Macroeconomics, Canadian Edition, 3rd edition Patrick OBrien Solution Manual

Type:

Solution Manual

Resource:

Macroeconomics

Edition:

3rd Edition

Author(s):

R. Glenn Hubbard Anthony Patrick O’Brien

INSTRUCTOR’S RESOURCE MANUAL Edward Scahill Eric Moon University of Toronto

Macroeconomics Third Canadian Edition R. Glenn Hubbard Columbia University

Anthony Patrick O’Brien Lehigh University

Apostolos Serletis University of Calgary

Jason Childs University of Regina

Contents PART 1: INTRODUCTION CHAPTER 1

Economics: Foundations and Models .................................................. 1-1

CHAPTER 2

Trade-offs, Comparative Advantage, and the Market System ............. 2-1

CHAPTER 3

Where Prices Come From: The Interaction of Supply and Demand ... 3-1

PART 2: MACROECONOMIC FOUNDATIONS AND LONG-RUN GROWTH CHAPTER 4

GDP: Measuring Total Production and Income................................... 4-1

CHAPTER 5

Unemployment and Inflation ............................................................... 5-1

CHAPTER 6

Economic Growth, the Financial System, and Business Cycles .......... 6-1

CHAPTER 7

Long-Run Economic Growth: Sources and Policies ........................... 7-1

PART 3: SHORT-RUN FLUCTUATIONS CHAPTER 8

Aggregate Expenditure and Output in the Short Run .......................... 8-1

CHAPTER 9

Aggregate Demand and Aggregate Supply Analysis........................... 9-1

PART 4: MONETARY AND FISCAL POLICY CHAPTER 10 Money, Banks, and the Bank of Canada ............................................ 10-1 CHAPTER 11 Monetary Policy ................................................................................. 11-1 CHAPTER 12 Fiscal Policy ....................................................................................... 12-1 CHAPTER 13 Inflation, Unemployment, and Bank of Canada Policy ..................... 13-1 PART 5: THE INTERNATIONAL ECONOMY CHAPTER 14 Macroeconomics in an Open Economy ............................................. 14-1 CHAPTER 15 The International Financial System ................................................... 15-1

CHAPTER 1 | Economics: Foundations and Models

CHAPTER 1 | Economics: Foundations and Models Brief Chapter Summary and Learning Objectives 1.1

Three Key Economic Ideas (pages 3–6) Explain these three key economic ideas: People are rational. People respond to incentives.

Optimal decisions are made at the margin.

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1.2

People must make choices as they try to attain their goals. People make choices because resources are scarce. Most of economics analyzes what happens in markets.

The Economic Problem All Societies Must Solve (pages 6–10) Discuss how a society answers these questions: What goods and services will be produced?

How will the goods and services be produced? Who will receive the goods and services produced?

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A limited amount of resources can produce a limited amount of goods and services.

The cost of producing more of one good is the value of what must be given up to produce it.

Economic Models (pages 10–13) Understand what economic models are and aren’t, and why they are a good idea.

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1.4

Economists use models—simplified versions of reality—to analyze real-world issues.

Economists accept a model if it leads to hypotheses that are confirmed by statistical analysis.

Microeconomics and Macroeconomics (pages 13-14) Distinguish between microeconomics and macroeconomics.

1.5

The Language of Economics (pages 14–15) Define important economic terms. (It’s not all Greek.)

Appendix A: Using Graphs and Formulas (pages 21–32) Review the use of graphs and formulas.

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CHAPTER 1 | Economics: Foundations and Models

Key Terms Allocative efficiency, p. 9. A state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it.

Centrally planned economy, p. 7. An economy in which the government decides how economic resources will be allocated.

Economic model, p. 3. A simplified version of reality used to analyze real-world economic situations.

Economic variable, p. 11. Something measurable that can have different values, such as the price of coffee.

Economics, p. 2. The study of the choices people make to attain their goals, given their scarce resources.

Equity, p. 9. The fair distribution of economic benefits.

Macroeconomics, p. 14. The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

Marginal analysis, p. 5. Analysis that involves comparing marginal benefits and marginal costs.

Market, p. 3. A group of buyers and sellers of a good or service and the institutions or arrangements by which they come together to trade.

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Market economy, p.8. An economy in which the decisions of households and firms interacting in markets allocate economic resources.

Microeconomics, p. 13. The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

Mixed economy, p. 9. An economy in which most economic decisions result from the interaction of buyers and sellers in markets, but in which the government plays a significant role in the allocation of resources.

Normative analysis, p. 12. Analysis concerned with what ought to be.

Opportunity cost, p. 6. The highest-valued alternative that must be given up to engage in an activity.

Positive analysis, p. 12. Analysis concerned with what is.

Productive efficiency, p. 9. A situation in which a good or service is produced at the lowest possible cost.

Scarcity, p. 2. A situation in which unlimited wants exceed the limited resources available to fulfill those wants.

Trade-off, p. 6. The idea that, because of scarcity, producing more of one good or service means producing less of another good or service.

Voluntary exchange, p. 9. A situation that occurs in markets when both the buyer and seller of a product are made better off by the transaction.

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CHAPTER 1 | Economics: Foundations and Models

Chapter Outline You versus Caffeine If you are like 65 percent of Canadians, you had a cup of coffee this morning—you might even be drinking one now. The simple pleasure of a cup of coffee is brought to you by hundreds of people working in a variety of occupations. Someone planted coffee, someone picked it and someone else took it to a port. A dockworker loaded a ship and a ship’s crew transported the beans to North America. More dock workers, shippers, roasters, packagers, more shippers, retail store workers or baristas and finally you get a cup of coffee. All this happens through the complexities of the markets. Any disturbance in this sequence can change how much you pay. For example, changes in weather patterns or crop yield can change what all Canadians have to pay for their morning cup. Economics helps explain how markets work and what determines prices.

Source: International Coffee Organization http://www.ico.org/coffee_prices.asp.

Teaching Tips There are special features that open and close each chapter of the book: 1. The introduction, or chapter opener, uses a real-world business example to preview the economic issues discussed in the chapter.

2. A boxed feature titled Economics in Your Life and Career complements the business example that opens the chapter. Economics in Your Life and Career poses questions that help students make a personal connection with the chapter theme. At the end of the chapter, the authors use the concepts described in the chapter to answer these questions.

You can use these features—the chapter opener and Economics in Your Life and Career —as the basis for classroom discussion, homework assignments, and examination questions. This Instructor’s Manual includes one extra Economics in Your Life and Career for each chapter so that you can present material in class that is different from the material found in the textbook.

People must make choices as they try to attain their goals. The choices people make represent the tradeoffs made necessary by scarcity. Scarcity is a situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economics is the study of the choices people make to attain their goals, given their scarce resources. An economic model is a simplified version of reality used to analyze real-world economic situations.

Teaching Tips It is important to define economics and explain what scarcity means at the beginning of the course, especially because many students will not have studied economics previously. Some students will better understand what scarcity means if you give them examples of things that are not scarce. You can provide examples of “free resources”—sand on a beach, fresh air—and ask students to contribute their own examples. Your students will quickly learn that the list of free resources is very much shorter than the list of scarce resources.

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CHAPTER 1 | Economics: Foundations and Models

1.1

Three Key Economic Ideas (pages 3–6) Learning Objective: Explain these three key economic ideas: People are rational, people respond to incentives, and optimal decisions are made at the margin.

A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. There are three important ideas students should learn to understand how people make choices and interact in markets: People are rational; people respond to economic incentives; and optimal decisions are made at the margin.

A. People Are Rational This assumption does not mean that everyone knows everything or always makes the “best” decision.

Rational individuals weigh the benefits and costs of each action and choose an action if the benefits outweigh the costs. When deciding, people believe it is their best interest; they may be wrong.

B. People Respond to Economic Incentives Economists emphasize that consumers and firms consistently respond to economic incentives. When incentives change, people’s actions change accordingly.

C. Optimal Decisions Are Made at the Margin Economists use the word marginal to mean an extra or additional benefit or cost of a decision. The optimal decision is to continue any activity to the point where the marginal benefit equals the marginal cost.

Marginal analysis involves comparing marginal benefits and marginal costs.

Teaching Tips You don’t need to spend a lot of class time with explanations because subsequent chapters will reinforce students’ understanding of what markets are and the “three key economic ideas.” This section of the chapter includes a Solved Problem that shows the step-by-step process of solving an economic problem related to a chapter learning objective. Solved Problem 1.1 is an example of marginal analysis: whether a student should study an extra hour or watch an episode of favourite show on Netflix. You can work through the Solved Problem in class and assign the related end-of-chapter problems as homework. This Instructor’s Manual includes some Extra Apply the Concept features and Extra Solved Problems that are not in the text so that you have unique problems to present in class or to assign as homework.

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The Economic Problems All Societies Must Solve (pages 6–10) Learning Objective: Discuss how a society answers these three economic questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?

Every society faces the economic problem that it has only a limited amount of economic resources, and so it can produce only a limited amount of goods and services. Society faces trade-offs. A trade-off is the idea that because of scarcity, producing more of one good or service means producing less of another good or service. Every activity has an opportunity cost, which is the highest-valued alternative that must be given up to engage in an activity. Trade-offs force society to answer three fundamental questions: What goods and services will be produced?

How will the goods and services be produced?

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CHAPTER 1 | Economics: Foundations and Models Who will receive the goods and services produced?

A. What Goods and Services Will Be Produced?

The answer to this question is determined by the choices consumers, firms, and the government make.

Each choice made comes with an opportunity cost, measured by the value of the best alternative given up.

B. How Will the Goods and Services Be Produced?

Firms choose how to produce the goods and services they sell. For example, firms often face trade-offs between using more workers and using more machines.

C. Who Will Receive the Goods and Services Produced?

In Canada, who receives the goods and services produced depends largely on how income is distributed.

An important policy question is whether the government should intervene to make the distribution of income more equal. The debate over how much taxation and government spending is appropriate will continue as long as societies must address the three fundamental questions.

D. Centrally Planned Economies versus Market Economies Societies organize their economies in two main ways. A centrally planned economy is an economy in which the government decides how economic resources will be allocated. A market economy is an economy in which the decisions of households and firms interacting in markets allocate economic resources. Today, only a few small countries, such as Laos and North Korea, still have completely centrally planned economies. In a market economy, your income is determined by the payments you receive for what you sell. Markets usually reward hard work. Generally, the more extensive the training you have and the more hours you work, the higher your income will be.

E. The Modern “Mixed” Economy Some government intervention is designed to raise the incomes of the elderly, the sick, and people with limited skills. Some economists argue that government intervention makes it more accurate to refer to the economies of Canada and most other countries as mixed economies rather than market economies. In a mixed economy, most economic decisions result from the interaction of buyers and sellers in markets, but the government plays a significant role in the allocation of resources. Even the United States and China are mixed economies that rely on a combination of both the market and central planning to provide people with a variety of goods and services. Although China remains a political dictatorship, production of most goods is determined in markets.

F. Efficiency and Equity Market economies tend to be more efficient than centrally planned economies. There are two types of efficiency. Productive efficiency is a situation in which a good or service is produced at the lowest possible cost. Allocative efficiency is a state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it. Voluntary exchange is a situation that occurs in markets when both the buyer and seller of a product are made better off by the transaction.

Markets promote efficiency but don’t guarantee it. Inefficiency arises from various sources. Governments can alter the level of efficiency in a market. Sometimes governments may reduce efficiency by interfering with voluntary exchanges in markets. The production of some goods may damage the environment when firms ignore the costs of environmental damage. In this case, government intervention can increase efficiency.

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CHAPTER 1 | Economics: Foundations and Models Society may not find an efficient economic outcome to be desirable. Many people prefer economic outcomes that they consider fair or equitable even if these outcomes are less efficient. Equity is the fair distribution of economic benefits. Equity is harder to define than efficiency. Programs designed to increase equity may reduce efficiency.

Teaching Tips Ask students for examples of government regulation of private markets in Canada. Responses may include: making the sale of cocaine and narcotics illegal; minimum age requirements for the purchase of alcoholic beverages and cigarettes; or the prohibition of the sale of new drugs before their effectiveness is demonstrated through government supervised tests. Ask students whether one of these examples of government regulation promotes equity or fairness. The difficulty in defining equity will soon become apparent.

To show how students may value equity less than they claim, an economics teacher at a college in Western New York once told her students at the beginning of her course that their grades would be auctioned to the highest bidders. Because grades are typically normally distributed, she offered to sell a few A grades, a few more B grades, and so on. Although the announcement produced shock and grumbling, the auction proceeded, with frenzied bidding for A grades. As prices for A grades rose, bidding switched to B grades. Because few students bothered to bid for C grades, one enterprising student bid on several such grades in the belief that those who lost out on getting an A or B would have to buy their C grades from him—for a higher price than he paid! After about a week, the instructor informed the class the auction was intended only as an economics lesson; they would have to earn their grades the old-fashioned way!

Extra Solved Problem 1.2 Advising New Government Leaders Suppose that a low-income country experiences a change in government leadership. Prior to this change, the country had a centrally planned economy. The new leaders are willing to try a different system if someone can convince them that it will yield better results. They hire an economist from a country with a market economy to advise them and will order their citizens to follow the economist’s recommendations for change. The economist suggests that a market economy replace central planning to answer the nation’s economic questions (what, how, and who).

What will the economist suggest the leaders order their citizens to do in order to change from a centrally planned economy to a market economy?

Are there reasons why the leaders and citizens of this country might not accept the economist’s suggestions?

Briefly explain.

Solving the Problem Step 1:

Review the chapter material.

The problem is about different types of economic systems, so you may want to review the section “Centrally Planned Economies versus Market Economies” on pages 7-8 of the textbook.

Step 2:

What will the economist suggest the leaders order their citizens to do?

Market economies allow members of households to select occupations and purchase goods and services based on self-interest and allow privately owned firms to produce goods and services based on their self-interests. Therefore, the economist would advise the leaders of the poor country to not issue any orders. Government officials should have no influence over individual decisions made in markets.

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CHAPTER 1 | Economics: Foundations and Models

Step 3:

Do you believe the leaders and citizens will accept the economist’s suggestions?

Even democratically elected leaders, especially those with significant government involvement in the country’s resource allocation, will find it difficult to accept the new system. They may wonder how self-interested individuals will produce and distribute goods and services so as to promote the welfare of the entire country. This new system requires a significant reduction in government influence in people’s lives, but history has shown that government officials are often reluctant to give up this influence. Acceptance is most likely when the leaders have some knowledge and experience with the successful operation of a market economy in other countries.

Ordinary citizens are more likely to accept the economist’s suggestions because they will have more freedom to pursue their own economic goals.

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CHAPTER 1 | Economics: Foundations and Models

Extra Apply the It’s Saturday Afternoon: Why Aren’t You at the Game?

Concept For many students in the United States, attending college football games is an enjoyable way to spend Saturday afternoons in the fall. However, some colleges have experienced a decline in the number of students attending their games. In 2016, average attendance at the 130 schools that make up the Division I Football Bowl Subdivision (43,106) was the lowest since 2000 (42,631).

What explains the decrease in the number of students willing to attend football games? Rising ticket prices are one reason for the decline. One student at the University of Michigan was quoted as saying: “People are looking to trim costs, and for a lot of folks, football is an easy thing to cut. It’s not essential to going to college.”

Remember that the opportunity cost of engaging in an activity is the value of the best alternative that must be given up to engage in that activity. The opportunity cost of attending a college football game is not just the price of a ticket. If the price of a ticket to a game is $50, your opportunity cost is the ticket price plus the value you place on what else you could do if you don’t attend the game. At one time, relatively few college football games were televised, but today multiple cable networks broadcast games. If you attend your college’s games, you miss the opportunity to watch the games being broadcast at the same time—in high-definition with replays shown from multiple camera angles and expert commentary to clarify what is happening. When watching games in your room or at a sports restaurant, you can also post to Facebook, Instagram, or Twitter, read e-mail, surf the Web, and take or receive phone calls. Wi-Fi and cellular reception is often poor in college stadiums, making these activities difficult.

So the opportunity cost of attending college football games has increased in recent years, not just because ticket prices have risen but because the number of alternative activities that students value highly has also increased. We expect that when the opportunity cost of engaging in an activity increases, people will engage in that activity less, as we’ve seen with student attendance at college football games.

Colleges have responded to declining student attendance by reducing ticket prices, improving Wi-Fi and cellular service, and installing high-definition video boards that show replays as they appear on television.

Whether these attempts to lower the opportunity cost of attending college football games will succeed remains to be seen.

Sources: Jon Solomon, “College Attendance in 2016: Crowds Decline for the Sixth Straight Year,” CBSSports.com, December 16, 2016; Adam Rittenberg, “Attendance Challenges Big Deal for B1G,” espn.com, February 14, 2014; and Ben Cohen, “At College Football Games, Student Sections Likely to Have Empty Seats,” Wall Street Journal, August 27, 2014.

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Economic Models (pages 10–13) Learning Objective: Understand what economic models are and aren’t, and why they are a good idea.

Models are simplified versions of reality used to analyze real-world situations. To develop a model, economists generally follow five steps.

1. Decide on the assumptions to use in developing the model.

2. Formulate a testable hypothesis.

3. Use economic data to test the hypothesis.

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CHAPTER 1 | Economics: Foundations and Models 4.

5.

Revise the model if it fails to explain well the economic data.

Retain the revised model to help answer similar economic questions in the future.

A. The Role of Assumptions in Economic Models Models are based on making assumptions because models must be simplified to be useful. For example, when using models, economists make behavioural assumptions about the motives of consumers and firms.

Economists assume consumers will buy goods and services that will maximize their satisfaction.

Economists assume that firms act to maximize their profits.

