Macroeconomics 17th Canadian Edition by Christopher Ragan SOLUTIONS MANUAL

SOLUTIONS MANUAL for

Macroeconomics Seventeenth Canadian Edition

Christopher T.S. Ragan

Contents Part One: What Is Economics?

Chapter 1: Economic Issues and Concepts Chapter 2: Economic Theories, Data, and Graphs Chapter 3: Demand, Supply, and Price

1 3 13 25

Part Two: An Introduction to Macroeconomics Chapter 4: What Macroeconomics Is All About Chapter 5: The Measurement of National Income

36 38 45

Part Three: The Economy in the Short Run Chapter 6: The Simplest Short-Run Macro Model Chapter 7: Adding Government and Trade to the Simple Macro Model Chapter 8: Real GDP and the Price Level in the Short Run

52 54 65 75

Part Four: The Economy in the Long Run Chapter 9: From the Short Run to the Long Run: The Adjustment of Factor Prices Chapter 10: Long-Run Economic Growth

85 86 96

Part Five: Money, Banking, and Monetary Policy Chapter 11: Money and Banking Chapter 12: Money, Interest Rates, and Economic Activity Chapter 13: Monetary Policy in Canada

105 107 115 124

Part Six: Macroeconomic Problems and Policies Chapter 14: Inflation and Disinflation Chapter 15: Unemployment Fluctuations and the NAIRU Chapter 16: Government Debt and Deficits

132 133 141 150

Part Seven: Canada in the Global Economy Chapter 17: The Gains from International Trade Chapter 18: Trade Policy Chapter 19: Exchange Rates and the Balance of Payments

159 160 169 177

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List of Boxes Applying Economic Concepts 1-1 The High Opportunity Cost of Your University Degree 1-2 Economics Needs the Other Social Sciences 2-1 Where Economists Work 2-2 Can Economists Design Controlled Experiments to Test Their Theories?

3-1 Demand and Supply Shocks Created by the COVID-19 Pandemic 3-2 Why Apples but Not iPhones?

4-1 The Terminology of Business Cycles 4-2 How the CPI Is Constructed 5-1 Value Added Through Stages of Production 5-2 Calculating Nominal and Real GDP 6-1 The Simple Multiplier: A Numerical Example 7-1 How Large Is Canada’s Multiplier?

8-1 Analyzing the 2020 Pandemic Recession with the AD/AS Model 10-1 What Does Productivity Growth Really Look Like?

10-2 A Case Against Economic Growth 10-3 Climate Change and Economic Growth 11-1 Are Cryptocurrencies Really Money?

11-2 Confidence and Risk in Canadian Banking 12-1 Understanding Bond Prices and Bond Yields 12-2 Three Propositions About Money Neutrality 13-1 What Determines the Amount of Currency in Circulation?

14-1 Is Deflation the Cause or Result of a Weak Economy?

15-1 Stocks and Flows in the Canadian Labour Market 15-2 Wage Flexibility and the Rise of the “Gig” Economy 15-3 Unemployment and Policy During the “Pandemic Recession” 16-1 From World War to Global Pandemic: The Fall and Rise of Government Debt 17-1 Two Examples of Absolute and Comparative Advantage 17-2 Comparative Advantage and Global Supply Chains 18-1 Canadian Wine: A Free-Trade Success Story 19-1 A Student’s Balance of Payments with the Rest of the World 19-2 Fixed Exchange Rates and Foreign-Exchange Reserves

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7 21 30 34 64 72 82 89 104 115 146 164 191 230 232 254 267 276 294 307 324 356 378 384 394 420 436 444 471 482 490

Lessons from History 8-1 The 1997–1998 Asian Crisis and the Canadian Economy 9-1 Fiscal Policy in the Great Depression 10-1 Should Workers Be Afraid of Technological Change?

11-1 Hyperinflation and the Value of Money 13-1 Two Views on the Role of Money in the Great Depression 16-1 The Modern Greek Tragedy of Debt Dynamics 18-1 Tariff Wars and the Stark Lessons from the Great Depression 19-1 Mercantilism, Then and Now

192 216 245 262 332 412 460 497

Extensions in Theory 3-1 The Distinction Between Stocks and Flows 5-1 Arbitrary Decisions in National Income Accounting 6-1 The Theory of the Consumption Function 6-2 The Algebra of the Simple Multiplier 9-1 The Phillips Curve and the Adjustment Process 14-1 The Phillips Curve and Inflation Expectations 17-1 The Gains from Trade More Generally

53 113 129 148 206 362 434

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________________________________________ Part One What Is Economics?

________________________________________ This opening Part of the book provides an introduction to economics. The central themes of Chapter 1 are scarcity, choice, opportunity cost, and the self-organizing role of markets. The chapter also examines the gains from specialization and trade, the role of money, the effects of globalization, and ends with a discussion of the various types of economic systems. Chapter 2 examines how economists build their models and test their theories. It also addresses central methodological issues, the most important being the idea that the progress of economics (like all scientific disciplines) depends on relating our theories to what we observe in the world around us. Finally, the chapter has an extensive section on graphing. Chapter 3 introduces the basic microeconomic model of demand and supply, and the determination of (relative) prices.

Our feeling is that this three-chapter introduction to economics, which includes the workhorse model of demand and supply, is a very useful starting point for students in a macroeconomics course.

Some students will have already completed a micro course, perhaps just a few weeks ago, in which case a very quick review of these chapters is all that is necessary. But many students take a macro course without having already taken a micro course, and for them especially, this three-chapter introduction will be very useful. *** Chapter 1 opens with a brief tour of some key economic issues in Canada and other countries—from rising protectionism and the dangers of climate change to accelerating technological change and growing income inequality. The purpose is to whet the reader’s appetite for the kinds of issues economists are thinking about today. This offers a natural segue to the discussion of scarcity, without which few of these issues would be very interesting. The chapter addresses the fundamental concepts of scarcity, choice, and opportunity cost, illustrating these ideas with a production possibilities boundary. (It is worth noting that these concepts are relevant to all economies, whether they are organized by central planning or by free markets.) We then examine the complexity of modern market economies, examining the decision makers, production, trade, money, and globalization.

Finally, we examine different types of economic systems, including traditional, command, and freemarket systems. We emphasize that all actual economies are mixtures, containing elements of all three pure systems.

Chapter 2 provides a longer introduction to the methodological issues of economics than is usually included in introductory texts. We do this because most students believe that the scientific method is limited to the natural sciences. But to appreciate economics, they must understand that its theories are also open to empirical testing and that these theories continually change as a result of what the empirical evidence shows. We understand that some instructors feel their time is so limited that they cannot spend class time on Chapter 2. We believe that even if it is not covered in class, Copyright © 2023 Pearson Canada Inc.

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students’ attention should be called to the issues addressed in the chapter. Our experience is that students benefit from some discussion of the scientific method and from the insight that the social sciences are not all that different from the “hard” sciences, at least in their basic approaches.

The chapter begins by making the distinction between positive and normative statements. We then work carefully through the various elements of economic theories, including definitions, assumptions, and predictions. Testing theories is as important as developing them, so we emphasize the interaction between theorizing and empirical observation. We then present various types of economic data, and this gets us into a detailed discussion of index numbers, time-series and crosssection data, and graphs. The final section of the chapter goes through graphing in detail.

Chapter 3 covers the basic theory of demand, supply, and price. This is the student’s first really decisive hurdle. When it is cleared, students will have mastered some economic theory and will be ready to start applying it. A box addresses the kinds of industries where the model of demand and supply can usefully be applied, and also those where it can’t.

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_______________________________________ Chapter 1: Economic Issues and Concepts _______________________________________ This chapter is in three main sections, after a short introductory mention of some key economic issues of the day. The first substantive section develops the concepts of scarcity, choice, and opportunity cost. To ensure the student really understands what opportunity cost is all about, we have a box that examines the opportunity cost of a university or college degree. This should be a familiar example to which students can easily relate. The production possibilities boundary is then introduced, and it is shown to embody the three key concepts of scarcity, choice and opportunity cost. Its nature as a frontier between attainable and unattainable is worth stressing, as is the fact that what is attainable is itself subject to change. Four key economic problems are then discussed, and each one is expressed in terms of the production possibilities boundary. These questions give the student an inkling of the types of questions addressed both in microeconomics and in macroeconomics.

The chapter’s second section examines the complexity of modern economies, asking why the things we want to purchase are almost always available. What produces this remarkable coordination? We discuss the market as an instrument that brings order to the economy as a whole.

Along the way, the student is introduced to Adam Smith’s “invisible hand”. The section also discusses who makes the choices in a market economy, and why incentives matter. We show the circular flow of income and expenditure as a way of showing the interaction between consumers and producers. We also examine the nature of maximizing decisions (both utility and profit), and the importance of decisions at the margin. Finally, on the production side, we examine the role of specialization, the division of labour, globalization, and the importance of money in facilitating trade.

The chapter’s third and final section deals with comparative economic systems. Students will read in almost every chapter of this book about a market economy. Contrasting it with planned and traditional economies is a good way to gain some insight into the concept at the outset. We emphasize that actual economies are rarely, if ever, well represented by the extremes; instead, actual economies are mixed economies, with varying degrees of government ownership and planning. Students are introduced to Karl Marx’s argument for a centrally planned economy. While Marx had many things right, we argue that central planning has not been successful in proving itself as an efficient way of organizing an economy, allocating resources, or generating prosperity for a large fraction of the population.

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Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) land, labour, capital; factors b) opportunity cost c) production possibilities boundary d) scarcity (because points outside the boundary are unattainable); downward (or negative); the opportunity cost associated with any choice e) constant; increasing f) increases (meaning that more units of good B must be given up to get an extra unit of good A)

Question 2 a) self; self-interest b) incentives c) firms; households; governments d) increase (maximize); increase (maximize) e) margin; (marginal) cost Question 3 a) division; specialization b) trade c) money d) globalization

Review Questions Question 4 Any realistic production possibilities boundary displays scarcity, the need for choice, and opportunity cost.

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Scarcity: The production possibilities boundary (PPB) separates attainable combinations of goods from those that are unattainable. Thus scarcity is shown by the existence of some unattainable bundles of goods.

Choice: Because of scarcity, societies must somehow choose how resources are to be allocated; thus a particular point on the PPB must be chosen.

Opportunity Cost: The slope of the PPB is negative, revealing the opportunity cost that is unavoidable every time a choice is made. For the economy as a whole, the decision to produce more of one good must involve a decision to produce less of some other good.

Question 5 Consider any country’s production possibilities boundary, and suppose the two products are X and Y. A technological improvement in industry X shifts the PPB out (along the X axis), increasing the maximum amount of X that can be produced. Note that the maximum amount of Y that can be produced has not changed. But since the PPB has shifted out, there are many combinations of both goods that are now available that were not before, and some of these involve producing more of both goods. Thus, even though the technology for producing Y has not changed, the technological improvement in X does allow the country to choose to produce more of both products.

Question 6 The central ideas illustrated by the two-good version of the production possibilities boundary (PPB) are scarcity, choice, and opportunity cost. Exactly the same ideas can be illustrated in a more realistic three-good version of the model, which is more complicated to draw, or by the much more realistic N-good version of the model (with N ≥ 4), which is impossible to draw. Thus the assumption of only two goods is merely a simplifying one: it allows us to easily grasp and illustrate some central points that would be more difficult to understand in the more general N-good case.

Question 7 a) If all Canadian families had $80,000 of after-tax income (roughly the Canadian average), it would be difficult to say that real poverty existed in Canada. At this level of income, all families would easily have enough income to provide the essentials of food, shelter, and clothing, and could also have much beyond these essentials. However, there would still be many things that these families could not afford, such as expensive university education, expensive vacations, a cottage in the country, etc. Defining poverty with any precision is difficult, and we will say more about this in Chapter 18. b) Would scarcity exist in such a setting? Yes, certainly. By scarcity we mean simply an excess of wants over the resources available to satisfy those wants. And scarcity would exist for each of those families because most (if not all) of them would still desire to have more than they actually had.

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Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

c) Scarcity is an excess of wants over the resources available to satisfy those wants. Poverty—at least in its “absolute form”—is concerned with a level of resources below some threshold of sufficiency. One can conceivably eliminate poverty, as in part (a), but that would not eliminate scarcity.

Question 8 Microeconomics is the study of the allocation of resources within and across individual markets, and the determination of relative prices and quantities in those specific markets. Little or no attention is paid to the behaviour of the aggregate economy. Macroeconomics is the study of the determination of aggregates such as aggregate output, employment, the price level, the unemployment rate, and the exchange rate. When doing macroeconomics, little or no attention is paid to what is going on in the individual markets for specific products.

Question 9 In the answers that follow, note that the statements are made ceteris paribus. In other words, the predicted result of a change in some specific price is made under the assumption that nothing else changes. a) As the price of ski-lift tickets rises, you are likely to substitute toward other leisure activities (whose price has not increased) and thus reduce your purchases of ski-lift tickets. b) As the hourly wage for your weekend job rises, the opportunity cost of not working rises. So you are more likely than before to decide not to go skiing, and to work instead. c) As the fine for speeding rises, the cost of being caught speeding clearly increases. The benefit of driving over the speed limit is presumably unchanged, however. So an increase in the value of speeding tickets is likely to cause you to reduce your speed (and to watch more carefully for hidden police cars!). d) The higher the weight placed on the assignment, the greater is the incentive for you to work hard on that assignment (and thus hopefully receive a higher grade on the assignment and on the course). This is one obvious reason why professors like to put significant weight on midterm exams —to get students to work hard early in the course rather than leaving all the work to the few days before the final exam! e) As tuition fees for one specific institution increase, you are likely to substitute toward other institutions whose fees have not increased, and thus reduce your desire to attend the first institution.

(For small changes in tuition fees, this effect may be very small because of the perceived large differences between some educational institutions.)

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Question 10 There are two reasons why the specialization of labour is more efficient than self-sufficiency. First, since individual abilities differ, specializing allows each person to focus their energies on what they do best, leaving everything else to be done by others. As a result, total output will rise. Second, as people specialize, they often “learn by doing” and become even better at their specific task.

Thus specialization often leads to improvements in ability that would not otherwise occur.

Question 11 The market for doctors’ services depends heavily on the specialization of labour. A person with back pain will not know what is wrong. They go to a general practitioner (GP) who is somewhat familiar with a broad range of symptoms and illnesses. The GP may rule out the simplest possible causes for the pain, and in the process determine that the patient requires the services of a specialist who diagnoses and treats the patient’s back. The patient is referred to this specialist who may diagnose a ruptured disk and perform the delicate surgery necessary to solve the problem. Given this reliance on specialization, the market depends on having relatively more GPs who see a large number of patients and act as “gatekeepers” for patients to the more specific specialists.

Question 12 Traditional systems: Behaviour is based primarily on tradition, custom, and habit.

Command systems: Decisions about production and consumption are determined by a central planning authority.

Free-market systems: Production and consumption decisions are made privately, by decentralized producers and consumers.

Mixed systems: These economic systems contain elements of tradition, command, and free markets.

Question 13 This quote, if put to a group of students, would stimulate much interesting discussion, not only about views on how alternative economic systems work, but also about the words used to describe them.

The term planned economy, for example, describes the conscious use of centralized decision making for key economic decisions, but the results of that process often look anything but planned, with shortages in some sectors, surpluses in others, and often a rather dispirited and unmotivated private sector. On the other hand, the unplanned decentralized market economy––though surely not perfect—creates a much more orderly looking set of outcomes.

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Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Problems Question 14 In general, the opportunity cost (measured in dollars) for any activity includes three things: • the direct (dollar) cost of the activity, plus • the dollar value of whatever you give up in order to do the activity, minus • whatever dollar “savings” the activity generates In this case, the direct cost of transportation, lift tickets and accommodation of $300 is definitely included. The income of $120 that you give up also counts. Finally, we must deal with the restaurant meals of $75. Surely you would have eaten some food even if you hadn’t gone skiing, so the full $75 is not included. But given the relatively high price of restaurant meals compared to buying your own groceries, you will probably include most of the $75. Thus the opportunity cost of the ski trip is $420 plus some (large) fraction of the $75.

Question 15 a) The budget line is shown below. If all $240,000 is spent on ATVs, you could purchase 30 of them; if all the money is spent on snowmobiles, you could purchase 20 of them. The downward sloping line divides the attainable from the unattainable combinations of ATVs and snowmobiles.

b) The opportunity cost of one ATV is the number of snowmobiles that must be given up to purchase an additional ATV. Since each ATV costs $8000 and each snowmobile costs $12000, the opportunity cost of one ATV is 2/3 of a snowmobile. c) The opportunity cost of one snowmobile is the number of ATVs that must be given up to purchase an additional snowmobile. It is equal to 1.5 ATVs. Note that the opportunity cost of an ATV (in terms of forgone snowmobiles) is the inverse of the opportunity cost of a snowmobile (in terms of forgone ATVs). d) In this case, the prices of ATVs and snowmobiles are independent of how many are purchased.

This fact is reflected by the budget line being linear (of constant slope). So both of the opportunity costs are independent of how many are purchased.

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Question 16 In each scenario, one could choose to plot the production possibilities boundary, where the two numbers provided are the two intercepts along the two axes. The slope of the boundary would show the opportunity cost of each door (or each window). Alternatively, one can compare the two maximum values, as provided in the question. a) The factory could produce either 1000 windows or 250 doors (or many intermediate combinations). In order to produce one extra door, it must give up 4 (=1000/250) windows. In other words, the opportunity cost of one extra door is 4 windows. b) The opportunity cost of one extra door is 1 window (=500/500). c) The opportunity cost of one extra door is 3 windows (=1200/400). d) The opportunity cost of one extra door is 1.35 windows (=942/697). e) The opportunity cost of one extra door is 1.33 windows (=600/450).

Question 17 This question is good for forcing students to think through the computation of opportunity cost and also in showing how the allocation of labour in particular ways can maximize total output. a) You can catch 6 fish or collect 3 bundles of firewood in one day’s work. Thus, your opportunity cost of one additional bundle of firewood is 2 fish (6/3 = 2). For your friend, the opportunity cost of one additional bundle of firewood is 4 fish (8/2 = 4). b) To allocate tasks in the output-maximizing way, each person should do the task for which they have the lower opportunity cost. You have the lower opportunity cost of collecting firewood. Your friend has the lower opportunity cost of catching fish (0.25 of a bundle for your friend as compared to 0.5 of a bundle for you). So for the two of you to collectively maximize output you should specialize in collecting firewood and your friend should specialize in catching fish. c) What is the total amount of output after two days, if you allocate labour as in part (b)? In two days, you would collect 6 bundles of firewood and your friend would catch 16 fish. The reverse pattern of specialization would yield only 4 bundles of firewood and 12 fish, which is clearly inferior.

Question 18 a) At point a, 2.5 tonnes of clothing and 3 tonnes of food are being produced per year. At point b, annual production is 2.5 tonnes of clothing and 7 tonnes of food. At point c, annual production is 6.5 tonnes of clothing and 3 tonnes of food. b) At point a, the economy is either using its resources inefficiently or it is not using all of its available resources. Point b and c represent full and efficient use of available resources because they are on the PPB. c) At point b, the opportunity cost of producing one more tonne of food (and increase from 7 to 8) is the 2.5 tonnes of clothing that must be given up. The opportunity cost of producing one more tonne of clothing (from 2.5 to 3.5) appears, from the graph, to be approximately 0.75 tonnes of food that must be given up (from 7.0 to about 6.25).

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Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

d) Point d, is unattainable given the economy’s current technology and resources. Point d can become attainable with a sufficient improvement in technology or increase in available resources.

Question 19 a) As the table shows, there are only 250 workers in Choiceland, and to construct the production possibilities boundary (PPB) we must imagine all the combinations of workers in each sector.

Using the two middle columns from the table, we can plot the output levels on a graph to get the following PPB:

b) If the economy is already producing 45 units of X and 900 units of Y, then 15 extra units of X can only be produced by reducing the production of Y by 300 units. The opportunity cost of 15 units of X is therefore 300 units of Y (or 300/15 = 20 units of Y per unit of X). If the economy is already producing 60 units of X (and 600 units of Y), the opportunity cost of producing an additional 15 units of X is the full 600 units of Y that must be given up. This implies an opportunity cost of 600/15 = 40 units of Y per extra unit of X. Thus, we see that the opportunity cost of X rises when more of X is already being produced. c) If the economy is producing 40 units of X and 600 units of Y, then either some resources are not being used or they are being used inefficiently; the economy is operating inside the production possibilities boundary. It would thus be possible to improve the use of resources and increase output of X by 20 units without reducing the output of Y at all. In this sense, the extra output of X has no opportunity cost in terms of forgone units of Y.

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d) If any given amount of labour can now produce 10 percent more of good Y, then the PPB shifts up in a particular way. Specifically, the Y values increase by 10 percent for any given X value, as shown below.

Question 20 a) It doesn’t matter how the two axes are labelled in this case; just label them X and Y. The long civil war destroys much of the country’s infrastructure and likely reduces the country’s ability to produce all products. So the PPB shifts inwards, as shown below in part (a) of the figure. b) The axes are now labelled Food and Clothing. The new technology doubles the maximum amount of food that can be produced, and so shifts the PPB outward in the manner shown in part (b) of the figure. Note that the vertical intercept (maximum amount of clothing) does not change. c) The axes are again labelled Food and Clothing, as in part (c). In this situation, the earthquake destroys many clothing factories and so shifts the PPB inward, reducing the maximum possible amount of clothing (but leaving unaffected the maximum possible amount of food). d) The axes are labelled X and Y, as shown in part (d) of the figure. The immigration increases the labour force and increases the country’s ability to produce all products. The PPB shifts outward, increasing the maximum possible amounts of both X and Y. Since the new level of immigration is occurring each year, every year will see such an outward shift in the PPB.

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Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

*****

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______________________________________________ Chapter 2: Economic Theories, Data, and Graphs ______________________________________________ This chapter provides an introduction to the methods economists use in their research. We integrate a detailed discussion of graphing into our discussion of how economists present economic data and how they test economic theories.

In our experience, students typically do not learn enough about the connection between theory and evidence, and how both are central to understanding economic phenomena. We therefore recommend that considerable emphasis be placed on Figure 2-1, illustrating the process of going from model building to generating hypotheses to confronting data and testing hypotheses, and then returning to model building (or rebuilding). There is no real beginning or end to this process, so it is difficult to call economics an entirely “theory driven” or “data driven” discipline. Without the theory and models, we don’t know what to look for in the data; but without experiencing the world around us, we can’t build sensible models of human behaviour and interaction through markets. The scientific approach in economics, as in the “hard” sciences, involves a close relationship between theory and evidence. *** The chapter is divided into four major sections. In the first section, we make the important distinction between positive and normative statements and advice. Students must understand this distinction, and that the progress of any scientific discipline relies on researchers’ ability to separate what evidence suggests is true from what they would like to be true. We conclude this section by explaining why economists are often seen to disagree even though there is a great deal of agreement among them on many specific issues. This leads to a box on where economists typically get jobs and the kind of work they often do.

The second section explains the elements of economic theories and how they are tested. We emphasise how a theory’s or model’s definitions and assumptions lead, through a process of logical deduction, to a set of conditional predictions. We then examine the testing of theories. It is here that we focus on the interaction of theory and empirical observation (Figure 2-1). We emphasize the importance of the distinction between correlation and causation, with a simple example.

The chapter’s third section deals with economic data. We begin by explaining the construction of index numbers, and we use them to compare the volatility of two sample time series. Index numbers are so pervasive in discussions of economic magnitudes that students must know what these are and how they are constructed. We then make the distinction between crosssectional and time-series data, and at this point students are introduced to two types of graph.

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This brings us to the chapter’s final section, on graphing. We show how a relation can be expressed in words, in a table, in an equation, or on a graph. We then go into considerable detail on linear functions, slope, non-linear functions, and functions with minima and maxima. In this discussion, the student is introduced to the concept of the margin, described as the change in Y in response to a one-unit change in X. In all cases, the graphs apply to real-world situations rather than abstract variables. Pollution abatement, hockey-stick production, firm profits, and fuel consumption are our main examples.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) models (or theories) b) endogenous; exogenous c) (conditional) prediction; empirical d) (positively) correlated; causal e) self-interest; utility; profits Question 2 a) index; relative b) absolute value of the price; absolute value of the price c) cross-section d) scatter e) time-series Question 3 a) ∆Y/∆X b) 500; positively; 4 c) 12; negatively; -0.2 d) tangent e) zero; zero Copyright © 2023 Pearson Canada Inc.

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Review Questions Question 4 a) normative (“The government should impose…” is inherently a value judgement.) b) positive (In principle, we could determine the impact that foreign aid actually has.) c) positive (In principle, we could determine the extent to which fee increases affect access.) d) normative (What is or is not unfair is clearly based on a value judgement.) e) normative (Use of the expression “too much” is a value judgement.) f) normative (“The government should provide …” is inherently a value judgement.)

Question 5 a) In the Canadian wheat sector, the amount of rainfall on the Canadian prairies is an exogenous variable; the amount of wheat produced is an endogenous variable. b) To the Canadian market for coffee, the world price of coffee is exogenous; the price of a cup of coffee at Tim Horton’s is endogenous. c) To any individual student, the widespread unavailability of student loans is exogenous; their own attendance at university or college is endogenous. d) To any individual driver, the tax on gasoline is exogenous; his or her own decision regarding which vehicle to purchase is endogenous.

Question 6 The observed correlation cannot lead to a certain inference about causality. It is consistent with the theory that the increase in demand for homes leads to an increase in the price of lumber (which is generally a pretty sensible theory!), but it is also consistent with a different theory – one in which some unobserved factor leads to both the increase in demand for homes and separately to the increase in the price of lumber. Correlation does not imply causality!

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Problems Question 7 a) Using 2009 as the base year means that we choose $85 as the base price. We thus divide the actual prices in all years by $85 and then multiply by 100. In this way, we will determine, in percentage terms, how prices in other years differ from prices in 2009. The index values are as follows: Year

Price ($)

Physics textbook price index

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

85 87 94 104 110 112 120 125 127 127 130

(85/85) × 100 = 100 (87/85) × 100 = 102.4 (94/85) × 100 = 110.6 (104/85) × 100 = 122.4 (110/85) × 100 = 129.4 (112/85) × 100 = 131.8 (120/85) × 100 = 141.2 (125/85) × 100 = 147.1 (127/85) × 100 = 149.4 (127/85) × 100 = 149.4 (130/85) × 100 = 152.9

b) The price index in 2014 is 131.8, meaning that the price of the physics textbook is 31.8 percent higher in 2014 than in the base year, 2009. c) From 2016 to 2019, the price index increases from 147.1 to 152.9but this is not an increase of 5.8 percent. The percentage increase in the price index from 2016 to 2019 is equal to [(152.9147.1)/147.1]×100 = 3.94 percent. d) These are time-series data because the data are for the same product at the same place but at different points in time.

Question 8 a) Using Calgary as the “base university” means that we choose $6.25 as the base price. Thus we divide all actual prices by $6.25 and then multiply by 100. In this way, we will determine, in percentage terms, how prices at other universities differ from Calgary prices. The index values are as follows:

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University

Price per pizza

Index of pizza prices

Dalhousie Laval McGill Queen’s Waterloo Manitoba Saskatchewan Calgary UBC Victoria

$6.50 5.95 6.00 8.00 7.50 5.50 5.75 6.25 7.25 7.00

(6.50/6.25)×100 = 104 (5.95/6.25)×100 = 95.2 (6.00/6.25)×100 = 96 (8.00/6.25)×100 = 128 (7.50/6.25)×100 = 120 (5.50/6.25)×100 = 88 (5.75/6.25)×100 = 92 (6.25/6.25)×100 = 100 (7.25/6.25)×100 = 116 (7.00/6.25)×100 = 112

b) The university with the most expensive pizza is Queen’s, at $8.00 per pizza. The index value for Queen’s is 128, indicating that pizza there is 28 percent more expensive than at Calgary. c) The university with the least expensive pizza is Manitoba, at $5.50 per pizza. The index value for Manitoba is 88, indicating that the price of pizza there is only 88 percent of the price at Calgary.

It is therefore 12 percent cheaper than at Calgary. d) These are cross-sectional data. The variable is the price of pizza, collected at different places at a given point in time (March 1, 2022). If the data had been the prices of pizza at a single university at various points in time, they would be time-series data.

Question 9 a) Using 2014 as the base year for an index number requires that we divide the value of exports (and imports) in each year by the value in 2014, and then multiply the result by 100. This is done in the table below.

Year 2014 2015 2016 2017 2018

Exports 11794 12210 12552 13252 13756

Export Index (11794/11794)(100) = 100 (12210/11794)(100) = 103.5 (12552/11794)(100) = 106.4 (13252/11794)(100) = 112.4 (13756/11794)(100) = 116.6

Imports 3264 3455 3651 3916 4003

Import Index (3264/3264)(100) = 100 (3455/3264)(100) = 105.9 (3651/3264)(100) = 111.9 (3916/3264)(100) = 120.0 (4003/3264)(100) = 122.6

b) It appears that imports were a little more volatile over this period than exports – or at least they grew faster than did exports. Both imports and exports grew in each year, and did not decline at all during this period, so “volatile” does not really apply. c) The index number for exports increased from 100 to 116.6 between 2014 and 2018, so exports grew by 16.6 percent. Imports grew by 22.6 percent over the same period.

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Question 10 This is a good question to make sure students understand the importance of using weighted averages rather than simple averages in some situations. a) The simple average of the three regional unemployment rates is equal to (5.5 + 7.2 + 12.5)/3 = 8.4. Is 8.4% the “right” unemployment rate for the country as a whole? The answer is no because this simple, unweighted (or, more correctly, equally weighted) average does not account for the fact that the Centre is much larger in terms of the labour force than either the West or East, and thus should be given more weight than the other two regions. b) To solve this problem, we construct a weighted average unemployment rate. We do so by constructing a weight for each region equal to that region’s share in the total labour force. From the data provided, the country’s total labour force is 17.2 million (5.3 + 8.4 + 3.5). The three weights are therefore: West: weight = 5.3/17.2 = 0.308 Centre: weight = 8.4/17.2 = 0.488 East: weight = 3.5/17.2 = 0.203 These weights should sum exactly to 1.0, but due to rounding they do not quite do so. Using these weights, we now construct the average unemployment rate as the weighted sum of the three regional unemployment rates.

Canadian weighted unemployment rate = (.308 × 5.5) + (.488 × 7.2) + (.203 × 12.5) = 7.75 This is a better measure of the Canadian unemployment rate because it correctly weights each region’s influence in the national total. Keep in mind, however, that for many situations the relevant unemployment rate for an individual or a firm may be the more local one rather than the national average.

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Chapter 2: Economic Theories, Data, and Graphs 19

Question 11 a) These data are best illustrated with a time-series graph, with the month shown on the horizontal axis and the exchange rate shown on the vertical axis.

b) These cross-sectional data are best illustrated with a bar chart.

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c) These cross-sectional data are best illustrated in a scatter diagram; the “line of best fit” is clearly upward sloping, indicating a positive relationship between average investment rates and average growth rates.

Question 12 a) Along Line A, Y falls as X rises; thus the slope of Line A is negative. For Line B, the value of Y rises as X rises; thus the slope of Line B is positive. b) Along Line A, the change in Y is –4 when the change in X is 6. Thus the slope of Line A is ΔY/ΔX = -4/6 = -2/3. The equation for Line A is: Y = 4 – (2/3)X c) Along Line B, the change in Y is 7 when the change in X is 6. Thus the slope of Line B is ΔY/ΔX = 7/6. The equation for Line B is: Y = 0 + (7/6)X Question 13 Given the tax-revenue function T = 10 + .25Y, the plotted curve will have a vertical intercept of 10 and a slope of 0.25. The interpretation is that when Y is zero, tax revenue will be $10 billion. And for every increase in Y of $100 billion, tax revenue will rise by $25 billion. The diagram is as shown below:

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Chapter 2: Economic Theories, Data, and Graphs 21

Question 14 a) The slope of the straight line connecting two points is equal to the change in Y between the points divided by the change in X between the points. In this case, the change in Y from the first point to the second is 3; the change in X is 9. Thus the slope of the straight line is 3/9 = 1/3. b) From point A to point B, the change in Y is 20 and the change in X is -10. Thus the slope of the straight line is -20/10 = -2. c) The slope of the function is the change in Y brought about by a one-unit change in X, which is given by the coefficient on X, -0.5. d) The slope of the function is the change in Y brought about by a one-unit change in X, which is given by the coefficient on X, 6.5. e) The slope of the function is the change in Y brought about by a one-unit change in X, which is given by the coefficient on X, 3.2. f) The Y intercept of a function is the value of Y when X equals 0. In this case the Y intercept is 1000. g) The Y intercept of a function is the value of Y when X equals 0. In this case the Y intercept is 100. h) The X intercept of a function (if it exists) is the value of X when Y equals 0. In this case, when Y equals 0 we have the equation 0 = 10 – 0.1X which yields -10 = -0.1X which gives us X = 100.

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Question 15 Let A be the firm’s annual spending on advertising and let R be the firm’s annual revenues. The equation for advertising (A) as a function of revenues (R) is A = 100,000 + (0.15)R. Question 16 a) For each relation, plot the values of Y for each value of X. Construct the following table: (ii)

Y = 50 + 2X + .05X2

(iii) Y = 50 + 2X - .05X2

(i)

Y = 50 + 2X

X

Y

X

Y

X

Y

0 10 20 30 40 50

50 70 90 110 130 150

0 10 20 30 40 50

50 75 110 155 210 275

0 10 20 30 40 50

50 65 70 65 50 25

Now plot these values on scale diagrams, as shown below. Notice the different vertical scale on the three different diagrams.

b) For part (i), the slope is positive and constant and equal to 2. For each 10-unit increase in X, there is an increase in Y of 20 units. For part (ii), the slope is always positive since an increase in X always leads to an increase in Y. But the slope is not constant. As the value of X increases, the slope of the line also increases. For part (iii), the slope is positive at low levels of X. But the function reaches a maximum at X=20, after which the slope becomes negative. Furthermore, when X is greater than 20, the slope of the line becomes more negative (steeper) as the value of X increases.

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Chapter 2: Economic Theories, Data, and Graphs 23

c) For part (i), the marginal response of Y to a change in X is constant and equal to 2. This is the slope of the line. In part (ii), the marginal response of Y to a change in X is always positive, but the marginal response increases as the value of X increases. This is why the line gets steeper as X increases. For part (iii), the marginal response of Y to a change in X is positive at low levels of X. But after X=20, the marginal response becomes negative. Hence the slope of the line switches from positive to negative. Note that for values of X further away from X=20, the marginal response of Y to a change in X is larger in absolute value. That is, the curve flattens out as we approach X=20 and becomes steeper as we move away (in either direction) from X=20.

Question 17 The four scale diagrams are shown on the next page, each with different vertical scales. In each case, the slope of the line is equal to ∆Y/∆X, which is often referred to as “the rise over the run” – the amount by which Y changes when X increases by one unit. (For those students who know calculus, the slope of each curve is also equal to the derivative of Y with respect to X, which for these curves is given by the coefficient on X in each equation.)

Question 18 The six required diagrams are shown below. Note that we have not provided specific units on the axes. For the first three figures, the tax system provides good examples. In each case, think of earned income as being shown along the horizontal axis and taxes paid shown along the vertical axis. The first diagram might show a progressive income-tax system where the marginal tax rate rises as income rises. The second diagram shows a proportional system with a constant marginal tax rate. The third diagram shows marginal tax rates falling as income rises, even though total tax paid still rises as income rises.

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24 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

For the second set of three diagrams, imagine the relationship between the number of rounds of golf played (along the horizontal axis) and the golf score one achieves (along the vertical axis). In all three diagrams the golf score falls (improves) as one golfs more times. In the first diagram, the more one golfs the more one improves on each successive round played. In the second diagram, the rate of improvement is constant. In the third diagram, the rate of improvement diminishes as the number of rounds played increases. The actual relationship probably has bits of all three parts—presumably there is a lower limit to one’s score so eventually the curve must flatten out.

Question 19 a) The slope of any curve at any point is equal to the slope of a tangent line to that curve at that point. At point A on the curve shown in the question, the slope of the tangent line is ½ = 0.5, and hence this is the slope of the curve at point A. For point B, the slope of the tangent line is 1 and so this is the slope of the curve at point B. For point C, the slope of the tangent line is 2/.5 = 4 and so this is the slope of the curve at point C. b) The marginal cost of producing good X is shown by the slope of the curve (the change in total cost as output increases by one unit). The slope is clearly rising as the monthly level of production rises, showing that marginal cost increases as output increases. c) The slope of the function is positive and increasing (getting steeper) as the level of monthly production increases. *****

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__________________________________ Chapter 3: Demand, Supply, and Price ___________________________________ This fundamental chapter is divided into three sections: demand, supply, and price determination.

The first two sections of the chapter are treated with a conscious parallelism. We talk in some detail about demand here, but virtually identical comments apply to supply.

A point worth emphasizing to the students is that when we think about a demand curve, we are not asserting that price is the only, or even the most important, determinant of quantity demanded.

Students are introduced to the important distinction between movements along curves and shifts of curves and the related terminology that distinguishes between “changes in quantity demanded” and “changes in demand”. Figures 3-3 and 3-4 are designed to clarify this distinction. The terminology is important and we suggest that you spend some time on it in class. A mathematician would distinguish between the value of the function and the function itself. We label a shift in the demand curve as an increase or a decrease in demand, in contrast to movements from one point to another along a given demand curve, which we label a change in quantity demanded. Despite our renewed efforts at clarity on these points, students should be alerted to possible confusions, especially early in their use of the concepts of supply and demand. Careful attention to context almost always makes clear what is being discussed.

Our use of the expressions “a change in quantity demanded” and “a change in demand”, although quite orthodox, have given some instructors trouble in the past. It is therefore worthwhile to spend some time explaining our approach. Since we do not want to teach students things that they will have to unlearn in their subsequent courses, we follow the established practice of defining quantity demanded as the dependent variable in the demand function: Qid = D(pi, p-i, Y, tastes, ...), with pi being the product’s own price, p-i being a vector of all other prices, and Y being money income. With this definition, a “change in quantity demanded” occurs in response to a change in any of the independent variables, not just the product’s own price. Thus a movement along a demand curve is always a change in the quantity demanded; but a change in quantity demanded is not necessarily a movement along a demand curve, since it can have causes other than just a change in the product’s own price.

The demand curve––which is simply the relationship between price and quantity demanded, ceteris paribus––refers to the relation Qid = d(pi), where all of the other independent variables are held constant. A “change in demand” refers to a shift in this relation due to a change in any one of the variables that are normally being held constant.

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26 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Confusion sometimes arises because some textbooks define a change in quantity demanded to be only a movement along a demand curve. This begs the question of how to describe a change in Qid when an independent variable other than pi changes. Our usage conforms with common usage in economics in calling any change in Qid a change in quantity demanded. A movement along a given demand curve is only one such change.

