why it slopes upward. An increase in output from Y1 to Y2 raises money demand, shifting the money demand curve from MD(Y1) to MD(Y2). With money supply fixed at MS, there must be a higher real interest rate to get equilibrium in the asset market. This gives two points

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Figure 9.13

of the LM curve, plotted on the right half of the figure. The result is that higher output increases the real interest rate along the LM curve, so the LM curve slopes upward. The LM curve would shift down and to the right if the nominal money supply or expected inflation increased or if the price level or nominal interest rate on money decreased. In addition, the curve would shift down if there were a decrease in wealth, a decrease in the risk of alternative assets relative to the risk of holding money, an increase in the liquidity of alternative assets, or an increase in the efficiency of payment technologies. For constant output, if real money supply exceeds the real quantity of money demanded, the real interest rate will decline to increase the real quantity of money demanded until equilibrium is reached. This process occurs because people who find themselves with excess money balances purchase assets, thus increasing the market price of the assets and reducing the real interest rate. General equilibrium is a situation in which all markets in an economy are simultaneously in equilibrium. This is shown in Fig. 9.14 as the point at which the FE line and the IS and LM curves intersect. If the economy is not initially in general equilibrium, output and the real interest rate are determined by the intersection of the IS and LM curves, Then adjustment of the price level moves the LM curve until it intersects the FE line and IS curve. Figure 9.14 There is monetary neutrality if a change in the nominal money supply changes the price level but has no effect on real variables. Once prices adjust, money is neutral in the IS-LM model, because a change in the money supply that shifts the LM curve is matched by a proportional change in the price level that returns the real money supply back to its original level and moves the LM curve back to its original location. Classical economists believe that money is neutral in the short run, but Keynesians believe that there may be sluggish adjustment of the price level, so that changes in the money supply affect output and the real interest rate in the short run. Both classicals and Keynesians believe money is neutral in the long run. The aggregate demand curve relates the price level to the aggregate demand for . 152

Chapter 9: The Is–Lm–Fe Model

goods and services. It is downward sloping, because with a fixed nominal money supply, an increase in the price level shifts the LM curve up, so the level of output at the IS-LM intersection is lower. Factors that shift the aggregate demand curve to the right include (1) an increase in expected future output, which reduces desired saving, raises desired consumption, and shifts the IS curve up; (2) an increase in government purchases, which reduces desired saving and shifts the IS curve up; (3) an increase in expected future MPK, which increases desired investment and shifts the IS curve up; (5) an increase in the nominal money supply, which raises the real money supply and shifts the LM curve down; (6) a decrease in the interest rate on money, Which decreases the demand for money and shifts the LM curve down; and (7) an increase in the expected inflation rate, which reduces the demand for money and shifts the LM curve down.

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Numerical Problems 1.

Sd = Y – Cd – G = Y – (3600 – 2000r + 01 Y) – 1200 = –4800 + 2000r + 0.9Y.

(1) Using the equation that goods supplied equals goods demanded gives Y = Cd + Id + G = (3600 – 2000r + 0.1Y) + (1200 – 4000r) + 1200 = 6000 – 6000r + 0.1Y. So 0.9Y = 6000 – 6000r. At full employment, Y = 6000. Solving 0.9 × 6000 = 6000 – 6000r, we get r = 0.10. (2) Using the equivalent equation that desired saving equals desired investment gives Sd = Id –4800 + 2000r + 0.9Y = 1200 – 4000r 0.9Y = 6000 – 6000r When Y = 6000, r = 0.10. So we can use either equation to get the same result. When Y = 6400, we get r = .04.

Figure 9.15

c. When G = 1320, desired saving becomes Sd = –4920 + 2000r + 0.9Y. Sd is now 120 less for any given r and Y; this shows up as a shift in the Sd line from S1 to S2 in Fig. 9.15. Setting Sd = Id, we get –4920 + 2000r + 0.9Y = 1200 – 4000r 6000r + 0.9Y = 6120.

At Y = 6000, this is 6000r = 6120 – (0.9 x 6000) = 720, so r = 0.12. The marketclearing real interest rate increases from 0.10 to 0.12. Md / P = 2000 + 0.2Y – 20 000i = 2000 + 0.2Y – 20 000 ([r + πe) = 2000 + 0.2Y – 20 000(r + .05) = 1000 + 0.2Y – 20 000r. Setting M / P = Md / P 1500 = 1000 + 0.2Y – 20 000r 20,000r = –500 + 0.2Y r = (–500 / 20 000) + (0.2Y / 20 000) = –0.025 + (Y / 100,000). When Y = 5000, r = 0.025. When Y = 6000, r Figure 9.16 = 0.035. a These points are plotted as line LM in Fig. 9.16. M = 3600, so M / P = 1800. Setting money supply equal to money demand: 1800 = 1000 + 0.2Y – 20 000r . 154

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20,000r = –800 + 0.2Y r = –0.04 + (Y / 100 000). When Y = 5000, r = 0.01. When Y = 6000, r = 0.02. The LM curve is shifted down from LMa to LMb in Fig. 9.20, since the same level of Y gives a lower r at equilibrium c.

Md / P = 2000 + 0.2Y – 20,000(r + πe) = 2000 + 0.2Y – 20 000r – (20 000 × 0.04) = 1200 + 0.2Y – 20 000r. Setting money supply equal to money demand: 1500 = 1200 + 0.2Y – 20 000r 20 000r = –300 + 0.2Y r = –0.015 + (Y/100 000). When Y = 5000, r = 0,035. When Y = 6000, r = 0.045.

The LM curve is shifted up from LMa to LMC in Fig. 9.20, since there is a higher real interest rate for every given level of output. First, we will find the IS curve. Sd = Y – Cd – G = Y –[200+0.8(Y – T) – 500r] – G = Y – [200 + (0.6Y – 16) – 500r] – G = –184 + 0.4Y + 500r – G. Setting Sd = Id gives –184 + 0.4Y + 500r – G = 200 – 500r. Solving this for Y in terms of r gives Y = (960 + 2.5G) – 2500r. When G = 196, this is Y = 1450 – 2500r. Next, we’ll find the LM curve. Setting money demand equal to money supply gives 9890/P = 0.5Y – 250r – 25, which can be solved for Y = 19 780/P + 50 + 500r. With full-employment output of 1000, using this in the IS curve and solving for r gives r = 0.18. Using Y = 1000 and r = 0.18 in the LM curve and solving for P gives P = 23. Plugging these results into the consumption and investment equations gives C = 694 and / = 110.

With G = 216, the IS curve becomes Y = 1500 – 2500r. With Y = 1000, the IS curve gives r = .20, the LM curve gives P = 23.27, the consumption equation gives C = 684, and the investment equation gives I = 100.

First, look at labour market equilibrium. Labour supply is NS = 55 + 10(1 – t)w. Labour demand comes from the equation w = 5A – 0.005A ND. Substituting the latter equation into the former, and equating labour supply and labour demand gives N = 100. Using this in either the labour supply or labour demand equation then gives w = 9. Using N in the production function gives Y = 950.

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Next, look at goods market equilibrium and the IS curve. Sd – Y – Cd – G = Y – [300 – 0.8(Y – T) – 200r] – G – Y – [300 – (0.4Y – 16) – 200r] – G = –284 – 0.6Y – 200r – G. Setting Sd = Id gives –284 + 0.6Y + 200r – G = 258.5 – 250r. Solving this for r in terms of Y gives r = (542.5 – G)/450 – 0.004/3 Y. When G = 50, this is r = 1.31666… –0.004/3 Y. With full-employment output of 950, using this in the IS curve and solving for r gives r = 0.05. Plugging these results into the consumption and investment equation gives C = 654 and I = 246.

Next, look at asset market equilibrium and the LM curve. Setting money demand equal to money supply gives 9150/P = 0.5Y – 250(r – 0.02), which can be solved for r = [0.5Y – (5 – 9150/P)]/250. With Y = 950 and r = 0.05. solving for P gives P = 20.

With G = 72.5, the IS curve becomes r = 1.3666... – 0.004/3 Y. With Y = 950. the IS curve gives r =.10, the LM curve gives P = 20.56, the consumption equation gives C = 644. and the investment equation gives I = 233.5. The real wage, employment, and output are unaffected by the change. The IS curve is found by setting desired saving equal to desired investment. Desired saving is Sd = Y – Cd – G = Y – [1275 – 0.5(Y – T) – 200r] – G. Setting Sd = Id gives Y – [1275 – 0.5(Y – 200r] – G = 900 – 200r, or Y = 4350 – 800r+ 2G – T. The LM curve is M / P = L = 0.5Y – 200i = 0.5Y – 200(r + π) – 0.5Y – 200r. d.

T = G = 450, M = 9000. The IS curve gives Y = 4350 – 800r – 2G – T = 4350 – 800r + (2 x 450) – 450 = 4800 – 800r. The LM curve gives 9000 / P = 0.5Y – 200r. To find the aggregate demand curve, eliminate r in the two equations by multiplying the LM curve through by 4 and rearrange the resulting equation and the IS curve.

LM: 9000 / P = 0.5Y – 200r. Multiplying by 4 gives 36 000 / P = 2Y – 800r. Rearranging gives 800r = 2Y – 36,000 / P. IS: Y = 4800 – 800r. Rearranging gives 800r = 4800 – Y. Setting the right-hand sides of these two equations to each other (since both equal 800r) gives: 2Y – (36.000 / P) = 4800 – Y, or 3Y = 4800 + (36 000 / P), or Y = 1600 – (12 000 / P); this is the AD curve. With Y = 4600 at full employment, the AD curve gives 4600 = 1600 + (12 000 / P), or P = 4. From the IS curve Y = 4800 – 800r, so 4600 = 4800 – 800r, or 800r = 200, so r = 0.25. Consumption is C = 1275 + 0.5(Y – T) – 200r = 1275 + 0.5(4600 – 450) – (200 x 0.25) = 3300. Investment is I = 900 – 200r = 900 – (200 × 0.25) = 850. Following the same steps as above, with M = 4500 instead of 9000, gives the aggregate demand curve AD:. Y = 1600 + (6000 / P). With Y = 4600, this gives P = 2. Nothing has changed in the IS equation, so it still gives r = 0.25. And nothing has changed in either the consumption or investment equations, so we still get C = 3300 and I = 850. Money is neutral here. as no real variables are affected and the price level changes in proportion to the money supply.

T = G = 330, M = 9000. The IS curve is Y = 4350 – 800r – 2G – T = 4350 – 800r – (2 x 330) – 330 = 4680 – 800r. . 156

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LM: 36,000 / P = 2Y – 800r, or 800r = 2Y – 36 000 / P. IS: Y = 4680 – 800r, or 800r = 4680 – Y. AD: 2Y – (36,000 / P) = 4680 – Y, or (36,000 / P) + 4680 = 3Y, or Y = 1560 – (12 000 / P). With Y = 4600 at full employment, the AD curve gives 4600 = 1560 + (12 000 / P), or P = 3.95. From the IS curve, Y = 4680 – 800r, so 4600 = 4680 – 800r, or 800r = 80, so r = 0.10. Consumption is C = 1275 + 0.5(Y – T) – 200r = 1275 – 0.5(4600 – 330) – (200 × 0.10) = 3390. Investment is I = 900 – 200r = 900 – (200 x 0.10) = 880. 6.

A = 2, ƒ1 = 5, ƒ2 = 0.005, n0 = 55, nW = 10, c0 = 300, cY = 0.8, cr = 200, t0 = 20, t = 0.5, i0 = 258.5, ir = 250, ℓ0 = 0, ℓy = 0.5, ℓr = 250.

These values are all calculated directly, using the equations in the Appendix 9.B. They should match the results in Numerical Problem 4, above.

See the answer to part b.

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Analytical Problems 1. a. The increase in desired investment shifts the IS curve up, as shown in Fig. 9.17. The price level rises, shifting the LM curve up to restore equilibrium. Since the real interest rate rises, consumption declines. In summary, there is no change in the real wage, employment, or output; there is a rise in the real interest rate, the price level, and investment; and there is a decline in consumption.

Figure 9.18

Figure 9.17

b. The rise in expected inflation shifts the LM curve down as shown in Fig. 9.18. The price level rises, shifting the LM curve up to restore equilibrium since the real interest rate is unchanged. consumption and investment are unchanged. In summary, there is no change in the real wage, employment, output, the real interest rate, consumption, or investment: and there is a rise in the price level.

Figure 9.19

c. The increase in labour supply is shown as a shift in the labour supply curve in Fig. 9.19(a). This leads to a decline in the real wage rate and an increase in employment. The rise in employment causes an increase in output, shifting the FE line to the right in Fig. 9.19 d. To restore equilibrium the price level must decline, shifting the LM curve down. Since output increases and the real interest rate declines, consumption and investment increase. In summary, the real wage, the real interest rate, and the price level decline; and employment, output, consumption, and investment rise. . 158

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Figure 9.21

Figure 9.20

e. The reduction in the demand for money gives results identical to those in part (b). 2.

The increases in the price of oil reduces the marginal product of labour, causing the labour demand curve to shift to the left from ND1 to ND2 in Fig. 9.20. Since households’ expected future incomes decline, labour supply increases NS1 to NS2 (but by assumption, the shift to the left in labour demand is larger than the shift to the right in labour supply). At equilibrium, there is a reduced real wage and lower employment. The productivity shock results in a shift to the left of the fullemployment line from FE1 to FE2 in Fig. 9.21, as both employment and productivity decline. Because the shock is permanent, it reduces future output and reduces the future marginal product of capital, both of which result in a downward shift of the IS curve. The new equilibrium is located at the intersection of the new IS curve and the new FE line. If, as shown in the figure, this intersection lies above and to the left of the original LM curve, the price level will increase and shift the LM curve upward (from LM1 to LM2) to pass through the new equilibrium point. The result is an increase in the price level, but an ambiguous effect on the real interest rate. Since output is lower, consumption is lower. Since the effect on the real interest rate is ambiguous, the effect on saving and investment are ambiguous as well, though the fall in the future marginal product of capital would tend to reduce investment.

Figure 9.22

Figure 9.23

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The result is different from that of a temporary supply shock; when the shock is temporary there is no impact on future output or the marginal product of capital, so the IS curve does not shift. In that case the price level increases to shift the LM curve up from LM1 to LM2 in Figure 9.22 to restore equilibrium. In that case, the real interest rate unambiguously increases. Under a permanent shock, the IS curve shifts down. so the rise in the real interest rate is less than in the case of a temporary shock, and the real interest rate can even decline. a. The decrease in expected inflation increases real money demand, shifting the LM curve up, as shown in Fig. 9.23. The real interest rate rises and output declines. b. The increase in desired consumption shifts the IS curve up, as shown in Fig. 9.24. This causes the real interest and output to rise. c. The increase in government purchases shifts the IS curve up, with the same result as in part (b). d. If Ricardian equivalence holds, the increase in taxes has no effect on either the IS or LM curves, so there is no change in either the real interest rate or output. If Ricardian equivalence doesn’t hold, so that the increase in taxes reduces consumption spending, the IS curve shifts down, as shown in Fig. 9.25. Both the real interest rate and output decline. e. An increase in the expected future marginal productivity of capital shifts the IS curve up, with the same result as in part (b) The change in Eq. (9.B.10) has no effect on employment, the real wage, or output. The only effect this has is on the term βIS, which is now βIS = [1 - (1- t) cY - iY]/ (cr + ir). The real interest rate and price level are still determined by Eqs. (9.B.22) and (9.B.23), respectively. The change in the money demand function affects only the equation determining the price level. Eq (9.B.23). It is now P = M/ [ℓ0 + ℓyΫ – ℓr (αIS – βISΫ + πe )].

Figure 9.24

Figure 9.25

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CHAPTER 10: EXCHANGE RATES, BUSINESS CYCLES, AND MACROECONOMIC POLICY IN THE OPEN ECONOMY LEARNING OBJECTIVES I.

Goals of Chapter 10 A. Two primary aspects of interdependence between economies of different nations 1. International trade in goods and services 2. Worldwide integration of financial markets B. Interdependence means that nations are dependent on each other, so policy changes in one country may affect other countries

II.

Notes to Eighth Edition Users A. A Closer Look 10.1 and 10.2 have been updated. B. Section 10.1 is now more focused on the relationship between real exchange rate and net exports. C. Section 10.7 is now more condensed in the analysis of choosing an exchange rate system.

TEACHING NOTES I.

Exchange Rates (Sec. 10.1) A. Nominal exchange rates 1. The nominal exchange rate tells you how much foreign currency you can obtain with one unit of the domestic currency a. For example, if the nominal exchange rate is 78 yen per dollar, one dollar can be exchanged for 78 yen. b. Transactions between currencies take place in the foreign exchange market. c. Denote the nominal exchange rate (or simply, exchange rate) as enom in units of the foreign currency per unit of domestic currency. 2. Under a flexible-exchange-rate system or floating-exchange-rate system, exchange rates are determined by supply and demand and may change every day; this is the current system for major currencies. 3. In the past, many currencies operated under a fixed-exchange-rate system, in which exchange rates were determined by governments. a. The exchange rates were fixed because the central banks in those countries offered to buy or sell the currencies at the fixed exchange rate. b. Examples include the gold standard, which operated in the late 1800s and early 1900s, and the Bretton Woods system, which was in place from 1944 until the early 1970s. c. Even today, though major currencies are in a flexible-exchangerate system, some smaller countries attempt to fix their exchange rates against a major currency; for example, Argentina until recently adopted a system under which its currency, the peso, traded one-for-one with the US dollar. B. A Closer Look 10.1: The Effective Exchange Rate 1. Although the majority of Canada’s international trade in goods and services takes place with the United States, not all Canadian exports . 161

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go to the US and not all imports come from the US. The Bank of Canada calculates the Canadian Dollar Effective Exchange Rate Index (CERI) – the weighted average of nominal exchange rates for the Canadian dollar against the currencies of Canada’s six largest trading partners. The figure plots values of the CERI and values of Canada-US nominal exchange rate. It shows for the most part the CERI and the CanadaUS exchange rate move in tandem.

Real exchange rates 1. The real exchange rate tells you how much of a foreign good you can get in exchange for one unit of a domestic good. 2. If the nominal exchange rate is 78 yen per dollar, and it costs 312 yen to buy a hamburger in Tokyo compared to 3 dollars in Vancouver, the price of a Canadian hamburger relative to a Japanese hamburger is 0.75 Japanese hamburgers per Canadian hamburger. 3. The real exchange rate is the price of domestic goods relative to foreign goods, or e = enomP/PFor (10.1). 4. To simplify matters, we’ll assume that each country produces a unique good. 5. In reality, countries produce many goods, so we must use price indexes to get P and PFor. 6. If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country. Appreciation and depreciation 1. In a flexible-exchange-rate system, when enom fails, the domestic currency has undergone a nominal depreciation (or it has become weaker); when enom rises, the domestic currency has become stronger and has undergone a nominal appreciation. 2. In a fixed-exchange-rate system, a weakening of the currency is called a devaluation, a strengthening is called a revaluation. 3. We also use the terms real appreciation and real depreciation to refer to changes in the real exchange rate.

Numerical Problem 1 is a simple example of appreciation and depreciation. E.

Purchasing power parity 1. To examine the relationship between the nominal exchange rate and the real exchange rate. Think first about a simple case in which all countries product the same goods, which are freely traded. a. If there were no transportation costs, the real exchange rate would have to be e = 1, or else everyone would buy goods where they were cheaper. b. Setting e = 1 in Eq. (10.1) gives P = PFor/enom (10.2) c. This means that similar goods have the same price in terms of the same currency, a concept known as purchasing power parity, or PPP. d. Empirical evidence shows that purchasing power parity holds in the long run but no in the short run because in reality, countries produce different goods, because some goods aren’t traded, and because there are transportation costs and legal barriers to trade.

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II.

When PPP doesn’t hold, using Eq. (10.1), we can decompose changes in the real exchange rate into parts: Δe/e = Δenom/enom + ΔP/P - ΔPFor/PFor 3. This can be arranged as Δ enom/enom = Δe/e + πFor - π (10.3). 4. Thus a nominal appreciation is due to a real appreciation or a lower rate of inflation than in the foreign country. 5. In the special case in which the real exchange rate doesn’t change, so that ∆e/e = 0. the resulting equation in Eq. (10.3) is called relative purchasing power panty, since nominal exchange-rate movements reflect only changes in inflation. a. Relative purchasing power parity works well as a description of exchange-rate movements in high-inflation countries, since in those countries, movements in relative inflation rates are much larger than movements in real exchange rates. 6. A Closer Look 10.2: McParity a. As a test of the PPP hypothesis, the Economist magazine periodically reports on the prices of Big Mac hamburgers in different countries. b. The prices, when translated into dollar terms using the nominal exchange rate, range from a low of US $2.10 in South Africa to a high of US $6.59 in Switzerland, so PPP definitely doesn’t hold. The real exchange rate and net exports 1. The real exchange rate is important because it represents the rate at which domestic goods and services can be traded for those produced abroad. a. An increase in the real exchange rate means people in a country can get more foreign goods for a given amount of domestic goods. 2. The real exchange rate also affects a country’s net exports (exports minus imports). a. Changes in net exports have a direct impact on export and import industries in the country. b. Changes in net exports affect overall economic activity and are a primary channel through which business cycles and macroeconomic policy changes are transmitted internationally. 3. The real exchange rate affects net exports through its effect on the demand for goods. a. A high real exchange rate makes foreign goods cheap relative to domestic goods, so there’s a high demand for foreign goods (in both countries). b. With demand for foreign goods high, net exports decline. c. Thus the higher the real exchange rate, the lower a country’s net exports.

How Exchange Rates Are Determined: A Supply-and-Demand Analysis (Sec. 10.2) A. What causes changes in the exchange rate? 1. To analyze this. we’ll use supply-and-demand analysis, assuming a fixed price level. 2. Holding prices fixed means that changes in the real exchange rate are matched by changes in the nominal exchange rate.

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3. The nominal exchange rate is determined in the foreign exchange market by supply and demand for the currency. 4. Demand and supply are plotted against the nominal exchange rate, just like demand and supply for any good (Fig. 10.1: like text Fig. 10.1). a. Supplying dollars means offering dollars in exchange for the foreign currency. b. The supply curve slopes upward, because if people can get more units of foreign currency for a dollar, they’ll supply more dollars. c. Demanding dollars means wanting to buy dollars in exchange for the foreign currency. Figure 10.1 d. The demand curve slopes downward, because if people need to give up a greater amount of foreign currency to obtain one dollar, they’ll demand fewer dollars. 5. Why do people demand or supply dollars? a. People need dollars for two reasons: (1) To be able to buy Canadian goods and services (Canadian exports) (2) To be able to buy Canadian real and financial assets (Canadian capital inflows). b. These transactions are the two main categories in the balance of payments accounts: the current account and the capital account. c. People want to sell dollars for two reasons: (1) To be able to buy foreign goods and services (Canadian imports) (2) To be able to buy foreign real and financial assets (Canadian capital outflows). 6. Factors that increase demand for Canadian exports and assets will increase demand for dollars, shifting the demand curve to the right and increasing the nominal exchange rate. a. For example, an increase in the quality of Canadian goods relative to foreign Figure 10.2 goods will lead to an appreciation of the dollar (Fig. 10.2; like text Fig. 10.2). B. Macroeconomic determinants of the exchange rate and net export demand . 164

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1. Look at how changes in real output or the real interest rate are linked to the exchange rate and net exports, to develop an open-economy IS- LM model. 2. Effects of changes in output (income) a. A rise in domestic output (income) raises demand for goods and services, including imports, so net exports decline. b. To increase purchases of imports, people must sell the domestic currency to buy foreign currency, increasing the supply of foreign currency, which reduces the exchange rate. c. The opposite occurs if foreign output (income) rises (1) Domestic net exports rise (2) The currency appreciates. 3. Effects of changes in real interest rates a. A rise in the domestic real interest rate (with the foreign real interest rate held constant) causes foreigners to want to buy domestic assets, increasing the demand for domestic currency and raising the exchange rate. b. The rise in the exchange rate leads to a decline in net exports c. The opposite occurs if the foreign real interest rate rises. (1) Domestic net exports rise. (2) The currency depreciates.

III.

C. Summary Table 16: Determinants of the exchange rate (real or nominal) 1. A rise in domestic output (income) or the foreign real interest rate causes the exchange rate to fall. 2. A rise in foreign output (income), the domestic real interest rate, or the world demand for domestic goods causes the exchange rate to rise. D. Summary Table 17: Determinants of net exports 1. A rise in domestic output (income) or the domestic real interest rate causes net exports to fall. 2. A rise in foreign output (income), the foreign real interest rate, or the world demand for domestic goods causes net exports to rise. The International Asset Market: Interest Rate Parity (Sec. 10.3) A. Returns on Domestic and Foreign Assets 1. An illustrative example: invest $10,000 for one year a. Canadian bonds pay 8% b. German bonds pay 6% c. To maximize return, which to buy? d. Gross nominal return on Canadian bond is 1.08 (get back $10 800) e. Say the current exchange rate is 0.7 euros to the dollar, future exchange rate is 0.679 euros to the dollar f. Gross nominal return on the German bond is (1.06) 0.7/0.679 = 1.0928 g. Thus the German investment pays back $10 928 h. More generally, gross nominal rate of return on a foreign bond is 1 + iFor - Δenom/enom (10.5) B. Interest Rate Parity 1. The interest rate parity condition: . 165

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Investors will be indifferent to domestic and foreign assets of comparable risk and liquidity whenever the gross nominal returns are the same (1 + i) = (1 + iFor)enom/efnom (10.6). b. The interest rate parity condition can also be expressed in terms of real exchange rates (1 + r) = (1 + rFor)e/ef (10.8). c. Interest rate parity conditions suggest that unless financial markets expect large exchange rate fluctuations, domestic and foreign interest rates will move in tandem. C. Application: Explaining the movements in Canadian and US interest rates 1. Text Fig. 5.1 shows that between 1970 and 2015, Canadian interest rates increased relative to the US rates. 2. The interest rate parity condition helps explain the relative movements in Canadian and US interest rates. a. One possible explanation is that savers were expecting the nominal exchange rate to depreciate. Why? (1) Between 1975 and 1995, the debts of Canadian governments were large and growing relative to those in the US. (2) The relative growth in Canadian government debt led savers to expect higher inflation rate in Canada. (3) An expected high Canadian inflation rate relative to that of the US led savers to expect that the nominal exchange rate will depreciate. (4) The interest rate parity condition implies that the Canadian interest rate must be higher relative to the US rate if the nominal exchange rate is expected to depreciate. b. Following the 2008-2009 financial crisis the debt of the US government is expected to rise whereas the increase in debts of Canadian government will be far more muted; this suggests Canada’s domestic interest rate, i, will decrease relative to foreign rate, iFor. Data Application The interest rate parity is unfortunately not a very accurate predictor of exchange rate changes. See Kenneth Froot and Richard Thaier, “Anomalies: Foreign Exchange,” Journal of Economic Perspectives. Summer 1990, pp. 179–192. IV.

The IS-LM-FE Model for an Open Economy (Sec. 10.4) A. Only the IS curve is affected by having an open economy instead of a closed economy: the LM curve and FE line are the same. 1. The IS curve is affected because net exports are part of the demand for goods. 2. The IS curve remains downward sloping. 3. Any factor that shifts the closed-economy IS curve shifts the open- economy IS curve in the same way. 4. Factors that change net exports .

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(given domestic output and the domestic real interest rate) shift the IS curve. a. Factors that increase net exports shift the IS curve up. b. Factors that decrease net exports shift the IS curve down. B. The open-economy IS curve 1. The goods-market equilibrium condition is Sd – /d = NX (10.10). a. This means that desired foreign lending must equal foreign borrowing. b. Equivalently, Y = Cd + Figure 10.3 Id + G + NX (10.11). c. This means the supply of goods equals the demand for goods and is derived using the definition of national saving, Sd = Y – Cd – G. 2. Plotting Sd – Id and NX illustrates goods-market equilibrium (Fig. 10.3; like text Fig. 10.3) a. Net exports can be positive or negative. b. The net export curve slopes downward, because a rise in the real interest rate increases the real exchange rate and thus reduces net exports. c. The S – I curve slopes upward, because a rise in the real interest rate increases desired national saving and reduces desired investment. d. Equilibrium occurs where the curves intersect. 3. To get the open-economy IS curve, we need to see what happens when domestic output changes (Fig. 10.4; like text Fig. 10.4). a. Higher output increases saving, so the S – I curve shifts to the right. b. Higher output reduces net exports, so the NX curve shifts to the left. c. The new equilibrium occurs at a lower real interest rate, so the IS curve is downward sloping.

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Figure 10.4

Factors that shift the open-economy IS curve 1. Any factor that raises the real interest rate that clears the goods market at a constant level of output shifts the IS curve up. a. An example is a temporary increase in government purchases (Fig 10.5; like text Fig 10.5). b. The rise in government purchases reduces desired national saving, shifting the S – I curve to the left, shifting the IS curve up. c. Anything that reduces desired national saving relative to investment shifts the IS curve up.

Figure 10.5

2. Anything that raises a country’s net exports, given domestic output and the domestic real interest rate, will shift the open-economy IS curve up (Fig. 10.6; like text Fig. 10.6).

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a. The increase in net exports is shown as a shift to the right in the NX curve . b. This raises the real interest rate for a fixed level of output, shifting the IS curve up. c. Three things could increase net exports for a given level of output and real interest rate. (1) An increase in foreign output, which increases foreigners’ demand for domestic exports. (2) An increase in the foreign real interest rate, which makes people want to buy foreign assets, causing the exchange rate to depreciate, which in turn causes net exports to rise. (3) A shift in worldwide demand toward the domestic country’s goods, for example, as occurs if the quality of domestic good improves.

Figure 10.6

Analytical Problem 1 looks at the effect of trade barriers that reduce imports 3

Summary Table 18: International factors that shift the IS curve a. An increase in foreign output, the foreign real interest rate, or the demand for domestic goods relative to foreign goods all shift the IS curve up. The international transmission of business cycles 1. The impact of foreign economic conditions on the real exchange rate and net exports is one of the principal ways by which cycles are transmitted internationally. 2. What would be the effect on Canada of a recession in the United States? a. The decline in US output would reduce demand for Canadian exports, shifting the Canadian IS curve down b. In a Keynesian model, this leads to recession in Canada. c. In a classical model, the decline in net exports wouldn’t affect Canadian output. 3. A similar effect could occur because of a shift in preferences (or trade restrictions) for Canadian goods. . 169

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Macroeconomic Policy in a Small Open Economy with Flexible Exchange Rates (Sec. 10.5) A. Key question 1. To what extent are domestic fiscal and monetary policies useful for offsetting the effects of international shocks affecting the domestic economy? 2. Use the Mundell-Fleming model---i.e. the small open economy ISLM model that results from the assumption that the exchange rate is not expected to change---to analyze this question. B. A fiscal expansion 1. Look at a temporary increase in domestic government purchases using the Mundell-Fleming model. a. The rise in government purchases shifts the IS curve up (Fig. 10.7; like text Fig. 10.7). b. The domestic interest rate temporarily rises above the foreign rate to where IS2 intersects LM1 c. Arbitrage opportunities induce capital flow into Canada

Figure 10.7

d. The Canadian dollar appreciates which in turn makes exports more expensive, net exports fall and the IS curve shifts to the left. e. The IS curve continues to shift left so long as there are arbitrage opportunities. f. The process ends when the IS curve has shifted all the way back to its initial position where the domestic interest rate once again equals the foreign rate. g. The Mundell-Fleming model predicts that fiscal policy is ineffective in changing domestic output when there is a flexible exchange rate, even when the price level is fixed. h. Fiscal policy is unable to influence domestic output because the induced exchange rate appreciation reduces net exports dollar- for-dollar.

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Numerical Problems 3 and 4 illustrate the effects of an increase in government purchases on output, the exchange rate, and net exports. C. A monetary expansion 1. Consider the effects of an increase in domestic money supply in the Mundell-Fleming model. 2. Short-run effects (Fig. 10.8; like text Fig. 10.8) a. The increase in domestic money supply shifts the LM curve down from LM1 to LM2. b. The domestic interest rate temporarily falls below the foreign rate to where LM2 intersects IS1. c. Arbitrage opportunities induce capital flow from Canada.

Figure 10.8

The Canadian dollar depreciates which in turn makes exports cheaper, net exports rise and the IS curve shifts to the right e. The IS curve continues to shift rightwards so long as there are arbitrage opportunities. f. The process ends when the IS curve has shifted all the way to its new position IS2 where the domestic interest rate once again equals the foreign rate g. The Mundell-Fleming model predicts that with a fixed price level, a monetary expansion cause an expansion of domestic output, depreciation in the exchange rate, and an increase in net exports Long-run effects (Fig. 10.8; like text Fig. 10.8) a. In the long run, wages and prices in the domestic economy rise and the LM curve returns to its original position b. All real variables, including net exports and the real exchange rate, return to their original levels c. Thus there is no long-run effect on any real variables . 171

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VI.