B. Forming and Testing Hypotheses in Economic Models An economic variable is something measurable that can have different values, such as the price of coffee in Canada. A hypothesis in an economic model is a statement that may be correct or incorrect about an economic variable. We must test a hypothesis before we can accept it. To test a hypothesis, we analyze statistics on the relevant economic variables. Economists accept and use an economic model if it leads to hypotheses that are confirmed by statistical analysis.

C. Normative and Positive Analysis Positive analysis is analysis concerned with what is. Normative analysis is analysis concerned with what ought to be.

D. Economics as a Social Science Because economics studies the actions of individuals, it is a social science. Economics considers human behaviour in every context, not just in the context of business. Economists have played an important role in formulating government policies in areas such as the environment, health care, and poverty.

Extra Solved Problem 1.3 Snowfalls and Skiing Marsha Shawn is a university student and downhill skier who lives near The Ski Chalet, a ski resort located in B.C.. For a course project Marsha and four other students are required to develop an economic model.

Marsha suggests that their model test the impact of snowfalls on the sale of ski equipment (skis, boots, poles) and snowboards at the six ski shops located within a ten kilometre radius of The Ski Chalet. Marsha and the other students in her group agree that to have an impact on equipment sales a snowfall would have to result in at least four inches of new snow. How would you recommend that Marsha and the other students develop their model? Suggest an alternative model for Marsha in the event that the model fails to explain the data she uses to test her model.

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CHAPTER 1 | Economics: Foundations and Models

Solving the Problem Step 1:

Review the chapter material.

The problem is about how to use models to analyze economic issues, so you may want to review the section “Economic Models,” which begins on page 10 of the textbook.

Step 2:

To develop and test a model of the relationship between snowfall and sales of ski equipment the students in Marsha’s group should follow these steps: 1.

2.

3.

4.

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1.4

Decide on the assumptions to use in developing the model. For example: sales of ski equipment and snowboards are greater after snowfalls (four or more inches) than are sales at other times during the period that The Ski Chalet is open.

Formulate a testable hypothesis. Sales of ski equipment and snowboards at the six ski shops located near the Ski Chalet are higher (for example, by 5 percent or more) within one week following snowfalls of four or more inches than other weeks that The Ski Chalet is open.

Use economic data to test the hypothesis. Marsha’s group must obtain sales data from the six ski shops and agree on the number of observations (especially the number of times a snowfall of at least four inches is observed) required to test their hypothesis.

Revise the model if it fails to explain the economic data well. Suggest an alternative model.

The model could fail if large number of skiers and snowboard owners buy their equipment prior to the months that The Ski Chalet is open, or if large numbers rent, rather than purchase, their equipment. One alternative model would compare the sales of lift tickets or rental equipment in weeks following snowfalls of four or more inches and other weeks during the time The Ski Chalet is open.

Retain the revised model to help answer similar economic questions in the future. If the data support the model, one can assume that there is a relationship between snowfalls and equipment sales. Tests of the model with data from different time periods or in different locations could either support or refute these results. Acceptance of a model is always tentative pending the acquisition of new data or additional statistical analysis.

Microeconomics and Macroeconomics (pages 13-14) Learning Objective: Distinguish between microeconomics and macroeconomics.

Microeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

Extra Solved Problem 1.4 Microeconomic and Macroeconomic Views Sports fans are used to seeing game action on television from different camera angles. For popular events such as the Olympics, the World Series, and the Super Bowl, network coverage captures action from ground level as well as from higher locations. At some events, there is a camera located in a blimp that circles above the stadium where the event is held. The aerial view of the blimp’s camera is often visually appealing but is never broadcast for very long because the athletes are barely visible. Coverage of the events often includes a view from a mobile or “sideline” camera that can zoom in on individual players or fans sitting

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CHAPTER 1 | Economics: Foundations and Models in the stands, a degree of detail much greater than that provided by the aerial view. How do the different camera angles help to explain the difference between microeconomics and macroeconomics?

Solving the Problem Step 1:

Review the chapter material.

The problem concerns the differences between microeconomics and macroeconomics, so you may want to review the section “Microeconomics and Macroeconomics,” which appears on pages 13-14 of the textbook.

Step 2:

Compare the focus of microeconomics with the television coverage of a sports event.

Microeconomics focuses on how individual households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. This focus is similar to that of a sideline camera at a football game. The camera can focus in on an individual player or fan.

Step 3:

Compare the focus of macroeconomics with the television coverage of a sports event.

Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. Macroeconomics does not study the decisions made by individuals but the consequences of the actions of all decision makers in an economy. This is similar to the blimp’s aerial view of the venue where a sports event occurs. One can see the entire venue, but the blimp’s point of view is too far away to see any individual player or fan.

Extra Apply the Macroeconomic and Microeconomic Analysis Concept Economists separate the study of how households and firms make choices and interact in markets (microeconomics) from the study of the economy as a whole (macroeconomics). But some issues can be viewed from both perspectives. Labour productivity is one such issue.

Labour productivity—the quantity of goods and services that can be produced by one worker or by one hour of work—is a microeconomic topic. Labour productivity increases when a firm invests in capital or when a firm's technology improves. Increased labour productivity allows a firm to earn higher profits and to pay its workers higher wages.

Macroeconomists also study labour productivity because it determines the standard of living a country can achieve for its citizens. An increase in productivity is beneficial in the long run, but it can slow the growth of jobs in the short run. During the post-WWII economic expansion from 1950 to 1972, Canada experienced an average growth rate per capita of 2.8 percent. One reason for this was an increase in labour productivity.

Productivity growth in Canada decreased after 1972, and the reasons for this slowdown are not fully understood. Some economists believe that the structural change from the production of goods to the production of services after the mid ‘70s has led to measurement errors. Others suggest that increases in environmental protection and workplace safety cause biased estimations. Still others suggest the rapid increase in oil prices after 1972. These issues are discussed more fully in Chapter 7.

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CHAPTER 1 | Economics: Foundations and Models

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The Language of Economics (pages 14–15) Learning Objective: Define important economic terms.

This section provides a brief definition and preview of terms students will see throughout the book: entrepreneur, innovation, technology, firm (company or business), goods, services, revenue, profit, household, factors of production or economic resources, capital, and human capital.

Extra Economics in Your Life and Career: Is Cheating an Optimal Decision?

In their best-selling book Freakonomics, Steven D. Levitt and Stephen J. Dubner stated: “Who cheats?

Well, just about anyone, if the stakes are right . . . . Cheating . . . is a prominent feature in just about every human endeavor.” Evidence that some people cheat surfaced in the summer of 2011 when the superintendent of the board of the Atlanta school district resigned after a report documented widespread cheating on standardized tests that implicated officials from about 80 percent of Atlanta’s elementary and middle schools. In 2015, an Atlanta jury convicted 11 teachers as a result of the cheating scandal.

Steven Levitt and other economists assume that decision makers—students and nonstudents alike—are rational. They compare the benefits and costs of their options and make choices for which the expected benefits exceed the expected costs. The benefits of (successful) cheating may be monetary; for example, K-12 teachers in some states are eligible for bonus payments of up to $25,000 if their students perform well on standardized tests. New technology has made it easier for high school and college students to cheat. The widespread use of cell phones and Internet access makes it easier (less costly) to share exam answers and buy term papers.

Sources: Steven D. Levitt and Stephen J. Dubner, Freakonomics New York: HarperCollins 2005, pages 24–25; Patrik Jonsson, “America’s biggest teacher and principal cheating scandal unfolds in Atlanta,” Christian Science Monitor, July 5, 2011; Mary Beth McCauley, “Atlanta school cheating: When teachers cheat, what do you tell the kids?” Christian Science Monitor, September 5, 2013; and Valerie Strauss, “How and Why Convicted Teachers Cheated on Standardized Tests,” Washington Post, April 1, 2015.

Question: For the sake of argument, let’s assume that you would never cheat. Under what circumstances are students in general more or less likely to cheat on an economics examination?

Answer: Your economics instructor will be pleased if you would never cheat under any circumstances.

But cheating is more likely when: (a) the positive consequences of receiving a high grade are significant (for example, a high grade is necessary to maintain a scholarship, gain admittance to medical school, or get a good job offer) and/or (b) the probability of getting caught is low (the instructor gives the same multiplechoice exam to all students in a large classroom with no supervision). Reducing the benefit and increasing the cost of getting caught will reduce the incidence of cheating. If appeals to personal integrity are not enough to convince students not to cheat, a more effective deterrent may be for potential employers to let students know that they fire dishonest employees.

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CHAPTER 1 | Economics: Foundations and Models

Appendix Using Graphs and Formulas (pages 21–32) Learning Objective: Review the use of graphs and formulas.

Graphs simplify economic ideas and help make ideas more concrete. Economists and policymakers can use graphs to help solve real-world problems.

Graphs of One Variable Figure 1A.1 displays examples of two common types of graphs: bar graphs and pie charts. The height of the bars in the bar graph represents the market shares of automobile firms. The pie chart shows the same information with market shares represented by the size of the pie’s slices. Information on economic variables can also be displayed in time-series graphs. These graphs are displayed on a coordinate grid. The vertical axis (y-axis) of a coordinate grid measures the value of one variable. The point where the vertical axis intersects the horizontal axis is the origin. The horizontal axis of a coordinate grid measures the value of another variable. The points in a coordinate grid represent the values of the two variables. Figure 1A.2 illustrates examples of time-series graphs.

Graphs of Two Variables Both microeconomics and macroeconomics use two-variable graphs extensively. Figure 1A.3 illustrates the graph of a linear or straight-line demand curve where price is measured along the vertical axis and quantity is measured along the horizontal axis.

A. Slopes of Lines The slope of a straight line indicates how much the variable measured along the y-axis changes as the variable measured along the x-axis changes. Slope can be measured between any two points on the line because the slope of a straight line has a constant value. The slope can be expressed as the change in the value measured on the vertical axis divided by the change in the value measured on the horizontal axis; slope can also be expressed using the Greek letter delta (Δ) to stand for the change in a variable (slope = Δy /Δx). The slope is also referred to as the rise over the run.

Slope =

Change in value on the vertical axis y Rise = = Change in the value on the horizontal axis x Run

B. Taking into Account More Than Two Variables on a Graph The demand curve in Figure 1A.4 shows the relationship between the price of pizza and the quantity of pizza sold, but the quantity of any good sold depends on more than just the price of the good. Allowing other variables to change will cause the position of the demand curve in the graph to change. The table in Figure 1A.5 shows the effect of a change in the price of hamburgers on the quantity of pizza demanded. By shifting the demand curve we take into account the effect of changes in a third variable.

C. Positive and Negative Relationships Sometimes the relationship between two variables is negative, as in the case with the price of pizza and the quantity of pizza demanded. The relationship between two variables can be positive, as in Figure 1A.6 which shows values for income and consumption spending in Canada for the years 2008 to 2011.

D. Determining Cause and Effect Inferring cause-and-effect relationships by observing graphs can lead to incorrect conclusions. One reason for this is that there may be an omitted variable that is not accounted for in the graph. A related problem in

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CHAPTER 1 | Economics: Foundations and Models determining cause and effect is reverse causality; this occurs when we conclude that changes in variable X cause changes in variable Y, when changes in variable Y cause changes in variable X.

E. Are Graphs of Economic Relationships Always Straight Lines?

The relationship between two variables is linear when it can be represented by a straight line. Few economic relationships are actually linear. However, it is often useful to approximate a nonlinear relationship with a linear relationship.

F. Slopes of Nonlinear Curves To measure the slope of a nonlinear curve at a particular point, we must measure the slope of a tangent to the curve at that point. A tangent line touches the curve at only one point. The slope of a tangent is measured in the same way as the slope of any straight line.

Formulas This section reviews several useful formulas and shows how to use them.

A. Formula for a Percentage Change The formula for a percentage change between two variables for any two periods is Value in the second period − Value in the first period  100 .

Percentage change = Value in the first period

B. Formulas for the Areas of a Rectangle and a Triangle The formula for the area of a rectangle is Base × Height. The formula for the area of a triangle is ½ (Base × Height).

C. Summary of Using Formulas Follow these steps when using a formula: 1. Make sure you understand the economic concept the formula represents.

2. Make sure you are using the correct formula for the problem you are solving.

3. Make sure the number you calculate using the formula is economically reasonable.

Teaching Tips You can assign the appendix as “on-your-own” reading. But don’t assume students will understand the formula for computing a slope or a percentage change. Reviewing these formulas in class will be time well spent, either at this point in the course or when these formulas are first applied. Unlike bar charts and pie charts, students will need to use graphs of two variables and percentage changes often throughout the remainder of the text.

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System Brief Chapter Summary and Learning Objectives 2.1

Production Possibilities Frontiers and Opportunity Costs (pages 36–42) Use a production possibilities frontier to analyze opportunity costs and trade-offs.

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2.2

The economic resources available to countries when producing goods and services are scarce. Decision makers face trade-offs as a result of scarcity.

The model of production possibilities frontier is used to analyze opportunity costs and trade-offs that individuals, firms, or countries face.

Comparative Advantage and Trade (pages 42–47) Understand comparative advantage and explain how it is the basis for trade.

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2.3

Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than other producers.

The Market System (pages 48–52) Explain the basic idea of how a market system works.

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Markets enable buyers and sellers of goods and services to trade.

Entrepreneurs, those who own or operate businesses, produce goods and services that consumers want, and decide how these goods and services should be produced to yield the most profit.

It is essential for governments to protect rights to private property in order for a market system to work well.

Key Terms Absolute advantage, p. 44. The ability of an individual, a firm, or a country to produce more of a good or service than potential trading partners, using the same amount of resources.

Allocative efficiency, p, 36. A state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it.

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Circular-flow diagram, p. 49. A model that illustrates how participants in markets are linked.

Comparative advantage, p. 45. The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than potential trading partners.

Economic growth, p. 42. The ability of the economy to increase the production of goods and services.

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System Entrepreneur, p. 48. Someone who operates a business, bringing together the factors of production—labour, capital, and natural resources—to produce goods and services.

Factor market, p. 48. A market for the factors of production, such as labour, capital, natural resources, and entrepreneurial ability.

Factors of production, p. 35. The inputs used to make goods and services.

Free Market, p. 50. A market with few government restrictions on how goods or services can be produced or sold, on who can buy or sell goods or services, or on how factors of production can be employed.

Market, p. 48. A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

Opportunity cost, p. 36. The highest-valued alternative that must be given up to engage in an activity.

Product market, p. 48. Markets for goods— such as computers—and services—such as haircuts.

Production possibilities frontier (PPF), p. 36.

A curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology.

Property rights, p. 51. The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

Scarcity, p. 35. A situation in which unlimited wants exceed the limited resources available to fulfill those wants.

Trade, p. 42. The act of buying and selling.

Chapter Outline Managers Making Choices at Toyota The managers at firms such as Toyota must make decisions regarding the production and marketing of their products. These decisions include the location and relocation of manufacturing plants and the production methods used at these plants. For example, producing more of one model of automobile means producing fewer of other models.

2.1

Production Possibilities Frontiers and Opportunity Costs (pages 36–42) Learning Objective: Use a production possibilities frontier to analyze opportunity costs and trade-offs.

Scarcity is a situation in which unlimited wants exceed the limited resources available to fulfill those wants.

Factors of production are the inputs used to make goods and services, such as workers, capital, natural resources and entrepreneurial ability.

A production possibilities frontier (PPF) is a curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology.

A production possibilities frontier is a simple model that can be used to analyze trade-offs Toyota faces in deciding how many of each type of automobile (in the textbook example, either Corolla sedans or Lexus RX450h SUVs) it should produce given its limited resources and its technology.

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

A. Graphing the Production Possibilities Frontier Combinations of products on the frontier are technically efficient because the maximum output is obtained from the available resources. Combinations inside the frontier are inefficient because some resources are not being used efficiently. Combinations outside the frontier are unattainable with current resources. This can be used to emphasize the concept of scarcity and, since only one point on the PPF can be chosen, it also illustrates the concept of allocative efficiency.

Opportunity cost is the highest-valued alternative that must be given up to engage in an activity.

Allocative efficiency is a state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it.

B. Increasing Marginal Opportunity Costs A “bowed out” PPF illustrates increasing marginal opportunity costs, which occur because some workers, machines, and other resources are better suited to one use than another. Increasing marginal opportunity costs illustrate an important concept: The more resources already devoted to any activity, the smaller the payoff to devoting additional resources to that activity.

C. Economic Growth Economic growth is the ability of the economy to increase the production of goods and services.

Economic growth can occur if more resources become available or if a technological advance makes resources more productive. Growth may lead to greater increases in production for one good than another.

Growth is illustrated by an outward shift of the PPF. This shift may be symmetric or asymmetric as illustrated in Fig 2.3 on p. 41.

Teaching Tips By using a consumer good on the vertical axis and a capital good on the horizontal axis, it is then a simple task to illustrate endogenous growth. Any choice other than the vertical intercept involves the production of capital, which moves the curve out in the next period. The further down the PPF that is chosen, the more capital is produced and the faster the economy grows. The opportunity cost of growth can be measured in terms of foregone consumer goods. Allocation of resources to capital goods in the present results in increased production possibilities of both goods in the future.

2.2

Comparative Advantage and Trade (pages 42–47) Learning Objective: Understand comparative advantage and explain how it is the basis for trade.

Trade is the act of buying or selling. One of the great benefits of trade is that it makes it possible for people to become better off by increasing both their production and their consumption.

A. Specialization and Gains from Trade PPFs depict the combinations of two goods that can be produced if no trade occurs. If one individual, firm, or country’s PPF shows greater production of both goods, then this individual, firm, or country has an absolute advantage in producing both goods. Even in this case, trade makes sense as illustrated in Fig 2.5 on p. 44.

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

B. Absolute Advantage versus Comparative Advantage Absolute advantage is the ability of an individual, a firm, or a country to produce more of a good or service than potential trading partners, using the same amount of resources.

