Download SOLUTIONS TO MACRO END-OF-CHAPTER

BUSINESS ECONOMICS
Part II: Macroeconomics, 5th Edition
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
Dr. Kenneth Matziorinis
6.1
i) U = (L - N) = 17,576,000 - 16,501,000 = 1,075,000 persons in 2006
ii) UR = (U / L) x 100 = 1,075,000 / 17,576,000 x 100 = 6.1%
iii) NR = (N / CP) x 100 = 16,501,000 / 26,155,000 x 100 = 63.1%
iv) NGR = N t - N t-1 / N t-1 x 100 = 16,501,000 - 16,137,000 / 16,137,000 x 100 =
2.25% growth in employment (people with jobs) from 2005 to 2006
v) LGR = L t - L t-1 / L t-1 x 100 = 17,576,000 - 17,324,000 / 17,324,000 x 100 =
1.45% growth in the country’s labour force in 2006
vi) Labour force (L) is the total number of persons of working age (i.e. 15 years and
over) who are able and willing to work. Who offer their labour services to the
economy
vii) POPGR = POP t - POP t-1 / POP t-1 x 100 = 32,524,000 - 32,197,000 /
32,197,000 x 100 = 1.0% growth in Canada’s population between 2005 and 2006
viii) PR = (L / CP) x 100 = 17,576,000 / 26,155,000 x 100 = 67.2%
The
participation rate shows the proportion of persons who are of working age and
able to work who are interested or willing to work.
ix)
The "full-employment" unemployment rate in Canada is presently considered to
be around 6%.
x) Three types of unemployment:
Frictional Unemployment: Here people are unemployed because they voluntarily
decided to quit their job so that they can get a better job, move to another part of the
country, go back to school, give birth to a child etc. It reflects personal factors which
have nothing to say about the state of labour markets or the economy.
Structural Unemployment: Here people lose their job against their will. The reason
has to do with the fact that their job skill is no longer current or in demand by employers
because the skill has been superceded by machines or the market is no longer interested
in the product that skill is used to make. Structural unemployment is concentrated in
specific job skill areas and industries so it tends to be localized.
Cyclical Unemployment: Here people lose their job because the state of the overall
economy is bad. When total demand for goods and services falls, employers cut down on
production which results in lay-offs for a portion of the workforce. Cyclical
unemployment is easy to detect since it affects the vast majority of industries and spreads
across all regions of the economy.
6.2
You divide the unemployment rate by the seasonality factor: i.e. UR / SF = S.A.U.R.:
Month
Seasonally
Unadjusted
Seasonality
Factor
Seasonally
Adjusted
Jan
13.7
1.105
12.4
Feb
13.6
1.088
12.5
Mar
14.0
1.120
12.5
Apr
13.2
1.065
12.4
May
12.2
0.992
12.3
Jun
11.7
0.967
12.1
Jul
11.2
0.941
11.9
Aug
10.9
0.940
11.6
Sep
10.4
0.920
11.3
Oct
10.3
0.920
11.2
Nov
10.7
0.964
11.1
Dec
11.1
1.000
11.1
_______________________________________________________________
UNADJUSTED AND SEASONALLY-ADJUSTED UNEMPLOYMENT RATE
IN CANADA, BY MONTH
15
Percent (%) UR
15
14
14
13
13
12
12
11
11
10
10
9
Jan
9
Feb
Mar
Apr
May
Unadjusted
6.3
Jun
Jul
Aug
Sep
Oct
Nov Dec
Seasonally Adjusted
You are given the following annual inflation data for Canada for the 1969-82 period:
Year
Rate of Inflation
CPI
1969
4.8
94.3
1970
3.0
97.1
1971
3.0
100.0
1972
4.8
104.8
1973
7.8
113.0
1974
11.0
125.4
1975
10.7
138.8
1976
7.2
148.8
1977
8.0
160.7
1978
8.9
175.0
1979
9.3
191.3
1980
10.0
210.4
1981
12.5
236.7
1982
10.9
262.5
_________________________________________________________________
a)
See table above:
Eg.: 100 x 1.048 = 104.8; 104.8 x 1.078 = 113.0; 113.0 x 1.1= 125.4
Eg.: 100 / 103.0 = 97.1; 97.1 / 103.0 = 94.3
b)
The CPI is a measure of cumulative inflation over time in goods and services
bought at the retail level by households only, i.e. consumer goods and services
only.
The IPI is a measure of cumulative inflation over time in the price of all goods
and services sold in the economy, i.e. consumer, producer, government and export
prices, and is the broadest or economy-wide measure of inflation available, for
this reason it is used as the GDP price deflator in the calculation of real GDP.
c)
The federal government in conjunction with the Bank of Canada have set a target
for annual inflation at 2%, within a band of 1% - 3% over time.
d)
Headline inflation is the all-items number reported every month by Statistics
Canada which makes the headlines in newspapers.
The core inflation strips out volatile components of the index such as food and
energy prices that can swing up and down from month to month so we have a
more clearer or stable view of underlying inflation in the country.
6.4
i) AE = C + I + G + X - M = Aggregate expenditure or aggregate demand for
domestically produced goods and services.
AE = $ 1,364,903 million in 2005
ii) GDP = AE + ∆V = $ 1,375,080 million in 2005
This is the formula used in the expenditure approach to measure GDP or national
income.
iii) GDP > AE, because during the year 2005 the total production (output) of goods in
Canada exceeded the demand for them. Producers had unsold goods which they added to
their existing stock of inventories. As a result, there was a net accumulation of
inventories equal to $10.2 billion. When this happens it is a bad sign about the direction
of the economy because it implies that firms will have to reduce output in the near future
in order to bring their inventories closer to line with demand and this results in
employment cut-backs and a slowdown in the economy.
iv) During the year inventories rose by $ 10,177.0 million (+∆V). This happened
because the demand for goods fell short of the production of goods (i.e. sales failed to
match production).
v) ( X / GDP ) x 100 = 520,379 / 1,375,080 x 100 = 37.8 %
In 2005 Canada exported 37.8 % of its total production of goods and services. It
shows that Canada's economy depends a lot on the rest of the world for jobs and its
income.
vi) ( I / GDP) x 100 = 289,370 / 1,375,080 x 100 = 21.0 %
This rate is called the rate of gross fixed capital formation (GFCF) and shows what
portion of our annual output of goods and services is devoted toward the future. The more
we spend on new machinery and equipment and the construction of factory, commercial
and engineering structures such as roads, bridges, pipelines, sewers etc. the better off we
are going to be in the future. It is an important indicator of a country's underlying
economic health and long-term economic prospects.
6.5
i) NDI = Wages and salaries + Corporation profits + government business enterprise
profits + interest and miscellaneous investment income + net farm incomes +
unincorporated business income and rent + inventory valuation adjustment. NDI
represents the dollar value of factor services (resources) such as labour, capital, land and
entrepreneurial services supplied by households to firms annually.
NDI = (694,041 + 189,357 + 14,578 + 61,070 +1,321 + 83,636 + ( - 933) =
$ 1,043,070 million in 2005
ii) GDP = NDI + CCA + IT ; this is the factor income approach to the measurement of
national income;
GDP = 1,043,070 + 156,181 + 175,829 = $ 1,375,080 million in 2005
iii) In 2005 Canada's income shares were as follows:
Employment Income: Wages & Salaries / NDI = 694,041 / 1,043,070 x 100 =
66.5%
Corporate Profits: Corporate Profits / NDI = 189,357 / 1,043,070 x 100 = 18.2%
Investment Income: Investment income / NDI = 61,070 / 1,043,070 x 100 =
5.9%
iv) Capital consumption allowance (CCA) is a sum of money firms deduct from their
revenues in order to determine their profit. It is a cost of doing business and represents
the amount by which fixed capital goods such as buildings, machinery and equipment are
used up or consumed annually in the process of producing goods and services for sale.
CCA is known as depreciation in economics. Generally accepted accounting principles
(GAAP) require that the cost of a durable fixed asset such as a machine or a building be
amortized over a period of time instead of being charged as an operating expense in the
year of acquisition. The idea behind this is simple. If the asset has a useful life of say 10
years, its cost should be spread over 10 years as well to reflect the fact that it is gradually
being used up in production.
6.6
i) GNP = GDP + investment income received from non-residents - investment
income paid to non-residents.
GNP = 1,375,080 + 47,213 - 71,753 = $ 1,350,540 million in 2005
ii) GNP and GDP defer in the way they define Canadian income. GDP defines as
Canadian income all income generated inside Canada's geographical borders, even
though part of that income ends up in the pockets of non-residents who supplied the
resources that made it possible to generate that income. GNP, on the other hand, defines
as income all income that ends up in the pockets of Canadian residents, irrespective of
where in the world this income was generated. Thus to find GNP we add to GDP income
that Canadians received from production activity outside their borders but subtract the
income from Canadian production activity that was paid to investors who reside outside
our borders. Since Canada is a net-debtor nation, which means that we owe foreigners
more than they owe us, we pay them more than they pay us with the result that the
income that accrues to Canadian residents is less than the income that is generated inside
our borders.
iii) NNP = GNP - CCA = 1,350,540 - 175,829 = $ 1,174,711 million in 2005
iv) Net investment income paid to non-residents (- $24,540 million) / GDP x 100
(47,213 - 71,753) /1,375,080 x 100 = 1.8% of GDP
6.7
i) PI = NDI - Corporate income taxes - Retained Earnings + Transfer Payments +
Miscel. Adjustments. It represents the total income Canadian households received from
all sources but before personal income taxes.
PI = 1,043,070 - 49,492 - 95,790 + 133,766 + 693 = $ 1,032,247 million in 2005
ii) PDI = PI - Personal income taxes (incl. social security contributions). It is the
sum of money -after taxes- that Canadians have available to spend or to save, as they see
fit.
PDI = 1,032,247 - 240,761 = $ 791,486 million in 2005
iii) PDI / Population = 791,486,000,000 / 32,300,000 = $ 24,504 per person
iv) GDP / Population = 1,375,080,000,000 / 32,300,000 = $ 42,572 per person;
this is a broad measure of a country's standard of living.
v) Sp / PDI x 100 = 30,785 / 791,486 x 100 = 3.9%
In 2005 Canadian households saved 3.9% of their after-tax income and they spent
(consumed) the rest.
vi) C / PDI x 100 = 760,701 / 791,486 x 100 = 96.1 %
Remember that PDI = C + Sp, and the consumption and saving rates add up to 100%
6.8
I) Real GDP = GDP / IPI x 100 = 1,446,307 / 112.8 x 100 = $ 1,282,187
millions of constant 2002 dollars in 2006
and 1,375,080 / 110.2 x 100 = $1,247,804 million in 2005
ii)
Rate of growth (GR) = Real GDP t - Real GDP t-1 / Real GDP t-1 x 100 =
1,282,187 - 1,247,804 / 1,247,804 x 100 = 2.8 % in 2006
iii) Rate of overall inflation (IR) = IPI t - IPI t-1 / IPI
112.8 - 110.2 / 110.2 x 100 = 2.4 % in 2006
iv) Rate of consumer inflation (IR) = CPI
109.1 - 107.0 / 107.0 x 100 = 2.0 % in 2006
t
t-1
x 100 =
- CPI t-1 / CPI
t-1
x 100 =
v) Rate of population growth (POPGR) = POP t - POP t-1 / POP t-1 x 100 =
32,623,000 - 32,300,000 / 32,300,000 x 100 = 1.0 % in 2006
vi) Per capita GDP = GDP / Population = $ 1,446,307,000,000 / 32,623,000 = $
44,334 per person
vii) Standard of living is how well-off, how prosperous, the average person in a
country is. It measures the overall wellbeing of a society which includes goods and
services, private and public goods and services, work and leisure. It is measured using
GDP (or GNP) per capita. Although the per capita GDP is more representative of the
goods and services consumed through markets on which we spend money, it is highly
correlated with non-monetary indicators of well-being such as quality of health care and
life expectancy.
viii) Personal disposable income per capita = PDI / Population =
$842,302 / 32,623,000 = $ 25,819 per person in 2006. Measures how much money we
have available for consumption and saving each year.
ix) Personal disposable income per household = PDI / Households =
$842,302 / 12,547,300 = $ 67,130 per household in 2006. Measures how much money the
average household earns after taxes but including transfer payments from government
each year in Canada.
x) A household is a self-contained unit of economic and social organization. Like a
cell in biology, it is the smallest building block in the economy. Members of households
make joint production, consumption, saving and investment decisions for their common
good. The average number of persons per household is 2.6.
xi) Inflation-adjusted rate of growth in household disposable income is the annual
percent increase in real PDI
Real PDI = PDI / CPI x 100 = $842,302 / 109.1 x 100 = $772,046 million in 2006
and $791,486 / 107.0 x 100 = $739,707 million in 2005
Rate of growth in real PDI = Real PDI t - Real PDI t-1 / Real PDI t-1 x 100 =
$772,046 - $739,707 / $739,707 x 100 = 4.4 %
xii) The rate of advance in Canada’s living standard is the annual per cent increase in
the real per capita GDP.