This result holds in the long run in the Keynesian model, but it holds immediately in the classical model; monetary expansion affects only the price level even in the short run Though a monetary contraction doesn’t affect the real exchange rate, it does affect the nominal exchange rate because of the change in the domestic price level Since enom = ePFor/P, the increase in P reduces the nominal exchange rate by the same percentage as the increase in the price level and the money supply

Fixed Exchange Rates (Sec. 10.6) A. Fixed-exchange-rate systems are important historically 1. Canada has been on a flexible-exchange-rate system since the early 1970s 2. But fixed exchange rates are still used by many countries 3. There are two key questions we’d like to answer a. How does the use of a fixed-exchange-rate system affect an economy and macroeconomic policy? b. Which is the better system, flexible or fixed exchange rates? (Sec. 10.7) B. Fixing the exchange rate 1. The government sets the exchange rate, perhaps in agreement with other countries 2. What happens if the official rate differs from the rate determined by supply and demand? a. Supply and demand determine the fundamental value of the exchange rate (Fig. 10.9; like text Fig. 10.9) b. When the official rate is above its fundamental value, the currency is said to be overvalued c. The country could devalue the currency, reducing the official rate to the fundamental value

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d. The country could restrict international transactions to reduce the supply of its currency to the foreign exchange market, thus raising the fundamental value of the exchange rate (1) If a country prohibits people from trading the currency at all, the currency is said to Figure 10.9 be inconvertible e. The government can supply or demand the currency to make the fundamental value equal to the official rate (1) If the currency is overvalued, the government can buy its own currency (a) This is done by the nation’s central bank using its official reserve assets to buy the domestic currency in the foreign exchange market (b) Official reserve assets include gold, foreign bank deposits, and special assets created by agencies like the International Monetary Fund (c) The decline in official reserve assets is equal to a country’s balance of payments deficit Data Application In Llad Phillips and John Pippenger “Stabilization of the Canadian Dollar: 1975-1986” Canadian Journal of Economics, May 1993. a model of Canadian foreign exchange market intervention is developed. Their main finding is that the Bank of Canada has over this period consistently intervened, often with a lag. This intervention seems ;o have some success in influencing exchange rates. (2) A country can’t maintain an overvalued currency forever, as it will run out of official reserve assets (a) In the gold standard period, countries sometimes ran out of gold and had to devalue their currencies (b) A speculative run may end the attempt to support an overvalued currency i) If investors think a currency may soon be devalued, they may sell assets denominated in the overvalued currency, increasing the supply of that currency on the foreign exchange market ii) This causes even bigger losses of official reserves from the central bank and speeds up the likelihood of devaluation (3) Thus an overvalued currency can’t be maintained for very long

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Similarly, in the case of an undervalued currency, the official rate is below the fundamental value a. In this case, a central bank trying to maintain the official rate will acquire official reserve assets b. If the domestic central bank is gaining official reserve assets, foreign central banks must be losing them, so again the undervalued currency can’t be maintained for long Monetary policy and the fixed exchange rate 1. The best way for a country to make the fundamental value of a currency equal the official rate is through the use of monetary policy 2. For an overvalued currency, a monetary contraction is desirable a. In the Mundell-Fleming model, a monetary expansion creates an overvalued exchange rate b. Conversely, a monetary contraction creates an undervalued exchange rate c. Plotting the relationship between the money supply and the nominal exchange rate shows the level of the money supply for which the fundamental value of the exchange rate equals the official rate (Fig. 10.10; like text Fig. 10.14) (1) A higher money supply yields an overvalued currency (2) A lower money supply yields an undervalued currency

Figure 10.10

This implies that countries can’t both maintain the exchange rate and use monetary policy to affect output a. Using expansionary monetary policy to fight a recession would lead to an overvalued currency b. So under fixed exchange rates, monetary policy can’t be used for macroeconomic stabilization

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However, a group of countries may be able to coordinate their use of monetary policy a. If two countries increase their money supplies together to fight joint recessions, there needn’t be an overvaluation b. One country increasing its money supply by itself would lead to a depreciation c. But when the other country increases its money supply, it provides an offsetting effect d. If the money supplies expand in each country, they offset each other, so the exchange rate needn’t change 5. Overall, fixed exchange rates can work if countries in the system have similar macroeconomic goals and can coordinate changes in monetary policy but the failure to cooperate can lead to severe problems Fiscal policy and the fixed exchange rate 1. Short run effects of a fiscal expansion a. All else equal, a fiscal expansion would create an undervalued exchange rate b. The solution to an undervalued exchange rate is a domestic monetary expansion c. Thus, with a fixed exchange rate, the central bank must accommodate the fiscal expansion with a monetary expansion d. With a fixed price level, the Mundell-Fleming model therefore predicts a fiscal expansion causes an expansion of domestic output 2. Long-run effects of a fiscal expansion a. With output exceeding the full-employment level, the domestic price level increases b. Given the nominal exchange rate and the foreign price level, an increase in the domestic price level results in an increase in the real exchange rate c. Net exports falls resulting in a leftward shift in the IS curve d. This creates an overvalued nominal exchange rate e. The solution to an overvalued exchange rate is a domestic monetary contraction resulting in a leftward shift in the LM curve f. The process continues until both the IS and LM curves move back to their initial positions g. Thus, in the long-run, the fiscal expansion has no impact on output h. But, the real exchange rate has increased in step with the increase in the domestic price level 3. Application: Provincial fiscal policies a. The Ontario government controls about 20% of all government spending and taxation in Canada and therefore is capable of exerting a sizable influence on the Canadian economy b. According to the Mundell-Fleming model then, what would be the effects of a fiscal expansion in Ontario? c. Flexible exchange rates (1) The Mundell-Fleming model predicts that a fiscal expansion in Ontario will have no effect on Canadian output (2) However, output in Ontario would be higher and the increased output would come at the expense of the remaining provinces in Canada

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d. e.

VII.

With exchange rates fixed, a fiscal expansion in Ontario will increase output in Ontario as well as in all other provinces in Canada These results suggest that if provincial outputs are positively correlated then provincial fiscal policies should be discouraged under flexible exchange rates

Choosing an Exchange Rate System (Sec. 10.7) A. Fixed versus flexible exchange rates 1. Flexible-exchange-rate systems have problems, because the volatility of exchange rates introduces uncertainty into international transactions

Data Application Maurice Obsffeld and Kenneth Rogoff, “The Mirage of Fixed Exchange Rates,” Journal of Economic Perspectives, Fall 1995, pages 73–93, argue that since all fixed exchange rate regimes have ended in some form of collapse the only viable choice for a country is between a flexible exchange rate and a currency union. 2. There are two major benefits of fixed exchange rates a. Stable exchange rates make international trades easier and less costly b. Fixed exchange rates help discipline monetary policy, making it impossible for a country to engage in expansionary policy; the result may be lower inflation in the long run Policy Application Some prominent economists have called for a return to fixed exchange rates. Ronald I. McKinnon puts forth his suggestion that the major industrial countries return to a system of fixed exchange rates in his article “Monetary and Exchange Rate Policies for International Financial Stability: A Proposal.” Journal of Economic Perspectives, Winter 1988, pp. 83–103. Arthur J. Roinick and Warren E. Weber. from the Federal Reserve Vank of Minneapolis, present their views in “A Case for Fixing Exchange Rates,,” Federal Reserve Bank of Minneapolis 1989 Annual Report. 3. But there are some disadvantages to fixed exchange rates a. They take away a country’s ability to use expansionary monetary policy to combat recessions b. Disagreement among countries about the conduct of monetary policy may lead to the breakdown of the system 4. Open-economy trilemma a. A country can choose only two of the following three features: (1) Fixed exchange rate to promote trade (2) Free international movements of capital (3) Autonomy for domestic monetary policy 5. Which system is better may thus depend on the circumstances a. If large benefits can be gained from increased trade and integration, and when countries can coordinate their monetary policies closely, then fixed exchange rates may be desirable

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b. Countries that value having independent monetary policies, either because they face different macroeconomic shocks or because they hold different views about the costs of unemployment and inflation than other countries, should have a floating exchange rate Policy Application Rather than fixing exchange rates against a group of countries, an option for a smaller country like Canada is to peg its currency to that of a larger trading partner. Richard Harris, in Trade, Money, and Wealth in the Canadian Economy, C.D. Howe, Toronto, 1993, argues that Canada should peg its dollar to the US dollar. He believes that, for Canada, the benefits of real exchange rate stability outweigh the costs of giving up an independent monetary policy. B. Currency unions 1. Under a currency union, countries agree to share a common currency a. They often cooperate economically and politically as well 2. To work effectively, a currency union must have just one central bank a. Since countries don’t usually want to give up control over monetary policy by not having their own central banks, currency unions are very rare b. But a currency union has advantages over fixed exchange rates because having a single currency reduces the costs of trading goods and assets across countries and because speculative attacks on a national currency can no longer occur 3. But the major disadvantage of a currency union is that all countries share a common monetary policy, a problem that also arises with fixed exchange rates a. Thus if one country is in recession while another is concerned b. about inflation, monetary policy can’t help both, whereas with flexible exchange rates, the countries could have monetary policies that help their particular situation C. The self-correcting small open economy 1. Unlike a closed economy, an open economy is subject to unexpected events such as changes in foreign incomes, foreign interest rates, the tastes of foreigners for domestically produced goods, and the demand for foreign assets which can push the economy out of general equilibrium 2. Despite this, the need for stabilization policies may not be greater than in a closed economy because there exist self-correcting mechanisms in a small open economy, in addition to the price adjustment mechanism, which are absent in a closed economy 3. Flexible exchange rates: a. Under flexible exchange rates, unexpected events which shift the IS curve has no impact on the output of a small open economy b. By contrast, any unexpected events that affect the LM curve will have a magnified impact on output in an open economy with flexible exchange rates

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4. Fixed exchange rates: a. Under fixed exchange rates, unexpected events which shift the IS curve will have a magnified effect on the domestic output b. Any unexpected events that cause the LM curve to shift, on the other hand, will have no impact on output in an open economy with fixed exchange rates D. Application: Macroeconomic policy responses to the 2008-2009 financial crisis a. Financial crisis exposed Canada (and the world economy) to two major shocks. i. Fall in the financial market liquidity around the world pushed up world interest rates (LM curve for Canada shifts to the left) ii. Dramatic slowdown in the economy if the US (IS curve for Canada shifts to the left) b. Policy responses include increase in money supply (shifts LM to the right) and governments expand their spending (shifts IS to the right) c. Muted fiscal policy would be consistent with the evaluation of the ineffectiveness of fiscal policy as a response to recession. d. Politically unpopular and worldwide coordinated response reduce the crowding out of net exports due to an appreciation and make fiscal expansion more effective. E. More advanced models of the open economy 1. More advanced models of the open economy would allow for a. The FE line to respond to unexpected events such as changes in world energy prices b. Expectations of exchange rate changes c. Partial price level adjustment in the short run 2. However, the conclusions drawn from the relatively simple model (presented in Section 10.4) will continue to hold in more sophisticated and advanced models incorporating the above features VIII.

Key Diagram 9: The IS-LM Model of A Small Open Economy A. Diagram Elements 1. The IS curve gives combinations of real output and the real interest rate that equalize the aggregate quantities of goods supplied and demanded 2. The LM curve gives the real interest rate that clears the asset market 3. The FE line is vertical at full employment output B. Factors that Shift the Curves 1. Any factor that raises the full employment output shifts the FE line to the right 2. For a constant output, any change that reduces real money demand relative to real money demand increases the real interest and shifts the LM curve up. 3. Anything that raises a country’s net exports will shift the open economy IS curve up.

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IX.

Appendix 10.A: An Algebraic Version of the Open-Economy IS-LM Model A. The IS curve is modified, but the LM curve and FE line are unchanged 1. The LM equation is given by a. Y = γ + (1/Pl Y)M + (l r/l Y)r (10.A.1) 2. Desired consumption and investment are given by a. Cd = co + cY[Y – (to + tY)] – crr (10.A.2) d b. I = io – irr (10.A.3) 3. Net exports depend negative{y on domestic income Y and the domestic real interest rate r, and positively on foreign income YFor and the foreign real interest rate rFor NX = xo - xYY + xYFYFor - xr(r - rFor) (10.A.4) 4. The goods market equilibrium condition is Sd = Id + NX or Y = Cd + Id + G+ NX (10.A.5) 5. Plugging Eqs. (10.A.2), (10.A.3), and (10.A.4) into (10.A.5) gives the IS equation (cr + ir + xr)r = co + io + G - cYto + xo + xYFYFor + xrrFor - [1 - (1 - t)cY + xY]Y (10.A.7) 6. Writing this more simply, r = α’IS - β’ISY (10.A.8) α’IS = (co + io +G - cYto + xo + xYFYFor + xrrFor)/(cr + ir + xr) (10.A.9) β’IS = [1 - (1-t)cY + xY]/(cr + ir + xr) (10A.10) 7. These equations confirm the points made about the IS curve in the text a. The IS curve slopes downward, since β’IS is positive b. Any factor that shifts the close-economy IS curve also shifts the open-economy IS curve through changes in α’IS c. For a given output and real interest rate, any factor that increases net exports shifts the open-economy IS curve up, as it increases the intercept term α’IS B. Fiscal and monetary policy in the algebraic model: Flexible exchange rates 1. In the text we analyzed the effects of fiscal and monetary expansions using a version of the Mundell-Fleming model in which the domestic interest rate r is always equal to the foreign rate rFor 2. Equation (10.A.4) implies that r equals rFor when xr is very large 3. Equations (10.A.9) and (10.A.10) imply that α’IS = rFor and β’IS = 0 when xr is very large 4. Thus, the IS equation (10.A.8) reduces to r = rFor (10.A.12) 5. The model used in the text is therefore represented by equations (10.A.12) and (10.A.1) 6. It follows from these equations that fiscal policy is ineffective while monetary policy is effective 7. These equations also imply that an increase in rFor raises domestic output (see the LM equation) 8. By contrast, a change in foreign output has no effect on domestic output

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C. Fiscal and monetary policy in the algebraic model: Fixed exchange rates 1. Under fixed exchange rates, the LM equation simply determines the domestic money supply for alternative values of domestic output and the interest rate 2. Thus, the LM equation can be ignored 3. Under fixed exchange rates, r and rFor have no effect on net exports 4. The net exports equation (10.A.4) therefore modifies to NX = x0 – xYY +xYFYFor 5. The modified IS equation, obtained by combining equations (10.A.2), (10.A.3), (10.A.5) and (10.A.14), is given by Y = [c0 + i0 + x0 – cYt0 – (cr + ir)rFor + G + xYFYFor]/[1 – cY(1 – t) + xY] (10.A.16) 6. Equation (10.A.16) confirms the results explained in the text

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1.

How Does Using the US Dollar as its Currency Affect Panama’s Economic Policy?

Panama uses the US dollar as its official currency. How does this affect Panama s ability to control its economy? By choosing to use the US dollar as its official currency, Panama closely ties its economy to its larger northern neighbour. This has implications in many areas. Panama, as a small country, has taken advantage of using a major world currency as its domestic monetary unit to become a banking centre. It has deliberately set up its banking regulations to encourage banks doing business throughout the world to locate in Panama. Banks find it convenient to do business in Panama not only because the domestic currency is one of the major international currencies, but also because the government is responsive to their needs. Panama has limited control over its supply of money. Domestic balances can easily be transferred to the United States or other international centres. Thus interest rates and inflation rates will be similar to those prevailing in the United States. Any deviation has the potential to cause flows of funds that are relatively large compared to the size of the Panamanian economy. Since their money supply and exchange rates are essentially determined abroad, the government of Panama must rely mainly on fiscal policy in any attempt to change the course of the economy. 2.

How Predictable Are Exchange Rates?

Economists’ theories of exchange rates are very well developed, especially after hundreds of years of experience. How precisely do you think financial market participants, such as currency traders, can forecast exchange rates? It turns out that despite all our economic theories and extensive empirical work, forecasts of exchange rates are notoriously bad over short horizons. For long time periods, like two years or more, exchange-rate forecasts aren’t too bad when based on economic theories like purchasing power parity. But for forecasts of one year or less, the exchange rate often moves in exactly the opposite direction that economic theory predicts. For example, suppose you look in the financial section of the newspaper and see that one-year Canadian government bonds are paying an interest rate that’s one percent higher than the interest rate on a comparable US bond. A theory known as interest rate parity might suggest to you that the reason the interest rates are different is largely attributable to the fact that investors expect the US dollar to appreciate one percent against the Canadian dollar over the next year. But, surprisingly, in such situations, forecasts based on interest-rate parity are generally wrong, and in fact, on average, the US dollar depreciates one percent against the Canadian dollar. Evidence like this suggests that economists need to do a lot more work to be able to predict exchange rates effectively. Recently, computers are allowing economists to use some very fancy models, in which the riskiness of exchange rates changes over time, to make better exchange-rate forecasts. But, so far at least, short-term exchange-rate forecasting is far more an art than a science.

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1.

The nominal exchange rate is the rate at which two currencies can be exchanged for each other in the market. The real exchange rate is the price of domestic goods relative to foreign goods. Changes m the real exchange rate are related to changes in the nominal exchange rate depending on changes in the price levels of the two countries: Δe/e = enom/enom + ΔPFor/ PFor

The two major types of exchange-rate systems are fixed exchange rates and flexible exchange rates. In a fixed-exchange-rate system, exchange rates are set at officially determined levels. In a flexible-exchange-rate system, exchange rates are determined by conditions of demand and supply in the foreign exchange market. Currently, the major currencies of the world are on a flexible-exchangerate system.

Purchasing power parity, PPP, is the idea that similar foreign and domestic goods, or baskets of goods. should have the same price when priced in terms of the same currency. Purchasing power parity does seem to explain exchange rates in the long run, but over shorter periods it doesn’t work well because countries produce very different sets of goods, because some goods aren’t traded internationally, and because there are transportation costs and legal barriers.

An increase in domestic income leads people to buy more goods, including imported goods, so net exports decline. An increase in foreign income leads foreigners to buy more goods, including goods exported from the domestic country, so net exports increase. An increase in the domestic real interest rate makes domestic assets more attractive and foreign assets less attractive to both domestic and foreign investors. This causes a reduction in the supply of the domestic currency on the foreign exchange market and an increase in demand for the domestic currency on the foreign exchange market. The result is an appreciation of the domestic currency, which leads to a decline in net exports.

Foreigners demand dollars in the foreign exchange market to be able to buy Canadian goods and services (Canadian exports) and Canadian real and financial assets (Canadian capital inflows). Americans supply dollars to the foreign exchange market to be able to buy foreign goods and services (Canadian imports) and real and financial assets in foreign countries (Canadian capital outflows). The demand for dollars increases if the demand for Canadian goods increases, the domestic real interest rate increases, foreign income increases, or the foreign real interest rate decreases. The supply of dollars increases if the demand for foreign goods increases, the domestic real interest rate decreases, domestic income increases, or the foreign real interest rate increases.

The IS-LM model for the open economy differs from the closed-economy IS-LM model in that international influences may shift the IS curve. Factors that raise a country’s net exports, given domestic output and the domestic real interest rate, shift the IS curve upward, while factors that reduce a country’s net exports shift the IS curve downward. A recession could be transmitted from one country to another because a recession in one country reduces the net exports of other countries, shifting their IS curves down. In the Keynesian model, this would lead to a reduction in output in the other countries.

Expansionary fiscal policy increases output and the real interest rate in the short run (using a Keynesian model), both of which lead to a reduction of net exports. Expansionary monetary policy increases output in the short run, which tends to . 182

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reduce net exports, but reduces the real interest rate, which tends to increase net exports (by reducing the exchange rate). The overall effect is potentially ambiguous, but the effects of changes in the real exchange rate on net exports may be weak in the short run, so it is likely that net exports will decline. 8.

In the short run, expansionary monetary policy increases output (using a Keynesian model), which tends to decrease net exports, leading to an increased supply of the domestic currency in the foreign exchange market, causing it to depreciate. Expansionary monetary policy also reduces the real interest rate. causing reduced demand for domestic assets, again causing the currency to depreciate. With the price level fixed, there is both a real and nominal depreciation. In the long run, expansionary monetary policy causes a depreciation in the nominal exchange rate alone. In the long run, no real variables are affected by the expansionary policy; only nominal variables are affected. So the price level is higher, but real exchange rates are not affected. Using the equation enom = ePFOR/P, and since the real exchange rate, e, and the foreign price level PFOR are unaffected, the nominal exchange rate is lower.

The MundelI-Fleming model implies that net exports are very responsive to small international differences in interest rates. Under a floating exchange rate, a change in fiscal policy will have no effect on output, because its effect on the exchange rate will change net exports in the opposite direction. For example. a fiscal expansion will cause an appreciation, and a fall in net exports. In contrast, the model implies a large effect of monetary policy, since there the effect on the exchange rate leads to a change in net exports that acts in the same direction as the policy change.

10. The fundamental value of a currency is the value of the exchange rate that would be determined by free-market forces of demand and supply without government intervention. When the official exchange rate is higher than its fundamental value, it is said to be overvalued. This is a problem, because to maintain the official exchange rate, the central bank will have to buy the currency with official reserve assets. To prevent having an overvalued currency, the country can change the official exchange rate, restrict international transactions, or use contractionary monetary policy. 11. A country is limited in changing its money supply under a fixed-exchange-rate system, because only one level of the money supply is consistent with the official exchange rate being equal to its fundamental value. As a result, a country isn’t free to use expansionary monetary policy to combat recession. The only exception occurs when different countries coordinate their use of monetary policy. If countries use expansionary monetary policy at the same time, then the currencies won’t become overvalued or undervalued relative to each other. But coordination is likely only if countries face the same economic circumstances and share common macroeconomic goals. 12. The open-economy trilemma is a list of features a country can choose in its monetary system: (1) a fixed exchange rate; (2) international capital mobility; (3) autonomy for domestic monetary policy. A fixed exchange rate may be desirable if it encourages trade. Capital mobility adds to efficiency and promotes growth. Autonomy for monetary policy means that monetary policy can be used for stabilization (discussed in Chapter 13) regardless of the policies of foreign countries. Imagine that Canada decides to increase the money supply to reduce unemployment. This policy change will lead to a depreciation, as long as financial capital is mobile, as investors move out of Canadian dollar assets with low interest rates. So continuing with this policy (monetary autonomy) requires either allowing this depreciation (and not having a fixed exchange rate) or limiting capital mobility (with controls or taxes).

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Numerical Problems 1.

The price level in the West is Pw = 5 guilders per ordinary soap bar. The price level in the East is PE = 100 florins per deluxe soap bar. The real exchange rate is 2 ordinary soap bars per deluxe soap bar. a. Use the formula enom = ePFor/P = 2 ordinary soap bars per deluxe soap bar x 5 guilders per ordinary soap bar / 100 florins per deluxe soap bar = 0.10 guilders per florin, or 10 florins per guilder. b. Inflation in the West is πw = 10%. Inflation in the East is πe = 20%. The real exchange rate is constant. Use Eq. (10.3) to get Δenom/enom = (Δe/e) + πFor – π = 0. So the nominal exchange rate (guilders per florin) depreciates at a 10% rate. The East Bubble florin depreciates, the West Bubble guilder appreciates. a. The financial market expected the exchange rate to appreciate. b. The financial market expected the exchange rate to be 0.71159 in 3 months. c. She would have realized a rate of return equal to 4.116%. Begin by writing the equation for the IS curve, which is Sd – Id = NX. Sd = Y – Cd – G = Y – (300 + 0.5Y – 200r) – G. NX = 150 – 0.1Y – 0.5e = 150 – 0.1Y – 0.5(20 + 600r) = 140 – 0.1Y – 300r. Using these in the IS curve equation gives: (0.5Y – 300 – 200r – G) – (200 – 300r) = 140 – 0.1Y – 300r. Rearranging terms and simplifying gives the IS curve: 800r = 640 – 0.6Y – G.

a. With G = 100 and Ϋ = 900, the IS curve gives 800r = 640 – 540 – 100 = 200, so r = .25. Then e = 20 – 600r = 170, NX = 150 – 90 – 85 = –25, C = 300 + 450 – 50 = 700, and I = 200 – 75 = 125. b. With Ϋ = 940, the IS curve gives 800r = 640 – 564 + 100 = 176, so r = .22. Then e = 20 + 600r = 152, NX = 150 – 94 – 76 = –20, C = 300 + 470 – 44 = 726, and / = 200 – 66 = 134. The rise in domestic output reduces the real interest rate and real exchange rate, and increases net exports, consumption, and investment. c. With G = 132, the IS curve gives 800r = 640 – 564 + 132 = 208, so r = .26. Then e = 20 + 600r = 176, NX = 150 – 94 – 88 = –32, C = 300 + 470 – 52 = 718, and / = 200 – 78 = 122. The rise in government spending increases the real interest rate and the real exchange rate, and decreases net exports, consumption, and investment. 4. Begin by writing the equation for the IS curve, which is Sd – /d = NX. Sd = Y − Cd − G = Y – {200 + 0.6[Y – (20 + 0.2Y)] – 200r} − G = 0.52Y – (188 + G) + 200r Using these in the IS curve equation gives: 0.52Y – (188 + G) + 200r – (300 – 300r) = 150 – 0.08Y – 500r. Rearranging terms and simplifying gives the IS curve: 1000r = (638 + G) – 0.6Y

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The LM curve comes from the expression M/P = L, which is 924/P = 0.5Y – 200r. In the long run we’ll use this equation to find the price level, so we’ll write this as P = 924/(0.5Y – 200r). In the short run we’ll combine the LM curve with the IS curve to find equilibrium, so we’ll write it as 200r = 0.5Y – 924/P. a. With G = 152 and Ϋ = 1000, the IS curve gives 1000r = 790 – 600 = 190. so r = 0.19 From the LM curve, P = 924/(500 – 38) = 2. Then NX = 150 – 80 – 95 = –25, C = 200 – 0.6(1000 – 220) – 38 = 630, and / = 300 – 57 = 243. b. In the short run with G = 212 and P = 2, the IS curve gives 1000r = (638 + 212) – 0.6Y, and the LM curve is 200r = 0.5Y – 462. Take five times the LM equation and subtract it from the IS equation to get (850 + 2310) – 3.1Y = 0, or Y = 1019.36. Plug this in the LM equation to get r = 0.24. Then NX = 150 – 81.55 – 120 = –51.55, C = 200 + 0.6(1019.36 – 224) – 48 = 629.29, and / = 300 – 72 = 228. In the long run, using Y = 1000 in the IS curve gives 1000r = (638 + 212) – (0.6 × 1000) = 250, so r = 0.25. Then NX = 150 – 80 – 126 = –56. C = 200 + 468 – 50 = 618, and I = 300 – 75 = 225. c. The nominal money supply remains at 924. Then the LM curve implies, P = 924/(500 – 50) = 2.05. It then follows that the real money supply is 450. Thus, in the long-run, the price level will go up and the real money supply will go down. 5.

a. r = 0.175 (17.5%). Using either IS or LM, the value of r at

= 300.

b. Domestic output falls to Y = 175. With fixed price level and fixed exchange rate, short run equilibrium occurs on IS at r = 0.225. Using the equation of LM, if Y = 175 and r = 0.225, then M = 42.5. c. Domestic output increases to Y = 320. With a fixed price level and flexible exchange rate, short run equilibrium occurs on LM at r = 0.225. Using the equation of IS, if Y = 320 and r = 0.225, then e = 32. d. In the long run, the price level increases if the exchange rate is flexible but decreases if it is fixed.

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Analytical Problems 1.

a. Import restrictions cause net exports to increase. The IS curve, then, shifts to the right. The result is a temporary increase in the domestic interest rate above the foreign interest rate. This presents arbitrage opportunities which cause a capital inflow into the domestic economy. As a result, the domestic currency appreciates and this causes net exports to fall. The fall in net exports causes the domestic interest rate to fall until it is again equal to the foreign interest rate. The IS curve has returned to its original position. In equilibrium, there has been no change in output, no change in the interest rate, and no change in net exports. The real exchange rate has appreciated, exports have fallen and imports have decreased. b. The answer to part (a) is not affected if the domestic price level is allowed to adjust. The reason is that unless we believe the exchange rate responds only very slowly to the temporary increase in the domestic interest rate, there is no reason to believe there is a change in output. As a consequence, there is no change in the price level. c. Import restrictions cause net exports to increase. The IS curve shifts to the right. The result is a temporary increase in the domestic interest rate above the foreign level. If the exchange rate is fixed, the resulting capital inflow creates an undervalued exchange rate. The solution to an undervalued exchange rate is for the domestic central bank to increase the domestic money supply. The LM curve shifts to the right until the domestic interest rate is equal to the foreign interest rate. This halts the capital inflow and keeps the value of the exchange rate constant. Domestic output has increased, the real exchange rate is not affected, exports are not affected, imports have been reduced, and net exports have increased. d. The fact that output has increased means that the domestic price level increases. As a consequence, the real exchange rate increases. This causes net exports to fall (exports fall and imports rise) and the IS curve shifts back to the left. The domestic money supply must be reduced in order to prevent an over or undervaluation of the currency. In the end, both IS and LM have returned to their original positions. When we allow the price level to adjust, the import restriction ends up having no effect on output. The real exchange rate has increased due to the increase in the domestic price level. Net exports are unaffected, however. Exports have been reduced and imports have decreased by equal amounts.

a. The actions of legislators in Country B cause Country A exports to fall. A fall in net exports shifts IS to the left causing a temporary fall in the domestic interest rate below the foreign interest rate. The result is a capital outflow from Country A and an exchange rate depreciation. The depreciation causes exports to increase, imports to decrease, and net exports to increase. The IS curve returns to its original position. In the end, there is no change in output, no change in net exports, imports have been reduced, and exports have been decreased. b. Assuming a relatively speedy response of the exchange rate to the change in the domestic interest rate, allowing the price level to change has no impact on . 186

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the solution to part (a). c. The fall in exports caused by foreign legislation causes IS to shift to the left. The result is an overvalued exchange rate. The solution to an overvalued exchange rate is for the domestic central bank to decrease the domestic money supply. The LM curve shifts to the left until the domestic interest rate is equal to the foreign interest rate. This halts the capital outflow and keeps the value of the exchange rate constant. Domestic output has fallen, the real exchange rate is not affected, net exports have fallen, exports have fallen, and imports have fallen. d. Since output has fallen, the domestic price level falls. This causes the real exchange rate to fall which in turn causes exports to increase, imports to decrease and net exports to increase. The IS curve shifts back to the right as does the LM curve (so as to prevent any over or undervaluation of the currency). In the end we return to the original equilibrium that was observed prior to the foreign legislation. Output is unaffected, net exports are unaffected, exports have fallen and imports have fallen. 3.

a. The monetary expansion in Country Y causes the world interest rate to decrease. The implication is that the domestic interest rate in Country X is above the world interest rate. Country X realizes a capital inflow that produces a currency appreciation. Net exports decrease causing IS to shift to the left until the domestic interest rate falls sufficiently to equal the world interest rate. Country X output decreases, net exports decrease, and the interest rate decreases. b. The fiscal expansion in Country Y causes the world interest rate to increase. The implication is that the domestic interest rate in Country X is below the new, higher, world interest rate. Country X realizes a capital outflow that produces a currency depreciation. Net exports increase causing IS to shift to the right until the domestic interest rate increases to equal the world interest rate. Country X output increases, net exports increase, and the interest rate increases.

An increase in full employment output shifts the FE line to the right. In the short run, there is no other change. In the long run, the economy is below the full employment level of output and hence the price level falls. The causes the real exchange rate to fall. The currency depreciation causes net exports to increase shifting the IS curve to the right. At the same time, the fall in the price level causes the LM curve to shift to the right. IS and LM interest at the new higher level of full employment output and at the foreign interest rate. Output increases, the price levels falls, the real exchange rate falls, net exports increase.

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CHAPTER 11: CLASSICAL BUSINESS CYCLE ANALYSIS: MARKET-CLEARING MACROECONOMICS LEARNING OBJECTIVES I.

Goals of Chapter 11 A. Use the IS-LM/AD-AS model with rapidly adjusting wages and prices to present the classical model B. Examine the relationship between money and the business cycle

II.

Notes to Eighth Edition Users A. Figure 11.4 has been updated. B. A Closer Look 11.1 has been updated with new data.

TEACHING NOTES I.

Business Cycles in the Classical Model (Sec. 11.1) A. The real business cycle theory 1. Any business cycle theory has two components a. A description of the types of shocks believed to affect the economy the most b. A model that describes how key macroeconomic variables respond to economic shocks 2. Real business cycle (RBC) theory a. Real shocks to the economy are the primary cause of business cycles (1) Examples: Shocks to the production function, the size of the labour force, the real quantity of government purchases, the spending and saving decisions of consumers (affecting the IS curve or the FE line) (2) Nominal shocks are shocks to money supply or demand (affecting the LM curve) b. The largest role is played by shocks to the production function, which the text has called supply shocks, and RBC theorists call productivity shocks (1) Examples: Development of new products or production methods, introduction of new management techniques, changes in the quality of capital or labour, changes in the availability of raw materials or energy, unusually good or bad weather, changes in government regulations affecting production (2) Most economic booms result from beneficial productivity shocks; most recessions are caused by adverse productivity shocks

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The recessionary impact of an adverse productivity shock (1) Results from Chapter 3: Real wage, employment, output, consumption, and investment decline, while the real interest rate and price level rise (2) So an adverse productivity shock causes a recession output declines), whereas a beneficial productivity shock causes a boom (output increases); but output always equals full-employment output Real business cycle theory and the business cycle facts (1) The RBC theory is consistent with many business cycle facts (a) If the economy is continuously buffeted by productivity shocks, the theory predicts recurrent fluctuations in aggregate output, which we observe (b) The theory correctly predicts procyclical employment and real wages

Numerical Problem 1 looks at the relationship between real wages and employment over the business cycle and the issue of whether the labour-supply curve should be flat or steep to be consistent with the data. (c)

The theory correctly predicts procyclical average labour productivity, if booms weren’t due to productivity shocks, we would expect average labour productivity to be countercyclical because of diminishing marginal productivity of labour (d) The theory has also had some success at explaining international aspects of the business cycle (the behaviour of the current account) (2) The theory predicts countercyclical movement of the price level, which seems to be inconsistent with the data (a) But R. Todd Smith, when using some newer statistical techniques for calculating the trends in inflation and output, find evidence that the price level is countercyclical after World War II for most countries. (b) Also, the money supply is not literally fixed, as our ISLM analysis assumed, but is procyclical, which may cause a less countercyclical movement in the price level (c) The surge in inflation after the oil price shocks of 1973–1974 and 1979–1980 is consistent with RBC theory Application: Calibrating the business cycle a. A major element of RBC theory is that it attempts to make quantitative, not just qualitative, predictions about the business cycle

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RBC theorists use the method of calibration to work out a detailed numerical example of the theory (1) First they write down specific functions explaining the behaviour of people in the economy; for example, they might choose as the production function for the economy, Y = AKaN1-a (2) Then they use existing studies of the economy to choose numbers for parameters like a in the production function; for example, a = 0.3 (3) Next they simulate what happens when the economy is hit by various shocks to different sectors of the economy (4) Prescott’s computer simulations (text Figs. 11.1 and 11.2) match post-World War II data fairly well

Data Application For a good survey article on real business cycles, see George Stadler, “Real Business Cycles.” Journal of Economic Literature, December 1994, pages 1750–83. 4.

Are productivity shocks the only source of recessions? a. Critics of the RBC theory suggest that except for the oil price shocks of 1973, 1979, and 1990, there are no productivity shocks that one can easily identify that caused recessions b. One RBC response is that it doesn’t have to be a big shock; instead, the cumulative effects of many small shocks can cause a business cycle (Fig. 11.3)

Numerical Problem 5 shows how the growth in Solow residual relates to the growth in productivity. Theoretical Application For more on criticisms of the RBC theory and the RBC response to the critics, see the discussion in the Federal Reserve Bank of Minneapolis Quarterly Review, Fall 1986, and the Journal of Economic Perspectives, Summer 1989. c.