If the two individuals have different opportunity costs for producing two goods, each individual will have a comparative advantage in the production of one of the goods. Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than potential trading partners. Comparing the possible combinations of production and consumption before and after specialization and trade occur proves that trade can be mutually beneficial. Determining whether a specific trade will lead to gains requires that we know the exchange ratio.

C. Comparative Advantage and the Gains from Trade The basis for trade is comparative advantage, not absolute advantage. Individuals, firms, and countries are better off if they specialize in producing the goods and services for which they have a comparative advantage and obtain the other goods and services they need by trading.

Teaching Tips Even good students have difficulty understanding comparative advantage. A good example of comparative advantage is the career of baseball legend Babe Ruth. Before he achieved his greatest fame as a home-run hitter and outfielder with the New York Yankees, Ruth was a star pitcher with the Boston Red Sox. Ruth may have been the best left-handed pitcher in the American League during his years with Boston (1914–1919), but he was used more as an outfielder in his last two years with the team. In fact, he established a record for home runs in a season (29) in 1919. The Yankees acquired Ruth in 1920 and made him a full-time outfielder. The opportunity cost of this decision for the Yankees was the wins he could have earned as a pitcher. But because New York already had skilled pitchers, the opportunity cost of replacing him as a pitcher was lower than the cost of replacing Ruth as a hitter. No one else on the Yankees could have hit 54 home runs, Ruth’s total in 1920; the next highest total was 11. It can be argued that Ruth had an absolute advantage as both a hitter and pitcher in 1920, but a comparative advantage only as a hitter.

2.3

The Market System (pages 48–52) Learning Objective: Explain the basic idea of how a market system works.

A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Markets can be physical or virtual places and are composed of buyers (demanders) and sellers (suppliers). A product market is a market for goods—such as computers—or services—such as haircuts. A factor market is a market for the factors of production, such as labour, capital, natural resources, and entrepreneurial ability.

An entrepreneur is someone who operates a business, bringing together the factors of production— labour, capital, and natural resources—to produce goods and services.

Factors of production are the inputs used to make goods and services.

A. The Circular Flow of Income A circular-flow diagram is a model that illustrates how participants in markets are linked. The diagram demonstrates the interaction between firms and households in both product and factor markets. The diagram is a simplified version of reality. For example, it leaves out the important roles of the

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System government, the financial systems, and the international sector. Nevertheless, this diagram is useful to show how the market system successfully coordinates the independent activities of many people.

B. The Gains from Free Markets A free market is a market with few government restrictions on how goods or services can be produced or sold, on who can buy or sell goods or services, or on how factors of production can be employed. Adam Smith is considered the father of modern economics. His book, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, was an influential argument for the free-market system. A key to understanding Adam Smith’s argument is the assumption that individuals usually act in a rational, selfinterested way. This assumption underlies nearly all economic analysis.

C. The Legal Basis of a Successful Market System The absence of government intervention is not enough for a market economy to work well. Government must provide secure rights to private property. Government can help the market function properly by enforcing contracts between individuals through an independent court system. Property rights refer to the rights that individuals or firms have to the exclusive use of their property, including the right to buy or sell it. Property rights in Canada are based on British common law (except in Quebec, where the civil code system is in effect). The Sale of Goods Act governs contract law for the sale of goods except land.

Court enforcement of property rights is necessary for the market system to work. If property rights are not well enforced, economic efficiency is reduced.

Teaching Tips To initiate class discussion regarding intellectual property rights, ask students these questions: 1. How many of you have downloaded music via the Internet?

2. Should the government have the right to grant exclusive rights to musicians and other artists to produce and sell their creative works?

3. Should the government fine or prosecute individuals who illegally obtain music, books, movies, and other creative works in violation of property rights laws?

Note to instructor: Canada’s Copyright Act permits copying onto blank CDs, and a levy is charged on the purchase of this type of recordable medium. However, digital recording devices such as MP3 players are not included.

Extra Solved Problem 2.3 Adam Smith’s “Invisible Hand” Alan Krueger, an economist at Princeton University who served as chair of the Council of Economic Advisers in the Obama administration, has argued that Adam Smith “worried that if merchants and manufacturers pursued their self-interest by seeking government regulation and privilege, the invisible hand would not work its magic.”

Source: Alan B. Krueger, “Rediscovering the Wealth of Nations,” New York Times, August 16, 2001.

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What types of regulation and privilege might merchants and manufacturers seek from the government?

b.

How might these regulations and privileges keep the invisible hand from working?

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

Solving the Problem Step 1:

Review the chapter material.

This problem is about how goods and services are produced and sold and how factors of production are employed in a free market economic system as described by Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations. You may want to review the section “The Gains from Free Markets,” which begins on page 50.

Step 2:

Answer part (a) by describing the economic system in place in Europe in 1776.

At the time, governments gave guilds—associations of producers—the authority to control production. The production controls limited the amount of output of goods such as shoes and clothing, as well as the number of producers of these items. Limiting production and competition led to higher prices and fewer choices for consumers. Instead of catering to the wants of consumers, producers sought favours from government officials.

Step 3:

Answer part (b) by contrasting the behaviour of merchants and manufacturers under a guild system and a market system.

Because governments gave producers the power to control production, producers did not have to respond to consumers’ demands for better quality, greater variety, and lower prices. Under a market system, producers who sell poor-quality goods at high prices suffer economic losses; producers who provide better-quality goods at low prices are rewarded with profits.

Therefore, it is in the self-interest of producers to address consumer wants. This is how the invisible hand works in a free market economy, but not in most of Europe in the eighteenth century.

Extra Apply the An Elementary Case of Copyright Concept The U.S. Congress provides copyright protection to authors to give them an economic incentive to invest the time and effort required to write books. While a book is under copyright, only the author—or whoever the author sells the copyright to—can legally publish a paper or digital copy of the book. Once the copyright expires, however, the book enters the public domain, and anyone is free to publish the book. Copies of classic books written in the 1800s, such as Mark Twain’s Huckleberry Finn and Charles Dickens’s Oliver Twist, are available from many publishers that do not have to pay a fee to the authors’ heirs.

Arthur Conan Doyle was a doctor in England when he published his first story featuring the detective Sherlock Holmes in 1887. Anyone who wants to publish any of the Sherlock Holmes stories that Doyle wrote from 1887 through the end of 1922 is free do so. But the last 10 Sherlock Holmes stories that Doyle wrote from 1923 to 1927 remain under copyright protection. Doyle’s heirs argue that because the author continued to develop the personalities of Sherlock Holmes and his companion Dr. John Watson in the 10 stories that remain under copyright protection, the characters cannot be used in new books, films, or television shows without payment. Doyle’s heirs have asked anyone who wants to include Holmes in a new work to pay them a fee of $5,000 per use.

The producers of two recent Sherlock Holmes films starring Robert Downey, Jr., and the producers of the television series Sherlock, starring Benedict Cumberbatch, and Elementary, starring Jonny Lee Miller, agreed to pay the fee, as have most authors of books using Holmes as a character. In 2011, when Leslie S. Klinger published A Study in Sherlock, a collection of new stories involving Sherlock Holmes, his publisher insisted that he pay the usual fee to Doyle’s descendants. But two years later, when Klinger

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System decided to publish another collection, In the Company of Sherlock Holmes, he decided that rather than pay the fee he would sue Doyle’s descendants, hoping the federal courts would rule against their copyright claims.

Federal Appeals Judge Richard Posner—who is also an economist—eventually ruled in favour of Klinger.

He argued that copyright law did not allow authors or their heirs to require fees for the use of characters from stories in the public domain. He also noted that, “the longer the copyright term is, the less publicdomain material there will be and so the greater will be the cost of authorship, because authors will have to obtain licenses from copyright holders for more material.” As a result of this ruling, for the first time since 1887, anyone can use Sherlock Holmes as a character in a book, television show, or movie without having to pay a fee.

Sources: Jennifer Schuessler, “Appeals Court Affirms Sherlock Holmes Is in Public Domain,” New York Times, June 17, 2014; Jennifer Schuessler, “Conan Doyle Estate Told to Pay Legal Fees,” New York Times, August 5, 2014; Eriq Gardner, “Conan Doyle Estate Loses Appeal Over ‘Sherlock Holmes’ Rights,” Hollywood Reporter, June 16, 2014; and Leslie S. Kling v. Conan Doyle Estate, Ltd. (7th Cir. 2014), media.ca7.uscourts.gov.

Extra Economics in Your Life and Career: International Trade and Household Income Outsourcing refers to firms producing goods and services outside of their home country. Economists and policymakers have debated the effect of international trade and outsourcing on employment in most industrialized countries. Mark Carney, former Governor of the Bank of Canada and current Governor of the Bank of England, in a September 2012 speech said “Canada’s improved terms of trade cause income, wealth, and GDP to rise.”

Questions: (a) Should Canada eliminate all trade barriers if this increases the risk of some workers losing their jobs to outsourcing? (b) What type of job would make you more or less vulnerable to outsourcing?

Answers: (a) Given the opposition from firms and workers in industries that would be harmed by free trade, it is unlikely that Canada would eliminate all internal and external trade barriers. Studies shows that opposition to free trade has a significant cost. (b) The jobs most vulnerable to outsourcing are primarily the relatively lower-wage positions.

Source: Mark Carney, “Dutch Disease,” Bank of Canada, September 7, 2012. https://www.bankofcanada.ca/2012/09/dutch-disease/.

Extra Economics in Your Life & Career: Economists Express Their Agreement on Free Trade During the summer of 2017, fifteen former leaders of the White House Council of Economic Advisors signed a letter to President Trump urging him not to place tariffs on imports of steel into the United States. The letter notes that “Among us are Republicans and Democrats alike, and we have disagreements on a number of policy issues. But on some policies there is near universal agreement. One such issue is the harm of imposing tariffs on steel imports.” Tariffs are taxes imposed by government on imports.

Those who endorse tariffs and other barriers to free international trade believe that such barriers protect domestic industries and the jobs of their employees.

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CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

Questions: (a) Why do many economists, including those who have served for both Republican and Democratic administrations, support free trade policies and oppose tariffs and trade barriers even if these barriers are designed to protect domestic workers from losing their jobs? (b) What types of jobs would be most vulnerable to job losses due to competition from imports?

Answers: (a) As you learned in this chapter, countries are better off if they specialize in producing goods and services in which they have a comparative advantage and trading with other countries for other goods and services. Tariffs prevent countries from taking full advantage of the benefits from free trade. The argument that economists who have worked for both Democratic and Republican governments made is based on positive economic analysis (analysis concerned with what is) rather than normative analysis (analysis concerned with what ought to be). Ben Bernanke, former chairman of the Federal Reserve Board, has cited a study that examined the effect of international trade on income in the United States since World War II: “. . . the increase in trade . . . has boosted U.S. annual incomes on the order of $10,000 per household. The same study found that removing all remaining barriers to trade would raise incomes anywhere from $4,000 to $12,000 per household.” (b) Another study cited by Bernanke found that the 21 occupations in the United States that were most vulnerable to imports from foreign firms were primarily for relatively low-wage positions. In general, the greater the skill requirements for the job you hold, the less vulnerable you will be to losing your job due to competition from imports.

Sources: Nick Timiraos, “Former White House Economists to Donald Trump: Don’t Impose Steel Tariffs,” Wall Street Journal, July 12, 2017; Ben Bernanke, “Embracing the Challenge of Free Trade: Competing and Prospering in a Global Economy,” The Federal Reserve Board, May 1, 2007. http://www.federalreserve.gov/boarddocs/speeches/2007/20070501/default.htm; and “Why Open Markets Matter,” oecd.org/trade/whyopenmarketsmatter.htm.

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand

CHAPTER 3 | Where Prices Come From:

The Interaction of Supply and Demand Brief Chapter Summary and Learning Objectives 3.1

The Demand Side of the Market (pages 59–67) Discuss the variables that influence demand.

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3.2

The most important factor affecting the demand for a product is its price.

Other factors that affect demand include income, prices of related goods, tastes, population and demographics, and expected future prices.

The impact of a price change can be broken into two different effects: the substitution effect and the income effect.

The Supply Side of the Market (pages 67–72) Discuss the variables that influence supply.

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3.3

The most important factor affecting the supply for a product is its price.

Other factors that affect supply include prices of inputs, technological change, prices of substitutes in production, the number of firms in the market, and expected future prices.

Market Equilibrium: Putting Buyers and Sellers Together (pages 72–75) Use a graph to illustrate market equilibrium.

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3.4

The intersection of demand and supply curves results in an equilibrium price and an equilibrium quantity.

A surplus exists when the market price is above the equilibrium price. A shortage exists when the market price is below the equilibrium price.

The Effect of Demand and Supply Shifts on Equilibrium (pages 75–81) Use demand and supply graphs to predict changes in prices and quantities.

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An increase in demand increases the equilibrium price and equilibrium quantity. A decrease in demand decreases the equilibrium price and equilibrium quantity.

An increase in supply decreases equilibrium price and increases the equilibrium quantity.

A decrease in supply increases equilibrium price and decreases the equilibrium quantity.

Appendix: Quantitative Demand and Supply Analysis (88–90) Use quantitative demand and supply analysis.

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand

Key Terms Ceteris paribus (“all else equal”) condition, p. 61. The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant.

Competitive market equilibrium, p. 72. A market equilibrium with many buyers and many sellers.

Complements, p. 62. Goods and services that are used together.

Market demand, p. 59. The demand by all the consumers of a given good or service.

Market equilibrium, p. 72. A situation in which quantity demanded equals quantity supplied.

Normal good, p. 62. A good for which the demand increases as income rises and decreases as income falls.

Demand curve, p. 59. A curve that shows the relationship between the price of a product and the quantity of the product demanded.

Perfectly competitive market, p. 58. A market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market.

Demand schedule, p. 59. A table that shows the relationship between the price of a product and the quantity of the product demanded.

Quantity demanded, p. 59. The amount of a good or service that a consumer is willing and able to purchase at a given price.

Demographics, p. 63. The characteristics of a population with respect to age, race, and gender.

Quantity supplied, p. 67. The amount of a good or service that a firm is willing and able to supply at a given price.

Income effect, p. 61. The change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power.

Inferior good, p. 62. A good for which the demand increases as income falls and decreases as income rises.

Law of demand, p. 60. The rule that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease.

Law of supply, p. 68. The rule that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

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Shortage, p. 73. A situation in which the quantity demanded is greater than the quantity supplied.

Substitutes, p. 62. Goods and services that can be used for the same purpose.

Substitution effect, p. 60. The change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power.

Supply curve, p. 68. A curve that shows the relationship between the price of a product and the quantity of the product supplied.

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand Supply schedule, p. 68. A table that shows the relationship between the price of a product and the quantity of the product supplied.

Technological change, p. 69. A change in the quantity of output a firm can produce using a given quantity of inputs

Surplus, p. 73. A situation in which the quantity supplied is greater than the quantity demanded.

Chapter Outline How Smart Is Your Water?

Between 2013 and 2018, total Canadian sales of carbonated beverages such as Coke and Pepsi declined by $90 million, while sales of bottled water increased by 1.1 percent. In 1994, Pepsi responded to increased demand for bottled water by introducing Aquafina water. In 1999, Coke introduced Dasani water. However, Nestlé Canada, Inc., better known for making chocolate, has quietly become the leading producer of bottled water in Canada. Coca-Cola and PepsiCo aren’t content to sit and watch Nestlé grow in the Canadian market for bottled water. By 2017, Pepsi introduced LIFEWTR and Coke introduced smartwater, premium waters that sell for higher prices than other brands. But the firms faced competition from brands such as Nestlé’s Perrier and Danone’s Evian. Although competition is not good news for firms such as Coke and Pepsi, it increases choices of available products and lowers prices for consumers.

3.1

The Demand Side of the Market (pages 59–67) Learning Objective: Discuss the variables that influence demand.

A perfectly competitive market is a market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market.

When we discuss demand, we are considering not what a consumer wants to buy, but what a consumer is willing and able to buy.

A. Demand Schedules and Demand Curves A demand schedule is a table showing the relationship between the price of a product and the quantity of the product demanded. The amount of a good or service that a consumer is willing and able to purchase at a given price is called the quantity demanded. A graph is often used to plot the numbers from a demand schedule; this graph is called a demand curve. A demand curve shows the relationship between the price of a product and the quantity of the product demanded. Market demand refers to the demand by all the consumers of a given good or service.

B. The Law of Demand The inverse relationship between the price of the product demanded and the quantity of the product demanded is known as the law of demand: Holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease. The law of demand holds for any market demand curve.

C. What Explains the Law of Demand?

The law of demand is explained by substitution and income effects. The substitution effect of a price change refers to the change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes. When the price of a .

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand good falls, consumers will usually purchase a larger quantity of that good and fewer substitute goods. The income effect of a price change is the change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power. When the price of a good falls, the increased purchasing power of consumers’ incomes will usually lead them to purchase a larger quantity of the good. The substitution and income effects happen simultaneously whenever a price changes.

D. That Magic Latin Phrase Ceteris Paribus The ceteris paribus (“all else equal” in Latin) condition is the requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant. If we allowed a variable other than price to change, that might affect the willingness of consumers to buy a product and then consumers would change the quantity they demand at each price.

We can illustrate this by shifting the market demand curve.

E. Variables that Shift Market Demand Many variables other than price can influence demand. The five most important are: income, prices of related goods, tastes, population and demographics, and expected future prices. The income that consumers have to spend affects consumers’ willingness and ability to buy a good. A normal good is a good for which the demand increases as income rises and decreases as income falls. An inferior good is a good for which the demand increases as income falls, and decreases as income rises. Substitutes are goods and services that can be used for the same purpose. When two goods are substitutes, the more you buy of one, the less you will buy of the other. A decrease in the price of a substitute causes the demand curve for a good to shift to the left. An increase in the price of a substitute causes the demand curve for a good to shift to the right. Complements are goods and services that are used together. When two goods are complements, the more you buy of one, the more you will buy of the other. A decrease in the price of a complement causes the demand curve for a good to shift to the right. An increase in the price of a complement causes the demand curve for a good to shift to the left.