The final section of this chapter is both straightforward and basic. We begin with a brief discussion of the concept of a market. We have a box explaining that the demand-and-supply model can only be used in markets that satisfy some conditions, in particular large numbers of producers and consumers and more-or-less identical products. We then bring together a market demand curve and a market supply curve to examine an equilibrium price. The next step is to introduce the standard shifts of the curves to derive the comparative static predictions, often called the laws of supply and demand. We have added a worked-out numerical example of a market equilibrium.

The chapter closes with a brief discussion of “Relative Prices”. The section explains the importance of relative prices and how, in basic price theory, a “rise” or a “fall” in price means a rise or a fall relative to all other prices. Our own experience is that it is useful to meet this issue head on rather than sweeping it under the carpet. *** A Caveat. Perhaps the biggest mistake that new instructors to a principles course make in teaching the material of this chapter is to assume that, because it is so basic to them, it can be covered very quickly. Our experience suggests that this is not the case and that a good deal of repetition is important. Figures 3-7 and 3-8 are worth developing on the blackboard or on an overhead, or by using the PowerPoint slides for this text that are available from the publisher. You may also find it valuable to spend the time necessary to work through a few numerical examples of market equilibrium similar to the one in the main text or in the Study Exercises.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) desired; actual b) time; time; flow c) price; quantity demanded; increases d) consumers’ income; prices of other goods; tastes; population; changes in weather e) ceteris paribus; constant

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Chapter 3: Demand, Supply, and Price 27

Question 2 a) desired; actual b) time; time; flow c) price; quantity supplied; increases d) prices of inputs; technology; taxes or subsidies; prices of other products; number of suppliers; changes in weather Question 3 a) supply; left; decrease; supply b) demand; right; increase; demand c) demand; right; increase; demand d) supply; left; decrease; supply e) supply; left; decrease; supply f) demand; left; decrease; demand Question 4 a) negatively b) positively c) supply; demand d) equals e) rise; equilibrium quantity f) rise; equilibrium quantity Review Questions Question 5 a) Decrease in quantity of fish demanded (movement up along the demand curve due to the resulting increase in price) b) Decrease in quantity of fish demanded (movement up along the demand curve after the price rises) c) Demand for fish decreases (demand curve shifts to the left) d) Demand for fish decreases (demand curve shifts to the left) e) Demand for fish decreases (demand curve shifts to the left) f) Demand for fish increases (demand curve shifts to the right)

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28 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Question 6 This is a straightforward repetition of the example given in the text, only now applied to housing. a) An increase in population (or average household income) will shift the demand curve for housing to the right and raise equilibrium house prices. b) As prices rise, individual households will reduce the quantities they demand (perhaps by buying smaller houses or by only buying later in life) thus moving upward along the demand curve.

The word “prohibitive” may lead some students to make the error in believing prices are so high that no one is buying housing. But, of course, prices stay high only if there are enough purchasers willing to take up all of the available supply at those high prices. The two observations are not inconsistent— they refer to two different phenomena.

Question 7 a) The finding that eating chicken can improve your health will likely lead to an increase in the demand for chicken (and a reduction in the demand for less healthy meats). This will be shown by a rightward shift in the demand curve for chicken. b) As the price of beef rises, consumers will substitute away from beef and toward other meats, including chicken. This will be shown by a rightward shift in the demand curve for chicken. c) If chicken is a normal good—meaning that consumers want more of it when their real income rises—then the rise in household income leads to an increase in the demand for chicken. This will be shown by a rightward shift in the demand curve for chicken.

Question 8 a) The ideal growing conditions in the Ivory Coast lead to an increase in supply from that country; since it is the world’s largest supplier of cocoa beans, there is likely a noticeable increase in the world supply. The world supply curve shifts to the right. b) The large increase in the world price of coffee beans means that farmers currently growing cocoa beans (in many countries) have a more attractive alternative. If they substitute toward growing more coffee beans and fewer cocoa beans, the supply of cocoa beans falls—a leftward shift in the world supply curve. c) The rise in wages increases the costs for cocoa farmers, making this activity less profitable. Other things being equal, this is predicted to reduce current supply of cocoa beans. The result is a reduction in the world supply of cocoa beans—a leftward shift in the supply curve. d) Apparently the profits being earned by cocoa farmers (in many countries) are high enough to attract entry by new farmers. The entry of new farmers results, after a suitable period required for them to set up their operations, in an increase in the overall supply of cocoa beans. The world supply curve shifts to the right.

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Chapter 3: Demand, Supply, and Price 29

Question 9 a) The reduction in the size of the peach harvest due to bad weather is a decrease in the supply of peachesa leftward shift of the supply curve. (For a given demand curve, this leads to an increase in equilibrium price.) b) An increase in income leads to an increase in the demand for all normal goods. Assuming restaurant meals are a normal good, there will be a rightward shift in the demand curve for restaurant meals. For a given upward-sloping supply curve, this shock leads to an increase in the equilibrium price and quantity of restaurant meals. This is an increase in the quantity supplied of restaurant meals (caused by the price increase). c) Technological improvements in electronic publishing reduce the cost of producing e-books and therefore cause an increase in supplya rightward shift of the supply curve for e-books. (This causes a fall in the equilibrium price and an increase in equilibrium quantity.) d) Greater awareness of the benefits of a low-carb diet lead to a reduction in demand for bread (and other high-carb food items) and thus, for a given supply curve, to a reduction in the equilibrium price and quantity of bread. As price falls, there is a reduction in the quantity of bread supplied.

Question 10 The diagram below shows the world market for copper, and the initial equilibrium is shown as point E1, with the initial demand curve D1 and supply curve S1. The fast economic growth in China leads to an increase in China’s demand for copper, and since China is a large economy, this effect is strongly felt in the world copper market; the world demand curve therefore shifts to the right, to D2. The explosion in the Chilean port causes a temporary reduction in the world supply of copper because some large fraction of the world’s copper, even though ready for shipment, cannot get to market. This event leads to a leftward shift of the supply curve, to S2. The new equilibrium is shown at point E2. Each of these events on their own would be predicted to lead to an increase in the equilibrium price of copper; when acting together, the effect on the world price will be even larger. The overall effect on the equilibrium quantity of copper exchanged is unclear without knowing the relative sizes of the two shifts, although the case we have drawn shows the case where the demand increase outweighs the supply reduction and so overall equilibrium quantity rises.

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30 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Question 11 See the two diagrams below, which both show an increase in the demand for kale but little or no increase in the equilibrium price. Part (a) shows an increase in demand but a supply curve that is almost horizontal, indicating that producers can easily increase their output in response to an increase in demand. The effect of the increase in demand on price is negligible. Part (b) shows a more conventional market with an upward-sloping supply curve. In this case, the increase in demand for kale occurs together with an increase in the overall supply (possibly unconnected events) and the effect on equilibrium price is negligible.

Question 12 The figures below show the world market for wheat on the right and the Canadian market for wheat on the left. Since wheat is an internationally traded good, its (single) world price is determined by the intersection of the world demand and world supply curves. With the world supply curve given

by S0, the equilibrium world price is p0. At this world price, Canada is a net exporter—shown in the left diagram by an excess supply in Canada at price p0.

Russia is a major producer of wheat and therefore contributes substantially to the world supply of wheat. A severe drought in Russia will reduce the Russian crop and have a significant effect on the world’s supply of wheat, shifting the supply curve to the left from S0 to S1. This will drive the world price up from p0 to p1. North American wheat farmers benefit because they experience a higher world price at which to sell their product, but suffer none of the quantity Copyright © 2023 Pearson Canada Inc.

Chapter 3: Demand, Supply, and Price 31

consequences of the drought. In fact, they increase their quantity supplied from point A to point B in the left-hand figure. Their income is unambiguously higher than it would be had the Russian drought not happened. The increase in income for Canadian wheat farmers is shown by the shaded area. (Note that the higher price leads to more wheat production in Canada but less wheat consumption; the difference represents an increase in Canadian wheat exports to other countries.)

Problems Question 13 a) decrease; quantity demanded b) to the right; increase c) increased; decreased d) quantity demanded e) The appropriate diagram is shown below.

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Question 14 a) The equilibrium price, where quantity demanded equals quantity supplied, is $320 per tonne. b) At $280, there is excess demand equal to 4.0 million tonnes (per period). c) At $360, there is excess supply equal to 4.0 million tonnes (per period). d) At a price of $280, the excess demand will lead consumers to bid up the price in their efforts to satisfy their (excess) demands. Price will eventually rise. e) At a price of $360, the excess supply will lead producers to bid down the price in their efforts to sell their (excess) supply of the product. Price will eventually fall.

Question 15 a) At a price of $4.00 per can, quantity demanded is 2 million cans per year and quantity supplied is 8 million cans per year. There is a surplus of 6 millions cans per year. b) At a price of $1.50 per can, quantity demanded is 12 million cans per year and quantity supplied is 3 million cans per year. There is a shortage of 9 millions cans per year. c) Equilibrium, where quantity demanded equals quantity supplied, occurs at a price of $3.00 per can and at a quantity of 6 millions cans per year.

Question 16 a) The demand and supply curves for coffee are shown below. Note that the horizontal axis has a break in the scale so that we can focus on the range of quantity beyond Q = 10.

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Chapter 3: Demand, Supply, and Price 33

b) From the table in the question, or by reading off the diagram, we can see the following pattern of excess demands and supplies. Recall that excess demand at any given price is equal to quantity demanded minus quantity supplied.

Price

Excess Demand (+) or Supply (−)

$2.00 2.40 2.60 3.50 3.90 4.30

+18 +14 +9 0 −5 −9

c) The equilibrium price is the price at which quantity demanded equals quantity supplied. In other words, it is the price at which excess demand is exactly zero. From the table or the diagram we can see that the equilibrium price of coffee is $3.50 per kilogram. d) If a minimum price for coffee were set equal to $3.90 per kg, there would be an excess supply of coffee equal to 5 million kg per year. The only way the government(s) could enforce this minimum price, and prevent the price from falling to the free-market equilibrium level, would be to purchase the excess supply of 5 million kg annually.

Question 17 a) From 2021 to 2022, the price rises and the quantity is unchanged. One possibility is a reduction in supply (crop failure?) with a vertical demand curve. Another possibility is an increase in demand with a vertical supply curve. A less extreme and thus more likely possibility is an increase in demand combined with a reduction in supply that leaves Q unchanged. b) From 2021 to 2022, the price falls and quantity increases. The simplest possibility is that there has been an increase in supply (a bumper crop?) and no change in demand—but quantity demanded increases in response to the decline in price. c) From 2021 to 2022, the price and quantity both fall. The simplest possibility is that there has been a decline in demand (a recession which reduces demand for the crop?). The supply curve is stable but quantity supplied falls in response to the decline in price. d) From 2021 to 2022, the price is stable but quantity rises. One possibility is that demand increases and the supply curve is horizontal—reflecting that producers can easily produce more of the crop in response to the increase in demand. Another possibility is that both demand and supply increase, but keep the overall price unchanged.

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Question 18 a) The demand curve is: QD = 100 – 3p. This is a straight-line demand curve with a slope of –1/3.

The horizontal intercept (p = 0) is QD = 100. The vertical intercept (QD = 0) is p = 33.33. The supply curve is: QS = 10 + 2p. This is a straight-line supply curve with a slope of ½. When p = 0, QS = 10.

Both curves are plotted below.

b) Equilibrium requires QD = QS. This equality defines the equilibrium price, p*. c) Imposing QD = QS, we have 100 − 3p = 10 + 2p. Solving for p we get 90 = 5p or p = 18. This is what we call p*, the market-clearing price. d) Substituting p* = 18 into the demand function we get Q* = 100 − 3(18) = 46. If we substitute p* instead into the supply function we get Q* = 10 + 2(18) = 46. (Since the demand and supply curves intersect at p* = 18, Q* must be the same whether we use the demand curve or the supply curve.) e) Now there is an increase in demand. The new demand function is QD = 180 − 3p. Equilibrium requires QD = QS which means 180 − 3p = 10 + 2p. The solution for p* is therefore 5p* = 170 or p* = 34. Substituting p* back into the demand curve we get Q* = 180 − 3(34) or Q* = 78. The law of demand says that an increase in demand leads to a rise in both the equilibrium price and the equilibrium quantity. Both predictions are correct. f) Now with the new demand curve in place there is an increase in supply. The new supply curve is QS = 90 + 2p. Equilibrium requires 180 − 3p = 90 + 2p. This gives p* = 18. Substituting p* back into the demand curve leads to Q* = 180 − 3(18) or Q* = 126.

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Chapter 3: Demand, Supply, and Price 35

Question 19 The solution approach is simple. Equate QD and QS to solve for P*. Then substitute this P* back into the demand (or supply) curve to solve for Q*. a) P* = 1, Q* = 8 b) P* = 9, Q* = 1180 c) P* = 120, Q* = 70 d) P* = 2000, Q* = 5600 e) P* = 50, Q* = 5000 *****

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_____________________________________ Part Two An Introduction to Macroeconomics

_____________________________________ This Part of the book provides an introduction to macroeconomics. Instructors who are pressed for time can probably have students read Chapter 4 independently. It is an introductory chapter that does not contain any significant ideas not examined in more detail later in the text. The chapter is also almost exclusively descriptive as opposed to analytical. For these reasons, students can read the chapter to whet their appetite for what is to come. Chapter 5, which examines the measurement of national income, is core material and should be discussed in class. *** It is worth emphasizing at the outset which general approach to macroeconomics is taken in this textbook.

Broadly speaking, there are two different streams of research in macroeconomics, even though the researchers in the two groups are generally interested in understanding the same macroeconomic phenomena. The first group of researchers takes an approach to macroeconomics that is based explicitly on microeconomic foundations. These economists build models of the economy that are populated by workers, consumers, and firms, all of whom are assumed to be optimizers—that is, individuals are assumed to maximize their utility and firms are assumed to maximize their profits. Having explicitly modelled these agents' optimization problems, and their resulting choices for work effort, consumption, investment, and production, the economists proceed to aggregate the choices of these agents to arrive at the model's values for aggregate employment, consumption, output, and so on.

The second group of researchers builds macroeconomic models based only implicitly on these same micro foundations. Although they often analyze the behaviour of individuals and firms, they do not formally aggregate their behaviour to derive the aggregate relationships in their models. Instead, these economists construct their models by using aggregate relationships for consumption, investment, and employment, each of which has been subjected to extensive empirical testing and is assumed to represent collectively the behaviour of the many firms and consumers in the economy.

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Chapter 4: What Macroeconomics Is All About 37

A second difference between these two general approaches relates to the assumptions regarding the flexibility of wages and prices. Economists using the first approach often assume that wages and prices are flexible and adjust relatively quickly to clear their respective markets.

In contrast, economists using the second approach usually assume that because of the nature of well-established institutions in both labour and product markets, such as labour unions, long-term employment contracts, or costs associated with changing prices, wages and prices are slow to adjust, and thus markets can be in disequilibrium for longer periods of time.

This textbook follows the second approach to macroeconomic analysis. The macro model we begin building in Chapter 6 is not formally derived from the behaviour of optimizing firms and consumers, although the macro relationships we introduce are well motivated by microeconomic behaviour. Moreover, the model begins in its simplest version by assuming no wage and price flexibility. But as we gradually make the model more complicated and also more realistic, we introduce some wage and price flexibility. In later chapters we will see that the degree of wage and price flexibility is crucial in determining how the economy responds to shocks of various kinds, including changes in government policy. We will also see that our macroeconomic model is sufficiently versatile that we can use it to illustrate the case of perfect wage/price flexibility as a special case. *** Chapter 4 provides introductory discussions of national income, the price level and inflation, employment and unemployment, productivity, interest rates and credit flows, the exchange rate, and international trade. There are several interesting boxes throughout these introductory discussions that deal with the definitions or construction of the various macroeconomic variables. The chapter’s final section emphasizes that the major macroeconomic issues generally fit into one of two categories: long-run economic growth and short-run economic fluctuations. Importantly, questions of appropriate fiscal and monetary policies enter both categories.

Chapter 5 examines the measurement of national income. Here we emphasize the circular flow of income and expenditure, and discuss how this idea lies at the heart of the national income accounts. We stress that there are three ways to measure national income, all of which must give the same answer: the sum of values added; the sum of expenditures; and the sum of factor incomes. This chapter also discusses the distinction between real and nominal measures of national income, and thus presents the basics of the (implicit) GDP deflator. The chapter ends with the discussion––one we think should be emphasized in class––of things not included in conventional measures of national income. Students should be made aware of the fact that, although measures of national income do a pretty good job of measuring the flow of marketed output in the economy, they do not measure (and nor are they designed to measure) overall welfare or well-being. It is easy to think of examples where GDP rises but overall welfare declines.

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___________________________________________ Chapter 4: What Macroeconomics Is All About ___________________________________________ After a brief introduction, the chapter begins with a simple comparison of macroeconomics and microeconomics—emphasizing the essential macro focus on economic aggregates. Students who have just finished a study of microeconomics should be referred back to Chapter 3 for a quick review of the difference.

The remainder of the chapter is devoted to a study of key macroeconomic variables. Potential and actual GDP, the labour force, employment, unemployment, the price level and inflation, productivity, interest rates, and the exchange rate are defined and their behaviour over the last few decades examined. We also include a discussion of why policymakers are concerned with each of these variables. This chapter is designed to make students think about why the performance of these variables matters.

The chapter’s final section stresses that most major macroeconomic issues generally fit into one of two categories: long-run growth and short-run fluctuations. Importantly, questions of appropriate fiscal and monetary policies enter in both categories.

Answers to Study Exercises Fill-in-the-Blank Questions (Note in this chapter that GDP and “output” are terms often used interchangeably.)

Question 1 a) Gross Domestic Product (GDP); product; income b) value terms (dollars) c) prices; quantities d) potential output e) actual GDP; potential GDP; actual GDP; potential GDP; actual GDP; potential GDP Question 2 a) working (employed); not working but looking for work (unemployed); unemployed; labour force b) frictional unemployment; structural unemployment c) 137; 37 percent

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Chapter 4: What Macroeconomics Is All About 39

d) (137.0 – 136.0)/(136.0) = 1.0/136.0 = 0.7 percent e) interest rate f) minus g) exchange rate h) rise; fall Review Questions Question 3 a) During booms, the prospects of finding a job improve, and this may lead people who are currently outside the labour force to enter the labour force and begin searching for jobs. b) Even if employment is rising during a boom, the entry of new job searchers into the labour market, who are counted as unemployed workers, may actually lead to an increase in the measured unemployment rate. c) If discouraged unemployed workers leave the labour force, the measured unemployment rate will tend to fall. d) This is not obviously true. The unemployment rate could fall because of a reduction in unemployment and a rise in employment (with a constant labour force). In this case, most people would see this as clearly positive. But if employment is constant and discouraged workers leave the labour force, the measured unemployment rate will fall even though there is little positive in this situation. For this reason, many economists prefer to focus on the pattern of employment rather than the unemployment rate.

Question 4 Output per person is GDP/POP, where GDP is output and POP is the total population. Clearly, GDP can rise even though GDP/POP may fall. Algebraically, this will happen if POP is rising faster (in percentage terms) than GDP. In the absence of technical change, this outcome may simply reflect the diminishing returns to labour. Over a ten-year period, however, this is probably only possible if the rate of technical progress is small or if the rate of increase in the other factors of production (especially capital) is small. Is this good for the economy? Overall living standards depend on the amount of output per person, rather than on the amount of total output. A decline in output per person, if sustained over many years, is probably undesirable because average material living standards will be declining.

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40 Instructor’s Solution Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Question 5 It is important to realize that the exchange rate is simply a price and, like changes in the prices of other goods, a change in the exchange rate will typically be good for some people and bad for others.

The question relates to a weakening of the Canadian dollar, meaning a depreciation of the Canadian dollar and thus a rise in the exchange rate (where we define the exchange rate to be the Canadiandollar price of one unit of foreign currency). A depreciation of the Canadian dollar is good for anybody who wants to sell goods, services, or assets to foreigners because the weak Canadian dollar makes these products less expensive in the eyes of foreign buyers. The depreciation is bad for those who are buying foreign goods, for the weaker dollar implies a higher Canadian-dollar price of foreign goods.

It is also important to think about why the exchange rate changes and how the cause of the change determines whether it is “good” or “bad” for the Canadian economy overall. For example, a reduction in the world’s demand for Canadian goods will lead to a depreciation of the Canadian dollar. This depreciation may be good for some exporters (of the goods that are still in demand) but will clearly be bad for exporters as a group.

Problems Question 6 a) The output gap is equal to (Y–Y*). When expressed as a percentage of potential output we have (Y–Y*)/Y*. The output gaps for the nine years in the table are: 2014: 2015: 2016: 2017: 2018: 2019: 2020: 2021: 2022:

gap = (1168–1188)/1188 = −20/1188 = −1.7% gap = (1184–1196)/1196 = −12/1196 = −1.0% gap = (1197–1205)/1205 = −8/1205 = −0.7% gap = (1211–1215)/1215 = −4/1215 = −0.3% gap = (1225–1225)/1225 = 0/1225 = 0.0% gap = (1240–1236)/1236 = 4/1236 = 0.3% gap = (1253–1247)/1247 = 6/1247 = 0.5% gap = (1262–1258)/1258 = 4/1258 = 0.3% gap = (1270–1270)/1270 = 0/1270 = 0.0%

b) Potential GDP (or output) is the level of output produced when all factors of production are being used at their normal rates. Output can exceed potential when labour works overtime or when capital and land are used more intensively than normal. c) A recessionary output gap only requires Y to be below Y*. It does not require Y to actually fall.

When Y does fall, we usually say there is a recession. In the data shown, GDP rises steadily, so there is no recession (but there is a recessionary output gap from 2014 through 2017). d) When the economy is at “full employment”, with GDP equal to potential GDP, we often say that the unemployment rate is at its “natural rate”. GDP equals potential GDP in two years—2018 and 2022. In both years the unemployment rate is 7.6%. So the natural rate of unemployment is 7.6%.

When unemployment is at its natural rate, the only unemployment is frictional and structural. There is no cyclical (or deficient demand) unemployment.

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Chapter 4: What Macroeconomics Is All About 41

Question 7 The unemployment rate is equal to the number of people unemployed divided by the number of people in the labour force (which is itself equal to the number employed plus the number unemployed). a) Unemployment rate = 1.5 million/20 million = 7.5%. b) Number unemployed = 16 million − 14 million = 2 million. Unemployment rate = 2 million/ 16 million = 12.5%. c) Labour force = 900,000 + 2.25 million = 3.15 million. Unemployment rate = 900,000/3.15 million = 28.6%. d) Unemployment rate = 500,000/8.2 million = 6.1%.

Question 8 a) Real GDP per worker is found by dividing column 2 by column 3. This is the simplest measure of labour productivity. The values are: Year 1 Year 5 Year 10 Year 15

$38,462 $42,279 $46,154 $50,667

b) We now must divide column 2 by the product of columns 3 and 4. The values are much lower because they are output per hour rather than output per worker: Year 1 Year 5 Year 10 Year 15

$19.23 $21.52 $23.91 $26.67

c) The total percentage changes over the 15-year period are: Real GDP: Output per worker: Output per hour worked:

52.0 % 31.7 % 38.7 %

d) Note that hours worked per worker falls by 5 percent over the 15-year period. This explains why output per worker grows by less over the period than output per hour worked. (The numerator in both measures is the same whereas the denominator rises by less in the second measure.) e) Output per hour worked is a better measure of productivity than output per worker because it uses a more accurate measure of the total labour input. The change in hours worked is not visible when we use only the number of workers as the measure of input; if hours worked are changing (as they are in this example), we need to take account of these changes in order to get an accurate measure of productivity.

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42 Instructor’s Solution Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Question 9 a) The rate of inflation for the current year is equal to the percentage change in the CPI from the previous year to the current year. The CPI in the current year is equal to the CPI from the previous year times one plus the current year’s rate of inflation (expressed as a growth rate). The missing data are: 2012: 2013: 2014: 2015: 2016: 2017: 2018: 2019: 2020:

inflation = (121.6 − 119.9)/119.9 = 1.4% CPI = (121.6)(1.012) = 123.1 inflation = (125.7 − 123.1)/123.1 = 2.1% inflation = (126.6 − 125.7)/125.7 = 0.7% CPI = (126.6)(1.014) = 128.4 inflation = (130.4 − 128.4)/128.4 = 1.6% CPI = (130.4)(1.015) = 132.4 inflation = (136.0 − 132.4)/132.4 = 2.7% CPI = (136.0)(1.007) = 137.0

b) The CPI never falls (in annual data) between 2010 and 2020 and thus average prices (as shown) never fall. Average prices come closest to being stable in the year with the lowest rate of inflation—in both 2015 and 2020, the inflation rate was only 0.7%. c) The rate of inflation is the closest to being stable between 2017 and 2018, 1.6% and 1.5%, respectively. d) See the diagram below. With the price level on the vertical axis, a stable price level is shown by a line with zero slope—a horizontal line. A stable rate of inflation, however, is shown by a line that is not only upward sloping but with ever-increasing slope. This is because a constant percentage change in the price level means that in each successive year the price level increases by more and more in absolute terms. For example, with a 10% rate of inflation, the price level progresses from 100 to 110 to 121 to 133.1 to 146.4 to 161.1 to 177.2 to 194.9 etc.

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Chapter 4: What Macroeconomics Is All About 43

Question 10 These data are drawn from The Economist, in January 2021. a) The real interest rate is technically defined to be the nominal interest rate minus the expected rate of inflation. But if expectations of the future are determined by the current inflation rate, then the real interest rate is equal to the nominal interest rate minus the current inflation rate. The real interest rates (r, in percent per year) for the various countries are: Australia: Canada: Euro area: Japan: Switzerland: UK: USA:

r = 1.1 − 0.8 = 0.3% r = 0.8 − 0.8 = 0.0% r = −0.5 − 0.3 = −0.8% r = 0.0 − 0.1 = −0.1% r = -0.5 − −0.9 = 0.4% r = 0.4 − 1.0 = −0.6% r = 1.1 − 1.2 = −0.1%

b) Lenders seek the highest real rate of return (assuming that the risk of default and exchange-rate changes is held constant). The highest real interest rate in January of 2021 was available in Australia. c) Borrowers seek the lowest real rate of return (assuming that the risk of exchange-rate changes is held constant). The lowest real interest rate in January of 2021 was in the Euro area (where the real interest rate was negative 0.8 percent).

Question 11 These data are drawn from The Economist in February of 2018.

Canadian-Dollar Exchange Rate Currency

February 2018

U.S. dollar Japanese yen British pound Swedish krona Euro

February 2017

1.25 0.011 1.74 0.16 1.54

1.31 0.012 1.64 0.15 1.41

a) To see which currencies appreciated relative to the Canadian dollar, we need to see the currencies for which the Canadian exchange rate increased—because this means that it took more Canadian dollars to purchase one unit of these foreign currencies in 2018 than in 2017. The answers are: the British pound, the Euro, and the Swedish krona appreciated against the Canadian dollar during this time period. b) By the same logic (in the opposite direction), the U.S. dollar and the Japanese depreciated against the Canadian dollar between 2017 and 2018—during this period, the number of Canadian dollars required to purchase one unit of these foreign currencies fell.

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44 Instructor’s Solution Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

c) From February 2017 to February 2018, the Canadian dollar appreciated against the U.S. dollar.

Over the same period, the Canadian dollar depreciated against the euro. But what happened to the U.S. dollar relative to the euro?

Begin with February 2017.

1 $ Cdn = 0.763 $U.S.

but also 1 $ Cdn = 0.709 euro.

Thus 0.763 $ U.S. = 0.709 euro, or 1 $ U.S. = 0.929 euro in February 2017.

Now do the same for February 2018.

1 $ Cdn = 0.80 $ U.S. but also 1 $ Cdn = 0.649 euro.

Thus 0.80 $ U.S. = 0.649 euro, or 1 $ U.S. = 0.812 euro in February 2018.

So from February 2017 to February 2018, the U.S. dollar depreciated (by about 13 percent) relative to the euro. *****

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____________________________________________ Chapter 5: The Measurement of National Income ____________________________________________ Our treatment of national income accounting emphasizes GDP as the core measure of the level of economic activity. But we emphasize that measures of national income and measures of “national well-being” are not the same. *** In the opening section of the chapter we discuss the income-output concept with which students are most familiar––the output of individual firms. This allows us to deal with double counting at the outset and to define an industry’s output as its value added. There is a box that works through an example of value added so that students can get a sense of the magnitude of the mistake that would be made if national income were computed by simply adding up the value of all firms’ output.

We then introduce the national income and expenditure accounts in the second section. We show the two equivalent ways of measuring total output and the income claims that it generates (in addition to simply summing up total value added in the economy): GDP from the expenditure side and GDP from the income side. By adding a diagram of the circular flow at this point in the discussion, students can more easily see the logical connection between income and expenditure.

Students are often puzzled by some of the accounting conventions used, such as treating interest on the public debt as a transfer. For this reason we have a box that examines the arbitrary nature of some conventions used in national income accounting. Students should know that arbitrariness is necessary whenever accounting is undertaken—the important thing is to be consistent over time in the use of accounting conventions.

The final section of the chapter goes “beyond the basics” of simple national income accounting in four ways. First, we develop the difference between real and nominal GDP, and in so doing develop the idea of the (implicit) GDP deflator. This leads to a box that goes through an example of real and nominal GDP in a hypothetical economy, and also constructs the GDP deflator.

Second, we examine the various things that are not measured by conventional measures of national income. Finally, we examine the relationship between real GDP, “living standards”, and “social well-being”.

In our view, all of these topics are central, and we hope that instructors who feel pressed for time will at least stress to their students the importance of the issues. It is especially important to stress that measures of national income, though capturing pretty well the changes in the level of overall economic activity, are not measures of welfare or well-being (nor are they intended to measure such things). It is easy to think of situations where national income rises even though welfare certainly falls; the opposite situation is also easy to imagine. There is a lot of discussion these days about indexes of social well-being and also about “happiness”, and it is worth having a thorough discussion in class about how these concepts are much broader than GDP.

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46 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) double counting; overestimate b) value added; value added; non-labour inputs (or “intermediate inputs”) c) expenditure; income; expenditure; income; equal d) consumption; investment; government purchases of goods and services; net export expenditures; Ca + Ia + Ga + NXa (subscript “a” for “actual” expenditures) e) wages and salaries; interest; business profits; indirect taxes net of subsidies; depreciation Question 2 a) prices; quantities (real output); base-period; real b) average income per person c) productivity Review Questions Question 3 a) Automobile purchases by consumers are included as part of consumption, C. They are considered a durable good. b) Automobile purchases by firms are included as part of investment, I. c) Expenditures on new machinery by companies in Canada are considered part of Canadian investment, I. It is irrelevant who owns the companies. (If the government purchases machines, it is considered part of G, although we could also divide G into current purchases and “investment” purchases.) d) This is not included as investment in Canada, though it would be considered as part of investment expenditure in the United States. e) Expenditures on new machinery by companies in Canada are considered part of Canadian investment, I. It is irrelevant who owns the companies. f) Reduction in business inventories is considered negative investment (I) in Canada. g) Purchases of second-hand cars and trucks are not included in the national accounts because this does not represent expenditure on newly produced goods and services. h) The hiring of economic consultants by government is part of government purchases, G. i) The purchase of Canadian-made software by a Japanese firm is part of exports, X.

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Chapter 5: The Measurement of National Income 47

Question 4 a) A firm’s value added is equal to the payments it makes to its employees plus its profits. In other words, it is equal to its total revenues minus the value of its purchases of inputs from other firms. If a firm now lays off its maintenance workers and “contracts out” its maintenance to an outside firm (suppose total expenditure is unchanged), its measured value added falls. b) When this company’s value added falls, the value added of some outside firm rises by the same amount (assuming that total expenditure is unchanged). In this case, total value added in the economy is unaffected.

Question 5 a) This is not a causal relationship, so we cannot say that a rise in one of the right-hand-side variables will lead to an increase in real GDP. What we can say is that whatever changes occur in the economy must satisfy this accounting identity, so that the change in the total GDP must be equal to the sum of the changes in the four expenditure components.

For example, we cannot simply say that an increase in Ca will lead to an increase in Y. We would need to know why Ca increases. Perhaps there is a reduction in Ia and a rise in Ca that leaves total spending and total output unchanged. b) An increase in imports does not necessarily lead to a reduction in real GDP – we need to know why imports change in the first place. Perhaps there is an overall rise in real GDP and this leads households to demand more imports. In this case, both real GDP and imports will rise together (although we would also want to know why real GDP increased).

Question 6 The key to this question is to recognize that changes in the expenditure on specific products are not sufficient to cause a change in GDP; if the level of aggregate production does not change, then GDP will not have changed. So in each situation we need to ask whether the suggested change in one type of expenditure actually leads to a change in total expenditure and whether aggregate production is likely to change. a) The increase in the demand for building materials leads to more expenditure on these products. If this increased demand leads to an increase in production of such goods (and if there is not an offsetting decrease in demand and production for other goods and services), then GDP will increase. b) The flood damage to the barley crop leads to a reduction in production. This is a clear reduction in real GDP. c) The good wheat-growing conditions lead to a larger-than-normal wheat harvest. For a given price of wheat (which is determined in global markets and unlikely to be affected by the growing conditions in Saskatchewan), this shock increases real GDP. d) The 50-percent decline in the world price of oil causes Alberta’s oil producers to decrease their oil production by 3 percent. Because the quantity of oil production falls, there is a decrease in real GDP.

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48 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

e) The 2020-21 pandemic led to a “shutdown” of many parts of most economies. Many people could continue working from home, but millions could not. For the people unable to work while isolating at home, their unemployment translates into a lack of production and thus, GDP. (Canadian GDP actually fell by over 10 percent during the second quarter of 2020—a huge decline!) f) The creation and distribution of effective vaccines in 2021 allowed many Canadians to return to work and production to increase. GDP increased sharply as this occurred, although by the end of 2021 Canadian GDP was still below where it was just prior to the beginning of the pandemic in early 2020. g) If Torontonians increase their demand for Maple Leafs tickets, they presumably reduce their demand for other goods (otherwise the building of the arena would affect their overall saving rate, which seems unlikely). For example, Torontonians attend more hockey games but attend fewer concerts, movies, or purchase fewer clothes or vacations. If total expenditure is unchanged, it is difficult to see why GDP would rise, though the composition of GDP would surely change. There would be more hockey-game services produced and fewer of other goods and services produced. h) The key point is to determine what people from Buffalo would have done if the new arena in Toronto were not built. If we assume that the building of the new arena leads U.S. residents who would not otherwise purchase Canadian goods to now come to Toronto and purchase various goods and services associated with their hockey visit, then Canadian real GDP would rise. But if it is just a substitution away from other Canadian goods toward the Maple Leafs hockey games, then there will be no effect on Canadian GDP. In this case it seems reasonable to assume that at least some of the expenditure would be new expenditure, and thus that Canadian GDP would rise.

Question 7 Generally, the two measures of inflation will be similar but not identical. Inflation as measured by the rate of change of the GDP deflator indicates the change in prices of goods and services produced in the Canadian economy. Inflation as measured by the rate of change of the Consumer Price Index indicates the change in prices of the goods and services consumed by the average Canadian household. The two “baskets of goods” are different. For example, forestry products (and the goods derived therefrom) will have a larger weight in the Canadian GDP deflator than in the CPI because Canada is a large net exporter of forestry products. Conversely, coffee, sugar, and tropical fruits and vegetables will have a larger weight in the CPI than in the GDP deflator because Canada consumes but does not produce these goods. So, in general, changes in the prices of traded goods will tend to influence the two price indexes differently. But even large changes in the prices of individual traded goods will have a small effect on either overall price index for the simple reason that the indexes are made up of many goods, each good having a very small weight. The two indexes tend to move together because the overall inflationary (or deflationary) pressures in the economy tend to apply to all goods and services.

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Chapter 5: The Measurement of National Income 49

Question 8 Norway is ranked very highly according to some formulas of “quality of life” (such as the UN’s Human Development Index) that includes a large number of factors that contribute to human welfare.

GDP is only one such factor. Others include crime rates, pollution, congestion, longevity, scenic beauty, income distribution, educational achievement, and political freedoms. Thus, Norway’s very high ranking in these other factors can lead to its overall high ranking, even though its real per capita GDP does not place it among the very top countries.

Problems Question 9 a) The farmer’s value added is their revenue of $1000 minus the $100 cost of the seeds (assuming no other non-labour input costs), which equals $900. The distributor’s value added is $300; the restaurant’s is $1200. There is also value added from the seed producer, which is presumably $100 (since we are not told of any other inputs). So the total value added for Canada is $2500, which is also the value of the “final good” (beet salads). b) The mining firm’s value added is $1 million. The aluminum company’s value added is $0.8 million.

The manufacturer’s value added is $1.2 million. The retailer’s value added is $2 million. And we assume that the firm that sells the inputs to the mining firm has value added of $1 million (since we are not told of any other inputs). So the total value added for Canada is $6 million, which is also the value of the “final good” (doors). c) The Canadian retailer’s value added is $600,000. The firm that sold those toys to the retailer is in another country, so its value added is not counted in Canada. So the total value added for Canada is $600,000.

Question 10 a) Using the expenditure approach, GDP = C + I + G + NX, where C is consumption (3900), I is gross private investment (1100 = 950 + 150), G is government purchases (1000), and NX is net exports (– 40 = 350 – 390). Therefore, GDP = 3900 + 1100 + 1000 – 40 = 5960 (millions of dollars).

(Note that in national-income accounting, I is gross investment. Net investment is gross investment minus depreciation. So the gross investment in this case is 950 + 150.) b) Using the income approach, GDP = wage and salaries (5000) plus interest (200) plus business profits (465) plus indirect taxes less subsidies (145 = 175 – 30) plus depreciation (150). The total is 5960 (millions of dollars). c) Net domestic income at factor cost is just the total of factor payments, which is the sum of wages and salaries plus interest plus business profits. Therefore, net domestic income at factor cost is 5000 + 200 + 465 = 5665 (millions of dollars).

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50 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Question 11 a) The GDP deflator is equal to (Nominal GDP/Real GDP) × 100. The deflator for each year is: 2017: 2018: 2019: 2020: 2021: 2022:

deflator = (775.3/798.4) × 100 = 97.1 deflator = (814.1/838.6) × 100 = 97.1 deflator = (862.9/862.9) × 100 = 100.0 deflator = (901.5/882.5) × 100 = 102.2 deflator = (951.3/920.6) × 100 = 103.3 deflator = (998.8/950.5) × 100 = 105.1

b) The percentage change in nominal GDP from 2017 to 2022 is (998.8 – 775.3)/775.3 = 0.288 or 28.8 percent. The percentage change in real GDP over the same period is (950.5 – 798.4)/798.4 = 0.191 or 19.1 percent. Thus, roughly two-thirds (19.1/28.8 = 0.663) of the change in nominal GDP from 2017 to 2022 was the result of changes in quantities, meaning that roughly one-third was the result of changes in prices.