But the critics suggest that shocks other than productivity shocks, such as wars and military buildups, have caused business cycles Does the Solow residual measure technology shocks? a. RBC theorists measure productivity shocks as the Solow residual (1) Named after Robert Solow, the originator of modern growth theory (2) Given a production function, Y = AKaN1-a, and data on Y, K, and N, the Solow residual is A = Y/(KaN1-a) (11.1) (3) It’s called a residual because it can’t be measured directly

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e. f.

The Solow residual is strongly procyclical in Canadian data between 1961 and 2015. (Figure 11.4) (1) This accords with RBC theory, which says the cycle is driven by productivity shocks But should the Solow residual be interpreted as a measure of technology? (1) If it’s a measure of technology, it should not be related to factors that don’t directly affect scientific and technological progress, like government purchases or monetary policy (2) But statistical studies show a correlation between these Measured productivity can vary even if the actual technology doesn’t change (1) Capital and labour are used more intensively at times (2) More intensive use of inputs leads to higher output (3) Define the utilization rate of capital uK and the utilization rate of labour uN (4) Define capital services as uKK and labour services as uNN (5) Rewrite the production function as Y = A(uKK)a(uNN)1-a (11.2) (6) Use this to substitute for Y in Eq. (11.1) to get Solow residual (11.3) (7) So the Solow residual isn’t just A, but depends on uK and uN (8) Utilization is procyclical, so the measured Solow residual is more procyclical than is the true productivity term A (a) Burnside-Eichenbaum-Rebelo evidence on procyclical utilization of capital (b) Fay-Medoff and Braun-Evans evidence on procyclical utilization of labour (i) Labour hoarding: firms keep workers in recessions to avoid incurring hiring and firing costs (ii) Hoarded labour doesn’t work as hard, or performs maintenance (iii) The lower productivity of hoarded labour doesn’t reflect technological change, just the rate of utilization (c) Basu-Fernald find that technology shocks are not procyclical but acyclical. Conclusion: Changes in the measured Solow residual don’t necessarily reflect changes in technology Also, the critics suggest that shocks other than productivity shocks, such as wars and military buildups, have caused business cycles

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Fiscal policy shocks in the classical model 1. The effects of an increase in government expenditures a. The increase in government expenditures effectively reduce people’s wealth, causing an income effect on labour supply b. The increased labour supply leads to a rise in equilibrium level of employment c. The rise in employment increases output d. The increase in government purchases shifts the IS curve to the right and prices must rise to shift the LM curve up to restore equilibrium e. The results help match the data better, since without fiscal policy the RBC model shows a correlation between output and average labour productivity that is too high f. So adding fiscal policy shocks to the model increases its ability to match the actual behaviour of the economy

Analytical Problems 2, 3, and 6 deal with various aspects of the classical IS-LM model. 2.

Should fiscal policy be used to dampen the cycle? a. Classical economists oppose attempts to dampen the cycle, since prices and wages adjust quickly to restore equilibrium b. Besides, fiscal policy increases output by making workers worse off, since they face higher taxes c. Instead, government spending should be determined by costbenefit analysis d. Also, there may be lags in enacting the correct policy and in implementing it (1) So choosing the right policy today depends on where you think the economy will be in the future (2) This creates problems, because forecasts of the future state of the economy are imperfect e. It’s also not clear how much to change fiscal policy to get the desired effect on employment and output Unemployment in the classical model 1. In the classical model there is no unemployment; people who aren’t working are voluntarily not in the labour force 2. In reality measured unemployment is never zero, and it is the problem of unemployment in recessions that concerns policymakers the most 3. Classical economists have a more sophisticated version of the model to account for unemployment a. Workers and jobs have different requirements, so there is a matching problem b. It takes time to match workers to jobs, so there is always some unemployment c. Unemployment rises in recessions because productivity shocks cause increased mismatches between workers and jobs d. A shock that increases mismatching raises frictional unemployment and may also cause structural unemployment if the types of skills needed by employers change e. So the shock causes the natural rate of unemployment to rise: there’s still no cyclical unemployment in the classical model . 192

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Theoretical Application A nice discussion of the classical view of unemployment is by Robert E. Lucas, Jr., Models of Business Cycles, Chapter V, New York: Basil Blackwell, 1987. 4. 5.

A recent study by Balakrishnan of IMF suggests a great deal of “churning” of jobs and workers occurs in the Canadian economy Baldwin, Dunne and Haltiwanger show that there is a tremendous amount of churning of jobs both within and across industries

Numerical Problem 6 is a coin-flipping exercise to show that random shocks can lead to big aggregate movements. 6.

II.

But this worker match theory can’t explain all unemployment a. Many workers are laid off temporarily; there’s no mismatch, just a change in the timing of work b. If recessions were times of increased mismatch, there should be a rise in help-wanted ads in recessions, but in fact they fall So can the government use fiscal policy to reduce unemployment? a. Doing so doesn’t improve the mismatch problem b. A better approach is to eliminate barriers to labour-market adjustment by reducing burdensome regulations on businesses or by getting rid of the minimum wage

Money in the Classical Model (Sec. 11.2) A. Monetary policy and the economy Money is neutral in both the short run and the long run in the classical model, because prices adjust rapidly to restore equilibrium B. Monetary non-neutrality and reverse causation 1. If money is neutral, why do the data show that money is a leading, procyclical variable? a. Increases in the money supply are often followed by increases in output b. Reductions in the money supply are often followed by recessions 2. The classical answer: Reverse causation a. Just because changes in money growth precede changes in output doesn’t mean that the money changes cause the output changes b. Example: People put storm windows on their houses before winter, but it’s the coming winter that causes the storm windows to go on, the storm windows don’t cause winter c. Reverse causation means money growth is higher because people expect higher output in the future; the higher money growth doesn’t cause the higher future output d. If so, money can be procyclical and leading even though money is neutral

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Data Application A recent review of empirical work testing the RBC theory of reverse causation is Shaghil Ahmed, “Does Money Affect Output?” Federal Reserve Bank of Philadelphia Business Review, July/August 1993. He finds mixed support for reverse causation, but does suggest that money growth is unlikely to be a major factor causing business cycles. 3.

Why would higher future output cause people to increase money demand? a. Firms, anticipating higher sales, would need more money for transactions to pay for materials and workers b. The Bank of Canada would respond to the higher demand for money by increasing money supply; otherwise, the price level would decline

Theoretical Application The early theoretical RBC models did not include a monetary sector at all—they assumed that money was unimportant for the business cycle. More recently, RBC theorists have been trying to incorporate money into their models. The focus so far has been trying to get the models to produce a liquidity effect. in which an increase in the money supply temporarily reduces nominal interest rates. See, Lawrence J. Christiano, “Modelling the Liquidity Effect of a Money Shock,” Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1991. C.

A Closer Look 11.1: Money and economic activity at Christmastime 1. A good example of reverse causation occurs every year before Christmas 2. In December both the money supply and economic activity are much higher than other months, due to gift-buying 3. Since the Bank of Canada knows that money demand is higher in December every year, it increases money supply at that time

Analytical Problem 4 works out another example of how reverse causation could occur through firms’ demand for money for transactions and the central bank’s money-supply response. D.

The non-neutrality of money: Additional evidence 1. Friedman and Schwartz have extensively documented that often monetary changes have had an independent origin; they weren’t just a reflection of changes or future changes in economic activity a. These independent changes in money supply were followed by changes in income and prices b. The interrelation between monetary and economic change has been highly stable c. The independent origins of money changes include such things as gold discoveries, changes in monetary institutions, and changes in the leadership of the Fed

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Theoretical Application For a thorough overview of how money works to affect the economy in various models, see the symposium on “The Monetary Transmission Mechanism,” in the Journal of Economic Perspectives, Fall 1995. 2. 3.

4. 5.

Romer and Romer reviewed and updated the Friedman-Schwartz analysis and found money is not neutral No comparable evidence links Canadian business cycles to changes in the money supply, although some evidence suggests money growth is non-neutral a. The depth of the Canadian recession of 1990-92 has been attributed to restrictive monetary policy b. The financial crisis beginning in 2007 that have precipitated to a near global recession showed money is not neutral So money does not appear to be neutral There is a version of the classical model in which money isn’t neutral— the misperceptions theory discussed next

Numerical Problems 2 and 3 and Analytical Problem 5 examine price level effects in the classical model. III.

The Misperceptions Theory and the Non-neutrality of Money (Sec. 11.3) A. Introduction to the misperceptions theory 1. In the classical model, money is neutral since prices adjust quickly a. In this case, the only relevant supply curve is the long-run aggregate supply curve b. So movements in aggregate demand have no effect on output 2. But if producers misperceive the aggregate price level, then the relevant aggregate supply curve in the short run isn’t vertical a. This happens because producers have imperfect information about the general price level b. As a result, they misinterpret changes in the general price level as changes in relative prices c. This leads to a short-run aggregate supply curve that isn’t vertical d. But prices still adjust rapidly B. The misperceptions theory (Key Diagram 11) 1. The misperception theory is that the aggregate quantity of output supplied rises above the full-employment level Y when the aggregate price level P is higher than expected 2. This makes the AS curve slope upward 3. Example: A bakery that makes bread a. The price of bread is the baker’s nominal wage; the price of bread relative to the general price level is the baker’s real wage b. If the relative price of bread rises, the baker may work more and produce more bread c. If the baker can’t observe the general price level as easily as the price of bread, he or she must estimate the relative price of bread

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4. 5. 6. 7. 8.

10.

!f the price of bread rises 5% and the baker thinks inflation is 5%, there’s no change in the relative price of bread, so there’s no change in the baker’s labour supply e. But suppose the baker expects the general price level to rise by 5%, but sees the price of bread rising by 8%; then the baker will work more in response to the wage increase Generalizing this example, if everyone expects prices to increase 5% but they actually increase 8%, they’ll work more So an increase in the price level that is higher than expected induces people to work more and thus increases the economy’s output Similarly, an increase in the price level that is lower than expected reduces output The equation Y = Y + b(P – Pe) [Eq. (11.4)] summarizes the misperceptions theory In the short run, the aggregate supply (SRAS) curve slopes upward and intersects the longrun aggregate supply (LRAS) curve at P = Pe (Fig. 11.1; like text Fig. 11.5) Eventually firms and individuals will adjust away from these positions and to positions shown by the LRAS curve. If observed price level turns out to be what was expected, the amount of output supplied must always intersect the LRAS at the expected price level (Key Figure 11.1 Diagram 10, like text Fig. 11.6)

Analytical Problem 1 contrasts the effects of a change in the future marginal product of capital in an RBC model to that in a misperceptions model. C.

Aggregate demand and aggregate supply equilibrium 1. Points on the AD curve represent combination of P and Y where the goods market (represented by IS) and the financial market (represented by LM) are both in equilibrium. 2. Equilibrium condition exists when AD intersects with AS. 3. The manner in which households and firms form their expectations about what the future may look like is a key ingredient of the AD-AS model. Rational price expectations 1. Economists suggest that it is reasonable to assume that in the face of uncertainty about the future, the public calculate what is known as rational expectations 2. The rational expectations hypothesis states that the public’s forecasts of key economic variables (including the price level) are based on reasoned and intelligent examination of economic data available at the time when the forecasts are made

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To form an intelligent expectation of economic variables the public is assumed to take into consideration what they observe about the state of the economy and what they have come to understand to be the nature of government economic policy 4. The rational price expectation is determined by the intersection of the LRAS and the expected position of the aggregate demand curve A Closer Look 11.2: Are price forecasts rational? 1. Economists can test whether price forecasts are rational by looking at surveys of people’s expectations 2. The forecast error of a forecast is the difference between the actual value of the variable and the forecast value 3. If people have rational expectations, forecast errors should be unpredictable random numbers otherwise, people would be making systematic errors and thus not have rational expectations 4. Many statistical studies suggest that people don’t have rational expectations 5. But people who answer surveys may not have a lot at stake in making forecasts, so couldn’t be expected to produce rational forecasts 6. Instead, professional forecasters are more likely to produce rational forecasts 7. Keane and Runkle, using a survey of professional forecasters, find evidence that these forecasters do have rational expectations 8. It seems likely that the greater a person’s incentive to make good forecasts, the more likely those forecasts are to be rational

Data Application The survey used by Keane and Runkle was begun by Victor Zarnowitz of the University of Chicago in 1968 and was run by the American Statistical Association and National Bureau of Economic Research until 1990. At that time the survey was taken over by the Federal Reserve Bank of Philadelphia and christened the “Survey of Professional Forecasters.” See the article by Dean Croushore, “Introducing: The Survey of Professional Forecasters,” Federal Reserve Bank of Philadelphia Business Review, November/December 1993. Unfortunately, there is nothing comparable here in Canada. F.

Monetary policy and the misperceptions theory 1. Because of misperceptions, unanticipated monetary policy has real effects; but anticipated monetary policy has no real effects because there are no misperceptions 2. Unanticipated changes in the money supply (Fig. 11.2; like text Fig. 11.8) a. Initial equilibrium where AD1 intersects SRAS1 and LRAS b. Unanticipated increase in money supply shifts AD Figure 11.2 curve to AD2 c. The price level rises to P2 and output rises above Y, so money isn’t neutral d. As people get information about the true price level, their Copyright © 2022 Pearson Canada Inc. 197

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expectations change, and the SRAS curve shifts left to SRAS2, with output returning to Y e. So unanticipated money isn’t neutral in the short run, but it is neutral in the long run 3. Anticipated changes in the money supply a. If people anticipate the change in the money supply and thus in the price level, they aren’t fooled, there are no misperceptions, and the SRAS curve shifts immediately to its higher level b. So anticipated money is neutral in both the short run and the long run Rational expectations and the role of monetary policy 1. The only way the central bank can use monetary policy to affect output is to surprise people 2. But people realize that the central bank would want to increase the money supply in recessions and decrease it in booms, so they won’t be fooled 3. If the public has rational expectations, the Bank won’t be able to surprise people in response to the business cycle; only random monetary policy has any effects

Data Application Do the data support the misperceptions theory? Robert Barro, “Unanticipated Money, Output, and the Price Level in the United States,” Journal of Political Economy, August 1978, pp. 549–580, found support for the misperceptions theory; his results suggested that output was affected only by unanticipated money growth. But others challenged these results and found that both anticipated and unanticipated money growth seem to affect output. See Frederic S. Mishkin, “Does Anticipated Monetary Policy Matter? An Econometric Investigation,” Journal of Political Economy, February 1982, pp. 22–51 For Canada Gilllan Wogin “Unemployment and Monetary Policy under Rational Expectations: Some Canadian Evidence” Journal of Monetary Economics, January 1980, 6, 59–68, finds results broadly similar to those of Barro. She finds that unanticipated M2 growth has temporary expansionary real effects on unemployment, while anticipated M2 growth had no significant real effects. Numerical Problem 4 looks at the misperceptions theory and unanticipated compared to anticipated changes in the money supply 4.

So even if smoothing the business cycle were desirable, the combination of misperceptions theory and rational expectations suggests that the central bank can’t systematically use monetary policy to stabilize the economy Propagating the effects of unanticipated changes in the money supply 1. It doesn’t seem that people could be fooled for long, since money supply figures are reported weekly and inflation is reported monthly 2. Classical economists argue that propagation mechanisms allow shortlived shocks to have long-lived effects 3. Example of propagation: The behaviour of inventories a. Firms hold a normal level of inventories against their normal level of sales b. An unanticipated increase in the money supply increases sales c. Since the firm can’t produce many more goods immediately, it draws down its inventories d. Even after the money supply change is known, the firm must produce more to restore its inventory level . 198

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e. IV.

Thus, the short-term monetary shock has a long-lived effect on the economy

Key Diagram 10: The Upward Sloping Short Run Aggregate Supply Curve A. Diagram Elements 1. The SRAS curve shows the amount of output firms are willing to offer for sale in the short run and its position is determined by the expected price level. B. Factors that Shift the Curves 1. An increase (decrease) in the expected price level shifts the SRAS up (down) 2. Any factor that increases full employment output shifts both the short run and long run aggregate supply curve to the right.

Theoretical Application Though the text presents the theories in the reverse order, the misperceptions theory came first (being developed in the 1970s) and the RBC theory came later (in the 1980s). Many classical economists moved away from the misperceptions theory because they weren’t convinced by its arguments for monetary non-neutrality; in particular, the information lag in observing money and prices didn’t seem long enough to cause much effect. For a broad review of how classical macroeconomic theory developed, as well as its relationship to Keynesian theory, see Robert J. Barro, “New Classicals and Keynesians, or the Good Guys and the Bad Guys,” National Bureau of Economic Research Working Paper No. 2982, May 1989. Also, Bennett McCallurn discusses the development of the classical approach in “New Classical Macroeconomics: A Sympathetic Account” Scandinavian Journal of Economics, 1989, pp. 223–252. V.

Key Diagram 11: The Misperceptions Version of the AD-AS Model A. Diagram Elements 1. When producers misperceive the price level, an increase in the general price level above the expected price level fools suppliers into thinking that the relative prices of their goods have increased, so all suppliers increase output. 2. In the long run, producers learn about the price level and adjust their expectations until the actual price level equals the expected price level. B. Factors that Shift the Curves 1. Any factor that shifts the IS-LM intersection to the right increases the aggregate quantity of goods demanded and will shift the AD curve to the right. 2. Any factor that increases full employment output shifts both the short run and long run aggregate supply curve to the right. 3. An increase (decrease) in the expected price level shifts the short run aggregate supply curve up (down).

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1.

Do Wages Adjust to Clear the Labour Market?

One of the key assumptions of classical macroeconomic theory is that wages adjust rapidly to bring about equilibrium in the labour market in a relatively short period of time. Is this a reasonable assumption? Some economists look at the labour-market statistics, which show large swings in unemployment and not much change in wages over the business cycle. They believe this indicates sluggish wage adjustment, supporting the Keynesian model over the classical model. One reason for wages to adjust sluggishly is the hypothesis of downward nominal wage rigidity. Under this theory, employers don’t want to reduce workers’ nominal wages, because it’s bad for morale and they fear a decline in productivity. If firms can’t reduce nominal wages, they will lay off workers in recessions. A highly cited article about wage rigidity in the United States is Akerlof, Dickens, and Perry, “The Macroeconomics of Low Inflation,” Brookings Papers on Economic Activity, 1996, pages 1-76. Allan Crawford and Seamus Hogan, “Downward Wage Rigidity,” Bank of Canada Review, Winter 1998-1999, report and explain in an accessible fashion the findings of wage rigidity in Canada. 2.

Are People’s Inflation Forecasts Rational?

When the misperceptions theory was developed in the late 1970s, a number of economists began testing people’s forecasts to see how rational they were. The theory implies that on average, people should not make systematic errors in forecasting. Of special importance are people’s forecasts of inflation, since these affect the aggregate supply curve. One way to test these theories is to examine the forecasts collected by surveys to see if people make serious forecasting errors. When this was done in the early 1980s, the results were pretty convincing—people’s inflation forecasts were clearly biased. People seemed to be making forecasts of inflation that were far too low. Even when inflation turned out to be higher than expected, people are very slow to change their forecasts. Most misperception theories relied on people forming rational expectations. In response, some classical economists simply argued that the surveys of forecasts weren’t adequate. Classical economists argued that the people who provided their forecasts for surveys didn’t have a strong incentive to forecast rationally. They weren’t investors with money at risk if their forecasts turned out to be wrong. And even if they did have money on the line, they might not have provided their true forecasts to the surveys. But these complaints about the surveys by classical economists weren’t necessary, as there is an alternative explanation for the lack of rationality in the survey forecasts. The result that forecasts aren’t rational is entirely because of the experience of the 1970s. For example, if you look at forecast survey data from the 1980s, the forecasts look quite good. But in the 1970s, the US and Canadian economies were hit by two major oil price shocks, which caught everyone by surprise. Then-current economic theories had no predictions about the response of output and inflation to an oil price shock, so forecasters did not forecast well. But the economic theories were then extended to deal with oil price shocks, and if you look at forecasts in 1986 and 1990 when there were substantial changes in the price of oil, the forecasts performed very well. . 200

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1.

The main feature of the classical IS-LM model that distinguishes it from the Keynesian IS-LM model is the classical model’s assumption that prices adjust quickly to restore equilibrium. Keynesians assume that prices are slow to adjust to restore equilibrium. The distinction is of practical importance because classicals are less likely than Keynesians to recommend government intervention to restore equilibrium.

The two main components of any theory of the business cycle are (1) a specification of the types of shocks or disturbances that are believed to be the most important in affecting the economy and (2) a model of the macroeconomy that describes how key variables respond to these economic shocks. In the real business cycle theory, productivity shocks are the primary source of cyclical fluctuations. The model of the economy is the classical IS-LM model.

A real shock is a disturbance to the real side of the economy that affects the IS curve or the FE line. A nominal shock is a disturbance to money supply or money demand that affects the LM curve. Real shocks include changes in the production function, in the size of the labour force, in the real quantify of government purchase, or in the spending and saving decisions of consumers. Real business cycle theorists consider shocks to the production function to be the most important. These include the development of new products or production methods, the introduction of new management techniques, changes in the quality of capital or labour, changes in the availability of raw materials or energy, unusually good or unusually bad weather, and changes in government regulations affecting production.

RBC theory is successful at explaining that employment is procyclical, that average labour productivity is procyclical, that the real wage is mildly procyclical, and that investment is more volatile than consumption, it is not so successful at measuring or identifying the productivity shocks that have caused business cycle fluctuations, or at explaining why unemployment occurs in downturns.

The Solow residual is the most common measure of productivity shocks. It is strongly procyclical, rising in expansions and declining in contractions. The Solow residual changes when total factor productivity changes, when capital utilization changes, and when labour utilization changes.

The increase in government purchases does not affect labour demand, but causes an increase in labour supply at any given real wage. This occurs because workers are poorer due to the current or future taxes they must pay to finance the increased government spending. Since labour demand is unchanged but labour supply increases, the real wage declines and employment rises. The rise in employment raises output in the economy. If the shift in the FE line is much smaller than the shift in the IS curve, the combination of shifts to the right in the FE line and IS curve also leads to a rise in the real interest rate and the price level.

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According to classical economists, fiscal policy should not be used to smooth out the business cycle because free markets produce efficient outcomes without government intervention, and because imperfect knowledge of the economy, political constraints on policy actions, and time lags make such stabilization policies impractical. Reverse causation means that expected future increases in output cause increases in the current money supply, and expected future decreases in output cause decreases in the current money supply. It may occur, for example, because businesses increase their money demand for transactions before they increase output. It is intended to explain the fact that money is procyclical and a leading variable in the context of a model in which money is neutral.

According to the misperceptions theory, an increase in the price level fools producers of goods into producing more, because they are unable to tell whether the increase in prices is a relative price increase or a rise in the general price level. The change in prices must be unexpected for this to occur, because to the extent that the price change was expected, producers would not be fooled into changing production.

In the classical model, money is neutral in both the short run and the long run. This is modified in the misperceptions theory in that anticipated monetary changes are neutral in the short run, but unanticipated monetary changes are not neutral in the short run. Both anticipated and unanticipated monetary changes are neutral in the long run.

10. Rational expectations means that the public’s forecasts of various economic variables are based on reasoned and intelligent examination of available economic data. If the public has rational expectations, the central bank will not be able to surprise the public systematically, and so it cannot use monetary policy to stabilize output.

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Numerical Problems 1.

a. Labour supply is given by the equation NS = 45 + 0.1w. Before the shock, labour demand is determined by the equation w = 1.0(100 – N). Setting labour supply equal to labour demand by substituting the labour demand equation into the labour supply equation gives N = 45 – 0.1w = 45 + [0.1 x 1.0(100 – N)] = 45 + 10 – 0.1N, or 1.1 N = 55, so N = 50. Then w = 1.0(100 – N) = 50. Output is Y = 1.0[(100 × 50) – (0.5 × 502)] = 3750. After the shock, repeating the above steps gives N = 45 + 0.1 w = 45 + [0.1 x 1.1(100 –N)] = 45 + 11 – 0.11N, or 1.11 N = 56, so N = 50.45. Then w = 1.1(100 – N) = 54.505. Output is Y = 1.11100 × 50.45) – (0.5 × 50.452)] = 4150. b. Now NS = 10 + 0.8w. Before the shock, N = 10 – 0.8w = 10 – [0.8 x 1.0(100 – N) = 10 + 80 – 0.8N, or 1.8N = 90, so N = 50. Then w = 1.0(100 – N) = 50. Output is Y = 1.0[(100 x 50) – (0.5 /. 502)] = 3750. After the shock, N = 10 + 0.8w = 10 + [0.8 x 1.1(100 – N)] = 10 + 88 – 0.88N, or 1.88N = 98, so N = 52.13. Then w = 1.1(100 – N) = 52.66. Output is Y = 1.1[(100 x 52.13) – (0.5 x 52.132)] = 4240. c. If the real wage is only slightly procyclical, then a flat labour supply curve, corresponding to the labour supply curve in part (b) is necessary, rather than a steep labour supply curve as in part (a). Figure 11.3 illustrates the difference in slopes of the two labour supply curves. A calibrated RBC model would fit the facts better if the labour supply curve were flat, that is, labour supply is sensitive to the real wage, as in part (b).

Figure 11.3

The IS curve gives Y = C + I + G = 600 + 0.5 (Y – T) – 50r + 450 – 50r + G = 1050 – 100r + 0.5Y – 0.5T + G, or 0.5Y = 1050 -100r - 0.5T + G, or Y = 2100 -200r + T + 2G. The LM curve gives M/P = L = 0.5Y – 100i = 0.5Y – 100 (r + πe) = 0.5Y -100r 5. a. M = 4320, G = T = 150. The IS curve is Y = 2100 - 200r –T + 2G = 2100 - 200r -150 + (2 x 150) = 2250 -200r. Output must be at its full-employment level of 2210. From the IS curve, 2210 = 2250 – 200r, or 200r = 40, so r = 0.20. Using this in the IM curve to find the price level gives M/P = 0.5Y – 100r – 5, or 4320 / P = (0.5 × 2210) – (.100 × 0.20) – 5. so P = 4320 / (1205 – 20 – 5) = 4320 / 1080 = 4. Then consumption is C = 600 + 0.5 (Y – T) – 50r = 600 + 0.5(2210 – 150) – (50 x 0.20) = 600 + 1030 – 10 = 1620. Investment is / = 450 – 50r = 450 – (50 × 0.20) = 440.

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b. When M increases to 4752, nothing in the IS curve is affected, so Y and r are the same as in part (a), as are C and I. The LM curve becomes 4752 / P = 1080, or P = 4.4. No real variables are affected, and the price level rises 10% just as the money supply did, so money is neutral. c. When G = T = 190, the IS curve shifts. It becomes Y = 2100 – 200r – T + 2G = 2100 – 200r – 190 + (2 x 190) = 2290 – 200r. With Y = 2210, this gives 2210 = 2290 – 200r, or 200r = 80, so r = 0.40. From the LM curve, 4320 / P = 0.5Y – 100r – 5 = (0.5 x 2210) – (100 x 0.40) – 5 = 1105 – 40 – 5 = 1060, so P = 4320 / 1060 = 4.075, C = 600 + 0.5(Y – T) – 50r = 600 + 0.5 (2210 – 190) – (50 x 0.40) = 600 + 1010 – 20 = 1590. 450 – 50r = 450 – (50 x 0.40) = 430. Fiscal policy is not neutral since the change in policy has real effects on the interest rate, consumption, and investment. 3.

The IS curve is found by setting desired saving equal to desired investment. Desired saving is Sd = Y – Cd – G = Y – [1275 + 0.5 (Y – T) – 200r] – G. Setting Sd = Id gives Y – [1275 + 0.5(Y –T) – 200r] – G = 900 – 200r, or Y = 4350 – 800r + 2G – T. The LM curve is M/P = L = 0.5Y – 200i = 0.5Y – 200(r + π) = 0.5Y – 200r. a. T = G = 450, M = 9000. The IS curve gives Y = 4350 – 800r+2G – T = 4350 – 800r + (2 × 450) – 450 = 4800 – 800r. The LM curve gives 9000/P = 0.5Y – 200r. To find the aggregate demand curve, eliminate r in the two equations by multiplying the LM curve through by 4 and subtracting the IS curve from it. LM: 9000 / P = 0.5Y 200r. Multiplying by 4 gives 36 000 / P = 2Y – 800r. IS: Y = 4800 – 800r. LM – IS = AD: (36,000 / P) – Y = 2Y – 800r – 4800 + 800r, or (36 000 / P) + 4800 = 3Y, or Y – 1600 + (12 000 / P) With Y = 4600 at full employment, the AD curve gives 4600 = 1600 + (12 000 / P), or P = 4. From the IS curve Y = 4800 – 800r, so 4600 = 4800 – 800r, or 800r = 200, so r = 0.25. Consumption is C = 1275 + 0.5(Y – T) – 200r = 1275 + 0.5(4600 – 450) – (200 x 0.25) = 3300. Investment is / = 900 – 200r = 900 – (200 x 0.25) = 850. b. Following the same steps as above, with M = 4500 instead of 9000, gives the aggregate demand curve AD. Y = 1600 + (6000 / P). With Y = 4600, this gives P = 2. Nothing has changed in the IS equation, so it still gives r = 0.25. And nothing has changed in either the consumption or investment equations, so we still get C = 3300 and / = 850. Money is neutral here, as no real variables are affected and the price level changes in proportion to the money supply. c. T = G =330, M = 9000. The IS curve is Y = 4350 = 800r + 2G – T = 4350 – 800r + (2 x 330) – 330 = 4680 - 800r LM: 36 000 / P = 2Y – 800r IS: Y = 4680 – 800r LM - IS = AD: (36 000 / P) – Y = 2Y – 800r - 4680 + 800r, or (36 000 / P) + 4680 = 3Y, or Y = 1560 + (12 000 / P) With Y = 4600 at full employment, the AD curve gives 4600 = 1560 – (12 000 / P), or P – 3.95. From the IS curve, Y = 4680 – 800r, so 4600 = 4680 – 800r, or 800r = 80. so r = 0.10. Consumption is C = 1275 – 0.5(Y – T) – 200r = 1275 – 0.5(4600 – 330) – (200 x 0.10) = 3390. Investment is / = 900 – 200r = 900 – (200 x 0.10) + 880.

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AD: Y = 300 + 30(M / P), AS: Y = 500 + 10(P – Pe) M = 400. a. Pe = 60. Setting AD = AS to eliminate Y, we get 300 + 30(M / P) = 500 + 10(P – Pe). Plugging the values of M and Pe gives 300 + (30 x 400 / P) = 500 + 10(P – 60), or 300 + (12 000 / P) = 500 + 10P – 600, or 400 + (12 000 / P) = 10P. Multiplying this equation through by P / 10 gives 40P + 1200 = Pe, or Pe – 40P 1200 = 0. This can be factored into (P – 60)(P + 20) = 0, P can’t be negative, so the only solution to this equation is P = 60. At this equilibrium P = Pe, so Y = 500, and the economy is at full-employment output. b. With an unanticipated increase in the money supply to M = 700; the expected price level is unchanged at Pe = 60. The aggregate demand curve is Y = 300 + 30(M / P) = 300 + (30 x 700 / P) = 300 + (21 000 / P). The aggregate supply curve is Y = 500 + 10(P – Pe) = 500 + 10( P – 60) = 10P - 100. Setting AD = AS to eliminate Y gives 300 + (21 000 / P) = 10P – 100, or 400 – (21 000 / P) = 10P, or P – 40 – (2100 / P) = 0. Multiplying through by P gives Pe – 40P – 2100 = 0. This can be factored as (P – 70)(P – 30) = 0, which has the positive solution P = 70. From the AD curve, Y = 300 – (21 000 / P) = 300 (21 000 / 70) = 600. c. When M – 700 and is anticipated P = Pe. Then the AD curve is Y = 300 + (21 000 / P) and the AS curve is Y = 500. Setting AD = AS gives 500 = 300 + (21 000 / P, which has the solution P = 105.

a. To find the Solow residual, use the equation for the production function, dividing through to solve for A: A = Y / K0.3N0.7. Assuming there’s no change in utilization rates, this is the measured Solow residual. Given that equation, plugging in the values for Y, K, and N, gives the Solow residual as 1.435 in 2011 and 1.507 in 2012. The growth rate of the Solow residual is [(1.507/1.435) − 1] x 100% = 5.0%. b. With no change in utilization rates, the growth rate of the Solow residual equals the growth rate of productivity (A), 5.0%. c. With a change in utilization rates, the production function is modified, as shown in Eq. (11.2). Now productivity is measured as A = Y / (uKK)0.3(uNN)0.7 but the Solow residual is still measured as in part (a). Setting uN = 1 in year 2011 and 1.03 in year 2012, we calculate the value of A as 1.435 in 2011 (as in part a), and 1.476 in 2012. This is an increase in productivity of [(1.476/1.435)−1] x100% = 2.9%, significantly less than the 5.0% increase in the Solow residual.

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d. Setting uN = 1 in year 2011 and 1.03 in year 2012, and uK = 1 in year 2011 and 1.03 in year 2012, we calculate the value of A as 1.435 in 2011 (as in part a), and 1.463 in 2012. This is an increase in productivity of [(1.463/1.435) − 1] x 100% = 2.0%, again significantly less than the 5.0% increase in the Solow residual. This problem illustrates the idea that the measured Solow residual grows faster than productivity when the utilization rates of capital and labour increase. Figure 11.4

An example is shown in Figure 11.4. There are several long cycles in output.

a. With an unemployment rate of 8%, there are initially 0.8 million unemployed and 9.2 million employed. Since 1% of the employed become unemployed, 9.2 million x 0.01 = 92 000 move from employment to unemployment each month. Since 19% of the unemployed become employed, 0.8 million x 0.19 = 152 000 from unemployment each month. Since the same number move from employed to unemployed is smaller than the number moving from unemployed to employed, the unemployment rate will fall to 7.4% in February and to 6.92% in March. b. Note: All amounts are in millions. April: Employed (E) to Unemployed (U):9.308 x 0.03 = 0.279. U to E is 0.692 x 0.19 =0.13148. So U = 0.692 + 0.279 – 0.13148 = 0.840. The unemployment rate (u) = 8.4%. May: E to U: 9.16x 0.01 =0.0916. U to E is 0.84 x 0.19 = 0.1596. So U = 0.84 + 0.0916 – 0.1596 = 0.772 and u = 7.72%. June: E to U: 9.228 x 0.01 = 0.09228. U to E is 0.772 x 0.19 = 0.14668. So U = 0.772 + 0.09228 – 0.14668 = 0.7176 and u = 7.176%. July: E to U: 9.2824 x·0.01 = 0.092824. U to E is 0.7176 x 0.19 = 0.136344. So U = 0.7176 + 0.092824 – 0.136344 = 0.67408 and u = 6.7408%.