Real per capita GDP = Real GDP / Population =
$ 1,282,187,000,000 / 32,623,000 = $ 39,303 in 2006
and
$ 1,247,804,000,000 / 32,300,000 = $ 38,632 in 2005
Rate of advance (growth) in standard of living:
Real per capita GDP t - Real per capita GDP t-1 / Real per capita GDP t x 100 =
$39,303 - $38,632 / $38,632 x 100 = 1.7 %
6.9
I) Productivity ( Output per worker) = Real GDP / Persons Employed (N) =
(1,446,307 / 112.8 x 100) / 16,484,000 = $ 77,784 in 2006
and
(1,375,080 / 110.2 x 100) / 16,170,000 = $ 77,168 in 2005
ii) Rate of productivity growth (PRGR) =
Real GDP / N t - Real GDP / N t-1 / Real GDP / N t-1 x 100 =
$77,784 - $77,168 / $77,168 x 100 = 0.8 %
iii) Rate of growth in the labour force (LGR):
LGR = L t - L t-1 / L t-1 x 100 = 17,593,000 - 17,343,000 / 17,343,000 x 100 =
1.44 % growth in the country’s labour force in 2006
iv) Employment rate of growth (NGR):
NGR = N t - N t-1 / N t-1 x 100 = 16,484,000 - 16,170,000 / 16,170,000 x 100 =
1.94 % growth in employment (people with jobs) in 2006
v) Potential Rate of Growth (PGR) = Labour force growth + productivity growth
= 1.44 % + 0.80 % = 2.24 % in 2006
vi) The target for growth in the economy is 3.0%. In 2006 the economy’s capacity to
produce grew by only 2.24%, which is substantially below the target. If this rate does not
rebound, then the future rate of growth in the economy will slow down which will slow
down the rate of advance in our living standards.
What is worse, however, is that our productivity growth ( 0.8%) is severely below what it
should be (2.0%) which means that if we cannot find ways to work “smarter” we have to
work “harder” by forcing more people out in the labour force (1.44%) !
In 2006 we were lucky, because employment (1.94%) grew faster than the labour force
(1.44%), thus if you add the growth in employment with that of productivity (0.8%)
1.94% + 0.80% = 2.74% you find by how much the economy grew during the year
(2.8%). Now that the pool of unemployed persons is drying out, the economy’s growth is
bound to slow unless productivity rebounds.
Productivity growth has become Canada’s #1 problem and most significant
challenge for the future.
6.10
I) Population in 2005 + births - deaths + immigration - emigration = Population in
2006 = 32,523,898 + 343,517 - 234,914 + 256,559 - 36,311 = 32,852,749 in 2006
ii) Natural increase in population: births - deaths = 343,517 - 234,914 = 108,603
iii) Net migration: immigration - emigration = 256,559 - 36,311 = 220,248
iv) Birth rate out of 1000: Births / Population x 1000 = 10.56 per thousand
v)
Death rate out of 1000: Deaths / Population x 1000 = 7.22 per thousand
vi) Population increase in % between 2005 and 2006:
POPGR = POP t - POP t-1 / POP t-1 x 100 =
32,852,749 - 32,523,898 / 32,523,898 x 100 = 1.0 %
6.11
i)
A turning point is when real GDP stops growing and starts falling, or stops
falling and begins growing
ii)
The peak is an upper turning point, the maximum point of the business cycle
iii)
The trough is the lower turning point or the minimum point of the business cycle
iv)
Expansion is when real GDP is rising from quarter to quarter or year to year
v)
Recovery is the early part of economic expansion following a trough and until the
previous peak has been surpassed
vi)
Boom is the latter part of an expansion, close or at the peak of the economic cycle
vii)
Recession is two consecutive (back-to-back) quarters of decline in real GDP.
When output has been falling for six months the economy is said to be in
recession.
viii)
Depression is a deep and prolonged drop in real GDP accompanied with falling
product and asset prices. Typically output can fall by more than 5% and
keep falling or not rising for a period of 5-10 years
6.12
c)
Year
Actual
GDP
Unemp.
Rate (%)
Employ.
Rate (%)
Potential
GDP
GDP
Gap
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
824.2
825.1
808.2
815.5
833.9
874.0
898.5
913.6
951.2
991.3
1046.3
1100.8
1120.4
1152.9
1174.4
1210.9
1247.8
1282.2
7.5
8.1
10.3
11.2
11.4
10.4
9.5
9.6
9.1
8.3
7.6
6.8
7.2
7.7
7.6
7.2
6.8
6.3
92.5
91.9
89.7
88.8
88.6
89.6
90.5
90.4
90.9
91.7
92.4
93.2
92.8
92.3
92.4
92.8
93.2
93.7
837.6
844.0
846.9
863.3
884.7
916.9
933.2
950.0
983.6
1016.2
1064.4
1110.2
1134.9
1174.1
1194.7
1226.6
1258.5
1286.3
13.4
18.9
38.7
47.8
50.8
42.9
34.7
36.4
32.4
24.9
18.1
9.4
14.5
21.2
20.3
15.7
10.7
4.1
During the period 1990-1997 Canada underwent a mini-depression as the output gap
grew substantially larger and remained large for a considerably long period, much longer
than is usually the case in a typical recession. This episode represents the worst economic
performance since the Great Depression of the 1930s. It is not until 1998 that Canada’s
economy started to perform better, coming close to closing the gap in 2000, but was
interrupted by the dot.com stock meltdown of 2000-2001 and the 2001 recession in the
USA. Fortunately the damage on Canada was not too big during the 2001-2003 period,
Canada managing just narrowly to avoid a recession. The gap was finally closed in 2007.
Problem 6-12
Potential, Actual and GDP Gap, Canada: 1989-2006
Billions of Real Dollars
1400
200
175
1200
150
125
100
1000
75
50
800
25
0
600
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Actual GDP
Potential GDP
GDP Gap
6.13
i) Real GDP = GDP / IPI x 100 = 1,459.3 / 113.2 x 100 = $ 1,289.1 billion in Q4
2006
ii) GDP is the market value of all final goods and services produced by the market
sector of the economy during the year. Nominal GDP is based on each year's current
market prices whereas Real GDP is based on some base year's constant prices. Nominal
GDP is not comparable over time because it incorporates the effect of inflation. Real
GDP has the inflation effect removed and represents the level of output in the economy.
Hence, Real GDP is a more meaningful measure of production.
iii) Per capita GDP in nominal terms: GDP / Population = 1,459,300,000,000 /
32,730,213 = $ 44,586 per person valued at 2006 prices
Per capita GDP in real terms: Real GDP / Population = 1,289,134,000,000 /
32,730,213 = $ 39,387 per person valued in constant 2002 dollars ( i.e. based on 2002
prices).
iv) UR = U / L x 100 = (L - N) / L x 100 = 1,076,000 / 17,716,000 x 100 =
6.1%
v) PR = L / CP x 100 = 17,716,000 / 26,363,000 x 100 = 67.2%
vi) Assuming that the economy's "full-employment" unemployment rate is at 6%,
potential GDP is the output that would be produced if 94% or .94 of the labour force
were employed. To get a rough estimate of the potential GDP we can use the simple rule
of three:
Actual GDP
Actual NR
=
Potential GDP
"Full employment" NR
thus, 1,459.3 / .939 = Potential GDP / .94
Potential GDP = $ 1,460.9 billion in 2006
Output or GDP Gap = Potential GDP - Actual GDP = 1,460.9 - 1,459.3 = $ 1.6
billion, the economy is very close to full employment!
vii) - Canada's expected growth rate for 2006/2007: 3.0%
$1,289.1 x 1.03 = $ 1,327.8 billion in Q4, 2007
- Canada's expected inflation rate for 2006/2007: 2.5%
113.2 x 1.025 = 116.0 in Q4, 2007
- Canada's expected nominal GDP in Q4, 2007:
Expected Real GDP x Expected Implicit Price Index / 100 =
1,327.8 x 116.0 / 100 = $ 1,540.2 billion
viii) Output per worker: RGDP / N = 1,289,100,000,000 / 16,640,000 =
$ 77,470 per employed person. Output per employee is a general measure of labour
productivity. One of the three measures of a country’s long-term economic prospects.
6.15
a) The three most important indicators of short-term economic performance are:
•
•
•
The seasonally-adjusted rate of unemployment
The annual rate of inflation (using the CPI or the IPI)
The annual rate of economic growth (using Real GDP or GNP)
b) The three most important indicators of long-term economic performance are:
•
The rate of productivity growth
•
The rate of gross fixed capital formation (business & public
investment)
•
The rate of national saving in the economy
c)
Total Production
National Income
Economic power
Standard of living
Cost of living
Loss of Purchasing power
Size of Manpower
Job Creation
Productivity
Willingness to work
Tax burden
Willingness to save
Willingness to spend
Consumer spending power
Cost of borrowing
Real GDP
GDP or GNP
GDP or GNP
Per Capita GDP or GNP
CPI or IPI
Rate of Inflation
Labour Force
Unemployment Rate
RGDP / Person Employed (N)
Participation Rate
Personal + Indirect Taxes / PI
Personal Saving / PDI
Personal Consumption C/PDI
Personal Disposable Income PDI
Interest Rate
6.16
Macroeconomic Indicators
1993
Unemployment Rate
Inflation Rate
Growth Rate
Productivity Growth Rate
National Saving Rate
Investment (GFCF) Rate
Living Standard (GDP/IPI/Pop)
PDI per capita (PDI/CPI/Pop)
11.1 %
1.9 %
2.2 %
1.5 %
13.7 %
18.0 %
$29,053
$20,145
2005
6.9 %
2.2 %
3.0 %
1.1 %
23.8 %
21.0 %
$38,632
$22,901
Ideal
< 6.0 %
< 2.0 %
> 3.0 %
> 2.0 %
> 20.0 %
> 20.0 %
As it can be seen from the above results, Canada’s three short-term indicators of economic
performance have improved during this period, the unemployment rate is down, the growth rate
is up and the inflation rate remains low. The three long-term indicators of economic performance
show even stronger improvement, the savings and investment rates are up considerably to
healthy levels while the productivity growth rate remains low. Obviously we still have some
challenging work to do on the productivity side, but overall this is a big turn-around compared to
1993.