Consumers can also be influenced by an advertising campaign for a product. Economists would say that the advertising campaign has affected consumers’ taste for the product. Taste is a catch-all category that refers to the many subjective elements that enter into a consumer’s decision to buy a product. When consumers’ taste for a product increases, the demand curve will shift to the right, and when consumers’ taste for a product decreases, the demand curve for the product will shift to the left. Population refers to the total number of consumers. As population increases, the number of consumers grows and so does demand. An increase in population will shift the demand curve to the right. Demographics refer to the different types of people that make up a population. Changes in demographics can change demand for certain products. As the demographics of a country or region change, the demand for particular goods will increase or decrease because different categories of people tend to have different preferences for those goods. Expected future prices can also affect demand. For example, if enough consumers become convinced that houses will be selling for lower prices in three months, the demand for houses will decrease now. If enough consumers become convinced that the price of houses will be higher in three months, the demand for houses will increase now as some consumers try to beat the expected price increase.

F.

A Change in Demand versus a Change in Quantity Demanded

It is important to understand the difference between a change in demand and a change in quantity demanded. A change in demand refers to a shift in the demand curve. A shift will occur if there is a change in one of the variables, other than the price of the product, that affects the willingness of consumers to buy the product. A change in quantity demanded refers to a movement along the demand curve as a result of a change in the product’s price.

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand

Teaching Tips There is no magic formula for making students understand the difference between a change in quantity demanded and a change in demand. This difference needs to be reinforced through classroom discussion, use of examples of these changes, and homework assignments. Even good students mistake a movement along a demand curve with an increase or a decrease in demand. A simple way to avoid this error is to note that only one variable can cause a change in quantity demanded (price), whereas a change in any of the non-price factors results in a change in demand. A good mnemonic that students seem to respond to is that if the variable in question is on one of the axes, it’s a movement along the curve (change in quantity demanded); if it isn’t on either of the axes, it’s a shift.

Encourage students to study Table 3.1, which lists the variables that shift demand curves, and Figure 3.3, which illustrates the difference between a change in demand and a change in quantity demanded.

Extra Solved Problem 3.1 Welcome to GM Place Rogers Arena For many years, corporations purchased advertising time during professional sporting events—such as Canadian Football League (CFL) and National Hockey League (NHL) games—to promote their products.

During the latter part of the twentieth century, a new form of sponsorship emerged, as corporations purchased naming rights to the arenas and stadiums where these games are played. Maple Leaf Gardens has been replaced by the Air Canada Centre, the Montreal Canadiens play in the Bell Centre (formerly the Molson Centre), the Ottawa Senators call Scotiabank Place home, the Vancouver Canucks host opponents at Rogers Arena (formerly GM Place). Even CFL stadiums have corporate sponsors. The Saskatchewan Roughriders now play at Mosaic Stadium and the Winnipeg Blue Bombers throw footballs at Investors Group Field. Although many diehard sports fans complain about the practice, especially when the name changes, sports franchise owners welcome the revenue generated through the sale of naming rights.

a. How does corporate sponsorship affect the demand for the sponsor’s product? b. Why have so many companies purchased naming rights rather than purchase time to broadcast commercials during games?

Solving the Problem Step 1:

Review the chapter material.

This problem refers to a variable that shifts a market demand curve, so you may want to review the section “Variables that Shift Market Demand,” which begins on page 54 in the textbook.

Step 2:

How does corporate sponsorship affect the demand for the sponsor’s product?

Consumers can be influenced by an advertising campaign to buy a sponsor’s product.

Consumers’ tastes are affected by advertising. Taste refers to a composite category that represents many subjective factors.

Step 3:

Why have so many companies purchased naming rights rather than purchase time to broadcast commercials during games?

Cable and satellite television offer consumers many more programming choices than were available to viewers in the 1950s and 1960s. Televisions are operated with remote controls which allow viewers to change channels during commercial breaks without leaving their seats; mute buttons silence commercial messages with the touch of a finger; digital video recorders allow viewers to fast forward through commercials. Advertisers cannot be

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand guaranteed that viewers will see their commercials, but this technology does not affect exposure to sponsors who purchase naming rights. Commentators refer to the venue by name, newspaper and magazine articles refer to the sponsor’s name whenever the venue’s title is used, and company logos appear on screen during broadcasts of the games.

Extra Food Retailers Respond to Changing Demographics Apply the Concept The demographics of Canada are continually changing, due in part to the aging of the “Baby Boomers” (those born between 1947 and 1965) and the “Millenials” (those born between 1981 and 2004—also known as “Generation Y” or the “Echo Boomers”) as well as from the effects of immigration. A recent Statistics Canada report show that the median age of the population has increased from 27.2 years in 1956 to 38.8 years in 2006 and is expected to reach 46.9 years by 2056. As the baby boomers age, “consumer products and services will need to adapt to meet their changing needs” (FreshPlaza). Family-sized packages will magically be transformed into senior-sized, though probably labeled as something a little more marketable. The Millenials on the other hand will desire higher quality as their earning power increases and they satisfy their preference for healthy living. They will also be more inclined than their parents to use different technologies, including smart sensors.

Changes in the ethnic make-up of the population are causing an increase in the number of Asian largeformat grocery stores such as T&T and P.A.T, and an increase in the “ethnic” offerings of the mainstream retail chains such as Sobeys, Loblaws, Metro, Safeway, and Costco.

Demographics is one of the determinants of demand and any changes to the existing make-up of the population will have an effect on the demand for certain products and services.

Sources: “Canadian Demographics at a Glance” Statistics Canada, https://www150.statcan.gc.ca/n1/pub/91-003-x/91-003x2007001-eng.htm. “Food retailing changing in Canada” FreshPlaza, https://www.freshplaza.com/article/111887/FoodRetailing-changing-in-Canada/#SlideFrame_1, David K. Foot with Daniel Stoffman “Boom, Bust & Echo 2000: Profiting from the demographic shift in the new millennium” Macfarlane, Walter and Ross 1998

Extra Superstore Responds to a Growing Islamic Population Apply the Concept The spending power of Canada’s Islamic population is rapidly increasing. So it is no surprise that firms have begun to respond: National grocery store chains have begun to carry meat that conforms to Islamic dietary rules (Halal). Loblaw Companies owns a variety of grocery stores, including the Real Canadian Superstores. Many of these stores now have sections devoted to Halal foods and meats. In the past, food intended to address specific religious dietary restrictions were sold in smaller specialty shops (although some kosher foods have been common in supermarkets for years).

The increase in spending by the households of recent immigrants is due partly to increased numbers and partly to rising incomes.

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand As the demand for goods purchased by the households of recent immigrants increases, a larger quantity can be sold at every price. Firms have responded by devoting more resources to serving this demographic group.

Question: Name three products whose demand is likely to increase rapidly if the following demographic groups increase at a faster rate than the population as a whole: a. Teenagers b. Children under age five c. People over age sixty-five

Answer: a. Music downloads, video streaming, text messaging services, video game subscriptions b. Diapers, developmental toys, child care services c. Medical services, cruise ship tours, nursing homes

Extra Apply the Are Smartwatches Substitutes for Smartphones?

Concept Two products are rarely perfect substitutes because consumers may find them more or less useful for some purposes. As Apple and other firms began selling smartwatches, a key question they needed to answer was whether consumers considered smartwatches close substitutes for smartphones. You can use either a smartwatch or a smartphone to check the time, send a text, keep a list of appointments, or use a GPS map. But you need a smartphone if you want to surf the Web or watch a movie, while you are better off buying a smartwatch if you want to monitor your heartbeat or keep track of how many calories you are burning while exercising.

So, smartwatches and smartphones are substitutes—but they aren’t perfect substitutes. To correctly forecast sales and produce the correct quantity of smartwatches, firms that sell them need to evaluate how similar consumers consider smartwatches and smartphones to be. Many people who might consider buying a smartwatch already own a smartphone. So, the closer consumers consider the two products to be as substitutes, the less likely they are to buy a smartwatch in addition to a smartphone.

When Apple introduced the Apple Watch in 2015, sales were initially very strong, which would seem to indicate that many consumers believed that the unique features of the smartwatch made it worth buying, even if they owned a smartphone. Some analysts, though, wondered how large future sales would be after people who buy each new electronic device soon after it hits the market—early adopters—had made their purchases. One early reviewer of the Apple Watch noted that he was unsure “that I need this thing on my wrist every day.” Similarly, the Economist magazine offered the opinion, “Apple seems unlikely to turn its watch into the next big must-have gadget. … People are unlikely to want to shell out … US$350 … for something with so few extra functions.”

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand Other industry observers were more optimistic about the size of the market for smartwatches. Writing in the Wall Street Journal, one analyst argued that smartwatches performed several functions faster or more conveniently than smartphones. He concluded, “Billions of consumers who own a smartphone are likely to consider purchasing a smartwatch.” In the end, as with most new products, the success of smartwatches depends on whether consumers see them as filling a need that other products don’t meet. In other words, if consumers believe that smartwatches are very different from smartphones, they are more likely to buy smartwatches.

Sources: Joshua Topolsky, “Apple Watch Review: You’ll Want One, but You Don’t Need One,” bloomberg.com, April 8, 2015; “The Time Machine,” Economist, March 9, 2015; and Daniel Matte and Kevin McCullagh, “Will Smartwatches Be a Hit?” Wall Street Journal, May 10, 2015.

Extra Apply the Forecasting the Demand for iPhones Concept One of the most important decisions that managers of any large firm face is choosing which new products to develop. A firm must devote people, time, and money to design a new product, negotiate with suppliers, create a marketing campaign, and perform many other tasks. But any firm has only limited resources and so faces a trade-off: Resources used to develop one product will not be available to develop another product.

Ultimately, the products a firm chooses to develop will be those that it believes will be the most profitable.

So, to decide which products to develop, firms need to forecast the demand for those products.

David Sobotta, who worked at Apple for 20 years and eventually became its national sales manager, has described discussions at Apple during 2002 about whether to develop a tablet computer. According to Sobotta, representatives of the U.S. National Institutes of Health urged Apple to develop a tablet computer, arguing that it would be particularly useful to doctors, nurses, and hospitals. In 2001, Bill Gates, chairman of Microsoft, had predicted that “within five years … [tablet PCs] will be the most popular form of PC sold in America.” Apple’s managers decided not to develop a tablet computer, however, because they believed the technology available at that time was too complex for an average computer user, and they also believed that the demand from doctors and nurses would be small. Apple’s forecast was correct. Despite Bill Gates’s prediction, in 2006, tablet computers made up only 1 percent of the computer market. According to Sobotta, “Apple executives had a theory that the route to success will not be through selling thousands of relatively expensive things, but millions of very inexpensive things like iPods.”

Apple continued to work on smartphones, developing the technology to eliminate keyboards in favour of touchscreen displays. Rather than proceed immediately to building a tablet computer, Steve Jobs, then Apple’s CEO, realized he could use this technology in a different way: “I thought ‘My God we can build a phone out of this.’” From its introduction in 2007, the iPhone was an immediate success. By mid-2015, Apple had sold more than 600 million iPhones worldwide.

As Apple attempts to forecast demand for its iPhone, it needs to consider two factors: competition from other firms producing smartphones and competition from substitute goods, including tablets and smartwatches. By 2015, industry analysts were divided as to whether Apple would be able to maintain its share of the smartphone market in the face of increasing competition from other firms. The outlook for substitute goods was also mixed. Smartphones were an increasing share of the overall worldwide cellphone market, so there are relatively few consumers left to switch to smartphones from basic cellphones. The increasing availability of apps, including mobile payment apps like Apple Pay that can be used in place of credit cards, was increasing the usefulness of smartphones. But some consumers preferred to use tablets, with their larger screens, for checking e-mail and surfing the Web. With apps like

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand FaceTime or WhatsApp, a tablet can be used to make phone calls. Another unknown was the extent to which sales of smartwatches might eventually cut into smartphone sales.

As any firm does in forecasting demand, Apple faced a trade-off: If it were too cautious in expanding capacity or buying components for smartphones, other firms might seize a large share of the market. But, if Apple was too optimistic, it ran the risk of spending on capacity to produce more units than it could actually sell—an outcome that might turn potential profits into losses. Apple has spent billions of dollars buying large quantities of motion sensors, screens, and other components from suppliers. That will be money well spent … if the forecast of demand turns out to be accurate. Time will tell whether the future demand for smartphones will be as large as Apple and other firms were forecasting.

Sources: Daisuke Wakabayashi, “Apple Earnings Surge 33% on iPhone Sales,” Wall Street Journal, April 27, 2015; David Sobotta, “What Jobs Told Me on the iPhone,” (London) Guardian, January 3, 2007; “Jobs Says iPad Idea Came before iPhone,” Associated Press, January 2, 2010; and “More Smartphones Were Shipped in Q1 2013 Than Feature Phones, an Industry First According to IDC,” www.idc.com, April 25, 2013.

3.2

The Supply Side of the Market (pages 67–72) Learning Objective: Discuss the variables that influence supply.

Many variables influence the willingness and ability of firms to sell a good or service. The most important of these variables is price. Quantity supplied is the amount of a good or service that a firm is willing and able to supply at a given price. Holding other variables constant, when the price of a good rises, producing the good is more profitable and the quantity supplied will increase. When the price of a good falls, the good is less profitable and the quantity supplied will decrease. Devoting more resources to the production of a good results in increasing marginal costs. Producers are likely to find that the cost of producing additional units of a good will increase as they run existing factories for longer hours and pay higher prices for components and higher wages to their workers.

A. Supply Schedules and Supply Curves A supply schedule is a table that shows the relationship between the price of a product and the quantity of the product supplied. A supply curve is a curve that shows the relationship between the price of a product and the quantity of the product supplied.

B. The Law of Supply We expect most supply curves to be upward sloping according to the law of supply, the rule that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied. If only the price of a product changes, there is a movement along the supply curve, which is an increase or decrease in the quantity supplied. If any other variable that affects the willingness of firms to supply a good changes, then the supply curve will shift; this results in an increase or decrease in supply. When firms increase the quantity of a product they wish to sell at a given price, the supply curve shifts to the right. When firms decrease the quantity of a product they wish to sell at a given price, the supply curve shifts to the left.

C. Variables That Shift Market Supply The following are the most important variables that shift market supply: prices of inputs, technological change, prices of substitutes in production, the number of firms in the market, and expected future prices.

The factor most likely to cause a supply curve to shift is a change in the price of an input. If the price of an input (anything used in the production of a good or service) rises, the supply will decline and the supply curve will shift to the left. If the price of an input declines, the supply will increase and the supply curve will shift to the right. Technological change is a positive or negative change in the ability of a firm

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand to produce a given level of output with a given quantity of inputs. A positive technological change will shift a firm’s supply curve to the right; a negative technological change will shift a firm’s supply curve to the left.

Alternative products that a firm could produce are called substitutes in production. If the price of a substitute in production (for example, a tablet computer that can connect to Internet only by Wi-Fi) increases, the supply of the product (tablet computers that connect to the Internet by Wi-Fi or a cellular network) will shift to the left. If a firm expects that the price of its product will be higher in the future, the firm has an incentive to decrease supply in the present and increase supply in the future. When firms enter a market, the supply curve shifts to the right; when firms exit a market, the supply curve shifts to the left.

D. A Change in Supply versus a Change in Quantity Supplied A change in supply refers to a shift in the supply curve. The supply curve will shift when there is a change in one of the variables, other than the price of the product, that affects the willingness of suppliers to sell the product. A change in quantity supplied refers to a movement along the supply curve as a result of a change in the product’s price.

Teaching Tips Be careful not to refer to an increase in supply as “a downward shift” or a decrease in supply as “an upward shift.” An increase in supply should be referred to as a “shift to the right.” Because demand curves are downward sloping, an increase in demand appears in a graph as an “upward shift.” Students will associate “upward” with “increase.” Little harm is done with respect to demand curves, but because supply curves are upward-sloping, a decrease in supply appears in a graph as an “upward shift.”

Consistently refer to both changes in demand and supply as being “shifts to the right” and “shifts to the left” to avoid confusion.

Encourage students to study Table 3.2, which lists the variables that shift market supply curves, and Figure 3.6, which illustrates the difference between a change in supply and a change in quantity supplied.

Extra What’s in Your Tank Isn’t On Your Plate Apply the Concept Ethanol is an environmentally friendly, alcohol-based alternative fuel produced from corn and other crops that contain starches. Several US states have passed legislation that requires gas stations to sell a mixture of gasoline and ethanol. As the demand for ethanol and corn increases, so does the price of corn. With refiners hogging corn supplies, real hogs have felt the impact. Corn has long been a staple of the pig diet.