Question 12 a) Nominal GDP is simply the sum of price × quantity for the two goods. The values are: Year 1:

Nominal GDP = (100 × $2) + (40 × $6) = $200 + $240 = $440

Year 2: Nominal GDP = (120 × $3) + (25 × $6) = $360 + $150 = $510 b) Real GDP is computed by using the prices from the base year. Since Year 1 is the base year, nominal and real GDP are the same in that year. The values are: Year 1:

Real GDP = (100 × $2) + (40 × $6) = $200 + $240 = $440

Year 2:

Real GDP = (120 × $2) + (25 × $6) = $240 + $150 = $390

Real GDP falls from Year 1 to Year 2 by a percentage equal to (390 – 440)/440 = –0.114 or –11.4 percent. c) The GDP deflator is equal to (Nominal GDP/Real GDP) × 100. Using Year 1 as the base year, nominal and real GDP are the same in Year 1. The values for the GDP deflator are: Year 1:

GDP Deflator = (440/440) × 100 = 100

Year 2:

GDP Deflator = (510/390) × 100 = 130.8

The change in the GDP deflator from Year 1 to Year 2 is (130.8 – 100)/100 = 0.308 or 30.8 percent. d) To do this we must first compute real GDP in both years, using Year 2 as the base year. Since Year 2 is the base year, nominal and real GDP are the same in that year. The values of real GDP are: Year 1:

Real GDP = (100 × $3) + (40 × $6) = $300 + $240 = $540

Year 2:

Real GDP = (120 × $3) + (25 × $6) = $360 + $150 = $510

Now, compute the GDP deflator (base year 2) as: Year 1:

GDP Deflator = (440/540)×100 = 81.5

Year 2:

GDP Deflator = (510/510)×100 = 100.0 Copyright © 2023 Pearson Canada Inc.

Chapter 5: The Measurement of National Income 51

e) Let’s compile the information we have gathered in the following table.

Base Year

Change of Real GDP from Year 1 to Year 2

Change in GDP Deflator from Year 1 to Year 2

Year 1

–11.4%

30.8%

Year 2

(510 − 540)/540 = −5.6%

(100 – 81.5)/81.5 = 22.7%

These numbers may look puzzling. Does real GDP fall by 11.4% or only by 5.6%? Do prices rise by 30.8% or only by 22.7%? Which are the “correct” figures?

This is a good way to understand why the choice of base year affects calculations of real GDP and the GDP deflator. The key point here is that if there are changes in relative prices from one year to the next, then the choice of base year will matter. To understand why, suppose we choose Year 1 as the base year. In this case, the relative price of honey to milk is 6/2 or 3. The very large drop in the quantity of honey produced (from 40 to 25 kg) is weighted heavily, and thus real GDP drops significantly. But if we use Year 2 as the base year, the relative price of honey to milk is 6/3 or only 2.

In this case, the same large drop in the quantity of honey gets a smaller weight than in the case where Year 1 is the base year. *****

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_______________________________________ Part Three The Economy in the Short Run

_______________________________________ This part of the book contains three core theory chapters for analyzing the real macro economy in the short run. It is here that we build the basic short-run model of national-income determination that forms the foundation for most of what follows in the book. In these three chapters, we develop only the real side of the economy, leaving the monetary aspects to be developed after our detailed treatment of the long run in Part 4.

There are two logical halves to this part of the book. In the first, Chapters 6 and 7 develop the distinction between desired and actual aggregate expenditure and then put these concepts together in the Keynesian Cross apparatus to illustrate the meaning of equilibrium. We explain the multiplier in considerable detail. Note that these first two chapters are built around two related assumptions:  the price level is constant; and  the level of output is demand determined.

In the second logical half of the Part, Chapter 8 relaxes these two assumptions. We introduce the aggregate demand (AD) and aggregate supply (AS) curves and show how these tools can be used to examine the simultaneous determination of real GDP and the price level. AD and AS curves are considered the most effective tools for studying macroeconomic behaviour, at least at the introductory level. But these concepts are not simple to teach. Significant classroom time spent at this point will have its payoff later when macroeconomic topics and policies can be understood better as a result. *** In Chapter 6, we present the Keynesian Cross of the AE curve and the 45-degree line in a simple model of a closed economy without government. This simple structure allows us to determine equilibrium income when the price level is constant, output is demand determined, and all of the parts of the model are easy to see. In Chapter 7, we add government and foreign trade, still keeping the assumptions that the price level is constant and real GDP is demand determined.

There are significant benefits to breaking the discussion of the Keynesian Cross into two chapters. First, the version of the model in Chapter 6 with a closed economy and no government allows the students to learn and become comfortable with three difficult but crucial concepts in the simplest possible setting—desired versus actual expenditure, equilibrium national income, and the simple multiplier. Second, Chapter 7 not only introduces the student to government and international trade, but it also forces them to think through the equilibrium and multiplier concepts a second time.

Our experience suggests that students need to see and work with this material several times before they really know it, and therefore in our view this two-chapter approach is desirable.

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Chapter 6: The Simplest Short-Run Macro Model 53

Chapter 8 introduces the concept of the AD curve as the locus of price-income combinations that yield expenditure equilibrium (purchasers are just prepared to purchase the total GDP that is produced). After that, we introduce the AS curve and determine macroeconomic equilibrium as the combination of real GDP and the price level at which (1) purchasers are willing to buy the total GDP that is produced, and (2) producers are willing to supply that same level of GDP. In past editions there has been somewhat of a bias toward the demand side of the economy. We have redressed this by stressing the importance of supply shocks, both positive and negative. *** Our view is that there are significant benefits from delaying the AD/AS analysis until after the constant-price, Keynesian Cross model is fully developed. We realize that some other textbooks, in an early attempt to interest the students by showing them what the completed model will be able to do, put an introductory chapter with AD/AS analysis before the chapters with the Keynesian Cross.

In our view, however, this approach is difficult to defend on pedagogic grounds. We stress that the AD curve is an equilibrium locus (which embodies the simple multiplier) rather than an ordinary demand curve. Students can only fully appreciate this point, however, after they have understood the equilibrium and the simple multiplier developed in the Keynesian Cross model.

Two Caveats on Terminology: We use terminology whereby a change in demand means a shift in the AD curve while a change in quantity demanded refers to a movement along the AD curve (and similarly for the AS curve). Shifts in the AD and AS curves are called demand shocks and supply shocks, respectively. Readers have indicated that there is a wide divergence in the use of the word “shock”. Some use it to mean unexpected shifts and others to mean any shift. We have chosen the latter terminology. No matter of substance turns on this use of words. As long as instructors understand that we use the word “shock” as a synonym for a shift, whether anticipated or unanticipated, all should be well.

Another caveat concerns our labelling of the aggregate supply curve as AS rather than SRAS. Our view is that the SR makes learning a little more cumbersome for students and adds no real benefit.

By using just AS to label the aggregate supply curve, our treatment is symmetric with the demand side. We continue to assume (and emphasize throughout) that factor prices and technology are constant when we draw any given AS curve, and that changes in factor prices or technology cause the AS curve to shift. In later chapters, we replace the label LRAS with Y*, and simply refer to Y* as the “anchor” to which real GDP returns after all adjustment has occurred.

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_____________________________________________ Chapter 6: The Simplest Short-Run Macro Model _____________________________________________ In both this chapter and the next, we hold the price level constant and exogenous (as well as the interest rate and the exchange rate). We thus develop the well-known Keynesian Cross apparatus.

This model should not be taken literally, as it once was, as a description of all of the forces that help to determine national income in the short run. Instead, it merely determines the level of income at which agents will willingly purchase exactly what is produced, given the existing price level and levels of investment and government expenditures. The analysis of these forces is only the first step toward the derivation of the AD curve, which allows for the influence on demand of changes in the price level. The AD curve, in turn, is just one step toward the simultaneous determination of real GDP and the price level by the combined forces of aggregate demand and aggregate supply. *** This chapter is divided into three sections. In the first section, we develop the important distinction between desired and actual expenditure. We then go on to discuss the determinants of desired consumption and investment. Our streamlined discussion of consumption and saving leads to a box containing an intuitive discussion of the differences between the Keynesian consumption function, in which current consumption depends only on current income, and the Friedman-Modigliani consumption functions, in which current consumption depends on some concept of “permanent” or “lifetime” income. In the spirit of the permanent-income theory, wealth is also introduced as a variable even in the simple consumption function. The discussion of wealth is in preparation for shifts in the consumption function brought about when changes in the price level cause changes in private-sector wealth. We have tried to be especially clear and systematic in our treatment of what causes the consumption function to shift, including changes in interest rates, wealth, and expectations.

Our discussion of investment examines the importance of the real interest rate, changes in sales, and business confidence. We now have a numerical example to illustrate how a change in sales leads to an increase in inventory investment, and also make reference to Keynes’ notion of “animal spirits” when discussing the role of business confidence. We present some data on investment so students can see for themselves the volatility of its various components. After this discussion, however, we then make it clear that the remainder of the chapter treats investment as autonomous expenditure (with respect to national income), and why this is a reasonable assumption. The section closes by summing desired consumption and desired investment together to get the desired aggregate expenditure (AE) function. Note that we reserve the term marginal propensity to spend to apply to the relationship between total expenditure and national income.

The chapter’s second section introduces the concept of equilibrium national income—the level of real GDP such that desired aggregate expenditure equals actual national income. We emphasize the unintended changes in firms’ inventories as a way for the reader to understand what is happening out of equilibrium.

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Chapter 6: The Simplest Short-Run Macro Model 55

The final section of the chapter goes on to examine the effects of changes in autonomous expenditure on equilibrium national income. We show that an increase in desired consumption is equivalent to a reduction in desired saving. We then introduce the simple multiplier. Students usually find the multiplier difficult at first sight, so we have taken care to introduce it slowly and to consider it from more than one point of view. For those students who are not frightened by simple algebra, a box provides a clear example of the power of formal reasoning, by deriving the multiplier relation much more economically than can be done using words and geometry. Others can ignore the algebraic box and focus instead on the intuition and the diagrams provided in the text. The chapter ends with a brief discussion of the importance of expectations and the possibility of self-fulfilling prophesies in the simple macro model.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) Ca + Ia (Note: we would also include Ga and NXa in an open economy with government) b) C + I

(Note: we would also include G and NX in an open economy with government)

c) actual; desired d) autonomous; induced; a; b e) autonomous f) C + I; desired aggregate expenditure; actual national income (GDP) g) $47 billion; 0.92; YD = Y (no taxes) and consumption is the only induced part of desired expenditure Question 2 a) accumulate; reduce; fall b) fall; increase; rise c) upward; rise; 45-degree d) more; simple multiplier (× $10 billion) e) larger; 1/(1 − z)

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56 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Review Questions Question 3 a) The consumption function shifts up and the AE function therefore shifts up. Equilibrium national income increases. (Since the consumption function shift up, the saving function must shift down by the same amount.) b) The purchase of new houses is the residential component of investment. The investment function shifts down, assuming that housing construction falls when house sales fall. This shifts the AE function down and reduces the equilibrium level of national income. c) This is a reduction in desired inventory investment caused by pessimism regarding the future state of the economy. The investment function shifts down, the AE function shifts down, and equilibrium national income falls. d) The allowance of “accelerated depreciation” means that firms can claim larger costs for capital depreciation than normal, thus improving the profitability of any given investment. The investment function shifts up, the AE function shifts up, and equilibrium national income increases. e) The rise in values in the stock market creates wealth (on paper) for those who own equities. This increase in wealth leads to a rise in desired consumption, an upward shift in the consumption function. The AE function shifts up and equilibrium national income rises. (Since the consumption function shifts up, the saving function shifts down by the same amount.) f) The headline describes people saving (and thus not spending) as a result of isolating inside their homes during the COVID-19 pandemic in 2020-21. For a given amount of income, this suggests a downward shift of the consumption function (and thus an upward shift in the saving function). The downward shift in the consumption function would cause a similar shift in the AE function. Taken by itself, this reduction in planned spending would reduce equilibrium GDP. g) The headline suggests that as the COVID-19 vaccines are rolled out (during 2021), the expected economic recovery would produce optimism among businesses, who would then increase their planned investment as a result. This is an upward shift in the investment function and thus an upward shift of the AE function. Taken by itself, this increase in planned spending would lead to an increase in equilibrium GDP. Question 4 a) National income accounting is based on actual expenditures. Desired expenditures are not observed whereas actual expenditures are. It would be impossible to base accounting on an unobserved concept. b) A sudden decrease in desired consumer expenditure would result in a sudden decrease in actual consumption. This would probably lead to an unanticipated increase in inventories, as consumers are no longer buying as many goods as before, and so the unsold products accumulate in firms’ inventories. Inventories are part of investment, and so measured (actual) investment would rise. This would be an increase in inventory investment.

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Chapter 6: The Simplest Short-Run Macro Model 57

c) See the figure below. Suppose the economy begins at point A, in equilibrium with national output and income equal to YE. The sudden reduction in desired consumption is a downward shift in the consumption function and thus in the AE function. The immediate effect is for desired expenditure to fall to point B, even though production remains at YE. The vertical distance between points A and B reflects the amount by which inventories are accumulating as a result of the reduction in desired (and actual) consumer expenditure. This accumulation of inventories is an unintended or unplanned increase in investment. The reduction in desired consumption expenditure will eventually, through the multiplier process, lead to a reduction in equilibrium national income, and the economy will adjust toward point C.

Question 5 a) When actual national income is Y1, desired aggregate expenditure is b. Actual output is a and so desired aggregate expenditure exceeds actual output. Inventories are being depleted—this is unplanned negative inventory investment. b) The depletion of inventories eventually leads firms to increase the level of output so they can replenish their inventories. The rise in output generates a rise in income and this induces an increase in desired aggregate expenditure. We move up and to the right along the AE curve. But as long as AE exceeds actual output, the depletion of inventories leads firms to increase output.

The economy eventually settles down where AE cuts the 45-degree line. At this point actual output is exactly equal to the level of desired aggregate expenditure, and the level of inventories is constant. c) When actual national income is Y2, desired aggregate expenditure is d. Actual output is e and so desired aggregate expenditure is less than actual output. Inventories are being accumulated—this is unplanned positive inventory investment.

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58 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

d) The unintended accumulation of inventories eventually leads firms to reduce the level of output.

The reduction in output reduces income and this induces a decrease in desired aggregate expenditure. We move down and to the left along the AE curve. But as long as AE is less than actual output, the accumulation of inventories leads firms to reduce output. The economy eventually settles down where AE cuts the 45-degree line. At this point actual output is exactly equal to the level of desired aggregate expenditure, and inventories are neither being depleted nor accumulated.

Question 6 To best examine this question, note that the equilibrium condition, Y = C + I, can also be expressed as Y – C = I which is the same as S = I. So equilibrium in our simple macro model can be seen as the level of national income at which desired saving equals desired investment.

With this in mind, consider the figure below, which shows the equilibrium level of national income in terms of desired saving and desired investment. The initial equilibrium is point A. The rise in desired saving shifts the saving function upward to S but does not affect the investment function. The accompanying reduction in desired consumption leads to an unintended accumulation of inventories and thus leads firms to reduce the level of output. After the multiplier has worked itself out, the level of equilibrium income has fallen but the equilibrium level of saving is unchanged.

Thus, the attempt to increase saving leads to a reduction in national income but no increase in overall saving—the “paradox of thrift”.

Question 7 It is easy in the model to allow for the possibility that investment has an induced component as well as an autonomous component. In this case, the slope of the AE curve, which is ordinarily just equal to the marginal propensity to consume, becomes MPC + β, where β is the marginal propensity to invest. The new AE curve is obviously steeper than the AE curve in the simplest model. This increase in the marginal propensity to spend implies that the simple multiplier increases.

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Chapter 6: The Simplest Short-Run Macro Model 59

One intriguing possibility is that β is sufficiently large that the marginal propensity to spend, MPC + β, exceeds one. In this case, if the level of autonomous expenditure is positive, the AE function would never intersect the 45-degree line and there would be no equilibrium. This unusual possibility should force us to think about the reasons why there might be an induced component to desired aggregate investment, and whether the induced component is likely to be large. Recall that we should not confuse current income with expected future income when discussing the determinants of desired investment. Since investment is an activity done today in order to generate a return in the future, it is future income that is likely to be the important determinant of current investment, not current income. For this reason, there is a solid reason to expect a small or zero induced component in current desired investment.

Problems Question 8 a) The average propensity to consume (APC) is equal to desired consumption divided by disposable income. See the completed table below.

YD

C

APC

0 100 200 300 400 500 600 700 800

150 225 300 375 450 525 600 675 750

— 2.25 1.50 1.25 1.125 1.05 1.00 0.96 0.94

MPC — 75/100 = 0.75 75/100 = 0.75 75/100 = 0.75 75/100 = 0.75 75/100 = 0.75 75/100 = 0.75 75/100 = 0.75 75/100 = 0.75

b) See the table above. The marginal propensity to consume (MPC) is equal to the change in desired consumption divided by the change in disposable income that brought it about. The MPC is shown as the change from one row in the table to the next. c) The equation for this consumption function is C = 150 + (0.75)YD. The constant term is the level of autonomous desired consumption; the slope is the MPC.

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60 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

d) See the figure below. The 45-degree line shows where desired consumption equals disposable income. This occurs only once along the consumption function, at the break-even level of income, Y*, which equals $600. The APC equals one at Y*. The slope of the consumption function is the MPC, which in this case is 0.75.

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Chapter 6: The Simplest Short-Run Macro Model 61

Question 9 a) Desired saving is equal to disposable income minus desired consumption. We can compute desired saving (S) from the table in Question 8. The plotted desired saving function is shown below. The slope of the function is the marginal propensity to save, S/YD, which equals one minus the marginal propensity to consume. In this case the marginal propensity to save is equal to 0.25.

YD

C

S

0 100 200 300 400 500 600 700 800

150 225 300 375 450 525 600 675 750

–150 –125 –100 –75 –50 –25 0 25 50

b) To show this to be true, begin by noting that disposable income must either be consumed or saved.

Thus YD = C + S Now divide both sides by YD to get 1 = C/YD + S/YD This shows that the average propensity to consume plus the average propensity to save must equal one. c) The equation for the saving function is S = −150 + (0.25)YD. The constant term is the level of autonomous desired saving and the slope is the marginal propensity to save.

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62 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Question 10 a) See the table below.

Y

C = 500 + .9Y

I

AE = C + I

0 2000 4000 6000 8000 10000

500 + (0.9)0 = 500 500 + (0.9)2000 = 2300 500 + (0.9)4000 = 4100 500 + (0.9)6000 = 5900 500 + (0.9)8000 = 7700 500 + (0.9)10000 = 9500

100 100 100 100 100 100

600 2400 4200 6000 7800 9600

b) Autonomous expenditure is the sum of autonomous consumption and autonomous investment, which in this model is 600. c) In the model in this chapter, there is no government and hence no taxation. The result is that disposable income, YD, is the same as national income, Y. d) Equilibrium national income is that level of national income where actual income, Y, equals desired aggregate expenditure, AE. Thus, the equilibrium level of national income is 6000.

Question 11 a) The (desired) aggregate expenditure function shows the total desired expenditure at each level of national income.

AE = C + I  AE = 1400 + 0.8Y + 400  AE = 1800 + 0.8Y b) Equilibrium requires that Y = AE (this is the equation for the 45-degree line). The equilibrium level of national income is therefore the value of Y that solves the following equation: Y = 1800 + 0.8Y  Y(1 – 0.8) = 1800  Y = 1800/(0.2)  Y = 9000 c) When Y = 9000, consumption equals 1400 + (0.8  9000) = 8600. Saving therefore equals Y – C which is 9000 – 8600 = 400. Investment equals 400.

(Note that equilibrium national income can also be determined as that level of real GDP where desired saving equals desired investment; see the Additional Topic on the book’s MyEconLab for more information.)

Question 12 The marginal propensity to spend on national income (z) is the slope of the AE function, which in the simple model of this chapter is just equal to the MPC. The simple multiplier is equal to 1/(1 − z). a) z = 0.4

 simple multiplier = 1/(1 − 0.4) = 1/0.6 = 1.67

b) z = 0.62

 simple multiplier = 1/(1 − 0.62) = 1/0.38 = 2.63

c) z = 0.92

 simple multiplier = 1/(1 − 0.92) = 1/0.08 = 12.5 Copyright © 2023 Pearson Canada Inc.

Chapter 6: The Simplest Short-Run Macro Model 63

d) z = 0.57

 simple multiplier = 1/(1 − 0.57) = 1/0.43 = 2.33

e) z = 0.2

 simple multiplier = 1/(1 − 0.2) = 1/0.8 = 1.25

f) z = 0.35

 simple multiplier = 1(1 − 0.35) = 1/0.65 = 1.54

g) The size of the simple multiplier depends on the slope of the AE function, not its vertical height, which is why it does not depend on the level of autonomous expenditure. As z rises, the slope of the AE function also rises, and this means that there is more induced spending in response to any increase in Y, which makes the multiplier process result in a larger total change in Y. Question 13 a) See the figure below. When wealth is 10 000, the AE function is AE = 500 + 0.75Y + (.05)(10 000) + 150  AE = 1150 + 0.75Y Using the equilibrium condition, Y = AE, the equilibrium level of national income is the level of Y that solves the following equation: Y = 1150 + 0.75Y  Y(1 – 0.75) = 1150  Y = 1150/.25  Y = 4600

b) The marginal propensity to spend (on national income) is the slope of the AE function—it shows how much desired spending rises when national income increases by $1. (In this model, with no government and no foreign trade, the marginal propensity to spend is simply the marginal propensity to consume.) Here, the marginal propensity to spend (which we denote z) is equal to 0.75. c) The value of the simple multiplier is 1/(1 – z). In this economy, z = 0.75 and so the value of the simple multiplier is 1/(1 – 0.75) = 1/(0.25) = 4.

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64 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

d) If desired investment increases from 150 to 250, this is an increase in autonomous expenditure of 100. Given the multiplier of 4, the change in equilibrium national income will be 400. This is shown in the diagram above as the AE function shifts to AE and equilibrium national income rises to 5000. e) Let’s suppose that I has already increased to 250 as in part (d). If wealth now increases from 10000 to 15000, the level of autonomous consumption increases by 5000(.05) = 250. Thus the new AE function becomes AE = 1500 + (.75)Y As households increase their autonomous consumption by 250, the AE function shifts up by 250 and the equilibrium level of national income increases by 250 × 4 = 1000. Equilibrium national income rises to 6000. *****

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________________________________________________________________ Chapter 7: Adding Government and Trade to the Simple Macro Model ________________________________________________________________ In this chapter we add government and foreign trade to the simple model from Chapter 6, developing a more complete short-run model of national-income determination under the assumption of constant and exogenous prices (as well as interest rates and exchange rates). We provide extended discussions of government and net exports, going beyond the minimum necessary for the Keynesian Cross, and laying the groundwork for discussions of fiscal, monetary, and trade policy throughout the remainder of the book. *** The chapter is divided into five sections. In the first section, we introduce the government sector.

Following national-income accounting conventions, we define G as government purchases of goods and services (as distinct from total government expenditures) and T as taxes net of transfers. It makes sense to combine taxes and transfers because transfer payments affect disposable income just as do taxes, but with the opposite sign. It is worth emphasizing this basic point. We also make the point that when discussing government, we mean all levels of government. This is especially important in Canada because the combined provincial governments play an even larger role in taxing and spending than does the federal government.

The second section introduces exports and imports. Note that we introduce the net export function as one of the endogenous parts of aggregate demand rather than treating net exports as exogenous, as is often done (either implicitly or explicitly) in introductory treatments. We treat exports as autonomous with respect to national income whereas imports are assumed to increase with national income. This discussion of net exports, which includes discussions of the role of the exchange rate and international relative prices, provides the foundation that the students need in later chapters when dealing with the importance of open-economy macroeconomic policy. In our discussion of how changes in the price level or exchange rate lead to changes in net exports, we include a cautionary note that the price level and exchange rate are exogenous variables in this chapter but will be made endogenous in later ones. This point should be stressed in class.

The third section discusses the determination of equilibrium national income. We carefully and systematically build the AE function in stages. First, we modify the consumption function to include the distinction between national income and disposable income. Students often have trouble with the transition from consumption as a function of disposable income, which is the basic behavioural relationship, to consumption as a function of national income, which is what we need for constructing the AE function in this chapter. It is worth spending a bit of extra time on this point; we use some simple algebra to make the point very clear. Note that we reserve the term marginal propensity to consume for the behavioural relationship between consumption and disposable income; in contrast, the slope of the AE function is the marginal propensity to spend out of national income.

We next add net exports and government purchases to investment and consumption. From this point on, the equilibrium is conceptually identical to the one developed in Chapter 6.

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The chapter’s fourth section examines changes in the equilibrium level of national income.

We begin the section with a clear discussion of why the simple multiplier is reduced by the presence of (induced) imports and income taxes. We then examine the effects of changes in exports, government purchases and tax rates. We have a box discussing realistic values for the multiplier in Canada, and relating this to the type of announcements often made by politicians. This gets us to a brief introduction of fiscal stabilization policy, a theme that we take up in more detail in later chapters.

The chapter closes with a short but important section discussing the limitations of the basic short-run model with a fixed price level. In our experience, too few instructors cover this material; but more should, since otherwise students will not learn that the short-run model of the Keynesian Cross is only applicable in certain situations. We repeat the two central themes—the concept of equilibrium and the multiplier. We also emphasize that the model of demand-determined output is best suited either to a situation in which there are unemployed resources or a situation in which there are price-setting firms who initially respond to demand shocks by changing the level of output, and only later change their prices. This discussion then serves as a transition to the later chapters in which we develop the AD/AS model with an endogenous price level. It may be worth emphasizing that, although a variable price level changes the size of the simple multiplier, the equilibrium condition holds in any macroeconomic equilibrium, no matter how elaborate or complicated the model.

Finally, the short Appendix to the chapter lays out the algebra of a simple, linear version of the macro model. Some instructors make this treatment a central part of their teaching of macroeconomics, and others prefer to stick to graphs and words. Putting the model in the Appendix allows instructors to take either route. At the end of the Appendix the numbers that we have used throughout Chapters 6 and 7 are substituted into the algebra, to show that everything works.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) autonomous b) transfers; transfers c) one dollar (so t=0.3 indicates an average net tax rate of 30 percent) d) disposable income e) deficit; surplus; G-T = 0 or G = T Question 2 a) autonomous; foreign income and international relative prices (including the exchange rate) b) imports; one dollar

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Chapter 7: Adding Government and Trade to the Simple Macro Model 67

c) NX = X – mY; rise; negatively d) rise; down and get steeper; fall; up and get flatter Question 3 a) less b) net tax rate; marginal propensity to import; marginal propensity to spend on domestic output c) taxes; imports d) 1/(1 - z); MPC; MPC(1 - t) – m e) lower; smaller Question 4 a) constant; demand b) constant; requiring higher prices to cover higher costs; demanded; supply

Review Questions Question 5 a) Welfare payments are a transfer; they go directly to individuals and they are not payment for goods or services provided. b) Teachers’ wages and salaries are a purchase of a service. c) Same as (b); the purpose of the education is irrelevant. d) These are purchases of goods and services (provided to users free of charge). e) Same as (d). f) These are transfers; no goods or services are being transacted.

Question 6 This question is important, and is a good one to discuss in class. Students are often confused by the apparent similarity of the national-income-accounting identities and the equilibrium condition. This is because instructors often become lazy in making the important distinction between actual and desired. But this difference is crucial. a) National income is not always at its equilibrium level. If we started at equilibrium and then a shock occurred, the AE function would shift and it would take some real-time adjustment in order to get to the new equilibrium.

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68 Instructor’s Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

b) When measuring national income, we have (from the expenditure approach) Y = Ca + Ia + Ga + NXa, where the “a” subscript denotes actual values. The equilibrium condition, in contrast, is Y = C + I + G + NX where the absence of any subscript is used to denote desired purchases. To illustrate the important difference between desired and actual expenditures, simply consider a level of national income different from the equilibrium level, and explain which components of aggregate expenditure are different from their desired values (we usually think of unintended changes in inventories so that I  Ia when income is not at its equilibrium level).

Question 7 a) The decrease in G shifts AE down in a parallel fashion. Other things being equal, this event leads to a reduction in equilibrium national income. b) The increase in Canadian wheat exports (X) shifts AE up in a parallel fashion. Other things being equal, this event leads to an increase in equilibrium national income. c) The decrease in I shifts AE down in a parallel fashion. Other things being equal, this event leads to a reduction in equilibrium national income. d) The reduction in income-tax rates raises disposable income, and hence desired consumption expenditure, in relation to national income. But there is unlikely to be a change in the autonomous level of desired consumption. As a result, AE rotates upward, becoming steeper. Other things being equal, equilibrium national income rises. e) The import restriction reduces U.S. imports from Canada, and thus reduces Canadian exports (X).

If the reduction in Canadian lumber exports is not replaced by exports to other countries (or by exports of other products), the AE function in Canada shifts down in a parallel fashion. Other things being equal, this event causes Canadian equilibrium national income to fall. f) The booming Chinese economy suggests an increase in Chinese demand for Canadian exports (X).

This shifts the AE function upward in a parallel fashion. Other things being equal, this event will lead to an increase in Canadian equilibrium national income. g) The depreciation of the Canadian dollar (which in this chapter we treat as an exogenous event) leads to a rise in Canadian exports and a fall in the marginal propensity to import. The net export function shifts up due to the change in X and becomes flatter due to the reduction in m. The AE function shifts upward (and flattens out) and the equilibrium level of national income rises. h) The new government spending to build infrastructure (roads, bridges, sewers, etc.) leads to an increase in G, an upward and parallel shift of the AE function, and an increase in the equilibrium level of real national income.

Question 8 a) In general, the two fiscal tools are spending and taxation. In order to stimulate a slumping economy, government could increase government purchases and/or reduce some taxes. b) An increase in government purchases by $5 billion will add directly to aggregate demand by this amount and, through the multiplier effect, lead to an eventual change in national income equal to $5 billion times the simple multiplier.

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Chapter 7: Adding Government and Trade to the Simple Macro Model 69

c) In contrast, a reduction in personal income taxes of $5 billion will add directly to disposable income, only a fraction of which (determined by the MPC) will then be spent. So the initial direct increase in aggregate demand will be $5 billion times the MPC. The eventual effect on national income (after the multiplier effect) will be smaller than in the case of the increase in spending. d) The important difference between (b) and (c) partly explains why governments trying to fight recessions often rely more on temporary increases in spending rather than on tax reductions—as was true in Canada, for example, in the federal budgets of 2009 and 2010, designed in response to the major global recession that began in 2008. The goal is (and was) to maximize the impact on aggregate demand for each dollar of fiscal capacity “used” (that is, either increases in G or reductions in T).

Problems Question 9 a) The government’s budget balance is equal to T–G. If G is $155 billion for any level of national income, the balance is straightforward to compute. The completed table is shown below.

National Income (Y)

Net Tax Revenues (T)

Budget Balance (T–G)

100 200 300 400 500 600 700 800

45 70 95 120 145 170 195 220

–110 –85 –60 –35 –10 15 40 65

b) We are told that T = t0 + t1Y. The net tax rate (t1) is the amount by which net tax revenues rise in response to a rise in national income. In this case, each $100 billion increase in real national income leads to a $25 billion increase in net tax revenues. Thus, the value of t1 is 0.25. Also, since net tax revenues are linearly related to Y, we can see that if Y were zero, net tax revenues would equal $20 billion. So the value of t0 is $20 billion. c) The interpretation of t0 is the level of net tax revenues that would exist if national income were zero. This is value of net tax revenues that are not related to the level of national income. d) The interpretation of t1 is the net tax rate – the amount by which net tax revenues rise as a result of a $1 increase in national income. e) The increase in G by $15 billion means that the budget balance falls by $15 billion at each level of national income.

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Question 10 a) Net exports are equal to exports minus imports. If exports are equal to $300 billion for any level of national income, then net exports are easily computed. The completed table is shown below.

National Income (Y)

Imports (IM)

Net Exports (X – IM)

100 200 300 400 500 600 700 800

85 120 155 190 225 260 295 330

215 180 145 110 75 40 5 –30

b) See the figure below. The net export function is downward sloping because increases in real national income lead to increases in imports (IM) but leave exports (X) unchanged. Thus X – IM falls as real national income rises.

c) We are told that IM = m0 + m1Y. The marginal propensity to import (m1) is the change in imports that results from a $1 change in national income. From the information provided in the table above, for each $100 billion increase in national income, imports increase by $35 billion. Thus, the value of m1 is 0.35. This is the (absolute value of the) slope of the net export function. We can see from the table that imports are linearly related to national income, so if Y were equal to 0, the value of imports would be $50 billion. So the value of m0 is $50 billion. d) The interpretation of m0 is the value of imports that would exist if national income were zero. This is the value of imports that is not related to changes in the value of national income. e) The interpretation of m1 is the change in imports that results from a $1 change in national income.

It is the marginal propensity to import.

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f) Suppose that the net export function applies to Canada, and that one of our major trading partners experiences a recession. In this case, firms and households in that foreign country will demand fewer Canadian goods and services. This foreign recession therefore results in a reduction in Canada’s exports, X. Net exports will decline at any level of Canadian national income. Thus, the net export function will shift down. For example, a reduction in Canadian exports of $20 billion would shift the net export function vertically downward by $20 billion.

Question 11 a) C = 15 + (0.75)YD b) T = (0.2)Y c) YD = Y – T  YD = Y – (0.2)Y  YD = (0.8)Y C = 15 + (0.75)(0.8)Y  C = 15 + (0.6)Y d) C = 15 + (0.75)YD  e) AE = C + I + G  AE = 15 + (0.6)Y + 20 + 30  AE = 65 + (0.6)Y f) The marginal propensity to spend out of national income, z, is the slope of the AE function. From part (e), the AE function for Sunrise Island is AE = 65 + (0.6)Y. In this model, z = 0.6. g) The simple multiplier for Sunrise Island is equal to 1/(1-z) = 1/(1-0.6) = 1/.4 = 2.5.

Question 12 a) The consumption function is: C = c + (MPC)YD YD is the difference between national income and total tax revenues: YD = Y – tY = Y(1 – t) Putting this expression for YD into the consumption function, we get the relationship between consumption and national income: C = c + (MPC)Y(1 – t ) b) The AE function is: AE = c + (MPC)Y(1 – t) + I0 + G0 + (X0 – mY) We can collect all of the autonomous terms together, and collect all of the terms in Y together, to simplify the AE function as: AE = [c + I0 + G0 + X0] + [MPC(1 – t) – m]Y c) The equilibrium condition is Y = AE. Imposing this condition, and using A to be the sum of all the autonomous terms, we get Y = A + [MPC(1 – t) – m]Y d) The equilibrium value of national income is the value that solves the above equation. Call this value YE. The solution is YE = A/(1 – z) Where z = [MPC(1 – t) – m] is the marginal propensity to spend out of national income.

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e) If the level of autonomous spending increases by A, then the equilibrium level of national income rises by 1/(1 – z) times A. 1/(1 – z) is the simple multiplier.

Question 13 a) Desired investment (I) is 50, as shown by the height of the line marked I in the figure. b) Government purchases (G) is 50, shown by the difference between the I and G+I lines in the figure. c) The vertical intercept of the AE function is 150. This is total autonomous expenditure, including consumption, investment, government, and exports. We know that government and investment sum to 100. We are told that autonomous exports are 25. Thus, the level of autonomous consumption must be 25. d) Total autonomous expenditure is 150, the vertical intercept of the AE function. e) A decrease in G by $25 billion will shift the AE function down (in a parallel fashion) by $25 billion. Equilibrium national income will fall by $25 billion times the simple multiplier. f) An increase in the net tax rate rotates the AE function down (and so it becomes flatter) but maintains its vertical intercept. Equilibrium national income will fall. g) An increase in desired investment by $50 billion will shift the AE function up (in a parallel fashion) by $50 billion. Equilibrium national income will rise by $50 billion times the simple multiplier. h) A reduction in the marginal propensity to import will rotate upward the AE function (and so it becomes steeper) while maintaining its vertical intercept. Equilibrium national income will rise.

Question 14 a) Recall that the marginal propensity to spend out of national income is equal to z = MPC(1–t) – m and that the simple multiplier is equal to 1/(1–z).

The values of z and the simple multipliers for the various hypothetical economies are: Economy A: Economy B: Economy C: Economy D:

z = 0.75  (1 – 0.2) – 0.15 = 0.45  Multiplier = 1.82 z = 0.75  (1 – 0.2) – 0.30 = 0.30  Multiplier = 1.43 z = 0.75  (1 – 0.4) – 0.30 = 0.15  Multiplier = 1.18 z = 0.90  (1 – 0.4) – 0.30 = 0.24  Multiplier = 1.32

b) Comparing Economies A and B, we see that the marginal propensity to spend out of national income is higher in the economy with the lower value of m. A lower marginal propensity to import means that each $1 increase in national income leads to a smaller increase in expenditure on imports, and thus a larger increase in expenditure on the output of domestic producers. Thus, the multiplier will be higher when m is smaller. c) Comparing Economies B and C, we see that the economy with the lower income-tax rate has the higher marginal propensity to spend out of national income. Other things equal (like MPC and m), a

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Chapter 7: Adding Government and Trade to the Simple Macro Model 73

lower tax rate means that each $1 increase in national income leads to a larger increase in disposable income and thus a larger increase in desired consumption expenditures. Thus, the multiplier is larger when t is smaller. d) Comparing Economies C and D, we see that the economy with the higher MPC has the higher marginal propensity to spend out of national income. Other things equal (like t and m), a higher MPC means that each $1 increase in national income leads to a larger increase in desired consumption expenditures. Thus, the multiplier is larger when MPC is higher.

Question 15 a) The AE function is: AE = 50 + (0.7)YD + 75 + 100 + (50 − 0.15Y) 

AE = 225 + (0.7)(Y − 0.2Y) + (50 − 0.15Y)



AE = 225 + (0.7)(0.8)Y + (50 − 0.15Y)



AE = 275 + (0.41)Y

See the figure below. Total autonomous expenditure is 275, which is the vertical intercept of the AE function.

b) The slope of the AE function is 0.41, which is the marginal propensity to spend out of national income, z. c) To compute the equilibrium level of national income, use the equilibrium condition: Y = AE

 Y = 275 + (0.41)Y  Y(1 - 0.41) = 275  YE = 275/(0.59) = 466.1 Copyright © 2023 Pearson Canada Inc.

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d) If X rises from 50 to 100, the AE function shifts up by 50. Equilibrium national income rises by 50 times the simple multiplier. Since z = 0.41, the simple multiplier is 1/(1 − 0.41) = 1/0.59 = 1.69. So equilibrium national income rises by 50×1.69 = 84.5 to 550.6. e) The simple multiplier is 1/(1-z) = 1/(1 − 0.41) = 1/.59 = 1.69. *****

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_______________________________________________________ Chapter 8: Real GDP and the Price Level in the Short Run _______________________________________________________ This chapter makes the crucial shift from the Keynesian Cross, which takes the price level as given, to the AD/AS apparatus, where the price level is determined endogenously. We take the time and space needed for deriving the AD curve clearly and honestly, without cutting corners. We emphasize that the AD curve is an equilibrium locus rather than an ordinary demand curve like the ones we use in microeconomics. Our derivation shows clearly that the simple multiplier is embedded within the AD curve, and we think it is important for students to know this. Some other introductory books give a brief and simple explanation for the AD curve rather than an involved one. Our experience suggests, however, that by cutting corners early, the students will just have more difficulties later on. *** The chapter is divided into three sections. In the first section, the AD curve is developed in two steps.