6.14
Formulae:
Real GDP: GDP / IPI x 100
Growth Rate: RGDP t - RGDP t-1 / RGDP t-1 x 100
Inflation Rate: IPI t - IPI t-1 / IPI t-l x 100
Problem 6.14
Nominal
Year
GDP
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
98.4
109.9
129.0
154.0
173.6
200.0
221.0
244.9
279.6
314.4
360.5
379.9
411.4
449.6
485.7
512.5
558.9
613.1
657.0
679.9
685.4
700.5
727.2
770.9
810.4
836.9
882.7
915.0
982.4
1076.6
1108.0
1152.9
1213.2
1290.8
1375.1
1446.3
Implicit
Price Index
24.3
25.7
28.2
32.4
35.9
39.3
42.0
44.8
49.2
55.2
60.1
65.1
68.7
70.9
73.2
75.1
78.8
82.4
86.1
88.9
91.5
92.7
94.0
95.1
97.2
98.8
100.0
99.6
101.3
105.5
106.7
107.8
111.4
114.7
118.6
121.4
Real
GDP
404.9
427.6
457.4
475.3
483.6
508.9
526.2
546.7
568.3
569.6
599.8
583.6
598.8
634.1
663.5
682.4
709.3
744.1
763.1
764.8
749.1
755.7
773.6
810.6
833.7
847.1
882.7
918.7
969.8
1020.5
1038.4
1069.5
1089.0
1125.4
1159.4
1191.4
Rate of
Inflation
--5.8
9.7
14.9
10.8
9.5
6.9
6.7
9.8
12.2
8.9
8.3
5.5
3.2
3.2
2.6
4.9
4.6
4.5
3.3
2.9
1.3
1.4
1.2
2.2
1.6
1.2
-0.4
1.7
4.1
1.1
1.0
3.3
3.0
3.4
2.4
Rate of
Growth
--5.6
7.0
3.9
1.7
5.2
3.4
3.9
4.0
0.2
5.3
-2.7
2.6
5.9
4.6
2.8
3.9
4.9
2.6
0.2
-2.1
0.9
2.4
4.8
2.9
1.6
4.2
4.1
5.6
5.2
1.8
3.0
1.8
3.3
3.0
2.8
OUTPUT (REAL GDP) GROWTH IN CANADA:
1971 - 2006
1200
Real GDP (Constant 1997 Dollars)
1100
1000
900
800
700
600
500
400
300
72
74
76
78
80
82
84
86
88
90
Real GDP
92
94
96
98
00
02
04
06
RATE OF INFLATION AS MEASURED BY THE
IMPLICIT PRICE INDEX: 1971 - 2006
16
Annual Percent (%) Rate of Change in I.P.I.
14
12
10
8
6
4
2
0
-2
72
74
76
78
80
82
84
86
88
90
92
Rate of Inflation
94
96
98
00
02
04
06
RATE OF GROWTH (IN REAL GDP) IN CANADA:
1971 - 2006
8
Annual Percent (%) Rate of Growth in Real GDP
%
7
6
%
%
5
4
%
%
%
%
3
2
%
%
%
%%
%
%%
%
%
%
%
%
%
%
%
%
1
0
%
%
%%
% %
%
%
%
-1
-2
-3
%
%
-4
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
% Rate of Growth
GROWTH IN CANADA'S LIVING STANDARD,
1971 - 2006
40
Per Capita Real GDP in 1997 Dollars (000s of $)
37.5
35
32.5
30
27.5
25
22.5
20
17.5
15
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
Per Capita Real GDP
CANADA’S COST OF LIVING AS MEASURED BY THE
IMPLICIT PRICE INDEX (CPI): 1962 – 2004
140
Implicit Chained Price Index (IPI), 1997 = 100
120
100
80
60
40
20
0
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
Implicit Price Index
6.17
a)
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
100.0
101.7
104.6
107.2
110.9
115.1
119.7
125.1
129.2
133.0
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
139.2
150.1
166.3
184.3
198.1
213.9
233.2
254.4
280.4
315.2
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
349.5
369.4
385.7
400.7
417.5
435.9
453.4
476.0
498.9
526.8
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
534.7
544.3
545.4
556.9
565.8
574.8
580.0
589.9
605.8
621.6
2002
2003
2004
2005
2006
635.3
653.1
664.8
679.4
693.0
b)
Since 1962, the cost of living in Canada has risen almost 7 times or 693.
d)
$100 / 605.8 X 100 = $14.43. $100 in 1962 will buy you today less than $14.5
worth of products. The buying power of money has shrank to one seventh of its
value in 1962.
e)
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
50.5
51.3
52.8
54.1
56.0
58.1
60.4
63.2
65.2
67.1
2002
2003
2004
2005
2006
320.7
329.7
335.6
343.0
349.9
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
70.3
75.8
83.9
93.0
100.0
108.0
117.7
128.4
141.5
159.1
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
176.4
186.5
194.7
202.3
210.8
220.0
228.8
240.3
251.8
265.9
CANADA’S COST OF LIVING AS MEASURED BY THE
CONSUMER PRICE INDEX (CPI): 1962 – 2006
1962 = 100.0
800
CPI ( 1962 = 100.0 )
700
600
500
400
300
200
100
0
62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
CPI
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
269.9
274.7
275.3
281.1
285.6
290.2
292.8
297.8
305.8
313.8
7.1 You are provided with the following fictitious national income and consumption data:
Y=GDP
C
S
MPC
MPS
APC
APS
240
260
-20
0.75
0.25
1.08
-0.08
260
275
-15
0.75
0.25
1.06
-0.06
280
290
-10
0.75
0.25
1.04
-0.04
300
305
- 5
0.75
0.25
1.02
-0.02
320
320
0
0.75
0.25
1.00
0.00
340
335
5
0.75
0.25
0.99
0.01
360
350
10
0.75
0.25
0.97
0.03
380
365
15
0.75
0.25
0.96
0.04
400
380
20
0.75
0.25
0.95
0.05
420
395
25
0.75
0.25
0.94
0.06
440
410
30
0.75
0.25
0.93
0.07
__________________________________________________________________
a)
Calculate S, MPC, MPS, APC and APS
S = Y - C Eg.: -20 = 240 - 260
MPC = )C =
)Y
MPS =
)S
)Y
275 - 260 = 15 = 0.75
260 - 240
20
= -15 - (-20) = +5 = 0.25
260 - 240
20
also MPS = 1.00 - MPC = 1.00 - 0.75 = 0.25
APC
=
C
Y
=
260
240
=
APS
=
S =
Y
-20
240
= -0.08
1.08
also APS = 1.00 - APC = 1.00 - 1.08 = -0.08
b)
Explain the difference between MPC and APC.
MPC is the relative change in consumption expenditure ()C) to a given change in income
()Y) and expresses how fast we spend the money we earn. It is called the marginal propensity
to consume and it measures the rate of spending in relation to the rate of earning. In the above
example, it says that the average consumer tends to spend seventy five cents out of every dollar
they earn. By measuring how fast we spend the money we earn, MPC serves as a measure of our
willingness to spend (consume) and captures consumer psychology. It is the most important
behavioural variable in macroeconomic theory. When consumer sentiment shifts from a mood of
optimism to a mood of pessimism, the amount we spend out of every dollar we earn diminishes
and the MPC declines.
APC is the cumulative average of total consumption expenditure to total income (C/Y) and
it is called the average propensity to consume. It includes autonomous consumption (") which is
how much we have to spend to survive, even when we do not earn any income. Since it is the
average of two totals, it does not capture changes in consumer psychology and therefore it lacks
the behavioural significance that the MPC has.
Observe that APC tends to fall as our income rises from a value greater than one (APC > 1)
to a value of less than one (APC < 1). In other words, at low levels of income, we cannot help
but consume more than we earn because our survival needs come first. But as our income rises to
a higher level, we consume more, and even though we consume more we spend less than we earn
and we can afford to save as well. At the break/even level of income, we spend as much as we
earn, so at that point we neither go to debt any more, nor do we save either, i.e. (APC = 1)
c)
On graph paper, plot (C) against (Y) (i.e., C on Y-axis; Y on X-axis). Then draw the 45
degree line (hint: plot Y against Y).
See attached diagram
d)
What is the break/even level of income? What is the meaning of this concept?
The break/even level of income (Yb/e) = $320 billion. It is where Y = C or S = 0
e)
What is the slope of the consumption function? What is it equal to?
The slope of the consumption function is )C / )Y = 0.75 and is equal to the MPC
f)
On separate graph paper, plot (S) against (Y) (i.e., S on Y-axis (vertical) and Y on X-axis
(horizontal).
See attached diagram
g)
What is the break/even level of income? Should it be the same as (d) above?
The break/even level of income is (Yb/e) = $320 billion. It is where S = 0 or Y = C
h)
What is the slope of the Saving Function? What is it equal to?
The slope of the saving function is )S / )Y = 0.25 and is equal to the MPS or 1 - MPC
Income and Consumption Expenditure
and the Break/Even Point
440
Income (Y) vs. Consumption (C)
420
400
380
360
340
320
300
280
260
240
240
260
280
300
320
Income (Y)
340
360
380
400
420
440
400
420
440
Consumption (C)
Saving vs Dis-saving
40
35
30
25
20
15
10
5
0
-5
-10
-15
-20
-25
-30
-35
-40
240
260
280
300
320
340
360
Saving (S)
380
7.2 You are given the following national income and expenditure data for the Canadian
economy, in billions of dollars ($).
GDP=Y=AS
C
I
G
X
M
AE=AD
Change in
Inventory
280
160
70
80
90
70
330
-50
300
175
70
80
90
75
340
-40
320
190
70
80
90
80
350
-30
340
205
70
80
90
85
360
-20
360
220
70
80
90
90
370
-10
380
235
70
80
90
95
380
0
400
250
70
80
90
100
390
+10
420
265
70
80
90
105
400
+20
440
280
70
80
90
110
410
+30
460
295
70
80
90
115
420
+40
____________________________________________________________________
a)
Calculate AE for each level of income (Y) and determine the equilibrium level of income (Ye)
and changes in inventories.
See above table. Ye = $380 billion, where AS = AE or where )V = 0
b)
On graph paper, plot the AE and AS curves; point out the equilibrium point (AE and AS on
vertical axis, Y on horizontal axis; AE, AS and Y are in billions of dollars).
See attached diagram
c)
Calculate the MPC, MPS, MPM and MPCD.
MPC = )C =
)Y
175 - 160 = 15 = 0.75
300 - 280
20
MPS =
1 - MPC
)M
)Y
MPM =
=
= 1 - 0.75
75 - 70 =
300 - 280
= 0.25
5 = 0.25
20
MPCD = MPC - MPM = 0.75 - 0.25 = 0.50
What it means is that consumers tend to spend 75% of the income they earn while they spend
25% of the income they earn on imported goods and services. In other words, only 50% of the
income they earn gets spent on domestically produced goods and services.