But soaring corn prices—in December 2011, a bushel of corn cost nearly $6, more than double the price of a few years before—have caused many farmers to turn to a cheaper alternative: junk food! Apparently, pigs have a real sweet tooth. “Pigs can be picky eaters; they like the sweet stuff” noted Alfred Smith, a North Carolina pig farmer. The sweet stuff includes cookies, licorice, cheese curls, candy bars, and other treats. Pennsylvania farmers take advantage of nearby food suppliers. Hershey Co. sells leftover cocoa and Kit Kat scraps to farmers. Dwight Hess, a cattle feedlot operator in Marietta Pennsylvania, uses Hershey and Herr Foods, a maker of potato chips and other snacks, to supply a cattle ration that includes a blend of chocolate bars and large chunks of chocolate, as well as popcorn, pretzels, potato chips and cheese curls in addition to corn and barley. In Canada, prices of feed wheat and barley, substitutes for corn in the livestock industry, have been increasing. As fodder prices rise, the cost of raising livestock such as hogs and cattle increases and so, too, must their prices. The effect in Canada is not as pronounced

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand as it is in the US because Canadian producers are more inclined to use barley than corn, and ethanol is not mandated as a fuel source as it is in the US. Sources: Lauren Etter, “With Corn Prices Rising, Pigs Switch to Fatty Snacks,” Wall Street Journal, May 21, 2007; Garance Burke, “Calif. rule increasing ethanol mix in gas to spur biofuel,” Mercury News, June 15, 2007; and “Crop Cutbacks by Farmers Spell Higher Food Prices,” Wall Street Journal, March 31, 2009, “Higher Canadian Grain Prices Cause for Concern” Farmscape Article 2488, May 19, 2007.

3.3

Market Equilibrium: Putting Buyers and Sellers Together (pages 72–75) Learning Objective: Use a graph to illustrate market equilibrium.

The purpose of markets is to bring buyers and sellers together. The interaction of buyers and sellers in markets results in firms producing goods and services most desired by consumers. A market equilibrium is a situation in which quantity demanded equals quantity supplied. A competitive market equilibrium is a market equilibrium with many buyers and many sellers.

A. How Markets Eliminate Surpluses and Shortages A market that is not in equilibrium moves toward equilibrium. When a market is in equilibrium, it remains in equilibrium. A surplus is a situation in which the quantity supplied is greater than the quantity demanded. When there is a surplus, firms have unsold goods piling up, which gives them an incentive to increase their sales by cutting the price. Cutting the price simultaneously increases the quantity demanded and decreases the quantity supplied. A shortage is a situation in which the quantity demanded is greater than the quantity supplied. When a shortage occurs, some consumers will be unable to obtain the product, and firms will realize they can raise the price without losing sales. A higher price will simultaneously increase the quantity supplied and decrease the quantity demanded. At a competitive market equilibrium, all consumers willing to pay the market price will be able to buy as much as they want, and all firms willing to accept the market price will be able to sell as much of the product as they want. There will be no reason for the price to change unless either the demand curve or the supply curve shifts.

B. Demand and Supply Both Count Neither consumers nor firms can dictate what the equilibrium price will be. No firm can sell anything at any price unless it can find a willing buyer, and no consumer can buy anything at any price without finding a willing seller.

Extra Responding to a Sawdust Shortage Apply the Concept The decline in the housing market resulted in falling prices for new homes and pink slips for many construction workers. But as fewer trees were cut down for use in construction, another market experienced a shortage and soaring prices. Though the shortage was not headline news, it had a significant impact on horse and chicken farms, pet stores, automobile parts manufacturers, oil rig operators, blueberry farmers, and many other firms. The shortage occurred in the market for sawdust; the price of a ton of sawdust jumped from $25 in 2006 to $100 in 2008. “Getting sawdust never used to be a problem. People would approach us to take sawdust — if not for free, then pretty close to free,” said Paul Gill, a Vancouver area blueberry farmer. Sawdust and wood shavings are commonly used as bedding for horses and chickens. Blueberry farmers use it to keep down the weeds around their plants and to retain moisture. Particle-board manufacturers use sawdust to make an inexpensive building material. Pulverized sawdust called “wood flour” is mixed with plastic polymers to make a material used to cover steering

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand wheels and dashboards. Pet stores use pine wood shavings as bedding for mice, and wineries buy oak sawdust as a flavoring agent. Oil rig operators pour sawdust into rock formations to give their drill bits something to grind through.

The housing collapse of 2007 caused a 21% decline in BC lumber output. To make matters worse, as the supply was falling, demand was rising particularly from kraft paper producers and the pellet industry that exports primarily to Europe for power generation. Falling supply and rising demand are responsible for the increasing price of sawdust.

Source: Joel Millman, “Sawdust Shock: A Shortage Looms as Economy Slows,” Wall Street Journal, March 3, 2008, “A Shortage of Sawdust” Vancouver Sun, April 11, 2008.

3.4

The Effect of Demand and Supply Shifts on Equilibrium (pages 75–81) Learning Objective: Use demand and supply graphs to predict changes in prices and quantities.

Demand and supply curves in most markets are constantly shifting, and the prices and quantities that represent equilibrium are constantly changing.

A. The Effect of Shifts in Supply on Equilibrium When the market supply curve shifts to the right, there will be a surplus at the original equilibrium price.

The surplus is eliminated as the price falls to the new equilibrium and the quantity rises to a new equilibrium. If existing firms exit the market, the supply curve will shift to the left, causing the equilibrium price to rise and the equilibrium quantity to fall.

B. The Effect of Shifts in Demand on Equilibrium For a normal good, an increase in income will shift the market demand curve to the right, causing a shortage at the original equilibrium price. To eliminate the shortage, the equilibrium price and quantity rise. If the price of a substitute good were to fall, the demand for the good would decrease. This change would cause the demand curve to shift to the left, and the equilibrium price and quantity would both decrease.

C. The Effect of Shifts in Demand and Supply over Time The effect is ambiguous when both supply and demand shift at the same time. For instance, in many markets, the demand curves shift to the right over time as population and income grow. The supply curve also shifts to the right as new firms enter the market and positive technological change occurs. Whether the equilibrium price in a market rises or falls over time usually depends on whether demand shifts to the right more than supply does. When demand shifts more than supply, the equilibrium price rises. When supply shifts to the right more than demand, the equilibrium price falls.

D. Shifts in a Curve versus Movements along a Curve It is important to remember that when a shift in a demand curve or a supply curve causes a change in equilibrium price, the change in price does not cause a further change in demand or supply.

Teaching Tips Table 3.3 on page 78 summarizes all combinations of shifts in demand and supply over time and the effects of these shifts on price and quantity.

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand

Extra Economics in Your Life and Career In addition to advertising campaigns, consumer tastes can be affected in other ways, including through the behaviour of peers. Several economists have studied how the behaviour of university students affects a special group of peers: their roommates. One study examined data from a large university that uses a lottery system to assign dormitory roommates for some of its incoming first-year students. The 1,357 students who used the lottery system did not request a specific roommate nor did they request special housing. The study found no evidence that one roommate’s family background (measured by parental income and education) or academic background (measured by high school grade point average and admission test scores) affected his or her roommate’s grade point average at the end of the first or second years. But there was evidence that another measure of student behaviour had a negative effect on the grade point average of roommates.

Question: What type of behaviour by students would have a negative impact on the grade point average of their roommates?

Answer: The study found that males who were assigned roommates who drank alcohol prior to attending university obtained, on average, a lower grade point average than those assigned to non-drinking roommates. Male students’ grade point averages were reduced by 0.28 points by having a roommate who “drank frequently” in the year prior to university and 0.26 by having a roommate who “drank occasionally.” This effect was not observed among female students or students with relatively high grade point averages but was very evident among students whose grade point averages were among the lowest 10% of all students.

Source: Michael Kremer and Dan Levy, “Peer Effects and Alcohol Use among College Students,” Journal of Economic Perspectives, vol. 22, no. 1 – Summer 2008 – pp. 189–206.Extra Economics in Your Life and Career

Following devastating hurricanes that hit Texas, Florida, and Puerto Rico in 2017 Donald Boudreaux, a professor of economics at George Mason University, argued that high prices for water, gasoline, and airline fares would aid in the recovery from such disasters and criticized politicians who called for capping prices of essentials items to protect consumers from “price gouging” by sellers: …high prices are an essential way to ensure that resources get where they are desperately needed.

Imposing artificially low prices creates shortages of vital supplies and makes it harder for people to recover from disasters.

Question: Why would measures to prevent prices from rising in the aftermath of a hurricane make it more difficult for people to recover from the hurricane?

Answer: Price increases for vital goods and services that follow natural disasters are the result of increased scarcity, rather than the actions of greedy producers. Donald Boudreaux explained “Price hikes prompt consumers to use fuel more judiciously…diminishing pressure on supplies… [and] create a financial incentive for suppliers to move their product from outside the area to…high-demand zones. As supplies return to normal, so do prices.” Although people suffer significant hardships from hurricanes and other natural disasters, well-intentioned measures to protect consumers from paying higher prices may have the unintended result of making recovery from the disasters more difficult.

Source: Donald J. Boudreaux, “‘Price Gouging’ After a Disaster Is Good for the Public,” Wall Street Journal, October 4, 2017.

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CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand

Appendix Quantitative Demand and Supply Analysis (pages 88–90) Learning Objective: Use quantitative demand and supply analysis.

Graphs help us understand economic change quantitatively. Often, though, economists, business managers, and policymakers want to know more than the qualitative direction of change; they want a quantitative estimate of the size of the change. A quantitative analysis of market equilibrium will tell us how much prices and quantities change after a demand or supply curve shifts.

Demand and Supply Equations The first step in a quantitative analysis is to supplement our use of demand and supply curve with demand and supply equations. For example, suppose that economists have estimated that the demand for apartments in Toronto is: QD = 3000000 ‒ 1000P and the supply of apartments is: QS = ‒450000 + 1300P. We have used QD for the quantity of apartments demanded per month, QS for the quantity of apartments supplied per month, and P for the apartment rent, in dollars per month. The competitive market equilibrium occurs when the quantity demanded equals the quantity supplied, or: QD = QS. We can use this equation, which is called an equilibrium condition, to solve for the equilibrium monthly apartment rent by setting the quantity demanded from the demand equation equal to the quantity demanded from the supply equation: 3000000 ‒ 1000P = ‒450000 + 1300P P = 3450000/2300 = $1500.

We can then substitute this price back into either the demand equation or the supply equation to find the equilibrium quantity of apartments rented: QD = 3000000 ‒ 1000P = 3000000 ‒ 1000(1500) = 1500000 QS = ‒450000 + 1300P = ‒450000 + 1300(1500) = 1500000.

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CHAPTER 4 | GDP: Measuring Total Production and Income

CHAPTER 4 | GDP: Measuring Total Production and Income Brief Chapter Summary and Learning Objectives 4.1

Gross Domestic Product Measures Total Production (pages 95-105) Explain how total production is measured.

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4.2

Economists use gross domestic product (GDP) to measure total production. GDP is the market value of a country’s total production. It includes only the values of final goods and services.

Does GDP Measure What We Want It to Measure? (pages 105-108) Discuss whether GDP is a good measure of well-being.

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4.3

Some shortcomings of GDP as a measure of well-being include the following: It does not include the value of leisure; it is not adjusted for pollution or other negative effects of production; and it is not adjusted for changes in crime and other social problems.

Real GDP versus Nominal GDP (pages 108-111) Discuss the difference between real GDP and nominal GDP. ▪

4.4

Real GDP holds prices constant, which makes it a better measure than nominal GDP of changes in the production of goods and services from one year to the next.

Other Measures of Total Production and Total Income (pages 111-113) Become familiar with other measures of total production and total income.

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Besides GDP, measures of total production and total income include GNI (gross national income), net national income, household income, and household disposable income.

Key Terms Business cycle, p. 94. Alternating periods of economic expansion and economic recession.

Consumption, p. 103. Spending by households on goods and services.

Consumption of capital, p. 100. The amount of capital that wears out (depreciates) during use.

Economic growth, p. 95. The ability of an economy to produce increasing quantities of goods and services.

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Expansion, p. 95. The period of a business cycle during which total production and total employment are increasing.

Expenditure approach, p. 99. Measuring GDP by adding up all the different types of expenditures in the economy.

Exports, p. 102. Goods and services produced in Canada that will be consumed by citizens of another country.

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CHAPTER 4 | GDP: Measuring Total Production and Income Final consumption expenditure, p. 101.

Purchases of goods and services that will be used to satisfy individual or community businesses.

Macroeconomics, p. 94. The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

Final good or service, p. 96. A good or service purchased by a final user.

Microeconomics, p. 94. The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

GDP deflator, p. 110. A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100.

Net exports, p. 102. Exports minus imports.

Government spending, p. 103. Spending on consumption goods and capital undertaken by government.

Gross domestic product (GDP), p. 95. The market value of all final goods and services produced in a geographic area (country) during a period of time, typically one year.

Gross fixed capital formation, p. 101.

Purchases of capital by firms, government, and households.

Gross mixed income, p. 101. Paid to the owners of small business, this includes payments for labour and capital.

Gross operating surplus, p. 100. Payments made to owners of capital.

Household production, p. 105. Goods and services people produce for themselves.

Imports, p. 102. Goods and services produced by other countries that will be consumed by Canadians.

Income approach, p. 99. Measuring GDP by adding up all income received by the owners of factors of production.

Inflation rate, p. 95. The percentage increase in the price level from one year to the next.

Intermediate good or service, p. 96. A good or service that is an input into another good or service, such as car seats.

Net operating surplus, p. 100. Payments to the owners of capital in excess of depreciation.

Nominal GDP, p. 108. The value of final goods and services evaluated at current-year prices.

Price level, p. 110. A measure of the average prices of goods and services in the economy.

Real GDP, p. 108. The value of final goods and services evaluated at base-year prices.

Recession, p. 95. The period of a business cycle during which total production and total employment are decreasing.

Statistical discrepancy, p. 102. One half of the difference between the estimates of GDP generated by the expenditure approach and the income approach.

Taxes less subsidies, p. 101. Payments to government by businesses net of transfers from government to businesses Transfer payments, p. 97. Payments by the government to households for which the government does not receive a new good or service in return.

Underground economy, p. 105. Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

Value added, p. 104. The market value a firm adds to a product.

Investment, p. 103. The purchase of capital by firms. .

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CHAPTER 4 | GDP: Measuring Total Production and Income

Chapter Outline The Health of the Canadian Economy Many different factors influence the state of the Canadian economy. One of those factors is exports to other countries. As the United States changed its approach to international trade in 2018, Canada became caught up in a number of trade disputes. As part of its new approach, the United States (our biggest trading partner) levied tariffs on some Canadian products, including steel and aluminium. At the same time, the prices for oil, gas, and many of the natural resources Canada exports remained low. The result has been layoffs and plant closures in different parts of the country and a slowdown in economic growth.

Canadian exporters were feeling the effects of the business cycle, which refers to the alternating periods of economic expansion and recession that occur in all economies. Production and employment increase during expansions and decrease during recessions. Whether the general level of economic activity in a country is increasing is important to all kinds of firms; it is also important to workers wondering if they will be able to keep their jobs and to college and university students wondering if they will be able to find jobs after they graduate.

One US study found that college students who graduate during a recession have to spend more time looking for a job and end up accepting jobs that pay 10 percent less (on average) than the jobs accepted by those who graduate during economic expansions. What makes this even worse is the authors of the study found that students who graduate during recessions will continue to earn less for as long as 15 years after graduation. A similar Canadian study found that people who completed university during a recession had lower average earnings for 10 years or more after graduation. Some people try to avoid graduating in a recession by applying to graduate school. The overall state of the economy is important to you!

Based on Lisa B. Kahn, “The Long-Term Labour Market Consequences of Graduating from College in a Bad Economy,” Labour Economics, Vol. 17, No. 2, April 2010, pp.303-316; Oreopoulos, P., von Wachter, T., & Heisz, A. (2012). The short- and longterm career effects of graduating in a recession. American Economic Journal: 4(1), 1-29.

4.1

Gross Domestic Product Measures Total Production (pages 95-105) Learning Objective: Explain how total production is measured.

Microeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. The business cycle refers to alternating periods of economic expansion and economic recession. An expansion is the period of a business cycle during which total production and total employment are increasing. A recession is the period of a business cycle during which total production and total employment are decreasing. Economic growth refers to the ability of an economy to produce increasing quantities of goods and services. The inflation rate is the percentage increase in the price level from one year to the next.

A. Measuring Total Production: Gross Domestic Product Economists use gross domestic product (GDP) to measure total production. GDP is the market value of all final goods and services produced in a country during a period of time, typically one year. In Canada, Statistics Canada compiles data used to compute GDP. Economists measure total production in an economy by taking the value, in dollar terms, of all goods and services produced. GDP includes only final goods and services. A final good or service is a good or service purchased by a final user. An intermediate good or service is a good or service that is an input

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CHAPTER 4 | GDP: Measuring Total Production and Income into another good or service, such as car seats. If we included the value of intermediate goods and services in GDP, we would be double counting. GDP includes only production that takes place during the indicated time period. GDP does not include the value of used goods.

B. Production, Income, and the Circular-Flow Diagram When we measure the value of total production in the economy by calculating GDP, we are simultaneously measuring the value of total income. The circular-flow diagram illustrates the interaction of firms and households in markets. Households supply the factors of production to firms in exchange for income. Firms sell goods and services to three groups: domestic households, foreign firms and households, and the government. Transfer payments are payments by the government to households for which the government does not receive a new good or service in return. These payments are not included in the GDP. The circular-flow diagram also allows us to trace the ways households use their income.

Households spend some of their income on domestically produced goods and services and some is spent on foreign-produced goods and services. Households use some of their income to pay taxes to the government. Some income is not spent but deposited in banks or used to buy stocks and bonds. The circular-flow diagram shows that we can measure GDP either by calculating the total value of expenditures on final goods or services or by calculating the value of total income. We get the same dollar amount of GDP with either approach.

C. Measuring GDP There are two approaches to measure the GDP. The income approach measures GDP by adding up all the income received by the owners of factors of production. When using the income approach, Statistics Canada breaks income down into four categories.

- Compensation of employees covers all the benefits workers receive from providing their labour to firms.

- Gross operating surplus means the payments made to the owners of capital by firms and government for the use of their capital.

- Gross mixed income refers to the income paid to the owners of small businesses. This includes payments for labour and capital - Taxes less subsidies represent the payments to government by businesses net of transfers from government to businesses.