First, the effects of exogenous changes in the price level are studied. The critical relation here is that the AE curve is shifted upward by a fall in the price level and downward by a rise in the price level.

In the text, we rely on two effects to establish this relation. There is the wealth effect, based on the idea that changes in the price level change the private sector’s wealth (held either as cash or bonds denominated in money terms). There is also the external effect, whereby a change in the domestic price level affects net exports (for given exchange rates and foreign prices). A third, and probably more important, effect works through the money market and interest rates; this effect is alluded to but is not fully explained until money is included in the model in Chapter 12.

With the relationship between the price level and the AE curve in hand, the student is then ready for the second step in developing the AD curve. The AD curve shows, for each arbitrarily selected price level, the level of national income at which desired expenditure just equals actual income. (It says nothing about whether producers would want to produce that income, only that if it is produced, purchasers will be willing to buy it.) The negative relation between the price level and equilibrium income gives rise to the negative slope of the AD curve. We have a clear discussion explaining that the AD curve is not downward sloping for the same reason as micro demand curves.

The chapter’s second section introduces the aggregate supply (AS) curve, which we derive as the relationship between the price level and the amount of aggregate output firms wish to supply on the assumption that factor prices and technology are given. We stress that changes in productivity and changes in factor prices—such as wages or raw materials prices—lead to shifts in the AS curve.

We have much more to say about these shifts in the next chapter when discussing the economy’s adjustment toward long-run equilibrium.

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The third section then brings together the AD and AS curves to determine the price level and equilibrium real GDP––what we call “macroeconomic equilibrium”. We then go on to examine the effects of aggregate demand and supply shocks, by which we mean any event that causes a shift in either the AD or the AS curve. When discussing aggregate demand shocks, we explain why the size of the multiplier is reduced by the induced change in the price level (assuming the AS curve is upward sloping). We show that some of the effects of a demand shock will be dissipated by a rise in the price level, thus diminishing the real effects even in the short run. We also make the connection between the special case of the horizontal AS curve and the model from Chapters 6 and 7 in which the price level is held constant.

In this Chapter we give equal billing to AD and AS shocks. We discuss the negative supply shock created by the OPEC cartel in the 1970s; we also discuss the positive supply shock created by the large reduction in raw materials prices following the 1997-98 Asian economic crisis. We have also added a new box using the AD/AS model to analyze the broad outlines of the COVID-19 pandemic—a very unconventional recession!

We close with a brief but important discussion stressing that many real-world shocks involve both aggregate demand and aggregate supply shocks, where the 2014-2015 decline in world oil prices is used as an example. This discussion leads to a box that examines the effect of the 1997-98 Asian crisis on the Canadian economy, which also had both demand-side and supply-side effects.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) exogenous; endogenous b) consumption; net exports c) reduction; reduction; down; increase; increase; up d) fall; down; rise; up e) AD f) AE; AD g) shift up; shift to the right Question 2 a) aggregate supply (AS) b) factor prices; technology Copyright © 2023 Pearson Canada Inc.

Chapter 8: Real GDP and the Price Level in the Short Run 77

c) increases d) excess capacity; unit costs e) capacity; unit costs f) factor prices; technology; shocks Question 3 a) aggregate demand (AD); aggregate supply (AS); real GDP; the price level b) rise; rise; fall; fall c) fall; rise; rise; fall d) smaller e) positive; upward; rightward; rise; downward

Review Questions Question 4 a) The holder of cash experiences a reduction in wealth as a result of an increase in the price level, because the purchasing power of a given amount of cash is reduced. The private sector’s wealth therefore declines, which reduces desired consumption (at any income level) and thus shifts the AE function downward. b) Deposits held in a bank account are assets for the depositors but a liability for the banks. An increase in the price level reduces the real value of these deposits. The depositor’s wealth is decreased but that of the bank (or its owners) is increased. Private sector wealth is unchanged, and the AE function is unaffected. c) A mortgage is a loan from a financial institution to a homeowner where the value of the home is used as collateral for the loan. A rise in the price level means that the homeowner makes payments of reduced real value, and the financial institution receives payments of reduced real value. The homeowner is wealthier, but the owners of the financial institution are less wealthy.

The wealth of the private sector is unchanged, and so the AE function is unaffected. d) The holder of the corporate bond has loaned money to the corporation. The rise in the price level means that the loan repayment (principal and interest) is reduced in real value. The holder of the bond is therefore made less wealthy. The issuer of the bond (the corporation or its owners) is made wealthier. The overall wealth of the private sector is unchanged, and hence the AE function is unaffected.

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e) The holder of the government bond has loaned money to the government. The rise in the price level means that the loan repayment (principal and interest) is reduced in real value. The holder of the bond is therefore made less wealthy, at least this is the direct effect. The issuer of the bond (the government) is made wealthier. The direct effect is therefore to reduce the overall wealth of the private sector, and so the AE function shifts downward.

(Note: There is also an indirect effect. Government debt must eventually be repaid through future taxes. But the increase in the price level that reduces the real value of the government’s outstanding debt means that taxpayers will have to pay fewer taxes in the future compared to what they would have had to pay if the price level had remained constant. Thus, the direct effect to reduce bondholders’ wealth is offset by an indirect effect that raises future taxpayers’ wealth. The net effect of the change in the price level depends crucially on whether the private sector recognizes these future tax liabilities, and on whether today’s bondholders are also future taxpayers. Most empirical evidence suggests that individuals do not fully recognize these changes in future tax liabilities associated with changes in the government debt. Thus, the increase in the price level leads to a reduction in the wealth of today’s holders of government bonds.)

Question 5 a) An increase in Openland’s domestic price level, for a given exchange rate and foreign prices, means that domestic goods have increased in price relative to foreign goods. This will cause domestic and foreign consumers to substitute away from domestic goods toward foreign goods.

The reduction in net exports in Openland caused by the rise in its domestic price level leads to a downward shift in Openland’s AE function and a reduction in its equilibrium national income. b) The argument in part (a) is relevant for Openland but not for Autarkland, for the simple reason that there is no foreign trade in Autarkland. Thus, a rise in the price level leads to a reduction in equilibrium income in Autarkland only for one reason—the reduction in private-sector wealth and thus expenditure. In Openland, both effects are operating. The rise in the price level reduces private-sector wealth and thus desired expenditure, but it also reduces net export expenditure. This explains why Openland has a flatter AD curve than Autarkland—a rise in the price level reduces equilibrium GDP by more in Openland than in Autarkland. c) The answer was already stated in part (b). The AD curve in Autarkland is downward sloping because, even though there is no foreign trade, a rise in the price level still reduces the wealth of the private sector and thus reduces desired expenditure (and thus equilibrium national income).

Question 6 a) An increase in the minimum wage increases costs for the many firms whose workers earn wages at this level. This is a negative AS shock, shifting the AS curve upward and to the left. b) An increase in productivity, with wages held constant, causes a reduction in unit labour costs for firms. This is a positive AS shock, shifting the AS curve downward and to the right.

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Chapter 8: Real GDP and the Price Level in the Short Run 79

c) An increase in demand for Canada’s exports is a positive AD shock, shifting the AD curve to the right. This causes a movement along the AS curve, upward and to the right. d) Advances in AI that reduce costs in all service industries are a positive AS shock, shifting the AS curve downward and to the right. e) The decline in firms’ desired investment is a negative AD shock, shifting the AD curve to the left. This causes a movement along the AS curve, downward and to the left.

Question 7 a) This is the cause of a shift in the AS curve. The rise in the world price of oil leads to an increase in firms’ costs and thus a shift of the AS curve up and to the left. This is a negative aggregate supply shock. Its effect is to reduce equilibrium real GDP and increase the equilibrium price level.

(Note that for countries that are producers of oil, such as Canada, the OPEC shock is also a positive AD shock because the increase in price that foreigners are prepared to pay for our exports is akin to an increase in demand for those exports.) b) The increase in the world prices of commodities in 2002-2008 was a negative supply shock because it increased the prices of inputs for many manufacturing firms in Canada. This is a shift of the AS curve to the left. This had the effect of reducing growth and increasing inflationary pressures. At the same time, the rise in prices for commodities was caused by an increase in the world demand for these goods, many of which are major Canadian exports. So there was also a positive aggregate demand shock for Canada. This had the effect of increasing both GDP growth and inflationary pressures. Because Canada is a net exporter of raw materials, the demand effect dominates—so the net effect should be to increase both growth and inflation. See the box at the end of Chapter 23 for a fuller discussion. c) This is a cause of a leftward shift in the AD curves of the countries that reduced their defence spending. Other things equal, these cuts would reduce equilibrium GDP and the price level. d) The reduction in corporate income-tax rates is a fiscal expansion. This is the cause of a rightward shift in the AD curve (as investment demand is stimulated), with the effect of increasing the equilibrium GDP and the price level. e) The increase in the level of government purchases is a fiscal expansion. This is the cause of a rightward shift in the AD curve, with the effect of increasing the equilibrium GDP and price level. f) The onset of strong recovery in the United States led to an increase in U.S. demand for many Canadian exports. For Canada, this is a positive shock to aggregate demand. Taken alone, this shock tends to increase growth and inflationary pressures in Canada. g) The massive decline in the world price of oil is both an AD and an AS shock for Canada. Since many Canadian firms produce and sell oil on the world market, the decline in price is a negative AD shock for Canada. But since many Canadian firms also use oil as an input to their production processes, the decline in price is a positive AS shock for Canada. The net effect on Canadian GDP Copyright © 2023 Pearson Canada Inc.

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depends on the size of these two effects. But since Canada is a net exporter of oil (and so we produce more than we use), we can conclude that the demand effect outweighs the supply effect, and so the overall effect is to reduce Canadian GDP. h) A reduction in desired investment (in this case caused by an increase in uncertainty) is a clear example of a negative demand shock, shifting the AD curve to the left and, ceteris paribus, causing a decline in equilibrium GDP and a decline in the price level. i) The requirement to close businesses and send workers home during the pandemic is essentially an economy-wide negative supply shock. Even though the economy has the labour and capital and land and technology capable of generating output, the public-health situation mandated that people avoid working in proximity with others, and this effectively reduced the productive capacity of the economy. Taken by itself, this is a negative supply shock, shifting the AS curve to the left and reducing real GDP.

Question 8 a) A horizontal AS curve reflects the fact that firms are prepared to supply any amount of output that is demanded of them without requiring an increase in prices. There are two situations that might lead to this “passive” supply response. The first is when the economy has many unemployed resources, both labour and capital. In this case, firms have excess capacity and they can increase output easily without driving up unit costs. The second situation is where firms are price setters— that is, they have market power in the markets in which they sell their products. Price-setting firms often respond to changes in demand by initially changing their level of output, and only later adjusting their prices. b) An upward sloping AS curve reflects the fact that firms are only prepared to supply more output if prices rise. This is expected in situations where firms can only increase their output by using their existing resources, especially capital, more intensively. The “law” of eventually diminishing returns to the variable factor (usually labour) means that increases in output may only be possible by driving up unit production costs, thus requiring a rise in prices. c) Output is said to be demand determined in Economy A, the one with the horizontal AS curve.

In this economy, the AD curve alone determines the level of equilibrium GDP. d) An increase in autonomous expenditure, ∆Α, leads to a rightward shift of the AD curve. The distance of the shift is exactly equal to the change in autonomous expenditure times the simple multiplier, z. This is true in both economies. In Economy A, the AS curve is horizontal and so equilibrium GDP changes by the full amount of the AD shift. In Economy B, however, the change in equilibrium GDP is less than the full shift because the price level rises. As the price level rises, desired aggregate expenditure is choked off—this is a movement upward and along the new AD curve. Thus, Economy A, the one with demand-determined output, has a larger multiplier than Economy B.

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Chapter 8: Real GDP and the Price Level in the Short Run 81

Problems Question 9 a) The completed table is shown below. Recall that M is constant at 6000.

P

M/P

AE

1 2 3 4 5 6

6000 3000 2000 1500 1200 1000

AE = 950 + 0.8Y AE = 650 + 0.8Y AE = 550 + 0.8Y AE = 500 + 0.8Y AE = 470 + 0.8Y AE = 450 + 0.8Y

b) See the figure below. Note that all of the AE functions have the same slope, 0.8. (The vertical and horizontal scales are not the same in the figure, and so the AE functions do not appear to have a slope of 0.8, but they do!) The various AE functions differ only by their vertical intercept.

For a higher price level, real wealth is lower, and thus the autonomous part of desired expenditure is lower.

c) Equilibrium national income is that level of income where Y = AE. In general form we have Y = AE ⇒ Y = A + 0.8Y ⇒ Y(1 – 0.8) = A ⇒ Y = A/(0.2)

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In the six specific cases we get: P = 1: Y = 950/0.2 = 4750 P = 2: Y = 650/0.2 = 3250 P = 3: Y = 550/0.2 = 2750 P = 4: Y = 500/0.2 = 2500 P = 5: Y = 470/0.2 = 2350 P = 6: Y = 450/0.2 = 2250 Note that each successive increase in the price level has a smaller effect on wealth and equilibrium national income than the previous increase. This may appear odd, but it makes sense. The increase in the price level from 1 to 2 is a 100 percent increase in the price level, and this cuts real wealth in half. In contrast, the increase in the price level from 5 to 6 is an increase of only 20 percent and reduces real wealth by only 16 percent. (See the second column in the table above for how real wealth, M/P, is affected by the changes in P.) d) See the diagram below.

e) The expression for the AE function is: AE = 350 + 0.8Y + 0.1 (M/P) The first term is just the autonomous component of desired aggregate expenditure, including consumption, investment, government purchases, and exports. The second term shows the marginal propensity to spend out of national income. As we saw last chapter, this is a combination of the marginal propensity to consume out of disposable income, the net tax rate, and the marginal propensity to import. The third term is the new element in the AE function. It shows that for a given nominal value of assets (M), a rise in the price level reduces the real value of those assets (M/P) and, through this reduction in wealth, leads to less desired aggregate expenditure.

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Question 10 a) See the diagram below.

b) The macroeconomic equilibrium is where the AD and AS curves intersect. The equilibrium price level is 110; the equilibrium level of real GDP is $900 billion. c) At a price level of 100, firms are prepared to supply an amount of output equal to $825 billion.

The level of desired expenditure is $1000 billion. So there is excess demand in this situation, and the price level will increase (bringing forth more supply and choking back the level of demand). d) At a price level of 120, firms are prepared to supply output of $975 billion, but total desired expenditure is only $800 billion. There is excess supply, which will tend to push the price level down (encouraging demand and choking back supply). e) Suppose real GDP equals $900 billion while potential GDP is $950 billion. Recalling the terms introduced in Chapter 4, this situation is referred to a recessionary output gap.

Question 11 a) The AD curve is given by: YAD = 710 – 30P + 5G This AD curve is entirely conventional. The first term combines the effects of autonomous expenditure such as consumption, investment, and exports. The second term shows that increases in the price level lead to reductions in desired expenditure (due to reductions in wealth). The third term shows separately the effect of government purchases, and shows that an increase in G leads to a rightward shift of the AD curve, which increases output demanded for any level of P.

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b) What is value of the simple multiplier? If we held the price level constant, as in Chapters 6 and 7, the simple multiplier would be given by the amount by which a $1 increase in G increases equilibrium GDP. The coefficient on G in the AD curve is precisely this simple multiplier since a $1 increase in G leads to a rightward shift of the AD curve by $5 (which would equal the increase in equilibrium GDP if the AS curve were horizontal, as is the case with the constant price level in Chapters 6 and 7). c) The AS curve is given by: YAS = 10 + 5P – 2POIL This is also entirely conventional. The amount of output that firms are willing to supply increases when the price level rises. When firms increase output, the law of diminishing returns means that their unit costs are driven up, and so they are only prepared to provide more output at a higher price level. Oil is an important input to the production process for many firms, and so a rise in the price of oil, other things equal, leads to an increase in firms’ costs. This reduces the amount of output that firms are prepared to supply. d) To solve this two-equation system, we equate YAD with YAS. In this way, we are finding the level of Y where the two curves intersect. Doing this, we get: 710 – 30P + 5G = 10 + 5P – 2POIL Now we want to solve this equation for the equilibrium level of P, which will depend on the two exogenous variables, G and POIL. Combining terms and rearranging, we get: 700 + 5G + 2POIL = 35P ⇒ P* = 20 + (0.14)G + (0.06)POIL Now we substitute this value of P* into either the AD or the AS curve to get the equilibrium level of real GDP. Using the AD curve we get: Y* = 710 + 5G – 30[20 + (0.14)G + (0.06)POIL] ⇒

Y* = 710 + 5G – 600 – (4.2)G – (1.8)POIL

⇒

Y* = 110 + (0.8)G – (1.8)POIL

e) What is the effect of a change in G on the level of equilibrium GDP and price level? From the equation for P*, it is clear that a rise in G leads to an increase in the price level. From the equation for Y*, it is clear that a rise in G leads to a rise in real GDP. This is exactly what we would expect from a positive aggregate demand shock when the AS curve is upward sloping. f) What is the effect of a change in POIL? From the equation for P*, it is clear that a rise in POIL leads to an increase in the price level. From the equation for Y*, it is clear that a rise in POIL leads to a fall in real GDP. This is exactly what we would expect from a negative aggregate supply shock when the AD curve is downward sloping. *****

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_______________________________________ Part Four The Economy in the Long Run

________________________________________ This part of the book contains two core theory chapters for analyzing how the economy evolves from its short-run equilibrium to its long-run equilibrium, and also how the economy grows in the long run. Our view is that long-run economic growth should not be considered “extra” material that may be covered after the more “central” topics are covered, or that might be left out altogether by instructors who are pressed for time. Long-run economic growth is a central topic that should be covered in any introductory macroeconomics class; it is just as important for students to understand why real GDP displays ongoing increases over periods of several decades as it is for students to understand the causes of business cycles.

Chapter 9 emphasizes the adjustment of the AS curve to changes in factor prices that are generated by output gaps. This is the adjustment process that moves the economy from a short-run equilibrium to a long-run equilibrium, and introduces the student to the idea that some (temporary) inflation is caused by excess demand. To emphasize this adjustment process, we have a box on the simple Phillips curve in which we stress that the economy’s position along the Phillips curve determines the rate of shift of the AS curve. Chapter 9 also explores fiscal policy in detail, building on the introduction to these issues from Chapter 7. Automatic stabilizers and an introduction to discretionary fiscal policy are introduced. We also have a detailed discussion of fiscal policy and long-run growth, including an explanation of “supply side” economics. Treating fiscal policy in this way, rather than as the topics of separate chapters, allows students to see the basic macroeconomic model put to use from the start. We believe that this treatment streamlines the discussion and makes both the model and its applications more teachable. (Chapter 16 returns to fiscal policy by exploring debt and deficits in detail.)

Chapter 10 then offers a detailed analytical discussion of the process of long-run economic growth. This chapter stresses the main points about the importance of capital accumulation, as well as its opportunity cost. We have an explicit model of loanable funds to illustrate the relationship between investment, saving, and long-run growth. We present data on cross-country investment and growth rates, and discuss the importance of technical change. The modern theories of endogenous growth are also included here, but we have streamlined this discussion slightly.

For those instructors who wish to cover money and monetary policy before long-run growth, it is easy to do so. Simply proceed from Chapter 9 straight to Chapters 11-13. (The skipped Chapter 10 can be covered at any time.) But for those instructors who share our view of the centrality of longrun growth, even at the introductory level, we hope you appreciate the book’s current structure. ***

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______________________________________________ Chapter 9: From the Short Run to the Long Run: The Adjustment of Factor Prices ______________________________________________ This chapter examines the AD/AS apparatus as the adjustment of factor prices to output gaps moves the economy from its short-run equilibrium to its long-run equilibrium, with Y=Y*. The chapter is divided into three sections. The first two sections examine the process of factor-price adjustment and how the economy returns to its long-run equilibrium. The final section adds material on fiscal policy, and generally ties the model together through a number of applications, including the paradox of thrift and a discussion of fiscal policy during the Great Depression.

Note that we make the explicit assumption that we are holding technology, and thus the level of productivity, constant throughout the entire analysis. Thus the key relationship of the chapter is how nominal wages and other factor prices adjust to output gaps with productivity held constant. We therefore describe nominal wages as falling during recessionary output gaps. We alert the students to the empirical fact that nominal wages rarely fall, even when there is a recessionary output gap, because of ongoing productivity growth and inflation. So we emphasize again that in our analysis we are assuming constant productivity and zero expected inflation. *** The chapter’s opening section contains a brief discussion of the various “macro states” that macroeconomists use in their analysesthe short run, the adjustment process, and the long run. In each case we outline the key assumptions made during each state, as well as highlighting the key predictions regarding the sources of changes in real GDP. This is the ideal place for this important discussion; students have just worked through three chapters using a short-run version of the model and are just about to examine the adjustment process and then the details of long-run economic growth.

After this introductory discussion, the chapter examines induced shifts in the AS curve due to changes in factor prices caused by excess demands or supplies in factor markets. The AS curve shifts upward in the face of an inflationary output gap and downward in the face of a recessionary output gap. We emphasize that productivity (technology) is being held constant throughout the analysis, not because it is realistic but because it clarifies the nature of the adjustment process and helps students to focus on the key issues. (In Chapter 10, this assumption is relaxed when we explore long-run economic growth.) We have a discussion and a detailed box on the simple Phillips curve, which is really no more than a simple graphical way of capturing the process of factor-price adjustment in response to output gaps. We emphasize that any point on the Phillips curve determines the rate at which the AS curve is shifting, and we now include Canadian data to show the empirical relationship between output gaps and wage changes over the past few decades. (We briefly mention the idea that changes in inflation expectations will shift the Phillips curve, but delay a detailed treatment until Chapter 14.) We also emphasize the idea that potential output, Y*, acts like an “anchor” for the economy, to which real GDP returns after factor prices have fully adjusted to output gaps caused by AD or AS shocks.

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The chapter’s next section examines the effects of aggregate demand and supply shocks. An important part of this discussion concerns the speed of adjustment of factor prices (and thus the rate at which the AS curve shifts). The core of much continuing debate between New Keynesian and New Classical economists turns on the speed of factor-price adjustment and thus the length of time the economy will remain away from long-run equilibrium. For this reason, we reject the attempts of some textbooks to carry a stable AS curve through most of their treatment. In our experience, students are familiar with the idea of wage costs varying with the state of the economy and are therefore ready to accept the idea that the AS curve will shift when deviations of output from Y* cause factor prices to change. We close the section by briefly examining the nature of the economy’s long-run equilibrium.

The final section introduces discretionary fiscal policy as a stabilization tool, and uses the study of fiscal policy to bring together all of the material on AD/AS analysis, in the long and short run. Much of the effect of fiscal policy, of course, cannot be understood without an understanding of money and interest rates. Thus, we reserve our discussion of budget deficits, crowding out, and the national debt until Chapter 16. Here we introduce the basic idea of using fiscal policy to shift the AD curve. We also discuss the paradox of thrift (noting that it does not exist in the long run) and we discuss the problem of lags in the practical design and execution of fiscal policy. A box discusses the severity of the Great Depression in terms of the drop in output and the rise in unemployment and argues that the fiscal responses at the time—largely contractionary to keep deficits from rising—probably exacerbated the economic situation. The chapter ends with a reminder that the effects of policy in the short run––in stabilizing real GDP around Y*––may be quite different from the effects of policy on the level of Y* itself. This is a theme to which we return in later chapters.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) constant (and exogenous); constant; aggregate demand; aggregate supply b) flexible (and endogenous); output gaps (excess demand or supply in factor markets); constant; “anchor” Question 2 a) inflationary; recessionary b) unit; prices; upward (or to the left) c) unit; prices; downward (or to the right) d) slower; inflationary; wage stickiness

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Question 3 a) positive AD; AD; right; inflationary output; rise; AS; upward; potential; a higher b) negative AD; AD; recessionary; fall; AS; downward; potential; a lower c) negative AS; AS; upward; recessionary; adjustment; recessionary gap d) positive AS; AS; downward; inflationary; rise; AS upward; potential; the initial Question 4 a) potential output (Y*); price level b) potential output c) increase; increase d) investment; AD; increase; investment; potential output Review Questions Question 5 a) In Economy A, the short-run equilibrium level of real GDP is greater than potential GDP, Y*. The only way firms can produce more than Y* is to work their factors of production more intensively.

Workers work longer shifts or overtime. Capital is used for longer periods before being maintained.

Land is used more intensively. This means that factor markets are in excess demand, and this excess demand puts upward pressure on factor prices. As factor prices rise, firms’ unit costs start to increase. b) As firms’ unit costs start to rise in Economy A, the AS curve starts to shift upward and to the left. This shift indicates that firms are only prepared to supply the same level of output at higher prices (to offset their higher costs). As the AS curve shifts up, the equilibrium level of GDP falls and the equilibrium price level rises. This process continues until Y = Y*, at which point factor markets are clearing and factor prices stop rising. c) In Economy B, the short-run equilibrium level of real GDP is less than potential GDP, Y*. Firms produce less than Y* by working their factors of production less intensively than normal. Workers are laid off or work short shifts. Some capital equipment is idle. Some land is unused. This means that factor markets are in excess supply, and this excess supply puts downward pressure on factor prices. As factor prices fall, firms’ unit costs start to decrease. d) As firms’ unit costs start to fall in Economy B, the AS curve starts to shift downward and to the right. This shift indicates that firms are prepared to supply the same level of output at lower prices (because their costs have fallen). As the AS curve shifts down, the equilibrium level of GDP rises and the equilibrium price level falls. This process continues until Y = Y*, at which point factor markets have cleared and factor prices are stable.

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Question 6 a) See the figure below. The diagram shows the equilibrium at Y* and P0, as determined by the curves AD0 and AS0. This economy is in long-run equilibrium because Y = Y* and thus there is no pressure on factor prices to either rise or fall.

b) The reduction in the world’s demand for this country’s goods is a reduction in autonomous expenditure. This is a negative aggregate demand shock, with the AD curve shifting to the left to AD1. Real GDP falls to Y1 and the price level falls to P1. c) At Y1, there is a recessionary output gap. Factors of production are used less intensively than normal, and so there is excess supply of factors. This excess supply forces factor prices to fall, thereby reducing firms’ costs and shifting the AS curve downward and to the right. The AS curve shifts eventually to AS1, although due to sticky wages this adjustment may take quite a while. Real GDP eventually returns to Y* and the price level stabilizes at P2. d) If wages fall only slowly in response to excess supply, then the adjustment back to Y* will be very slow. This means output will be below potential and unemployment will be above the natural rate (or NAIRU) for an extended period of time. An alternative to waiting for this natural (and slow) adjustment process is to shift the AD curve to the right through the use of an expansionary fiscal policy. In this way, output can be returned to Y* more quickly. If wages were not sticky downwards, the adjustment would be quick and there would be less of a role for such fiscal stabilization policy.

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Question 7 a) See the figure below. The diagram shows the equilibrium at Y* and P0, as determined by the curves AD0 and AS0. This economy is in long-run equilibrium because Y = Y* and thus there is no pressure on factor prices to either rise or fall.

b) The reduction in the world price of raw materials (iron ore) is a positive supply shock. (Since the country is not assumed to produce iron ore, there is no demand shock.) The reduction in the price of iron ore reduces unit costs for firms that use iron ore as an input. The AS curve shifts to the right to AS1. Real GDP rises to Y1 and the price level falls to P1. c) At Y1, there is an inflationary output gap. Factors of production are used more intensively than normal, and so there is excess demand for factors. This excess demand forces factor prices to rise, thereby increasing firms’ costs and shifting the AS curve upward and to the left, reversing the initial shift. The AS curve eventually shifts back to AS0, where output has returned to Y* and the price level has returned to P0. (Note, however, that the rise in wages means that real wages are higher in the new long-run equilibrium than was the case in the initial long-run equilibrium.) d) If factor prices respond quickly to the inflationary gap, then output will return relatively quickly to Y*. In this case there is not a strong case for a fiscal contraction. If factor prices are slow in responding, there is more of a role for fiscal policy.

Question 8 Consider personal and corporate income taxes separately.

Personal income-tax cuts can produce both a demand-side and supply-side stimulus. By increasing households’ disposable income (for any given level of Y), the tax cut will increase desired consumption and shift the AD curve to the right. One possible problem is that if the tax cut is viewed to be temporary, households may not increase their desired consumption because they expect that taxes will rise again in the near future. On the supply side, a cut in personal income-tax rates increases the return to working (as opposed to leisure) and thus may increase the overall supply of labour. (By reducing real wages, this would shift the AS curve to the right.) There is some debate about how large this effect might be and also about how long it would take to fully take effect.

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Reductions in corporate income-tax cuts can also generate both demand-side and supply-side effects.

By increasing the productivity of new investment, the tax cuts can stimulate firms’ investment demand and thus provide a boost to aggregate demand – a rightward shift of the AD curve.

Reductions in corporate taxes also have the effect of reducing firms’ costs and thus lead them to supply more output at any given price level – a positive aggregate supply shock.

Question 9 a) Other things being equal, a smaller simple multiplier implies a steeper AD curve; a larger simple multiplier implies a flatter AD curve. For a larger simple multiplier, any given exogenous change in the price level (which causes a shift of the AE curve) will cause a larger change in equilibrium GDP, and thus imply a flatter AD curve. b) In the presence of any given AS shock, it should be clear that the short-run effect on equilibrium GDP will be smaller when the AD curve is steeper. And we know from (a) that the steeper AD curve occurs when the simple multiplier is smaller. Thus, the smaller is the simple multiplier, the steeper is the AD curve and thus the more stable is real GDP in response to AS shocks. c) For any given change in autonomous desired expenditure, such as desired consumption or desired investment, the size of the horizontal shift in the AD curve is given by the change in autonomous spending times the simple multiplier. (With an unchanged price level, this shift is the full change in equilibrium GDP from the simple model in Chapters 6 and 7.) d) For any given positively sloped AS curve, a larger horizontal shift in the AD curve leads to a larger change in equilibrium GDP. From (c), we therefore know that for any given change in autonomous desired expenditure, a smaller simple multiplier implies a smaller AD shift and thus more stable real GDP. e) A smaller simple multiplier implies more stable real GDP in response to either AD or AS shocks.

Decreases in MPC, increases in t, and increases in m all lead to a smaller simple multiplier, and thus to greater output stability.

Question 10 a) Yes, assuming that the number of unemployed workers eligible for EI benefits varies negatively with real GDP (as it generally does). b) No—the reverse is true. Expenditures fixed in nominal (dollar) terms are a built-in stabilizer in times of rising price levels, since it leads to reductions in spending that tend to slow down the inflationary forces. In contrast, cost-of-living escalators (which raise nominal pay-outs when prices are rising) will act to destabilize those inflationary forces. c) Yes, particularly if the income-tax system is progressive. Increases in real GDP will lead to increases in taxes paid which act to dampen the income-induced increase in spending. Review the material in Chapter 7 for more details. d) One supposes that this will be a built-in stabilizer substituting production of university education for transfer payments of welfare. But many might merely postpone university in order to get a “free ride” 10 years later.

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Question 11 a) Following the increase in G, the AD curve shifts to AD1 and the short-run equilibrium moves to point B. Real GDP and the price level have both increased. b) At point B there is an inflationary gap, with Y > Y*. Excess demand for factors puts upward pressure on factor prices. The AS curve shifts upward, taking real GDP back to Y* and increasing the price level further to P2. Point C is the new long-run equilibrium. c) Compare points A and C. The higher price level at C (for a constant exchange rate and foreign prices) has led to a reduction in net exports as compared with point A. In addition, by reducing private-sector wealth (real value of money and bonds), the higher price level has also led to a reduction in consumption. (Interest rates are also higher at point C, leading to a reduction in consumption and investment, but we will not cover interest rates in detail until Chapter 12.) Thus, the increase in G has pushed up the price level and “crowded out” some private expenditure (exports and consumption). There has therefore been a change in the composition of (an unchanged amount of) real GDP – more G but less C and NX. d) The analysis is essentially the same, except the effect on the composition of GDP is quite different. Suppose for simplicity that the government reduces personal income tax rates. a) With a reduction in the personal income-tax rate, the AD curve shifts to the right, leading to an increase in equilibrium GDP and the price level. b) An inflationary gap is created, and the excess demand in factor markets put upward pressure on wages and other factor prices. The increase in unit costs leads to an upward shift in the AS curve, which moves the economy from point B to point C. c) In the new long-run equilibrium at point C, the level of G is unchanged. For given value of Y*, this implies that C + I + NX is also unchanged. NX is lower because of the rise in the domestic price level (and I is lower because of the higher interest rate, as we will see in Chapter 12). So the tax reduction has increased aggregate consumption more than enough to offset the decline due to the higher price level. So in the new long-run equilibrium, the rise in C exactly offsets the decline in NX and I. Another important possibility worth mentioning is that the value of Y* might be affected by the change in fiscal policy, and this would change the extent of crowding out. But here we need to know more details. If the reduction in tax rates stimulates more work effort or increases the productivity of private capital, potential GDP is likely to rise. In this case, the extent of crowding out will fall (because point C will occur at a level of potential output that is greater than its initial level). This is also possible with an increase in government purchases, especially if the government spends more on the kind of infrastructure that is likely to increase the productivity of private capital.

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Problems Question 12 a) The output gap is simply Y – Y*, where in this case Y* is $800 billion. See the completed table below.

Situation

A B C D E F G H

Output Gap

Rate of Wage Change

AS curve Shift?

–25 –15 –5 0 5 15 25 35

–2.0% –1.2% –0.2% 0.0% 1.0% 2.4% 4.0% 5.8%

Down Down Down No shift Up Up Up Up

b) When Y > Y*, firms use factors more intensively than normal and so factor markets are in a state of excess demand. This pushes wages and other factor prices up. When Y < Y*, firms use factors less intensively and so factor markets are in a state of excess supply. This excess supply pushes wages and other factor prices down. c) A rise in factor prices increases firms’ costs and thus shifts the AS curve upward. A fall in factor prices reduces firms’ costs and thus shifts the AS curve downward. See the completed table above. d) See the figure below. Though the Phillips curve is not as smooth as the ones shown in the text, note that an inflationary output gap of $25 billion leads wages to rise (point G) by more than a recessionary output gap of the same size, which leads wages to fall (point A).

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Question 13 a) The output gap is equal to the difference between actual GDP and potential GDP, expressed as a percentage of potential GDP: (Y – Y*)/Y*. The missing values in the table are: Economy 1:

Output gap = (10 050 – 9100)/9100 = 950/9100 = 10.4%

Economy 2:

Output gap = (70 000 – 77 000)/77 000 = –7000/77 000 = –9.1%

Economy 3:

Output gap = (115 000 – 130 000)/130 000 = –15 000/130 000 = –11.5%

Economy 4:

Output gap = (4000 – 3700)/3700 = 300/3700 = 8.1%

Economy 5:

Output gap = (50 000 – 50 000)/50 000 = 0/50 000 = 0.0%

Economies 1 and 4 have inflationary (positive) output gaps. Economies 2 and 3 have recessionary (negative) output gaps. Only Economy 5 has no output gap because actual GDP is exactly equal to potential GDP. (Note that the first four output gaps are very large by the standards of those typically experienced in modern developed economies. An output gap of 2-4% (either positive or negative) is usually considered quite significant.) b) Unused capacity refers to labour or capital or land that could be used to produce goods and services but instead is idle or not employed. This occurs during recessionary gaps; the idle factors of production are the reason why actual GDP is below its potential level. Economies 2 and 3 have lots of unused productive capacity. c) When actual GDP is above potential GDP, factors of production are being used more intensively than is normal. This usually means that there is excess demand for the factors of production.

Economies 1 and 4 have lots of excess factor demand. d) Other things being equal, nominal wages (and other factor prices) will tend to rise when there is excess demand for factors of production (a positive output gap) and they will tend to fall when there is excess supply in factor markets (a negative output gap). In addition, nominal wages tend to rise faster with a positive X% output gap than they tend to fall with a negative X% output gap.

Economies 1 and 4 have excess demand and thus have rising nominal wages; Economies 2 and 3 have excess supply of factors and thus we see nominal wages falling, but only slowly. e) With productivity being held constant, unit labour costs will rise when nominal wages are rising, and they will fall when nominal wages are falling. So unit labour costs are rising in Economies 1 and 4 and they are falling in Economies 2 and 3.

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Question 14 a) The simple multiplier is equal to 1/(1-z) where z = MPC(1-t)-m.

Economy A: z = (0.84)(0.85) – 0.19 = 0.524  Simple multiplier = 2.1 Economy B: z = (0.84)(0.60) – 0.19 = 0.314  Simple multiplier = 1.46 Economy C: z = (0.93)(0.85) – 0.12 = 0.671  Simple multiplier = 3.04 Economy D: z = (0.75)(0.70) – 0.27 = 0.255  Simple multiplier = 1.34 Economy E: z = (0.75)(0.90) – 0.30 = 0.375  Simple multiplier = 1.6 b) For a given AD shock, the AD curve will shift more when the simple multiplier is larger. So the economy that experiences the largest swings in GDP following AD shocks is Economy C, whereas the one with the smallest swings is Economy D. c) For a given AD shock, the simple multiplier determines the size of the horizontal shift of the AD curve. But the short-run change in real GDP depends on this shift and also the steepness of the AS curve. The steeper the AS curve, the smaller the change in GDP. d) Economies A and B differ by the net tax rate. Economy B has a higher tax rate, and this leads to a smaller simple multiplier. It follows that, in response to AD shocks, there is more automatic stabilization in Economy B than in Economy A. e) For a given shift of the AD curve, the short-run change in real GDP depends on the steepness of the AS curve. The steeper the AS curve, the smaller the change in GDP. *****

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______________________________________ Chapter 10: Long-Run Economic Growth ______________________________________ Our view is that long-run economic growth is the single most important contributor to rising average material living standards, and that growth performance will be a matter of continuing concern well into the 21st century. We hope most instructors will choose to teach this chapter and emphasize to their students the importance of long-run growth. In our treatment, we have tried not only to reflect the ongoing interest in macro growth models but also the less-well-known wealth of research on microeconomic behaviour with respect to growth-creating innovation. *** The chapter is divided into four sections. In the first section, we examine the nature of economic growth and explore some of its costs and benefits. We make a number of fundamental points. First, although much focus in macroeconomics (and in the previous four chapters) is directed at shifts in the AD and AS curves, long-run growth is really all about the growth of potential output, Y*. Second, even small changes in growth rates can have an enormous impact on the level of GDP (or per capita GDP) after several years. Third, there are significant opportunity costs of growth and also social costs, the latter arising from the displacement of firms and workers that often accompany the development of new technologies. The discussion of the costs associated with growth leads to a box that presents the modern case against continued economic growth in the developed economies (and relates to the chapter’s final section on the limits to growth). We conclude the section by noting that growth in real GDP is due to growth in the labour force, growth in human or physical capital, and growth in the level of technology. The various theories of growth that we examine in the chapter focus on one or more of these fundamental determinants of growth.