460
AS vs. AE and Equilibrium Income
440
420
400
380
360
340
320
300
280
280
300
320
340
360
380
AS
AE
400
420
440
460
d)
Calculate the Multiplier (k) of the economy.
k =
1
1 - MPCD
=
1
=
1 - 0.50
1
= 2x
0.50
What this means is that every dollar injected into the economy in the form of an expenditure
triggers two dollars of additional economic activity in the form of additional output and income.
e)
Assuming that the full-employment (Yf) level of income occurs at Yf=$420 billion, how large
is the output (GDP) gap? How large is the expenditure gap? What type of expenditure gap
do we have? Recessionary or Inflationary? Illustrate on graph b) above.
The output gap or GDP gap = Yf - Ye = $420 - $380 = $40 billion
This means that the economy is producing $40 billion below its maximum production
capacity or potential output or “full-employment” level of GDP. When the economy is producing
below its potential it is characterized with high unemployment and is what happens when the
economy undergoes a recession. It is called a recessionary or deflationary gap.
The economy is not producing up to capacity because there is not enough aggregate demand
(AE) to propel the economy to a higher level of production. Hence we have a recessionary gap.
The size of the recessionary gap = GDP gap =
k
$40
2
= $20 billion
What this means is that if aggregate demand (AE) where to rise by $20 billion, the multiplier
effect would trigger a $40 billion rise in output and income,
i.e. )AE x k = )Y or $20 x 2 = $40 billion
See the next diagram for a graphical illustration: If the AE curve where to shift upwards by $20
billion to AE’, the equilibrium level of income Ye will increase to the full-employment level of
income Yf, and equilibrium at full employment will be achieved, i.e. Ye = Yf
460
440
420
400
380
360
340
320
300
280
280
300
320
340
360
AS
380
AE
400
420
440
460
AE'
7.3 You are given the following equation for the consumption function:
C = 100 + 0.8Y
a)
What is the level of autonomous consumption expenditure? What does this mean?
Autonomous consumption, " = 100
It means that even if income (Y) where to fall to xero, households will still spend $100
billion a year, the minimum they need to spend on consumption to survive.
b)
What is the marginal propensity to spend (MPC)? What does MPC mean? Discuss.
MPC = 0.8, It means that out of every dollar of income households will spend 80 cents. It
shows that consumers spend $80 out of every $100 they earn and this indicates their willingness
to spend out of income.
c)
Write the equation for the Saving Function. What is the marginal propensity to save
(MPS)? What does MPS mean? How are MPC and MPS related?
S = Y - C
S = Y - ( 100 + 0.8 Y)
S = Y - 100 - 0.8 Y
S = -100 + ( Y - 0.8 Y )
S = -100 + 0.2 Y
The MPS = 0.2 (the slope of the function). It means that out of every $100 earned,
households will tend to save $20, or 20% of their earned income.
Remember that: MPC + MPS = 1.00
or
d)
MPS = 1 - MPC = 1 - 0.8 = 0.2
Create a Table which shows the different levels of consumption (C) which correspond to
the different levels of income (Y) from 0 to 1000 in 100 increments. Then, on graph
paper
plot C against Y (Y should be on horizontal axis).
Income (Y)
Consumption ( C ) Saving
0
100
200
300
400
500
600
700
800
900
1000
100
180
260
340
420
500
580
660
740
820
900
-100
- 80
- 60
- 40
- 20
0
20
40
60
80
100
1000
900
800
700
600
500
400
300
200
100
0
0
100 200 300 400 500 600 700 800 900 1000
Income
Consumption
e)
Create another Table which shows the different levels of consumption (C) which
correspond to different rates of spending (MPC) from 0 to 1.00 in 0.10 increments. For
your purposes assume that the level of income remains constant at Y = 500. Then, on a
separate graph plot C against MPC.
Income (Y)
MPC
Consumption ( C )
500
0.00
0
500
0.10
50
500
0.20
100
500
0.30
150
500
0.40
200
500
0.50
250
500
0.60
300
500
0.70
350
500
0.80
400
500
0.90
450
500
1.00
500
_____________________________________________________
500
450
400
350
300
250
200
150
100
50
0
0
0.1
0.2
0.3
0.4
0.5
0.6
Consumption
0.7
0.8
0.9
1
7.4 a) MPC = 0.6, from C = 60 + 0.6 Y
MPM = 0.2, from M = 30 + 0.2 Y
MPCD = MPC - MPM = 0.6 - 0.2 = 0.4
k = 1 / 1 - MPCD = 1 / 1 - (MPC - MPM) = 1 / 1 - 0.4 = 1 / 0.6 = 1.67
b) To find Ye solve for AS = AE. Since AS = Y, then solve for Y = AE
Y = AE
= C+I+G+X -M
= 60 + 0.6 Y + 80 + 90 + 100 - ( 30 + 0.2 Y )
= 60 + 0.6 Y + 80 + 90 + 100 - 30 - 0.2 Y
= 300 + 0.4 Y
Y - 0.4 Y = 300
0.6 Y = 300
Y = 300/0.6 = 500
Therefore, Ye = $500 Billion
c)
Y = AE
= C+I+G+X -M
= 60 + 0.6 Y + 90 + 90 + 100 - ( 30 + 0.2 Y )
= 60 + 0.6 Y + 90 + 90 + 100 - 30 - 0.2 Y
= 310 + 0.4 Y
Y - 0.4 Y = 310
0.6 Y = 310
Y = 310/0.6 = 516.7
Therefore, Ye = $516.7 Billion. The Multiplier is not affected since neither MPC nor MPM
changed.
d)
Y = AE
= C+I+G+X -M
= 60 + 0.6 Y + 90 + 100 + 100 - ( 30 + 0.2 Y )
= 60 + 0.6 Y + 90 + 100 + 100 - 30 - 0.2 Y
= 320 + 0.4 Y
Y - 0.4 Y = 320
0.6 Y = 320
Y = 320/0.6 = 533.3
Therefore, Ye = $533.3 Billion. The Multiplier is not affected since neither MPC nor MPM
changed.
e)
Y = AE
= C+I+G+X -M
= 60 + 0.7 Y + 80 + 90 + 100 - ( 30 + 0.2 Y )
= 60 + 0.7 Y + 80 + 90 + 100 - 30 - 0.2 Y
= 300 + 0.5 Y
Y - 0.5 Y = 300
0.5 Y = 300
Y = 300/0.5 = 600
Therefore, Ye = $600 Billion
In this case the multiplier (k) does change since the MPC has increased to 0.7 from 0.6
k = 1 / 1 - MPCD = 1 / 1 - (0.7 - 0.2) = 1 / 1 - 0.5 = 1 / 0.5 = 2.0
7.6 You are given the following equations:
C = 20 + 0.87 Yd
Yd = Y - ( T + Sb )
T = 10 + 0.20 Y
Sb = 0.20 Y
I = 115
G = 140
X = 145
M = 10 + 0.25 Y
a)
Consumption Function
Relationship between PDI and GDP (or Y)
Tax Function
Business Saving Function
Investment Function
Government Expenditure Function
Export Function
Import Function
Since C and Sp is expressed as a function of Yd (i.e. PDI) we need to convert
these functions out of gross income (Y). Thus,
Yd = Y - ( 10 + 0.20 Y + 0.20 Y ) = Y - 10 - 0.40 Y =
Yd = - 10 + 0.60 Y
Sp = Yd - C
= Yd - 20 - 0.87 Yd = - 20 + 0.13 Yd
(Note that MPC out of Yd = 0.87 while MPSp out of Yd = 0.13)
Now, substitute Y for Yd:
Sp = - 20 + 0.13 ( - 10 + 0.60 Y ) = - 20 - 1.3 + 0.078 Y =
Sp = - 21.3 + 0.078 Y
b)
MPM = )M / ) Y = 0.25 which is the coefficient or slope of the import function
MPT = )T / ) Y = 0.20 which is the coefficient or slope of the tax function
MPS = MPSp + MPSb = 0.20 + 0.078 = 0.278
c)
The income multiplier (k) is:
k = 1 / MPW = 1 / (MPS + MPT + MPM) = 1 / 0.278 + 0.20 + 0.25 =
k = 1 / 0.728 = 1.37 x
d)
To calculate Ye we also need to convert the C-function as a function of Y:
C = 20 + 0.87 Yd = 20 + 0.87 ( - 10 + 0.60 Y ) = 20 - 8.7 + 0.522 Y
C = 11.3 + 0.522 Y
To find the equilibrium level of income (Ye) we need to solve for AS = AE
Since AS is also equal to Y, we solve for:
Y
Y
Y
Y
Y - 0.272 Y
0.728 Y
Y
Thus,
Ye
e)
=
=
=
=
=
=
=
=
AE
C+I+G+X-M
11.3 + 0.522 Y + 115 + 140 + 145 - 10 - 0.25 Y
401.3 + 0.272 Y
401.3
401.3
401.3 / 0.728 = 551.2
$551.2 billion
J = I + G + X = 115 + 140 + 145 = $ 400 billion
L = S + T + M = -21.3 + 0.078 Y + 0.20 Y + 10 + 0.20 Y + 10 + 0.20 Y
= - 1.3 + 0.728 Y = - 1.3 + 0.728 (551.2) = $ 400 billion
f)
C = 11.3 + 0.522 (551.2) = $299.0 billion
Sp = - 21.3 + 0.078 (551.2) = $21.7 billion
Sb = 0.20 (551.2) = $110.2 billion
St = - 21.3 + 0.278 (551.2) = $131.9 billion
T = 10 + 0.20 (551.2) = $120.2 billion
I / Y = 115 / 551.2 X 100 = 20.8%
X / Y = 145 / 551.2 X 100 = 26.3%
S + T = 131.9 + 120.2 = $252.1 billion
I + G = 115 + 140 = $255.0 billion
g)
7.8
a)
Yd = Y – (T + Sb) = Y – (0.25Y + 0.15Y) = Y – 0.40Y = 0.6Y
C = 20 + 0.95 Yd = 20 + 0.95 (0.6Y) = 20 + 0.57Y
Sp = Yd – C = Yd – (20 +0.95Yd) = -20 + (1-0.95Yd) = -20 + 0.05Yd
Since Yd = 0.6Y,
Sp = -20 + 0.05 (0.6Y) = -20 + 0.03Y
b)
MPS = MPSp + MPSb = 0.03 + 0.15 = 0.18
MPT = 0.25
MPM = 0.32
k =
1.33
c)
c)
________1 __________ =
_______1________ = __1__ =
MPS + MPT + MPM
0.18 + 0.25 + 0.32
AS =
Y =
Y =
Y =
Y =
Y =
Y - 0.25 Y =
0.75 Y =
Y=
Ye =
0.75
AE
AE
C+I+G+X–M
20 + 0.57Y +240 + 300 + 390 – (20 + 0.32Y)
20 + 0.57Y +240 + 300 + 390 – 20 - 0.32Y
930 + 0.25 Y
930
930
930 / 0.75 = $1,240.0
$1,240.0 Billion
S - I = -20 + 0.18Y –240 = 203.2 – 240 = -36.8 billion
T-G = 0.25Y – 270 = 310 – 300 = +10 billion
X-M = 390 – 20 – 0.32Y = 390 – 416.8 = -26.8 billion
In this economy, the domestic private sector investment expenditures exceed
domestic saving by $36.8 billion,which means that the currently generated
sources of funds are not sufficient to meet the financing needs of the business
sector. It means that the business sector has to find sources of funds outside the
domestic private sector of the economy. Luckily, the public sector has a surplus
of funds that can be lent to the private sector.