The expenditure approach measures GDP by adding up all the different types of expenditures in the economy. Statistics Canada groups expenditures into four broad categories.

- Final consumption expenditures captures all the domestic purchases of goods and services used to satisfy individual or community needs and wants.

- Gross fixed capital formation is the purchase of capital by firms, governments, and households.

- Investment in inventories refers to the finished products kept on hand by businesses to sell or inputs kept on hand to turn into finished products.

- Net exports of goods and services are the value of a country’s total exports minus its imports.

Exports are the goods and services produced in Canada that will be consumed by citizens of another country. Imports are goods and services produced by other countries that will be consumed by Canadians.

Statistics Canada’s GDP breakdown includes a statistical discrepancy that accounts for one half of the difference between the estimates of GDP generated by the expenditure approach and the income approach. To make the two approaches balance, Statistics Canada adds the value of the statistical discrepancy to the lower of the two estimates and subtracts this value to the greater. The statistical discrepancy is typically very small.

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CHAPTER 4 | GDP: Measuring Total Production and Income

D. The Expenditure Approach in Macroeconomic Models In classical macroeconomics models, economists typically use different categories to understand why GDP fluctuates and to forecast future GDP. Consumption is spending by households on goods and services, not including spending on new houses.

Consumption expenditures are divided into expenditures on services, nondurable goods, and durable goods. Investment represents the purchase of capital by firms. It also includes the households’ purchase of new houses. Government spending refers to spending on consumption goods and capital undertaken by federal, provincial, and local governments. The net exports are equal to exports minus imports. It is identical to Statistics Canada’s categorization.

A simple equation sums up the components of GDP:

Y = C + I + G + NX The equation tells us that GDP (Y) equals consumption (C) plus investment (I) plus government purchases (G) plus net exports (NX).

E. Measuring GDP Using the Value-Added Method An alternative way of calculating GDP is the value-added method. Value added is the market value a firm adds to a product. It is equal to the difference between the price for which the firm sells a good and the price it paid other firms for intermediate goods.

Extra Apply the Spending on National Security Concept The federal government created a new national security establishment after the terrorist attacks on September 11, 2001, to guard against future terrorist attacks. Spending by this establishment is intended to increase the security of the nation’s borders and transportation system, identify and arrest terrorists within Canada, and gather intelligence on potential terrorist threats.

The federal government spent $92 billion on national security between 2000/01 and 2010/11, according to a Rideau Institute Report published in 2011. This figure includes “the departments of National Defence, Foreign Affairs, Public Safety, Justice, the RCMP, the Canadian Security Intelligence Service, and the Canada Border Services Agency.”

Because Canada has a federal system of government, responsibility for some national security activities lies with provincial or local authorities. For example, spending to provide security for the Metro Vancouver Transit is the responsibility of the 21 municipalities that make up Metro Vancouver. Of course, governments at all levels have limited budgets, so at some point, spending more on national security requires them to spend less on other programs.

Sources: Security spending after 9/11 tops $92 billion, Meagan Fitzpatrick, CBC News, Sep 7 2011, accessed Nov 1 2013 http://www.cbc.ca/news/politics/security-spending-after-9-11-tops-92b-1.1043068.

Question: In recent years, Statistics Canada has classified government purchases into final consumption expenditures and gross fixed capital formation. Would you classify the expenditures for national security as government investment or as government consumption? Briefly explain.

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CHAPTER 4 | GDP: Measuring Total Production and Income

Answer: Government consumption consists of compensation of government employees and purchases of goods and services by the government, and government gross investment consists of government purchases of buildings, structures, equipment, and so on. Some of the expenditures for national security are government consumption, including spending for hiring additional government employees for the various departments involved in security, while other expenditures are government gross investment, including government spending on new buildings, equipment, and so on.

Extra Apply the Will U.S. Consumers Be Spending Less?

Concept In 2014, consumption was 68.5 percent of GDP in the United States. Consumption is a larger fraction of GDP in the United States than in most other high-income countries or in rapidly growing countries such as China and India. As shown in the following figure, over time, consumption in the United States has increased as a fraction of GDP. Through the mid-1980s, consumption was less than 65 percent of GDP. By the early 2000s, consumption had increased to about 70 percent of GDP.

U.S. households financed this increased consumption partly by reducing saving and partly by increasing borrowing. While households were saving about 10 percent of their income in the mid-1980s, saving dropped to about 1 percent by 2005. Low saving rates were partly due to an increase in household wealth resulting from rising housing prices and rising stock prices. In many parts of the country, housing prices increased rapidly between 2001 and 2006. Stock prices, as measured by the Dow Jones Industrial Average and the S&P 500, reached record highs in October 2007. Some households felt less need to save out of their current incomes because their homes and their investments in the stock market were increasing in value.

During the early 2000s, many households borrowed against the increased value of their homes by taking out home equity loans, which many banks were increasingly willing to grant. Banks and other financial firms also loosened the requirements for issuing credit cards, so some households with flawed credit histories were able to borrow against their credit cards to finance their spending. The ratio of loans and other household debt to household income, which had been about 65 percent in the mid-1980s, rose to a record 133 percent in 2007 before declining to 102 percent in mid-2011. Housing prices began to decline in 2006, and that decline accelerated with the start of the recession in December 2007. Stock prices also declined sharply. The combination of falling housing and stock prices wiped out trillions of dollars in household wealth. Banks and other financial institutions also tightened lending standards, making it more difficult for many households to borrow money. In the face of declining wealth and with reduced access

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CHAPTER 4 | GDP: Measuring Total Production and Income to loans, household saving rates began to increase, rising above 6 percent by 2009. As the economy recovered from the recession, the saving rate declined to about 5 percent in 2016.

Increased household saving can be good news for the economy in the long run because it provides more funds that firms can borrow to finance investment, which can lead to more rapid rates of economic growth. But in the short run, many firms—particularly firms such as Ford that sell consumer durables— worried that the slow recovery from the 2007 to 2009 recession was due in part to the determination of U.S. households to cut back on spending and increase saving.

Sources: U.S. Bureau of Economic Analysis; Organization for Economic Cooperation and Development; and United Nations.

Question An article on USAToday.com observed: “Consumer spending, once the driving force of the U.S. economy, is likely to remain stagnant for years as households struggle to cut debt and build up savings, economists say.” Why does cutting debt and building up savings affect consumer spending? If consumer spending remains stagnant, what will be the likely effect on the economy?

Source: Karina Frayter, “Economists: Consumers Won’t Save the Economy,” USAToday.com, October 2, 2011.

Answer Cutting debt and building up savings require, for a given amount of income, a decrease in consumer spending. If consumer spending remains stagnant, the economy will most likely grow slowly in the short run.

4.2

Does GDP Measure What We Want It to Measure? (pages 105-108) Learning Objective: Discuss whether GDP is a good measure of well-being.

Economists use GDP to measure total production in the economy. Most economists believe that GDP does a good—but not flawless—job of measuring production. GDP provides only a rough measure of well-being.

A. Shortcomings in GDP as a Measure of Total Production When Statistics Canada calculates GDP, it does not include two types of production: production in the home and production in the underground economy. Household production refers to goods and services people produce for themselves. The underground economy refers to the buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

B. Shortcomings of GDP as a Measure of Well-Being The main purpose of GDP is to measure a country’s total production. Although increases in GDP often lead to increases in the well-being of the population, GDP is not a perfect measure of well-being. The value of leisure is not included in GDP, and GDP is not adjusted for pollution or other negative effects of production. GDP is not adjusted for changes in crime and other social problems, and GDP may not provide good information about the goods and services consumed by the typical person.

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CHAPTER 4 | GDP: Measuring Total Production and Income

Extra Solved Problem 4.2 Measuring Economic Welfare Although GDP is widely used as a measure of the value of a country’s production and income, some economists argue that it is not a good measure of the progress countries make in raising the standard of living of their citizens. In 2010, British Prime Minister David Cameron announced the United Kingdom’s plans to construct a measure of well-being that would account for such factors as citizens’ satisfaction with their lives. France also announced an effort to construct an alternative to GDP as a measure of wellbeing. But measuring “well-being” is more difficult than measuring the market value of output. “There is more to life than GDP, but it will be hard to come up with a single measure to replace it . . .” commented Paul Allin, the director of the United Kingdom’s Measuring National Well-Being Project. Economists have long struggled to find an alternative to GDP as a welfare index. Among the earliest attempts was the “Measure of Economic Welfare (MEW),” by William Nordhaus and James Tobin in 1972. The MEW differs from GDP primarily in three ways. First, MEW subtracts estimates of the effect of “bads,” such as pollution, from GDP. Second, MEW excludes certain services, such as police protection, because increases in these services may reflect more crime and civil disorder, which would mean lower welfare.

Third, it adds an estimate of some activities—such as housework and leisure—that result in greater welfare but are not included in GDP. One critic of GDP wrote that the recession of 2007–2009 “. . . offers an excellent opportunity to get rid of [an economic concept] that has long outlived its usefulness: gross domestic product. . . . It ought to join buggy whips and VCRs on the dust-heap of history.”

Sources: Market Whitehouse, “Nations Seek Success Beyond GDP,” Wall Street Journal, January 10, 2011. William Norhaus and James Tobin, “Is Growth Obsolete?” Economic Growth, Fiftieth Anniversary Colloquium, Vol. 5. New York: National Bureau of Economic Research, 1972; and Eric Zencey, New York Times, August 10, 2009.

a. Do economists overstate the value of GDP as a measure of economic welfare? b. Should GDP be replaced as a measure of growth in the overall economy?

Solving the Problem Step 1:

Review the chapter material.

This problem is about whether gross domestic product is a good measure of well-being, so you may want to review the section “Does GDP Measure What We Want It to Measure?” which begins on page 105 in the textbook.

Step 2:

Answer part (a) by discussing whether economists overstate the value of GDP as a measure of economic welfare.

GDP was designed as a measure of production and income, not welfare. Although GDP is an imperfect measure of production—for example, it does not measure household production—it is very valuable as an indicator of the short-run and long-run performance of the overall economy. So economists typically do not overstate the value of GDP as a measure of economic welfare because they do not use GDP as a measure of welfare.

Step 3:

Answer part (b) by discussing whether GDP should be replaced as a measure of growth in the overall economy.

Despite its shortcomings as a measure of welfare, most economists agree that GDP is the best measure of growth of the overall economy. Over time, economists at Statistics Canada have made changes to improve the way GDP is calculated in order to make it a more accurate measure of the value of total production.

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CHAPTER 4 | GDP: Measuring Total Production and Income

4.3

Real GDP versus Nominal GDP (pages 108-111) Learning Objective: Discuss the difference between real GDP and nominal GDP.

A. Calculating Real GDP Statistics Canada separates price changes from quantity changes by calculating a measure of production called real GDP. Nominal GDP is the value of final goods and services evaluated at current-year prices.

Real GDP is calculated by designating a particular year as the base year and then using the prices of goods and services in the base year to calculate the value of goods and services in all other years. Real GDP is the value of final goods and services evaluated at base-year prices.

B. Comparing Real GDP and Nominal GDP Real GDP holds prices constant, which makes it a better measure than nominal GDP of changes in the production of goods and services from one year to the next. Because on average, prices rise from one year to the next, real GDP is greater than nominal GDP in years before the base year and less than nominal GDP for years after the base year. In the base year, real and nominal GDP are the same.

C. The GDP Deflator Economists and policymakers are interested not just in the level of production but also in the price level.

The price level is a measure of the average prices of goods and services in the economy. The GDP deflator is a measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100.

Extra Apply the Statistics Canada Updates GDP in 2012 Concept In 2012, Statistics Canada released the initial results of its revision of the national income and product accounts. Although not front-page news, major revisions of the national income and product accounts are rare events—this one a result of converting to International Standards that came into effect in 2009.

Statistics Canada normally revises previous period estimates as more information becomes available.

What makes this revision different is that they have revised the numbers for the past 30 years.

One of the more surprising results was that labour productivity in the business sector, measured as output per worker, was revised downward. The new figures show that labour productivity rose by only 1 percent between 1981 and 1990. Increasing labour productivity is one of the factors that determines long-run economic growth, and despite government incentives such as lower taxes and regulations, Canada continues to fall behind the United States.

The changes may also affect the estimates of full employment GDP, which has implications for the Bank of Canada’s monetary policy and government fiscal policy.

Source: Barrie McKenna, “Canadians even less productive than thought over past 30 years,” Globe and Mail, 12 October 2012, http://www.theglobeandmail.com/report-on-business/economy/economy-lab/canadians-even-less-productive-than-thought-over-past-30years/article4608828/ accessed Nov 1, 2013.

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CHAPTER 4 | GDP: Measuring Total Production and Income

4.4

Other Measures of Total Production and Total Income (pages 111-113) Learning Objective: Become familiar with other measures of total production and total income.

National income accounting refers to the methods Statistics Canada uses to track total production and total income in the economy. In addition to computing GDP, Statscan computes the following four measures of production and income: gross national product, national income, personal income, and disposable personal income.

A. Gross National Income (GNI) GNI is the value of incomes received by Canadians for the use of their factors of production no matter where in the world those factors of production are used, including outside Canada. GNI includes foreign production by Canadian firms but excludes Canadian production by foreign firms. For Canada, GNI is almost the same as GDP.

B. Net National Income (NNI) In producing goods and services, some machinery, buildings and equipment wear out and have to be replaced. Depreciation is referred to as the consumption of fixed capital. If we subtract this value from GNI, we are left with the net national income.

C. Household Income Household income is income received by households. To calculate personal income, we subtract the earnings that corporations retain rather than pay to shareholders in the form of dividends. We add in the payments received by households from the government in the form of transfer payments or interest on government bonds.

D. Household Disposable Income Household disposable income is equal to personal income minus personal tax payments, such as the federal income tax. Household disposable income is the best measure of the income households have available to spend.

E. The Division of Income We can measure GDP in terms of total expenditure or as the total income received by households. GDP calculated as the sum of income payments to households is sometimes referred to gross domestic income.

Extra Solved Problem 4.4 GDP and National Income: Accounting for Changes in the Stock of Capital Suppose you are hired to measure the population in your hometown. You could go door to door and determine how many people live in each household. But let’s assume that your mayor had the following data: (a) the town’s population the last time the census was taken, (b) the number of people who were born since the last census was taken, and (c) the number of people who moved into town since the last census was taken. Would adding these three numbers give you the current population? The answer is no; these numbers do not account for decreases in population since the last census due to deaths and outmigration (people who moved away from your town).

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CHAPTER 4 | GDP: Measuring Total Production and Income Included in GDP is the value of investment. Figure 4.2 on page 100 lists the value of Business Capital for 2018 as $416 billion. This number is an overestimate of the change in the nation’s stock of capital because some of this investment spending represented replacement of capital (buildings, machines, etc.) that had worn out. Using gross private domestic investment as a measure of the increase in the nation’s stock of capital is similar to computing a population census without accounting for people who died and moved elsewhere. Net investment, or net private domestic investment, subtracts from gross investment estimates of the “deaths” of the nation’s capital stock. In 2018, consumption of fixed capital (also called depreciation) equalled $230 billion. National income equals the difference between gross domestic product and the consumption of fixed capital. The following summarizes the difference between these two measures for 2018.

Gross domestic product Minus: consumption of fixed capital National income

2018 $ 2,242 $ 230 $ 2,012

National income is a better measure of the market value of final goods and services produced in a given time period than GDP because it incorporates the net change in the nation’s stock of capital. GDP does not account for the consumption of fixed capital.

Why don’t economists use national income rather than GDP as the primary measure of total production and income in the economy?

Solving the Problem Step 1:

Review the chapter material.

This problem is about measuring total production and income, so you may want to review the section “Other Measures of Total Production and Total Income,” which begins on page 111 of the textbook.

Step 2:

Answer the question by explaining why economists don’t use national income rather than GDP as the primary measure of total production and income in the economy.

There are two reasons why economists use GDP rather than national income to measure total production and income in the economy. First, measures of the consumption of fixed capital are estimates of depreciation rather than the actual amounts. It is impossible to accurately determine how much a building or machine is used up in a year. Second, in any year there will be a difference between the size of the national income and the size of the GDP, but the percentage change in national income will be nearly equal to the percentage change in GDP. Because the change in total production is of greater importance to economists than the level of total production, switching from GDP to national income would not result in much benefit.

Extra Apply the “I see lights! —increase GDP” Concept Canada and other industrialized nations recognize the importance of accurately calculating GDP and other measures of total production and income. In Canada, Statistics Canada publishes estimates of GDP every month. “The GDP measures rely heavily on a wealth of information from various areas of Statistics .