The second section examines the various well-established theories of long-run growth. We begin by examining the relationship between saving, investment and growth, and stressing the different short-run and long-run relationships. We present a loanable-funds model of the economy in the long run (with Y = Y*) to show how saving and investment are related. We also show some international cross-section data that confirm the strong relationship between investment and growth.

We then go on to develop Neoclassical growth theory, using the idea of an aggregate production function to frame the discussion. We make the important distinction between growth due to greater factor inputs and growth due to technological improvement, the latter permitting sustained increases in average material living standards as measured by per capita real GDP. We also discuss why technological change is difficult to measure, and why Solow’s method very likely understates the extent of technical change. The overall discussion of the importance of technical change leads to an historical box that explains why workers often fear technological change even though over the course of history it has probably created far more jobs than it has destroyed.

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The chapter’s next section examines more recent theories of economic growth––those theories based on endogenous technical change and on increasing returns. We briefly review a sample of the voluminous work on the microeconomic aspects of endogenous technological change that is not as widely known in North America as it probably should be.

The chapter’s final section examines whether there are limits to growth and discusses the importance of resource exhaustion and pollution. It is important for students to be aware of these challenges faced by modern economies, and how technological change may be able to deal with at least some of them. This sections ends with a box on the economic challenges associated with climate change and how this relates to ongoing economic growth.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) long-run economic growth b) per capita GDP c) consumption; output and consumption d) the four sources of growth are: •

labour-force growth

•

growth in physical capital

•

growth in human capital

•

technological improvement

Question 2 a) increase; consumption b) decrease c) investment; saving d) real interest rate; investment (or saving) e) investment; potential output

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Question 3 a) diminishing b) increases; decreases c) embodied d) endogenous; increasing e) diminishing; technology; technological change Review Questions Question 4 a) See the figure below. The opportunity cost for achieving the higher rate of growth is the consumption that must be given up in order to save more (which then finances the greater capital accumulation). b) The opportunity cost in this case is, in general terms, the same as in (a). In order to spend more on research and development (R&D) the level of consumption must be reduced. This reduction in consumption is the opportunity cost. We are unable to compare the size of the opportunity cost in the two cases, however, until we know more about how successful the R&D expenditures are in yielding more useful technologies.

c) The breakeven point is where the new growth path not only raises consumption to where it would have been on the old path but also “pays back” the forgone consumption. At point t*, the level of consumption on the new growth path is where it would have been had we remained on the old path.

But this is not the breakeven point, since at this point the old path would still have delivered more (cumulative) output. By t**, however, the extra consumption in area B is just large enough to make up for the reduction in area A. Therefore, t** is the breakeven point.

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Question 5 a) In each case below, the likely effect of the proposed policy would be to increase growth, but this in itself does not make the policy desirable — the policy may also introduce distortions that are undesirable.

To increase labour input: An increase in the permissible level of immigration would almost certainly increase the labour force and, at least in the long run, increase economic growth.

To increase capital accumulation: Reduced corporate taxation or the provision of investment tax credits would likely stimulate investment and lead to a larger capital stock.

To increase human capital: A policy to subsidize either general education or occupation-specific training would encourage the accumulation of human capital.

To increase the level of technology: This is more difficult, since we don’t really know where greater technology comes from. But policies to subsidize research and development (R&D) activities would stimulate R&D and thus be likely to lead to technological improvements. b) What are the costs of these policies? The costs of increasing the inflow of immigration depend to a large extent on how well these immigrants get integrated into the domestic economy, and whether governments need to spend real resources to aid in this integration. The other three policies all involve the spending of real resources, and thus involve obvious opportunity costs. c) Which policy dominates in terms of having the lowest cost-benefit ratio? Since some of the knowledge produced by more R&D is a public good (although some may be patentable and thus would be a private good, at least for a while), it is likely that the benefits from subsidizing R&D would dominate the other policies. The costs are tougher to estimate.

Question 6 a) See the diagram below. The national saving (NS) curve is upward sloping because a rise in the real interest rate leads households to reduce their current desired consumption. Since NS = Y* – C – G, a reduction in C is a rise in national saving. The investment demand (I) curve is downward sloping because a reduction in the real interest rate causes firms to increase their desired level of investment. b) A reduction in government purchases, G, leads to an increase in national saving at any given level of the interest rate. Thus, the NS curve shifts to the right, to NS1. At the initial interest rate, there is an excess supply of financial capital that reduces the equilibrium interest rate to r1*. At the lower interest rate, firms increase their desired investment to I1. The greater amount of investment means that capital is accumulating faster, thereby leading to a higher long-run growth rate of potential output.

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c) Recall that NS = (Y − T − C) + (T− G) = Y− C − G. An increase in (personal) taxes will lead to a reduction in disposable income and thus likely to a reduction in household consumption. But the negative effect of the increase in T on disposable income exactly offsets the positive effect on public saving. So the overall effect on national saving is determined by the effect on C. As C falls, national saving rises. If NS shifts to the right, then the same qualitative analysis applies as for part (b).

Question 7 a) The government could encourage national saving in several ways. First, it might reduce the level of government purchases, thus directly increasing public and national saving. Second, it could raise taxes, thereby likely reducing private saving but increasing public saving by more. Third, it could encourage more private saving through special tax-assisted saving accounts, such as RRSPs and TFSAs. In this case, however, one result of the policy would be to reduce government tax revenue and thus reduce public saving. So this approach will only lead to an increase in national saving if the increase in private saving more than offsets the decline in public saving. Any policy that resulted in an increase in national saving would shift the NS curve to the right (in the market for financial capital) and lead to a reduction in the equilibrium interest rate. The lower interest rate would encourage firms to increase their desired investment. The higher flow of investment implies a faster rate of capital accumulation which would likely lead to an increase in the growth rate of Y*. See part (a) of the figure below.

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b) See part (b) of the figure above. The government could encourage investment most easily through special tax treatment that makes investment more profitable for firms. An investment-tax credit is one example, whereby firms that make new investments receive a credit on their taxes for doing so. A general reduction in the corporate income-tax rate is another. An increase in desired investment (at any interest rate) will shift the I curve to the right and lead to an increase in the equilibrium interest rate. As the interest rate rises, the quantity of national saving will rise. The greater flow of investment implies a faster rate of capital accumulation which would likely lead to an increase in the growth rate of Y*. c) There is no simple rule of thumb for describing the relationship between the actual flow of investment and the interest rate. Other things being equal, firms’ desired investment will fall when interest rates risethis is simply the statement that the I curve is downward sloping. But the interest rate is determined endogenously in equilibrium, and its changes can be caused by shifts in either the I curve or the NS curve. The situations in (a) and (b) both have the equilibrium flow of investment rising, but the interest rate is moving in different directions in the two settings.

Question 8 a) Other things being equal (including the amount of known oil reserves), increases in population and real incomes should increase the demand for oil and, for a given global supply curve, cause a continual increase in its price. b) As the price rises, users of the resource are led to substitute away from the resource toward available substitutes. c) Part of the process of substitution away from a higher-price resource involves developing production methods that do not require the resource, or perhaps use less of that resource. These developments are technological improvements. Thus, part of the reason for technical change is as an endogenous response to the changing business environment.

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Question 9 The costs and benefits of growth are discussed in the chapter’s opening section, and the box called “A Case Against Economic Growth” offers a summary of the modern case against continued growth in the developed economies. The two key benefits of growth are: -

rising average material living standards

-

greater ability to redistribute income toward low-income persons

The key costs associated with economic growth are: -

depletion of natural resources associated with growth

-

environmental degradation associated with growth

-

social disruption associated with the process of “creative destruction” that typically accompanies economic growth

Of course, given his stated position, Dr. Suzuki emphasizes the costs of growth and pays scant attention to the benefits, and hence the real question of whether the benefits are worth the costs is not addressed in the quote.

Government policies that might improve overall welfare might include better policies designed to protect the environment and policies that assist workers in moving between sectors.

More extreme and contentious policies would include ones aimed directly at reducing the rate of economic growth, such as very high corporate tax rates or restrictions on the number of hours worked per week.

Problems Question 10 a) See the completed table below. If g is the annual growth rate, in each case the value in the cell is given by 100 × (1+g)N where N is the number of years.

Year

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

0 1 3 5 10 20 30 50

100 101.0 103.03 105.10 110.46 122.02 134.78 164.46

100 101.5 104.57 107.73 116.05 134.69 156.31 210.52

100 102.0 106.12 110.41 121.90 148.59 181.14 269.16

100 102.5 107.69 113.14 128.01 163.86 209.76 343.71

100 103.0 109.27 115.93 134.39 180.61 242.73 438.39

100 103.5 110.87 118.77 141.06 198.98 280.68 558.49

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b) See the table above. c) In the 3% growth case, real GDP in year 20 is 180.61. In the 1.5% growth case, it is 134.69. It is 34.1 percent larger in the 3% growth case than in the 1.5% growth case ((180.61 − 134.69)/134.69 = 34.1 percent). d) In the 3% growth case, real GDP in year 50 is 438.39. In the 1.5% growth case, it is 210.52. It is 108.2 percent larger in the 3% growth case than in the 1.5% growth case ((438.39 − 210.52)/210.52 = 108.2 percent).

Question 11 a) Private saving is equal to national income minus taxes minus desired consumption, Y* − T – C. In this case it is equal to 950 – 125 – 800 = 25. b) Public saving is equal to the government budget surplus, T – G. In this case it is 125 – 140 = − 15. c) National saving is equal to private plus public saving, which in this case is equal to 25 – 15 = 10. d) The interest rate is at its equilibrium level when desired saving equals desired investment. In this case, desired national saving equals 10 and desired investment equals 10, so the interest rate (not shown) is at its equilibrium level.

Question 12 a) See the completed table below.

Labour (L)

Capital (K)

Technology (T)

Real GDP (Y)

10 15 20 25

20 20 20 20

1 1 1 1

Y = 14.14 Y = 17.32 Y = 20.00 Y = 22.36

10 15 20 25

20 30 40 50

1 1 1 1

Y = 14.14 Y = 21.21 Y = 28.28 Y = 35.36

20 20 20 20

20 20 20 20

1 3 4 5

Y = 20.00 Y = 60.00 Y = 80.00 Y = 100.00

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b) The first four rows of the table display the diminishing marginal returns to labour. Each successive increase in L, with K and T fixed, yields smaller and smaller increments to output. c) The second four rows of the table show that the production function displays constant returns to scale. From one row to the next, the percentage change in K and L, with T held constant, is equal to the percentage change in output. d) The last four rows of the table show growth in output due to technological change. Such technological change is often described as a shift in the production function that relates measurable inputs (K and L) and output. *****

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_______________________________________ Part Five Money, Banking, and Monetary Policy

_______________________________________ This part of the book deals with money, its role in the economy, and how the Bank of Canada conducts its monetary policy. It can be thought of as completing the short-run macro model set out and developed in Part 3. A key part of this completion is the development of the links between the monetary and real sectors of the economy, which we summarize in Chapter 12 under the generic term the transmission mechanism. After first discussing the nature of money, we then describe in detail the empirically most important reason for the negative slope of the AD curve: that a rise in the price level reduces the real supply of money, pushes up interest rates, reduces desired investment expenditures, and thus reduces equilibrium national income.

Many issues must be understood in order for the student to have a good grasp of money’s role in the economy, and this complicates how the topics are ordered over these three chapters. We begin by talking about the banking system and about the process of money creation (Chapter 11).

We then talk about money demand and money supply and the determination of interest rates (Chapter 12). But throughout these discussions, we only allude to the real role of the Bank of Canada. In Chapter 13, however, with the basics of the money market solidly in place, we then talk in detail about how the Bank’s actions affect the money market and thus the real economy. After several editions, we feel this is the best order in which to present the material. We understand that it takes three chapters to get to the interesting policy discussions, and that some instructors would rather get more quickly to these issues, but we are convinced that students will better appreciate the policy debates with this ordering rather than if the topics were rearranged. *** Chapter 11 begins with a brief historical discussion of the evolution of money. This gets us to the concept of deposit money. All of the institutional material, whether about central banks or the commercial banking system, is presented together in this chapter. We then explore in detail how deposit money is created by the commercial banking system, and we have a boxed discussion of whether cryptocurrencies should be considered money (spoiler alert: not yet!).

Chapter 12 is the crucial theoretical chapter. Half of the chapter is devoted to understanding financial assets and developing the demand for money. The second half then discusses the nature of monetary equilibrium and the determination of interest rates. We examine how changes in money demand or money supply are linked to expenditure flows. We also discuss the conditions under which the monetary transmission mechanism breaks down and causes monetary policy to lose its effectiveness in affecting national income.

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Chapter 13 is the central policy chapter and presents an up-to-date treatment about how the Bank of Canada conducts its monetary policy. We begin by explaining why the Bank chooses to target the (overnight) interest rate rather than some measure of the money supply. We then discuss the motivation for inflation targeting, and how the Bank needs to monitor real GDP (and the output gap) in the short run as part of this targeting exercise. We discuss some important technical difficulties in the conduct of an inflation-targeting regime, and conclude the chapter by reviewing some recent policy challenges faced by the Bank of Canada. We encourage you to spend some time discussing these issues of real-world monetary policy—examining recent policy is an excellent way of driving home some of the theoretical principles discussed in the previous two chapters.

With these three chapters under their belts, students are ready for Part 6 of the book, where recurring macro policy issues are discussed in detail––inflation and disinflation, unemployment fluctuations and the NAIRU, and government budget deficits and debt.

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_______________________________ Chapter 11: Money and Banking _______________________________ The first section of this chapter deals with the nature of money and how it has evolved through history. We have a current boxed discussion of whether cryptocurrencies should be considered money, and an historical box discussing the erosion of money’s usefulness during hyperinflation.

Students find this material easy reading, interesting, and a bit of a relief from the sustained bout of theoretical and applied work in the previous few chapters. We find that many of our students come to us with some major misconceptions about money. (For example, money can retain its value only if it is backed by gold or something equally tangible.) This section is designed to inoculate students against the many myths and monetary cranks to which they will be exposed in everyday life.

The second section examines the Canadian banking system. In our discussion of the banking system, we focus on the general functions of the Bank of Canada and the motives of commercial banks. We note that commercial banks hold some amount of reserves even though they are not legally required to do so. We also discuss the crucial role that commercial banks play in the provision of credit as intermediaries, and how this function was significantly disrupted during the 2008 global financial crisis. We have a boxed discussion about confidence and risk in the banking system, which also describes some regulations applying to the banking sector.

With the institutional setting in place, we then go on to examine the process of money creation by the banking system. Our treatment of this process begins by considering a single “new” deposit to one bank in a multi-bank system. (We are very clear about what we mean by a new deposit––an immigrant with cash to deposit, the deposit of cash previously stashed below the mattress, or the deposit created after an open-market purchase of bonds by the Bank of Canada.)

With many banks in the system, cash drains from one bank to another cannot be ignored, although for simplicity we first assume that the banking system as a whole does not experience any cash drain.

At the end of the section we relax this assumption by allowing cash drains to the banking system.

This discussion helps students recognize that there is not a rigid multiplier linking increases in bank reserves to a precise increase in deposit money. Although one can obviously compute an average “money multiplier” at any given time, it is certainly not constant over time.

The final section examines the various definitions of the money supply. This section is intended to give some idea of the richness of monetary assets in the world, and to show that the concept of money is not unambiguous in its real-world application.

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Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) medium of exchange; unit of account; store of value b) unit of account; store of value c) fiat money d) banker to commercial banks; banker to federal government; regulator of money supply e) fractional; target reserve Question 2 a) new; expand deposits and loans b) 50; 950 c) increase; 20; $20,000 d) withdrawal; contract deposits and loans e) below; $19,000 Question 3 a) deposits b) cash c) currency; bank deposits d) medium of exchange; near money e) store of value; money substitute

Review Questions Question 4 Using M for medium of exchange, V for store of value, and A for unit of account, we would classify as follows: a) M, A, and V although its effectiveness drops during inflation. It is money in anyone’s definition.

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b) M only. Credit cards are a money substitute but money must eventually be used to settle the account. c) V, but neither M nor A. A painting is not money, although it can be converted into money by selling it (like most goods and assets). The ease with which it can be converted into money depends on the demand for the specific painting. d) V and M (at least, to the extent that transferability is permitted). A bank savings deposit is very close to money, if not money itself. e) Certainly V. A characteristic near money. Notice that its value will change if interest rates change, but the short period to redemption assures that the change in value will be small. Not really M, but a well-developed market makes it almost as liquid as a savings deposit. f) It is V to the extent that Canadian Tire stock retains its value in the stock market. Not A and not M. Not money, but a relatively liquid asset. g) It is M only inside Canadian Tire stores. It is V only to the extent that Canadian Tire continues honouring these bills, though its value declines as prices (within the store) rise. It is not Athe unit of account within Canadian Tire stores is the Canadian dollar, not Canadian Tire money.

Question 5 This exercise can be very instructive and not too time-consuming. The relative rates of return between January 2020 and January 2021 are (approximately) as follows: a) The value of the Canadian dollar (in terms of the U.S. dollar) increased by about 1.3 percent from January 2020 to January 2021, from about 77 U.S. cents to 78 U.S. cents. b) The S&P/TSX index increased from approximately 17,600 to 17,900 in this one-year period, an increase of roughly 1.7 percent (although it plunged by about 30 percent in March 2020 and then quickly recovered). c) The price of most Canadian government bonds increased slightly during this period as market interest rates gradually declined. d) The price of gold increased during this one-year period, from roughly $1560 (USD) per ounce to $1840 (USD) per ounce, an increase of about 18 percent. e) According to the Teranet-National Bank House Price Index, the average price of houses in Canada increased by just under 10 percent between January 2020 and January 2021, although the rates of increase were quite different in different regions of the country.

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Question 6 Commercial banks may at times choose to “hoard cash” rather than lend it to borrowers because hoarding cash may be the safer investment. During the financial crisis of 2008, and also in the few years that followed, not only was there concern regarding the credit-worthiness of many (especially corporate) borrowers, but many firms and households chose to reduce their demand for credit because of the quickly slowing economy. In such a setting, it is not unusual for commercial banks to choose the very safe option of “hoarding” cash reserves, and therefore doing less lending than would normally be the case. For a given amount of cash reserves in the banking system, less lending implies a lower money supply, where by money supply we mean one of the monetary aggregates that includes firms’ and households’ deposits at commercial banks.

Problems Question 7 a) The balance sheet for the Sunshine Bank is shown below.

Assets Cash reserves Deposits at the Bank of Canada Mortgage loans Foreign-currency reserves Total Assets

630 150 2100 6000 8880

Liabilities Demand deposits Notice (term) deposits Government deposits Shareholders’ equity Total Liabilities

4500 3600 180 600 8880

b) The bank’s total assets must equal its total liabilities (as always), and both are currently equal to $8800 million. c) The bank’s actual reserve ratio is equal to its cash reserves (excluding foreign currency, but including its deposits at the Bank of Canada) divided by its total deposits. In this case, the reserve ratio is 780/(4500 + 3600 + 180) = 780/8280 = 9.4%.

Question 8 a) If the Regal Bank is currently at its target reserve ratio, then the target ratio is given by the ratio of actual reserves to actual deposits. This is $200/$4000 = 0.05, or 5 percent. b) The value of the owners’ investment in the bank is the capital shown on the liability side of the balance sheet. This is what the firm is worth if it were to be sold. It is $400.

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c) See the balance sheet below. After the new deposit of $100, the Regal Bank has $4100 of deposits and capital of $400. The new cash goes into reserves, which now total $300. Loans are unchanged at $4200. The new reserve ratio (before there are any new loans made) is $300/$4100 = 0.073 or 7.3 percent.

Assets

Liabilities

Reserves $300 Loans $4200

Deposits $4100 Capital $400

d) If instead there is a withdrawal of $100, the new balance sheet is as shown below. The bank “pays” for the withdrawal out of reserves, and also reduces liabilities by the amount of the withdrawal. The new reserve ratio is 100/3900 = 2.6 percent.

Assets

Liabilities

Reserves $100 Loans $4200

Deposits $3900 Capital $400

Question 9 a) The key here is to understand the link between the new loans made in one “round” and the new deposits in the next round. The $900 of new loans in the first round become new deposits in the second round of banks (because the recipients of the loans must deposit their money somewhere).

These second-round banks then place 10 percent in reserves and lend out the balance. The completed table is shown below.

Round

∆Deposits

∆Reserves

∆Loans

First Second Third Fourth Fifth

$1000 $ 900 $ 810 $ 729 $ 656.10

$100 $ 90 $ 81 $ 72.90 $ 65.61

$900 $810 $729 $656.10 $590.49

b) See the table above for the third through fifth rounds. Note that in any row, the change in loans plus the change in reserves exactly equals the change in deposits. c) The total change in deposits after the first five rounds of deposit creation is the sum of the values in the first column. The total is $4095.10. d) The total change in deposits will be (1/0.1) × $1000 = $10 000.

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e) Reserves will be at their target levels. If deposits increase by $10 000, reserves will increase by $1000. Note that the entire initial new deposit of $1000 ends up in reserves, “supporting” the total new deposits of $10 000. The eventual total change in loans is $9000, the difference between the total change in deposits and the total change in reserves.

Question 10 a) The table is shown below. For a withdrawal, the process is the same as for a new deposit, except in reverse. Commercial banks “finance” withdrawals from their reserves, but then must reduce deposits to restore the target reserve ratio. They reduce deposits by reducing their outstanding stock of loans (that is, by “calling in” some of their existing loans).

Round

∆Deposits ∆Reserves

∆Loans

First Second Third

– $5000 – $4600 – $4232

– $4600 – $4232 – $3893.44

– $400 – $368 – $338.56

b) The eventual total change in deposits is –$5000 × (1/.08) = –5000 × (12.5) = –$62 500. The total change in reserves is 8 percent of the change in deposits, or (.08) × (–$62 500) = –5000 (which is exactly equal to the withdrawal of $5000). The eventual total change in loans is –$57 500.

Question 11 a) There is a new deposit of $3000, a target reserve ratio of 10 percent and a cash drain of 10 percent.

The eventual total change in deposits, after all rounds have been completed, will be $3000 × (1/(0.1 + 0.1)) = $3000 × (1/0.2) = $15 000. b) The eventual total change in reserves is 10 percent of the total change in deposits, or $1500. c) The eventual total change in loans is the difference between the total change in deposits and the total change in reserves, $13 500.

Question 12 This is a good question to illustrate the different roles of bank reserves and the public’s cash drain in affecting the extent of money creation stemming from a new deposit. In this question, let ∆X be the injection of cash into the Canadian banking system ($40 000). Ultimately, all of this new cash will be held either as reserves by the banks, R, or as cash by the public, C. That is, ∆C + ∆R = ∆X.

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If deposits are given by D, the change in reserves is given by ∆R = v∆D, where v is the reserve requirement. The change in the public’s cash holding is ∆C = c∆D, where c is the cash drain.

Substituting into the above equation we get, c∆D + v∆D = ∆X ∆D = ∆X/(v + c) ∆R = [v/(v + c)]∆X a) For v = 0.10 and c = 0, we have ∆D = $400 000 and ∆R = $40 000. b) For v = 0.10 and c = 0.05, we have ∆D = $266 667 and ∆R = $26 667. c) For v = 0.10 + .05 and c = 0.05, we have ∆D = $200 000 and ∆R = $30 000.

Question 13 a) The completed table is shown below.

Round

ΔAE

ΔY

First Second Third Fourth Fifth

$1000 (0.6) × 1000 = 600 (0.6)2 × 1000 = 360 (0.6)3 × 1000 = 216 (0.6)4 × 1000 = 129.60

$1000 (0.6) × 1000 = 600 (0.6)2 × 1000 = 360 (0.6)3 × 1000 = 216 (0.6)4 × 1000 = 129.60

b) The sum of the (infinite number of ) terms in the third column is: = 1000 + z1000 + z21000 + z31000 + …

For a value of z that is positive but less than one, one can prove that the sum is: = 1000 × (1/1−z) In this case, z = 0.6. The sum is therefore 1000 × (1/0.4) = 2500, which is the total change in GDP.

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c) The completed table is shown here: Round

ΔDeposits

ΔReserves

ΔLoans

First Second Third Fourth Fifth

$1000 (0.75) × 1000 = 750 (0.75)2 × 1000 = 562.50 (0.75)3 × 1000 = 421.88 (0.75)4 × 1000 = 316.41

(0.25) ×1000 = 250 (0.25)(0.75) × 1000 = 187.50 (0.25)(0.75)2 × 1000 = 140.63 (0.25)(0.75)3 × 1000 = 105.47 (0.25) (0.75)4 × 1000 = 79.10

(0.75) × 1000 = 750 (0.75)2 × 1000 = 562.50 (0.75)3 × 1000 = 421.88 (0.75)4 × 1000 = 316.41 (0.75)5 × 1000 = 237.31

d) The sum of the (infinite number of) terms in the second column is: = 1000 + (1 − v)1000 + (1 − v)21000 + (1 − v)31000 + …

For a value of (1 − v) that is positive but less than one, one can prove that the sum is: = 1000 × (1/v) In this case, v = 0.25. The sum is therefore 1000 × (1/0.25) = 4000, which is the total change in deposits. e) Taxes and imports “withdraw” or take away from each successive round of spending, and thus dampen the multiplying of income that follows an initial increase in autonomous spending. In the same way, the reserves held by commercial banks reduce the amount of each new deposit that can be loaned out, and this dampens the multiplying of deposits. *****

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____________________________________________________ Chapter 12: Money, Interest Rates, and Economic Activity ____________________________________________________ This chapter is the key theoretical chapter providing the link between the monetary and real sectors of the economy. Students have not yet seen how the Bank of Canada affects the money market but they now know from Chapter 11 what the money supply is and how a new bank deposit leads, through the process of deposit creation, into a multiple expansion of the money supply. In this chapter we examine the demand for money and then put it together with the supply of money to examine how interest rates are determined. Once this is done, we can describe the monetary transmission mechanism—that is, how changes in the money market lead to changes in the interest rate, exchange rate, desired aggregate expenditure, and real GDP and the price level. By the end of the chapter, what remains to be done to complete the study of money is a detailed examination of how the Bank of Canada implements its monetary policy, which we address in detail in Chapter 13. *** The chapter is divided into four sections. The first section offers a general discussion of bonds and other financial assets and the relationship between a bond’s market price, interest rates, and present value. We also mention default risk associated with a bond which is an important issue these days in some European countries. There is an applied box explaining some details of bond prices and yields, and how these relate to the perceived riskiness of the asset.

The second section focuses on the theory of money demand, explaining the relationship between money demand, real GDP, interest rates, and the price level. One problem that students often have is understanding that the different motives for holding money do not result in directly observable components to money demand––this much for transactions purposes, this much for precautionary purposes, and so on. We are very clear about this point.

Once the students understand the pricing of financial assets and the basics of money demand, they are ready to consider equilibrium in the money market and how this relates to the real side of the economy. This is the focus of the chapter’s third section. We first examine the liquidity preference theory of interest-rate determination, and show how changes in money demand or money supply lead to changes in the equilibrium interest rate. We then examine the transmission mechanism that links disturbances in the demand for or supply of money (what we call monetary disturbances or shocks) to shifts in the AD curve. We first present the closed-economy transmission mechanism, in which the focus is on interest rates and investment, and then expand the setting to an open economy, in which the focus is on the exchange rate and net exports. This is the critical part of the chapter, and it is worth developing these linkages very carefully. Our experience is that an understanding of the transmission mechanism is accessible to any first-year student—but care in exposition, practice with exercises, and some repetition by instructors is needed before students master it.

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At this point we are able to go back and tie up a major loose end: the explanation that works through interest-rate effects of why the AD curve slopes downward. This raises two pedagogic problems. First, the explanation represents a substantial diversion from the chapter’s main topic.

Second, by now students are so familiar with the downward-sloping AD curve that many hardly feel further explanation is necessary. We present a brief treatment that hopefully balances the need to make this important point with the need to not distract too much from the chapter’s main messages.

The chapter’s final section deals with some controversies over the strength of monetary forces. We begin by reviewing the short-run and long-run effects of an aggregate demand shock, but this time the cause of the AD shock is a change in the money supply. We have improved our treatment of long-run money neutrality, including an expanded discussion of the possibility of non-neutrality due to hysteresis effects in both investment and human capital. We also have a box on the issue of money neutrality and monetary reform. This brings us to a discussion of how the effects of monetary disturbances depend on the interest elasticity of money demand and the interest elasticity of investment. We pose the central issues here in terms of the historical debate between Keynesians and Monetarists. We recognize that this debate is all but over, but we feel that students should be aware that such a debate existed, and why it was important.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) money demanded; money supplied; interest rate b) buy; rise; fall c) sell; fall; rise d) monetary transmission mechanism; interest rate; interest rate; expenditure; expenditure; real GDP e) supply; reduction; increase f) demand; rise; reduction g) increase; decrease h) fall; depreciation; increase; rightward

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Question 2 a) real GDP (and any other real variables) b) steep; large c) flat; small d) large; investment; aggregate demand (AD) e) small; investment; aggregate demand (AD) f) steep; flat Review Questions Question 3 a) Transactions motive. These money balances are held to facilitate transactions. b) Transactions motive. The money is held to facilitate the transactions—the hiring and paying for labour services. c) This is the precautionary motive. The $1000 is there to provide the funds in the event of an unforeseen expenditure, such as roof repair, car repair, etc. d) Speculative motive. The investor is selling the bonds because they think the price of bonds may fall (which would happen if interest rates rise). If such speculation were not playing a role, they would simply hold the higher-yield asset to maximize the return. e) Precautionary motive. You are holding cash just in case you come across something that you might want to buy.

Question 4 a) The MD function is downward sloping because the nominal interest rate is the opportunity cost of holding money. Thus a fall in the nominal interest rate should lead to an increase in the quantity of money demanded. b) At iA, there is excess demand for money balances. Firms and households attempt to sell their current holdings of bonds (in return for money). This attempt in the aggregate to sell bonds drives down their price and thus drives the interest rate up. As the interest rate rises, firms and households reduce the quantity of money demanded. This process continues until i* is reached, at which point the amount of money available is willingly held. c) At iB, there is excess supply of money balances. Firms and households attempt to get rid of their excess money holdings by purchasing bonds. This attempt in the aggregate to buy bonds drives the price of bonds up and thus reduces the interest rate. As the interest rate falls, firms and households increase the quantity of money demanded. This process continues until i* is reached, at which point firms and households are willing to hold the available supply of money.

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d) An increase in the transactions demand for money, caused for example by an increase in real GDP, is illustrated in the figure by a rightward shift in the MD curve. At i*, there is excess demand for money. People try to sell some of their current bond holdings to satisfy their increased demand for cash. But there is only so much cash available. The effort in the aggregate to sell bonds drives the price of bonds down and thus causes the interest rate to rise, choking back the quantity of money demanded (an upward movement along the new MD curve). This adjustment continues until the existing supply of money is willingly held, at a new higher equilibrium interest rate.

Question 5 a) An increase in the money supply shifts MS to the right. At i0, there is now an excess supply of money. Firms and households try to purchase bonds with their excess money holdings, and this drives the price of bonds up and the interest rate down. As the interest rate falls, the quantity of desired investment increases—a movement down and to the right along the ID curve. b) A reduction in the demand for money (an increase in the demand for bonds) shifts the MD curve to the left. At i0, there is now an excess supply of money. As firms and households try to purchase more bonds, the price of bonds is driven up and the interest rate is driven down. This adjustment occurs until firms and households are once again willing to hold the unchanged amount of money balances (because the interest rate is now lower). As the interest rate falls, the quantity of desired investment increases, a movement down and to the right along the ID curve. c) Parts (a) and (b) show that, in terms of the effect on the amount of desired investment, a reduction in the demand for money looks just like an increase in the supply of money, in the sense that both shocks lead to a fall in the interest rate. This is an important feature of the monetary transmission mechanism. Since it is changes in the interest rate, other things equal, that determine changes in desired investment, changes in the demand for money can have similar effects as changes in the supply. What matters, ultimately, is what happens to the interest rate. A reduction in the interest rate coming about from a shock to the money market will stimulate investment; an increase in the interest rate coming about from a shock to the money market will reduce investment.

Question 6 a) An increase in the Canadian money supply initially leads to a reduction in Canadian interest rates.

Other things equal, the rate of return on Canadian bonds has fallen relative to the rate of return on bonds in other countries. This will lead investors, both in Canada and abroad, to switch away from Canadian bonds and toward foreign bonds. b) As investors switch their portfolio away from Canadian bonds toward foreign bonds they must sell the Canadian bonds in return for Canadian dollars, then sell the Canadian dollars in return for foreign currency, and then use the foreign currency to purchase foreign bonds. The selling of the Canadian dollars in the foreign-exchange market will cause a depreciation of the Canadian dollar. c) As the Canadian dollar depreciates, the Canadian-dollar price of foreign goods rises, which leads Canadian consumers to reduce their imports. In addition, foreigners will now find that Canadian products are cheaper in terms of foreign currency, and so will demand more Canadian goods. On both counts, therefore, Canadian net exports will rise.

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d) If the Bank of Canada does nothing to change its policy, but the U.S. Federal Reserve increases the U.S. money supply, then the initial effect will be a reduction in U.S. interest rates. Now the rate of return on Canadian bonds will have increased relative to those in the United States, and so investors will switch toward Canadian bonds. This portfolio switch will cause the Canadian dollar to appreciate and, other things equal, will cause a reduction in Canada’s net exports. This reduction in net exports will shift Canada’s AD curve to the left and reduce Canada’s equilibrium real GDP. The monetary expansion in the United States, if not matched by the Bank of Canada, will generate a negative aggregate demand shock in Canada.

Question 7 From Figure 12-10, it should be clear that a given change in the money supply will have a smaller short-run effect on real GDP when the MD curve is flatter and when the ID is steeper. In the first case, a relatively flat MD curve means that a given change in the money supply will have a relatively small effect on the interest rate. In the second case, a relatively steep ID curve means that a given change in the interest rate will have a relatively small effect on desired investment expenditure (and thus, through the multiplier, a relatively small effect on real GDP). Thus, changes in the money supply will have no short-run effect on real GDP in either one of two extreme cases: 1. the MD curve is horizontal (the so-called liquidity trap); 2. the ID curve is vertical.

In the 1950 and 1960s, the Keynesians argued that the MD curve was relatively flat and the ID curve was relatively steep, implying that monetary policy was relatively ineffective at affecting real GDP. The Monetarists argued that the MD curve was relatively steep and the ID curve was relatively flat, implying that monetary policy was very effective at changing real GDP.

Question 8 a) Large-scale declines in the value of stock markets lead to declines in the wealth of the households and firms who own shares of the companies whose stock-market value declines. This reduction in wealth is predicted to have a negative effect on desired aggregate spending—such as a reduction in desired consumption spending for any given level of real GDP. In addition, large and sudden stockmarket declines often lead to crises of confidence which generally lead to reductions in desired investment. The AD curve is predicted to shift leftward—a negative aggregate demand shock. b) The decline in aggregate demand, other things being equal, is predicted to lead to a short-run reduction in real GDP. The likely response by central banks is to reduce their policy interest rates in an attempt to stimulate aggregate demand to offset the initial shock. This is precisely what occurred throughout 2008 and 2009 in most countries. c) Yes, the Bank of Canada reduced its policy rate dramatically, by roughly 400 basis points (4 percentage points) from early 2008 to mid 2009. This can be easily verified by checking on the Bank of Canada’s website (www.bankofcanada.ca) and searching for data on the Bank’s target for the overnight interest rate during this period.

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Question 9 a) A recession in the United States will generally lead to a reduction in American demand for Canadian goods (Canadian exports). This is a reduction in Canadian aggregate demand (or at least a reduction in the growth of aggregate demand) and thus a negative AD shock for Canada. b) Suppose Canadian real GDP is initially equal to Y*. In the face of this negative demand shock, if it appears to be persistent, the Bank of Canada would probably ease its stance of monetary policy.

In this way, the reduction in aggregate demand (from the United States) can be offset by an increase in aggregate demand (from monetary expansion). If done well, real GDP can be kept close to potential output. c) A monetary expansion in the United States will reduce U.S. interest rates immediately. With highly mobile financial capital (and assuming no policy change in Canada), this will lead to a capital inflow into Canada and an appreciation of the Canadian dollar, which will tend to reduce Canadian net exports. Thus, a monetary expansion in the United States will, through the effects of capital mobility, tend to have a negative direct effect on aggregate demand in Canada.

Over a longer period of time, however, the higher U.S. real GDP generated by the U.S. monetary expansion will eventually lead to an increase in demand for Canadian exports. There will then be two opposing effects on the Canadian economy – the appreciation of the Canadian dollar acting to slow Canadian exports and the U.S. economic expansion acting to increase Canadian exports. d) The Bank of Canada is entirely independent of the U.S. Federal Reserve, but the high degree of capital mobility across international borders does have important implications for monetary policy in each country, but especially in the much smaller f the two – Canada.

A monetary expansion in the United States will tend to cause a capital flow toward Canada and an appreciation of the Canadian dollar, thus acting to slow Canadian aggregate demand. This slowing might lead the Bank of Canada to initiate an expansionary policy. A monetary contraction in the United States will tend to cause a capital outflow from Canada and a depreciation of the Canadian dollar, thus acting to stimulate Canadian aggregate demand. This stimulus might lead the Bank of Canada to initiate a contractionary policy.

In either situation, the policy in the United States may lead the Bank of Canada to initiate a similar policy action in Canada, not because there is any formal “dependence” by the Bank of Canada on the U.S. Federal Reserve but rather because the mobility of capital transmits the effects of monetary policy actions across boundaries.

Question 10 a) If portfolio managers substantially increase their demand for liquid assets such as cash, they accomplish this by selling some of their short-term or longer-term bonds and perhaps also some of their stocks. The resulting increase in the supply of bonds (and increase in the demand for money) leads to an increase in interest rates.

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b) The rise in interest rates described in part (a), ceteris paribus, would be expected to lead to a reduction in the interest-sensitive components of aggregate demand, especially business investment, residential investment, and the consumption of durables. Such a reduction in aggregate demand would tend to reduce the growth of real GDP and could even cause GDP to decline. c) Central banks could respond to this situation by increasing the supply of money and driving interest rates back down. Most central banks responded to the COVID-induced increase in cash demand in precisely this way: by providing massive amounts of liquidity to the financial system, they increased the supply of money and reversed the rise in interest rates.

Problems Question 11 a) We assume in each case that the payments are made at the end of years 1, 2, and 3. The present values are as follows: Treasury Bill:

PV = $1000/(1.04) = $961.54

Bond:

PV = $5000/(1.03)3 = $5000/(1.09273) = $4575.71

Bond:

PV = $200/(1.05) + $200/(1.05)2 + $200/(1.05)3 = $544.66

Stock:

PV = $50/(1.06) + $40/(1.06)2 + $60/(1.06)3 = $133.15

b) If the market price is less than the PV, then profits can be made by borrowing money (at the market interest rate) to buy the asset. The excess demand for the asset will drive up its price. If the market price is greater than the PV, there will be no demand for it, and the excess supply will reduce the price. Thus the PV is also the competitive equilibrium market price for the asset.