The public or government sector of the economy, on the other hand, is
generating more funds than it needs to finance its expenditures. It has a surplus
of funds of $10 billion that it can lend to the domestic private sector of the
economy.
Still, the total supply of funds generated by the private and public sectors of the
economy (S + T) is not enough to meet the demands from the private and public
sectors (I + G), which means that the country is short of funds by $26.8 billion.
The country will have to borrow these funds from the rest of the world.
The foreign sector of the economy is experiencing a deficit of $26.8 billion. This
means that the country as a whole is spending $26.8 billion more than it earns,
resulting in an international trade deficit of $26.8 billion. Conversely, when one
spends more than they earn, they need to borrow the difference, which means
that the country will have to import capital from the rest of the world.
e)
AE,AS
AS = Y = GDP
AE= C+I+G+X-M
$930
Ye = $1,240
J, L
Y = GDP
L = S+T+M
$930
J = I+G+X
Y = GDP
Ye
S, I
(S – I )
Y = GDP
-$36.8
T, G
(T – G)
+$10
Y = GDP
X, M
Y = GDP
-$26.8
NX = ( X – M )
7.9
a)
Yd = Y - 0.35Y - 0.15Y + 100
Yd = 100 + 0.50Y
b)
C = 30 + 0.90 (100 + 0.50Y)
C = 120 + 0.45Y
c)
Sp = -30 + 0.10 (100 + 0.50Y)
Sp = -20 + 0.05Y
d)
G = BG - TP = 230 - 100 = $130 bil.
e)
MPSp = 0.05 (from the personal saving function Sp)
MPSb = 0.15 (from the business saving function)
MPM = 0.30 (from the import function)
MPT = 0.35 (from the tax function)
----------MPW = 0.85
k = 1 / MPW = 1.176
f)
AS = AE
Y=C+I+G+X-M
Y = 120 + 0.45Y + 120 + 130 + 160 - 20 - 0.30Y
Y = 510 + 0.15Y
0.85Y = 510
Ye= $ 600 billion
g)
C = 120 + 0.45(600) = $390 bil.
I = $120
G = $130
X = $160
M = 20 + 0.30(600) = $200
T = 0.35(600) = $210 bil
BG = 130 + 100 = $230 bil
h)
Budgetary balance: T - BG = 210 - 230 = $-20 bil
i)
International trade balance: X - M = 160 - 200 = $-40 bil
j)
Savings/Investment balance: S - I = 100 - 120 = $-20 bil
where S = Sp + Sb =0.15Y - 20 + 0.05Y = -20 + 0.20Y
k)
(S - I) + (T - BG) + (M - X) = 0
or (S - I) + (T - BG) = (X - M)
Thus, ( -20 ) + ( -20 ) = ( -40 )
AE, AS
AS = Y = GDP
AE’ = C+I’+G+X-M
AE = C+I+G+X-M
Ye
Ye’
J, L
Y
L = S+T+M
J’ = I’+G+X
J = I+G+X
0
Ye
Ye’
Y
7.5 a) The effect of an improvement in business confidence (ψ) on the economy.
It results in up-ward parallel shifts in the injections (J) and aggregate expenditure (AE)
functions which induces a rise in demand, production, employment and the equilibrium national
income (Ye)
AE, AS
AS = Y = GDP
AE’ = C+I+G’+X-M
AE = C+I+G+X-M
Ye
Ye’
J, L
Y
L = S+T+M
J’ = I+G’+X
J = I+G+X
0
Ye
Ye’
Y
7.5 b) The effect of an increase in government spending (G) on the economy.
It results in up-ward parallel shifts in the injections (J) and aggregate expenditure (AE)
functions which induces a rise in demand, production, employment and the equilibrium national
income (Ye)
AE, AS
AS = Y=GDP
AE = C+I+G+X-M
AE’ = C’+I+G+X-M
Ye’ Ye
J, L
Y
L’ = S+T’+M
L = S+T+M
J = I+G+X
0
Ye’ Ye
Y
7.5 c) The effect of an increase in income tax rates (MPT) on the economy.
It results in up-ward rotational shift in the leakages (L) function and a down-ward rotational shift
in the aggregate expenditure (AE) function which induces a drop in demand, production,
employment and the equilibrium national income (Ye)
AE, AS
AS = Y=GDP
AE’ = C+I+G+X-M’
AE = C+I+G+X-M
Ye Ye’
J, L
Y
L = S+T+M
L’ = S+T+M’
J = I+G+X
0
Ye Ye’
Y
7.5 d) The effect of a decrease in the propensity to import (MPM) on the economy.
It results in down-ward rotational shift in the leakages (L) function and a up-ward rotational shift
in the aggregate expenditure (AE) function which induces a rise in domestic demand,
production, employment and the equilibrium national income (Ye)
AE, AS
AS = Y=GDP
AE = C+I+G+X-M
AE’ = C’+I’+G+X-M
Ye’
Ye
J, L
Y
L’ = S’+T+M
L = S+T+M
J = I+G+X
J’ = I’+G+X
0
Ye’
Ye
Y
7.5 e) The effect of an increase in interest rates (r) on the economy.
It results in up-ward rotational shift in the leakages (L) function as consumers increase their
saving rate (MPS) and decrease their consumption rate (MPC) and a down-ward rotational shift
in the aggregate expenditure (AE) function as businesses reduce capital investment spending (I)
which together induce a drop in domestic demand, production, employment and the equilibrium
national income (Ye)
8.1 a) Since we have an output gap (GDP gap) of $40 billion, it implies that the economy is not
producing at full-capacity (Yf), therefore, it is experiencing a recessionary gap
(deflationary gap) of $20 billion.
Therefore, the government should pursue an expansionary fiscal policy, i.e. increase the
level of government spending ()G) and decrease the level of taxes through a cut in income
tax rates ()MPT) or both.
b) Since the expenditure gap i.e. the amount of deficient spending power in the economy,
is equal to $20 billion, the government should raise spending by $20 billion, i.e.
)G
=
$20
Thus, + )G x k
=
+)Y
=
$40 billion
Or,
$20 x 2
c) The government should lower income taxes by a lump sum of $40 billion
-)T ÷ + )Yd + x (MPCD) ÷ )CD
-$40
+ $40
0.50
÷ + )AE x
+ $20
+ $20
x
k ÷
2
+ )Y
+ $40 billion
d) Initially, the government will have to borrow $20 billion (assuming it chooses the option
of raising government spending), thus the initial budget deficit will be $20 billion
Once the rise in government expenditures raises the country’s total income by $40
billion, the government stands to benefit as well by seeing its tax revenue rise by the change in
income times the marginal income tax rate (MPT) which is assumed to be 0.20 or 20%. The
government will see its tax revenue (T) rise by $8 billion
Thus, + )Y x MPT = + )T
+ $40 x 0.20
= + $8 billion
Thus the final impact on its budget deficit will not be $20 billion but $12 billion
+ )G = $20
Less + )T = $ 8
)G - )T
=
$12 billion
e) Initially, the government’s debt-to-GDP ratio stands at $150 / $380 = 39.5 %
After the expansionary policy action, the government’s debt-to-GDP ratio will fall to
38.6% because even though the public debt rises by $12 billion to $162 billion, the country’s
national income or GDP rises as well by $40 billion.
Increase in government debt: $150 + $12 = $162, thus $162 / $420 = 38.6 %
8.2 a) To find Ye solve for AS = AE. Since AS = Y, then solve for Y = AE
Y = AE
= C+I+G+X -M
= 70 + 0.6 Y + 75 + 80 + 70 - ( 10 + 0.2 Y )
= 70 + 0.6 Y + 75 + 80 + 70 - 10 - 0.2 Y
= 285 + 0.4 Y
Y - 0.4 Y = 285
0.6 Y = 285
Y = 285/0.6 = 475
Therefore, Ye = $475 Billion
b) If Yf = $500 Billion, then
GDP Gap or Output Gap is: Yf - Ye = $500 - $475 = $25 Billion
The Expenditure Gap is: GDP Gap / Multiplier
The Multiplier (k) is: 1 / 1 - MPCD = 1 / 1 - (0.6 - 0.2) = 1 / 1 - 0.4 = 1 / 0.6 = 1.667
Therefore, the GDP Gap is $25 / 1.67 = $15 Billion
Since Ye < Yf, we have a Recessionary (Deflationary) Gap
c) The type of fiscal policy recommended here is Expansionary fiscal policy, i.e. an
increase in government spending (+)G) or a decrease in tax collections (-)T) or a
combination of both.
d) )G x k = )Y
)G x 1.667 = $25
Therefore, )G = $15 Billion
8.3 a) marketable bonds are issued in large denominations for terms ranging from 1 year to 30
years, and pay a fixed rate of interest over the duration of the bond until they mature.
Treasury bills are issues in smaller denominations for terms ranging from 3 months (91
days) to 365 days. They do not carry a coupon rate of interest but rather are sold at a
discount over their face value, but when they mature they pay the full face value.
Canada savings bonds are not really bonds, rather they are government securities that
issued to the retail investing public. They can be redeemed (cashed in) at any time, and the
holder receives the accrued interest until the day they cash them in. They are similar to a
bank term deposit certificate.
b) The relationship between interest rates and bond prices is inversely proportional,
meaning that whenever interest rates rise, the price of bonds falls and whenever interest
rates fall, the price of bonds rises. This happens because they carry a fixed rate of interest
over the life of the bond.
8.4 a) An Expansionary fiscal policy is a deliberate government budgetary action designed to
give a boost to the economy, namely an increase in government spending (+)G) or a
decrease in tax collections (+)T) or a combination of both.
b) A Contractionary fiscal policy is deliberate government budgetary action designed to
slow down the growth in aggregate demand in the economy and by extension reduce the
rate of inflation by taking pressure off limited production capacity, namely through a
decrease in government spending (-)G) or an increase in tax collections (+)T) or a
combination of both.
c) Automatic or Built-in Stabilizers are various government programs or institutional
features that have the result of automatically raising government spending and
automatically lowering tax collections when the economy slows down; and automatically
lowering government spending and raising tax collections when the economy picks up.
The best example of an automatic stabilizer is the Employment Insurance System. When
the economy slows down, falls into recession and workers lose their jobs, they stop paying
premiums into the employment insurance fund, i.e. like a tax cut (-)T) but they draw out
of the plan employment insurance payments, like an increase in government spending
(+)G). Other examples include a) social assistance (welfare payments to the poor when
employment insurance payments run out); b) the progressive nature of the income tax
system, i.e. as personal income rises, we are pushed to a higher tax bracket and as personal
income falls we are pushed to a lower tax bracket, thus the marginal propensity to pay tax
(MPT) falls when the economy slows down and rises when the economy picks u; and c)
agricultural support programs whereby during years of low agricultural output farmers’
income is subsidized by the government to ease the negative impact on their financial
condition.
d) An annually-balanced budget is a budget that the government is supposed to balance,
i.e. T = G in each calendar or fiscal year, i.e. over a twelve month period.
A cyclically-balanced budget is a budget that the government is supposed to balance over
the span of the business cycle, i.e. over a seven (7) year period. The advantage of the
cyclically-balanced budget is that the government’s hands are not tied, instead the
government has the leeway to run budget deficits during recession years with the budget
returning automatically to balance or surplus during expansion years. This way, the
government has the room to exercise its fiscal policy obligations toward the economy.