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CHAPTER 4 | GDP: Measuring Total Production and Income Canada, from other federal departments and agencies, from provincial government departments, and from private industry sources. This large amount of information is compiled, integrated and analysed as part of the complex process of arriving at GDP by industry.”* The national income data published for some areas of the world, such as sub-Saharan Africa and developing nations in other regions, are not measured so carefully. The quality of data from Iraq, Myanmar, Somalia, and Liberia are so poor that national income and price data do not appear in the Penn World Tables, a standard source for international macroeconomic data. Three economists from Brown University, J. Vernon Anderson, Adam Storeygard, and David N. Weil, use an unusual framework for supplementing data for countries that have unreliable measures of their national income and output: using satellite images of an area’s night-time lights. Henderson, Storeygard, and Weil suggest combining official data with changes in a country’s lights as viewed from outer space using US Air Force weather satellite picture composites. In a United States National Bureau of Economic Research working paper, the authors’ observations of ten years of changes in light density were combined with income data to produce estimates of economic growth. The authors explain that “Consumption of nearly all goods in the evening requires lights. . . . As income rises, so does light usage per person, in both consumption and many investment activities.” The authors reported that using their methodology suggested that the Democratic Republic of the Congo experienced a 2.4 percent annual rate of GDP growth compared to an official rate of minus 2.6 percent for the same time period. Myanmar’s official annual growth rate of 8.6 percent was revised downward to 3.4 percent for the same time period. Henderson stated that “Our hope is that people start using this when they don’t have actual data on economic growth . . . or when the numbers are pretty bad.” * Statistics Canada, Definitions, Data Sources and methods, Gross Domestic Product by Industry http://www23.statcan.gc.ca/imdb/p2SV.pl?Function=getSurveySDDS=1302&Item_Id=1538&lang=en

Sources: Steven Landefeld, Eugene P. Seskin, and Barbara Fraumeni, “Taking the Pulse of the Economy: Measuring GDP,” Journal of Economic Perspectives, vol. 22, no. 2, spring 2008, pages 196–197. “Economists Measure GDP Growth From Outer Space,” ScienceDaily, September 6, 2009. http://www.sciencedaily.com/releases/2009/09/090904165302.htm, and Statistics Canada, Definitions, Data Sources and methods, Gross Domestic Product by Industry http://www23.statcan.gc.ca/imdb/p2SV.pl?Function=getSurveySDDS=1302&Item_Id=1538&lang=en

Extra Economics in Your Life and Career: What’s the Best Country for You to Live In? Since 1990, the United Nations Development Programme (UNDP) has ranked the world’s “most desirable places to live.” The rankings are based on a Human Development Index (HDI), which includes national measures of life expectancy at birth, mean years of schooling, expected years of schooling, and per capita GDP. In 2015, the five nations that scored the highest HDI values were as follows: (1) Norway, (2) and (3) Australia and Sweden (tied), (4) Germany, and (5) Denmark. The United States and Canada were tied at 10.

Question: If you were asked to make your own list of the best places to live, how important would a country’s per capita real GDP be as a criterion? What other factors would you consider in making your list?

Answer: A list of “best places to live” is subjective. Someone who enjoys skiing and ice skating might rank a country that had a cold, snowy climate higher than someone who hated cold weather. Since GDP per capita is a measure of the real income people have to obtain goods and services, it is a good criterion to use to rank countries, but GDP provides only one measure of well-being. Examining other measures of the quality of life in each country—for example, political freedom, environmental quality, racial and gender equality—would help you make your choice. The UNDP rankings are less useful for differentiating Norway from Australia, for example, than for distinguishing countries that had wider

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CHAPTER 4 | GDP: Measuring Total Production and Income differences in their HDI values. Chad (186), Niger (187), and the Central African Republic (188) ranked lowest on the UNDP list for 2015. These counties had low per capita incomes, relatively low life expectancies, and poor education.

Source: “Human Development Reports. Human Development Data.” http://hdr.undp.org/en/data

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CHAPTER 5 | Unemployment and Inflation

CHAPTER 5 | Unemployment and Inflation Brief Chapter Summary and Learning Objectives 5.1

Measuring the Unemployment Rate and the Labour Force Participation Rate (pages 122-126) Define the unemployment rate and the labour force participation rate, and understand how they are computed.

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5.2

Statistics Canada uses the results of a monthly household survey to calculate the unemployment rate, the labour force participation rate, and the employment-population ratio. An establishment survey, or payroll survey, is used to measure total employment in the economy.

Types of Unemployment (pages 126-129) Identify the four types of unemployment.

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5.3

There are four types of unemployment: frictional, structural, cyclical, and seasonal.

Explaining Unemployment (pages 129-131) Explain what factors determine the unemployment rate.

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5.4

Government policies can reduce the level of frictional and structural unemployment by aiding job search and worker retraining.

Some government policies can add to the level of frictional and structural unemployment by increasing the time workers devote to searching for jobs, by providing disincentives for firms to hire workers, or by keeping wages above market level.

Measuring Inflation (pages 131-135) Define price level and inflation rate, and understand how they are computed.

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5.5

The price level measures the average prices of goods and services in the economy. The inflation rate is equal to the percentage increase in the price level from one year to the next.

Using Price Indexes to Adjust for the Effects of Inflation (pages 135-136) Use price indexes to adjust for the effects of inflation.

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5.6

To correct for the effects of inflation, we can divide a nominal variable by a price index and multiply by 100 to obtain a real variable.

Real versus Nominal Interest Rates (pages 137-138) Distinguish between the nominal interest rate and the real interest rate.

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The real interest rate is the nominal interest rate minus the inflation rate.

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5.7

Does Inflation Impose Costs on the Economy? (pages 138-140) Discuss the problems inflation can cause.

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When the inflation rate is different from the expected inflation rate some people gain and some people lose.

Key Terms Consumer price index (CPI), p. 132. An average of the prices of the goods and services purchased a typical household.

Cyclical unemployment, p. 128.

Unemployment caused by a business cycle recession.

Discouraged workers, p. 124. People who are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them.

Efficiency wage, p. 131. A higher-than-market wage that a firm pays to increase worker productivity.

Employment-population ratio, p. 123. A measure of the portion of the population engaged in paid work.

Frictional unemployment, p. 126. Short-term unemployment that arises from the process of matching workers with jobs.

Inflation, p. 131. A general increase in the prices of goods and services over time.

Menu costs, p. 139. The costs to firms of changing prices.

Natural rate of unemployment, p. 128. The normal rate of unemployment, consisting of frictional unemployment plus structural unemployment.

Nominal interest rate, p. 137. The stated interest rate on a loan.

Price level, p. 132. A measure of the average prices of goods and services in the economy.

Producer price index (PPI), p. 135. An average of the prices received by producers of goods and services at all stages of production.

Real interest rate, p. 137. The nominal interest rate minus the inflation rate.

Seasonal unemployment, p. 128.

Unemployment that is due to seasonal factors, such as weather or the fluctuation in demand for some products during different times of the year.

Inflation rate, p. 132. The percentage increase in the price level from one year to the next.

Structural unemployment, p. 127.

Unemployment that arises from a persistent mismatch between the skills and attributes of workers and the requirements of jobs.

Labour force, p. 122. The sum of employed and unemployed workers in the economy.

Unemployment rate, p. 122. The percentage of the labour force that is unemployed.

Labour force participation rate, p. 123. The percentage of the working-age population in the labour force.

Working age population, p. 122. People 15 years of age and older who are legally entitled to work in Canada.

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Chapter Outline Why Would General Motors Close its Oshawa Assembly Plant When the Canadian Economy is Growing?

General Motors (GM) has had production facilities near Toronto for 110 years. Its Oshawa assembly plant first opened in 1953. The plant currently produces several popular models, including the Chevrolet Equinox, Cadillac XTS, Buick Regal, and the Chevrolet Impala. This isn’t the first time GM has been in the news concerning a potential closure in Ontario. During the 2008–2009 recession, a shrinking economy and falling automotive sales led both the federal government and the Ontario provincial government to bail out the Canadian automotive industry, contributing $13.7 billion to GM and Chrysler Canada to keep the companies from closing plants in Canada. In November 2018, GM announced it would close its Oshawa assembly plant, meaning roughly 2800 people will lose their jobs. This comes despite economic growth of nearly 2 percent in the Canadian economy. The closure doesn’t come as the result of currently low or falling sales, but as the result of GM wanting to devote more of its scarce resources to producing autonomous, electric, and low-emission vehicles. While the GM assembly plant closure is horrible news for those losing their jobs and the community of Oshawa, the GM plant is only one part of the big picture.

In contrast to the layoffs at GM, the national unemployment rate is just 5.6 percent, well below its peak of 8.7 percent during the 2008–2009 recession.

5.1

Measuring the Unemployment Rate and the Labour Force Participation Rate (pages 122-126) Learning Objective: Define the unemployment rate and the labour force participation rate, understand how they are computed.

A. The Labour Force Survey Each month Statistics Canada conducts the Labour Force Survey to collect data needed to compute the monthly unemployment rate. This survey focuses only on the working age population (i.e. the people 15 years old of age and older who are legally entitled to work in Canada). They then use this data to calculate the unemployment rate. People are considered employed if they worked during the week before the survey or if they were temporarily away from their jobs. People are considered unemployed if they did not work in the previous week but were available for work and had actively looked for work during the previous four weeks.

The labour force is the sum of employed and unemployed workers in the economy. The unemployment rate is the percentage of the labour force that is unemployed. Discouraged workers are people who are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them. The labour force participation rate is the percentage of the working-age population in the labour force. The employment-population ratio measures the percentage of the working age population that is employed.

B. Problems with Measuring the Unemployment Rate The unemployment rate is not a perfect measure of the current state of joblessness. During a recession, an increase in the number of discouraged workers occurs, but these workers are not counted as unemployed.

The Labour Force Survey (LFS) also counts people as being employed if they hold part-time jobs even though they would prefer to hold full-time jobs. There are other problems that cause the measured unemployment rate to overstate the extent of joblessness. The survey that is used to measure the unemployment rate does not verify the responses of people included in the survey. A person might claim .

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CHAPTER 5 | Unemployment and Inflation to be actively looking for a job to remain eligible for government programs for the unemployed. Other people might be employed but engaged in illegal activity or might want to conceal a legitimate job to avoid paying taxes.

C. Trends in Labour Force Participation The labour force participation rate determines the amount of labour that will be available to the economy from a given population. The higher the labour force participation rate, the more labour will be available and the higher a country’s level of GDP. The labour force participation rate of adult men has declined gradually since 1981, but the labour force participation rate of adult women has increased sharply. The overall labour force participation rate rose from 61.5 percent in 1976 to a high of 67.2 percent in 2008.

D. How Long Are People Typically Unemployed?

In the modern Canadian economy, the typical unemployed person stays unemployed for a relatively brief period of time, although that time lengthens significantly during a recession.

E. Job Creation and Job Destruction over Time The Canadian economy creates and destroys thousands of jobs every year. The creation and destruction of jobs results from changes in consumer tastes, technological progress, and the successes and failures of entrepreneurs in responding to shifting consumer tastes and technological change. When the LFS announces the increases or decreases in the number of people employed and unemployed each month, these are net figures.

5.2

Types of Unemployment (pages 126-129) Learning Objective: Identify the four types of unemployment.

A. Frictional Unemployment and Job Search Most workers spend some time engaging in a job search, and most firms spend time searching for someone to fill a job opening. Frictional unemployment is short-term unemployment that arises from the process of matching workers with jobs. There will always be some workers who are frictionally unemployed because they are between jobs and in the process of searching for new ones.

B. Structural Unemployment Structural unemployment is unemployment that arises from a persistent mismatch between the skills and attributes of workers and the requirements of jobs. This type of unemployment can last for longer periods than frictional unemployment because workers need time to learn new skills.

C. Cyclical Unemployment When the economy moves into recession, many firms find their sales falling and cut back on production.

As production falls, firms lay off workers. Cyclical unemployment is unemployment caused by a business cycle recession.

D. Seasonal Unemployment Seasonal unemployment is unemployment that is due to seasonal factors, such as weather or the fluctuation in demand for some products during different times of the year. Examples include department stores hiring in November and December followed by layoffs in January, ski resorts closing down at the end of the ski season, and construction companies laying off workers in parts of Canada with harsh winter weather. Statistics Canada publishes two sets of unemployment figures each month: one that is seasonally adjusted and another that is not seasonally adjusted.

The seasonally adjusted data eliminate the effects of seasonal unemployment. .

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E. Full Employment The natural rate of unemployment is the normal rate of unemployment, consisting of frictional unemployment plus structural unemployment. The natural rate of unemployment is also called the fullemployment rate of unemployment.

Teaching Tips Though categorizing unemployment as frictional, structural, or cyclical is useful in understanding the sources of unemployment, Statistics Canada provides estimates of total unemployment. It does not classify unemployment as frictional, structural, or cyclical.

Extra Solved Problem 5.2 The Reasons for Unemployment Some of the data Statistics Canada collects regarding the reasons people are unemployed appear in the following table (numbers are in thousands, not seasonally adjusted).

Unemployment

Year 2004 2005 2006 2007 2008 2009 2010 2011 2012

Rate 7.2 6.8 6.3 6.0 6.1 8.1 8.1 7.5 7.3

Number 1,234.4 1,177.8 1,109.3 1,079.6 1,105.4 1,490.7 1,495.4 1,394.6 1,372.0

Reason for unemployment

Total 1,182.0 1,137.1 1,074.6 1,042.7 1,066.3 1,491.3 1,462.9 1,348.5 1,323.7

Job losers Temporary layoff 82.0 79.3 82.5 78.2 77.3 117.0 81.6 71.9 71.3

Other 1,100.0 1,057.8 992.1 964.5 989.0 1,374.3 1,381.3 1,276.6 1,252.4

Job leavers 134.4 120.0 117.2 115.1 116.4 116.4 114.1 118.0 119.6

New and reentrants 500 493.8 469.1 458.7 476.6 604.8 628.5 602.6 611.3

Source: Statistics Canada. Labour force survey estimates Table 282-0054, Table 282-0215.

a. Calculate the percentage of the unemployed who lost their jobs and the percentage that left their jobs from 2004 to 2012. b. Explain why the results in part a may sum to a value greater than 1.

Solving the Problem Step 1:

Review the chapter material.

This problem is about the sources of unemployment, so you may want to review the section “Types of Unemployment,” which begins on page 126 in the textbook.

Step 2:

Answer part (a) by calculating the percentage of the unemployed who lost their jobs and the percentage that left their jobs from 2004 to 2012.

For example, the percentage of job losers in 2004 can be calculated as (1,182.0/1,234.4)  100 = 95.8%. The percentage of re-entrants and new entrants in 2004 is (500)/1234.4  100 = 40.5%. The percentages for the three categories in each year are as follows:

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CHAPTER 5 | Unemployment and Inflation

Year 2004 2005 2006 2007 2008 2009 2010 2011 2012

Step 3:

Percentages of those unemployed Job Losers Job Leavers 95.8% 10.9% 96.5% 10.2% 96.9% 10.6% 96.6% 10.7% 96.5% 10.5% 100.0% 7.8% 97.8% 7.6% 96.7% 8.5% 96.5% 8.7%

Answer part (b) by calculating the total percentage of the unemployed who were either lost their jobs or left their jobs.

These percentages can add up to more than 100 percent of the unemployed if for some reason a person was unemployed in the previous period and is no longer in the labour force. Two reasons for this are the aging of the baby boomers and discouraged workers.

5.3

Explaining Unemployment (pages 129-131) Learning Objective: Explain what factors determine the unemployment rate.

A. Government Policies and the Unemployment Rate Governments can help reduce the level of frictional unemployment by pursuing policies that help speed up the process of matching unemployed workers with unfilled jobs. Governments can help reduce structural unemployment by implementing policies that aid worker retraining. Some government policies, however, can add to the level of frictional and structural unemployment. In the Canada and most industrial countries, the unemployed are eligible for Employment Insurance (EI) payments. The unemployed spend more time searching for jobs because they receive these payments. EI helps the unemployed maintain their income and spending, which lessens the personal hardship of being unemployed and reduces the severity of recessions. In Canada, unemployed workers are typically eligible to receive EI payments equal to about 55 percent their previous wage (maximum $562/week: 2018) for up to 45 weeks.

Each province and territory in Canada sets the lowest legal wage that firms can pay workers. If the minimum wage is set above the market wage determined by the demand and supply of labour, the quantity supplied of labour will be greater than the quantity of labour demanded. As a result, the unemployment rate will be higher than it would be without the minimum wage. Studies estimate that a 10 percent increase in the minimum wage reduces teenage unemployment by about 2 percent.

B. Labour Unions Labour unions are organizations of workers that bargain with employers for higher wages and better working conditions for their members. In unionized industries, the wage is usually above what otherwise would be the market wage. Theoretically, the higher wage results in employers in unionized industries hiring fewer workers, but most economists believe that this does not affect the overall unemployment rate much because only about 14.3 percent of workers outside the government sector are unionized by the end of 2018.

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C. Efficiency Wages Many studies have shown that workers are motivated to work harder by higher wages. An efficiency wage is a higher-than-market wage that a firm pays to increase worker productivity. Efficiency wages are another reason economies experience some unemployment even when cyclical unemployment is zero.

Extra Solved Problem 5.3 The Greying of the Unemployment Rate The unemployment rate changes not only as the number of unemployed workers changes (the numerator of the unemployment rate formula) but also as the size of the labour force changes (the denominator of the unemployment rate formula). As the textbook notes, there has been a dramatic increase in the number of women in the labour force since the mid 1970s. The participation rate among adult women increased from 45.7 percent in 1976 to 62.4 percent in 2010. In the early part of the twenty-first century, the labour force will be affected by the aging of the “baby boomers”—Canadians born between 1946 and 1964.

According to the 2012 estimates, the median age of Canadians was 40.0 years, an increase of 6.4 years since 1992. Despite improvements in health care and the increased life expectancy of Canadians, many older workers are leaving the labour force. In 1976, 15.4 percent of men 65 years and older were in the labour force. In 2012 this figure is about 17.1 percent. For women the numbers are 4.2 percent and 8.8 percent respectively. The average age of retirement in 2011 for men was 63.2, compared to an average age of 61.3 in 1997.

There are several reasons why many workers today retire earlier than in years past. First, many boomers have greater disposable incomes than people in other age groups and choose to use this income to consume more leisure. Second, career advancement becomes more difficult after age 40. Third, a large number of Canadian companies offer older workers early retirement plans, while few offer incentives to delay retirement. If these trends continue, the disappearance of baby boomers from the labour force will have a significant impact on the size of the labour force. a. What effect will the retirement of the baby boomers have on the unemployment rate? b. Can the size of the labour force increase despite of the retirement of older workers?

Solving the Problem Step 1:

Review the chapter material.

This problem is about factors that determine the unemployment rate, so you may want to review the section “Explaining Unemployment,” which begins on page 129 in the textbook.