Question 12 a) Present Value (PV) = $100/(1.08) + $100/(1.08)2 + $1000/(1.08)3 = $92.59 + $85.73 + $793.83 = $972.15 b) You should not buy the bond at $995 because it is only “worth” $972.15. This is a different way of saying that if, instead of buying the bond at this high price, you invested $995 at the market interest rate (8 percent), you would do better than buying the bond. The implied bond yield (at a price of $995) is less than the market interest rate. In this situation, since there should be little demand for the bond at this price, we should expect the bond price to decline in the near future. c) You should buy the bond at the price of $950 because you can make a profit by doing so. You could buy the bond for $950 and ought to be able to sell it for $972.15 since that is the bond’s “worth” in terms of present value. The implied yield at the offered price is greater than the market interest rate. Since there should be great demand for the bond at this price, we should expect the bond price to rise in the near future.

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d) If the bond price is exactly $972.15, then the implied yield is exactly equal to the market interest rate, 8 percent. e) We have just seen that if bond prices differ from their PV, then there will be market pressures moving the bond price toward the PV. The competitive market equilibrium price of bonds is exactly the bond’s PV. So if bond prices tend to be equal to PV, then bond yields tend to equal the market interest rate. Thus market interest rates and bond yields tend to rise and fall together.

Question 13 a) To compute the yield of the bond, we use the formula P(1+x)N = V where x is the yield, P is the current market price, N is the number of years to maturity, and V is the bond’s face value. Using this formula, the yields are: Bond 1a: (926)(1+x) = 1000

→ 1+x = 1000/926 = 1.0799 → x = 7.99%

Bond 1b: (850)(1+x) = 1000

→ 1+x = 1000/850 = 1.1765 → x = 17.65%

Bond 2a: (1270)(1+x)5 = 2000 → (1+x)5 = 2000/1270 = 1.5748 → → 1+x = (1.5748).2 = 1.0951 → x = 9.51% Bond 2b: (838)(1+x)5 = 2000

→ (1+x)5 = 2000/838 = 2.3866 → → 1+x = (2.3866).2 = 1.1900 → x = 19.00%

Bond 3a: (1760)(1+x)10 = 5000 → (1+x)10 = 5000/1760 = 2.8409 → → 1+x = (2.8409).1 = 1.1101 → x = 11.01% Bond 3b: (684)(1+x)10 = 5000 → (1+x)10 = 5000/684 = 7.3099 → → 1+x = (7.3099).1 = 1.2201 → x = 22.01% b) For all of the “a” bonds, we see that the bond yield increases with the term to maturity. This likely reflects the fact that lenders (bond holders) require a higher rate of return in order to have their funds tied up for longer periods of time. This is often referred to as a “term premium”. c) Notice that for any given term to maturity, the yield on the “b” bond is higher than the yield on the “a” bond. This probably reflects greater riskiness of borrower “b” than of borrower “a”, at least as perceived by the lenders (the bond holders). d) Once we know the bond’s current market price, we have all that we require in order to compute its yield (since the bond’s face value and term to maturity are already known). The market interest rate is irrelevant to this calculation. But the market interest rate is crucial for determining the bond’s present value, which then determines the bond’s equilibrium market price. So the general market interest rate and bond yields are closely connected: a change in market interest rates will lead to a change in any bond’s present value, which leads to a change in the bond’s market price.

This change then leads to a change in the bond’s yield.

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Question 14 a) As the money supply increases to $385 billion, MS0 shifts to MS1, but before real GDP or the price level change, the effect is to reduce the interest rate from 3% to 1%. b) In response to the lower interest rate, the AD curve shifts to AD1, which increases real GDP to $1250 billion and the price level to 105. The increase in P and Y both have the effect of increasing money demand, so MD shifts from MD0 to MD1, and the interest rate increases to 2%. c) In the short-run equilibrium described in (b), real GDP is above potential GDP, and so there is an inflationary gap. There is excess demand in factor markets which puts upward pressure on wages and other factor prices. d) As wages and other factor prices rise, firms’ unit costs also begin rising. These cost increases mean that the AS curve begins shifting upward, eventually shifting all the way to AS1. e) Wages and other factor prices stop rising when there is no longer excess demand in the factor markets; this occurs only when real GDP returns to potential GDP. The new (long-run) equilibrium occurs when real GDP is $1200 billion and the price level is 110. As the economy adjusts (with rising P and Y falling back toward Y*), the money demand curve continues shifting to the right.

In the new long-run equilibrium, money demand is MD2 and the interest rate is back to its starting point at 3%. f) The increase in the money supply was not neutral in the short run since its impact was to increase real GDP (and other real variables, too). g) The increase in the money supply was neutral in the long run since there was no change in any real variable once the economy attained its new long-run equilibrium. The long-run change in the real money supply was zero; the nominal money supply increased by 10 percent, but the price level also increased by 10 percent. *****

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____________________________________ Chapter 13: Monetary Policy in Canada ____________________________________ This chapter examines the details of how the Bank of Canada conducts its monetary policy. We view this chapter as one that provides students with the “real world” payoff from their investment in theory in the previous two chapters. *** The chapter is divided into four sections. In the opening section, we explain how any central bank can choose either to influence the money supply directly or influence the interest rate directly. For several reasons, including its imperfect control over the money supply, and the uncertainty regarding shifts in the money demand curve, the Bank of Canada and most other central banks choose to influence the interest rate directly. We explain how the Bank sets a target for the overnight interest rate, and how the money supply then adjusts endogenously. This leads to a box on open-market operations, which is now only rarely mentioned by central banks but nonetheless is going on behind the scenes on a regular basis. (Although during the COVID-19 pandemic the Bank of Canada employed “quantitative easing”, which we address at several points in the chapter and explain as a deviation from the Bank’s normal operations.)

The chapter’s second section explains the Bank’s policy regime of inflation targeting. We explain why many central banks over the past 30 years have come to see this as the best way to focus the attention of monetary policy. We emphasize why the short-run monitoring of the output gap is an essential aspect of pursuing a long-run inflation target, and why inflation targeting acts as a stabilizing policy—we even introduce the term of the “divine coincidence”. We also discuss two technical difficulties associated with inflation targetingthe need to distinguish between “core” and overall CPI inflation, and the difficulty of interpreting the source of changes in the exchange rate and of what such changes imply for the conduct of monetary policy.

The third section discusses lags and their implications for monetary policy. One of the important implications of the long lags in the monetary transmission mechanism is that in order to provide stabilization, monetary policy must be forward-looking; actions taken today by the Bank of Canada will have no effect on output for several months and the effects on inflation will take even longer. We have a discussion explaining why this sometimes creates communications difficulties for the Bank.

As the historical debate between the Monetarists and Keynesians also involves the issues of lags and uncertainty, this section seemed like an appropriate place to put a historical box discussing this classic debate about the role of monetary forces during the Great Depression. Though much of this debate centres around the causes of the Great Depression in the United States, Canada's experience serves as somewhat of a “control” since Canada experienced a recession of a similar magnitude but without the wave of bank failures that plagued the United States.

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The chapter’s final section gives a brief history of the last four decades of Canadian monetary policy. This section naturally has an injection of new material to cover the last few years of policy issues and challenges, including the Bank of Canada’s foray into “quantitative easing” during the pandemic in 2020-21. The focus is not so much on a chronological history of main events but rather on extracting from history the main themes and lessons for future monetary policy.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) the money supply; interest rates b) interest rate; open-market operations c) money (deposit) creation; interest rates; money demand Question 2 a) overnight interest rate b) 25 basis (one-quarter of a percentage point); lend any amount; 25 basis; accept deposits c) open-market operations; currency d) reduces; raises e) expansionary; reducing; contractionary; raising Question 3 a) rate of inflation; 2 (two) b) output gap c) target for the overnight interest rate; open-market operations d) changes in expenditure take time; the multiplier process takes time e) 9-12 months; 18-24 months f) destabilizing

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Review Questions Question 4 a) Many central banks, over many years, had experiences that eventually led them to adopt inflationtargeting regimes. The two lessons are (1) high inflation is damaging for the economy and (2) sustained inflation is ultimately determined by monetary policy. b) When real GDP is above potential output, pressures usually develop that tend to push inflation above the two-percent target, and the Bank will generally tighten its policy (raise its policy interest rate) in order to slow down the economy’s growth, thus returning real GDP toward potential.

Conversely, when real GDP is below potential output, pressures usually develop that reduce inflation below the two-percent target, and the Bank will generally loosen its policy (reduce its policy interest rate) in order to speed up the economy’s growth, thus returning real GDP toward potential. Thus, the size and sign of the output gap plays a key role in the Bank of Canada’s monetary policy.

Question 5 This is an important question that requires thinking through the details of the money market and the importance of money-demand shocks. Central here, however, is the disagreement about what constitutes a “stable” monetary policy, and this depends on the view of the transmission mechanism.

If you believe that “money matters”, for reasons unrelated to interest rates and exchange rates, then unstable growth in the money supply would be considered unstable monetary policy. If, however, you take the more mainstream view (as this book does) that money matters because it affects interest rates and exchange rates, then unstable interest rates would be considered unstable monetary policy. a) If the money demand (MD) curve is stable, then controlling the growth rate of money will be indistinguishable from controlling interest rates. This will be a stable monetary policy. In a diagram of the money market, the stable MD curve implies that changes in the money supply will lead directly to changes in the interest rate. Thus, if the money supply is stable so will interest rates be stable. b) If money demand is subject to random shocks, then controlling interest rates will be very different than controlling money growth rates. The former will avoid fluctuations in interest rates whereas the latter will be characterized by sharp changes in interest rates in response to the changes in money demand. In a diagram of the money market, the fluctuations in the MD curve (with a constant supply of money) will imply fluctuations in the interest rate, and these will cause fluctuations in the amount of desired investment spending. c) As we say in the text, one advantage of the Bank’s policy of conducting its policy in terms of short-term interest rates is that unstable money demand does not lead to unstable monetary policy.

If MD shocks occur (as they do), the Bank must adjust reserves in the banking system so as to maintain its announced policy interest rate (the target for the overnight interest rate). The alternative would be to set reserves and then have the MD shocks contribute to instability in interest rates.

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Question 6 a) The rising stock market implies an increase in wealth, at least as measured on paper. If we assume that some of this increased wealth gets consumed (the marginal propensity to consume out of wealth is approximately 0.05), then the rising stock market fuels an increase in aggregate demand, and may contribute to an inflationary gap. This is shown by a rightward shift in the AD curve, possibly raising GDP above Y*. b) In this case, a tightening of monetary policy may be appropriate as a means of keeping output near potential. A tightening of monetary policy will, in general, slow the rise in the stock market, and may cause an outright fall in stock-market values. This is because, first, a rise in interest rates reduces the PV of any given flow of earnings and, second, the monetary tightening reduces the future stream of firms’ profits. Thus a monetary tightening will reduce values in the stock market and reduce wealth, thus leading to less desired consumption expenditure.

One problem with monetary tightening in this situation is that it is difficult to determine precisely how much to tighten. It is relatively easy to measure the increase in wealth associated with an increase in stock-market values. But it is difficult to know by how much aggregate expenditure is increasing as a result, and also difficult to know how much tightening can occur without causing a “crash” in the stock market. c) A sudden crash in the stock market reduces the amount of wealth and thus reduces desired consumption expenditure. It may also lead firms to reduce their desired investment if they are unable to finance their projects by the issuance of new shares. In addition, stock-market crashes of this magnitude create a great deal of uncertainty and sometimes even panic, an environment in which many firms decide to reduce their desired investment. For all three reasons, there is likely to be a large leftward shift in the AD curve.

Question 7 a) Since Canada produces and is a net exporter of many raw materials, an increase in their world price represents a positive AD shock for Canada. Canada’s AD curve shifts to the right (assuming no change in the exchange rate). b) If foreigners increase their demand for Canadian government bonds, there is no direct effect on the demand for Canadian goods and services, so Canada’s AD curve is unchanged (assuming no change in the exchange rate). c) As the Canadian dollar appreciates, foreigners and Canadians substitute away from Canadian products toward foreign products. This reduction in Canadian net exports is represented by a leftward shift of Canada’s AD curve. In case (a), the initial rightward shift of the AD curve is offset by the leftward shift caused by the appreciation of the Canadian dollar. In case (b), there is no initial shift of the AD curve, but the appreciation of the Canadian dollar leads to a leftward shift of the AD curve.

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d) In case (a), it is likely that the overall effect is a rightward shift of the AD curvethe appreciation dampens but does not completely offset the initial positive shock to aggregate demand. In this case, to the extent that the shock is deemed to be long-lasting, the appropriate response by the Bank of Canada is to tighten monetary policy to try to offset the overall effects of the shock.

In case (b), the overall effect is a leftward shift of the AD curve. In this case, to the extent that the shock is deemed to be long-lasting, the appropriate response by the Bank of Canada is to loosen monetary policy to try to offset the overall effects of the shock.

This example illustrates why the appropriate response by the Bank of Canada to a change in the exchange rate depends crucially on the cause of the change.

Question 8 a) Core inflation is less volatile than CPI inflation because it intentionally excludes some of the most volatile items in the CPI, such as the prices of fruits and vegetables and energy and the effects of changes in indirect (sales) taxes. b) If the prices of these volatile items are moving roughly in line with average prices, then core inflation and CPI inflation will be similar. But if the prices of these volatile items are moving quite differently, core inflation and CPI inflation will be quite different. In these situations, which measure of inflation is a better guide for the Bank of Canada?

The Bank constructs its measure of core inflation so that it can abstract from these volatile items and thereby more easily detect the underlying trend in domestic inflationary pressures. In addition, the prices of many of the excluded items are set in world markets and therefore their changes do not reflect changes in excess demand or supply conditions in the Canadian economy.

So during times when there is price volatility in these selected items, the Bank is likely to get a better indication of excess demand (or supply) pressures in the Canadian economy by examining core inflation rather than CPI inflation.

Question 9 a) During the early months of the COVID-19 pandemic, there was enormous uncertainty about the impact on the economy. This uncertainty led many financial institutions to increase their demand for liquid assets (cash), and this led interest rates to rise sharply. The Bank of Canada was trying to maintain liquidity among the commercial banks and reverse the spike interest rates, all in an attempt to maintain aggregate demand and the level of economic activity (as much as possible in these dramatic circumstances). b) The Bank’s actions considerably increased the total amount of reserves in the banking system.

But if commercial banks continue to hold most of these reserves rather than lend them to borrowers, then the increase in the overall money supply (such as M2 or M2+) could be modest. In fact, this is what actually occurred. Broad measures of the money supply did grow considerably faster in 2020 than in previous years, but not nearly as quickly as the massive growth in reserves.

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c) The inflationary danger of the large increase in reserves is less severe in this case precisely because the reserves are not leading to the creation of new lending (and thus to enormous growth in the money supply). Inflation would be a bigger future threat if the increases in reserves were leading to roughly proportionate increases in the money supply (with a roughly constant money multiplier).

Problems Question 10

Commercial Banks Assets Liabilities Reserves Deposits – $100 000 (no change)

Bank of Canada Assets Liabilities Bonds Currency in circulation – $100 000 – $100 000

Bonds + $100 000 a) When the Bank of Canada sells the government bonds to a commercial bank, the commercial bank experiences a decline in reserves and in increase in bonds. Total assets are unchanged; this is just a portfolio switch between bonds and cash. b) The Bank of Canada has sold a bond and so its assets fall by $100 000. In return, the Bank of Canada receives $100 000 cash that is no longer “in circulation” and thus is no longer a liability for the Bank. c) The amount of currency in circulation has fallenbecause the commercial bank used this currency to purchase the bonds from the Bank of Canada. Once this cash is inside the Bank of Canada, it is no longer in circulation in the Canadian economy.

Question 11 a) The interest rate is determined by the demand for and the supply of money. For a given MD curve, it follows that the equilibrium interest rate must lie along the MD curve. If the Bank wants to set a target for the money supply, it must accept the resulting interest rate. Conversely, if the Bank wants to set a target for the interest rate, it must provide the money supply necessary to make that target interest rate the equilibrium. But two independent targets—like points A or B in the figureare not feasible.

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b) Suppose the money demand curve can shift randomly between MD1 and MD0 in the figure above.

If monetary policy sets the money supply, then the interest rate will fluctuate between i1 and i0, and thus the stance of monetary policy will be changing as well. In contrast, if monetary policy sets the interest rate, the interest rate will be stable, but the money supply will be fluctuating (as the Bank would have to accommodate changes in money demand through its open-market operations). To the extent that the monetary transmission mechanism works mostly through changes in the interest rate (which is how we describe it in the text), then the policy that sets the interest rate will generate a more stable monetary policy. c) If the Bank of Canada reduces its target for the overnight interest rate, other market interest rates will also fall. This will lead to an increase in borrowing from commercial banks which, eventually, will run out of currency. When commercial banks need more currency, they can sell some of their bonds to the Bank of Canada in return for cash. This is an open-market purchase of bonds by the Bank of Canada, and it increases the amount of money in circulation in the economy.

Question 12 a) When the Government of Canada issues a new bond and sells it to a commercial bank, this transaction does not affect the Bank of Canada’s assets at all. It also does not affect the Bank’s total liabilities, although it likely leads to a change in the composition of its liabilities. To facilitate the payment for the bond purchase, the Bank (who is the government’s “fiscal agent”) debits the commercial bank’s reserve account at the Bank of Canada, and credits the government’s account at the Bank of Canada by the same amount. b) The transaction from part (a) has no direct impact on the nation’s money supply. The commercial bank used excess cash reserves to purchase the government bond, which now show up in the government’s hands, so this transaction is simply a redistribution of existing Bank liabilities.

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c) If the Bank of Canada purchases $5 billion of government bonds from a commercial bank, the new bonds appear as additional assets on the Bank’s balance sheet. The Bank creates new money with which to purchase these bonds, and this appears as new (electronic) reserves in the commercial bank’s account at the Bank of Canada. So the Bank’s assets and liabilities both increase by $5 billion. d) The transaction from part (c) leads to an increase in what is called the monetary base—currency plus reserves. Presumably the commercial bank sold the interest-earning bond to the Bank of Canada because it preferred to have the cash with which to lend out to customers (and earn even more interest). So the increase in the commercial bank’s reserves will likely be used to increase its lending, eventually leading to an increase in broader measures of the money supply. e) When the Bank of Canada increases its demand for government bonds, and at the same time increases its supply of money, it tends to increase bond prices and reduce bond yields. If the Bank is purchasing mainly longer-term government bonds, its impact will be felt on longer-term interest rates, which are the interest rates most relevant for the interest-sensitive components of aggregate demand, such as residential and business investment. The Bank’s actions are designed to keep longer-term interest rates down and to stimulate aggregate demand. f) The Bank’s actions will certainly increase the amount of reserves in the bank system. But if commercial banks continue to hold those reserves as a way to increase their liquidity, and they do not increase their lending to businesses and households, then the overall impact on broader measures of the money supply such as M2 and M2+ may be quite modest. This is actually what happened throughout 2020 and 2021: the reserves in the banking system increased massively but the broader money supply increased much more modestly. *****

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_______________________________________ Part Six Macroeconomic Problems and Policies

_______________________________________ This part of the textbook offers three chapters, each of which covers an important macro policy topic.

The chapters are written so that they can be covered in any order. This allows instructors with time constraints to pick and choose among the three chapters. *** In Chapter 14, we examine the process of constant and sustained inflation and the issues surrounding the process and costs of disinflation. We begin by showing how a constant inflation appears in the simple AD/AS model. We have a brief discussion about how people form their expectations about inflation, as well as a box examining the possible dangers of deflation. We also have a significant discussion of the sacrifice ratio.

Chapter 15 examines unemployment fluctuations and the NAIRU. We contrast marketclearing models with non-market-clearing models of the labour market, and how these models can offer explanations for unemployment fluctuations. In the discussion of long-term employment relationships we have a box on the rise of the “gig” economy and what this likely implies for the extent of wage rigidity. In the section on the determinants of NAIRU we have a discussion of how some policies affect labour-market flexibility and thus affect NAIRU. Chapter 16 discusses government budget deficits and debt. We emphasize the importance of the primary deficit as well as using the structural budget deficit (also called the cyclically adjusted deficit) to assess the stance of fiscal policy. There is a box that applies the simple equation of debt dynamics to the dramatic situation in Greece. This chapter has been updated, and now includes the significant fiscal tightening in Canada between 1995 and 2007, the onset of the global recession in 2008 and the accompanying return to large budget deficits, the planned return to budget balances up to 2019, and then the massive increase in expenditure and budget deficits as a result of the COVID19 pandemic.

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___________________________________ Chapter 14: Inflation and Disinflation ___________________________________ This chapter examines inflation, with an emphasis on the causes of constant or sustained inflation and the methods and costs of reducing a sustained inflation. Note the emphasis on “sustained”. As we make clear in the text, we view sustained (or constant) inflation as a monetary phenomenon, in which monetary policy and inflationary expectations reinforce one another. We distinguish this from transitional inflation that is caused by the economy’s adjustment to one-time shocks. *** The chapter is divided into three sections. The first section shows how the simple AD/AS model can be modified to incorporate a constant rate of inflation. This involves discussing why wages change, the formation of inflation expectations, and how the economy’s equilibrium can have the AD and AS curve both shifting up at the same rate, while real GDP remains constant and equal to Y*. This is a pure expectational inflation that is validated by money creation (or we could say that it is a pure monetary inflation that is also expected). Even if the rest of the chapter is not taught, we feel that this section should be. Though inflation is currently low in Canada and many western countries, inflation is a sufficiently important macroeconomic phenomenon that students should see how it is incorporated in the basic AD/AS model. We also have a box that examines the potential dangers, as well as some of the misunderstanding, about the phenomenon of deflation.

The second section discusses shocks and policy responses. We examine both demand shocks and supply shocks. We emphasize the difference between shocks that are validated by the central bank and those that are not. Throughout all of the analysis, the student is reminded of the asymmetric adjustment mechanism; wages (and other factor prices) tend to fall more slowly in the face of excess supply than they increase in the face of excess demand. This asymmetry, of course, has significant implications for the appropriate policy to end a sustained inflation. This section also develops the idea that the only way real GDP can be held above Y* in the long run is with ever-increasing inflation. This brings us to a summary where we review the causes and consequences of inflation.

The chapter’s final section examines the reduction of a sustained inflation. The role of inflationary expectations is highlighted, as is the rate of monetary validation. Here, the asymmetric adjustment mechanism makes its appearance. As the rate of monetary validation is reduced, but inflation expectations remain, the economy moves into recession. From this point, the monetary authority can choose either to have a one-time monetary expansion (at the risk of rekindling inflation expectations) or to let real wages fall to bring output back to potential. This is an important policy dilemma. We explain the costs of disinflation and we show how the sacrifice ratio is measured. We end the chapter with a brief discussion of the potential for an increase in inflation as a result of the dramatic actions taken by central banks during the COVID-19 pandemic.

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Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) non-accelerating inflation rate of unemployment b) potential output (Y*) c) output gap (excess demand or supply); expectational; aggregate supply (AS) d) rise; supply e) output gap; expected inflation; supply shocks f) validating; increase; 6 Question 2 a) right; inflationary b) potential output (Y*); reducing (or preventing from increasing); increase; rise c) aggregate demand (AD); aggregate supply (AS); excess demand (Y > Y*); potential output (Y*); price level d) monetary; e) validation; expectations f) recession (lost output) Review Questions Question 3 a) This is a “wage-push” (or “cost-push”) theory of a supply-shock inflation. Of course, the long-term continuation of such an inflation requires that the cost push be validated by monetary policy. Possibly the speaker feels that the economic power of British unions caused the upward push on the price level, while the political power of the unions led to its validation by monetary policy. b) Supply shock. This time, a favourable supply shock (a reduction in the world price of oil) is leading to a rightward shift of the AS curve and this works to reduce the inflation rate.

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c) Political tensions in the Middle East often lead to increases in the world price of oildue to interruptions in supply (actual or expected). The rise in the world price of oil is a classic negative AS shock because it increases firms’ unit costs and shifts the AS curve upward and to the left, reducing output and raising the price level. This is what we call supply-shock inflation. d) This would be demand inflation. The low-interest-rate policy would cause a rightward shift in AD. At the time, in October 2008, the Canadian economy was close to potential output, but a major global recession had just begun and would soon hit Canada very forcefully. The concern about future inflation was misplaced, given that aggregate demand was in the process of falling—some offsetting stimulus from the Bank of Canada would be important in preventing real GDP from falling, or at least in reducing the magnitude of its fall. e) A supply shock. The bumper crops for many crops would generally lead to a reduction in crop prices and thus a reduction in some food prices, thus putting downward pressure on the rate of inflation. This is a rightward shift of the AS curve. f) The wage growth is probably driven by an inflationary gap which puts excess demand in labour and other factor markets. As this wage growth shifts the AS curve upward, the price level will be rising. The central bank is likely to raise its policy interest rate to reduce the inflationary gap and reduce this inflationary pressure. g) The headline makes it sound like the “economic collapse” is primarily a negative aggregate demand shock because it will “dampen price pressures”. The COVID-19 pandemic did, indeed, produce a reduction in aggregate demand, so a reduction in demand inflation would be predicted.

However, the pandemic also created a negative aggregate supply shock because of the intentional shutting down of productive capacity, and this by itself would tend to push up prices. h) This headline is clearly indicating likely future demand inflation. The QE policies by the Bank of Canada represent a significant monetary expansion, injecting liquidity into the banking system and helping to keep longer-term interest rates low. These policy actions, if effective, will stimulate aggregate demand. If they do so at a time when the economy is already recovering from the pandemic recession (which was actually the case during the summer of 2021), there is a possibility that “over stimulation” of aggregate demand will lead to demand inflation.

Question 4 a) If the Bank of Canada does not respond to the positive AD shock, then the economy’s natural adjustment process comes into play. The excess demand for factors occurring because of the inflationary output gap (when Y = Y1) leads wages and other factor prices to rise. As factor prices rise, firms’ costs rise and the AS curve shifts up. This adjustment will continue until the price level equals P2 and output returns to Y*.

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b) Once output gets to Y1, the Bank of Canada can attempt to keep output constant by expanding the money supply. In this situation, however, both inflation expectations and excess demand will be driving inflation. In the diagram, as the AS curve begins to shift upward due to the inflationary expectations and rising factor prices, the AD curve must shift enough to keep the macroeconomic equilibrium at Y1. Then, in the next period, when the AS curve shifts again, the AD curve must also shift once more. This process must continue, keeping the level of output constant at Y1. c) The only way the Bank of Canada can maintain output at Y1 (and thus to maintain a positive output gap) is to ensure that actual inflation is greater than expected (see the basic equation for inflation in the chapter’s first section). But when actual inflation exceeds expected inflation, expectations will adjust upward. For actual inflation to remain above expected inflation, the actual rate of inflation must therefore be ever increasing, which means ever-increasing rates of money growth.

Question 5 a) If the Bank of Canada does not respond to the negative AS shock, then the economy’s natural adjustment process comes into play. The excess supply for factors occurring because of the recessionary output gap (with Y=Y1) eventually leads wages and other factor prices to fall. As factor prices fall, firms’ costs fall and the AS curve shifts downward and to the right. This adjustment will continue until the price level returns to its starting point, at the initial long-run equilibrium. b) Once output gets to Y1, the Bank of Canada can attempt to offset the effect of the shock by expanding the money supply. In the diagram, the AD curve must shift enough to return the level of output to Y*, but the price level will rise to where AS1 intersects the vertical Y* curve. c) The danger of validating negative supply shocks is that it may lead to an increase in inflation expectations. After all, both the negative shock and the monetary expansion lead to transitional inflation, and so firms and households may think that the central bank has decided permanently to aim toward a higher inflation rate (which would increase inflation expectations and shift upward the AS curve, thus fuelling more inflation). Thus, it is important when validating negative supply shocks for the central bank to signal that it is not aiming for permanently higher inflation but instead is simply offsetting the one-time shock. The alternative to validating the shock is to do nothing, thus allowing the economy’s natural adjustment mechanism to operate. The problem here is that wages and other factor prices may fall only slowly, thereby permitting a protracted recessionary period.

Question 6 a) The announcement of high employment growth, at a time when U.S. output is already close to and approaching potential GDP, leads to fears that inflationary pressures may occur in the near future (caused when Y rises above Y*). This suggests that the U.S. Federal Reserve (the U.S. central bank) may soon step in to slow things down––by engineering a tightening of monetary policy.

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b) For any given stock, which represents the claim on a stream of future dividends, an increase in the interest rate (caused by the monetary tightening) reduces the present value of the dividend stream and thus lowers the market price of the stock. The monetary tightening also reduces the level of economic activity (eventually) and thus reduces the value of the dividend stream. For both reasons, stock-market prices often fall following a monetary-policy induced increase in interest rates. c) If people expect U.S. interest rates to increase in the near future (due to a tightening of U.S. monetary policy), then they will anticipate the capital flow away from Canada that would be associated with that rise—this would occur because bond holders would prefer to hold high-yield U.S. bonds than low-yield Canadian bonds, other things equal. Such a capital flow would lead to a depreciation of the Canadian dollar. But if people expect the Canadian dollar to depreciate in the future, they will sell it now, leading to a current depreciation. So the anticipated rise in U.S. interest rates would be accompanied by a current depreciation of the Canadian dollar. This would stimulate net exports for Canada.

Question 7 a) If the policy of disinflation is more credible—meaning that private agents expect the central bank to carry out its announced intentions—then those same private agents will reduce their inflation expectations more readily. As these inflation expectations fall, the AS curve’s rate of upward shift will begin to slow. This will reduce the output loss for any given path of the AD curve. b) Two things to note here. First, the Bank of Canada can be very clear (and repetitive) about its intentions to reduce the inflation rate (that is, to “disinflate”). The more people hear the message, the more they (might) believe it. Second, and probably more important, the Bank can establish a reputation for “disliking” inflation—especially by taking actions to reduce inflation after various shocks push the inflation rate above the central bank’s target. The building of such a reputation can take several years. c) Yes. If the Bank of Canada tends to respond to adverse supply shocks by not validating them and, instead, forcing the requisite reduction in wages and other factor prices, then it will acquire the reputation of being “hard” on inflation. In this case, by showing that they are prepared to experience the recession necessary to fight the inflationary effects of an adverse supply shock, they have also revealed that they are prepared to experience the recession needed to reduce a sustained inflation. Private agents will therefore be more inclined to believe the Bank’s announced intentions to disinflate.

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Problems Question 8 a) The size (and sign) of the output gap is revealed by the size of the excess-demand effect on wages.

If the excess-demand effect is positive, as in A and B, then there is an inflationary output gap. When the excess-demand effect is negative, as in D and E, there is a recessionary output gap. In case C there is no excess-demand effect on wages, so there is no output gap—GDP is at Y*. b) In the absence of supply shocks, which we are assuming not to occur in this question, the total effect on nominal wages is the excess-demand effect plus the inflation expectations effect. The total wage changes are: Case A: wage change = 7% Case B: wage change = 4% Case C: wage change = 3% Case D: wage change = –3% Case E: wage change = 1% c) For a given level of productivity (which we are holding constant in this chapter), the AS curve will shift up if wages are rising and shift down if wages are falling. Thus the AS curve is shifting up in all cases except D, in which it is shifting down.

Question 9 a) The announcement of the monetary expansion should lead households, workers and firms to expect an increase in the price level (eventually by the full 5 percent). This expected inflation should lead some wages and other factor prices to rise now, thus shifting the AS curve upward and to the left. The size of this AS shift depends partly on the extent to which peoples’ expectations are forwardlooking. b) The AS shift also depends on the credibility of the central bank’s announcement. If the central bank’s announcement is not believed, then there is no reason to expect future inflation because there is no reason to believe that the money supply will increase. Conversely, if the announcement is fully credible, then inflationary expectations should rise and the AS curve should shift up immediately and by the full amount (5 percent). c) A sustained and constant rate of inflation of, say, 5 percent per year appears in an AD/AS diagram with both the AD curve and the AS curve shifting up by 5 percent per year, with the macroeconomic equilibrium moving up along a vertical Y* curve. Output is stable at Y* and the inflation rate is also constant (with the price level increasing at 5 percent per year). The AD curve is shifting up because of the ongoing increase in the money supply. The AS curve is shifting up because of the entrenched inflationary expectations. In equilibrium, these expectations are being fulfilled.

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d) As we explained in the text, actual inflation equals expected inflation plus excess-demand inflation plus supply-shock inflation. In the absence of supply shocks, constant inflation means that expectations will eventually converge to actual inflation. But with actual and expected inflation being equal, excess-demand inflation must be zero. Thus, a constant, sustained inflation is only possible when there is neither excess demand nor excess supply—that is, when Y equals Y*.

Question 10 a) With θ = 0.1, expected inflation will tend to adjust only slowly toward the inflation target. It will be heavily influenced by last year’s inflation rate. See the fourth column in the table below.

Year 1 2 3 4 5 6 7 8

Inflation Target 2 2 2 2 2 2 2 2

Rate of Inflation 10 9 6 3 2 2 2 2

Inflation Expectations for Next Year θ = 0.1 θ = 0.9 0.2 + 9.0 = 9.2 1.8 + 1.0 = 2.8 0.2 + 8.1 = 8.3 1.8 + 0.9 = 2.7 0.2 + 5.4 = 5.6 1.8 + 0.6 = 2.4 0.2 + 2.7 = 2.9 1.8 + 0.3 = 2.1 0.2 + 1.8 = 2.0 1.8 + 0.2 = 2.0 0.2 + 1.8 = 2.0 1.8 + 0.2 = 2.0 0.2 + 1.8 = 2.0 1.8 + 0.2 = 2.0 0.2 + 1.8 = 2.0 1.8 + 0.2 = 2.0

b) See the figure below.

c) With θ = 0.9, expected inflation never deviates very far from the inflation target. See the last column in the table above.

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d) Expectations are more backward looking when θ = 0.1. In this case, the announced inflation target has only a gradual effect on expected inflation whereas the past inflation rate has a large effect. e) The discussion in the chapter makes clear that the more quickly inflationary expectations adjust to an announced disinflation, the less output will fall in the adjustment process—that is, the smaller the sacrifice ratio will be. So when θ = 0.9, expectations are not heavily influenced by the past inflation rate and are instead influenced heavily by the announced inflation target. This will be a case of a relatively low-cost disinflation—the sacrifice ratio will be small compared to the situation in which θ = 0.1.

Question 11 a) Recall that the sacrifice ratio is equal to the cumulative loss of GDP due to the disinflation (expressed as a percentage of potential GDP) divided by the percentage-point reduction in inflation.

The sacrifice ratios (SR) are: Case A: SR = [(100/900) × 100]/5 = 11.11/5 = 2.22 Case B: SR = [(30/900) × 100]/2 = 33.3/2 = 1.67 Case C: SR = [(60/900) × 100]/6 = 6.67/6 = 1.11 Case D: SR = [(80/900) × 100]/8 = 8.89/8 = 1.11 b) When expectations are more forward looking, they adjust more quickly during the process of disinflation, perhaps in response to an announcement by the central bank that it wants to reduce the rate of inflation. The faster adjustment of expectations means that the AS curve shifts up by less, and the result is that output falls by less than otherwise would be the case. The smaller reduction in output contributes to a smaller sacrifice ratio. c) When a central bank announcement of disinflation is more credible, expectations will be less guided by past inflation and more influenced by the announced inflation target. This makes expectations more forward looking, and the same argument from (b) carries through. *****

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____________________________________________________ Chapter 15: Unemployment Fluctuations and the NAIRU ____________________________________________________ This chapter examines cyclical, frictional and structural unemployment. In the analysis of the previous few chapters, real GDP fluctuated in response to fiscal, monetary or trade-related shocks, and these fluctuations in GDP caused changes in employment and unemployment. At this point, however, we are ready to think more carefully about what goes on inside the labour market—behind the scenes of the AD/AS diagram. Since our focus here is on the labour market, we have very little explicit AD/AS analysis in this chapter. At first glance, this exclusion makes the chapter appear unconnected to the rest of the text, but it should be emphasized that we are really examining some of the underpinnings of the basic macro model. For example, our discussion examines the labourmarket adjustment that lies behind the adjustment of the AS curve in response to output gaps, and it also examines the determinants of NAIRU and thus the determinants of potential output, Y*. *** The chapter is divided into four sections. The first section examines basic facts and definitions regarding unemployment. We discuss that the measurement of unemployment is difficult and that the official data often miss some of the “true” unemployment that disappears from view as discouraged workers leave the labour market. We also emphasize that jobs are simultaneously being created and destroyed in any dynamic economy. This leads to a large box about the importance of gross flows in the labour market. Understanding the magnitude of flows in the Canadian labour market is central to understanding the importance of frictional and structural unemployment (though it is unfortunate that Statistics Canada no longer makes these data available, so the figure in the box is quite dated).

The second section examines unemployment fluctuations. This discussion develops both market-clearing and non-market-clearing models, and characterizes the difference between the two approaches as being how quickly wages adjust to clear the labour market. We give more space to the non-market-clearing approach for the simple reason that we think it better matches the available empirical evidence. Our discussion of non-market-clearing theories of unemployment fluctuations includes menu costs and wage contracts, efficiency wages, and union bargaining. Our discussion of the importance of long-term employment relationships leads to a box on the rise of the “gig” economy and what this likely means for the extent of wage rigidity.

The chapter’s third section examines the NAIRU and why it changes. Here we spell out in detail what is meant by frictional and structural unemployment, and why the distinction between the two concepts is often blurred. Although it is not possible to label each unemployed person as being frictionally or structurally unemployed, the distinction helps our understanding. The distinction can be made clear in some theoretical models. Consider two models with no cyclical unemployment. In one model there are static costs and demands but there is labour turnover, and so all unemployment is frictional. In the other model no one leaves a job voluntarily and all workers live forever but costs and the pattern of demand are changing. In this case, all unemployment is structural.

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Note that structural unemployment need not be permanent. It only requires that the source of unemployment is a shifting structure of demand for labour relative to its supply, so that with any lag in the adjustment of supply, there will be a mismatching in terms of skills or location between the demand and supply. Individuals adjust and find new jobs, but as long as the adjustment takes time, there will always be a pool of people structurally unemployed. We make the point that not all unemployment is undesirable since a spell of unemployment permits workers and firms to locate each other until an appropriate match is made. In our discussion of why the NAIRU changes we explain why policies sometimes affect labour-market flexibility and thus affect NAIRU. We consider, in particular, the effects of EI and mandated job security. The latter is not that important in North America but is quite important in Europe, and thus may be important for understanding the different labour-market performances in the two regions.