8.5
a) The public debt is the total debt accumulated by the government sector. It is the total
amount borrowed over the years and outstanding at a given point of time. An other way of
defining it is as the sum of all deficits minus surpluses over the years. In Canada, the
public debt is the debt of the federal government, but since provincial governments also
have the power to borrow, public debt should also include the total debt accumulated by all
provincial governments. When we add the debts of the two levels of government we have
total government debt. An even broader measure of debt should also include the debts of
municipal governments.
b) A budget surplus is when government revenues for the year exceed government
expenditures leaving a surplus of funds.
A budget deficit is when government expenditures for the year exceed government
revenues, leaving a deficit that needs to be financed by borrowing money.
A balanced budget is when the level of government revenues for the year is equal to
the level of government expenditures.
c) The budget deficit is the difference between what the government spends during a year
and what it collects in revenues (is a flow variable). The public debt on the other hand is
the total debt accumulated over time and outstanding at a point in time (is a stock variable).
d) The budget deficit is the excess of what the government spends minus what it collects
during a single year (T - G). The trade deficit, is the excess of what a country imports
from the rest of the world minus what it exports to the rest of the world during a given year
(X - M). A more complete measure of the trade balance is known as the current account
balance.
e) Public debt is the debt of the government or public sector. Private debt is the debt of
the private sector of the economy, meaning the combined debt of households and
businesses.
f) Public debt is the total debt of the government sector of the economy (federal,
provincial and local or municipal levels of government). External debt is the debt of the
country owed to non-residents, i.e. to counterparties in the rest of the world. The external
debt includes both debts of the public as well as private sectors of the economy.
8.7 a) The three options a government has to finance a budget deficit are:
i) borrow from the general public, i.e. borrow from its own citizens, directly from
individuals as with Canada Savings Bonds or indirectly through institutions such as banks,
life insurance companies, pensions funds and investment funds.
ii)
borrow from foreigners (non-residents), i.e. borrow savings from other countries.
iii)
borrow from the central bank. Since central banks are part of the government,
borrowing from a central bank implies the creation of money, i.e. like “printing money”
b) The federal government issues securities which are IOUs. There are three types of
securities issued by the federal government:
i) bonds (securities with terms ranging from 1 year to 5, 10, 20 and 30 years). Bonds are
redeemable only at maturity, i.e. the end of the term; are transferable, i.e. can be sold in the
secondary market and pay a fixed interest rate for the term of the bond called the coupon
rate.
ii) treasury-bills (securities with terms less than 1 year, like 1 month, 3 months , 6
months , 9 months and up to 364 days). Like bonds, t-bills are redeemable only at
maturity, but are transferable before maturity. Unlike bonds they do not carry a coupon
rate, rather they are discount instruments, meaning they are purchased at a discount to their
face value, the difference being the gain. In Canada, they are issued every two weeks on a
Wednesday.
iii) Canada Savings Bonds. CSBs are not really bonds but investment certificates, since
they are redeemable, i.e. cashable at any time prior to maturity without risk of losing the
interest earned to that day.
c) The potentially most inflationary means of financing a budget deficit is borrowing
from the central bank since it involves the creation of money. The least inflationary
method is borrowing from the general public, i.e. internal borrowing from your own
citizens.
8.8 a)
(100.0 - 98.175) / 98.175 x (365 / 91) x 100 = 7.46%
b)
(100.0 - 99.116) / 99.116
x (365 / 182)
c)
(100.0 - X ) / X x (365 / 91) x 100 = 5.27%
(100.0 - X) / X x 365 / 91 = 0.0527
36500 - 365 X / 91 X = 0.0527
4.7957 X = 36500 - 365 X
369.7957 X = 36500
The Bid Price (X) = 98.703
d)
(100.0 - X ) / X x (365 / 224 ) x 100 = 5.61%
The Bid Price (X) = 96.672
x 100 = 1.79%
8.9
Year
1962
1967
1972
1977
1982
1987
1992
1997
2002
2007
B
Net
Public
Debt
C
D
E
G
Federal
GDP
IPI
Total Interest Governmt
current $ 2002=100 Populati Cost Revenues
on
14825
44665
15.8
18583
832
6506
17707
69698
18.8
20378
1182
9974
22079 109913
23.8
22218
2110
17119
41517 220973
38.9
23726
4708
35283
107622 379859
60.4
25117 15114
67289
281832 558949
73.1
26449 28718
86746
445729 700480
85.9
28367 43861
126086
608996 882733
92.8
29907 47281
149889
565312 1152905
100.0
31373 39651
183930
523905 1530540
116.6
32970 33945
235966
B/C*100 F/G*100 F/C*100 F/B*100 B/D*100 B/D*100/E
a) ( i )
Year
1962
1967
1972
1977
1982
1987
1992
1997
2002
2007
F
( ii )
( iii )
( iv )
Interest
Interest
Cost to Interest Cost to
to
Debt-to- Revenue GDP
Public
GDP
Debt
Ratio
Ratio
Ratio
Ratio
33.2%
25.4%
20.1%
18.8%
28.3%
50.4%
63.6%
69.0%
49.0%
34.2%
b) Discussion:
12.8%
11.9%
12.3%
13.3%
22.5%
33.1%
34.8%
31.5%
21.6%
14.4%
1.9%
1.7%
1.9%
2.1%
4.0%
5.1%
6.3%
5.4%
3.4%
2.2%
5.6%
6.7%
9.6%
11.3%
14.0%
10.2%
9.8%
7.8%
7.0%
6.5%
(v)
Real
(vi)
Real
Debt
Debt
per
2002 $
Capita
93829
94186
92769
106727
178182
385543
518893
656246
565312
449318
5049
4622
4175
4498
7094
14577
18292
21943
18019
13649
i) The debt-to-GDP ratio decreased between 1952 and 1977, increased between 1977
and 1997 and has been falling ever since. From a high of 69% of GDP in 1997, it has
come down to 34.2% in 2007.
ii) When you divide the annual interest cost of servicing the public debt by total federal
government revenue, you will find that while in the 1950s and 1960s interest charges
absorbed close to 10% of federal revenue, by the 1980s and 1990s, interest payments
account for a third of federal government revenue. This indicates that the federal
government had less money to allocate toward all other functions of government. A
financial squeeze. Since then the situation has improved dramatically with interest
payments accounting for less than 15 cents out of every dollar of federal revenue.
iii) Has the same significance as ii) above, but instead relates interest charges to GDP.
Interest charges accounted for over 6% of GDP in 1992 compared to less than 2% in the
1950s and 1960s. In 2007, had fallen down to only 2.2% of GDP.
iv) The interest charges to public debt shows the effective average rate of interest being
paid by the federal government to service its debt. The average rate of interest paid on
federal debt has more than doubled during this period from less than 6.0% in the 1950s to
over 12.0% in the 1980s. In 2007 it was down to 6.5%, around where it was in 1967.
v) By dividing the gross public debt by the implicit price deflator, we get a picture of the
real (inflation adjusted) level of public debt. Debt per capita increased slowly between
1952 and 1972, but has doubled since then. This dramatic rise in the debt level is not
sustainable in the future. Sooner or later any government is forced to stop borrowing,
starts raising taxes and cut spending. This is what happened during the 1990s. Since 1997
the federal government has achieved budget surpluses, which have brought down the
debt/GDP ratio to 34.2 % in 2007.
vi) On a per capita basis, the federal government debt rose dramatically between 1972
and 1997 but has been falling as fast since then.
Conclusion: The growth in the federal government's debt has not been fictional, nor is it
only due to inflation. The public debt has risen in real terms, has risen relative to the
population and relative to our production. Obviously by the 1990s, Canada reached its
limits in terms of the ability of the federal government to carry any more debt. Since 1997,
the situation has improved dramatically and continues to improve.
8.10
Since potential GDP, Yf = $575 billion and the actual or Ye = $551.2 billion,
a)
GDP gap = Yf - Ye = $23.8 billion, since Ye < Yf, it is a recessionary
(deflationary) gap
The size of the expenditure gap = GDP Gap / k = $23.8 / 1.37 = $17.37 billion
b)
It is recommended that the government pursue expansionary fiscal and/or
expansionary monetary policies, i.e. +)G, - )T, + )Sm, - )r
c)
If the government chooses to eliminate the gap by raising expenditures, it should
increase them by the amount of the expenditure gap, i.e. by $17.37 billion, i.e.
+)G x k = +)Y
Following this fiscal policy action the government budget deficit will rise from
$ -19.8 bil. to $ -32.4 billion. T - G = 10 + 0.20 (575.0) - (140 + 17.37) = 125.0 157.37 = $-32.4 billion. The budget deficit will increase by $12.6 billion
d)
If the government chooses to eliminate the gap by cutting taxes, it should cut
income tax rates by:
- )I ==> + )Yd ===> MPC ===> + )CD ===> + )AE ===> k ===> + ) Y
To find )T, solve for Yf = AE:
Yf = C + I + G + X - M
575 = 11.3 + J(575) + 115 + 140 + 145 - 10 - 0.25 (575)
- 575 J= 11.3 + 115 + 140 + 145 - 10 - 0.25 (575) - 575
- 575 J= - 317.45
J= 0.552, where 0.552 is the new coefficient of the consumption function
C = 20 + 0.87 Yd
Yd = -10 + 0.60 Y = Y - 10 - .20 Y - 0.20y
C = 11.3 + 0.522 Y
where 0.522 = 0.87 (0.60)
Then, if 0.522 = 0.87 J, then J = 0.634
Yd = - 10 + 0.634 Y = Y - 10 - 0.166 Y - 0.20 Y
T = -10 + 0.166 Y, thus the new MPT will be = 0.166
Therefore, the tax rate must be lowered from 20% to 16.6 %
Following this fiscal policy action the budget deficit will rise to $ -34.5 billion,
i.e.
T - G = 10 + 0.166 (575) - 140 = $-34.5 billion
The budget deficit will rise by $14.7 billion, assuming no other variables such as
MPC, MPM and MPSb have changed.
8.11
e)
Clearly raising government spending option results in a lower deficit than the taxcutting option.
a)
Since potential or full-employment GDP occurs at Yf = 1,200 and the equilibrium
level, as calculated in problem 7.8, occurs at Ye = 1,240, we are facing a negative
output gap which means that the economy is operating beyond its fullemployment
point, i.e.
GDP gap = Yf - Ye = 1,200 - 1,240 = -40 billion
In this case we are facing an inflationary expenditure gap, the magnitude of which
depends on the income multiplier (k). To find out the size of the inflationary gap
solve for:
Expenditure gap ()AE) x k = GDP Gap, or
GDP gap / k = Expenditure gap = -40 / 1.33 = -30 billion
b)
To close the gap and bring the economy back to a non-inflationary equilibrium
where Ye = Yf, the government needs to follow contractionary fiscal and/or
monetary policies, i.e. -)G, + )T, - )Sm, + )r
c)
If the government chooses to eliminate the gap by cutting expenditures, it should
reduce them by the amount of the expenditure gap, i.e. by $30 billion, i.e.
-)G x k =
+)Y or
-30 x 1.33 = -40 billion
Following this fiscal policy action the government budget surplus will rise from
$ +10 bil. to $ +30 billion.
T - G = 0.25 Y – G = 0.25 (1200.0) - 270 = 300 - 270 = $+30 billion.
The budget surplus will increase by $20 billion
d)
If the government chooses to eliminate the gap by raising taxes, it should raise
income tax rates which will produce the following results:
+ )I ==> - )Yd ===> MPC ===> - )CD ===> - )AE ===> k ===> - ) Y
To find out by how much the government needs to raise income tax rates ∆MPT,
solve for Yf = AE, where τ is the tax rate and now becomes our unknown
variable.