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Analytical Problems 1.

a. The increase in MPKf leaves aggregate supply unchanged, since expected future labour income and expected future wages are unchanged. But aggregate demand increases, because firms increase investment, shifting the IS curve up. There is no shift in either the LM curve or the FE line. Figure 11.5(a) shows that the increase in aggregate demand causes no change in output, since the AS curve is vertical, but the price level increases. Figure 11.5(b) shows the shift to the right in the IS curve from IS1 to IS2. To get the economy to equilibrium, the price level rises so that the LM curve shifts from LM1 to LM2. The real interest rate increases as a result. In the labour market, there is no change in labour demand or supply, so employment and output are unchanged. Since the real interest rate rises, saving increases and consumption declines. Since investment equals saving, investment also rises.

Figure 11.6

b. The misperceptions theory gets a different result. As shown in Fig. 11.6. the shift in the aggregate demand curve from AD1 to AD2 increases both output and the price level as the economy moves along the short-run aggregate supply curve SRAS. The difference in this result compared to the result in part (a) comes from producers misperceiving the change in the price level as a change in relative prices, and increasing their labour demand and output. Figure 11.5

a. In the case of a permanent increase in government purchases, the income effect on labour supply, which arises because the present value of taxes increases to pay for the added government spending, is much higher than in the case of a temporary increase in government spending. So workers increase their labour supply more when the government spending change is permanent than when it is temporary. b. Desired national saving is unaffected . 207

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by the change in government spending if the change in consumption is just equal to the change in taxes, so there is no shift in the saving curve. If investment is also unaffected by the change in government spending, then the IS curve does not shift. c. Figure 11.7 shows the effect of the increase in government purchases on the economy. The FE line shifts to the right from FE1 to FE2 due to the increase in labour supply. To restore equilibrium, the price level must decline to shift the LM curve from LM1 to LM2. So output rises and the real interest rate declines. If consumption falls less than the increase in government purchases, the IS curve shifts up from IS1 to IS2 in Fig. 11.8. As a result of the shift in the IS curve, the real interest rate and the price level will fall by less than in the case in which current consumption falls by 100, and in fact, the real interest rate and the price level may even rise if the IS curve shifts by a lot, as shown in the figure. 3.

The temporary increase in government purchases causes an income effect that increases workers’ labour supply. This results in an increase in the fullemployment level of output from FE1 to FE2 in Fig. 11.9. The increase in government purchases also shifts the IS curve up and to the right from IS1 to IS2, as it reduces national saving. Assuming that the shift to the right in the IS curve is larger than the shift to the right in the FE line, the price level must rise to get back to equilibrium at full employment, by shifting the LM curve up and to the left from LM1 to LM2. The result is an increase in output and the real interest rate. Figure 11.10 shows the impact on the labour market. Labour supply shifts from NS1 to NS2, leading to a decline in the real wage and a rise in employment. Average labour productivity declines, since employment rises while capital is fixed. Investment declines, since the real interest rate rises.

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Figure 11.8

Figure 11.9

Figure 11.10

Chapter 11: Classical Business Cycle Analysis: Market-Clearing Macroeconomics

To summarize, in response to a temporary increase in government purchases, output, the real interest rate, the price level, and employment rise, while average labour productivity and investment decline. a. The business cycle fact is that employment is procyclical. The model is consistent with this fact, since employment rises when government purchases rise, causing output to rise. b. The business cycle fact is that the real wage is mildly procyclical. The model is inconsistent with this fact, since it shows a decline in the real wage when government purchases rise and output rises. c. The business cycle fact is that average labour productivity is procyclical. The model is inconsistent with this fact, since it shows a decline in average labour productivity when government purchases rise and output rises. d. The business cycle is that investment is procyclical. The model is not consistent with this fact. as investment falls when government purchases rise and output rises. e. The business cycle is that the price level is procyclical. The model is consistent with this fact, as the price level rises when government purchases increase and output increases. 4.

a. An increase in expected future output increases money demand, so the LM curve shifts up. As shown in Fig. 11.11, the upward shift in the LM curve from LM1 to LM2 leads to a decline in the price level so that the equilibrium in the economy can be restored by shifting the LM curve from LM2 to LM3. So the price level declines. b. If the Bank of Canada wants to stabilize the price level, then it increases the money supply in response to the increase in money demand, so that the LM curve shifts from LM2 to LM3 without a decline in the price level. This represents reverse causation, because the rise in future output causes the current money supply to increase. It might appear that the rise in the current money supply caused the rise in future output because of this timing, but in fact the reverse is true.

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Figure 11.11

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Expressing real terms in trillions of widgets, the real money demand of both countries taken together before unification is (0.10 x 2) + (0.40 x 1) = 0.6. The total output of the two countries is 3 trillion. So real money demand is 20% of output. After unification, real money demand falls to 10% of output. So real money demand falls by one half. As Fig. 11.12 shows, this decline in real money demand causes the LM curve to shift from LM1 to LM2. To restore fullemployment equilibrium, the price level must rise to shift the LM curve up from LM2 to LM3. Since this is the same LM curve as at the start, and since the nominal money supply has not changed, the reduction of Figure money demand by one half means the 11.12 price level must double. The answer does not change if we use the misperceptions theory, because the change in the price level should be completed anticipated. To offset the fall in money demand due to the currency swap, the central bank could decrease the nominal money supply by 50%, so that the LM curve would not shift and there would be no change in the price level.

The temporary wage tax has a small income effect but a large substitution effect, so labour supply is reduced. As Fig. 11.13 shows, this increases the (pretax) real wage rate and reduces employment. The reduction in employment shifts the FE line from FE1 to FE2 in Fig. 11.14, while the increase in government purchases shifts the IS curve from IS1 to IS2. To restore equilibrium, where IS, LM, and FE intersect, the price level must rise. so that the LM curve shifts from LM1 to LM2. The result is an increase in the real interest rate and a decline in output.

Figure 11.13

Figure 11.14

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Goals of Chapter 12 A. Present the central ideas of Keynesian macroeconomics 1. Wages and prices are rigid or “sticky” and do not adjust quickly to restore general equilibrium 2. The economy may be in disequilibrium for long periods of time 3. The recession is not an optimal response of the free market to an aggregate demand shock; rather, it is a disequilibrium in which high unemployment reflects an excess supply of labour 4. Therefore, the government should act to stabilize the economy B. Discuss the potential causes of wage and price rigidity

II.

Notes to Eighth Edition Users A. A new section on “How Large is the Fiscal Policy Multiplier?” has been added to Section 12.5. B. A new Figure 12.6 has been added.

TEACHING NOTES I.

Real wage, W/P

Nominal-Wage Rigidity (Sec. 12.1) A. The Keynesian model of nominal wage rigidity suggests that nominal wages are slow to adjust to changes in the labour market conditions because firms and workers sign nominal wage contracts 1. The labour contracts specify the nominal wage and not the real wage 2. The contracts specify employment conditions and nominal wages for an extended period 3. Since the multi-period wage NS contracts are signed before the future state of the economy is known, both firms and workers must form an expectation of ND what they believe will happen to prices during the duration of Labour, N the contract B. The short-run aggregate supply curve with labour contracts 1. Canadian labour contracts Figure 12.1 usually specify employment conditions and the nominal wage rate for one to three years 2. Employers decide on workers’ hours and must pay them the contracted nominal wage 3. As long as the price level that is observed during the period of the nominal contract is equal to what both sides of the wage negotiation Expected to observe when they negotiated the contract, the real wage will clear the labour market and full employment will result. (Fig 12.1; like text Fig. 12.1) 4. The result is an upward-sloping short-run aggregate supply curve (Fig 12.2; like text Fig. 12.2) a. As the price level rises, the real wage declines, since the . 211

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nominal wage is fixed As the real wage declines, firms hire more workers and thus increase output

Figure 12.2

e. C.

The positive relationship between output supplied and the price level resulting from the nominal wage contracts is captured by equation Y = Y – b(P – Pe) (12.1) In the nominal wage rigidity model actual output deviates from the full-employment level because P differs from Pe and the labour contract prevents adjustment of the negotiated nominal wage until the contract expires Thus, the actual output will differ from full-employment output for the term of the labour contract

Price expectations and the Keynesian short-run aggregate supply curve 1. Equation (12.1) implies that there is different SRAS for every expected price level 2. The is so because a. The need to sign a contract that commits them to a nominal wage for a number of years into the future, firms and workers must form an expectation of what they believe will be the level of prices in the future b. The nominal wage rigidity model assumes that firms and workers form a rational price expectation c. Firms and workers calculate rational price expectations based on where they expect to observe the location of the aggregated demand curve during the period of the nominal wage contract d. An expected change in the location of the aggregate demand curve will alter firms’ and workers’ expectations of the price level and hence, alter the position of the SRAS

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Theoretical Application The idea that nominal wage contracts lead to a fixed nominal wage in a theoretical Keynesian model was developed by Stanley Fischer, “Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule,” Journal of Political Economy, February 1977, pp. 191–205, and John B. Taylor, “Aggregate Dynamics and Staggered Contracts,” Journal of Political Economy, February 1980. pp. 1–23. But empirical analysis casts doubt on the theory. Using data on Canadian industries, Shaghil Ahmed, “Wage Stickiness and the Non-neutrality of Money: A Cross-Industry Analysis,” Journal of Monetary Economics, 1987, pp. 25–50, shows that industries in which wages have a higher degree of indexation to the price level do not have a markedly lower output response to nominal shocks, as would be suggested by a contracting model. II.

Monetary and Fiscal Policy in the Keynesian Model (Sec. 12.2) A. Monetary policy 1. The Keynesian model a. The short-run equilibrium (1) The equilibrium output in the short-run is determined at the intersection of the IS and LM curves and the AD and SRAS curves (2) In the short-run, the economy can be off the FE line and LRAS curve because the actual price level differs from what was expected when nominal wage contracts were signed b. The long-run equilibrium (1) In the long-run, old wage contracts expire and the nominal wage is renegotiated on the basis of an updated rational Figure 12.3 expectation of the price level and is intended to generate a real wage desired by the firms and workers

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(2)

Thus, in the long-run, the real wage and employment return to market clearing levels and output returns to the fullemployment level (3) The adjustment of the expected price level causes the LM and SRAS curves to restore the general equilibrium with fullemployment output (4) The equilibrium output in the long-run, then, is determined at the intersection of the IS and LM curves and the FE line in the IS-LM diagram, and the AD, SRAS, and LRAS curves in the AD-AS diagram c. Fig. 12.3 (like text Fig. 12.3) shows the short-run and long-run equilibrium output, interest rate and the price level Numerical Problem 2 and Analytical Problems 1 and 2 use the IS-LM and AD-AS diagram 2.

Anticipated monetary policy a. Anticipated changes in money supply have no effect on real variables (1) Labour market participants adjust their expected price level as soon as they learn of the planned change in the money supply (2) The negotiated nominal wage contracts fully reflect the expected change in the price level caused by the anticipated change in the aggregate demand (3) Thus, there is no change in the real wage and, hence, no change in employment and output b. In terms of the IS-LM and AD-AS diagram, the position of the LM curve and, hence, the position of the AD curve is determined by the anticipated level of the money supply (1) When the change in money supply is anticipated, employers and workers will identify a rational price expectation such that the anticipated position of the AD curve intersects the LRAS curve at full-employment output (2) Therefore, if the changes in money supply are anticipated by the labour market participants, they will have no real effects

Unanticipated monetary policy a. Short-run effects (1) An unanticipated increase in the nominal money supply shifts the LM curve down and to the right and shifts the AD curve up and to the right (2) These shifts raise output, raise the price level above what was expected at the time when the labour contracts were signed, and lower the real interest rate in the short run (3) Output rises in the short run because (a) The price level is higher than what was expected . 214

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(b) Given that the nominal wage is fixed by the labour contract, the real wage lower than expected (c) Firms respond to the lower wage rate by hiring more workers and hence by expanding output b.

Long-run effects (1) Eventually the labour contract expires and the labour market participants adjust their expectations of the price level (2) The adjustment to the higher expected price level and the expiry of the old labour contract means that firms and workers negotiate a new, higher, nominal wage (3) The newly negotiated nominal wage yields an expected real wage that clears the labour market and restores the full-employment level of output (4)

Monetary expansion raises the price level proportionally but has no real effects in the long run Thus, the Keynesian model of nominal wage rigidity predicts that money is not neutral in the short run but is neutral in the long run

Theoretical Application Some Keynesians disagree with the view presented in the textbook that a change in monetary policy has no effect on the long-run aggregate supply curve. J. Bradford DeLong and Lawrence H. Summers. “How Does Macroeconomic Policy Affect Output?” Brookings Papers on Economic Activity 2:1988, pp. 433–480, argue that macroeconomic stabilization policy, including monetary policy, can change the full-employment rate of output. They cite data showing the asymmetric response of output to policy changes, suggesting that better stabilization policies can increase the average level of output.

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Fiscal policy 1. The effects of anticipated and unanticipated fiscal expansion are shown in Fig. 12.4 (like text Fig.12.4) 2. Anticipated fiscal policies a. An anticipated fiscal policy will cause labour market participants to adjust their expectations of the price level b. Firms and workers will negotiate a nominal wage contract that leaves the real wage unaffected by the anticipated price change c. Thus, anticipated fiscal policies will have no effect on real variables

Figure 12.4

Unanticipated fiscal policies a. The short-run effects (1) An unanticipated increase in government spending or a tax cut shifts the IS and AD curves up and to the right (2) These shifts raise output, raise the price level above what was expected, and raise the real interest rate in the short run b. The long-run effects (1) Firms and workers adjust their expectations of the price level (2) Newly negotiated nominal wage contracts reflect the adjustment in the expected price level and therefore yields the desired real wage which clears the labour market (3) Thus, in the long run, output returns to the full-employment level but the real interest rate increases

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Unanticipated fiscal policy is not neutral in the long run because it affects the real interest rate and, hence, the composition of output between consumption, investment, and government purchases

The effect of lower taxes a. Keynesians believe that a reduction of (lump-sum) taxes is expansionary, just like an increase in government purchases b. Keynesians reject Ricardian equivalence, believing that the reduction in taxes increases consumption spending, reducing desired national saving and shifting the IS curve up c. The only difference between lower taxes and increased government purchases is that when taxes are lower, consumption increases as a percentage of full-employment output, whereas when government purchases increase, government purchases become a larger percentage of fullemployment output

Comparing fiscal and monetary policy in the Keynesian model 1. Fiscal and monetary policies are both referred to as aggregate demand policies because both policies affect the position of the aggregate demand curve 2. Anticipated fiscal and monetary policies have no effect on the real variables 3. By contrast, unanticipated fiscal and monetary policies both affect output and employment in the short run 4. While an unanticipated monetary policy is neutral in the long run, an unanticipated fiscal policy is not 5. Monetary and fiscal policies affect the composition of spending differently

Numerical Problem 3 looks at fiscal policy and monetary policy in the Keynesian AD-AS framework. III.

Criticisms of the Nominal-Wage Rigidity Assumption (Sec. 12.3) A. There have been several objections to the Keynesian theory of nominal wage rigidity 1. Less than one-third of the Canadian labour force is unionized and covered by long-term wage contracts; however, some nonunion workers get wages similar to those in union contracts, and other workers may have implicit contracts that act like long-term contracts 2. Some labour contracts are indexed to inflation, so the real wage is fixed, not the nominal wage; however, most contracts aren’t completely indexed 3. The theory predicts that real wages will be countercyclical, but in fact they are procyclical; however, if there are both aggregate supply shocks and aggregate demand shocks, real wages may turn out on average to be procyclical, but could still be countercyclical for demand shocks B. In response to the criticisms, Keynesians suggest a theory of price rigidity . 217

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to supplement the theory of wage rigidity IV.

Price Stickiness (Sec. 12.4) A. Price stickiness is the tendency of prices to adjust slowly to changes in the economy 1. Keynesians developed the nominal price rigidity model to explain the evidence of a procyclical movement of real wages while retaining the result that aggregate demand shocks play an important role in explaining business cycles 2. Like the nominal wage rigidity model and the classical model with misperceptions, the nominal price rigidity model also predicts that unanticipated aggregate demand shocks affect real output in the short run but are neutral in the long run B.

Sources of price stickiness: Monopolistic competition and menu costs 1. Monopolistic competition a. If markets had perfect competition, the market would force prices to adjust rapidly; sellers are price takers, because they must accept the market price b. In many markets, sellers have some degree of monopoly; they are price setters under monopolistic competition c. Keynesians suggest that many markets are characterized by monopolistic competition d. In monopolistically competitive markets, sellers do three things (1) They set prices in nominal terms and maintain those prices for some period (2) They adjust output to meet the demand at their fixed nominal price (3) They readjust prices from time to time when costs or demand change significantly e. Menu costs and price setting (1) The term menu costs comes from the costs faced by a restaurant when it changes prices—it must print new menus (2) Even small costs like these may prevent sellers from changing prices often (3) Since competition isn’t perfect, having the wrong price temporarily won’t affect the seller’s profits much (4) The firm will change prices when demand or costs of production change enough to warrant the price change

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Theoretical Application One of the first articles to present the combination of monopolistic competition and menu costs as the cause of price stickiness was N. Gregory Mankiw, “Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly,” Quarterly Journal of Economics, May 1985. pp. 529–537. f.

Empirical evidence on price stickiness (1) Studies involving interviews have concluded that almost half of firms change prices once a year or less (Blinder) (2) Other studies suggest that prices are quite flexible (Bils and Klenow on average time between price changes among 350 categories of goods) (3) Results from Bils and Klenow is due in part to firms temporarily adjusting prices for sales (Nakamura and Steinsson) (4) Prices of many goods are very sticky in response to monetary policy shocks but more flexible in response to shocks to supply and demand that affect the relative price of the good compared with other goods (Boivin and Giannoni) (5) The low pass-through of changes in the exchange rate to Canadian dollar prices of import goods may be evidence of price stickiness. A similar phenomenon was found for export prices (Schembri) Meeting the demand at the fixed nominal price (1) Since firms have some monopoly power, they price goods at a markup over their marginal cost of production: P = (1 + η)MC (12.3) (2) If demand turns out to be larger at that price than the firm planned, the firm will still meet the demand at that price, since it earns additional profits due to the markup (3) Since the firm is paying an efficiency wage, it can hire more workers at that wage to produce more goods when necessary

Theoretical Application The major articles underlying Keynesian theory are collected in the volume New Keynesian Economics, edited by N, Gregory Mankiw and David Romer, Cambridge, Massachusetts: MIT Press, 1991. The main topics covered are costly price adjustment, the staggering of wages and prices, imperfect competition, coordination failures, the labour market, the credit market, and the goods market.

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(4)

This means that the economy can produce an amount of output that is not on the FE line during the period in which prices haven’t adjusted

The Keynesian Theory of Business Cycles and Macroeconomic Stabilization (Sec. 12.5) A. Keynesian business cycle theory 1. Keynesians think aggregate demand shocks are the primary source of business cycle fluctuations 2. Aggregate demand shocks are shocks to the IS or LM curves, such as fiscal policy, changes in desired investment arising from changes in the expected future marginal product of capital, changes in consumer confidence that affect desired saving, and changes in money demand or supply 3. A recession is caused by a shift of the aggregate demand curve to the left, either from the IS curve shifting down, or the LM curve shifting up 4. The Keynesian theory fits certain business cycle facts a. There are recurrent fluctuations in output b. Employment fluctuates in the same direction as output c. Money is procyclical and leading d. Investment and durable goods spending is procyclical and volatile (1) This is explained by the Keynesian model if shocks to investment and durable goods spending are a main source of business cycles (2) Keynes believed in “animal spirits,” waves of pessimism and optimism, as a key source of business cycles e. Inflation is procyclical and lagging (1) The Keynesian model fits the data on inflation, because the price level declines after a recession has begun, as the economy moves toward general equilibrium 5. Procyclical labour productivity and labour hoarding a. Labour productivity is procyclical presents problems for Keynesian model. b. As discussed in Section 11.1, firms may hoard labour in a recession rather than fire workers, because of the costs of hiring and training new workers c. Such hoarded labour is used less intensively, being used on make-work or maintenance tasks that don’t contribute to measured output d. Thus, in a recession, measured productivity is low, even though the production function is stable e. So labour hoarding explains why labour productivity is procyclical in the data without assuming that recessions and expansions are caused by productivity shocks

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Macroeconomic stabilization 1. Keynesians (except some new Keynesians) favour government actions to stabilize the economy 2. Recessions are undesirable because the unemployed are hurt

Theoretical Application Several prominent macroeconomists discuss their views of the Keynesian model of business cycles in a symposium in the Journal of Economic Perspectives, Winter 1993. 3.

Suppose there’s a shock that shifts the IS curve down, causing a recession (text Fig. 12.5) a. If the government does nothing, eventually the price level will decline, restoring general equilibrium. But output and employment may remain below their full-employment levels for some time b. The government could increase the money supply, shifting the LM curve down to move the economy to general equilibrium c. The government could increase government purchases to shift the IS curve back up to restore general equilibrium. d. Using monetary or fiscal policy to restore general equilibrium has the advantage of acting quickly, rather than waiting some time for the price level to decline e. But the price level is higher in the long run when using policy than it would be if the government took no action f. Both scenarios return the economy to full employment. i. The choice of monetary or fiscal policy affects the composition of spending ii. An increase in government purchases crowds out consumption and investment spending, because of a higher real interest rate iii. Tax burdens are also higher when government purchases increases, further reducing consumption

Analytical Problem 4 looks at the benefits of using government purchases to combat recessions. Policy Application In The Return of Depression Economics (W.W. Norton, 1994), Paul Krugman argues that the Japanese depression is due to insufficient aggregate demand. He also has a special web page on Japan, web.mit.edu/krugman/www/, where you can read updates on the policy mix in Japan and Krugman’s views. 4.

Difficulties of macroeconomic stabilization a. Macroeconomic stabilization is the use of monetary and fiscal policies to moderate the business cycle; also called aggregate demand management b. In practice, macroeconomic stabilization hasn’t been terribly successful

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c. One problem is in gauging how far the economy is from full employment, since we can’t measure or analyze the state of economy perfectly d. Another problem is that we don’t know the quantitative impact on output of a change in policy e. Also, because policies take time to implement and take effect, using them require good forecasts of where the economy will be six months or a year in the future: but our forecasting ability is quite imprecise Analytical Problem 3 looks at how lags in the effect of policy can influence decisions about how to use policy. f. These problems suggest that policy shouldn’t be used to “fine tune” the economy, but should be used to combat major recessions Policy Application

A general analysis of the possibility of using activist monetary policy, which contrasts the results from classical and Keynesian theories, is Tom Stark and Herb Taylor, “Activist Monetary Policy for Good or Evil? The New Keynesians vs. the New Classicals,” Federal Reserve Bank of Philadelphia Business Review, March/April 1991. 5.

How large is the fiscal policy multiplier? a. Since the 2008-2009 recession, a renewed debate about the size of government expenditure multiplier. b. Government expenditure multiplier depends on the size of the parameters that summarize how households and firms respond to change in economic environment (see Eq. 12.B.7 in Appendix 12.B) c. An increase in G will shift AD from AD1 to AD2 (text Fig. 12.6). d. The multiplier describes the size of the horizontal shift in the AD curve. Once we allow the price level to adjust upward, the multiplier grows smaller. e. The steeper the SRAS, the smaller will be the change in real output resulting from any change in G. f. Using the U.S. economy, Auerbach and Gorodnichenko (2012) found that the government expenditure multiplier varies between values close to zero during period of full employment to a value of 1.5 in periods of recessions. g. Size of multiplier will vary by these parameters: i. Country – smaller multiplier for highly open countries and larger multiplier for country that has adopted a fixed exchange rate (see Chapter 10). ii. Behaviour of the central bank – larger multiplier when the central bank chooses to hold the interest rate constant. iii. Forms of government expenditure – larger multiplier with spending on infrastructure than transfer to individuals.

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Level of government debt – smaller multiplier when government debt exceeds a certain level. h. All these suggest multiplier is not a constant. iv.

IV.

Supply shocks in the Keynesian model 1. Until the mid-1970s, Keynesians focused on demand shocks as the main source of business cycles 2. But the oil price shock that hit the economy beginning in 1973 forced Keynesians to reformulate their theory 3. Now Keynesians concede that supply shocks can cause recessions, but they don’t think supply shocks are the main source of recessions 4. An adverse oil price shock shifts the FE line left (text Fig. 12.6) a. The1 average price level rises, shifting the LM curve left (from LM to LM2), because the large increase in the price of oil outweighs the menu costs that would otherwise hold prices fixed b. The LM curve could shift farther left than the FE line, as in the figure, though that isn’t necessary c. So in the short run, inflation rises and output falls d. There’s not much that stabilization policy can do about the decline in output that occurs, because of the lower level of fullemployment output e. Inflation is already increased due to the shock; expansionary policy to increase output would increase inflation further

A Closer Look 12.1 The Classical-Keynesian Debate and the 2008-2009 Recession 1. One fundamental difference has always been the degree to which a model incorporated microeconomic foundations. 2. For the recession, Keynesians emphasize that the financial crisis highlights the fact that the real world is characterized by imperfections – challenge the assumptions by Classical economists that of perfect information and readily adaptable households and firms. 3. Classical economists point to the fact that aggressive policy does not bring along employment.

Key Diagram 12: The Keynesian Version of the AD-AS Model A. Diagram Elements 1. The Keynesian theory of the business cycle is based on the assumption that workers and firms find it preferable to allow their nominal wages and prices to adjust only occasionally. 2. The short run aggregate supply curve shows the amount of output firms are willing to offer for sale in the short run and its position is determined by the expected price level. 3. In the long run, wages and prices adjust to market clearing level and expected price level equals to the actual price level. B. Factors that Shift the Curves 1. An expected price level increase (decrease) will shift the SRAS up (down). 2. Any factor that increases full employment output shifts both the short run and long run aggregate supply curves.

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Appendix 12.A: Real-Wage Rigidity A. Wage rigidity is important in explaining unemployment 1. In the classical model, unemployment is due to mismatches between workers and jobs 2. Keynesians are skeptical, believing that recessions lead to substantial cyclical employment 3. To get a model in which unemployment persists, Keynesian theory posits that the real wage is slow to adjust to equilibrate the labour market B. Some reasons for real-wage rigidity 1. For unemployment to exist, the real wage must exceed the marketclearing wage 2. If the real wage is too high, why don’t firms reduce the wage? a. One possibility is that the minimum wage and labour unions prevent wages from being reduced (1) But most Canadian workers aren’t minimum wage workers, nor are they in unions (2) The minimum wage would explain why the nominal wage is rigid, but not why the real wage as rigid (3) This might be a better explanation in Europe, where unions are far more powerful b. Another possibility is that a firm may want to pay high wages to get a stable labour force and avoid turnover costs—costs of hiring and training new workers c. A third reason is that workers’ productivity may depend on the wages they’re paid—the efficiency wage model C.

The Efficiency Wage Model 1. Workers who feel well treated will work harder and more efficiently (the “carrot”); this is Akerlof’s gift exchange motive 2. Workers who are well paid won’t risk losing their jobs by shirking (the “stick”) 3. Both the gift exchange motive and shirking model imply that a worker’s effort depends on the real wage (Fig. 12.5; like text Fig. 12.A.1) 4. The effort curve, plotting effort against the real wage, is S- shaped a. At low levels of the real wage, workers make, hardly any effort b. Effort rises as the real wage increases As the real wage becomes very high, effort flattens out as it reaches the maximum possible level

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Wage determination in the efficiency wage model 1. Given the effort curve, what determines the real wage firms will pay? 2. To maximize profit, firms choose the real wage that gets the most effort from workers for each dollar of real wages paid 3. This occurs at point B in Fig. 12.5, where a line from the origin is just tangent to the effort curve 4. The wage rate at point B is called the efficiency wage

Figure 12.5

Figure 12.6

5. The real wage is rigid, as long as the effort curve doesn’t change Employment and Unemployment in the Efficiency Wage Model 1. The labour market now determines employment and unemployment, depending on how far above the market- clearing wage is the efficiency wage (Fig. 12.6; like text Fig. 12.A.2) 2. The labour supply curve is upward sloping, while the labour demand curve is the marginal product of labour when the effort level is determined by the efficiency wage 3. The difference between labour supply and labour demand is the amount of unemployment 4. The fact that there’s unemploy-ment puts no downward pressure on the real wage, since firms know that if they reduce the real wage, effort will decline

Analytical Problem 5 takes a more sophisticated look at the labour market, dividing it into one sector with an efficiency wage and another sector in which the real wage equates labour demand and supply. Numerical Problem 6 looks at the determination of the efficiency wage and employment. VI.

Appendix 12.B: Aggregate Demand Policies and the Position on the Aggregate Demand Curve A. Effect on aggregate demand of a change in the nominal money supply M. 1. Recall from Appendix 9.B we derive an expression for the AD curve: Y=[αIS – αLM + (1/γr)(M/P)]/(βIS + βLM) (12.B.1)

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If the nominal money supply changes by ΔM then the change in output must be: ΔY/ΔM = [(1/γr)(1/P)]/(βIS + βLM) (12.B.3) a. This expression measures the size of the horizontal shift in the AD curve caused by a change in the nominal money supply. Given all parameters are positive, ΔY/ΔM is positive. Effect on aggregate demand of a change in government purchase G. From (12.B.1), the change in output caused by a change in government purchase is equal to ΔY = ΔαIS/ βIS + βLM

(12.B.4)

Rewrite this will yield ΔY/ΔG =1/(βIS + βLM)(cr + ir) a.

(12.B.5)

This expression measures the size of the horizontal shift in the AD curve caused by a change in the size of government purchases. Given all parameters are positive, ΔY/ΔG is positive. It is important to stress that the above calculations assume the price level does not change. The true change in output resulting from a monetary or a fiscal policy will depend on the size of the shift in the AD curve and on the slope of the SRAS curve. Also fluctuations in AD are not solely the result of policy variables. Thus Keynes’ so called “animal spirits” which produce waves of pessimism and optimism affecting c0 and i0 and shock to money demand affecting γ0 also give rise to shifts in AD.

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1.

Do Lags Eliminate the Effectiveness of Fiscal Policy?

Keynesian economists in the past have encouraged the use of fiscal policy to combat recession. They believe that wages and prices do not adjust rapidly enough to bring the economy to full employment in a reasonable period of time without the help of changes in government expenditures. However, fiscal policy takes a long time to be implemented. Can we expect it to be effective in combating recessions? Fiscal policy can’t be changed rapidly. When the economy goes into a recession, we usually don’t know it until several months later. Once a recession has been identified, a program must be devised. The next step is to convince the legislature that the expansionary program is necessary and to gain agreement on its specific provisions. Only once the necessary laws are passed can the program be implemented. Changes in taxes are implemented relatively rapidly, but if changes in expenditures are passed, more time is needed. The government may contract with the private sector, but it must often request and evaluate bids and select someone to administer the program before the funds can be spent. When the government itself supervises the program, new workers must be hired and trained. In either case, a period of several months if not a year or more is required before the program can be implemented. Since 1945, business cycle contractions have average twelve months. To pass through all the stages outlined above and for fiscal policy to take effect seems to exceed the eleven months of an average contraction. Some recessions are even shorter; for example, the 1980 recession lasted only six months, entirely too short a period of time for discretionary fiscal policy to have an impact. In fact, government intervention may actually make the economic situation worse. If a stimulus package is implemented after the recession is over, it may result in upward pressure on prices and encourage a boom and bust cycle rather than long-term sustainable growth. 2.

Do Prices Adjust Slowly?

One of the main differences between Keynesians and classical economists is their disagreement over how quickly prices adjust to changes in the economy. Which point of view seems more in line with what happens in the economy? In some markets, prices do adjust rapidly. This is particularly true in commodity markets such as those for corn and wheat. It is also true for items such as gasoline. While gas stations are individualized by their location and services, prices still change frequently. On the other hand, many prices are changed only infrequently. The text mentions such items as magazines and items sold through catalogues. While the authors point out that the monetary cost of such price changes is generally small, there may be other costs that are more important. Changing prices may encourage rivals to change their prices, too, and thus set off price wars that damage most competitors. The airline industry is noted for frequent price changes and destructive competition. In addition, an increase in price above the customary cost may cause consumers to rethink old habits and move to other products. Your students may wish to discuss whether they side with the Keynesians or the classicals on the question of price rigidity. In looking at price movements, it is probably important that discussants explicitly define which goods’ prices are being discussed, since this may be critical in determining an individual’s point of view. . 227

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3. The Kobe Earthquake and Reconstruction Spending In January 1995 the city of Kobe in Japan was hit by a massive earthquake. Measuring 7.2 on the Richter scale, the earthquake killed over 5000 people and made over 70 000 others homeless. The quake caused a huge amount of economic destruction. Bridges and highways collapsed, office and apartment buildings were destroyed. The total damages to the Japanese economy were huge. Since Kobe is one of Japan’s principal ports, there was a great deal of disruption of international trade. We can think of the Kobe earthquake as a negative supply shock, shifting the FE line down as it reduces the nation’s industrial capacity. In Fig. 12.7 this leads to an immediate inflation as the LM curve shifts up to LM1 and the FE line moves from FE0 to FE1. It is also likely that the effect of the earthquake may have shifted down the IS curve as the uncertainty of future income led to a fall in consumer spending.

Figure 12.7

The government of Japan responded to the earthquake with expansionary measures for Figure 12.6 reconstruction spending. In the short run, these measures are likely to be inflationary, unless accompanied by restrictive monetary policies. However, given a package of measures to encourage private sector rebuilding, in the medium term the return of industrial capacity to its pre-earthquake level will shift out the FE line back to FE0), and increase output to its original level.

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1.