The chapter’s final section briefly discusses ways of reducing unemployment. This section is straightforward and uses the theoretical categories developed earlier in the chapter. Our experience is that students find this discussion an interesting way of putting the earlier discussion into perspective. Our discussion of reducing cyclical unemployment leads to a new box on the recession caused by the COVID-19 pandemic, and explains how the employment dynamics were quite different than in traditional recessions. It also makes the point that conventional macro stabilization policies, such as fiscal and monetary stimulus, are not effective in driving an economic recovery during a pandemic; the best recovery tool is the development of effective vaccines.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) the gross flows of workers between employment and unemployment b) larger c) roughly 500,000 to 600,000 d) less than; frictional; structural e) clears; wages; voluntary f) adjust; cyclical (and involuntary) Question 2 a) frictional; structural; greater b) structural c) 2.2; cyclical; 6.0; frictional; structural d) rise; frictional

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e) lower f) recessionary output; fiscal; monetary Review Questions Question 3 The emphasis here is on the distribution of unemployment over the population. Both countries have the same total unemployment. In one country, it is evenly distributed—everyone is unemployed for 10 percent of the time. In the other country, it is very unevenly distributed—only 20 percent of the people ever lose their jobs. This setting is obviously highly stylized, but it makes an important point.

The different distribution of the same aggregate unemployment rate implies large differences in the expected unemployment duration in both countries. To the extent that long-term unemployment is the most serious part of the unemployment problem, then the country with unevenly distributed unemployment (Country A) has the more serious problem.

Question 4 a) See the diagram below. If wages are fully flexible, then wages will fall to w1 and employment will fall to L1.

b) Employment has fallen, but every worker who wants a job at the new wage, w1, has one. There is no involuntary unemployment. This is the market-clearing view of the labour market (sometimes referred to as the “New Classical” perspective). c) If wages cannot fully adjust to the negative shock, then they may only fall to some intermediate wage like w2. This lack of complete wage adjustment forces a larger reduction in employment, to L2. d) Now there is some involuntary unemployment. At the wage w2, there are some workers who cannot find jobs but would like them. This amount is shown in the diagram.

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Question 5 a) See the figure below.

b) The increase in raw materials prices increases firms’ costs and shifts the AS curve up and to the left. This is a negative aggregate supply shock. The equilibrium price level rises to P1 and real GDP falls to Y1. c) If wages and prices adjust instantly (and fully) to this shock, the excess supply following the shock immediately leads to reductions in wages and other factor prices and so the AS curve shifts back down immediately. Unemployment does not change. d) If wages and prices adjust only slowly, then the recessionary gap persists until wages and prices have completed their downward adjustment. The recessionary gap means that labour and other factor markets are in a state of excess supply. The unemployment rate rises, and then eventually falls back to the NAIRU as the AS curve shifts back to its starting position. e) The more realistic situation in the Canadian economy (and most economies) is one of relatively slow downward adjustment of wages and other factor prices. In response to significant negative AS shocks, the unemployment of labour and other factors is usually quite persistent.

Question 6 a) Cyclical unemployment. The reduction in demand for output leads to a reduction in demand for workers. This is often called “deficient demand” unemployment. b) Frictional unemployment, possibly with a structural dimension if there has been a decline in demand for people with the individual’s qualifications in his or her area. c) Structural unemployment. The greater use of robots reduces the need for some types of workers, and so unemployed workers need to search in other sectors for jobs and perhaps do some retraining.

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d) There is probably some structural unemployment in Alberta because it takes time for workers unemployed in one region or sector of the province to get absorbed into the expanding sectors. At the same time, there is probably some cyclical unemployment in this “sputtering” economy, due to deficient demand. There is also likely to be some structural unemployment in Ontario, although the “booming” description suggests that there is little or no cyclical unemployment in the picture. (As usual, frictional unemployment will exist in both provincial economies.)

Question 7 a) The unemployment that exists at E0 is only frictional and structural. Since output equals potential, and there is neither excess demand nor excess supply in aggregate factor markets, there is no cyclical unemployment. Since the unemployment rate is 8% when Y = Y*, we know that the NAIRU is 8%. b) Following the positive AD shock, output rises and the unemployment rate falls to 6.5%. There is cyclical unemployment of –1.5%. In other words, the unemployment rate has fallen below what it would be if labour markets were, in aggregate, in balance. Aggregate factor markets are in a state of excess demand. c) With factor markets in excess demand, wages and other factor prices start to rise. This pushes up firms’ costs and shifts the AS curve up and to the left. This adjustment continues until the macroeconomic equilibrium gets to E2, at which point factor markets are once again in balance. d) At E2, if there has been no change in the NAIRU, the unemployment rate has returned to 8%. At this point, all unemployment is either frictional or structural.

Question 8 a) The unemployment that exists at E0 is only frictional and structural. Since output equals potential, and there is neither excess demand nor excess supply in aggregate factor markets, there is no cyclical unemployment. Since the unemployment rate is 6% when Y = Y*, we know that the NAIRU is 6%. b) Following the negative AS shock, output falls and the unemployment rate rises to 7.5%. There is cyclical unemployment of 1.5%. In other words, the unemployment rate has risen above what it would be if labour markets were, in aggregate, in balance. Factor markets are in a state of excess supply. c) With factor markets in excess supply, wages and other factor prices eventually start to fall. This reduces firms’ costs and shifts the AS curve down and to the right (although perhaps quite slowly).

This adjustment continues until the macroeconomic equilibrium returns to E0, at which point factor markets are once again in balance. d) Back at E0, if there has been no change in the NAIRU, the unemployment rate has returned to 6%.

At this point, all unemployment is either frictional or structural.

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Question 9 a) The EI program is designed to eliminate some of the hardship associated with spells of unemployment. If the EI system is too generous, then unemployment spells are not particularly serious (at least in terms of forgone income), and so unemployed workers will be inclined to be very choosy about which jobs they accept. They will tend to reject merely “good” jobs, holding out instead for the “perfect” job. As a result, the amount of search unemployment will be high and the NAIRU will be high. But since people may choose not to accept jobs that are quite well suited to their skills, there may be too much search, and thus too much unemployment, for what is socially desirable. b) If the EI system is not generous enough, then unemployed workers will feel pressured to accept one of the first job offers that come along, because spells of unemployment are serious in terms of the level of income. But accepting an early job offer may actually be a poor use of society’s resources if workers and jobs end up being poorly matched. Not only will the match be less productive than it could be, but the poor job match will probably be terminated soon, thus imposing costs on society in terms of rehiring and retraining. There are genuine benefits to society in having a generous enough EI system to allow unemployed workers to find truly appropriate job matches. c) A reduction in the NAIRU following a reduction in EI generosity is a probable outcome, but it is not necessarily a desirable outcome. What matters is whether the EI program was at the “right” level of generosity to begin with. This is extremely hard to determine. At the optimal level of generosity, the marginal costs to society of having more workers searching must be equated with the marginal benefits to society of having better job matches.

Question 10 We often hear or read in the news about government spending programs that claim to “create jobs”, and students need to know how to evaluate such claims. This is a good issue that forces us to think carefully about the limitations of the income-expenditure model that we discussed at the end of Chapter 7. a) The increase in government spending on infrastructure projects (assuming that other government spending is not reduced by the same amount) causes a clear increase in aggregate demand. The rightward shift in the AD curve leads to a short-run increase in real GDP, and almost certainly an increase in employment. Over the longer run, however, the economy’s natural adjustment process will return real GDP back to Y*. If the level of potential output is unaffected by the infrastructure projects, then employment will likely return to its initial level. More likely in this case, however, the new infrastructure has the effect of increasing the level of Y*; in this case, the long-run effect of the policy may be a higher level of real GDP and employment. b) In general, the job-creating potential of new government spending is greater when the economy has some cyclical unemployment (that is, when real GDP is less than Y*). For an economy at full employment, the job creation will be temporary and only last as long as real GDP remains above Y*. There will also be a redistribution of jobs associated with the government spending. As government spending on sector X increases the demand for labour in that sector, real wages are driven up. Employers in other sectors then reduce their level of employment at the higher wage, and those workers move over to the X sector. Of course, it is very easy for the government to spend

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$1 billion on sector X and immediately see the new jobs associated with that spending. But what is not so easily observed is how many of those jobs came from the ranks of the unemployed (in which case they would genuinely be new jobs) and how many came from other sectors of the economy (in which case they would just be different jobs).

Question 11 The 2008 recession and financial crisis created a reduction in real GDP of roughly 3 percent, and it lasted for 1-2 years. The underlying cause was a negative aggregate shock. The fiscal policy response was to increase government spending, mostly on infrastructure projects that could begin and be completed relatively quickly—“shovel ready” projects. Such an increase in spending represents an increase in aggregate demand, thus directly addressing (and partially reversing) the underlying shock to the economy.

The 2020 pandemic recession had a very different underlying cause. The need for individuals to isolate safely in their homes (and not work in close proximity with others) to prevent the spread of the virus forced the immediate closure of many parts of the economy. This was mostly a negative aggregate supply shock. Employment and real GDP both fell by over 10 percent within just a few months. The government’s fiscal response was to provide massive amounts of financial relief to households and businesses, to replace the income that they were suddenly not earning. This was not conventional “fiscal stimulus” designed to increase aggregate demand—as there was no way for the economy to increase production in response to such stimulus. Because the loss of income was so much more widespread than what occurred during the 2008 recession, the size of the fiscal response in 2020 was commensurately larger, although very different in terms of how the government used the funds.

Problems Question 12 a) The unemployment rate is equal to the number of people unemployed divided by the labour force, expressed as a percentage. The labour force is the sum of employment and unemployment. On September 1, the unemployment rate is equal to (120,000)/(120,000 + 1,430,000) = (120,000)/(1,550,000) = 7.7%.

For October 1, the unemployment rate is equal to (120,000)/(1,500,000) = 8.0%.

For November 1, the unemployment rate is equal to (120,000)/(1,370,000) = 8.8%. b) Since the number of unemployed people is constant across these three months, the unemployment rate is changing only because of the change in the size of the labour force, which also means a change in the amount of employment. From September through November, there is a steady decline in the amount of employment, and this explains the rising unemployment rate. c) Notice that from September through November, the labour force is falling. What is likely happening is that people are losing their jobs and becoming unemployed, but at the same time existing unemployed people are becoming discouraged and leaving the labour force. If these two flows are equal, then the absolute amount of unemployment is constant. But in this case, the unemployment rate is not capturing those discouraged workers and so is underestimating the true amount of excess supply in the labour market.

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Question 13 a) The economy’s NAIRU is the weighted average of the NAIRU for each of the demographic groups, where the weights are given by each group’s proportion in the labour force. We are told that in Year 1 output equals potential, and thus the unemployment rate equals NAIRU. The aggregate NAIRU in Year 1 is therefore: NAIRU in Year 1 = (0.2 × 0.14) + (0.8 × 0.06) = 0.028 + 0.048 = 0.076 or 7.6% b) We use the same approach for each of the years 2 through 8.

NAIRU in Year 2 = (0.21 × 0.14) + (0.79 × 0.06) = 0.029 + 0.047 = 0.076 or 7.6% NAIRU in Year 3 = (0.22 × 0.14) + (0.78 × 0.06) = 0.031 + 0.047 = 0.078 or 7.8% NAIRU in Year 4 = (0.23 × 0.14) + (0.77 × 0.06) = 0.032 + 0.046 = 0.078 or 7.8% NAIRU in Year 5 = (0.25 × 0.14) + (0.75 × 0.06) = 0.035 + 0.045 = 0.080 or 8.0% NAIRU in Year 6 = (0.27 × 0.14) + (0.73 × 0.06) = 0.038 + 0.044 = 0.082 or 8.2% NAIRU in Year 7 = (0.29 × 0.14) + (0.71 × 0.06) = 0.041 + 0.043 = 0.084 or 8.4% NAIRU in Year 8 = (0.31 × 0.14) + (0.69 × 0.06) = 0.043 + 0.041 = 0.084 or 8.4% c) Output is, by assumption, always equal to potential for this 8-year period. But still the NAIRU rises. This occurs because the composition of the labour force is changing. The share of the labour force made up by the higher-unemployment group (youth) is rising and the share made up by the lower-unemployment group (adults) is falling. Even though the unemployment rate within each group is not changing, the demographic shift results in a change in the aggregate NAIRU. This is another example of why understanding the behaviour of aggregate variables requires an understanding of the micro component variables.

Question 14 a) See the top figure below (and notice the break in the two scales). Real GDP falls in 2011 and 2012—this is a recession. But notice that real GDP is below potential GDP from 2012 until 2018— this entire period displays a recessionary output gap. Notice also that potential GDP grows throughout the period shown, due presumably to growth in productivity and the growth in productive factors such as capital and labour.

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b) See the bottom figure below. The unemployment rate rises modestly when the recession starts in 2011 and then rises more sharply in 2012. It remains high when the recessionary gap is at its largest.

Then, as growth in real GDP begins to close the output gap, the unemployment rate falls.

c) The NAIRU is the unemployment rate that exists when real GDP is equal to potential GDP. This occurs twice in the period shown—in 2011 and in 2018. In both years, the unemployment rate is 6.8 percent. So this is the value of the NAIRU. d) In this example, the NAIRU is unchanged between 2011 and 2018. But this need not always be the case. As we discussed in the chapter, there are several reasons why NAIRU could change. One reason that NAIRU could increase is a change in the demographic mix of the labour market—an increase in the participation of high-unemployment groups (like youth) and a reduction in the participation of low-unemployment groups (like adult women). Another is an increase in the generosity of the employment-insurance (EI) program. *****

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________________________________________ Chapter 16: Government Debt and Deficits ________________________________________ This chapter examines several issues surrounding government deficits, surpluses and the stock of government debt. We continue some themes that were introduced in Chapters 7 and 9, and we also introduce several new ones. By placing this chapter after the complete development of the AD/AS model, and after the presentation of money and monetary policy, the discussion can take place with a reasonable level of sophistication. Our own views are close to what we might identify as the “mainstream” view that deficits matter, both for short-term stabilization and for long-term welfare, and we naturally give prominence to that view in the discussion. However, we do not hide the fact that there is controversy surrounding many of the views expressed, and we try to give opposing views a fair treatment.

It is worth emphasizing that this chapter is really examining much more than just the effect of the government budget on aggregate demand, although we do spend some time on this relationship. We also examine the simple arithmetic of the government’s budget constraint, the arithmetic explaining how the debt-to-GDP ratio changes over time, and the subtle linkages between the stock of debt and the effectiveness of fiscal and monetary policy that are not easily shown in the AD/AS model. *** The chapter is divided into four main sections. In the first section, we review some basic facts concerning debt and deficits. We argue that budget deficits are best viewed relative to the size of the economy, and thus present a figure giving the historical evolution of the deficit as a percentage of GDP. We develop the simple arithmetic of the government’s budget constraint––emphasizing the point that government expenditure must be financed either by borrowing or by taxes. We also make the important distinction between overall budget deficits and primary budget deficits. We argue— especially important for Canada—that when examining the size and effects of government budget deficits or surpluses, emphasis should really be placed on the combined budgets of all levels of government.

The second section examines two analytical issues that recur at several points throughout the chapter. The first issue involves judging the stance of fiscal policy with the use of the structural (or cyclically adjusted) budget deficit rather than simply the measured deficit. We provide some Canadian data showing the dramatic reduction in both the actual and the structural budget deficit beginning in 1995, and explain why it is too soon to know how much of the large change in the budget deficit caused by the COVID-19 pandemic will end up being structural. The second issue involves the determinants of changes in the debt-to-GDP ratio—what we here call “debt dynamics”.

We state the simple equation that governs debt dynamics, and then explain the intuition of the importance of real interest rates, GDP growth rates, and the primary budget balance. This discussion leads to a box that applies the arithmetic of debt dynamics to the situation in Greece, where bondholders came to expect the government to default and this expectation drove up bond yields and exacerbated the government’s fiscal situation.

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The chapter’s third section examines the effects of government debt and deficits. We begin by clearly stating an assumption that we make in the macro model: an increase in the government’s budget deficit leads to a decrease in national saving. The section then addresses three main questions.

First, do deficits crowd out private economic activity? Here we examine the effects in both open and closed economies, using the basic AD/AS model and showing its connection with the long-run version of the model developed in Chapter 10. Second, do deficits harm future generations? There is a detailed discussion of the burden of the public debt, which then leads to a brief discussion of capital budgeting. Third, can the accumulated stock of government debt hamper the conduct of macroeconomic policy? Here we make the points that high debt can hamper the conduct of monetary policy (by leading the market to expect future monetization and thus future inflation) and also hamper the conduct of fiscal policy (by removing the ability of the government to actively pursue counter-cyclical fiscal policy). This entire discussion leads to a new box which shows 140 years of data on government debt and interest rates for advanced economies. This discussion makes it clear why many policymakers now argue that even though public debt is historically very high (especially after the COVID-19 pandemic), the very low interest rates make servicing this debt easier than it has been in many years.

The final section offers a brief examination of formal fiscal rules, such as annually balanced budgets or cyclically balanced budgets. We emphasize that preferable to formal rules are guidelines that keep our focus on preventing the debt-to-GDP ratio from getting too high.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) tax revenues; borrowing b) spending; tax revenues c) primary budget; debt-service d) primary budget deficit; primary budget surplus Question 2 a) national income (real GDP) rises b) falls; rises c) potential GDP; taxing and spending policies d) larger; smaller e) primary budget surplus

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Question 3 a) rise; crowded out b) rise; appreciate; fall c) destabilizing d) business cycle (in a precise way) Review Questions Question 4 a) The budget deficit is equal to G + iD – T. G and iD are both autonomous with respect to real GDP. In contrast, net tax revenues change when real GDP changes. As real GDP rises, tax revenues rise (for a given tax rate) and transfers (such as employment insurance and welfare) fall. Thus, as real GDP rises, the overall budget deficit tends to fall. This explains the negative slope of the budget deficit function. b) If the government increases its level of purchases, the increase in G implies an upward shift in the budget deficit function. That is, the overall budget deficit will increase for any given level of real GDP. c) If the government increases the net tax rate, net tax revenues will rise (and thus the budget deficit will fall) for any given level of real GDP. The budget deficit function will rotate downward, becoming steeper (the slope of the budget deficit function is the negative of the net tax rate). d) The budget deficit can change for two general reasons. First, it can change because of a change in fiscal policy, either a change in government purchases, a change in net taxation, or both. Second, the budget deficit can change in the absence of a change in policy if the level of real GDP changes. The first type of change is shown by a shift of the budget deficit function; the second type of change is shown by a movement along the budget deficit function caused by a change in real GDP. e) An expansionary fiscal policy (an increase in G or a reduction in net tax rates) causes an upward shift in the budget deficit. A contractionary fiscal policy (a reduction in G or an increase in net tax rates) causes a downward shift in the budget deficit function. (If the net tax rate changes, the slope of the budget deficit function will also change.)

Question 5 a) If real GDP was equal to Y* when the budget surplus was $9.6 billion, then in the absence of any changes in fiscal policy, the small budget deficit in the next year would be explained by a reduction of real GDP below its potential level. In terms of a figure, this is simply a movement along (to the left) the budget deficit function, caused by a reduction in real GDP and resulting in an increase in the budget deficit.

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b) The large increase in the budget deficit for 2009-10 was a combination of two things: a further reduction of GDP below Y* (a global recession) and a change in fiscal policy toward more spending and lower taxes (policies of fiscal stimulus). In terms of a figure, there was both a leftward movement along the budget deficit function (because of the fall in real GDP) and a shift upward of the budget deficit function (as fiscal policy changed).

Question 6 a) At E1 there has been an increase in both real GDP and the price level. On both counts there will be an increase in the demand for money. If the money supply is unchanged during this fiscal expansion, the excess demand for money will push up interest rates relative to those that existed at E0. (It is also true that the increase in G leads to a reduction in national saving, which drives up the interest rate at Y*.) b) Other things being equal, the higher interest rate tends to reduce the amount of desired investment expenditure—this is the “crowding out” of investment caused by the fiscal expansion. Recall that we assume desired investment to be autonomous with respect to the level of real GDP. c) The inflationary output gap at E1 implies that factor markets are in a state of excess demand. This drives wages and other factor prices up and causes the AS curve to shift up and to the left. At the new long-run equilibrium, real GDP is back to Y* but the price level is higher than at E0. So we know that the demand for money and thus interest rates are higher at E2 than at E0. Desired investment expenditure is therefore lower at E2 than at E0. This is the crowding out of investment by the fiscal expansion. (It is also true that the reduction in national saving caused by the rise in G leads to a rise in the equilibrium interest rate at Y*.) d) In the long run (or perhaps the very long run), the reduction in investment caused by the fiscal expansion implies that the economy’s capital stock is not rising by as much as it otherwise would have. Thus, the long-run growth path of Y* will be reduced. For example, instead of Y* growing by 3 percent per year, it might now be growing by only 2.5 percent per year.

Question 7 The fiscal expansion causes the AD curve to shift to the right and increases both real GDP and the price level in the short run. As money demand increases, the domestic interest rate rises. So far, this is exactly the same as in Question 6. But in an open economy with highly mobile financial capital, an additional effect is seen on the exchange rate and net exports. The higher domestic interest rate attracts an inflow of financial capital (in pursuit of higher interest earnings) and this increases the demand for the Canadian dollar on foreign-exchange markets. This causes an appreciation of the Canadian dollar which, in turn, leads to a decline in next exports. This mechanism is the “crowding out” of net exports in an open economy caused by a fiscal expansion.

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Question 8 a) At E1 there has been a reduction in both real GDP and the price level. On both counts there will be a decrease in the demand for money. If the money supply is unchanged during this fiscal contraction, the excess supply for money will reduce interest rates relative to those that existed at E0. b) Other things being equal, the lower interest rate tends to increase the amount of desired investment expenditure. Recall that we assume desired investment to be autonomous with respect to the level of real GDP. c) The recessionary output gap at E1 implies that factor markets are in a state of excess supply. This eventually drives wages and other factor prices down and causes the AS curve to shift down and to the right. At the new long-run equilibrium, real GDP is back to Y* but the price level is lower than at E0. So we know that the demand for money and thus interest rates are lower at E2 than at E0.

Desired investment expenditure is therefore higher at E2 than at E0. This is the “crowding in” of investment by the fiscal contraction. d) In the long run (or perhaps the very long run), the increase in investment caused by the fiscal contraction implies that the economy’s capital stock is rising by more than it otherwise would have.

Thus, the long-run growth path of Y* will be increased. For example, instead of Y* growing by 3 percent per year, it might now be growing by 3.5 percent per year. e) There is a clear policy dilemma. A fiscal contraction may have desirable long-run effects on output and living standards, but the short-run effects are reduced output and a recessionary gap. This provides one explanation for why it is often politically difficult to reduce budget deficits. The costs are immediate and apparent (bankruptcies and unemployment) whereas the benefits are much later and harder to identify precisely.

Question 9 Interest payments on the existing stock of government debt are part of the federal budget every year.

Thus, if the interest rate that the government pays is variable, or if some of the existing debt can be refinanced at a lower rate, then the interest payments (and thus the overall budget deficit) will be lower. This was a significant factor in the deficit reduction of the mid 1990s. Even lower interest rates existed on Canadian government debt in the 2010-15 period, and contributed to smaller budget deficits than would otherwise have existed.

Question 10 a) In early 2018, the U.S. gross federal debt was about 104 percent of GDP; federal net debt was about 80 percent. In Canada in 2018, gross federal debt was about 89 percent of GDP; net federal debt was about 33 percent. (The gross-net distinction is more significant in Canada than in the United States because the Canadian government has more accumulated financial assets as a share of GDP, especially regarding public pension plans.)

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b) With the arrival of a significant recession, most governments will attempt to stimulate aggregate demand with a fiscal expansion, either by increasing government spending or by reducing taxes. In either case, the budget deficit will typically increase. If the government already has a very high debtto-GDP ratio, the increase in the deficit may put the debt ratio on a hard-to-control upward path, and this might create the expectation of future default by bondholders, which in turn would drive up risk premia on government debt. In such situations, governments may find that they have “no room” to design a counter-cyclical fiscal expansion. In contrast, if the debt-to-GDP ratio is quite low, then even a large increase in the budget deficit can occur without creating these unfavourable expectations. So a low debt ratio means that governments have a greater ability to use their fiscal policy to stabilize the economy in response to recessions. c) In 2018, the Canadian net debt ratio was significantly lower than that in the United States. Most economists agree that the U.S. fiscal situation is of serious concern, and that actions will soon need to be taken to slow the ascent (and eventually reverse) the upward trajectory of the U.S. debt ratio.

Problems Question 11 a) Recall that the overall budget deficit is equal to total government expenditure, including debtservice payments, minus total government net tax revenues. See the completed table below. b) The primary budget deficit is equal to the overall deficit minus the debt-service payments. Or, equivalently, it is equal to non-debt-service expenditures minus government net tax revenues. See the table below.

Year

Total Deficit G + iD – T

Primary Deficit G–T

Stock of Debt Dt = Dt-1 + ∆Dt

2016 2017 2018 2019 2020 2021 2022 2023

175 + 25 – 175 = 25 180 + 26 – 180 = 26 185 + 27 – 185 = 27 188 + 26 – 190 = 24 185 + 25 – 195 = 15 185 + 24 – 200 = 9 180 + 23 – 205 = – 2 175 + 22 – 210 = –13

175 – 175 = 0 180 – 180 = 0 185 – 185 = 0 188 – 190 = – 2 185 – 195 = –10 185 – 200 = –15 180 – 205 = –25 175 – 210 = –35

400 + 25 = 425 425 + 26 = 451 451 + 27 = 478 478 + 24 = 502 502 + 15 = 517 517 + 9 = 526 526 – 2 = 524 524 – 13 = 511

c) The overall budget deficit in any given year is equal to the change in the stock of debt, from that year to the next. Thus, the overall deficit of $25 billion in 2016 adds to the initial stock of debt of $400 billion so that by the end of 2016, the new stock of debt is $425 billion. This is shown in the first row.

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d) The same method as used in (c) is used for the remaining years. The stock of debt rises from 2016 to 2021 because the overall budget deficits in those years are positive. But beginning in 2022, the budget surpluses (negative deficits) imply that the stock of debt begins to fall. e) The stock of debt grew from $400 billion in 2015 to $511 billion at the end of 2023, an increase of 111/400 = 27.8 percent. If the debt-to-GDP ratio was unchanged over this period, then GDP must have also increased by 27.8 percent between 2015 and 2023.

Question 12 a) See the figure below.

b) The actual budget deficit is above the structural deficit between 1990 and 1994 because the actual level of real GDP is below the level of potential GDP. When real GDP is below Y*, net tax revenues are lower (than at Y*), and so the actual deficit is above the structural deficit. c) The actual budget deficit is below the structural deficit from 1995 to 1997 because during this time real GDP was above potential GDP, Y*. When this occurs, net tax revenues are higher than at Y*, making the budget deficit lower than at Y*. d) The stance of fiscal policy is best measured by the change in the structural (or cyclically adjusted) deficit – which is a shift of the budget deficit function. A rise in the structural deficit reflects an expansionary fiscal policy; a fall reflects a contractionary fiscal policy. Thus U.S. fiscal policy was expansionary from 1989 through 1993, as the structural deficit increased from 2.9% to 3.7%. e) After 1993, U.S. fiscal policy was quite contractionary, as the structural deficit fell from 3.7% in 1993 to 1.0% in 1997.

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f) U.S. fiscal policy began its contraction in 1993, and the structural deficit fell by 2.7 percentage points between 1993 and 1997. Canadian fiscal policy (combined governments) also began its contraction in about 1993, but the dramatic contraction did not really begin until 1995. From 1995 to 2000, the structural deficit in Canada declined by approximately 6 percentage points. Thus, the Canadian fiscal contraction was considerably sharper than the one in the United States (reflecting, in part, the perception that the deficit was a larger problem in Canada than in the United States).

Question 13 a) See the completed table below.

Year

d (debt-to-GDP ratio)

∆d (change in d) = x + (r-g)d

2016

0.70

0.03 + (0.02 × 0.7) = 0.044

2017

0.70 + 0.044 = 0.744

0.02 + (0.015 × 0.744) = 0.031

2018

0.744 + 0.031 = 0.775

0.01 + (0.01 × 0.775) = 0.018

2019

0.775 + 0.018 = 0.793

0.0 + (0.01 × 0.793) = 0.008

2020

0.793 + 0.008 = 0.801

– 0.01 + (0.005 × 0.801) = – 0.006

2021

0.801 – 0.006 = 0.795

– 0.02 + (0.005 × 0.795) = – 0.016

2022

0.795 – 0.016 = 0.779

– 0.03 + (0.0 × 0.779) = – 0.03

b) See the table above. The debt-to-GDP ratio at the end of 2017 is equal to the ratio in 2016 (0.70) plus the change in the ratio that occurs during 2017 (0.044), which is 0.744. c) See the completed table above. Note that the value for ∆d in one year (row) is used to compute the value of d for the next year (row). Also, the value of d for any one year (row) is used to compute the value of ∆d for that same year (row).

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d) See the figure above. The only discretionary variable is the primary deficit (or surplus).

Throughout the period we see the primary budget deficit falling, and eventually becoming a primary budget surplus. Since r exceeds g for the entire period, the simple equation we discussed in the text tells us that a primary budget surplus is required in order to reduce the debt-to-GDP ratio. Note that it is a necessary, though not sufficient, condition. Thus, the primary surpluses begin in 2020 and the debt-to-GDP ratio does not begin to fall until the next year. e) We have assumed in the textbook that the reduction in the primary deficit (achieved either through reductions in government purchases or tax increases, or both) will lead to an increase in national saving. Other things being equal, this will tend to push down real interest rates. *****

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_______________________________________ Part Seven Canada in the Global Economy

_______________________________________ International themes are woven throughout the book, and we address trade and exchange rates when necessary and mention the importance of globalization in the functioning of modern economies. But until now we have not addressed the international issues in detail. A systematic treatment of international economics is the purpose of the next three chapters.

The first two chapters of this part deal with the economics of international trade in goods and services. International trade is one of the most interesting and most important applications of applied microeconomic theory. The third chapter deals with exchange rates, the balance of payments, and open-economy macro policy topics such as the desirability of current account deficits and the benefits and costs of Canada’s fixing its exchange rate (to the U.S. dollar). *** Chapter 17 deals with the gains that arise from international trade, emphasizing the role of comparative advantage. We have data figures showing the importance of trade, both for the world and for Canada. We also have a simple demand-and-supply discussion of exports and imports that shows that actual trade patterns in competitive markets are predicted to follow the pattern of comparative advantage. We also discuss the terms of trade and why they matter.

Chapter 18 deals with the theory and practice of trade policy, which has become much commonly discussed and debated in recent years. We examine the valid cases for protection as well as several faulty arguments. We examine the effects of tariff and quotas in some detail. The chapter also includes a discussion of the World Trade Organization and the North American Free Trade Agreement, including the recent re-negotiations of NAFTA (and replacement with the USMCA).

Chapter 19 focuses on open-economy macroeconomics. It covers the balance of payments and the determination of exchange rates, in both flexible and fixed exchange-rate regimes. With the basics in place, we then examine three recurring policy issues. Are current account deficits undesirable? Is there is a “right” value for the Canadian dollar? Should Canada fix its exchange rate? ***

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___________________________________________ Chapter 17: The Gains from International Trade ___________________________________________ In this chapter, we develop the standard theory of the gains from trade that result from the exploitation of comparative advantages. We give a patient tabular exposition of comparative advantage and the gains from trade, including two examples discussed in a box. In a different box, we present a graphical representation of the gains from trade when the country’s production possibilities boundary displays the “usual” increasing opportunity costs. We have a discussion of exports and imports in a supply-and-demand framework that shows actual trade patterns following the pattern of comparative advantage. Finally, we have a thorough discussion of the terms of trade. *** In the first section, we have data showing the importance of international trade, both for the world and for Canada. We then explore in some detail the sources of the gains from trade. We present the gains due to specialization in a simple Ricardian setting, and we have a diagram showing these gains.

We have a box examining two numerical examples. We also have a box showing the gains from trade due to specialization in the more realistic setting in which countries have a concave production possibilities boundary. We then go beyond most introductory texts by discussing the gains from trade due to economies of scale and learning-by-doing. Though the Ricardian setting of a single factor and constant returns generates invaluable insights about the gains from trade, students must learn that a great deal of trade is undertaken in imperfectly competitive industries, and they should know the nature of the gains from this trade. We conclude the section by examining the sources of comparative advantage. The sources that we identify include different national factor endowments (Heckscher-Ohlin) and different climates. These are the traditional “natural” reasons and they set the stage for the discussion of acquired comparative advantage that follows.

In the second section we discuss the determination of trade patterns. It is one thing to show students that specialization and trade according to comparative advantage would be beneficial; it is quite another to show that this is actually what happens. We use a simple demand-and-supply framework, combined with the international law of one price, to show which goods Canada will export and which goods Canada will import. The central message is that Canada will export goods for which it is a low-cost producer (relative to the world) and it will import goods for which it is a high-cost producer (relative to the world). We take care to explain the connection between prices, costs of production, and comparative advantage. We think this section is a valuable part of the chapter and should help students think clearly about comparative advantage and actual trade flows.

We then ask whether comparative advantage is obsolete. We argue that comparative advantage is not obsolete––but what is obsolete is the idea that government policy cannot affect a country’s pattern of comparative advantage. This is obviously not an argument that government necessarily should try to change the pattern of comparative advantage; it only recognizes the implications of acquired comparative advantage. We have an optional box that discusses global supply chains and how they relate to the idea of comparative advantage. Our discussion sets the stage for the coverage of trade policy in the next chapter.

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The chapter concludes by discussing the terms of trade, and how changes in world markets can lead to either improvements or deteriorations in a country’s terms of trade. We show how changes in the terms of trade affect a country’s consumption possibilities, and we also present some data showing Canada’s terms of trade over the past few decades.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) global output (and therefore consumption) b) absolute advantage; absolute advantage c) opportunity costs d) absolute advantage e) increase f) comparative advantage; gains from trade Question 2 a) one price; a single b) supply; export; less than c) demand; world; domestic d) exports; imports; improvement e) imports; exports Review Questions Question 3 a) and b) The slopes of the PPBs show the opportunity costs in each country. The steeper PPB in France than in Canada shows that France must give up more wine per unit of lumber produced than is necessary in Canada. Equivalently, Canada must give up more lumber per unit of wine produced than is necessary in France. Thus, Canada has the comparative advantage in lumber and France has the comparative advantage in wine.

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c) With the relative prices shown by the slope of the dashed line, Canadian producers will specialize in the production of lumber, thereby maximizing Canada’s income. Production in Canada will take place where the dashed line touches Canada’s PPB. Similarly, French producers will specialize in the production of wine, thereby maximizing France’s income. French production will take place where the dashed line touches France’s PPB. Both of the dashed lines touch at the axis of the product in which the country has a comparative advantage, showing that each country will completely specialize. d) With specialization as in part (c), but consumers in both countries wanting to consume both goods, there is only one possible pattern of trade. Canada will export lumber and import wine, and France will do the reverse.

Question 4 a) In both markets, the absence of international trade implies that the equilibrium price will be the one that clears the domestic market. In the figure below, these prices are denoted pC.

b) Now suppose that Canada is open to world trade, and the world price of each product is denoted pW. In the newsprint market, the world price exceeds the domestic Canadian price. But the law of one price applies and so only the single world price applies (since Canada is a small player in the much larger world economy). At the high world price, Canadian producers increase their quantity supplied to Q1 and Canadian consumers reduce their quantity demanded to Q2. The balance is exported to the rest of the world. c) In the machinery market, the world price is less than the domestic Canadian price. But the law of one price applies and so only the single world price applies. At the low world price, Canadian producers reduce their quantity supplied to Q2 and Canadian consumers increase their quantity demanded to Q1. The balance is imported from the rest of the world.

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Question 5 a) The damage of Brazil’s coffee crop will lead to an increase in the world price of coffee (since Brazil is such a large producer of coffee). Coffee is an imported good for Canada, and thus this shock leads to a terms-of-trade deterioration for Canada. b) A large OPEC output restriction will lead to an increase in the world price of oil. Canada produces and exports oil, but it also imports oil. However, Canada is a net exporter of oil and so the rise in the price of oil should have a larger effect on Canada’s export price index than on its import price index.

Thus, Canada’s terms of trade should improve. c) The development of copper mines in Chile will reduce the world price of copper. Canada is a net exporter of copper and so this will lead to a deterioration of Canada’s terms of trade. d) The Asian recession leads to a reduction in pork demand and thus to a reduction in the world price of pork. Pork is an important Canadian export, so the decline in its price is a terms-of-trade deterioration for Canada. e) The large reduction in the Russian wheat crop would reduce the world supply and raise the world price. Since Canada is a net exporter of wheat, this price increase represents a terms-of-trade improvement for Canada. f) Canada is a large exporter of potash (an important ingredient for fertilizers). Any significant restriction of potash output will increase the world price and thus represent a terms-of-trade improvement for Canada. (As it happens, three Canadian potash-producing firms have created just such a cartel and attempt to influence the world price in such a manner.)

Question 6 A rise in the price of one’s exports is an improvement in the terms of trade; a rise in the price of one’s imports is a deterioration in the terms of trade. The probable effects on relative prices are: a) Favourable change in the terms of trade for coffee exporters, unfavourable change for coffee importers. b) Fall in the price of Korean steel relative to Canadian steel. This improves the terms of trade for Canada and worsens the terms of trade for Korea. c) No effect predicted since a general inflation should not change relative prices in any systematic way. d) There will be a fall in the world price of oil. The terms of trade worsen for oil exporters, and improve for oil importers.

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Question 7 The quote reflects the often-heard view that one country can only benefit from trade at the expense of its trading partner––that is, that international trade is a “zero-sum” proposition. This chapter formalizes the proposition that international trade gives rise to benefits to both trading countries–– that is, international trade is a “positive-sum” activity. Indeed, the theory in this chapter suggests that the only situation in which one country will not gain at all from trade is the situation where free trade leads to no change in that country’s terms of trade (and thus to no change in its pattern of production).

Question 8 The answer here is similar to the answer to Question 7. If trade agreements between two or more countries permit domestic consumers to get access to foreign products at lower prices and also permit domestic firms to get access to foreign markets, it is very difficult to see how benefits to the trading partner come at the expense of the domestic country—as President Trump often argues. The basic theory of the gains of trade is all about why international trade is not a zero-sum activity.

Of course, free-trade agreements usually result in the reallocation of resources within the partner countries, and these reallocations typically involve temporary unemployment and other disruptions. These are genuine costs of free trade, but they are generally short-lived and smaller in total than the aggregate gains to the country. The policy challenge is to make sure that the injured parties are assisted, partly so that political support for free trade can be solid and widespread.

Question 9 a) The connection between a nation’s wealth and its ability to freely engage in trade is the essence of what we have called in this chapter “the gains from trade”. A nation that refuses to engage in foreign trade forgoes the full amount of any possible gains from such trade. Especially for a small country such as Canada, the advantages of specialization and international trade are large. b) The theory of comparative advantage that we have developed in this chapter shows that the gains from trade between two countries depend on the differences between the two countries’ autarkic opportunity costs (the slopes of their PPBs). Specifically, the larger are the differences in the countries’ pre-trade opportunity costs, the larger will be the gains from specialization and trade. The logic is simple. If another country can produce some product at a much lower opportunity cost than is possible in my country, then we stand a lot to gain by not producing that good here but instead importing it from that country. c) There will be no benefits from specialization and trade if two countries have the same opportunity costs (the slopes of their PPBs are the same). As long as there are some differences, there will be some gains from trade. (The allocation of those gains between the two countries depends on the freetrade relative prices relative to the pre-trade opportunity costs.)