Since we know that Yf should equal Ye = 1,200, we substitute 1,200 for Ye in the
equation and solve for τ. Remember that T = τY and Yd = Y – (T + Sb). Thus,
Yd =
=
=
=
Y - (τ Y + Sb)
Y - τ Y – 0.15Y
(1-0.15) Y – τ Y
0.85Y – τ Y
Y = AE
1200 = C + I + G + X – M
1200 = 20 + 0.95 (0.85Y – τ Y) + 240 + 300 + 390 – 20 – 0.32Y
1200 = 20 + 0.95 [(0.85)(1200) – τ (1200)] +240 +300 + 90 – 0 –
0.32(1200)
1200 = 20 + 969 – 1140 τ + 910 –384
1200 = 1515 - 1140 τ
1140 τ = 315
τ = 315 / 1140 = 0.2763
Thus, the government will have to raise income tax rates from 25% to 27.63%, a rise of
2.763 percentage points.
Following this fiscal policy action the government budget surplus will rise from $ +10
bil. to $ +30 billion.
T - G = 0.2763 Y – G = 0.2763 (1200.0) - 300 = 331.56 -300 = $+31.56 billion.
The budget surplus will increase by $21.56 billion
f)
The impact on the government’s finances of either policy action is more or less
the same from the government’s budget balance point of view. Whether the
government should choose one or the other option will hinge on other factors and
policy objectives it might want to attain. For example, conservatives would prefer
to cut spending while liberals would prefer to raise taxes.
Problem # 9-1
Interest Rate (r)(%)
18
16
14
12
10
8
6
Money Demand (Dm)
30
40
50
60
70
80
90
Money Supply (Sm)
60
60
60
60
60
60
60
The money multiplier (Mk) is:
Mk =
1
1
=
=5
1− MPL 1− 0.8
9-1,b) Assuming that the Bank of Canada purchases $2 billion of treasury bills from chartered
banks it buys the securities from them and pays them with cash, thereby increasing their liquid
reserves. Then the banks take this cash and they loan it out to clients. Because the money
multiplier is x5, the total supply of money in the economy will increase by $2 bil X 5 = $ 10
billion. With the money supply higher by 10 billion, short-term interest rates will fall from 12%
to 10%. This is what is known as an expansionary monetary policy.
Hence, the money Supply will increase by $2 billion H 5 = $10 billion and interest rates fall to
10%.
9-1,c) Assuming that the Bank of Canada sells $2 billion of treasury bills to chartered banks, it
sells the securities to them and gets paid in cash from them, thereby reducing the cash reserves of
chartered banks by $2 billion. Because the money multiplier is x5, the total supply of money in
the economy is reduced by $2 bil x 5 = $10. With the money supply lower by $10 billion, shortterm interest rates will rise from 12% to 14%. This is what is known as a contractionary
monetary policy.
Hence, the money Supply will decrease by $2 billion H 5 = $10 billion and interest rates rise to
14%.
9-1,d) Assuming that as a consequence of the GDP increase the demand for money rises by $10
billion then, with the money supply remaining constant at $60 billion, the equilibrium interest
rate is pushed up from 12% to 14%. With more demand but the same supply of money in the
economy, money because more scarce, and the price of money increases.
9-1,e) To mitigate the rise in interest rates, the Bank of Canada can expand the supply of money
by $10 billion by buying $2 billion in treasury bills from the chartered banks as in 5.1 b above.
As a result interest rates remain constant at 12%. This is what is known as an accommodating
monetary policy..
9.2
a)
The main measures of money supply are:
M1: demand (chequing or non-interest paying deposits) with chartered banks
M2: demand, saving and term deposits (all deposits) with chartered banks
M2+ all deposits with banks and non-bank deposit taking financial institutions
(NBFIs)
9.3
b)
M1 consists of demand deposits only, whereas M2 consists of all deposits
c)
M2 consists of all deposits with chartered banks only whereas M2+ consists of all
deposits with banks and non-bank financial intermediaries (NBFIs) like trust
companies, caisse populaires.
d)
M2 and M2+
a)
The net interest spread is the difference between the average interest charged on
loans and the average interest paid on deposits
b)
The short-term interest rate is the interest rate charged or paid on deposits and
loans with short-term maturities, strictly speaking involving terms of 1 year or
less, but broadly speaking of terms ranging up to 5 years. Short-term interest rates
are known as money market rates.
c)
The long-term interest rate is the interest rate charged or paid on long-term
loans such as government and corporate bonds. These loans are better known as
securities and the interest rate is called the yield. It involves debt securities with
terms ranging from 5 years all the way out to 30 years. Bonds with a 10-year term
are the most representative of long-term bonds.
d)
The difference between long-term rates and short-term rates reflects the premium
a lender charges the borrower for assuming the risk of fixing the rate for a long
period of time, during which it is hard to predict what will happen to interest rates
in financial markets. It is known as the long vs short interest rate differential
and reflects the steepness of the yield curve. Since the lender takes on this risk it
is normal that he be compensated for the extra risk by charging a higher rate. This
is why normally, long-term interest rates are higher than short-term interest rates.
e)
The real rate of interest is the interest rate charged or received on a deposit or a
security less the current (or more strictly speaking the expected) rate of inflation.
Since inflation reduces the value of money, the lender loses when he lends money
an amount equal to the rate of inflation. With 3% inflation on a one year term
deposit, your money is worth 3% less at the end of the year. Therefore, to
compensate the lender for the loss in the value of their money the borrower is
asked to add the expected 3% inflation rate to the price of the loan, thereby
increasing the nominal rate paid on the loan. Thus if the lender wants to earn a
real 3% return on the money is lending, he will charge a total of 6%, if he
expects inflation to average 3% over the coming year.
9.4
The transmission mechanism describes how changes in the demand for money or the
supply of money have on interest rates and through interest rates on the rest of the
economy, namely aggregate demand, income, production, employment and prices. An
increase in the supply of money generally has a favourable effect on the economy while a
decrease in the supply has a restrictive effect.
The flow chart of the transmission mechanism:
Dm
C
r
Sm
k
AE
I
GDP, N,
Y
Graphical illustration of the effect of a decrease in the money supply (Sm) on the
economy:
r
%
Sm' Sm
1
r1
2
r0
r C
%
r1
r1
2
Dmr0
Qm1 Qm0
9.6
r I
%
Qm
I r0
3
I1
I0
I
AE,AS
AS
AE0
AE1
2
3
C1 C0
C
C
Y1 Y0Yf Y,GNP
Expansionary monetary policy is a central bank policy designed to stimulate an
expansion and create jobs in the economy by increasing the money supply (+)Sm) and
decreasing the level of short-term interest rates (-)r), i.e. increasing the availability and
reducing the cost of credit. It is used whenever the growth in aggregate demand is
slowing and unemployment is rising and the economy is at risk of falling into a recession
or in a recession.
Contractionary monetary policy is a central bank policy designed to slow down an
expansion and reduce inflationary pressures in the economy by reducing the money
supply (-)Sm) and increasing the level of short-term interest rates (+)r), i.e. reducing the
availability and increasing the cost of credit. It is used whenever the growth in aggregate
demand is higher than desirable or when the inflation rate is starting to rise above the
desired level.
9.9
a)
The appropriate macroeconomic policies to fight high unemployment in the
economy are i) expansionary fiscal policy, such as an increase in the level of
government spending (+)G) and decreasing the level of taxes (-)T) and ii)
expansionary monetary policy, such as an increase in the money supply (+)Sm) and a
decrease in short-term interest rates
(-)r).
b) The appropriate macroeconomic policies to fight rising inflation in the economy are
i) contractionary fiscal policy, such as a decrease in the level of government spending ()G) and increasing the level of taxes (+)T) and ii) contractionary monetary policy,
such as a decrease in the money supply (-)Sm) and an increase in short-term interest
rates (+)r).
9.8
a) The two most important instruments of monetary policy in Canada are the overnight
interest rate also known as the policy rate and open market operations
b)
Open market operations are purchases and sales of Government of Canada
treasury bills in the open market. Purchasing treasury bills from chartered banks it
increases their liquidity and expands their ability to lend. Selling treasury bills to
chartered banks reduces their liquidity and curtails their ability to make loans and hence
expand the money supply.
c)
The overnight financing rate is the rate at which major participants in the money
market (mostly banks) borrow and lend one-day funds to each other. The central bank
sets the target rate at which it wants to see banks charge each other on these day to day
loans. It is the principal instrument through which the central bank determines short-term
interest rates in the economy.
d)
The key policy rate of the Bank of Canada is the overnight financing rate.
e)
The bank rate is the minimum rate at which the Bank of Canada lends money to
the members of the Canadian Payments Association (e.g. banks). It is set at the upper
limit of the operating band which is 50 basis points with its midpoint the target for the
overnight financing rate. In effect it is 25 basis points higher than the target for the
overnight rate.
f)
The prime rate is the rate at which chartered banks lend to their most credit worthy
customers and serves as the benchmark upon all other chartered bank lending rates are
set.
9.11
a) The desired reserve or liquidity ratio is: Liquid Assets / Total Assets = $20 / $100 x
100 = 20%
b) The net interest margin (NIM) or interest spread is interest income minus interest
expense.
Income from securities
Income from loans
Total interest income
$20 x 0.08 = $1.60
$75 x 0.11 = $8.25
$9.85 billion
Interest Expense
(Interest paid on deposits)
$90 x 0.07 = $6.30
Net interest income
$3.55 billion
Thus, the NIM = $3.55 / $100 x 100 = 3.55 %
c) The bank’s net income is net interest plus other income minus loan loss provisions
minus non-interest expenses:
9.12
Income from securities
Income from loans
Total interest income
$20 x 0.08 = $1.60
$75 x 0.11 = $8.25
$9.85
less Interest on deposits
$90 x 0.07 = $6.30
equals Net interest income
plus Other income
less Provisions for credit losses
equals Total income
$3.55
$1.00
$1.50
$3.05
less Non-interest expenses
$1.75
equals Net income (profit)
$1.30
====
d) Return-on-Equity (ROE):
$1.30 / $10 x 100 = 13.0 %
e) Return-on-Assets (ROA):
$1.30 / $100 x 100 = 1.3 %
a)
100.0 - 98.365
-------------------98.365
365
X --------91
X
100 = 6.67 %
b)
100.0 - 92.184
---------------------92.184
365
X --------364
X
100 = 8.50 %
9.7
r
Sm
S’m
r
S’m
Sm
Dm
a) Policy induced drop in rates
9.13
9.14
Dm
b) Policy induced rise in rates
a)
When short-term interest rates rise, the carrying cost of holding bonds increases
and this reduces the attractiveness of holding bonds. Hence the demand for bonds
decreases which causes the price of bonds to fall.
b)
If there is a massive increase in the amount of bonds available for sale the supply
curve for bonds will shift to the right. Given the demand for bonds, the
equilibrium price of bonds will fall. A fall in the price means that prospective
buyers are demanding a higher return on the bonds. Since bonds pay a fixed
coupon rate during their term, paying less for bonds implies a rise in their yield,
which is to say in long-term interest rates.
a)
Nominal Rate (e.g. Prime Rate) - Inflation Rate = Real Prime Rate
b)
Real interest rates have been falling from the mid-1960s until the mid-1970s
reaching negative levels in the 1970s. Starting from 1981, real interest rates rose
to very high levels and more or less stayed at those levels through most of the
1980s. It can be inferred that monetary policy became a lot more restrictive or
contractionary during the 1980s than it was during the 1970s. With contractionary
policies in effect one would expect inflation to come down.
c)
The objective of monetary policy in Canada between 1981-1992 has been
contractionary. Yes it has achieved its intended objective because we can see that
the rate of inflation in Canada has come down considerably during the 1990s and
has stayed low. As a direct result of lowering inflation and inflation expectations,
eventually interest rates have fallen to the lowest levels during this period and the
economy has been expanding strongly.