These contracts specify what nominal wages will be paid over the course of the contract. They commit both labour demanders (firms) and labour suppliers (employees) to that wage for the length of the contract. The length of these contracts is typically measured in years rather than months. Keynesians suggest that negotiating nominal wage contracts reflects a sensible saw-off between the interests of employees and the interests of firms. As discussed in Chapter 3, firms are interested in negotiating a nominal wage contract which causes the real wage they pay workers to equal the marginal product of their employees. Employees are interested in negotiating a nominal wage which causes their real wage to equal the rate at which they are willing to trade work for leisure. Firms calculate the real wage relevant to them as the negotiated nominal wage divided by the price of the firm’s output. Employees calculate the real wage relevant to them as the negotiated nominal wage divided by an index of the price of all goods and services produced in the economy. The two sides of the labour bargain, then, have different ideas of what is the appropriate real wage. Firms and employees may therefore find it less costly to negotiate over the nominal wage, as opposed to the real wage, and to do so relatively infrequently.

Wage contracts commit firms and employees to a nominal wage for the length of that contract. Because the contracts commit both sides to a nominal wage in the future, and because both sides are really concerned about the future real wage, they must both form a forecast of what the price level (and, hence, the real wage) will be in the future in order to negotiate the preferred nominal wage. Since it is important that the price level forecast be as accurate as possible, economists assume firms and employees form what is called a rational price expectation. That is, they calculate a price forecast based on a reasoned and intelligent examination of all the available economic data. The result is known as a rational price expectation.

Price stickiness is the tendency of prices to adjust only slowly to changes in the economy. Keynesians believe it is important to allow for price stickiness to explain why monetary policy is not neutral.

Menu costs are the cost of changing prices. Menu costs may lead to price stickiness in. monopolistically competitive markets but not in perfectly competitive markets, because a monopolistically competitive firm’s demand is not as sensitive to the price as is a perfectly competitive firm’s demand. Monopolistically competitive firms may meet the demand at a fixed price when demand increases, because price exceeds marginal cost, so that profits still rise, and because the cost of changing prices may exceed the additional profit earned from doing so. A perfect competitor would lose all of its customers if its price were a little above the price changes by its competitors. But a monopolistically competitive firm would lose only some of its customers in this case.

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In the Keynesian model, money is not neutral in the short run, but it is neutral in the long run. In the short run, an increase in the money supply increases output and the real interest rate, while the price level and real (efficiency) wage are unchanged. In the long run, however, only the price level is changed, with no change in output, the real interest rate, or the real wage. In the basic classical model, money is neutral in both the short run and the long run, so only the price level is affected by a change in the money supply, just as in the long-run Keynesian model. The extended classical model with misperceptions is similar to the Keynesian model. In the short run, an increase in the money supply increases output and the real interest rate, just as in the Keynesian model. However, unlike the Keynesian model, the price level rises, as does the real wage. The long run of the extended classical model is identical to the classical model or the long run of the Keynesian model—only the price revel is affected.

In the Keynesian model in the short run, output and the real interest rate increase due to an increase in government purchases. In the long run, the real interest rate is higher, but output returns to its full-employment level. Since the real interest rate is higher in the long run, investment is lower and consumption is lower.

In response to a recession, policymakers can (1) make no change in macroeconomic policy (2) increase the money supply, or (3) increase government purchases. If they make no change in macroeconomic policy, then during the recession output is below its full-employment level. Over time, the price level will decline to restore equilibrium. In the long run, the price level will be lower and employment will return to the full-employment level. If policymakers increase the money supply, the economy returns to full employment without a change in the price level. The composition of output is the same as when the economy returns to full employment without monetary or fiscal policy. If policymakers increase government purchases, again the economy returns to fullemployment equilibrium without a change in the price level. However, the higher real interest rate caused by the expansionary fiscal policy reduces consumption and investment, and the higher taxes to pay for the government spending also reduce consumption relative to either the situation in which monetary policy is used, or in which there is no policy response at all. There are practical difficulties with increasing the money supply or increasing government purchases to return the economy to full employment. It is difficult to tell how far the economy is below full employment to know the right amount of fiscal or monetary stimulus to apply. We do not know exactly how much output will increase in response to a monetary or fiscal expansion. And since these policies take time to implement and more time to affect the economy, we really need to know where the economy will be six months or a year from now, not just where it is today, but such knowledge is very imprecise.

Employment is procyclical because a contractionary aggregate demand shock reduces both output and employment. Money is procyclical because price stickiness means that an increase in the money supply increases output as the aggregate demand curve moves along the flat, short-run, aggregate supply curve. Inflation is procyclical, because in a recession the price level declines over time to restore general equilibrium. Investment is procyclical for two reasons. First, shifts in the expected future marginal product of capital are important causes of cycles, shifting the IS and AD curves, thus affecting output in the same direction. Also, a shift in the LM curve leads to a change in the real interest rate, moving investment in the same direction as the change in output. . 230

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The Keynesian theory assumes that demand shocks cause most cyclical fluctuations. This means that during expansions when employment rises, average labour productivity declines, so it is countercyclical. But the business cycle fact is that average labour productivity is mildly procyclical. However, if labour hoarding occurs, so that a given measured amount of employment produces less output during recessions and more output during expansions, then measured average labour productivity would be procyclical.

10. In Keynesian analysis, a supply shock may reduce output in two ways: (1) a reduction in output, because the supply shock reduces the marginal product of labour, shifting the FE line to the left; and (2) a further reduction in output if the supply shock is something like an oil price shock that is large enough to cause many firms to raise prices, shifting the LM curve even further to the left than the FE line. Supply shocks create problems for stabilization policy because: (1) policy can do nothing to affect the location of the FE line; and (2) using expansionary policy risks worsening the already-high rate of inflation.

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Numerical Problems 1. a. Setting w = MPN, w = 10 / N N . This is the labour demand curve. b. At W = 20, w = W/P = 20/P. Since labour demand is given by w = 10 / N N , then 20/P = 10 N , N , or 2 N N = P. c. Y = 20 N N = 10P, or P = (1/10) Y, as shown in Fig. 12.7 by the SRAS curve. d. The IS curve is Y = 120 – 500r. The LM curve is M/P = 0.5Y – 500r, which can be rewritten as 500r = 0.5Y – (M / P). Plugging the LM curve into the IS curve to eliminate r gives Y = 120 – 500r = 120 – [0.5Y – (M / P)]. This can be rewritten as 1.5Y = 120 + (M / P). This is the AD curve. With M = 300, the AD curve is 1.5 Y = 120 + (300 / P), or Y = 80 – (200 / P). Figure 12.8 The AD curve is shown in Fig. 12.8. e. To find the intersection of the SRAS curve (Y = 10/P) and the AD curve [Y = 80 + (200 / P)], find the price level such that 10P = 80 + (200 / P). This can be rewritten as 10P2 = 80P – 200 = 0, or as P2 – 8P – 20 = 0. This can be factored as (P – 10)(P + 2) = 0. The nonnegative root is P = 10. At P = 10, from the SRAS curve, Y = 10 P = 10 x. 10 = 100. On the IS curve, 100 = 120 – 500r, or r = 0.04. Since P = 2 N N , or 10 = 2 N N , then N N = 5, or N = 25. The real wage is w = 20/P = 20/10 = 2. f. When the money supply falls to 135, the AD curve becomes 1.5Y = 120 = (135 / P), or Y = 80 = (90 / P). The AD curve intersects the SRAS curve where 10P = 80 = (90 / P). This can be rewritten as 10P2 – 80P – 90 = 0, or P2 – 8P – 9 = 0. This can be factored as (P – 9)(P + 1) = 0, which has the nonnegative solution P = 9. From the SRAS curve, Y = 10P = 10 x 9 = 90. From the IS curve 90 = 120 – 500r, which has the solution r = 0.06. Since P = 2 N N , N = (P/2)2 = 4.52 = 20.25. The real wage is w = W/P = 20/9 = 2 2/9. 2.

The IS curve is found from the equation Y = Cd + Id + G = 130 – 0.5(Y – 100) – 500r – 100 – 500r + 100, or 0.5Y = 280 – 1000r, or Y = 560 – 2000r. The LM curve comes from the equation M/P = L, which in this case is 1320 / P = 0.5Y – 1000r, or Y – (2640/P) + 2000r.

b. At full employment, Y = 500. Using this in the IS curves gives 500 = 560 – 2000r, which has the solution r = 0.03. Plugging the values for Y and r in the LM curve gives 500 = (2640 / P) + (2000 x 0.03), or 440 = 2640 / P, which has the solution P = 6. Then consumption is C = 130 + 0.5(Y – 100) – 500r = 130 + 0.5(500 – 100) – (500 x 0.03) = 315. Investment is / = 100 – (500 x 0.03) = 85. c. If desired investment increases to 200 – 500r, the IS curve shifts from IS1 to IS2 in Fig. 12.9. This can be . 232

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seen in the equation Y = Cd – Id – G = 130 + 0.5(Y – 100) – 500r + 200 – 500r + 100, or 0.5Y = 380 – 1000r, or Y = 760 – 2000r. In the short run, the price level remains fixed at 6, so the LM curve remains at LM1. With the price level equal to 6, the LM curve has the equation Y = (2640 / P) + 2000r = 440 + 2000r. The IS and LM curves intersect where 760 – 2000r = 440 + 2000r, or 320 = 4000r, which has the solution r = 0.08. At r = 0.08, output is given from the IS curve as Y = 760 – 2000r = 760 – (2000 x 0.08) = 600. Then consumption is C = 130 + 0.5(Y – 100) – 500r = 130 + 0.5(600 – 100) – (500 × 0.08) = 340. Investment is / = 200 – 500r = 200 – (500 x 0.08) = 160. In the long run, the price level rises to shift the LM curve from LM1 to LM2 to restore equilibrium. The IS curve is given by the equation Y = 760 – 2000r. At full employment, Y = 500, so the IS curve is 500 = 760 – 2000r, or 2000r = 260, which has the solution r = 0.13. The LM curve is given by the equation Y = (2640 / P) – 2000r. or 500 = (2640 / P) + (2000 x 0.13), or 240 = 2640 / P, which has the solution P = 11 Then consumption is C = 130 + 0.5(500 – 100) – (500 × 0.13) = 265. Investment is / = 200 – 500r = 200 – (500 x 0.13) = 135. 3.

The IS curve is Y = Cd + Id + G = 325 + 0.5(Y – 150) – 500r + 200 – 500r + G = 450 + 0.5Y – 1000r + G. This can be rewritten as 0.5Y = 450 – 1000r + G, or Y = 900 – 2000r + 2G. The LM curve is M/P = L = 0.5Y – 1000r. a. When G = 150, the IS curve is Y = 900 – 2000r + (2 x 150) = 1200 – 2000r. With M = 6000, the LM curve is 6000/P = 0.5Y – 1000r. At full employment, Y = 1000. The IS equation becomes 1000 = 1200 – 2000r, which has the solution r = 0.10. The LM equation is 6000/P = (0.5 x 1000) – (1000 x 0.10) = 400, which has the solution P =15. Consumption is C = 325 + 0.5(Y – T) – 500r = 325 – 0.5(1000 – 150) – (500 x 0.10) = 700. Investment is / = 200 – 500r = 200– (500 x 0.10) = 150. b. When G increases to 250, the IS curve shifts from IS1 to IS2 in Fig. 13.11. The new IS equation is Y = 900 – 2000r + 2G = 900 – 2000r + (2 x 250) = 1400 – 2000r. In the short run, the price level remains fixed at 15, so the LM curve remains at LM1. With the price level equal to 15, the LM curve has the equation 6000/15 = 0.5Y – 1000r, or Y = 800 + 2000r. The IS and LM curves intersect where 1400 – 2000r = 800 + 2000r, or 600 = 4000r, which has the solution r = 0.15. At r = 0.15, output is given from the IS curve as Y = 1400 – 2000r = 1400 – (2000 x 0.15) = 1100. Then consumption is C = 325 + 0.5(Y – 150) – 500r = 325 + 0.5(1100 – 150) – (500 x 0.15) = 725. Investment is / = 200 – 500r = 200 – (500 x 0.15) = 125. In the long run, the price level rises to shift the LM curve from LM1 to LM2 to restore equilibrium. The IS curve is given by the equation Y = 1400 – 2000r. At full employment, Y = 1000, so the IS curve is 1000 = 1400 – 2000r, or 2000r = 400, which has the solution r = 0.20. The LM curve is given by the equation Y = . 233

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(6000 / P) = 0.5Y –1000r = (0.5 × 1000) – (1000 × 0.20) = 300, which has the solution P = 20. Then consumption is C = 325 + 0.5(1000 – 150) – (500 × 0.20) = 650. Investment is / = 200 – 500r = 200 – (500 x 0.20) = 100. c. When the money supply increases to 7200, the LM curve shifts from LM1 to LM2 in Fig. 12.10. The LM equation is 7200 / P + 0.5Y – 1000r.

In the short run, the price level remains fixed at 15, so the LM curve has the equation 7200 / 15 = 0.5Y – 1000r, or Y = 960 + 2000r. The IS curve has the equation Y = 1200 – 2000r, as in part (a). The IS and LM curves intersect where 1300 – 2000r = 960 + 2000r, or 240 = 4000r, which has the solution r = 0.06. At r = 0.06, output is given from the IS curve as Y = 1200 – 2000r = 1200 – (2000 x 0.06) = 1080. Then consumption is C = 325 – 0.5(Y – 150) – 500r = 325 + 0.5(1080 – 150) – (500 x 0.06) = Figure 12.10 760. Investment is / = 200 – 500r = 200 – (500 x 0.06) = 170. In the long run, the price level rises to shift the LM curve from LM2 to LM3 = LM1 to restore equilibrium. The IS curve is given by the equation Y = 1200 – 2000r. At full employment, Y = 1000, so the IS curve is 1000 = 1200 – 2000r, or 2000r = 200, which has the solution r = 0.10. The LM curve is given by the equation Y = (7200 / P) = 0.5Y – 1000r = (0.5 x 1000) – (1000 x 0.10) = 400, which has the solution P = 18. Then consumption is C = 325 – 0.5(1000 – 150) – (500 x 0.10) = 700. Investment is / = 200 – 500r = 200 – (500 x 0.10) = 150. Notice that money is neutral in the long run. The IS curve is Y = Cd + I d + G = [600 + 0.8(Y − 1000) − 500r] +[400 − 500r] + 1000, so 0.2Y = 1200 − 1000r. Since π e = 0, the nominal interest rate (i) equals the real interest rate (r). a. Can the economy reach full employment? Since full-employment output is Y = 8000, for the economy to be on the IS curve, 0.2Y = 1200 − 1000r, so (0.2 x 8000) = 1200 − 1000r, or 1000r = −400, so r = i = −0.4. But since the nominal interest rate can’t be negative, this isn’t possible. Thus, the requirement that i be non-negative means that there’s no way to satisfy the goods market equilibrium condition at full employment. Assuming that the result is that i = 0 and that output is determined along the IS curve means that 0.2Y = 1200 (1000 x 0), so Y = 6000. Note that this is the best result possible, no matter what the money supply is, so monetary policy can’t restore full employment. b. To restore full employment while the nominal interest rate is zero clearly requires a shift in the IS curve. If we return to the original derivation and put G in the equation instead of using the original value of G = 1000, we get: Y = Cd + I d + G = [600 + 0.8(Y − 1000) − 500r] +[400 − 500r]+ G, so 0.2Y = 200 . 234

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+ G − 1000r. To get Y = 8000 and r = 0, we have 0.2 x 8000 = 200 + G − (1000 x 0), so G = 1400. Then the IS curve is 0.2Y = 1600 − 1000r. This is plotted in Figure 11.14 as IS2, while the original IS curve is IS1. Thus, raising G to 1400 can generate full employment, if the money supply is chosen so that the LM curve intersects the IS curve at the right point. Note that taxes are 1000, so the government must run a large budget deficit. What must the money supply be? Since P = 2, we need money supply (M/P) = money demand (L), so M/2 = 0.5Y − 200i = (0.5 x 8000) − (200 x 0) = 4000, so M = 8000. This situation is quite similar to the situation in Japan in the 1990s and suggests that to get out of the liquidity trap, Japan will need to use expansionary monetary policy, along with expansionary fiscal policy. 5.

a. The IS curve is given by Y = Cd + Id + G + NX = 120 + 0.5(Y – 100) + 120 – 200r + 100 + 60 + 0.5YFOR = 100r = 400 + 0.5Y – 500r. This can be rewritten as 0.5Y = 400 – 500r, or Y = 800 – 1000r. The LM curve is M/P = L, or 10 800 / P = 0.8Y – 200r. To find the aggregate demand curve, substitute the LM curve into the IS curve to eliminate r. To do this, multiply both sides of the LM curve by 5 to get 54 000 / P = 4Y – 1000r, or 1000r = 4Y – (54 000 / P). Then substitute this in the IS curve: Y = 800 – 1000r = 800 – [4Y – 54 000 / P)]. This can be rewritten as 5Y = 800 + (54 000 / P), or Y = 160 + (10 800 / P). b. With P = 18, the AD curve is Y = 160 + (10 800/18) = 760. From the IS curve, 760 = 800 –1000r, which has the solution r = 0.04. Consumption is C = 120 + 0.5(760 – 100) – (200 x 0.04) = 442. Investment is / = 120 – (200 x 0.04) = 112. c. In the long run, Y = 700. From the IS equation, 700 = 800 – 1000r, which has the solution r = 0.1. The LM curve then is 10 800/P = (0.8 x 700) – (200 x 0.1) = 540, which has the solution P = 20. Consumption is C = 120 + 0.5(700 – 100) – (200 x 0.1) = 400. Investment is / = 120 – (100 x 0.1) = 100. Net exports are NX = 110 – 100 x 0.1 = 100.

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The following table shows the real wage (w), the effort level (E), and the effort per unit of real wages (E / w). w E E/w 8 7 0.875 10 10 1.00 12 15 1.25 14 17 1.21 16 19 1.19 18 20 1.11 The firm will pay a wage of 12, since that wage provides the maximum effort per unit of the real wage (E / w = 1.25). The firm will employ 88 workers, since that is the number of workers for which w: MPN. As long as the supply of labour exceeds the demand for labour, labour supply has no effect on the firm’s decision. a. Using the definition, in Appendix 9.B, αIS = 0.6, βIS = 0.0005, αLM = 0, βLM = 0.0005, and ℓr = 1000. b. Y = 1000, r = 0.10. c. αIS = 0.7, Y = 1100 d. ΔY/ ΔG = 1/ [cr + ir) (βIS + βLM)] = 1/[(500 + 500) (0.0005 +0.0005)] = 1/ (1000 x 0.001) = 1 Output rises by 100.

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Analytical Problems 1. In Figs. 12.11 and 12.12, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the long-run equilibrium after the change.

Figure 12.9

Figure 12.11

Figure 12.12

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a. In Fig. 12.11, the increase in tax incentives increases investment, shifting the IS curve to the right from IS1 to IS2 in Fig. 12.10(a), and shifting the AD curve from AD1 to AD2 in Fig. 12.11(b). The short-run equilibrium is at point B. Output increases, the real interest rate increases, employment increases, and the price level is unchanged. To restore long-run equilibrium, the price level rises, shifting the LM curve from LM1 to LM2 in Fig. 12.11 (a) and the short-run aggregate supply curve from SRAS1 to SRAS2 in Fig. 12.11(b). The long-run equilibrium is at point C. Compared to the starting point, output is the same, the real interest rate is higher, employment is the same, and the price level is higher. b. In Fig. 12.12, the increase in tax incentives increases saving— shifting the IS curve from IS1 to IS2 in Fig. 12.12(a), and shifting the AD curve from AD1 to AD2 in Fig. 12.12(b). The short-run equilibrium is at point B. Output decreases, the real interest rate decreases, employment decreases, and the price level is unchanged. To restore long-run equilibrium, the price level rises, shifting the LM curve from LM1 to LM2 in Fig. 12.12(a) and the short-run aggregate supply curve from SRAS1 to SRAS2 in Fig. 12.12(b). The long-run equilibrium is at point C. Compared to the starting point, output is the same, the real interest rate is higher, employment is the same, and the price level is lower. c. A wave of investor pessimism reduces investment. This shifts the IS and AD curves to the left, having the same result as in problem part (b). d. An increase in consumer confidence increases consumption spending, shifting the IS curve and the AD curve to the right, with the same result as in problem part (a).

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Figure 12.13

Chapter 12: Keynesian Business Cycle Analysis: Non-Market-Clearing Macroeconomics

In Figs. 12.13–12.16, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the longrun equilibrium after the change. a. In Fig. 12.13, when bank pays a higher interest rate on chequing accounts, the demand for money rises, shifting the LM curve to the left from LM1 to LM2 in Fig. 12.13(a). As a result, the AD curve shifts to the left from AD1 to AD2 in Fig. 12.13(b). The new short-run equilibrium occurs at point B, where output is lower, the real interest rate is higher, employment is lower, and the price level is unchanged. In the long run, the price level decreases to shift the LM curve from LM2 to LM1, which is the same as LNP, to restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts Figure 12.15 down from SRAS1 to SRAS2. At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is lower. b. In Fig. 12.14, the introduction of credit cards reduces the demand for money—shifting the LM curve to the right from LM1 to LM2 in Fig. 12.14(a). As a result, the AD curve shifts from AD1 to AD2 in Fig. 12.14(b). The new short-run equilibrium occurs at point B, where output is higher, the real interest rate is lower, Figure 12.14 employment is higher, and the price level is unchanged. In the long run, the price level increases to shift the LM curve from LM2 to LM3, which is the same as LM1, to restore equilibrium at point C. . 239

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As a result, the short-run aggregate supply curve shifts up from SRAS1 to SRAS2. At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is higher. c. In Fig. 12.15, the reduction in agricultural output shifts the FE curve to the left from FE1 to FE2, and shifts the LRAS line from LIRAS1 to LRAS2. The rise in agricultural prices increases the price level, so the short-run aggregate supply curve shifts up from SRAS1 to SRAS2. Also, the rise in the price level shifts the LM curve up from LM1 to LM2. The short-run equilibrium is at point B, assuming that the LM curve shifts to the left more than the FE line. At point B, compared to the starting point, output is lower, the real interest rate is higher, employment is lower, and the price level is higher. If the water shortage persists, a new long-run equilibrium occurs at points C. To get to this equilibrium, the price level must decline, shifting the LM curve from LM2 to LM3, and the short-run aggregate supply curve from SRAS2 to SRAS3. Relative to point B, the new equilibrium has a higher output level, a lower real interest rate, higher employment, and a lower price level. (Relative to the initial equilibrium at point A, output and employment are lower, Figure 12.15 and the real interest rate and the price level are higher.) When the water shortage is over, then the economy goes back to point A in the long run, with no permanent effects.

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d. In Fig. 12.16, the beneficial supply shock makes more production possible at full employment, so the FE line shifts to the right in Fig. 12.16(a) from FE1 to FE2, and the LRAS line shifts from LRAS1 to LRAS2 in Fig. 12.16(b). There is no immediate change in the price level, so the LM curve remains at LM1 and the short-run aggregate supply curve remains at SRAS1. The shift of the FE curve does not affect aggregate demand in the short run; output, the real interest rate, and the price level are all unchanged in the short run. A shift in the production function shifts the effective labour demand curve and reduces employment in the short run.

If the supply shock persists, prices will decline, so the LM curve will shift from LM1 to LM2 and the SRAS curve will shift from SRAS1 to SRAS2. As shown in the diagrams, the economy reaches a new equilibrium at point C, with a higher output level, a lower real interest rate, and a lower price level. When the supply shock disappears, the economy returns to its equilibrium at point A. A lag in the impact of policy of six months, which is about the time it takes firms to adjust prices, could cause policy to be destabilizing. That is, monetary policy may be pushing the economy away from equilibrium.

Figure 12.16

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To see this, suppose the economy is in a recession at point A in Fig. 12.17. The shortrun aggregate supply curve SRAS1 intersects the aggregate demand curve AD1 at point A, to the left of the long-run aggregate supply curve LRAS. Suppose the Bank engages in expansionary monetary policy to try to shift the aggregate demand curve from AD1 to AD2 in six months, to push the economy to point B. But the recession leads Figure firms to reduce their prices, dropping the SRAS curve from SRAS1 to SRAS2. In the 12.17 absence of monetary policy action, the economy would get back to full employment because of the fall in the price level to point C. But the Bank action leads to a new equilibrium at point D. So the Bank causes the economy to overshoot the equilibrium point. The result may be to exaggerate the business cycle, pushing output too high in expansions. Then if the Bank responds to an expansion by using contractionary monetary policy, it may overshoot on the other side, causing a new recession.

If the Bank could forecast recessions well, it could stabilize the economy by using monetary policy appropriately before a recession begins. Or if the Bank’s policy takes effect before firms adjust prices, then it can also help stabilize output by shifting the AD curve before the SRAS curve shifts An increase in government purchases shifts the IS and AD curves to the right to return the economy to full employment, instead of waiting for the price level to fall to get there. The advantage of doing so, according to Keynesians, is that full employment is restored quickly, whereas if the price level must adjust, it may take a long time for full employment to be restored. In the short run, the fiscal expansion does not affect the real wage, since it is an efficiency wage. However, it increases employment and it increases current and future taxes to pay for the higher government spending. The effect on consumption is ambiguous, with the rise in output raising consumption, while the rise in taxes reduces consumption. In the long run, at full employment, the lasting effects of the fiscal expansion are to decrease consumption, because of the higher real interest rate and the higher taxes, with more of the economy’s output devoted to government purchases and less to the private sector. Whether a program of fiscal stimulus in response to a recession is worthwhile depends on the benefits of the government purchases and on how long it takes the economy to return to a full-employment equilibrium by a change in the price level. The more beneficial are government purchases, the more likely such a program is to increase economic welfare. The longer the free market takes to restore equilibrium, the more such a program is to increase economic welfare.

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a. In response to expansionary monetary policy, aggregate demand increases, increasing output and labour demand. This causes the labour demand curve to shift from ND1 to ND2 in the primary labour market, shown in Fig. 12.18. The result is an increase in employment and output with no change in the real wage in the primary labour market. Since more workers are now in the primary labour market, the labour supply in the secondary labour market decreases from NS1 to NS2. This causes an increase in the real wage, a decrease in employment, and a decrease in output in the secondary labour market.

Figure 12.18

Figure 12.17

b. Increased immigration has no effect in the primary labour market, since labour supply changes in general have no effect. In the secondary labour market, the immigration shifts the labour supply curve to the right from NS1 to NS2, causing a reduction in the real wage, increased employment, and increased output. However, to some extent these effects may be mitigated by the fact that increased immigration leads to increased aggregate demand, increasing labour demand in both the primary Figure 12.19 and secondary markets (Fig. 12.19). c. If there is a shift in the effort curve, the efficiency wage rises in the primary labour market. Since effort exerted at the higher wage is the same as before the change, the shift in the effort curve has no impact on the marginal product of labour, so there is no shift in the labour demand curve. So the effect of the higher real (efficiency) wage is to reduce employment and thus output in the primary labour market. This means that labour supply in the secondary labour market increases, shifting the labour supply curve from NS1 to NS2. The real wage falls, employment rises, and output rises in the secondary labour market, as Fig. 12.20 shows.

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Figure 12.20

d. The productivity improvement shifts the labour demand curve to the right, so at the fixed real (efficiency) wage, firms demand more labour. Employment increases, so output increases in the primary labour market. The increase in employment in the primary labour market reduces the labour supply in the secondary labour market, shifting the labour supply curve from NS1 to NS2.

Figure 12.21

This increases the real wage, and reduces employment and output in the secondary labour market. See Fig. 12.21.

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e. The productivity improvement in the secondary labour market has no effect on the primary labour market. In the secondary labour market, increased productivity increases the marginal product of labour so that labour demand increases from ND1 to ND2. The result is a higher real wage, higher employment, and increased output (Fig. 12.22).

Figure 12.22

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CHAPTER 13: UNEMPLOYMENT AND INFLATION LEARNING OBJECTIVES I.

Goals of Part IV: Macroeconomic Policy: Its Environment and Institutions A. How macroeconomic policy works and how it can best be used 1. Unemployment and inflation (this chapter) 2. Monetary institutions and policy (Ch. 14) 3. Fiscal institutions and policy (Ch. 15)

II.

Goals of Chapter 13 A. Why study unemployment and inflation together? 1. The most important macroeconomic problems 2. Phillips curve relationship B. Study relationship between inflation and unemployment 1. Has it changed over time? 2. Is there a trade-off between inflation and unemployment? C. Study the costs of inflation and unemployment; consider the implications for macroeconomic policy making

Ill.

Notes to Eighth Edition Users A. Figure 13.2 has been updated.

TEACHING NOTES I.

Unemployment and Inflation: Is There a Trade-off? (Sec. 13.1) A. Many people think there is a trade-off between inflation and unemployment 1. The idea originated in 1958 when A.W. Phillips showed a negative relationship between unemployment and nominal wage growth in Britain 2. Since then economists have looked at the relationship between unemployment and inflation 3. In the 1950s and 1960s many nations seemed to have a negative relationship between the two variables 4. Canada appears to be on one Phillips curve in the 1960s (text Fig. 13.1) 5. This suggested that policymakers could choose the combination of unemployment and inflation they most desired 6. But the relationship fell apart between the years of 1970–2015. (text Fig. 13.2) 7. The 1970s were a particularly bad period, with both high inflation and high unemployment, inconsistent with the Phillips curve B. The expectations-augmented Phillips curve 1. Friedman and Phelps: The cyclical unemployment rate (the difference between actual and natural unemployment rates) depends only on unanticipated inflation (the difference between actual and expected inflation) a. This theory was made before the Phillips curve began breaking down in the 1970s b. It suggests that the relationship between inflation and the unemployment rate isn’t stable 2. How does this work in the extended classical model?

Analytical Problem 3 looks at similar analysis in a Keynesian model. a. b.

First case: anticipated increase in money supply (Fig. 13.1: like text Fig. 13.3) (1) AD shifts right and SRAS shifts left, with no misperceptions . 246

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(2) Result: P rises, Y unchanged (3) Inflation rises with no change in unemployment Second case: unanticipated increase in money supply (Fig. 13.2; like text Fig. 13.4)

Figure 13.1

Figure 13.2

(1) AD expected to shift right to AD2, old (money supply expected to rise 10%), but unexpectedly money supply rises 15%, so AD shifts further right to AD2 new (2) SRAS shifts left based on expected 10% rise in money supply (3) Result: P rises and Y rises as misperceptions occur (4) So higher inflation occurs with lower unemployment (5) Long run: P rises further, Y declines to full-employment level Numerical Problems 2 and Analytical Problem 2 look at the misperceptions model and how it generates behaviour like the Phillips curve d.

Expectations-augmented Phillips curve equation: π = πe −h(u − ū) (13.1) (1) When π = πe, u = ū (2) When π < πe, u > ū (3) When π > πe, u < ū

Numerical Problem 1 uses the expectations-augmented Phillips curve. C.

The shifting Phillips curve 1. The Phillips curve shows the relationship between unemployment and inflation for a given expected rate of inflation and natural rate of unemployment

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Changes in the expected rate of inflation (Fig. 13.3; like text Fig. 13.5) a. For a given expected rate of inflation, the Figure 13.3 Phillips curve shows the trade-off between cyclical unemployment and actual inflation b. The Phillips curve is drawn such that π = πe when u = ū c. Higher expected inflation implies a higher Phillips curve Changes in the natural rate of unemployment (Fig. 13.4; like text Fig. 13.6) a.

For a given natural rate of unemployment, the Phillips curve shows the trade-off between unemployment and unanticipated inflation b. A higher natural rate of unemployment shifts the Phillips curve to the right Supply shocks and the Phillips curve

Analytical Problem 1 looks at possible ways to change the natural rate of unemployment. a.

A supply shock increases both expected inflation and Figure 13.4 the natural rate (1) A supply shock in the classical model increases the natural rate of unemployment, because it increases the mismatch between firms and workers (2) A supply shock in the Keynesian model reduces the marginal product of labour and thus reduces labour demand at the fixed real wage, so the natural unemployment rate rises So an adverse supply shock shifts the Phillips curve up and to the right The Phillips curve will be unstable in periods with many supply shocks

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Numerical Problem 3 looks at the effects of an aggregate demand shock and an aggregate supply shock on the Phillips curve. 5.

The shifting Phillips curve in practice a. Why did the original Phillips curve relationship apply to many historical cases? (1) The original relationship between inflation and unemployment holds up as long as expected inflation and the natural rate of unemployment are approximately constant (2) This was true in the Canada in the 1960s, so the Phillips curve appeared to be stable b. Why did the Canadian Phillips curve disappear in the 1970s? (1) Both the expected inflation rate and the natural rate of unemployment varied considerably more in the 1970s than they did in the 1960s (2) Especially important were the oil price shocks of 1973– 1974 and 1979–1980 (3) Also, the composition of the labour force changed in the 1970s and there were other structural changes in the economy as well, raising the natural rate of unemployment (4) Monetary policy was expansionary in the 1970s, leading to high and volatile inflation (5) Plotting unanticipated inflation against cyclical unemployment shows a fairly stable negative relationship between unanticipated inflation and cyclical unemployment from 1960 to 2015 (text Fig. 13.7)

Macroeconomic policy and the Phillips curve 1. Can the Phillips curve be exploited by policymakers? Can they choose the optimal combination of unemployment and inflation? a. Classical model: NO (1) The unemployment rate returns to its natural level quickly, as people’s expectations adjust (2) So unemployment can change from its natural level only for a very brief time (3) Also, people catch on to policy games; they have rational expectations and try to anticipate policy changes, so there is no way to fool people systematically

Policy Application The theory of rational expectations explains why the Phillips curve trade-off appeared to be stable for some time but failed when policymakers tried to exploit it. In the 1960s people assumed that any rise in inflation would be temporary. But once policymakers began to exploit the trade-off, people caught on quickly. Instead of having adaptive expectations, which were rational in the past, people began to watch what policymakers were doing. Then expected inflation changed quickly with changes in policy.

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Keynesian model: YES, temporarily (1) The expected rate of inflation in the Phillips curve is the forecast of inflation at the time the oldest sticky prices were set (2) It takes time for prices and expected prices to adjust, so unemployment may differ from the natural rate for some time

Theoretical Application The Keynesian models of the early 1970s assumed that people formed adaptive expectations, that is, that expected inflation depended only on past inflation, so πet = f(πt-1, πt-2, …). According to rational expectations theory, however, people base their inflation expectations on an economic model in which inflation depends on other variables, such as the growth rate of the money supply, the state of the economy, and expectations of future government deficits. Adaptive expectations could be rational, as in the 1950s and 1960s, because an economic model would suggest a simple time-series process for inflation. But once the central bank began using monetary policy for countercyclical policy, or for trying to exploit the Phillips curve, adaptive expectations became irrational. With rational expectations, people began to anticipate changes in monetary policy, and the Phillips curve began to shift with change in policy. 2.