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d) The diagram is simple, and is like Figure 17-3. If two countries have PPBs of exactly the same slope, and thus exactly the same pattern of opportunity costs, then the free-trade relative prices will also be that same slope. In this case, there will be no difference between each country’s PPB and each country’s free-trade consumption possibilities. Neither country will benefit at all from trade.

But if there are at least some differences in the pre-trade opportunity costs (as in Figure 17-3), then the free-trade terms of trade will result in an expansion of both countries’ consumption possibilities and so both countries will gain from trade.

Problems Question 10 a) Note that because the production possibilities boundary is a straight line, we know that the opportunity cost of either good is constant, no matter how much of it is being produced. The opportunity cost of producing more ice is the fish that are not produced. By moving from point B to point A, we produce 100 more tonnes of ice and we must forgo producing 15 tonnes of fish. b) Similarly, the opportunity cost of producing more fish is the ice that is not produced. From the diagram, it is clear that as we move from point A to point B, we produce 15 more tonnes of fish by giving up 100 tonnes of ice. Since the boundary is linear, it follows that to produce only 10 more tonnes of fish, we would have to give up (2/3) × 100 = 66.7 tonnes of ice.

Question 11 a) Brazil has the absolute advantage in both goods because the same amount of resources (1 million acres of land) can produce more of both goods than is possible in Mexico. b) The country with the comparative advantage in wheat is the country that produces wheat with the lowest opportunity cost—that is, the country that gives up the least corn for each bushel of wheat produced. Brazil must give up 1/3 of a bushel of corn to produce each bushel of wheat.

Mexico must give up 1/2 a bushel of corn to produce each bushel of wheat. Since 1/2 exceeds 1/3, it is clear that Brazil has a comparative advantage in wheat production. c) Using the same logic as in (b), we see that Mexico has a comparative advantage in corn production. d) It is certainly possible for a country to have an absolute advantage in both goods—this only requires that the country be more efficient than the other country in the production of both goods.

Here, by “more efficient” we mean less input per unit of output. In this case, Brazil is more efficient in both wheat and corn and so it has the absolute advantage in both goods. But comparative advantage is based on the idea of opportunity cost—what must be given up in the production of one good to get more of the other good. The opportunity cost is revealed by the slope of the production possibilities boundary. And if a country has a lower opportunity cost for one good then it must have a higher opportunity cost for the other good. Graphically, this simply says that if the PPB is steeper in one country than in another with respect to one axis, then it must be flatter in the first country than in the second with respect to the other axis.

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e) See the figure below. Note that each country has 1 million acres of land. So the most wheat that Brazil could produce is 90 million bushels; and the most corn it could produce is 30 million bushels. Similarly, Mexico could never produce more than 50 million bushels of wheat or 25 million bushels of corn.

f) The slope of a country’s production possibilities boundary shows the opportunity cost in that country for each good. For example, the slope of Brazil’s PPB in the figure is (negative) 1/3 (note the different scales on the two axes). This is the opportunity cost of one bushel of wheat in Brazil, meaning that Brazil must forgo 1/3 of a bushel of corn in order to produce an extra bushel of wheat.

The inverse of the slope is (negative) 3, which is the opportunity cost of one bushel of corn in Brazil.

Question 12 a) The values in the table show what can be produced with one unit of equivalent resources in each country. So the two countries are equally efficient at producing dairy products, but New Zealand is less efficient at producing beef than Australia. So Australia has the absolute advantage in the production of beef and neither country has an absolute advantage in the production of dairy products. b) To produce an extra 12 tonnes of dairy products in New Zealand, 4 tonnes of beef must be given up. So the opportunity cost of one tonne of dairy products in NZ is 4/12, which is 1/3 of a tonne of beef. In Australia, the opportunity cost of an extra tonne of dairy products is 16/12 = 1.33 tonnes of beef.

For the opportunity cost of beef in each country, the numbers are simply the inverses. In NZ, the opportunity cost of one tonne of beef is 3 tonnes of dairy products. In Australia, the opportunity cost of one tonne of beef is ¾ of a tonne of dairy products.

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c) Comparative advantages are given by the lowest opportunity costs. So in this example, New Zealand has the comparative advantage in producing dairy products and Australia has the comparative advantage in producing beef. d) See the figure below.

e) The slope of each country’s production possibilities boundary shows the opportunity costs of production in each country – how much of one good must be given up in order to produce one more unit of the other good. The steeper slope for Australia (note that the scales of the two diagrams are the same) indicates that dairy production can only be increased by giving up more beef production than is the case in NZ. In other words, the steep slope of the PPB in Australia shows that Australia is the higher-opportunity-cost producer of dairy (and thus the loweropportunity-cost producer of beef).

Question 13 a) The terms of trade is equal to Terms of Trade = (Index of Export Prices/Index of Import Prices) × 100 See the table below.

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Year

Import Prices

Export Prices

Terms of Trade

2014 2015 2016 2017 2018 2019 2020

90 95 98 100 102 100 103

110 87 83 100 105 112 118

(110/90) × 100 = 122.2 (87/95) × 100 = 91.6 (83/98) × 100 = 84.7 (100/100) × 100 = 100.0 (105/102) × 100 = 102.9 (112/100) × 100 = 112.0 (118/103) × 100 = 114.6

b) An improvement in the terms of trade is indicated by an increase in the value in the fourth column—it means that export prices are rising relative to import prices. Put another way, this means that the country needs to sell fewer units of its exports in order to get one unit of imports. A termsof-trade improvement occurs every year in this case beginning in 2016—the terms of trade continually increase from 2016 to 2020. c) The terms of trade deteriorate (fall) from 2014 through 2016. d) A terms-of-trade “improvement” is an increase in the price of exports relative to the price of imports. This is good for the country as a whole because it means that one unit of exports can purchase more units of imports, indicating that the country as a whole can get access to more overall consumption by giving up fewer of its own produced goods. *****

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_______________________ Chapter 18: Trade Policy _______________________ Most introductory textbooks have a single chapter on international trade, which includes both the simple theory of the gains from trade as well as some elementary aspects of trade policy. Given the importance of trade and trade policy to Canada, however, we feel it is valuable to offer a more thorough treatment. This separate chapter examines both the theory and practice of trade policy. We offer some reasonable arguments in favour of protection as well as some invalid ones. We review policies that raise import prices as well as policies that directly restrict quantities; we also discuss how the levying of tariffs can sometimes lead to “tariff wars”, as happened in the 1930s and may be happening again today. Finally, we discuss international trade agreements, such as the WTO and NAFTA (and its successor agreement, USMCA). We hope instructors will take the time to cover some of the central themes in this chapter. *** The chapter is divided into three sections. The first section deals with the theory of trade policy. Here we review the case for free trade (which was made in detail in Chapter 17) and then examine in detail the case for protectionism. We offer two general situations in which protection might sensibly be pursued. First, when a small country’s objective is other than maximizing its national income, trade protection might encourage industrial diversification or protect certain groups from foreign competition. Second, even when the goal is to maximize national income, trade protection may improve a country’s terms of trade, encourage infant industries, promote learning by doing, or help the country to earn pure profits with “strategic” exports. We then discuss in detail four commonly heard, but fallacious, arguments for protectionism. A box examines the connection between recessions and protectionism, motivated by the global recession of 2008-09 and how it led political leaders to commit to avoiding implementing protectionist measures.

The design of this section reflects our belief that it is very important for students to get a balanced treatment of the cases for and against free trade. Too many textbooks present the arguments (on either side) as if there is no sensible opposing view. We emphasize that there are some conditions under which free trade may not be optimal, but they tend to be rather special conditions; students should understand how special these conditions are.

The second section discusses methods of protection. We discuss policies that directly raise prices, such as tariffs; we also discuss policies that directly reduce quantities, such as import quotas.

In the case of quotas, the newly created rents are received by the foreign producers and their distributors, rather than by the domestic governments or producers. The long-lasting dispute between Canada and the United States over softwood lumber offers an excellent example of the choice between tariffs and quotas. We then examine trade-remedy laws and non-tariff barriers. Here we explore dumping and countervailing duties, and explain why the current system is protectionist in several respects. We end this section with a new discussion of the confrontation of trade policy with climate policy—a brief description of the emerging issue of “border carbon adjustments”.

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The chapter’s final section discusses current trade policy. We examine the WTO, the various types of regional trade agreements, and we also explain the effects of trade creation and trade diversion. The final discussion in the section centres around NAFTA, and its successor agreement, USMCA. We review the core elements of the agreement and briefly discuss the trade performance following the agreement. Our overall discussion of Canadian free trade leads to a box on Canadian wine—a surprising free-trade success story.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) comparative advantage; specialize; comparative advantage b) worse c) lower d) infant industry e) invalid; exported f) trade; employment Question 2 a) increase; decrease; increase; fall b) domestic producers; the government; domestic consumers; foreign producers c) reduction; deadweight d) increase; fall; increase e) domestic producers; foreign producers; domestic consumers f) reduction; deadweight Question 3 a) trade creation b) trade diversion; countries outside the group c) national treatment; domestic; foreign

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Review Questions Question 4 a) See the figure below. The demand and supply curves are for Canadian consumers and Canadian producers, respectively. The world price, pw, is shown below the price that would exist in Canada if Canada were a closed economy, pc. Canada produces Q1 units of steel and consumes Q2 units of steel, importing the difference from abroad.

b) We assume here that we are talking about one particular grade of steel, so that the foreign steel is identical to the domestic steel. With a tariff of t dollars per unit on imported steel, the price in Canada of imported steel will now be pw+t. But the law of one price says that identical products will sell for the same price, so the price of domestic steel will also rise by t dollars per unit (the price in the rest of the world will not be affected by the Canadian tariff since Canada is a small country). The Canadian price rises to pw+t. The quantity supplied domestically rises to Q3 while the quantity demanded domestically falls to Q4. Imports therefore fall from Q1Q2 to Q3Q4. c) Domestic consumers clearly lose since they consume less steel and pay a higher price per unit.

The loss of consumer surplus is shown by areas 1 plus 2 plus 3 plus 4. Canadian steel producers (and their workers) gain from the tariff since it raises the price and allows them to increase sales. The gain in producer surplus is shown by area 1. The taxpayers (in the form of the government) benefit by the amount shown in area 3, since this is the revenue raised by the tariff. Thus, area 1 is simply a redistribution away from consumers toward producers, and area 3 is a redistribution away from consumers toward taxpayers. We are left with areas 2 and 4 as a net loss to society—this is the deadweight loss of the tariff.

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Question 5 a) Before the tariff is imposed, the price of shoes is pw and Q1 units are produced in Canada. But Q2 units are consumed in Canada, so the difference, Q1Q2, is imported. After the tariff is imposed, the price is pw+t, and imports fall to Q3Q4. b) Canadian shoe production rises from Q1 to Q3 as a result of the tariff being imposed. The producer surplus of Canadian shoe producers increases by area A. c) The tariff raises the domestic price and reduces consumer surplus in Canada by areas A + B + C + D. d) The tariff revenue is equal to the per-unit tariff times the quantity of imports. The quantity of imports is Q3Q4. So the tariff revenue is shown by area C. e) The overall effect of the tariff is to create a net loss of surplus for the economy, represented by the areas B + D. This area is the deadweight loss of the tariff.

Question 6 a) At the world price of pw, Canadian consumers demand Q2 units of shoes, Q1Q2 of which must come from imports. If the government restricts the quantity of imports to Q3Q4, there will be an excess demand for shoes in Canada at the price pw. This excess demand forces up the Canadian price.

The equilibrium is reached when at the new price the demand for imported shoes just equals Q3Q4 units. (Note that as the Canadian price rises, two things reduce the quantity of imports demanded— an increase in domestic production and a reduction in domestic consumption.) From the diagram it is clear that this new price must be exactly equal to pw+t.

Note also that the law of one price is not violated here, although it may appear to be. The high price in Canada is caused by the import quota. There is no way that arbitrageurs could buy shoes at the low world price and then sell them at the high Canadian price because such arbitrage would violate the import quota and thus be illegal. So it is the obstacle to arbitrage that permits the price differential to exist. b) With a tariff, area C would be the tariff revenue. But with an import quota equal to Q3Q4 units, there is no tariff revenue. It is the foreign producers who now earn area C—they earn a higher price on their Q3Q4 exports to Canada than they earn on their other units. Having the right to sell in the import-restricted market is valuable! c) The effect on consumers is the same with a tariff or a quota—consumers face a higher price and their consumption falls in both cases. It is also the same for Canadian producers—they produce and sell more and also benefit from a higher price. The only difference is area C. With a tariff, this area is the tariff revenue for Canadian taxpayers (their government). With a quota, this area is revenue for foreign producers. For Canada overall, therefore, the tariff is preferable to the import quota.

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Question 7 a) These policies were referred to as “Voluntary Export Restrictions (VERs)”. VERs are voluntary because they raise profits for the foreign producers. Similar to the case of the import quota in the previous question, the VERs had the effect of restricting the volume of imports of Japanese cars into North America. By creating an “artificial” scarcity of cars, the VER drove up the price of all cars in North America. The result is that the Japanese producers are able to earn higher profits (as shown by area 3 in Figure 18-2 in the textbook). The VER effectively gives the Japanese producers some monopoly power that they might not have otherwise had. b) See the analysis in Question 6(b). With the VERs, the Japanese producers get extra revenue per car. In contrast, with a tariff the premium paid by the consumers would be collected by their own government in the form of tariff revenue. c) North American consumers are paying for the benefits to the Japanese producers (and to the domestic producers and their workers).

Question 8 This is a good question to make students think through the various types of trade polices that are available. It is important for students to see who gains and who loses from the alternative policies. a) The consumers in Houseland are made worse off, since the price of lumber will rise. These consumers will generally include firms that use lumber as an input. The lumber producers (and workers) in Houseland are better off, since they are protected and can sell their product at a higher price than before. The lumber producers and workers in Forestland are worse off since the tariff reduces the demand for their product. b) The export tax imposed by Forestland reduces the supply of lumber to Houseland and thus drives up the price of lumber in Houseland. The consumers in Houseland are worse off, just as in case (a). The lumber producers and workers in Houseland are better off, just as in case (a), since the price of their product is driven up. The lumber producers and workers in Forestland are also worse off, just as in case (a)—their product sells for a higher price in Houseland, but this benefit gets taxed away by their home government, leaving them with only the costs associated with reduced output levels. The one important difference from case (a), however, is that with the export tax the government of Forestland collects the tax revenue, whereas with the import tariff the government of Houseland collects the tariff (tax) revenue. c) The agreement to restrict exports from Forestland drives up the price of lumber in Houseland.

Consumers in Houseland are worse off. Lumber producers and workers in Houseland are better off. Lumber producers and workers in Forestland are now better off, since they are effectively imposing some monopoly power—by restricting output they are driving the price up. The extent of the price rise, of course, will depend on the elasticity of demand for lumber in Houseland.

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d) Which policy will get the most political support? In Houseland, all three policies are bad for consumers and good for the lumber producers and workers. So there will naturally be disagreement between these two groups over any of the policies. In Forestland, the lumber producers would probably favour the voluntary export restriction, but the government may feel it necessary to use an export tax in order to enforce such a restriction.

Question 9 a) American consumers would benefit from the dumping of Canadian steel into the U.S. market because they would be able to buy steel at a lower price than they otherwise could. American steel producers (and their workers) would be harmed since they would lose sales to the Canadian steel companies. b) With antidumping duties imposed on the imported Canadian steel, the U.S. steel producers would be protected—they would be better off. But American consumers would now be forced to pay a higher price than what would otherwise be the case—they would be worse off. c) The simple view of dumping is that the foreign (Canadian) producers are offering (for whatever reason) low-priced products to domestic (American) consumers, and the standard theory of the gains from trade suggests that the United States would be better off overall to trade freely, and thus to welcome the dumped steel with open arms. U.S. steel producers could then reallocate their resources toward the production of goods for which the United States has a comparative advantage.

A contrary view emphasizes that such dumping is rarely permanent. If the Canadian firms are dumping the steel as a means of driving the American producers out of business, then the longrun effect will be less competition and higher prices in the United States.

Question 10 These successive points are designed to show the student that the fear of cheap Chinese goods flooding into Canada and causing a major loss of Canadian jobs is probably highly unwarranted. a) Chinese comparative advantage depends on relevant unit labour costs, which is a combination of wage rates and labour productivity. The statement suggests that Chinese workers were cheap (per hour), but quite unproductive, and so expensive (per unit of output produced). b) The theory, and the experience of world trade and tariff reductions since 1947, shows that rich countries do not have to fear trading with poor countries. The gains from trade are generally shared (not necessarily equally) among the trading partners. c) As time passes, more and more production passes into this category where wage costs are a very low proportion of total costs. For such products, location will be mainly determined by factors other than relative wage rates.

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Problems Question 11 a) With no international trade in hockey sticks (autarky), the Canadian equilibrium price would be $100 and the quantity transacted would be 1.0 million sticks per year. b) With international trade and a world price of $120, Canadian firms would produce 1.2 million sticks and Canadian consumers would purchase 800,000. Canada would therefore export 400,000 hockey sticks per year. c) If the world price were instead $60, Canadian firms would produce only 600,000 sticks per year while Canadian consumers would purchase 1.4 million. The balance of 800,000 sticks per year would come from imports. d) If the world price were $60 but the Canadian government imposed a tariff of 50 percent, the tariffridden world price (in Canada) would increase to $90. Even though the tariff applies only to imported sticks, the fact that all sticks are identical means that all sticks in Canada will sell at this higher tariffridden price. In this situation, Canadian production rises to 900,000 sticks per year, Canadian consumption falls to 1.1 million, and the level of imports falls to 200,000 sticks per year. e) The beneficiaries of the tariff are the Canadian firms, who can now sell more sticks at a higher price, and their workers, who will be more in demand and may as a result receive higher wages and more secure employment. Those hurt by the Canadian tariff are Canadian consumers, who now must pay higher prices for the same product. f) With the 50 percent tariff in place, the total tariff revenue to the Canadian government is the volume of imports (200,000 sticks per year) times the tariff ($30 per stick). This is $6 million per year, which can be used to finance government priorities.

Question 12 a) With a 20 percent tariff on all imported towels, the lowest-price towels are those made in Canada.

Canada will produce its own towels—none will be imported. b) With no tariffs at all, the cheapest towels are the Bangladeshi ones. So Bangladeshi towels get imported into Canada. This is “trade creation”. c) With free trade between Canada and the United States, but a 20 percent tariff on goods from other countries, the U.S. towels now become the cheapest towels in the Canadian market. Canada imports U.S. towels and stops importing from towels from Bangladesh. This is “trade diversion”. d) Part (b) is trade creation. It is beneficial because Canada is buying from the cheapest producer rather than producing towels domestically at a higher price. Part (c) is trade diversion. It is not beneficial because trade is diverted from the genuinely low-cost producer (Bangladesh) toward a higher-cost producer (the United States) because of the tariff that applies only to Bangladesh.

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Question 13 a) A tariff of 33% on imported siding will increase the price within Canada from $6 to $8 per square foot (while leaving the world price of $6 unaltered). Canadian producers will move up the supply curve, increasing production from 200 000 to 350 000 bundles per month. As the price rises, Canadian consumers will reduce their quantity demanded, from 800 000 to 650 000 bundles per month. b) As a result of the tariff (and the reduced consumption and increased production), Canadian imports of siding will fall from 600 000 to 300 000 bundles per month. Each imported bundle has 100 square feet of siding, and the tariff is $2 per square foot. So the Canadian government will collect tariff revenues equal to $2 × 100 × 300 000 = $60 000 000 per month. c) If instead the Canadian government imposes a maximum level of imported siding of 300 000 bundles per month, the result will be that the Canadian price rises to the point where domestic demand equals domestic production + imports of 300 000 bundles. This implies a price of $8 per square foot, exactly the same as under the 33% tariff in part (a). Domestic production rises to 350 000 bundles per month and Canadian consumption falls to 650 000 bundles per month. Imports fall to 300 000 bundles per month. The effects on the domestic market under the tariff and the (equivalent) quota are exactly the same, except… d) …there is no tariff revenue for the Canadian government under the quota system. The higher price paid by Canadian consumers (on imported siding) goes to the foreign firms who are producing those imported goods. e) The $2 tariff and the 300 000 bundle import quota have exactly the same effects on domestic consumers and domestic producers. But they differ in terms of the tariff revenue which accrues to Canadian taxpayers (or their government). The tariff is a clearly preferred policy for Canada, since Canada gains by receiving the tariff revenue. *****

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___________________________________________________ Chapter 19: Exchange Rates and the Balance of Payments ___________________________________________________ This chapter addresses the balance of payments, exchange rates (both fixed and flexible), and openeconomy macro policy topics such as the desirability or undesirability of current account deficits, the theory of purchasing power parity, and the costs and benefits of having a fixed versus flexible exchange rate. *** The chapter is divided into four sections. In the first section, we lay out the structure of the balance of payments accounts. This is a logical start in that it provides basic facts, identifies key terms, and discusses the relationship among the key accounts. The object is to familiarize students with the meaning and significance of the major categories they are likely to encounter in everyday discussion.

We have clarified the explanation of why the balance of payments always balances. We also have a box showing an individual’s balance of payments with the world—this should help students understand that the concepts really are very simple (even though they often seem confusing!).

The second section focuses on the market for foreign exchange. We define the exchange rate and explain why foreign-exchange transactions are necessary in a world with foreign trade and country-specific currencies. We seek to take the mystery out of the notions of foreign exchange and exchange rates: a country’s money can be bought or sold, and has a price, just as any other commodity. We emphasize that since foreign currency has a “price”, a natural definition of the exchange rate is the number of Canadian dollars required to purchase one unit of foreign currency.

Thus, a rise in the exchange rate is a depreciation of the Canadian dollar. We proceed by discussing the supply of foreign currency and the demand for foreign currency in the foreign-exchange market.

This discussion is consistently linked to the previous discussion of the balance of payments accounts, which is a key reason for having placed the balance of payments accounts at the start of the chapter.

The next section on “The Determination of Exchange Rates” will be easier for students who have studied demand and supply in a micro course, but it can be handled with only Chapter 3 as a background. At the outset, after the concept of equilibrium in the foreign-exchange market is introduced, the distinction between fixed and flexible exchange rates arises as a simple distinction depending upon whether or not the monetary authorities intervene in the foreign-exchange market (which has implications for the domestic money supply). Managed floats are also briefly discussed.

We have a box discussing the details of how a central bank could operate a fixed exchange rate, and what it means for changes in the central bank’s holdings of foreign-exchange reserves; the box also examines the actual exchange-rate regime in China. In the final part of this section, students are presented with an explanation of the major forces that can cause exchange-rate changes.

The major payoff for students is in the chapter’s final section where we examine three important policy issues. The first issue is the desirability of current account deficits. Students are accustomed to being told by newscasters that Canada’s current account has “deteriorated” or “improved”, meaning that the current account deficit has increased or decreased, respectively. This rhetoric increased in recent years with the protectionist policies from the United States (which may

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or may not continue). We think it is important for students to know the various types of shocks that can lead to an increase in the current account deficit, and that not all of them are undesirable. This discussion leads to a box about mercantilism.

The second policy issue deals with the notion of a “correct” value for the Canadian exchange rate. Students often hear commentators argue that the Canadian dollar is “overvalued” or “undervalued”. The implication seems to be that there is something wrong with the operation of the foreign-exchange market. We argue that in a regime of flexible exchange rates, it makes little sense to think of the currency as being undervalued or overvalued—the free-market value is the “correct” value as determined by the forces of demand and supply. This value, of course, changes with great frequency, but that is because the underlying forces of demand and supply are also continually changing. This discussion leads to a thorough discussion of purchasing power parity. We emphasize that, despite the logic of the law of one price, applying this logic to aggregate price indexes can be misleading, and as a result there are good reasons to expect PPP not to hold, as the evidence so clearly shows.

The third policy issue is whether Canada should have a fixed exchange rate. This issue is often hotly debated in Canada and we think students should be aware of the basic arguments. We discuss how flexible exchange rates act to absorb shocks, reducing the impact of a shock on aggregate output and employment. We also explain how a fixed exchange rate can reduce transactions costs as well as the costs from exchange-rate uncertainty.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) payment (debit); trade; current b) receipt (credit); capital-service; current c) receipt (credit); capital; receipt (credit); capital d) balance of payments; zero Question 2 a) Canadian dollar; U.S.; Canadian b) more; rise; fewer; fall c) 1/0.896 = 1.12; 1.12 d) demand; supply; supply of; demand for; fall; appreciate e) increase; appreciate (the exchange rate will fall) f) increase; reduction; rise; depreciate

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Question 3 a) floating (or flexible) b) fixed (or pegged) c) excess supply of; purchase d) excess demand for; sell Review Questions Question 4 a) Suppose inflation in Canada is 5 percent per year but there is no inflation in other countries. As prices rise in Canada, the prices of Canadian goods rise relative to goods from elsewhere. Canadians therefore substitute toward more foreign goods, increasing the demand for foreign currency.

Similarly, foreign consumers substitute away from Canadian goods, thus reducing the supply of foreign currency. Thus, the demand curve shifts to the right and the supply curve shifts to the left.

Both shifts have the effect of increasing the exchange rate. Indeed, we expect that 5 percent annual inflation in Canada will lead to 5 percent annual depreciation of the Canadian dollar. b) An increase in foreign demand for Canadian goods means that at any given exchange rate there is an increase in the quantity of foreign exchange supplied. The supply curve shifts to the right and the exchange rate falls—that is, the Canadian dollar appreciates. c) If Canadian investors decide to purchase more foreign assets, there is an increase in the quantity of foreign exchange demanded at any given exchange rate. The demand curve shifts to the right and the exchange rate rises—that is, the Canadian dollar depreciates.

Question 5 The answers suggested here depend on identifying how the indicated change affects demand and/or supply curves for foreign currency. a) If, at a constant exchange rate, the quantity of oil imported decreases but because of price increases the expenditure on imported oil rises, the demand for foreign exchange must rise. This will tend to depreciate the home country's currency on the foreign-exchange market. b) The country’s currency will appreciate. At a given exchange rate, exports will look cheap to foreign consumers (which increases the supply of foreign exchange) and imports will look expensive to domestic consumers (which reduces the demand for foreign exchange). c) If rising labour costs lead to rising prices not matched elsewhere in the world, the rest of the world will demand fewer of our goods, and we will demand more goods from abroad. So there will be a reduction in the supply for foreign exchange, and an increase in demand. The exchange rate will rise (the domestic currency will depreciate). d) Gifts should have no effect on the exchange rate unless they substitute for purchases of the home-country exports, in which case there will be a fall in the demand for the home currency and thus a depreciation.

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e) This will appreciate the country’s currency. People with liquid financial capital in other countries will lend it out for short-term purposes in the country with the high interest rates (for given risk levels). If one country’s central bank raises interest rates sharply, the resulting flow of short-term capital into that economy will increase the supply of foreign exchange (and increase the demand for this country’s currency) and thus tend to appreciate its currency on the foreign-exchange market. f) This will lead to a diminished demand (or increased supply) for foreign exchange and will therefore lead to an appreciation of the domestic currency.

Question 6 This is an important question, for students should realize that there is no simple relationship between the exchange rate and the trade account, just as there is no simple relationship between the (equilibrium) price and quantity of any particular product. To know the relationship between changes in the exchange rate and the trade account, it is necessary to think about the cause of the change in the exchange rate. a) Suppose there is a substitution toward Canadian assets and away from assets in foreign countries.

As investors try to purchase Canadian assets, there is an increased demand for the Canadian dollar (and an associated increase in supply of foreign exchange) and thus an appreciation of the Canadian dollar. This appreciation leads to an increase in the foreign price of Canadian goods and thus a reduction in demand by foreigners for Canadian exports. At the same time, the appreciation makes foreign goods cheaper in Canada and leads to an increase in Canadian imports. Thus, we have an appreciation of the Canadian dollar, a fall in net exports, and (for given capital-service payments) a fall in the trade surplus. b) A reduction in the world’s demand for Canadian goods would decrease the supply of foreign exchange and lead to a depreciation of the Canadian dollar. It would also have the immediate effect of reducing Canadian exports. As Canadian income fell, so would spending on imports, but this decrease in imports would not offset the initial reduction in exports. Thus, the Canadian dollar depreciates, net exports fall, and thus (for given capital-service payments) the trade surplus falls.

Question 7 a) To fix (or peg) the exchange rate at e1, the Bank of Canada must be prepared to buy or sell any amount of foreign exchange at that price. Since e1 is above the free-market equilibrium exchange rate, we know that there will be an excess supply of foreign exchange. Thus, the Bank must purchase that excess supply of foreign exchange with Canadian dollars. But as soon as those “new” Canadian dollars leave the Bank, they are in circulation and are part of the money supply. Thus, the fixing of the exchange rate at e1 requires the Bank of Canada to increase the Canadian money supply in every period that such an excess supply of foreign exchange exists. The purchase of foreign currency shows up as a negative item in the capital account. b) By purchasing foreign exchange, the Bank of Canada is acquiring an asset. These purchases are a negative item in the capital account. Since the balance of payments overall must sum to zero, it follows that all parts of the balance of payments other than the central bank’s transactions must sum to a surplus. This situation is often referred to as a balance of payments surplus.

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c) To fix (or peg) the exchange rate at e2, the Bank of Canada must be prepared to buy or sell any amount of foreign exchange at that price. Since e2 is below the free-market equilibrium exchange rate, we know that there will be an excess demand for foreign exchange. Thus, the Bank must satisfy that excess demand for foreign exchange by selling its foreign-exchange reserves in return for Canadian dollars. But as soon as those Canadian dollars enter the Bank, they are no longer in circulation and are no longer part of the Canadian money supply. Thus, the fixing of the exchange rate at e2 requires the Bank of Canada to decrease the Canadian money supply in every period that such an excess demand for foreign exchange exists. The Bank’s sale of foreign-exchange reserves appears as a positive item in the capital account. d) By selling foreign exchange, the Bank of Canada is selling an asset. These asset sales are a positive item in the capital account. Since the balance of payments overall must sum to zero, it follows that all parts of the balance of payments other than the central bank’s transactions must sum to a deficit.

This situation is often referred to as a balance of payments deficit.

Question 8 a) See the figure below. The increase in world demand for lumber will increase the supply of foreign exchange (remember that lumber is a major Canadian export). This shifts the supply curve from S0 to S1, thus reducing the exchange rate from e0 to e1. This is an appreciation of the Canadian dollar. b) If instead Canada had a fixed exchange rate at e0, the Bank of Canada would prevent the appreciation of the Canadian dollar by buying up the increase in the supply of foreign exchange. In this case, the Bank would purchase FX0FX2 units of foreign currency per period to keep the exchange rate fixed at e0.

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c) See below for the AD/AS diagram. We begin in long-run equilibrium at potential output Y* and price level P0. The increase in world demand for lumber is a positive aggregate demand shock for Canada. The AD curve shifts to the right. But with a flexible exchange rate, the subsequent appreciation of the Canadian dollar (from e0 to e1 in the diagram above) raises the price of Canadian exports relative to foreign goods. Thus, we have the direct positive effect on net exports combined with the reduction due to the appreciation. The net effect is the shift from AD0 to AD1, which raises real GDP to Y1.

d) Again, we begin in long-run equilibrium at potential output and price level P0. But now the Canadian exchange rate is fixed at e0. The increase in world demand for lumber is a positive aggregate demand shock for Canada. But because the exchange rate is now fixed, there is no appreciation of the Canadian dollar to dampen this positive shock. As a result, the AD curve shifts to the right, this time to AD2. Real GDP rises to Y2, and thus the inflationary output gap is bigger than in the case of the flexible exchange rate. e) In response to a positive shock to the demand for exports, the currency will appreciate, cause a partial reduction in net exports, and thus dampen the effects of the initial shock. In response to a negative shock to the demand for exports, the currency will depreciate, cause a partial expansion of net exports, and thus dampen the effects of the initial shock. Thus, in response to external shocks to demand, a flexible exchange rate acts as a shock absorber, reducing the net effect on domestic output and employment.

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Question 9 The suggestion is attributed to former Prime Minister Pierre Trudeau but is probably apocryphal.

However, it is worth thinking through the issues anyway. a) To have balanced trade in each industry would seem to fly in the face of the gains from trade through specialization according to comparative advantage. Canada is a large exporter of forestry products. To have balanced trade in this industry would require either a huge reduction in exports or a large increase in imports. Neither would be desirable. The one situation in which balanced trade within an industry may be a natural outcome is when there is a large amount of product differentiation within an industry, as in some manufacturing industries. In these cases, Canada could specialize in some lines while other countries could specialize in others. But for many industries such intra-industry trade would not be significant. b) In order for trade to be balanced between every pair of countries, comparative advantages and consumers’ preferences would have to be aligned in special—and quite unlikely—ways. It may be natural for Japan to export many goods to Canada and buy very few in return simply because Japanese consumers have no desire for Canadian goods. This is not a problem so long as Canada can sell its goods to some country, so it can earn the income to purchase those imports from Japan.

There is no need, and probably no benefit, from having bilateral trade balances.

It is interesting to note that former U.S. President Donald Trump placed considerable emphasis on trade deficits country-by-country and also sector-by-sector. The analysis in the final section of this chapter suggests that trade deficits even for the country as a whole may not be undesirable, depending crucially on the underlying cause. For trade deficits with specific countries or in specific sectors, the case for concern weakens even further. Indeed, trade along the lines of comparative advantage suggests that trade deficits with specific countries and for specific products will reflect efficient specialization!

Question 10 This question is a good exercise because it forces students to think about the adding-up properties of the balance of payments accounts. a) In order to have the 20 percent depreciation (and maintain the exchange rate at that level), the Bank of Canada would have to enter the foreign-exchange market and buy (and continue to buy) massive amounts of foreign exchange. b) The large-scale purchase of foreign currency by the Bank of Canada would be accomplished by the Bank’s issuance of new Canadian currency. This would lead to an increase in the domestic money supply, and may or may not be consistent with the money growth necessary to achieve the Bank’s stated inflation target. (In general, a central bank can choose to target the exchange rate or to target the rate of inflation, but it is unlikely to be able to do both.)

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c) The Bank’s purchase of foreign exchange would be a deficit item in the official financing account, which must be balanced by surplus items in the rest of the accounts. The rise in exports and fall in imports is an increase in the current-account surplus; the inflow of foreign investment is a capitalaccount surplus. Thus, the exchange rate would be increased (dollar devalued) to the point where the excess supply of foreign exchange (created by the trade surplus and current account surplus) was exactly equal to the Bank’s purchases of foreign exchange.

The three predicted outcomes would not be possible with a cheaper dollar determined in a free market––a fixed exchange rate is central to the predicted outcome. If the dollar depreciated because of a change in the demand or supply of foreign exchange, the official financing account would be approximately in balance. In this case, the current account and capital account would have to sum to zero, and the predicted effects would not be possible.

Problems Question 11 a) Sophie’s trade balance is the value of her “exports” minus her “imports”. Her exports are the income that she earns by selling goods and services to the world—the $2500 from lifeguarding and the $3500 from lawn mowing. Her imports are the expenditures she makes on goods and services— the $1000 on coffee and pastry and the $3500 on tuition. Thus, Sophie’s trade balance is $6000 – $4500 = $1500. This is a trade surplus. b) Sophie’s current account balance is her trade balance plus her capital-service balance, the latter being the net interest earnings (or payments) on assets (or debts) plus the unilateral transfers.

Sophie’s capital-service balance is therefore the $150 she earns in interest plus the $1000 gift from her grandparents. Thus, her overall current account balance is the $1500 surplus on the trade account plus the $1150 surplus on her capital-service accountshe has a current account surplus of $2650. c) Sophie’s capital account balance shows the change in her holding of assets. She purchased mutual funds of $1200 and she increased her bank account by $1450. Thus, she has a capital account deficit (since her purchases of assets exceeded her sale of assets) of $2650. d) Sophie’s bank balance at the end of the year is not needed for computing her balance of payments.

This bank balance is part of Sophie’s stock of wealth; and the balance of payments accounts are all about flows, not stocks. We include by how much Sophie changes her stock of wealth (by purchasing assets) but not the stock itself.

Question 12 a) The trade balance is exports minus imports. In this case, it is $21 billion, a trade surplus. b) The CA balance is the trade balance plus net foreign-investment income (net payments from Canada of $31 billion). In this case, the CA balance is a deficit of $10 billion. c) The change in net foreign assets is $10 billion – meaning a net sale of assets to foreigners of this amount.

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d) The capital account is the change in net foreign assets plus the changes in official reserves. In this case, the capital account is a surplus of $10 billion. e) The balance of payments (as always!) is zero. The current account is a deficit of $10 billion; the capital account is a surplus of $10 billion. There is no statistical discrepancy! f) Since there has been no change in the holdings of official international reserves, it is quite likely that the central bank of FarawayLand has a pure flexible exchange-rate regime, with no intervention in the foreign-exchange market whatsoever. It is also possible, though less likely, that the country has a managed float, and that over the course of the year the central bank’s interventions have simply balanced out to zero. What is even less likely is that the country has a fixed exchange rate, since managing such a regime invariably requires interventions in the foreign-exchange market and these are very unlikely to sum up exactly to zero.

Question 13 a) See the table below. Since the exchange rate provided is the number of units of domestic currency required to purchase one U.S. dollar, the U.S.-dollar price of the Big Mac in each country is equal to the domestic-currency price divided by the exchange rate.

Country

U.S. dollar price of Big Mac

Canada U.S.A. Japan Euro Area China Russia

$6.77/1.28 = $5.29 (U.S.) $5.66/1.00 = $5.66 (U.S.) Yen 390/104.3 = $3.74 (U.S.) Euros 4.25/0.82 = $5.18 (U.S.) Yuan 22.40/6.48 = $3.46 (U.S.) Ruble 135/74.63 = $1.81 (U.S.)

b) Using The Economist’s logic, all of the currencies shown in the table are undervalued relative to the U.S. dollar since their domestic (U.S. dollar) price of Big Macs is “too low” relative to the price in the United States. c) Big Macs are not traded goods. You could not buy one in one country and ship it to another country and sell it. (Actually you could, but if you’ve ever tasted even a one-hour-old Big Mac, you wouldn’t want to!) But non-traded goods do not satisfy the law of one price and so there is no reason why the prices should be equal across countries. d) What you want to use for this sort of price comparison is a traded good that has a very low perunit transportation cost (relative to the price of the product). In other words, you want to choose a product that has a very high value-to-bulk ratio. Of the products listed, diamonds would work best, but computer RAM chips would also work well. Cement and fresh fruit would be poor choices. ***** Copyright © 2023 Pearson Canada Inc.