20
Percent (%) Rate
15
10
5
0
-5
66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 0 1 2 3 4 5 6 7
Prime Rate
Real Rate of Interest
REAL RATE OF INTEREST IN CANADA: 1966-2007
Prime Interest Rate minus Inflation Rate (IPI)
Year
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Prime
Rate
6
6
6.9
7.9
8.2
6.5
6
7.6
10.7
9.4
10
8.5
9.7
12.9
14.3
19.3
15.8
11.2
12.1
10.6
10.5
9.5
10.8
13.3
14.1
9.9
7.5
5.9
6.9
8.6
6
5
6.6
6.4
7.3
5.8
4.2
4.7
4
4.4
5.8
6.2
Infl. Rate Real Rate of Interest
4.9
4.4
4.3
5.1
4.4
4.7
5.8
9.7
15.3
10.6
9.6
6.6
6.7
10.1
10.1
10.7
8.4
5.5
3.3
3
3.1
4.6
4.5
4.5
3.3
2.9
1.3
1.5
1.1
2.3
1.6
1.3
-0.5
1.7
4.2
1.1
1.1
3.3
3.2
3.4
2.5
3.1
1.1
1.6
2.6
2.8
3.8
1.8
0.2
-2.1
-4.6
-1.2
0.4
1.9
3
2.8
4.2
8.6
7.4
5.7
8.8
7.6
7.4
4.9
6.3
8.8
10.8
7
6.2
4.4
5.8
6.3
4.4
3.7
7.1
4.7
3.1
4.7
3.1
1.4
0.8
1
3.3
3.1
10.1
You are provided with the following information regarding Canada's international
transactions for 2005: (billions of $)
a)
BALANCE OF PAYMENTS, 2005
Billions of Canadian Dollars
Current Account
Credit (+)
Merchandise exports
Merchandise imports
Balance on merchandise trade
Exports of services
Import of services
Balance on services
Investment receipts
Investment payments
Balance on investment income
Transfer receipts
Transfer payments
Balance on transfers
Balance on invisibles
Balance on Current Account
451.8
Debit (-)
Balance
388.3
+ 63.5
67.0
79.1
- 12.1
48.2
70.7
- 22.5
8.2
9.0
- 0.8
- 35.4
+ 28.1
Capital & Financial Account
Canadian direct investment abroad
Foreign direct investment in Canada
Portfolio investment abroad
Portfolio investment in Canada
Balance on Capital Account
Change in official international reserves
Statistical discrepancy
Overall balance of payments
-40.6
35.0
-53.3
26.6
Gross Domestic Product (GDP)
b)
What is the balance on merchandise trade?
balance on services?
balance on investment income?
balance on invisibles?
balance on current account?
value of our exports (X)?
value of our imports (M)?
value of our net exports (NX)?
balance on capital account?
overall balance of payments (BOP)?
What is the change in foreign exchange reserves?
- 32.3
- 1.7
5.9
0
1,375.1
+ $ 63.5
- $ 12.1
- $ 22.5
- $ 35.4
+ $ 28.1
$ 518.8
$ 467.4
$ 51.4
- $ 32.3
Zero
An increase of $1.7 billion
c)
What is the share of exports (X) and imports (M) as a percent of GDP in Canada in
2005?
X / GDP * 100 = 518.8 / 1375.1 = 37.7 %
d)
M / GDP * 100 = 467.4 / 1375.1 = 34.0 %
What is the current account balance as a percent of GDP in 2005?
NX / GDP * 100 = 28.1 / 1375.1 = 2.0 % of GDP
10.2
Using the classification and terminology of the BOP, identify each one of the following
transactions and indicate on which side of the ledger (credit or debit) they belong to. E.g.
export of goods, current a/c credit; import of services, current a/c debit; FDI investment,
capital a/c credit; FDI divestment, capital account negative credit; portfolio investment
abroad, capital a/c credit, etc.
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
l)
m)
n)
o)
Domtar sells 50,000 tons of newsprint to the New York Times.
GOODS EXPORT (+)
Alcan Aluminum sells its Greek subsidiary to a local Greek company.
CANADIAN FOREIGN DIRECT DIVESTMENT (-)
The Bank of Montreal lends $100 million to the Mexican state-owned company
Pemex. PORTFOLIO INVESTMENT ABROAD (-)
The Province of Quebec issues $200 million bonds on the Eurobond market.
PORTFOLIO INVESTMENT IN CANADA (+)
The Hudson's Bay Co. buys 5,000 pairs of ladies' shoes from an Italian firm.
GOODS IMPORT (-)
A resident of Canada sells 2,000 shares of IBM on the New York Stock
Exchange. PORTFOLIO DIVESTMENT ABROAD (-)
A resident of Canada buys a hotel in Morocco.
CANADIAN FOREIGN DIRECT INVESTMENT ABROAD (-)
Norsk Hydro, a Norwegian firm builds a $400 million magnesium smelting plant in
Quebec. FOREIGN DIRECT INVESTMENT IN CANADA (+)
Noverco, the Montreal-based gas utility buys a local gas utility based in
Burlington, Vt., U.S.A.
CANADIAN FOREIGN DIRECT INVESTMENT ABROAD (-)
A Pakistani worker living in Canada sends a $500 remittance to relatives in
Lahore. TRANSFER PAYMENT (-)
SNC-Lavalin, a Montreal-based engineering consulting firm is awarded a contract
to design a hydro-electric dam in China.
SERVICE EXPORT (+)
General Motors of Canada declares a $0.75 per share quarterly dividend to its
U.S. parent. INVESTMENT INCOME PAYMENT (-)
Hydro-Quebec makes annual payment of interest on its 20-year bonds to U.S.
investors. INVESTMENT INCOME PAYMENT (-)
McDonald's Canada makes a quarterly payment for royalties to its U.S. parent.
SERVICE IMPORT (-)
Japanese pension funds purchase new issues of Government of Canada bonds.
PORTFOLIO INVESTMENT IN CANADA (+)
10.3
Using Demand-Supply graphs illustrate what will happen to the foreign exchange value
of the Canadian dollar in each one of the following circumstances (draw a separate
graph for each case):
All other factors being constant:
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
Canadian merchandise exports rise
Demand shifts to the right, exchange rate rises
Canadian exports of services fall
Demand shifts to the left, exchange rate falls
Foreign direct investment into Canada rises
Demand shifts to the right, exchange rate rises
Portfolio investment into Canada falls
Demand shifts to the left, exchange rate falls
Canadian merchandise imports falls
Supply shifts to the left, exchange rate rises
Canadian imports of services rise
Supply shifts to the right, exchange rate falls
Canadian foreign direct investment abroad falls
Supply shifts to the left, exchange rate rises
Short-term capital flows into Canada rises
Demand shifts to the right, exchange rate rises
Canadian merchandise exports rise while short-term capital flows out of Canada
fall
Demand shifts to the right and supply shifts to the left and exchange rate rises
Canadian exports of services rise while Canadian imports of services rise
Demand shifts to the right and supply shifts to the right, exchange rate remains
unaffected
Investment income of Canadians rises while short-term capital inflows fall
Demand shifts to the right and demand shifts to the left, exchange rate remains
unaffected
10.4
You are given the following exchange rates for two dates: August 19, 2005 and August
18, 2006:
2005/08/19
1 Canadian Dollar buys
U.S. Dollar
Euro
British Pound
Japanese Yen
Swiss Franc
Mexican Peso
Chinese Renminbi
Russian Ruble
Indian Rupee
Australian Dollar
0.8238
0.6778
0.4592
91.1600
1.0500
8.8731
6.6756
23.5294
35.8423
1.0971
2006/08/18
0.8902
0.6949
0.4734
103.0600
1.0973
9.6246
7.0972
23.8095
41.3223
1.1736
a) Calculate the one year percent change in the value of the Canadian currency
(appreciation or depreciation).
b)
ANSWER: 0.8902 - 0.8238 / 0.8238 X 100 = 8.1% APPRECIATION
b)
Calculate the exchange value of each of the above currencies in terms of the
Canadian dollar (how many Canadian dollars do each of these currencies buy?).
2005/08/19
1 US Dollar buys
Canadian Dollar
1 Euro buys
Canadian Dollar
1 British Pound buys
1 Japanese Yen buys
1 Swiss Franc buys
1 Mexican Peso buys
1 Chinese Renminbi buys
1 Russian Ruble buys
1 Indian Rupee buys
1 Australian Dollar buys
c)
1.2139
1.4754
2.1778
0.0110
0.9524
0.1127
0.1498
0.0425
0.0279
0.9115
2006/08/18
1.1233
1.4390
2.1124
0.0097
0.9113
0.1039
0.1409
0.0420
0.0242
0.8521
Suppose the price of a Big Mac trio is $5.49 Canadian. Calculate the price in
each of the above currencies.
2005/08/19
2006/08/18
Price of Big Mac trio in:
U.S. Dollar
Euro
British Pound
Japanese Yen
Swiss Franc
Mexican Peso
Chinese Renminbi
Russian Ruble
Indian Rupee
Australian Dollar
4.52
3.72
2.52
500.5
5.76
48.71
36.65
129.18
196.77
6.02
4.89
3.81
2.60
565.8
6.02
52.84
38.96
130.71
226.86
6.44
d)
Now find the value of the U.S. dollar against all of these currencies and calculate
the percent appreciation or depreciation in its value between 2005 and 2006
1 US Dollar buys
e)
U.S. Dollar
Euro
British Pound
Japanese Yen
Swiss Franc
Mexican Peso
Chinese Renminbi
Russian Ruble
Indian Rupee
Australian Dollar
2005/08/19
2006/08/18
% Change
1.0000
0.8228
0.5574
110.66
1.2746
10.7710
8.1034
28.5620
43.5085
1.3318
1.0000
0.7806
0.5318
115.77
1.2327
10.8117
7.9726
26.7462
46.4191
1.3183
---- 5.13%
- 4.59%
+ 4.62%
- 3.29%
+ 0.38%
- 1.61%
- 6.35%
+ 6.68%
- 1.01%
Suppose the price of 1 ounce of gold is $623.85 U.S. Calculate the price of an
ounce of gold in each of the above currencies.
2006/08/18
1 oz of gold is in:
10.5
Canadian Dollar
Euro
British Pound
Japanese Yen
Swiss Franc
Mexican Peso
Chinese Renminbi
Russian Ruble
Indian Rupee
Australian Dollar
700.77
486.98
331.76
72223.1
769.02
6744.9
4973.7
16685.6
28958.5
822.42
Suppose the Bank of Canada was to maintain the value of the Canadian dollar at $0.85
U.S. Indicate what type of foreign exchange intervention you would recommend the
central bank take in each of the following cases, and illustrate each one using demand
and supply diagrams.
a)
Market forces are pushing the exchange value above 0.85 U.S.
ANSWER: SELL CANADIAN DOLLARS AND BUY US DOLLARS
b)
Market forces are pushing the exchange value below 0.85 U.S.
ANSWER: SELL US DOLLARS AND BUY CANADIAN DOLLARS