A Closer Look 13.1: The Lucas critique a. When the rules of the game change, behaviour changes b. For example, if batters in baseball were called out after two strikes instead of three, they’d swing more often when they have one strike than they do now c. Lucas applied this idea to macroeconomics, arguing that historical relationships between variables won’t hold up if there’s been a major policy change d. The Phillips curve is a good example it fell apart as soon as policymakers tried to exploit it e. Evaluating policy requires an understanding of how behaviour will change under the new policy, so both economic theory and empirical analysis are necessary

Theoretical Application The implications of the Lucas critique for future work on macroeconomics and business cycles were spelled out by Robert Lucas and Tom Sargent in their article, “After Keynesian Macroeconomics,” Federal Reserve Bank of Minneapolis Quarterly Review, Spring 1979, pp. 1-16. E.

The long-run Phillips curve 1. Long run: u = ū for both Keynesians and classicals 2. The long-run Phillips curve is vertical since when π = πe, u = ū (Fig. 13.5; like text Fig. 13.8) 3. Changes in the level of money supply have no long-run real effects; change in the growth rate of money supply have no long-run real effects, either

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Figure 13.5

II.

The Problem of Unemployment (Sec. 13.2) A. The costs of unemployment 1. Loss in output from idle resources a. Workers lose income b. Society pays for unemployment benefits and makes up lost tax revenue c. Using Okun’s Law (each percentage point of cyclical unemployment is associated with a loss equal to 2% of fullemployment output), if full-employment output is $1000 billion, each percentage point of unemployment sustained for one year costs $20 billion 2. Personal or psychological cost to workers and their families a. Especially important for those with long spells of unemployment b. increases in unemployment are associated with cardiovascular deaths, mental illness, crime, suicide, and homicide 3. There are some offsetting factors a. Unemployment leads to increased job search and acquiring new skills, which may lead to increase future output b. Unemployed workers have increased leisure time, though most wouldn’t feel that the increased leisure compensated them for being unemployed B. The long-term behaviour of the unemployment rate 1. The changing natural rate a. How do we calculate the natural rate of unemployment? b. Burns’ estimates: 4.5% in the mid-1960s, rising to 8.5% in the mid-1980s, most current estimates (2006) suggest a natural rate of about 6.3% (text Fig.13.9) Natural unemployment rate moves slightly upward following the recession of 2008-2009 c. Why did the natural rate rise from the 1960s to the 1980s? (1) Demographics changes; more teenagers, and women (a) Their unemployment rates are higher because of discrimination, lower educational attainment, interruptions of careers to have children (b) Their proportion of the population has been increasing . 251

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(c)

(2)

(3)

(4)

But these factors explain less than one percentage point of higher unemployment (d) And the average unemployment rate within each demographic group also rose Technological change (a) Technological changes have reduced the demand for low-skilled or poorly educated workers (b) Many industries and regions have grown while other have declined, worsening the mismatch between workers and firms Hysteresis in unemployment (a) Hysteresis: The natural rate of unemployment rises as the actual unemployment rate rises (b) Caused partly by deteriorating skills of the unemployed, which increases the mismatch problem (c) Caused partly by restrictions on firms’ ability to fire workers, making them reluctant to hire workers in good times (d) Caused partly by union-firm bargaining, as suggested by insider-outsider theory (e) Unions try to maximize wage rates to benefit siders; outsiders then can’t get jobs at wage rates that exceed market-clearing levels Changes in Employment Insurance (EI) legislation

Data Application A readable series of papers on the natural rate of unemployment appeared in the Winter 1997 issue of the Journal of Economic Perspectives. The results are somewhat negative: a number of authors argue that uncertainty about the value of the natural rate means that it is of no use in guiding policy. C.

Policies to reduce the natural rate of unemployment 1. Tax credits, subsidies for training and relocating unemployed workers a. Eliminate mismatch between workers and jobs. b. Encourage unemployed workers to move to where new jobs are being created. 2. Minimize the size of payroll taxes a. Extra costs (EI, WCB, CPP and QPP) paid by the firm are said to drive a “wedge” between the wage received by the worker and the total cost to the firm of hiring that worker. b. Reducing regulations whose benefits are less than the costs would help reduce unemployment 3. A high-pressure economy? a. Using expansionary monetary and fiscal policies to create a high-pressure economy could reduce the natural rate of unemployment if there is hysteresis

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III.

Critics suggest that there is little evidence of hysteresis in Canada, and that the attempt to use expansionary policy would create a high rate of inflation

The Problem of Inflation (Sec. 13.3) A. The costs of inflation 1. Perfectly anticipated inflation a. No effects if all prices and wages keep up with inflation b. Even returns on assets may rise exactly with inflation c. Shoe-leather costs: People spend resources to economize on currency holdings; the estimated cost of 10% inflation is 0.3% of GDP

Policy Application Shoe-leather costs are generated by people’s attempt to reduce how much cash they hold. Implicitly, inflation is like a tax on people’s cash holdings, because the government buys things with newly printed money (just like it could if it collected taxes to pay for them) and people who hold cash lose purchasing power (just as if their money was taxed). Some economists have gone so far as to suggest that using the inflation tax is beneficial to the economy, because much of the burden is borne by people in the underground economy and foreigners who use US dollars. See S. Rao Aiyagari, “Deflating the Case for Zero Inflation,” Federal Reserve Bank of Minneapolis Quarterly Review, Summer 1990. d. e.

Menu costs: the costs of changing prices (but technology may mitigate this somewhat) Features of the tax system that relates to a failure to adequately account for the effects of inflation on interest income, dividends, and capital gains.

Analytical Problem 4 looks at the costs of anticipated and unanticipated inflation in a cashless society. 2.

Unanticipated inflation (π - πe) a. Realized real returns differ from expected real returns (1) Expected r = i - πe (2) Actual r = i - π (3) Actual r differs from expected r by πe - π (4) Numerical example: i = 6%, πe = 4%, so expected r = 2%. If π = 6% actual r = 0%; π = 2%, actual r = 4% b. Similar effect on wages and salaries c. Result: transfer of wealth (1) From lenders to borrowers when π > πe (2) From borrowers to lenders when π < πe

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Data Application Since the inflation of the mid-1970s was a surprise to people, it led to a large transfer of wealth. The biggest winners in the 1970s were homeowners who owned land (which appreciated in value with inflation) and had fixed-rate mortgages (whose value fell with inflation). The biggest losers were the wealthy who owned stocks and bonds, as real returns fell dramatically because of inflation. d.

So people want to avoid risk of unanticipated inflation (1) They spend resources to forecast inflation (2) A Closer Look 13.2: Indexed contracts (a) People could use indexed contracts to avoid the risk of transferring wealth because of unanticipated inflation (b) Most financial contracts are not indexed, with the exception of some long-term contracts like adjustablerate mortgages (c) Many labour contracts are indexed by COLAs (costof-living adjustments) (d) Indexed contracts are more prevalent in countries with high inflation (e) Loss of valuable signals provided by prices (1) Confusion over changes in aggregate prices vs. changes in relative prices (2) People expend resources to extract correct signals from prices

Data Application For a review of the empirical evidence on the costs of inflation, see the article by John Driftill, Grayham E. Mizon, and Alistair Ulph, “Costs of Inflation,” in B. M. Friedman and F. H. Hahn, eds., Handbook of Monetary Economics, vol. II, Amsterdam: Elsevier Science Publishers, 1990, pp. 1014–1066. •

The costs of hyperinflation • Hyperinflation is a very high, sustained inflation (for example, 50% or more per month) (1) Hungary in August 1945 had inflation of 19,800% per month (2) Bolivia had annual rates of inflation of 1,281% in 1984, 11,750% in 1985, 276% in 1986 • There are large shoe-leather costs, as people minimize cash balances • People spend many resources getting rid of money as fast as possible • Tax collections fall, as people pay taxes with money whose value has declined sharply • Prices become worthless as signals, so markets become inefficient

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Data Application There are many wonderful stories one can tell to illustrate the problems that arise in hyperinflations. For example, there’s the story about the person who goes to the bank with a wheelbarrow full of money, but can’t get the wheelbarrow through the bank’s door. He goes inside to get help and when he returns, the money is still there but the wheelbarrow has been stolen. There’s also the mind-boggling size of the hyperinflation figures. For example, in Hungary between August 1945 and July 1946, the purchasing power of a unit of money fell by a factor of 4 octillion! That’s 4 000 000 000 000 000 000 000 000 000. Policy Application Given the costs of inflation and the vertical long-run Phillips curve, what is the optimal rate of inflation? Some economists suggest that the optimal rate of inflation is zero or even negative (so that the nominal rate of interest is zero). See the discussion by Michelle R. Garfinkel, “What Is an ‘Acceptable’ Rate of Inflation? A Review of the Issues,” Federal Reserve Bank of St. Louis Review, July/August 1989, pp. 3–15. The debate over the pursuit of zero inflation reached its peak in 1990 in the United States and Canada. Two conferences reflecting research on zero inflation were held in Canada: see Zero Inflation: The Goal of Price Stability, Richard G. Lipsey, ed., and Taking Aim: The Debate on Zero Inflation, Robert C. York, ed., both published by the C.D. Howe Institute, Ottawa, Ontario, 1990. Canada’s central bank adopted a target of zero inflation in the early 1990s. B.

Fighting inflation: The role of inflationary expectations 1. If rapid money growth causes inflation, why do central banks allow the money supply to grow rapidly? a. Developing or war-torn countries may not be able to raise taxes or borrow, so they print money to finance spending b. Industrialized countries may try to use expansionary monetary policy to fight recessions, then not tighten monetary policy enough later 2. Disinflation is a reduction in the rate of inflation a. But disinflations may lead to recessions b. An unexpected reduction in inflation leads to a rise in unemployment along the Phillips curve 3. The costs of disinflation could be reduced if expected inflation fell at the same time actual inflation fell 4. Rapid versus gradual disinflation a. The classical prescription for disinflation is cold turkey—a rapid and decisive reduction in money growth (1) Proponents argue that the economy will adjust fairly quickly, with low costs of adjustment, if the policy is announced well in advance (2) Keynesians disagree (a) Price stickiness due to menu costs and wage stickiness due to labour contracts make adjustment slow (b) Cold turkey disinflation would cause a major recession

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(c)

The strategy might fail to alter inflation expectations, because if the costs of the policy are high (because the economy goes into recession), the government will reverse the policy

Data Application Tom Sargent (“The Ends of Four Big Inflations”) suggests that high rates of inflation may be reduced quickly with little output loss if a country creates an independent central bank and changes its fiscal policy to eliminate government budget deficits. Robert Gordon (“Why Stopping Inflation May Be Costly: Evidence from Fourteen Historical Episodes”) suggests that there have been very few disinflation episodes without substantial output loss; most recent disinflations have been accompanied by substantial recessions. See their articles in Robert E. Hall, ed., Inflation: Causes and Effects, Chicago: University of Chicago Press, 1982 b.

The Keynesian prescription for disinflation is gradualism (1) A gradual approach gives prices and wages time to adjust to the disinflation

Policy Application In the mid 1970s the Bank of Canada embarked on an attempt at gradualism, aiming to bring clown inflation slowly by reducing the growth rate of M1. In face of financial innovation and the supply shocks of 1979-80 however the policy was quite ineffective. It was officially abandoned in 1982. (2)

Such a strategy will be politically sustainable because the costs are low A Closer Look 13.3: The sacrifice ratio a. When unanticipated tight monetary and fiscal policies are used to reduce inflation, they reduce output and employment for a time, a cost that must be weighed against the benefits of lower inflation b. Economists use the sacrifice ratio as a measure of the costs (1) The sacrifice ratio is the number of percentage points of output lost in reducing inflation by one percentage point (2) For example, a study of past disinflations by Laurence Ball found that Canadian inflation fell by 7.83 percentage points in the early 1980s, with a loss in output of 18.58 percent of the nation’s potential output (a) The sacrifice ratio was 18.58 divided by 7.83, which equals 2.37 c. Ball studied the sacrifice ratios for many different disinflations around the world in the 1960s, 1970s, and 1980s (1) The sacrifice ratios varied substantially across countries, from less than 1 to almost 3 (2) One factor affecting the sacrifice ratio is the flexibility of the labour market

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(a)

Countries with slow wage adjustment (for example, because of heavy government regulation of the labour market) have higher sacrifice ratios (3) Ball also found a lower sacrifice ratio from cold turkey disinflation than from gradualism Ball’s results should be interpreted with caution, since it isn’t easy to calculate the loss of output and because supply shocks can distort the calculation of the sacrifice ratio

Data Application A version of Bali’s article that is accessible to students is “How Costly Is Disinflation? The Historical Evidence,” Federal Reserve Bank of Philadelphia Business Review, November/December 1993, pp. 17–28. 6.

Wage and price controls a. Pro: Controls would hold down inflation, thus lowering expected inflation and reducing the costs of disinflation b. Con: Controls lead to shortages and inefficiency; once controls are lifted, prices will rise again c. The outcome of wage and price controls may depend on what happens with fiscal and monetary policy (1) If policies remain expansionary, people will expect renewed inflation when the controls are lifted (2) If tight policies are pursued, expected inflation may decline

Analytical Problem 5 looks at what happens if the government uses wage and price controls, but continues to use expansionary monetary policy.

Credibility and reputation a. Key determinant of the costs of disinflation: how quickly expected inflation adjusts b. This depends on credibility of disinflation policy; if people believe the government and if the government carries through with its policy, expected inflation should drop rapidly c. Credibility can be enhanced if the government gets a reputation for carrying out its promises d. Also, having a strong and independent central bank that is committed to low inflation provides credibility

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1.

Additional Costs of Anticipated Inflation

The interaction of the tax system with inflation. Most countries’ tax systems are not perfectly indexed for inflation. They impose taxes on nominal, not real, returns on investments (bonds and stocks), which distorts the prices on those assets. Also, capital gains are taxed in nominal terms, so investors may pay a big tax on assets whose value hasn’t even increased in real terms. Eytan Sheshinski, in “Treatment of Capital Income in Recent Tax Reforms and the Cost of Capital in Industrialized Countries,” in Larry Summers, ed., Tax Policy and the Economy 4, Cambridge, Mass.: MIT Press, 1990, pp. 25-42, found that the implicit tax rate on real investment returns exceeded 100% at times in the 1970s, and was over 50% in the 1980s, all because of taxing nominal returns instead of real returns. To see this in a simple example (with a simplifying assumption that the real return, not the after-tax real return, is fixed), consider two cases in which there’s a 30% tax rate. Case A has inflation of 0% and a nominal interest rate of 2%. An investor loses0.6% of the 2% return to taxation, thus netting 1.4% in both nominal and real terms. In case B, inflation is 5% and the nominal interest rate is 7%. Taxation costs 2.1% of the 7% return, leaving a nominal after-tax return of 4.9%. Subtracting the inflation rate gives a real after-tax return of −0.1%. (Though the simplifying assumption generates these results, this seems consistent with the data.) A solution to this problem is to adjust capital values for inflation before taxing them. The mortgage tilt problem. Mortgage loans are most often made at fixed rates for long terms. When inflation is positive, the constant nominal payment over time is much higher in real terms early in the life of the loan, and lower in real terms later in the life of the loan, because of a higher price level. This means that the burden of paying the loan is high when households are younger. So if the households are liquidity constrained, they may not be able to afford to buy a home as early as they could if there was no inflation. Here’s a numerical example. Consider a $100 000, 30-year mortgage. In case A inflation is 0% and the nominal interest rate is 5%. The monthly payment is $540, the real value of which is constant over time. Using a 28% rule used by lenders (that a person’s mortgage payment shouldn’t exceed 28% of income), a person would have to have income of $23 000 to qualify for the mortgage. In case B inflation is 5% and the nominal interest rate is 10%. The monthly payment on the mortgage is $880. But this amount declines steadily over time in real terms because of inflation. The income needed to qualify for the mortgage is $37 000. So in case B with higher inflation, the initial monthly payment is higher and the income needed to qualify for the loan is higher, so inflation discourages homeownership. (Again, the result wouldn’t be so dramatic except for some simplifications; the 28% rule might become a higher number if inflation were lower.) There is a potential solution to this problem, which is the introduction of a price-leveladjusted mortgage (PLAM); but PLAMs haven’t yet been adopted by financial institutions. 2. Can Unemployment Help Workers and the Economy? If an unemployed worker always accepted the first job offered, unemployment would decrease in the short run. However, such a practice is likely to reduce output and to lead to more frequent periods of unemployment over several years. Accepting the first opening made available will often put a person into a position that does not match his or her skills, preferences, and abilities. When the job and the individual are not well suited to each other, both the employer and the employee are likely to be dissatisfied and productivity will tend to be lower. Workers are more likely to leave such positions. Taking additional time to find a better fit normally will result in the worker finding a situation that makes good use of his or her skills and abilities. This will often lead to the new employee being very productive and staying with the new company for a long time. . 258

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1. The Phillips curve is an empirical negative relationship between inflation and unemployment. The Phillips curve relationship held for Canadian data in the 1960s, but broke down in the 1970s and 1980s. 2. In the traditional Phillips curve, inflation itself is related to the unemployment rate. In the expectations-augmented Phillips curve, it is unanticipated inflation (the difference between actual and expected inflation) that is related to cyclical unemployment (the difference between the unemployment rate and the natural rate of unemployment). The traditional Phillips curve appears in the data at times when both expected inflation and the natural rate of unemployment are fixed. 3. In the early 1960s the rate of inflation was fairly low (about 1% to 2%), and it didn’t vary much from year to year. But supply shocks hit the economy in both the midand the late-1970s, causing a rise in expected inflation and an upward shift in the Phillips curve. Expansionary monetary and fiscal policies kept inflation high in the 1970s until the Bank of Canada began pursuing contractionary monetary policy to reduce inflation after 1975. This was not very successful. However following the 1981–82 recession the economy moved to a lower Phillips curve, which was maintained in the 1980s. The instability of the Phillips curve is largely because of higher expected inflation associated with supply shocks in the 1970s. 4. Both classical and Keynesian economists agree that unanticipated events cause unanticipated inflation and so cause the unemployment rate to deviate from its fullemployment (or natural) rate. Classical economists stress that the economy adjusts very quickly to unanticipated events and, as a result, they believe that the unemployment rate deviates from the natural rate for only short periods of time. For this reason, classical economists believe there is little role for stabilization policy. Keynesian economists stress that the economy adjusts far less quickly to unexpected events and, as a result, they believe the unemployment rate can remain different from the natural rate for an extended period of time. For this reason, Keynesians believe that efforts by policy makers to move to economy back to the natural unemployment rate – efforts known as stabilization policy – are worthwhile. 5. The natural rate of unemployment is the rate of unemployment that exists when output is at its full-employment level. This occurs when the only unemployment is frictional and structural, not cyclical. The natural rate is crucial in understanding the Phillips curve. The natural rate of unemployment has moved higher over time in Canada, the United States and Europe due to a number of factors. First, demographic changes occurred that raised the natural rate. Groups in the labour force that have higher rates of unemployment have increased in size relative to groups that have lower rates of unemployment. Also, there have been structural changes in the economy that may have raised the natural rate in the 1970s. In Europe, hysteresis has kept the unemployment rate from declining much after it hit very high levels in the early 1980s. Hysteresis arises because of government regulation and bureaucratic aspects of firms and labour unions, and due to insiders keeping outsiders from gaining employment. To reduce the natural rate of unemployment, the government could support job training and worker relocation, reduce regulations to increase labour market flexibility, reform unemployment insurance, or create a high-pressure economy.

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Two costs of anticipated inflation are shoe-leather costs and menu costs. Two costs of unanticipated inflation are transfers of wealth and confusion of price signals. If the economy experiences hyperinflation, shoe-leather costs become very large as people try to minimize their cash holdings. Also, price changes so frequently they cease to serve as signals. Menu costs do not rise too much, as firms simply quote prices in terms of some other unit of account (a different country’s currency). Transfers of wealth also occur, especially since the government loses tax revenue as people delay paying taxes. The greatest potential cost of disinflation is that it may cause a recession. This occurs because inflation may fall below expected inflation, causing the unemployment rate to rise along the Phillips curve. However, if the disinflation is anticipated by the public, expected inflation will adjust quickly and the costs of disinflation will be low. One approach to disinflation is a cold turkey strategy. It has the advantage of reducing inflation quickly, but it may have high costs from increasing unemployment, according to Keynesians. So Keynesians suggest a gradualist policy to reduce inflation more slowly, but with less rise in unemployment. This also has the advantage of being politically sustainable, since policymakers are less likely to back off from disinflation.

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Numerical Problems 1.

Since the natural rate of unemployment is 0.06, π = πe – 2(u – 0.06), so u – 0.06 = 0.5(πe – π) or u = 0.06 + 0.5(πe – π). a. Year 1: u = 0.06 + 0.5(0.08 – 0.04) = 0.06 + 0.02 = 0.08. The unemployment rate is 0.02 higher than the natural rate. The percentage that output falls short of full-employment output is 2.5 x 0.02 = 0.05, or 5%. Year 2: u = 0.06 t 0.5(0.04 – 0.04) = 0.06. The unemployment rate equals the natural rate, since inflation equals expected inflation. Since unemployment is at its natural rate, output is at its full-employment level. b. Use equations: u = 0.06 + 0.5(πe − π), output shortfall = 2.5(u – 0.06). Year 1 2 3 4

π 0.08 0.04 0.04 0.04

πe 0.10 0.08 0.06 0.04

u 0.07 0.08 0.07 0.06

u–0.06 0.01 0.02 0.01 0.0

output shortfall 0.025 0.05 0.025 0.0

a. Equating aggregate demand to short-run aggregate supply gives: 300 + 10(M / P) = 500 + P – Pe, or 300 + (10 × 1000 / P) = 500 + P – 50, or 10 000 / P = 150 + P. Multiplying both sides of the equation by P and rearranging gives P2 + 150P – 10 000 = 0, which can be factored as (P – 50)(P + 200) = 0. This has the nonnegative solution P = 50. Since P2 is also 50, the expected price level equals the actual price level, so output is at its full-employment level of 500 and the unemployment rate is at the natural rate of 6%. These are the long-run equilibrium values of the three variables as well. b. When the nominal money supply increases unexpectedly to 1260, we again equate aggregate demand to short-run aggregate supply, which gives: 300 + 10(M/P) = 500 + P – Pe or 300 + (10 x 1260 / P) = 500 + P – 50, or 12 600 / P = 150 + P. Multiplying both sides of the equation by P and rearranging gives P2+ 150P – 12,600 = 0, which can be factored as (P – 60)(P + 210) = 0. This has the nonnegative solution P = 60. When P = 60, the short-run aggregate supply curve gives Y = 500 + P – Pe = 500 + 60 – 50 = 510. Output of 510 is 2% above full-employment output of 500, because (510 – 500) / 500 = 0.02. With a natural unemployment rate of 0.06, Okun’s Law gives 0.02 = –2(u – 0.06). This can be solved to get u = 0.05. In the long run, Pe adjusts to equal P, output adjusts to its full-employment level of 500, and unemployment adjusts to the natural rate of 0.06. To find P, use the aggregate demand curve to get 500 = 300 + 10(1260 / P), or 200 = 12 600 / P, which can be solved to get P = 63. The results of this exercise are consistent with the existence of an expectationsaugmented Phillips curve. Unexpected inflation reduces unemployment in the short run. In the long run. however, inflation is higher and unemployment returns to its natural rate.

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a. π = 0.10 – 2(u – 0.06) = 0.22 – 2u. This is shown as the Phillips curve labeled PCa in Fig. 13.6. If the central bank keeps inflation at 0.10, then u = 0.06, the natural rate of unemployment. b. With expected inflation rising to 12%, the Phillips curve is π = 0.12 – 2(u – 0.06) = 0.24 – 2u. This is the Phillips curve labeled PCb in the figure. The higher rate of expected inflation has caused the curve to shift up relative to where it was in part (a). With the actual inflation rate at 10%, the Phillips curve equation is 0.10 = 0.12 – 2(u – 0.06), which has the solution u = 0.07. So if the central bank tries to maintain the existing rate of inflation after a shock has raised inflation expectations, the unemployment rate increases. However, if the central bank could convince people that the inflation rate really would not rise, so that [Catch math] remains at 0.10, then the shortrun Phillips curve would remain at PCa, and the unemployment rate would not increase.

Figure 13.6

c. With the natural rate of unemployment rising to 0.08 at the same time that expected inflation rises to 0.12, the Phillips curve equation is π = 0.12 – 2(u – 0.08) = 0.28 – 2u. This is the Phillips curve labeled PCc in the figure. The new short-run Phillips curve is even higher than those for parts (a) and (b). With the actual inflation rate held to 10%, the equation becomes 0.10 = 0.28 – 2u, which can be solved to get u = 0.09. The unemployment rate rises both because the central bank holds inflation below expected inflation and because the natural rate has increased. This time, even if the central bank convinced people that inflation would remain just 10%, the unemployment rate would still rise to 8%, since the natural rate has increased to that level.

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Analytical Problems 1. a. The reduction in structural unemployment would reduce the natural rate of unemployment and thus would shift both the expectations-augmented Phillips curve and the long-run Phillips curve to the left. b. Despite the expense of the government program to reduce structural unemployment, it would have a permanent effect. Monetary expansion can work only temporarily—in the long run it has no effect. 2. The slope of the short-run aggregate supply curve will be much steeper in economy B, because producers increase their output only a small amount in response to an increase in price. But economy A’s short-run aggregate supply curve will be flatter, as people are likely to perceive price changes as changes in relative price rather than the aggregate price level, and thus will respond more strongly to changes in prices. The short-run Phillips curve will also be steeper in economy B, since unemployment, like output, won’t respond much to a change in inflation. But in economy A, unemployment and output will respond more strongly to price changes, and the short-run Phillips curve will be flatter. 3. a. In Fig. 13.7, the SRAS curve shifts up 10% each year, as does the AD curve. Unanticipated inflation is zero, as both actual and expected inflation are 10%. The economy is at full employment, since firms set their prices to exactly match the increase in the general price level.

Figure 13.7

Figure 13.8

b. The surprise increase in the money supply at mid-year leads to a rise in output, as shown in Fig. 13.8 by the shift of the AD curve from AD1 to AD2. Firms don’t adjust their prices, so the SRAS curve remains fixed at SRAS1. When the money supply rises by its regular 10% at the end of the year, the AD curve shifts up to AD3 and firms raise their prices by 15%, shifting the SRAS curve up to SRAS3. Actual inflation is 15%, but expected inflation was only 10%. As a result, there was a temporary increase in output above its full-employment level, and a temporary decline in unemployment below the natural rate. Thus for the year as a whole, cyclical unemployment was negative and unanticipated inflation was positive, just as in the expectations-augmented Phillips curve. In the cashless society, there would be no shoe-leather costs, as there would be no . 263

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cash balances on which to economize. But menu costs would remain for anticipated inflation. The costs of unanticipated inflation would remain as well: both the risk of wealth transfers plus confusion in price signals. a. Figure 13.9 shows the effects of increasing the money supply while holding the price level constant. Beginning at point A, the intersection of aggregate demand curve AD1 and short-run aggregate supply curve SRAS1, the increase in the money supply shifts the aggregate demand curve to AD2. Since prices cannot rise, the short-run equilibrium is at point B, with output above its full-employment level. b. When the price controls are removed, the price level will jump up, with the short-run aggregate supply curve Figure 13.9 shifting to SRAS2. The new equilibrium is at point C, where there is full employment. a. A new law that prohibits people from seeking employment before age eighteen is likely to reduce the natural rate of unemployment because teenagers have a higher-than-average unemployment rate. With no teenagers allowed in the labour force, the average unemployment rate would be lower. b. A service that makes looking for a job easier is able to match people and jobs more rapidly, which should reduce the natural rate of unemployment. c. If unemployed workers can receive benefits longer, they’ll be in less of a rush to take a job, so the job-matching process will take longer. As a result, the natural rate of unemployment will rise. d. A structural shift in the types of products people buy is likely to raise the natural rate of unemployment, because it will take time for the economy to shift workers from some types of occupations to others. e. A recession leads to a rise in cyclical unemployment, but doesn’t affect the natural rate of unemployment. However, if there’s hysteresis, the natural rate of unemployment might rise in the future.

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CHAPTER 14 MONETARY POLICY AND THE BANK OF CANADA LEARNING OBJECTIVES I.

Goals of Chapter 14 A. Look at how the money supply is determined B. Explore the question: How should the central bank conduct monetary policy? 1. Should the central bank offset cyclical fluctuations? 2. Should the central bank follow simple rules? 3. How should policy-making institutions be designed?

II.

Notes to Eighth Edition Users A. All data were updated. B. The Exchange Fund Account in Section 14.2 has been updated.

TEACHING NOTES I.

Principles of Money Supply Determination (Sec. 14.1) A. Three groups affect the money supply 1. The central bank is responsible for monetary policy 2. Depository institutions (banks) accept deposits and make loans 3. The public (people and firms) holds money as currency and coin or as bank deposits B. The money supply in an all-currency economy 1. A trading system based on barter is inconvenient 2. The creation of a central bank to print money can improve matters a. The central bank uses money it prints to buy real assets from the public; this gets money in circulation b. People accept the paper money if they believe other people will accept it in exchange c. The government often decrees that the paper money is legal tender, so that it can be used to pay off debts and the government will accept it for tax payments d. The central bank’s assets are the real assets it buys from the public; its liabilities are the paper money is issued e. That money is called the monetary base, or high-powered money 3. In an all-currency economy, the money supply equals the monetary base C. The money supply under fractional reserve banking 1. As an economy becomes more sophisticated financially, banks develop 2. If currency is easily lost or stolen, people may want to hold all their money in bank deposits and none in currency a. In this case, the consolidated balance sheet of banks has assets of all the currency in the economy and liabilities consisting of all the bank deposits b. The balance sheet of the central bank is unchanged from the case in the all-currency economy 3. The currency that banks hold is called bank reserves a. When bank reserves are equal to deposits, the system is called . 265

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100% reserve banking To make money, banks would have to change fees for deposits, since they earn no interest on reserves Rather than holding reserves that earn no interest, suppose a bank lent some of the reserves a. It could do this, since the flow of money in and out of the bank is fairly predictable and only a fraction of reserves is needed to meet the need for outflows b. If the bank needs to keep only 20% of the amount of its deposits on reserve to meet the demand for funds, it can lend the other 80% c. The reserve-deposit ratio would be 20% d. When the reserve-deposit ratio is less than 100%, the system is called fractional reserve banking When all the banks catch on to this idea, they will all make loans as the economy undergoes a multiple expansion of loans and deposits The process stops only when the banks’ currency holdings (reserves) are exactly 20% of their total deposits, with loans equal to 80% of total deposits a. For example, if the monetary base is $1 million, banks would make $4 million in loans, so their total assets would be $5 million b. In loaning the $4 million, banks create $4 million in new deposits c. Adding the $4 million in new deposits to the $1 million in existing deposits gives total liabilities in the banking system of $5 million b.

5. 6.

Numerical Problem 1 gives students practice dealing with bank balance sheets. 7. 8.

The money supply in this economy is equal to the total amount of bank deposits ($5 million in the example) The relationship between the monetary base and the money supply can be shown algebraically a. Let M = money supply, BASE = monetary base, DEP = bank deposits, RES = bank reserves, res = banks’ desired reservedeposit ratio (RES/DEP) b. Since no currency is held by the public, M = DEP (14.1) c. Banks want to hold (res) (DEP) in reserves, which must equal the amount of currency distributed by the central bank, so (res)(DEP) = BASE (14.2) d. Using Eqs. (14.1) and (14.2) gives M = DEP = BASE/res (14.3) e.

9. 10.

So an economy with fractional reserve banking and no currency held by the public has money supply equal to the monetary base divided by the reserve-deposit ratio Each unit of monetary base allows 1/res of money to be created The monetary base is called high-powered money because each unit of the base that is issued leads to the creation of more money

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Bank runs 1. In the example, banks plan on never having to pay out more than 20% of their deposits 2. If more people wanted to get their money from the bank, the bank would be unable to give them their funds 3. If people think a bank won’t be able to give them their money, they may panic and rush to withdraw their money, causing a bank run 4. Recent event includes the bank run on the Northern Rock Bank in U.K. (September 14, 2007) The money supply with both public holdings of currency and fractional reserve banking 1. If there is both public holding of currency and fractional reserve banking, the picture gets more complicated 2. The money supply consists of currency held by the public and deposits, so M = CU+ DEP (14.4) 3. The monetary base is held as currency by the public and as reserves by banks, so BASE = CU + RES (14.5) 4. Taking the ratio of these two equations gives M/BASE = (CU + DEP)/(CU + RES) (14.6) 5. This can be written as M/BASE = [(CU/DEP) + 1]]/[(CU/DEP) + (RES/DEP)] (14.7) 6. The currency-deposit ratio (CU/DEP, or cu) is determined by the public 7. The reserve-deposit ratio (RES/DEP, or res) is determined by banks 8. Rewrite Eq. (14.7) as M = [(cu + 1)/(cu + res)] BASE (14.8) 9. The term (cu + 1)/(cu + res) is the money multiplier a. The money multiplier is greater than 1 for res less than 1 (that is, with fractional reserve banking) b. If cu = 0, the multiplier is 1/res, as when all money is held as deposits c. The multiplier decreases when either cu or res rises

Numerical Problems 2 and 3 deal with the money multiplier. F.

Open-market operations 1. The most direct and frequently used way of changing the money supply is by raising or lowering the monetary base through openmarket operations 2. To increase the monetary base, the central bank prints money and uses it to buy assets in the market; this is an open-market purchase a. If the central bank wishes to increase the money supply by 10%, it purchases 10% more assets and its liabilities increase by 10%, which is the currency it issues b. To decrease the monetary base, the central bank sells assets in the market and retires the money it receives; this is an openmarket sale c. For a constant money multiplier, the decline or fall in the monetary base of 10% is matched by a decline or fall in the money supply of 10%

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Policy Application Most of the use of open-market operations turns out not to be related to changes in monetary policy at all, but rather to changes in money demand. There’s a seasonal component to money demand, which the Bank of Canada offsets by changing money supply so that interest rates don’t change over the seasons. There are also other factors that affect the money supply, such as the government’s use of funds. The Bank offsets these factors as well. II.

Monetary Control in Canada (Sec. 14.2) A. The Bank of Canada 1. The Bank of Canada was created in 1934, partly in response to political pressures arising from the Great Depression 2. Since 1938 the Bank has been a crown corporation with headquarters in Ottawa. It is directed by a board of directors which includes the governor, the senior deputy governor, the deputy minister of finance, and twelve part-time directors (private citizens appointed for a three year term) 3. On paper the Bank is an arm of government, as it must issue an annual report to the government, and the government may issue a binding directive to the Bank in the event of a disagreement 4. But in reality the Bank has more independence than the Bank of Canada Act suggests a. The government refrains from public criticism of the Bank’s actions b. It is widely accepted that if a directive were to be issued to the Bank, the governor would resign, damaging the government’s credibility in financial markets c. The outside members of the Board of Directors have little direct influence on Bank of Canada policy B. The Bank of Canada’s Balance Sheet 1. Balance sheet of Bank a. Largest Asset is the holdings of government securities (Table 14.2) b. Also owns foreign currencies and makes loans to banks and trust companies c. Largest liability is currency outstanding. Some is held by private banks, but most is held by the private sector d. Deposits made by the Canadian Payments Association, a cheque clearing organization of banks and trust companies, are also liabilities of the Bank e. Vault cash plus bank’s deposits at the Bank are total reserves 2. The monetary base equals bank reserves plus currency in circulation C. Tools of Monetary Policy 1. Overnight Rates (the most commonly used instrument of monetary control) a. Most money in Canada is in the form of demand deposits. To allow cheques to clear between banks, they hold balances at the Bank of Canada called settlement balances b. $100 cheque written on National Bank to Royal Bank, while an $80 cheque going the other way. Only $20 is transferred from the National Bank’s account at the Bank of Canada to the Royal Bank’s account c. Banks that hold settlement balances to clear such transfers are called direct clearers . 268

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e. f. g. h. i.

If banks have excessive settlement balances, they can lend them out and earn the overnight rate. Overnight rate is affected by the supply of balances Bank of Canada sets target band for overnight rate and implements it by lending and taking deposits from direct clearers Operating band is lowered to loosen monetary policy Bank rate is defined as upper edge of operating band Lender of last resort function: the Bank stands ready to provide reserves to banks that require cash Other interest rates (such as the prime rate) adjust quickly to changes in the overnight rate

Peter Howitt of Ohio State University discusses the institutional setting of Canadian monetary policy and the relationship between the Bank of Canada and the government in Canada, in Michelle Fratianni and Dominick Salvatore, Monetary Policy in Developed Economies: Handbook of Comparative Economic Policies, volume 3 (Westport, Conn: Greenwood Press) 1993. Howitt concludes that to a large extent the governor of the Bank of Canada solely determined Canadian monetary policy. 2. Open Market Operations a. By open market purchase or sale of government securities, the Bank could increase or reduce the monetary base b. The Bank uses Special Purchase and Resale Agreements (SPRA’s) and Sale and Repurchase Agreements (SRA’s) to conduct open market operations. An SPRA means the Bank buys Treasury bills from banks and investment dealers and sells them back the next day c. If the Bank wants to directly influence interest rates, it uses 91day Treasury bills for open market operations Policy Application In January 1999, the Bank of Canada’s operating procedures for making monetary policy changed as a result of the introduction of the Large-Value Transfer System. The changes are explained in Donna Howard’s article, “A Primer on the implementation of Monetary Policy in the LVTS Environment” in Bank of Canada Review, Autumn 1998. D.

The Exchange Fund Account 1. The Bank of Canada also manages the government’s holding of various foreign currencies (the exchange fund account) (Table 14.3) 2. These can be used to intervene in foreign exchange market 3. Intervention in the foreign exchange market to prevent currency depreciation must imply a contraction in the money supply 4. By the end of 2016, there was no gold held in the exchange fund account. 5. A Closer Look 14.1: The Bank of Canada’s Response to the 2007-2009 Financial Crisis

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a. The Bank of Canada took a number of extraordinary steps that were designed to calm financial market. b. The Bank added liquidity to the financial sector to keep it running smoothly. c. Financial conditions improved throughout 2009. By 2010 the Bank had reduced its injection of liquidity and by early 2010, financial conditions improved significantly in Canada. Setting monetary policy in practice 1. The IS-LM model makes monetary policy look easy—just change the money supply to move the economy to the best point possible a. In fact, it isn’t so easy because of lags in the effect of policy and uncertainty about the ways monetary policy works 2. Lags in the effects of monetary policy a. It takes a fairly long time for changes in monetary policy to have an impact on the economy b. Nominal interest rates and exchange rates change quickly, but output and inflation take much longer to respond to changes in monetary policy c. These longs lags make it very difficult to use monetary policy to control the economy very precisely d. Because of the lags, policy must be made based on forecasts of the future, but forecasts are often inaccurate e. The Bank of Canada has made preemptive strikes against inflation based on forecasts of higher future inflation 3. The channels of monetary policy transmission a. Exactly how does monetary policy affect economic activity and prices? There are two effects discussed in the textbook so far (1) The interest rate channel: as seen in the IS-LM model, a decline in money supply raises real interest rates, reducing aggregate demand, leading to a decline in output and prices (2) The exchange rate channel: in an open economy, tighter monetary policy raises the real exchange rate, reducing net exports, and thus aggregate demand (3) The credit channel: tighter monetary policy reduces both the supply and demand for credit b. How important are these different channels? (1) Suppose real interest rates are high, but the dollar has been falling; is monetary policy tight or easy? It depends on the relative importance of the different channels (2) In response, Bank of Canada uses a monetary conditions index (MCI) which is the weighted average of changes in the nominal interest rate and the nominal exchange rate

III. The Conduct of Monetary Policy: Rules Versus Discretion (Sec. 14.3) A. Monetarists and classical macroeconomists advocate the use of rules 1. Rules make monetary policy automatic, as they require the central bank to set policy based on a set of simple, prespecified, and publicly announced rules 2. Examples of rules a. Increase the monetary base by 1% each quarter . 270

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b. Maintain the price of gold at a fixed level 3. The rule should be simple; there shouldn’t be much leeway for exceptions 4. The rule should specify something under the Bank’s control, like growth of the monetary base, not something like fixing the unemployment rate at 4%, over which the Bank has little control Most Keynesians economists support discretion 1. Discretion means the central bank looks at all the information about the economy and uses its judgment as to the best course of policy 2. Discretion gives the central bank the freedom to stimulate or contract the economy when needed; it is thus called activist 3. Since discretion gives the central bank leeway to act, while rules constrain its behaviour, why would anyone suggest that the central bank follow rules? The monetarist case for rules 1. Monetarism is an economic theory emphasizing the importance of monetary factors in the economy 2. The leading monetarist is Milton Friedman, who has argued for many years (since 1959) that the central bank should follow rules for setting policy 3. Friedman’s argument for rules comes from four main propositions a. Proposition 1: Monetary policy has powerful short-run effects on the real economy. In the longer run, however, changes in the money supply have their primary effect on the price level (1) This proposition comes from Friedman’s research with Anna Schwartz on monetary history (2) Friedman and other monetarists think monetary policy is a main source of business cycles b. Proposition 2: Despite the powerful short-run effect of money on the economy, there is little scope for using monetary policy actively to try to smooth business cycles (1) First, the information lag makes it difficult to know the current state of the economy (2) Second, monetary policy works with a long and variable lag, so it isn’t clear how to set policy quantitatively (3) Third, wage and price adjustment is fast enough that by the time a change in policy begins to affect the economy, it may be moving the economy in the wrong direction, thus destabilizing the economy c. Proposition 3: Even if there is some scope for using monetary policy to smooth business cycles, the central bank cannot be relied on to do so effectively (1) Friedman believes the central bank responds to political pressure and tends to stimulate the economy in election years (2) Historically, monetary policy has tended to destabilize, rather than stabilize, the economy; so eliminating monetary policy as a source of instability would improve macroeconomic performance

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Proposition 4: The central bank should choose a specific monetary aggregate (such as M1 or M2) and commit itself to making that aggregate grow at a fixed percentage rate. year in and year out (1) The central bank needs to give up activist, or discretionary, policy completely and follow a simple rule (2) Friedman prefers a constant money growth rule, since the money supply is controllable by the central bank and the central bank would not follow destabilizing monetary policies (3) To reduce inflation to zero, the money growth target should be gradually lowered over time Rules and central bank credibility 1. New arguments for rules suggest that rules are valuable even if the central bank has a lot of information and forms policy wisely a. The new arguments suggest that rules improve the credibility of the central bank b. The credibility of the central bank influences how well monetary policy works 2. Rules, commitment, and credibility a. How does a central bank (or a dad) gain credibility? b. One way to get credibility is by building a reputation for following through on its promises, even if it’s costly in the short run c. Another, less costly, way is to follow a rule that is enforced by some outside agency (Mom, for example) d. Keynesians argue that there may be a trade-off between credibility and flexibility (1) To be credible, a rule must be nearly impossible to change (2) But if a rule can’t be changed, what happens in a crisis situation? (3) For example, if a rule is based on economic relationships that change suddenly, then the lack of flexibility may be very costly (4) So a rule may create unacceptable risks 3. The Taylor Rule a. The Taylor rule is given by i = π + 0.02 +0.5y + 0.5(π-0.02) (14.9) b. If the economy is “overheating” with output growing more rapidly than full-employment and inflation rising, the Taylor rule suggests that the Bank of Canada should tighten monetary policy by raising the real overnight interest rate. c. If the economy shows weakness, with output below its fullemployment level and inflation below its target, the Taylor rule would have the Bank of Canada reduce the real overnight interest rate below 2%, thereby easing monetary policy

Policy Application For a good description of the rules versus discretion issue applied to monetary policy, see the article by Herb Taylor, “Time Inconsistency: A Potential Problem for Policymakers,” Federal Reserve Bank of Philadelphia Business Review, March/April 1985, pp. 3-12. . 272

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Application: Shooting at targets 1. High unemployment and high inflation in the 1970s led central banks worldwide to experiment with alternative strategies for monetary policy, including targeting money growth and targeting inflation 2. Money-growth targeting a. Germany’s Bundesbank introduced money-growth targets in 1975 and has used the strategy ever since b. The US, Canada, the US, Switzerland, and others also adopted money targets in the 1990s c. Money-growth targeting means the central bank announced a money-growth rate that it will aim for over the next year or so (1) The idea is that by having money grow at the optimal rate, inflation and output will be at desired levels (2) Germany has been quite successful in targeting money growth

Data Application Students can easily see whether the Bank of Canada is meeting its inflation targets by inspecting a graph in the Monetary Policy Report twice each year. The graph shows the actual inflation rate and the target range since 1990. The report can be viewed at the Bank of Canada web site. 3.

Inflation targeting a. Since 1990, some countries have switched from targeting money growth to targeting inflation (1) On November 23, 2006, Bank of Canada renewed the 1– 3% target range for inflation to last until December 31,2016 b. Under inflation targeting, the central bank announces targets for inflation over the next 5 years c. Advantages of inflation targeting over money-growth targeting (1) It avoids the problem of instability in money demand (2) It’s easy to explain inflation targets to the public (since they understand what inflation is) than money-growth targeting (which most people don’t understand) (3) Better communication of the central bank’s goals will reduce uncertainty about what the central bank will do and may increase the bank’s accountability d. Disadvantages of inflation targeting relative to money-growth targeting (1) Inflation responds to policy actions with a long lag, so it’s hard to judge what policy actions are needed to hit the inflation target and hard for the public to tell if the central bank is doing the right thing (2) Thus, central banks may miss their targets badly, losing credibility

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Price level targeting a. It provides more certainty about the long term purchasing power of money than does inflation targeting b. The drawback is the central bank allow the rate of inflation to be variable c. The tradeoff between inflation targeting and price level targeting is that it provides the central bank with greater flexibility Other ways to achieve central bank credibility 1. Appointing a “tough” central banker a. Appointing someone who has a well-known reputation for being tough in fighting inflation may help establish credibility for the central bank b. For example, in 1979 the appointment of Paul Volcker to be chairman of the Fed was designed to convince people that President Carter was serious about stopping inflation c. Even in Volcker’s case, however, disinflation proved to be costly 2. Changing central bankers’ incentives a. People are more likely to believe a central bank is serious about disinflation if it has the incentive to care a lot about inflation b. In New Zealand, for example, the head of the central bank must be replaced if inflation targets aren’t met; as a result, inflation was reduced significantly, but at a cost of higher unemployment 3. Increasing central bank independence (text Fig. 14.3) a. If the executive and legislative branches of government can’t interfere with the central bank, people are more likely to believe that the central bank is committed to keeping inflation low and won’t cause a political business cycle b. Looking at evidence across countries, Alesina and Summers showed that the more independent the central bank, the lower the inflation rate from 1955 to 1988; also, the long-run level of unemployment is no higher in those countries

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1. Should There Be One Currency per Country? There is an old literature in international finance which discusses the question of the optimal area within which a single currency should be used. To most people a ‘single currency area’ coincides with the nation state. However, economists have speculated about whether two or more nations together might use a common currency (already there are examples of this; for instance, Panama uses the US dollar—see Additional Issues chapter 13). The traditional analysis of the optimal currency area boundaries argued that if nations are affected quite differently by various macroeconomic supply or demand shocks then they will require real exchange rate adjustment in order to efficiently respond to these shocks. If on the other hand the countries were mainly hit by common shocks, then there would be no need for real exchange rate adjustment. In that case, they could gain by adopting a single currency, which would reduce the frictions involved in international trade in goods and services between the countries. In 1999, most of the western European countries (excluding the UK) formed the European Monetary Union and have adopted a single currency known as the euro (Chapter 10, p. 334). Just as there are strategic difficulties in monetary policy making within a country, there are likely to be manifold problems with the operation of the common euro currency. For example, one country may be experiencing a recession and therefore desire lower interest rates, while another country may want to reduce inflation and therefore want higher interest rates. However, in a single currency region interest rates cannot differ across the two countries. The question remains as to how the common European central bank will solve such potential conflicts. 2. The Goal of Zero Inflation The Bank of Canada’s zero inflation policy has moved Canada down the rankings from a ‘high-inflation’ country in the 1970s and early 1980s to a ‘low inflation’ country in the 1990s. In 1998-1999, Canada’s annual inflation rate was about 1.2%. This contrasts with inflation rates of 14 percent in the late 1970s. This success on the inflation front did not come without some cost however. Canada’s recession in the early 1990s started earlier, and went deeper than that in the US One of the reasons was the very high Canadian dollar in the early 1990s which hurt export industries. Many blame the Bank of Canada’s high interest rate policies for the seventy of the recession. On the other hand, it may have been that the Bank’s policy was costly because it lacked ‘credibility’, perhaps due to persistent failures in reducing inflation in the past. Is the Bank’s decision to abandon traditional stabilization role for monetary policy in Canada and to focus exclusively on price stability desirable? Some economists argue that the Bank has been far too extreme in its concentration on inflation, that it has accepted very high unemployment for the nebulous benefits of bringing down inflation from relatively low levels to begin with. It may have chosen a very poor trade-off between inflation and unemployment. The Bank itself however argues that there is really no exploitable trade-off. No country has been successful at using monetary policy to improve its economic performance. On the other hand, there are some serious long-term costs of inflation. Therefore, the best possible policy that the central bank can follow is to maintain inflation at low, stable and predictable levels.

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3. Monetary Policy in a Multi-Region Country Canada’s different regions have very different economic cycles. In the late 1980s, Ontario was booming, while much of the Prairies and British Columbia had not fully recovered from the recession of the early 1980s. Likewise, in the early 1990s British Columbia hardly suffered at all from the recession that overtook central Canada. The disparate experience of the different regions makes it difficult to design an appropriate monetary policy. Some critics of the Bank of Canada argue that the Bank should allow more representation of regional concerns in formulating policy. Monetary policy however, is a ‘blunt instrument’, which cannot be used separately to address regional issues.

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1. The monetary base, or high-powered money, consists of the liabilities of the central bank that are usable as money. In an all-currency economy, the money supply equals the monetary base. 2. The money multiplier is the number of dollars of the money supply that can be created from each dollar of monetary base. In a system of 100% reserve banking, the reserve-deposit ratio is one and the money multiplier is one. Under fractional reserve banking, with all money held as deposits, the money multiplier is the reciprocal of the reserve–deposit ratio. The multiplier is higher under fractional reserve banking, because banks hold only part of the monetary base as reserves and create money in the form of deposits with their excess reserves. Under 100% reserve banking, deposits simply substitute for the currency that is held by banks as reserves—no new money is created by banking. So the money multiplier is higher under fractional reserve banking, in which banks create money, than under 100% reserve banking, in which banks do not create money. 3. Changes in the desire by the public for holding currency affect the currency-deposit ratio, thus changing the money multiplier. Similarly, changes in banks’ desire to hold reserves affect the reserve-deposit ratio, thus changing the money multiplier. Increases in either the currency-deposit ratio or the reserve-deposit ratio reduce the money multiplier. But these effects do not mean that the central bank cannot control the money supply, because changes in the money multiplier can be offset by changes in the monetary base to leave the money supply unchanged. 4. Suppose the Bank lowers the operating band for the overnight rate. This encourages banks to borrow reserves and increases the overnight rate. Since interest rates tend to move together, the rise in the overnight rate will tend to drive up other interest rates. This will lead to a fall in the money supply. 5.

An open market purchase of treasury bills raises the stock of base money. This leads to a fall in interest rates and an increase in the money supply.

The three channels of monetary policy transmission are the interest rate channel, the exchange rate channel, and the credit channel. The interest rate channel arises because tighter monetary policy raises the real interest rate, which reduces aggregate demand, leading to lower output and prices. The exchange rate channel comes about as tighter monetary policy raises the real exchange rate, leading to lower net exports, which reduces aggregate demand and thus reduces output and prices. The credit channel occurs when tighter monetary policy reduces the supply of credit, as banks lend less, and the demand for credit, as firms and consumers borrow less. With less borrowing and lending, consumption and investment decline, so aggregate demand falls, leading to declines in output and prices.

The monetarist response to the argument that discretion is more flexible than following a rule is to argue that (1) because of information lags, it is difficult for the central bank to tell what the appropriate policy is at a particular time; (2) there are long and variable lags between monetary policy actions and their economic results; and (3) the lags mean that by the time a policy change has an effect, it may be destabilizing—moving the economy in the wrong direction. Further, discretion allows political manipulation of the economy. The more recent argument is that the central bank’s credibility can be enhanced by tying itself to rules rather than relying on discretion. If people believe that the central bank is committed to a rule, they will know that the Bank will not take advantage of them by using unexpected inflation to increase output temporarily. As a result, inflation will be lower. . 277

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The use of money-growth or inflation targets does not seem to have increased central bank credibility significantly in any country other than Japan. In other countries, including the United States, Germany, and Canada, disinflations based on targeting money growth were accompanied by significant increases in unemployment. Besides money-growth or inflation targeting, a country could improve the credibility of the central bank by appointing a tough central banker, changing the central banker’s incentives, or by making the central bank more independent.

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Numerical Problems 1.

Initial balance sheet of banks (all amounts in florins): Assets Liabilities Reserves 500 000 Deposits 500 000 Banks want to hold reserves equal to only 20% of deposits. This is 0.20 x 500 000 = 100 000. So they have 400 000 they’d like to lend. If they lend 400 000, the public will hold half of it (200 000) in deposits and the other 200 000 in currency. Since the public holds 200 000 of additional currency, banks’ reserves are 500 000 – 200 000 = 300 000. The first-round balance sheet of banks is: Assets Liabilities Reserves 300 000 Deposits 700 000 Loans 400 000 Banks still want reserves to equal just 20% of deposits, or 0.20 x 700 000 = 140 000. Since they are still holding reserves of 300 000, they can lend another 160 000. Of this amount, 80 000 comes back to the bank in the form of new deposits, and the other 80 000 is held by the public in the form of currency. Banks have reduced their reserves by 80 000 from 300 000, so reserves are 220 000. The second-round balance sheet of banks is:

Assets Liabilities Reserves 220 000 Deposits 780 000 Loans 560 000 The process continues until banks reach their desired reserve-deposit ratio. Since the public wants to hold its money in equal amounts of currency and deposits, the currency-deposit ratio is 1. The money multiplier in this case is (cu + 1) / (cu + res) = (1 + 1) / (1 + 0.20) = 2 / 1.2 = 1 2/3. Since the monetary base is 1 million florins, the money supply is 1 2/3 million florins. Since half of the money supply is in currency and half is in deposits, these are each equal to 833 1/3 thousand florins. With a reserve-deposit ratio of 0.2, total reserves held by banks are 0.2 x 833 1/3 = 166 2/3 thousand florins. The final balance sheets are: Central Bank Assets Liabilities Coconuts 1 000 000 Currency 1 000 000 Banks Assets Liabilities Reserves 166 666 2/3 Deposits 833 333 1/3 Loans 666 666 2/3 Public Assets Liabilities Currency 833 333 1/3 Loans 666 666 2/3 Deposits 833 333 1/3 Net Worth 1 000 000 Dollar amounts are in millions of dollars. a. DEP = M – CU = 6 – 2 = 4. RES = res × DEP = 0.25 × 4 = 1. BASE = CU + RES = 2 + 1 = 3. multiplier = M/BASE = 6 / 3 = 2. b. RES = vault cash + reserves at central bank = 1 + 4 = 5. CU = BASE – RES = 10 – 5 = 5. M = CU + DEP = 5 + 20 = 25. . 279

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multiplier = M / BASE = 25 / 10 = 2.5. a. res = 0.4 – 2(0.10) = 0.2. multiplier = (cu + 1) / (cu + res) = (0.4 + 1) / (0.4 + 0.2) = 2 1/3. M = multiplier x BASE = 2 1 /3 × 60 = 140. Setting M/P = L gives 140/1 = 0.5Y – 10(0.10), or 140 + 1 = 0.5Y, which has the solution Y = 282. b. res = 0.4 – 2(0.05) = 0.3. multiplier = (cu + 1) / (cu + res) = (0.4 + 1) / (0.4 + 0.3) = 2. M = multiplier × BASE = 2 × 60 = 120. Setting M/P = L gives 120 / 1 = 0.5Y – 10(0.05), or 120 + 0.5 = 0.5Y, which has the solution Y = 241. c. In this case the multiplier is unchanged from part (a) at 2 1/3, so the money supply is unchanged at 140. Setting M/P = L gives 140 / 1 = 0.5Y – (10 x 0.05), or 140 + 0.5 = 0.5Y, which has the solution Y = 281. d. If the reserve-deposit ratio is unaffected by the real interest rate, the LM curve is steeper than when it is affected by the real interest rate. To see why, consider the effect of a decline in the real interest rate. If the reserve-deposit ratio is affected by the real interest rate, the fall in the real interest rate causes banks to hold more reserve, since they are cheaper (they have a lower opportunity cost). The increase in reserves reduces the money multiplier, reducing the nominal money supply. At the same time, the fall in the real interest rate increases the real demand for money. Since the price level is fixed in the short run, the decline in the nominal money supply means that the real money supply has declined as well. Since the real money supply declines while real money demand increases, something must adjust to restore equilibrium. Along an LM curve, given a particular real interest rate, output adjusts to restore equilibrium. A decline in output is necessary to reduce real money demand and restore equilibrium in the asset market. If the reserve-deposit ratio is not affected by the fall in the real interest rate, then there is no effect on money supply, just an increase in money demand. So it takes a smaller decline in output to restore the asset market to equilibrium. Since output need not change as much, this means that the LM curve is steeper.

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Analytical Problems 1.

a. The increase in banks’ reserve-deposit ratio reduces the money multiplier, causing the money supply to decline. b. The increased holding of cash raises the currency-deposit ratio, reducing the money multiplier and causing the money supply to decline. c. The sale of gold to the public has the same effect as an open-market sale of government securities—it reduces the monetary base, thus causing the money supply to decline. d. The availability of ATMs means people hold less cash and more deposits, reducing the currency-deposit ratio. This causes the money multiplier to increase, which causes the money supply to increase. e. When the Bank monetizes the government debt, the monetary base increases, so the money supply increases. f. When the Bank sells securities in exchange for yen, there is no change in the Canadian monetary base or in the Canadian money supply. The Bank has simply changed the composition of its assets. a. If the Bank targets the real interest rate, then money demand shocks are offset by changes in the money supply, so the LM curve does not move. To see this, look at Fig. 14.1, which depicts the result in a Keynesian model. Initially, real money supply is given by the MS1 line, while money demand is given by the curve MD1(Y1), where Y1 is the current level of output. Suppose a money demand shock increases money demand for a given level of output; then the money demand curve shifts to MD2(Y1). This tends to increase the real interest rate. When the Bank sees the rise in the real interest rate, it increases the money supply in response to reduce the real interest rate back to its targeted level of 3%. It is successful in doing so if it increases the real money supply to MS2

Figure 14.1

Figure 14.2

In terms of the LM curve, the result of targeting the real interest rate is shown in Fig. 14.2. Beginning at LM1, the shock to money demand shifts the LM curve up to LM2. If the Bank does not respond, this raises the real interest rate and reduces output. But when the Bank responds by increasing the money supply by just the right amount, the LM curve shifts back to LM1. Since the shock . 281

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causes the money supply to change, but does not affect output, the money supply is acyclical. By following the interest-rate-targeting rule, the AD curve is unaffected by money-demand shocks (since they are offset by money-supply changes), so it is more stable than if the Bank did not respond at all. b. When there are IS shocks, the rule does not work very well. Suppose a shock shifts the IS curve from IS1 to IS2, as shown in Fig. 14.3. Targeting the real interest rate requires the Bank to increase the money supply to shift the LM curve from LM1 to LM2. While this maintains the real interest rate at its initial level, output is above full-employment output. The money supply is procyclical, since the shift in the IS curve caused output to rise, and the increase in the money supply caused output to rise further. This response to IS shocks makes the aggregate demand curve less stable, as it shifts the AD curve farther to the right in response to an IS shock than it would have if the LM curve did not respond. Also, the Bank cannot maintain this policy in the long run, as the economy must return to full-employment output with a higher real interest rate on the new IS curve. If the Bank were to try to keep increasing the money supply in an attempt to shift the LM curve rightward and reduce the real interest rate, the result would be higher inflation.

Figure 14.3 Figure 14.4 c. When there are aggregate supply shocks, the rule also does not work very well. Suppose a supply shock shifts the FE line from FE1 to FE2, as shown in Fig. 14.4. In the short run, there is no effect on output or the real interest rate, since the equilibrium occurs where the IS curve intersects the LM curve. However, at this point output is below full-employment output. In the long run, the price level will fall, shifting the LM curve from LM1 to LM2 to reach the new long-run equilibrium. If the central bank tries to target the real interest rate at its initial level, it will have to reduce the money supply as the price level falls to keep the LM curve from shifting and to prevent the real interest rate from declining. Such a policy cannot be successful in the long run, as the economy must eventually return to full-employment output with a lower real interest rate. d. If the Bank targets the real interest rate, then money demand shocks are offset by changes in the money supply, so the LM curve does not move. Since the real interest rate remains the same, there is no change in the exchange rate and net exports will not be affected. Since the shock causes the money supply to change, but does not affect output, the money supply is acyclical. By following the interest-rate-targeting rule, the AD curve is unaffected by moneydemand shocks (since they are offset by money-supply changes), so it is more stable than if the Bank did not respond at all. e. When there are IS shocks, the rule does not work very well. Suppose a shock shifts the IS curve to the right. Targeting the real interest rate requires the Bank to increase the money supply to shift the LM curve to the right. While this . 282

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maintains the real interest rate at its initial level, output is above full-employment output. The money supply is procyclical, since the shift in the IS curve caused output to rise, and the increase in the money supply caused output to rise further. This increase in money supply will reduce the exchange rate and net exports will rise. This response to IS shocks makes the aggregate demand curve less stable, as it shifts the AD curve farther to the right in response to an IS shock than it would have if the LM curve did not respond. Also, the Bank cannot maintain this policy in the long run, as the economy must return to fullemployment output with a higher real interest rate on the new IS curve. If the Bank were to try to keep increasing the money supply in an attempt to shift the LM curve rightward and reduce the real interest rate, the result would be higher inflation. 3.

To examine Taylor’s rule, we’ll use the classical model with misperceptions. a. An increase in money demand causes the aggregate demand curve to shift to the left, reducing the price level and inflation and decreasing output, if the money supply is unchanged. In response to these changes in output and inflation, Taylor’s rule decreases the nominal Fed funds rate, which means the money supply is increased. This offsets the original shift in the aggregate demand curve and helps stabilize the economy. b. A temporary increase in government purchases causes the aggregate demand curve to shift to the right, increasing the price level and inflation and increasing output, if the money supply is unchanged. Assuming that output increases more than full-employment output, in response to these changes, Taylor’s rule increases the nominal Fed funds rate, which means the money supply is increased. This offsets the original shift in the aggregate demand curve and helps stabilize the economy. c. An adverse supply shock causes the aggregate supply curve to shift to the left, increasing the price level and inflation and decreasing output, if the money supply is unchanged. Assuming that output decreases more than fullemployment output, in response to these changes, Taylor’s rule is ambiguous about which way to move the nominal Fed funds rate, since higher inflation increases the funds rate but lower output decreases the funds rate. d. A decline in consumer confidence causes the aggregate demand curve to shift to the left, reducing the price level and inflation and decreasing output, if the money supply is unchanged. In response to these changes in output and inflation, Taylor’s rule decreases the nominal Fed funds rate, which means the money supply is increased. This offsets the original shift in the aggregate demand curve and helps stabilize the economy. e. An increase in export demand causes the aggregate demand curve to shift to the right, increasing the price level and inflation and increasing output, if the money supply is unchanged. In response to these changes in output and inflation, Taylor’s rule increases the nominal Fed funds rate, which means the money supply is decreased. This offsets the original shift in the aggregate demand curve and helps stabilize the economy.

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CHAPTER 15: GOVERNMENT SPENDING AND ITS FINANCING LEARNING OBJECTIVES I.

Goals of Chapter 15 A. Examine fiscal policy and its macroeconomic effects B. Look at definitions and facts about the government’s budget C. Discuss fiscal policy issues 1. Effects of government spending and taxes on economic activity 2. The burden of government debt 3. The link between budget deficits and inflation

II.

Notes to Eighth Edition Users A. A new section on “Laffer Curve” has been added to Section 15.2. B. Section 15.3 has been revised to be much clearer and easier to understand. C. The sections on “Revenue and Expenditure” have been amended to highlight key concepts. D. A Closer Look 15.1 has been updated. E. All data were updated

TEACHING NOTES I.

The Government Budget: Some Facts and Figures (Sec. 15.1) A. Defining the government sector 1. The government sector in Canada is defined by four major sectors: a. The federal government b. Provincial and territorial government c. Local government d. The Canada and Quebec Pension Plans 2. Thus, the total government sector is defined as the sum of the federal government, provincial and territorial government, local government, and the Canada and Quebec Pension Plan subsectors 3. The Bank of Canada is not included in the federal government subsector even though it performs an important governing function B. Government expenditure 1. Three categories of government expenditures a. Government purchases (G) (1) Spending on currently produced goods and services (2) Examples: spending on schools, government workers’ salaries, highway repairs b. Transfer payments (TR) (1) Transfers are expenditures for which the government receives no current goods or services in return (2) Examples: old age security, pensions for government retirees, welfare payments c. Net interest payments (INT) (1) Interest paid to holders of government bonds 2. Total government expenditure (federal, provincial, and local) is currently about forty percent of GDP 3. A comparison of the Canadian government spending to that of other OECD countries shows that over a span of nearly thirty years, from 1987 to 2016, the level of government spending in Canada adjusted from being significantly above the OECD average in 1987 to being slightly below in 2016 (text Table 15.1) C. Revenues . 284

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1. 2.

The main components on the revenue side are tax receipts. Three principal categories a. Direct taxes (1) Personal income taxes (2) Property taxes (3) Employment insurance contributions (4) Corporate income taxes (5) Direct taxes comprise three-quarters of all government revenue b. Indirect taxes (1) Mostly sales taxes (2) Indirect taxes comprise twenty percent of all government revenue c. Investment income, including revenue from loans to Crown corporations, farmers, students. The composition of spending and taxes: the Federal government versus provincial and local governments a. To see the overall picture of government spending, we usually combine federal, provincial, and local government spending b. But the composition of the federal government budget is quite different from provincial and local government budgets (text Table 15.2) (1) Goods and services (a) Three-quarters of provincial and local spending is purchases of goods and services (b) By contrast, only a quarter of federal spending is for purchases of goods and services (c) Of all government spending on goods and services, about four-fifths is done by provincial and governments (2) Transfer payments (a) The federal government spends more on transfer payments to individuals than provincial and local governments. Lower-tier government transfers are almost wholly to individuals and businesses.

Analytical Problem 1 looks at the reasons for inter-government transfers. (3)

(4)

Interest payments (a) Net interest is significant and positive for the federal government (b) Net interest payments in 2015 were $23.4 billion for the federal government and worth 8.2% of all federal spending Composition of revenue (a) Personal taxes account for just over 60% of federal revenue, but only 25% of provincial and local government receipts

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(b)

Indirect taxes provide for nearly 35% of provincial and local government revenue, but only about 19.9% of federal revenue

D. Surpluses or Deficits 1. When outlays exceed revenues, there is a deficit; when revenues exceed outlays, there is a surplus 2. Formally, surplus = tax revenues – expenditure = tax revenues – government purchases – transfers – interest payments = T – G – TR – INT (15.1) 3. Another useful surplus definition is the primary government budget surplus, which excludes net interest: primary surplus = tax revenues – expenditure + interest payments = tax revenue – government purchases – transfers = T – G – TR (15.2) i. a. The total surplus tells how much the government can pay down in debt and still pay for total expenditure ii. The primary surplus tells whether or not the government can afford its current programs iii. The primary surplus or deficit ignores interest payments, because those are payments for past government spending Numerical Problems 1, 2, 6, and 7 and Analytical Problem 4 deal with various aspects of the deficit (surplus) and primary deficit (surplus). 4. The relationship between the total budget surplus and the primary budget surplus (text Fig. 15.1) i. In 2015 the primary surplus of the federal government was $18.0 billion ii. But it ran an overall deficit of $5.4 billion – this due to the fact it needed to spend $23.4 billion in interest payments. Analytical Problem 2 asks students to look at actual data on the government budget balance and see what does the size of the actual budget balance relative to the size of the cyclically adjusted budget balance imply about the state of the economy. E.

A Closer Look 15.1: Government Budgets by Province and Territory 1. There are notable differences between provinces in spending, revenue, and deficits, and in the allocation by province of federal government spending and revenue 2. Statistics Canada provides annual data that identify the federal tax revenue and spending in each province and territory 3. For 2014 the federal government ran a surplus in four of the provinces and territories and deficits in the others 4. In 2014, consolidated provincial/territorial and local governments ran surpluses in 4 of the 10 provinces and in the Northwest Territories/Nunavut

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Policy Application Not everyone agrees with the budgetary choices that the Canadian federal government has made. The Alternative Federal Budget is a document prepared by the Canadian Centre for Policy Alternatives and Choices, a Winnipeg-based group. Their latest budget proposal can be viewed and downloaded from their website: www.policyalternatives.ca. II.

Government Spending, Taxes, and the Macroeconomy (Sec. 15.2) A. Fiscal policy and aggregate demand 1. An increase in government purchases increases aggregate demand by shifting the IS curve up 2. The effect of tax changes depends on the economic model a. Classical economists accept the Ricardian equivalence proposition that lump-sum tax changes have no effect on national saving or on aggregate demand b. Keynesians think a tax cut is likely to increase consumption and decrease saving, thus increasing aggregate demand 3. Classicals and Keynesians disagree about using fiscal policy to stabilize the economy a. Classicals oppose activist policy while Keynesians favour it b. But even Keynesians admit that fiscal policy is difficult to use (1) There is a lack of flexibility, because much of government spending is committed years in advance (2) There are long time lags, because the political process takes time to make changes 4. Automatic stabilizers and the full-employment surplus or deficit a. Automatic stabilizers cause fiscal policy to be countercyclical by changing government spending or taxes automatically b. One example is Employment Insurance, which causes transfers to rise in recessions c. The most important automatic stabilizer is the income tax system, since people pay less tax when their incomes are low in recessions, and they pay more tax when their incomes are high in booms d. Because of automatic stabilizers, the government budget surplus falls in recessions and rises in booms (1) The full-employment surplus is a measure of what the government budget surplus would be if the economy were at full employment (2) So the full-employment surplus doesn’t change with the business cycle, only with changes in government policy regarding spending and taxation (3) The actual budget surplus is much smaller than the fullemployment budget surplus in recessions (text Fig. 15.2)

Numerical Problem 3 looks at how automatic stabilizers affect the budget deficit over the business cycle.

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Government capital formation 1. Fiscal policy affects the economy through the formation of government capital—long-lived physical assets owned by the government, like roads, schools, and sewer systems 2. Also, fiscal policy affects human capital formation through expenditures on health and education 3. The government budgeting system distinguishes between current expenditures and capital expenditures 4. The resulting measure in the national accounts is called “saving”: saving = Sgovt = T – (G + TR + INT) (15.3) 5. To measure government spending including investment, it results in “net lending”: net lending = T – (G + TR +INT – dKgovt + Igovt) = saving + dKgovt – Igovt (15.4) 6. If new investment exceeds depreciation, then net lending is less than saving Incentive effects of fiscal policy 1. Average versus marginal tax rates a. Average tax rate = total taxes / pretax income b. Marginal tax rate = taxes due from an additional dollar of income c. Example: Suppose taxes are imposed at a rate of 25% on income over $10 000 (1) For someone earning less than $10 000, the marginal tax rate and average tax rate are both zero (2) Anyone earning over $10 000 would have a marginal tax rate of 0.25 (3) Someone earning $18 000 would pay ($18 000 – $10 000) x0.25 = $2000 in taxes, so he or she would have an average tax rate of 11.1% (4) Someone earning $100 000 would pay ($100 000 – $10 000) x 0.25 = $22,500 in taxes, so he or she would have an average tax rate of 22.5%. The distinction between average and marginal tax rates affects people’s decisions about how much labour to supply (5) If the average tax rate increases, with the marginal tax rate held constant, a person will increase labour supply (a) The higher average tax rate causes an income effect (b) With lower income, a person consumes less and wants less leisure, so he or she works more (6) If the marginal tax rate increase, with the average tax rate held constant, a person will decrease labour supply (a) The higher marginal tax rate causes a substitution effect (b) With a lower after-tax reward for working, a person wants to work less

Numerical Problem 4 and Analytical Problem 3 look at the effects of tax rates on labour supply. 2.

Application: The poverty trap a. Surprisingly, the highest marginal tax rates in Canada are faced by some relatively poor Canadians. This disincentive effect occurs as transfers under social programs fall with income . 288

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b. c.

Text Figure 15.3 shows the effective marginal tax rate for a single parent in Ontario in 2000, which often exceeds 70% Removing the poverty trap costs money and requires coordination between the different levels of government

Policy Application A classic supply-side experiment in the US was the Tax Reform Act of 1986. Four articles evaluating the results of this act are presented in a symposium in the Winter 1992 issue of the Journal of Economic Perspectives. 3.

Tax-induced distortions and tax rate smoothing a. In the absence of taxes, the free market works efficiently (1) Taxes change economic behaviour, reducing welfare (2) Thus tax-induced deviations from free-market outcomes are called distortions b. The difference between the number of hours a worker would work without taxes and the number of hours he or she actually works when there is a tax reflects the tax distortion c. The higher the tax rate, the greater the distortion d. Fiscal policymakers would like to raise the needed amount of government revenue while minimizing distortions

Policy Application Bev Dahlby calculates that the raising of $1 in taxes in Canada imposes an excess cost (over and above the $1) of 38 cents on the economy. See his article “The Distortionary Effects of Rising Taxes” in William B.P. Robson and William M. Scarth ed. Deficit Reduction: What Pain, What Gain?, C.D. Howe Institute, 1994. e.

It’s better to keep the tax rate constant over time than to raise it and lower it, because the higher tax rate has a higher distortion (1) For example, keeping the tax rate at a steady 20% is better than having it at 10% one year and 30% the next, since the distortions in the second year are much higher (2) Keeping a constant tax rate over time is called tax rate smoothing

Theoretical Application Robert Barro introduces the idea of tax smoothing in relation to the government debt in his article “On the Determination of Public Debt,” Journal of Political Economy, October 1979, pp. 940-971. (3)

The federal government hasn’t always smoothed tax rates as much as it could to minimize distortions (4) But borrowing to finance wars, thus avoiding the need to raise taxes a lot in war years, is consistent with the idea of tax rate smoothing The Laffer Curve a. The Laffer curve represents relationship between level of tax rate and the amount of tax revenue

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b. While no tax revenue will be collect at the two extreme values of the tax rate (0% and 100%), one would expect the government to collect tax revenue in between those two extreme values. And changes in the tax rate may cause tax revenue to rise or fall (text Fig. 15.4) c. At lower tax rates, a small increase in tax rate is unlikely to cause significant change in the tax base, hence it results in a net increase in tax revenue d. At higher tax rates, taxpayers will try to avoid paying more of their income in tax and the size of the tax base will fall, hence despite applying a higher tax rate, government collects less in revenue e. The trick bit is identifying at what tax rate revenue starts to fall with an increase in the tax rate f. Ferede and Dahlby find that in 2013, 5 of 10 provinces were on the downward sloping portion of their corporation income tax Laffer curve – so lowering tax rate would increase tax revenue III.

Government Deficits and Debt (Sec. 15.3) A. The growth of the government debt 1. The surplus or deficit is the difference between expenditures and revenues in any fiscal year 2. The debt is the total value of outstanding government bonds on a given date 3. The deficit is the change in the debt in a year – a. ∆B = nominal government budget deficit = −nominal government budget surplus (15.5) b. B = nominal value of government bonds outstanding 4. A useful measure of government’s indebtedness that accounts for the ability to pay off the debt is the debt–GDP ratio a. The Canadian debt-GDP ratio (text Fig. 15.5) fell from over 100% after World War II to a low point in the mid-1970s b. From 1975 the debt-GDP ratio rose sharply and hit its postwar high of 67% in 1996 c. The debt-GDP ratio in Canada has been falling since 1996 d. Canada’s debt – GDP ratio in 2016 was 30% and significantly lower than it was in the United States and was lowest of any country in the G7

Numerical Problem 5 looks at tax smoothing and labour supply. Data Application Tiff Macklem in “Some Macroeconomic Implications of Rising Levels of Government Debt”, Bank of Canada Review, Winter 1994–95, describes how government debt in Canada has changed since the mid 1970s, and goes on to investigate the effects of higher debt levels on macroeconomic performance. 5.

The change in the debt-GDP ratio from one year to the next is given by ∆(B/Y) = [(G +TR –T)/Y] + (i – g) (B−1 / Y) (15.6)

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Theoretical Application Andy Abel asks the question, “Can the Government Roll Over Its Debt Forever?” in the November/ December 1992 issue of the Federal Reserve Bank of Philadelphia Business Review. The answer to the question depends on whether there is too much capital in the economy, on the relation between the interest rate and growth rate, and on the presence of uncertainty. Economic research has provided no definitive answer to the question, however. a.

b. c. d.

So three things cause the debt-GDP ratio to rise (1) A high primary deficit (2) A high real interest rate (3) A low rate of GDP growth During World War II, large primary deficits raised the debt-GDP ratio For the next 30 years, primary deficits were small or negative, so the debt-GDP ratio fell After 1980 the debt-GDP ratio rose, both because of high primary deficits and because interest rates exceeded GDP growth rates Between 1996 and 2009, primary surpluses have been the main reason for the rapid reduction in the debt-GDP ratio over that time span

Data Application Nell Bruce and Douglas Purvis note that over the 1980s Canadian budget deficits were considerably lower, as a percentage of GDP, when adjusted for inflation. However, even with this adjustment, the deficit ratio (deficit to GDP) increased dramatically after the late 1970s. See their paper “Implementing a Prudent Fiscal Policy over the Medium Term” in Jack M. Mintz and Douglas D. Purvis ed. Policy Forum on Macropolicy Issues in the Medium Term, John Deutsch Institute for the Study of Economic Policy, Queens University, 1988. B.

A Closer Look 15.2: How large is the government debt? 1. There are different ways of thinking about government debt and hence different ways of measuring debt a. One way is think about government debt is as an indicator of the government’s ability to meet its interest obligations (1) From this perspective, a government’s net debt is the difference between its current financial liabilities and its current financial asset b. Another way of thinking about government net debt is to consider both current and long-term financial assets and liabilities (1) From this perspective, a government’s net debt is the unfunded liability—that is, the excess of future spending obligations over future tax revenue (2) According to William Robson of the C.D Howe Institute, Canadian governments have a large unfunded liability: about 100% of GDP

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(3)

This means that Canadian governments will need to increase tax rates, or hope for a faster rate of economic growth than Robson assumes in his calculations (4) The levels of government differ markedly in terms of their unfunded liabilities The burden of the government debt on future generations 1. People worry that their children will have to pay back the debt that past generations have accumulated 2. But Canadian citizens own most government bonds, so future generations will just be paying themselves 3. However, there could be a burden, because if tax rates have to be raised in the future to pay off the debt, the higher tax rates could be distortionary 4. Also, since bondholders are richer on average than non-bondholders, when the debt was repaid there would be a large transfer from the poor to the rich 5. Finally, government deficits reduce national saving according to many economists a. If so, with lower saving there will be lower investment b. Lower investment means a smaller capital stock c. A smaller capital stock means less output in the future d. So the future standard of living will be lower e. However, this assumes that government deficits reduce national saving; that is a key and unsettled question

Policy Application David Johnson in “Ricardian equivalence: Assessing the evidence for Canada” in William B.P. Robson and William M. Scarth Deficit Reduction: What Pain, What Gain? C.D. Howe 1994 argues that the evidence suggests that private saving in Canada has not increased to match the increase in the government deficit, indicating a failure of Ricardian equivalence. D.

Budget deficits and national saving: Ricardian equivalence revisited 1. When will a government deficit reduce national saving? a. It almost certainly does when government spending rises b. But it may not for a cut in taxes or increase in transfers 2. Ricardian equivalence: an example a. Suppose the government cuts taxes by $100 per person b. Since S = Y – C – G, national saving declines only if consumption rises (assuming Y is fixed at its full-employment level) c. Consumption might not rise if people realize that a tax cut today must be financed by higher taxes in the future (1) A tax cut of $100 per person could be financed by a tax increase of (1 + r)$100 next year (2) Then taxpayers’ ability to consume is the same with or without the tax cut (3) People will simply save the tax cut so they can pay off the future taxes d. As a result, national saving should be unaffected

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Ricardian equivalence across generations a. What if the higher future taxes are to be paid by future generations? b. Then people might consume more today, because they wouldn’t have to pay the higher future taxes c. But as Barro pointed out, if people care about their children, they’ll increase their bequests to their children so their children can pay the higher future taxes (1) After all, if people wanted to consume at their children’s expense, they could have lowered their planned bequests (2) So why should the fact that the government gives people a tax cut cause them to consume at their children’s expense?

Theoretical Application The classic article on bequests and Ricardian equivalence is Robert J. Barro, “Are Government Bonds Net Wealth?” Journal of Political Economy, 1974, pp. 1095–1117. Barro suggests that even if there are departures from Ricardian equivalence, examining the economy assuming Ricardian equivalence provides a useful baseline case. E.

Departures from Ricardian equivalence 1. The data show that Ricardian equivalence holds sometimes, but not always a. It did seem to hold in Canada in the early 1980s b. It certainly didn’t hold in the United States in the 1980s, when high government deficits were accompanied by low savings c. But overall, there seems to be little relationship between government budget deficits and national saving 2. What are the main reasons Ricardian equivalence may fail? a. Borrowing constraints (1) If people can’t borrow as much as they would like, a tax cut financed by higher future taxes essentially lets them borrow from the government b. Shortsightedness (1) If people don’t foresee the higher future taxes, or spend based on rules of thumb about their current after-tax income, they may increase consumption in response to a tax cut c. Failure to leave bequests (1) People may not leave bequests because they don’t care about their children, or because they think their children will be richer than they are, so they will increase consumption spending in response to a tax cut d. Non-lump-sum taxes (1) When taxes aren’t lump sum, changes in tax rates affect economic decisions (2) However, a tax cut won’t necessarily lead to an increase in consumption in this case

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Policy Application A debate over the value of generational accounts is presented in the Winter 1994 issue of the Journal of Economic Perspectives. Alan J. Auerbach, Jagadeesh Gokhale, and Laurence J. Kotlikoff present good reasons for using them in their article “Generational Accounting: A Meaningful Way to Evaluate Fiscal Policy,” while Robert Haveman questions their value in his article “Should Generational Accounts Replace Public Budgets and Deficits?” Policy Application In “Debt and Deficits in Canada: Some Lessons from Recent History”, Canadian Public Policy, June 1994, 20, 2, 152–64, Ronald Kneebone asks whether rules of behaviour need to be imposed on fiscal authorities at the provincial and federal level so as to constrain deficits and debt accumulation m Canada. He concludes that financial markets already impose quite tight constraints on provincial deficits, but fail to impose similar constraints at the federal level due to the Bank of Canada’s inability to commit not to monetize federal debt. IV.

Deficits and Inflation (Sec. 15.4) A. The deficit and the money supply 1. Inflation results when aggregate demand rises more quickly than aggregate supply 2. Budget deficits could be related to inflation, but we usually think of expansionary fiscal policy as leading to a one-time jump in the price level, not a sustained inflation 3. The only way for a sustained inflation to occur is for there to be sustained growth in the money supply 4. Can government deficits lead to ongoing increases in the money supply? a. Yes, if spending is financed by printing money b. The revenue that a government raises by printing money is called seignorage c. Usually, governments don’t just buy things directly with newly printed money, they do so indirectly (1) The Treasury borrows by issuing government bonds (2) The central bank buys the bonds with newly printed money (3) The relationship between the deficit and the increase in the monetary base is deficit = ∆B = ∆Bp + ∆Bcb = ∆Bp + ∆BASE (15.8) (4) ∆B is the increase in government debt, which is divided into government debt held by the public Bp and government debt held by the central bank Bcb (5) Changes in Bcb equal changes in the monetary base BASE (6) In an all-currency economy, the change in the monetary base is equal to the change in the money supply 5. Why would governments use money creation to finance deficits, knowing that doing so causes inflation? a. Developed countries rarely use seignorage, because it doesn’t raise much revenue

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But war-torn or developed countries are unable to raise sufficient tax revenue to cover government spending and may not be able to borrow from the public With an independent central bank, how is seignorage revenue determined? a. The government and central bank may engage in a game of ‘chicken’ b. The government may run large deficits, attempting to make the central bank buy government bonds c. The central bank can follow a policy of zero inflation, an attempt to make government to reduce its deficit d. This strategic game is probably not as important as that between the central bank and the private sector (seignorage is quite a small share of overall revenue, and the Bank of Canada answers to the federal government)

Policy Application If the government runs persistent budget deficits, can monetary policymakers keep inflation low? No, according to Thomas J. Sargent and Nell Wallace in their article “Some Unpleasant Monetarist Arithmetic,” Federal Reserve Bank of Minneapolis Quarterly Review, Fail 1981, pp. 1-17. Monetary policymakers lose control over inflation if government debt grows faster than the economy does. For then some of the government’s deficit must eventually be financed by seignorage.

Appendix 15.A: The Debt-GDP Ratio A. The government deficit is given by ΔB = G +TR – T +INT (15.A.1) B. Using the facts that INT = iB-1 and ΔB = B – B-1 in equation (15.A.1) one obtains B = G +TR –T + iB-1 + B-1 (15.A.2) C. The change in the debt-to-GDP ration is defined as Δ(B/Y) = (B/Y) – (B-1 / Y-1) (15.A.3) D. Use equation (15.A.2) to substitute for B in Eq. (15.A.3) to get: ∆(B/Y) = [(G +TR –T + iB-1 + B-1)/Y] – (B-1 / Y-1) (15.A.4) E. Finally, using the fact that Y = (1 + g) Y-1 to eliminate Y-1 from equation (15.A.4) and rearranging the resulting equation yields ∆(B/Y) = [(G +TR –T)/Y] + (i – g) (B-1 / Y) F. This is the same as equation (15.6) in the text

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION 1. How Has Government Spending Changed Over Time? Government spending is an important part of total spending. Does it change over the business cycle? How has government spending changed since 1960? Government spending can be divided into three areas—purchases, transfers, and services. Purchases include general administration and the work of various government departments. One would expect these expenditures to be relatively constant over the business cycle unless major fiscal policy changes take place. Transfer spending, on the other hand, might be countercyclical. Transfer programs are those that provide income for various recipients, such as unemployment insurance and social assistance. Many of the transfer programs increase when the economy is in recession. More people draw unemployment compensation and welfare payments when unemployment is high. The third major element in government expenditures is interest payments on the government debt. If interest rates fall during recessions, government interest payments should decrease as well, unless the government borrowing increases enough to outweigh the lower interest rates. 2. What is the Proper Role for Government? What is the appropriate role for government to play in the economy? A nation through its political process decides what government will do. In some countries government is a major player in sectors such as communications and health care. In other nations, government has a much more limited role. For example, in the United Kingdom, the government provides some television stations, which are paid for by a tax on set ownership. In Canada, health care is a government function. In the United States, television stations and health care are furnished by the private sector. Many Americans argue that services such as health care can best be provided by private suppliers, because they produce more efficiently and are more responsive to consumer demands. Most Canadians hold that health care should be a right and that the best way to insure its availability to all on an equitable basis is to have the government responsible for its provision. The British Broadcasting Commission is renowned for its fine reporting and excellent programming, Is it important to expose the masses to “better” quality programming, as the BBC does? Should television reflect the preferences of the people it serves, as some would argue it does in the United States? Which areas of the economy should the government enter? Should government intervene where there are clear economies of scale, as is the case with electricity and telephones? Should government become a service provider to insure equitable access to items such as health care and education? What role do we want our government to play in our economy? 3. Does the Source of Government Revenues Make a Difference? How taxes are levied can make a difference in the effect they have on economic output. Currently, of total revenue to all levels of government in Canada, about 58 percent is made up of direct taxes on persons, another 20% comes from indirect taxes, and only about 15% comes from taxes on corporations. Does this make for an efficient economy? Higher marginal tax rates on labour income reduce the incentive to work and may decrease productivity and growth. Higher indirect taxes, by raising prices, may decrease spending and lower GDP and well-being. Corporate taxes are often passed on to consumer in higher prices and may increase inflation. Increases in taxes that are costs to businesses will tend to raise prices and increase inflation. What is the best mix for our economy? . 296

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ANSWERS TO TEXTBOOK PROBLEMS Review Questions 1. The major sources of government expenditures are government purchases, transfer payments, and net interest payments. The major sources of government revenues are direct taxes on persons and enterprises, indirect taxes, and investment income. The federal government’s expenditures and revenues differ from those of provincial and local governments in that: (1) most spending on goods and services is done by provincial and local governments; (2) the federal government spends far more on transfers than on goods and services; (3) the federal government makes transfers to provincial and local governments; (4) the federal government is a large payer of net interest, while provincial and local governments have much lower net interest payments; and (5) most of the federal government’s revenues come from direct taxes, while provincial and local governments rely more heavily on indirect business taxes (sales taxes). 2. The overall budget surplus equals the primary budget surplus minus net interest. Both concepts are useful. The overall surplus tells how much the government can pay on its debt and still cover its expenditures. The primary surplus tells whether or not the government can afford its current programs. 3. The government deficit is the change in the government debt. A high growth rate of the debt-GDP ratio can be caused by: (1) high primary deficits, (2) a high nominal interest rate on government debt, and (3) a low growth rate of nominal GDP. 4. Fiscal policy affects the macroeconomy in three ways: (1) aggregate demand effects, (2) government capital formation, and (3) incentive effects. The aggregate demand channel affects the macroeconomy because expansionary fiscal policy shifts the IS curve upward and to the right, causing the AD curve to shift to the right as well. Both classicals and Keynesians agree that an increase in government spending shifts the IS and AD curves. There is disagreement about the effects of tax changes, however. Classicals generally believe in the Ricardian equivalence proposition, so that the IS and AD curves do not shift. Keynesians reject the Ricardian equivalence proposition and believe that the IS and AD curves do shift in response to tax changes. The formation of government capital affects the macroeconomy. The quantity and quality of public infrastructure, such as roads, schools, sewer and water systems, and hospitals, and important determinants of the growth rate of the economy. In addition, human capital formation, especially through education programs, affects the productivity of the labour force in the future. Fiscal policy also has incentive effects that influence the macroeconomy. Tax policies influence economic behaviour. Capital income taxes affect people’s decisions to save and invest, while labour income taxes affect people’s laboursupply decisions. 5. An automatic stabilizer is a provision in the budget that causes government spending to rise or taxes to fall automatically (without legislative action) when GDP falls. An example is unemployment insurance. The advantage of automatic stabilizers over legislated changes in spending and taxes is that they occur quickly, while legislation takes a long time to put in place. 6. An example would be no tax on income below $15 000, then a tax at 20% on income above $15 000. Someone with income of $30 000 would pay taxes of 0.20($30 000 – $15 000) = $3000. The average tax rate is 10%, while the marginal tax rate is 20%. The average tax rate most directly affects how wealthy a person feels, while the marginal tax rate affects the reward for working an extra hour.

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Increasing the tax rate increases distortions by more than reducing the tax rate (by the same amount) reduces distortions. Varying between a high and low tax rate leads to a greater average distortion than keeping the tax rate constant at a medium level. Government debt is a potential burden on future generations in two ways. First, if tax rates must be raised in the future to pay off the debt, then the economy wilt operate less efficiently in the future because of the increased distortions from the higher tax rates. Second, government deficits may reduce national saving, so the economy accumulates less capital and future output will be lower. Or if the government borrows from abroad, future citizens wilt face the burden of making interest payments to foreigners. In either case, the future standard of living will be lower. However, government deficits caused by (lump-sum) tax cuts do not reduce national saving if the Ricardian equivalence proposition is valid. This occurs because the tax cut does not cause consumption to rise, so there is no change in national saving. Ricardian equivalence might not hold if people face borrowing constraints, if they are shortsighted, if they fail to leave bequests, or if taxes aren’t lump-sum.

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Numerical Problems 1.

The following table shows the categories of the budget: Central Provincial Outlays Government Governments Purchases of goods and services 200 150 Transfers to persons 100 50 Transfers to provincial gov’ts. 100 0 Net interest paid 90 –30 TOTAL OUTLAYS 490 170 Receipts 500 100 Taxes Transfers from federal gov’t. 0 100 TOTAL RECEIPTS 500 200 Surplus 10 30 Primary surplus 100 0

Combined Governments 350 150 100 60 660 600 100 700 40 100

To calculate net interest paid in this table:

The central government has debt of 1000 and the nominal interest rate is 10%. so it pays 1000 × 0.10 = 100 in interest on its debt. Of this amount, since provincial governments hold debt of 200, they get 200 × 0.10 = 20 in interest, while the private sector gets the other 80 in interest payments. The central government receives 10 in interest, so its net interest payments are 100 – 10 = 90. Provincial governments receive 20 in interest from the central government and 10 in interest from the private sector, so their net interest payments are –30. The deficit in total outlays minus total receipts. The primary deficit is the deficit minus net interest payments. In the year in which the transfer is made, both the surplus and the primary surplus decrease by $1 billion. In the next year, surplus decreases by the amount of the increased interest payments, which total $1 billion times the nominal interest rate, or $1 billion x 0.10 = $100 million. The primary surplus is unchanged. In the following year, the government debt has increased by $1100 million ($1 billion due to the initial debt, plus $100 million of interest from the past year). So the surplus is lower by the amount $1100 million x 0.10 × $110 million. Again the primary surplus is unchanged. Deficit = G + TR + INT – T = 1800 + (800 – 0.05Y) + 100 – (1000 + 0.1Y) = 1700 – 0.15Y. The full-employment budget deficit is the deficit that would occur if the economy were at full employment. Full-employment output is 10 000, so the fullemployment deficit is 1700 – (0.15 × 10 000) = 200. a. When Y = 12 000, the deficit is 1700 – (0.15 x 12 000) = –100. This is smaller than the full-employment deficit of 200. b. When Y = 10 000, the deficit is 200 (as calculated above), which is equal to the full-employment deficit, since output is at its full-employment level. c. When Y = 8000, the deficit is 1700 – (0.15 x 8000) = 500. This is larger than the full-employment deficit of 200. In general, the full-employment deficit is unaffected by the state of the economy, while the actual deficit rises relative to the full-employment deficit in recessions and falls relative to the full-employment deficit in expansions. . 299

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a. In this situation, someone earning income Y between $8000 and $20 000 pays a total tax of T = 0.25(Y – $8000), while someone earning between $20 000 and $30 000 pays tax of T = $3000 + 0.30( Y – $20 000). Someone with income of $16 000 then pays tax of 0.25($16 000 – $8000) = $2000. This gives an average tax rate of $2000/$16 000 = 12.5%, while the marginal tax rate is 25%. Someone with income of $30 000 then pays tax of $3000 + 0.30($30 000 – $20 000) = $6000. This gives an average tax rate of $6000/$30 000 = 20%, while the marginal tax rate is 30%. b. In this situation, someone earning income Y between $6000 and $20 000 pays a total tax of T = 0.20(Y – $6000), while someone earning between $20 000 and $30 000 pays tax of T = $2800 +.30(Y – $20 000). Someone with income of $16 000 then pays tax of 0.20($16 000 – $6000) = $2000. This gives an average tax rate of $2000/$16 000 = 12.5%, while the marginal tax rate is 20%. Someone with income of $30 000 then pays tax of $2800 + 0.30($30 000 – $20 000) = $5800. This gives an average tax rate of $5800/$30 000 = 19.33%, while the marginal tax rate is 30%. c. The person making $16 000 has the same average tax rate, but a lower marginal tax rate, so there’s no income effect, just a substitution effect toward increased labour supply. The person making $30 000 faces the same marginal tax rate, so there’s no substitution effect, but has a lower average tax rate, so the income effect tends to reduce labour supply. If workers value their leisure at 90 goods per day, then 90 goods per day must be the equilibrium value of the after-tax real wage. a. Setting the real wage equal to the marginal product of labour gives 90 = 250 – N, or N: 160. Output is Y = 250N – 0.5N2 = (250 x 160) – (0.5 x 1602) = 27 200. b. With a marginal tax rate on wages of 25%, the after-tax real wage now must equal 0.75 × MPN. that is, w = 0.75 × MPN, so 90 = 0.75 x (250 – N), which has the solution N = 130. Output is Y = (250 × 130) – (0.5 × 1302) = 24 050. The cost of the distortion in terms of lost output is 27 200 – 24 050 = 3150. c. With a marginal tax rate on wages of 50%, the after-tax real wage now must equal 0.50 × MPN, that is, w = 0.50 × MPN, so 90 = 0.50 x (250 – N), which has the solution N = 70. Output is Y: (250 x 70) – (0.5 x 702) = 15 050. The cost of the distortion in terms of lost output s 27 200 –15 050 = 12 150, for changing the tax rate from 0% to 50%. Doubling the tax rate from 25% to 50% makes the distortion nearly four times as big. This suggests that taxes should be smoothed over time, since high tax rates increase the distortion more than proportionately.

From Eq. (15.1), we know that surplus = primary surplus - INT where INT = net interest payments on debt. Interest payments on debt are given by the interest rate times the debt outstanding. In this case, INT = $35 billion. Since the government is maintaining a balanced budget, the surplus = 0. For this to be so, the primary surplus must be equal to −$35 billion.

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a. From Eq. (15.6) we know that

 B−1   B   G ÷ TR - T    =   + (i − g )   Y Y     Y  We are told that Y = 1000, B-1 = 500, i = 0.07 and g = 0.05. The goal of the government is to choose the primary surplus such that )(B/Y) = 0. Using these values, the primary surplus (= G + TR – T) must be −$10 billion. The total surplus is the primary surplus (−$10 billion) plus interest payments (=0.07*$500 billion = $35 billion). The total surplus must therefore be $25 billion to keep the debt-to-GDP ratio constant. b. Now we are told that Y = 1000, B-1 = 500, i = 0.05 and g = 0.07. Using these values, the primary surplus (= G + TR – T) must be $10 billion. The total surplus is the primary surplus ($10 billion) plus interest payments (=.07*$500 billion = $35 billion). The total surplus must therefore be $45 billion to keep the debt-to-GDP ratio constant. This is not necessarily true. The answer depends on the size of the interest rate paid on outstanding government debt (i) and the growth rate of GDP (g). If i > g, then the debt-to-GDP ratio can only be reduced if there is a primary surplus. If, on the other hand, i < g, a primary surplus is not required to cause a fall in the debt-toGDP ratio. In fact, if i > g, then the debt-to-GDP ratio can be reduced even if there is a primary deficit.

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Instructor’s Manual for Macroeconomics, Ninth Canadian Edition

Analytical Problems 1.

The main reason for having a system of transfers from the federal government to provincial and local governments is that there are nationwide benefits to education, health, and welfare programs, but these programs are most efficiently administered at the provincial and local level. Since the benefits are nationwide, the programs should be paid for at least partly at the national level. However, since it takes local knowledge to provide the programs at the right level, provincial and local governments should decide the best way to provide the services. The advantage of such a system is that the national government can identify the external effects, that is, the features that makes these programs have nationwide benefits, and provide appropriate funding to pay for those benefits. The disadvantage of such a system is that the administration of the programs may become politicized. The grants may go to the regions with the most powerful politicians rather than the regions with the greatest needs and external benefits. In 1988, both the actual and the cyclically-adjusted budget balance were negative, indicating budget deficits. The cyclically-adjusted deficit in that year was larger than the actual budget deficit. This indicates that the economy was operating at more than full employment. That is, had the economy been operating at full employment, the federal government would have collected less in tax revenues, spent more on income support programs and hence, realized an even larger deficit. In 1998, both the actual and the cyclically-adjusted budget balance were positive, indicating budget surpluses. The cyclically-adjusted surplus in that year was larger than the actual budget surplus. This indicates that the economy was operating at less than full employment. That is, had the economy been operating at full employment, the federal government would have collected even more in tax revenues, spent less on income support programs and hence, realized an even larger surplus. This program has very bad incentive effects. For income (y) below $10 000, a person gets a transfer equal to $10 000 – y. So for every dollar of income a person earns, he or she loses a dollar of transfers. This is like having a marginal tax rate of 100%! The program makes it unlikely that a person with low income opportunities would want to work at all. A program with a better incentive effect would be to provide a subsidy to labour income. For example, suppose the program said that it would subsidize labour income at a 25% rate. If a person worked 2000 hours per year at a wage of $4 per hour, to get labour income of $8000, the subsidy would increase the person’s wage by 25% to $5 per hour, so he or she would earn $10 000 per year. Unlike the first program, which increased the effective marginal tax rate on labour income to 100%, this program increases the after-tax real wage rate by 25%, encouraging work effort. The advantage of this system is that it increases the effective after-tax real wage rate, so there is a substitution effect toward greater work effort. The disadvantages are that (1) there is an income effect toward lower work effort; and (2) if the program is cut off at a particular income level, then the effective marginal tax rate suddenly rises once people reach that level. This means there is a kink in the budget constraint, so people are likely to choose the point at which the kink occurs; and (3) it does not offer much help to those most in need: the unemployable and those with only very small potential income.

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Chapter 15: Government Spending and Its Financing

Begin with equation (15.6) which can also be written as: Growth rate of debt-GDP ratio = primary deficit/B + i – growth rate of nominal GDP. First, note that the debt-GDP ratio is the same in nominal terms or real terms, as is the primary deficit divided by the outstanding stock of bonds. Second, recall that the growth rate of nominal GDP equals the growth rate of real GDP + π, since nominal GDP equals real GDP times the price level. And third, one can use the approximation that i = r + π. So the above equation can be transformed into: Growth rate of real debt-GDP ratio = real primary deficit/real B + (r + π) – (growth rate of real GDP + π) = real primary deficit/real B + r – growth rate of real GDP. A balanced-budget amendment might prove useful if the government otherwise had a tendency to run a perpetual budget deficit. The amendment would provide a mechanism for fiscal discipline, forcing policymakers to balance the budget. But there could be significant disadvantages, since fiscal policy wouldn’t be as flexible. a. In particular, automatic stabilizers kick in during a recession to increase spending and reduce taxes, creating a budget deficit but stimulating the economy; however, these effects would have to be offset if the budget were to be balanced. b. Also, instead of smoothing taxes over time, the government would have to raise taxes when times were bad and incomes were low and reduce taxes when times were good and incomes were high, thus creating distortions to the economy. c. Finally, a balanced-budget amendment would fail to recognize that capital formation would help future generations, so deficit financing that’s paid off by taxes on future generations would be appropriate.

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