Step 2:

Answer part (a) by explaining what effect the retirement of baby boomers will have on the unemployment rate.

Holding other factors that affect the labour force constant, as baby boomers retire, the unemployment rate will rise because the numerator of the unemployment rate formula would not change much (relatively few baby boomers are unemployed), while the denominator becomes smaller as the labour force declines.

Step 3:

Answer part (b) by explaining whether the size of the labour force can increase despite the retirement of older workers.

It is possible, but unlikely, that labour force will increase, because the birth rate among women in the 1980s and 1990s was less than in the 1950s and 1960s. To offset the decline in the labour force due to the retirement of the baby boomers, there would have to be new job seekers—either immigrants or current Canadian residents who had not been in the labour force.

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5.4

Measuring Inflation (pages 131-135) Learning Objective: Define price level and inflation rate, and understand how they are computed.

The price level is a measure of the average prices of goods and services in the economy. The inflation rate is the percentage increase in the price level from one year to the next. The GDP deflator is the broadest measure of the price level, but if we want to know the impact of inflation on the typical household, the deflator may be misleading because it includes prices of products that are not purchased by the typical household. Changes in the consumer price index come closest to measuring changes in the cost of living as experienced by the typical household.

A. The Consumer Price Index To obtain prices of a representative group of goods and services, Statistics Canada surveys 17,792 households on their spending habits. The survey is used to construct a market basket of goods and services used by the typical Canadian family. The consumer price index (CPI) is an average of the prices of the goods and services purchased by a typical household. One year is chosen as the base year, and the value of the CPI is set equal to 100 for that year. In any other year the CPI equals the ratio of the dollar amount necessary to buy the market basket in that year divided by the dollar amount necessary to buy the market basket in the base year, multiplied by 100. The CPI is sometimes called the cost-of-living index.

B. Is the CPI Accurate?

The CPI is the most widely used measure of inflation. It is important that the CPI be as accurate as possible, but there are four biases that cause the CPI to overstate the true inflation rate: substitution bias, increase in quality bias, new product bias, and outlet bias. Statistics Canada continues to take steps to reduce the size of the bias.

C. The Producer Price Index In addition to the GDP deflator and the CPI, Statistics Canada also computes the producer price index (PPI), which is an average of the prices received by producers of goods and services at all stages of production. Changes in the PPI can give an early warning of future movements in the CPI.

Extra Solved Problem 5.4 Calculating the CPI The consumer price index (CPI) compares the cost of a market basket of goods in a given year with the cost of the same market basket in the base year. Suppose that a market basket includes (1) admission for two to a local theatre for a weekend movie, (2) a large box of popcorn at the theatre, (3) a large pepperoni pizza (carry-out from a local pizzeria), and (4) a two-litre bottle of diet Coke.

Year 1 2 3

Theatre admission for one person $5.00 6.00 6.50

Popcorn $2.00 2.50 3.00

Pizza $12.00 12.50 13.00

Diet Coke $1.25 1.40 1.50

Assume that Year 1 is the base year. Calculate the value of the CPI for each year and the rate of inflation for Years 2 and 3.

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Solving the Problem Step 1:

Review the chapter material.

This problem is about using the CPI to calculate the inflation rate, so you may want to review the section “Measuring Inflation,” which begins on page 131 in the textbook.

Step 2:

Determine the value of the market basket.

The value of the market basket is the sum of the quantity of each good included in the basket multiplied by its price. The market basket in this example has a quantity of two for theatre admissions, and a quantity of one for each of the other goods. The value of the market basket in Year 1, the base year, is (2  $5.00) + $2.00 + $12.00 + $1.25 = $25.25. The table in Step 3 gives the value of the market basket for all three years.

Step 3:

Calculate the value of the CPI and the inflation rates for Years 2 and 3.

The CPI is the ratio of the value of the market basket in a given year to the value of the market basket in the base year, multiplied by 100. We can use the CPI to calculate the inflation rate, which is the percentage change in the CPI from Year 1 to Year 2 and from Year 2 to Year 3. These values are in the following table: Year 1 2 3

Value of the Market Basket $25.25 28.40 30.50

CPI 100.0 112.5 120.8

Rate of Inflation — 12.5% 7.4%

Extra Explaining How the CPI Measures Apply the the Price Level and Rate of Inflation Concept There are many misconceptions about how the consumer price index (CPI) is constructed and exactly what it measures. Economists John Greenlees and Robert McCelland addressed these misconceptions in an article published in the Monthly Labor Review. They explain that “. . . when prices change, the goal of the CPI is to measure the percentage by which consumers would have to increase their spending to be as well off with the new prices as they were with the old prices . . . .” Statistics Canada conducts the Survey of Household Spending each year. The survey asks 17,792 Canadian households about their purchasing habits, including what they buy, how much they buy, and where they buy it. Based on the results of the survey, Statistics Canada constructs a shopping list, or basket of goods and services, that the average household buys. The types of goods and services that are included in the basket are updated very few years to reflect changing purchasing habits.

The Consumer Price Index (CPI) is an indicator of changes in consumer prices experienced by Canadians.

It is obtained by comparing, over time, the cost of a fixed basket of goods and services purchased by consumers. Since the basket contains goods and services of unchanging or equivalent quantity and quality, the index reflects only pure price change. The CPI is widely used as an indicator of the change in the general level of consumer prices or the rate of inflation. Since the purchasing power of money is affected by changes in prices, the CPI is useful to virtually all Canadians. Consumers can compare movements in the CPI to changes in their personal income to monitor and evaluate changes in their financial situation.

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5.5

Using Price Indexes to Adjust for the Effects of Inflation (pages 135-136) Learning Objective: Use price indexes to adjust for the effects of inflation.

Price indexes give us a way of adjusting for the effects of inflation so that we can compare dollar values from different years. To correct for the effects of inflation, we can divide a nominal variable by a price index and multiply by 100 to obtain a real variable. Economic variables that are calculated in currentyear prices are referred to as nominal variables.

Extra Solved Problem 5.5 Calculating Real Wages at Caterpillar In 2013, Caterpillar and the United Steelworkers Union signed a labour contract that froze the wages of caterpillar workers for six years. In 2013, the average wage at Caterpillar was about $27 per hour and the CPI was 233. Suppose the CPI rises to 260 in 2018, the last year of the contract. Calculate the percentage change between 2013 and 2018 in the real wage earned by an average Caterpillar worker. Be sure to explain what the values you calculate for the real wage represent.

Solving the Problem Step 1:

Review the chapter material.

This problem is about using price indexes to correct for the effects of inflation, so you may want to review the section “Using Price Indexes to Adjust for the Effects of Inflation” that begins on page 135 in the textbook.

Step 2:

Begin by defining the real wage in 2013 and 2018 and explaining what the values of the real wage represent.

The number of dollars a worker receives is the worker’s nominal wage. To calculate the worker’s real wage, we have to divide the nominal wage by the CPI for that year and multiply by 100. We can make the following calculations for the two years: For 2013:  $27     100 = $11.59  233 

For 2018:  $27     100 = $10.38  260  The base year for the CPI is the average of prices during the period 1982–1984. So, the values for the real wage we calculated are in 1982–1984 dollars. In other words, these values for the real wage tell us that in 2013, $27 would buy what $11.59 would have bought in 1982–1984, and that in 2018, $27 would buy what $10.38 would have bought in 1982–1984.

Step 3:

Complete the answer by calculating the percentage change in the real wage Caterpillar workers will receive.

This percentage change equals:  $10.38 − $11.59     100 = −10.4%. $11.59  

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CHAPTER 5 | Unemployment and Inflation We can conclude that if the estimate of the CPI in 2018 is correct, an average Caterpillar worker will experience about a 10 percent decline in his or her real wage between 2013 and 2018.

Extra Credit: The values we computed for the real wages Caterpillar workers earn are measured in 1982–1984 dollars. Because this period is more than 30 years ago, the values are somewhat difficult to interpret. We can convert the earnings to 2013 or 2018 dollars by using the method we used earlier to calculate your mother’s salary. But notice that, for purposes of calculating the change in the value of real average hourly earnings over time, the base year of the price index doesn’t matter. The change from 2013 to 2018 would still be −10.4 percent, no matter what the base year of the price index was. If you don’t see that this is true, test it by using the mother’s salary method to calculate the real wage for 2013 and 2018 in 2013 dollars. Then calculate the percentage change. Unless you make an arithmetic error, you should find that the answer is still −10.4 percent.

Question In 1924, the famous novelist F. Scott Fitzgerald wrote an article for the Saturday Evening Post titled “How to Live on $36,000 a Year,” in which he wondered how he and his wife had managed to spend all of that very high income without saving any of it. The CPI in 1924 was 17, and the CPI in 2012 was 230.

What income would you have needed in 2012 to have had the same purchasing power that Fitzgerald’s $36,000 had in 1924? Be sure to show your calculation.

Source: F. Scott Fitzgerald, “How to Live on $36,000 a Year,” Saturday Evening Post, April 5, 1924.

Answer We can convert Fitzgerald’s 1924 nominal income of $36,000 to an equivalent income in 2012 by multiplying the 1924 nominal income by the ratio of the CPI for 2012 to the CPI for 1924: $36,000 × (230/17) = $487,059. So, you would have needed an income of $487,059 in 2012 to have the same purchasing power that Fitzgerald’s $36,000 had in 1924.

Extra Even Workers with College Diplomas Suffer Real Apply the Earnings Loss from 2000 to 2010 Concept A slow-growing economy in 2011 left millions of Americans nervous about the future. But many were also nervous about a decline in their real earnings in the recent past. Data from the U.S. Census Bureau shows that real wages, which are nominal wages adjusted for inflation, declined from 2000 to 2010 for most groups classified by education level. Workers who had less than a high school education (12.4 percent of all workers) suffered a 10.9 percent decline over the decade. Although high school graduates (30.7 percent of all workers) had a real earnings decline of just over 5 percent, this decline was less than those who had some college (26.4 percent of workers) and college graduates (19.5 percent of workers). Even those who earned master’s degrees (8.0 percent of workers) earned less in 2010 than in 2000. Only those who earned advanced degrees—MD, JD, MBA, and Ph.D.—experienced an increase in their real earnings.

Values of the Consumer Price Index (CPI) are used to convert nominal earnings to real earnings. (See Solved Problem 5.1 in the textbook.) To compute the real earnings figures, a special version of the CPI was used: the Consumer Price Index Research Series Using Current Methods (CPI-U-RS). This index is used to estimate what the rate of inflation for all urban consumers would be using methods of estimation currently used for all years since 1978. For the period between December 1977 and December 1998, the

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CHAPTER 5 | Unemployment and Inflation annual increase in the CPI-U-RS is 4.28, compared to an annual increase in the CPI-U of 4.73 over the same period.

Sources: David Wessel, “Only Advanced-Degree Holders See Wage Gains,” Wall Street Journal, September 19, 2011; Bureau of Labor Statistics http://bls.gov.

5.6

Real versus Nominal Interest Rates (pages 137-138) Learning Objective: Distinguish between the nominal interest rate and the real interest rate.

The difference between nominal and real values is important when money is being borrowed and lent.

Because it is corrected for the effects of inflation, the real interest rate provides a better measure of the true cost of borrowing and the true return to lending than does the nominal interest rate. The nominal interest rate is the stated interest rate on a loan. The real interest rate is the nominal interest rate minus the inflation rate. For the economy as a whole, we can measure the nominal interest rate as the interest rate on overnight loans between commercial banks.

The nominal interest rate will be less than the real interest rate when the inflation rate is negative.

Deflation is a decline in the price level.

Extra Solved Problem 5.6 Computing the Real Rate of Interest The real interest rate is defined as the nominal interest rate minus the inflation rate. The textbook uses the bank rate (overnight loans between commercial banks) as a measure of the nominal interest rate. The real rate of interest can be estimated for 2006 through 2012 by using the average bank rate and the rate of inflation as measured by the December-to-December percentage change in the consumer price index.

2006 2007 2008 2009 2010 2011 2012 Bank rate 4.3 4.6 3.2 0.6 0.85 1.25 1.25 Percentage change in the CPI 1.7 2.4 1.2 1.3 2.4 2.3 0.8 Source: CANSIM Series V122530, V41693242.

a. What was the real interest rate in the years 2006 through 2012? b. Based on real interest rates from 2009 to 2011, why was it likely that the real rate will be higher in later years?

Solving the Problem Step 1:

Review the chapter material.

This problem refers to real and nominal interest rates, so you may want to review the section “Real versus Nominal Interest Rates,” which begins on page 137 of the textbook.

Step 2:

Answer part (a) by calculating the real interest rate in the years 2006 through 2012.

The real interest rate equals the nominal rate of interest minus the rate of inflation.

2006 2007 2008 2009 2010 2011 2012 Real interest rate 2.6 2.2 2 -0.7 -1.55 -1.05 0.45

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Step 3:

Answer part (b) by explaining why it is likely that the real rate will be higher in years after 2011.

It is unlikely that the real interest rate would continue to be negative indefinitely. A negative real interest rate means that lenders are receiving a negative real return on funds they have lent. Eventually, nominal interest rates will have to rise in order to make the real interest rate positive.

Extra Low Real Interest Rates on Treasury Debt Force Apply the Investors to Consider Alternatives Concept The U.S federal government’s deficit declined from $1.4 trillion in fiscal year (October 1–September 30) 2009 to $439 billion in fiscal year 2015. Although the size of deficit fell, the total national debt climbed to over $19 trillion in 2016. The U.S. Treasury has to sell hundreds of billions of dollars in securities annually to pay interest on this debt. Holding the demand constant, an increase in supply of Treasury securities will lead to lower prices and higher interest rates. But because the demand for Treasury securities also increased, interest rates remained low throughout 2015. Low real interest rates encourage firms and consumers to borrow to fund construction of new buildings, equipment and purchases of automobiles and other durable goods. But bondholders and retirees who seek steady income view low real interest rates on Treasury securities differently. William Gross, head of PIMCO, the world’s largest bond fund advised bondholders to “. . . find something else that’s attractive.” While Princeton economist Burton Malkiel agreed that U.S. Treasury securities are currently poor choices for investors, he endorsed two other types of bonds: (1) Tax-exempt municipal bonds, issued by state and local governments, that offer yields higher than those on Treasury debt, some of which are tied to reliable sources of revenue (for example, bridge and tunnel fees) and are free of state and local taxes; (2) bonds issued by foreign countries that are in better fiscal condition than the United States. Canada and Australia, for example, have low debt-to-GDP ratios and abundant natural resources that can be used to fuel economic growth.

Malkiel suggests that another strategy for savers: buy a portfolio of blue-chip common stocks that offer dividends.

In contrast to the United States, Canada’s government expects to maintain its debt-to-GDP ratio to its actual level, which may increase the attractiveness of Canadian government bonds. Upward pressure on bond prices will likely be sufficient to keep interest rates on Canadian bonds relatively low for the foreseeable future. In January 2017, Stephen Poloz, governor of the Bank of Canada, indicated that the Bank of Canada might cut their key rate. In April 2017, He took this option off the table but there are no indication that the bank rate will dramatically increase in the near future. Derek Holt, economist at Scotiabank, said: “I just don’t see the talk of rate hikes anytime soon as being credible”.

Sources: Matt Phillips, “Real Interest Rates: 1919–The Present,” Wall Street Journal, October 13, 2011; Burton G. Malkiel, “The Bond Buyer’s Dilemma,” Wall Street Journal, December 7, 2011; and Matt Cover, “At Current Rate of Federal Borrowing, Government on Track to Hit Legal Limit on National Debt on March 14,” cnsnews.com, February 24, 2011. Drew Hasselback, “Bank of Canada governor Stephen Poloz says rate cut remains on table” Financial Post January 18, 2017. Theophilos Argitis, “Poloz Takes Rate Cuts Off Table on Improving Canadian Outlook” Bloomberg April 12, 2017. Leah Schnurr, “Talk of a Bank of Canada rate hike just got a lot less credible — check out this inflation data” Financial Post April 21, 2017

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CHAPTER 5 | Unemployment and Inflation

5.7

Does Inflation Impose Costs on the Economy? (pages 138-140) Learning Objective: Discuss the problems that inflation causes.

A. Inflation Affects the Distribution of Income Inflation does not reduce the affordability of goods and services to the average consumer, but it still imposes costs on the economy. Inflation affects the distribution of income. Some people will find their incomes rising faster than the rate of inflation, and so their purchasing power will rise. Other people will find their incomes rising slower than the rate of inflation, and so their purchasing power will fall. The extent to which inflation redistributes income depends, in part, on whether the inflation is anticipated.

B. The Problem with Anticipated Inflation When inflation is anticipated, its main costs are that paper money loses some of its value. Anyone holding paper money will find its purchasing power decreasing each year by the rate of inflation. To avoid this cost, workers and firms will try to hold as little money as possible but will have to hold some. Firms that print catalogues listing prices of products will have to reprint them more frequently. Stores will devote more time and labour to changing prices. Menu costs are the costs to firms of changing prices.

Anticipated inflation raises taxes paid by investors because they are taxed on the nominal payments they receive rather than on the real payments.

C. The Problem with Unanticipated Inflation When people borrow money or banks lend money, they must forecast the rate of inflation, so they can calculate the real rate of interest on a loan. When the actual inflation rate turns out to be different from the expected rate, some people gain, and other people lose. This apparently unfair redistribution is a key reason why people dislike unanticipated inflation.

Extra Economics in Your Life and Career: How will the real interest rate affect the cost of your car loan?

Let’s assume that the old clunker you have been driving needs $500 in repairs in order to pass an annual car inspection. You are considering buying a new car, and you contact car dealers and banks to determine the best deal you can get on a car loan. Assume two different scenarios: (a) The lowest interest rate you find on a five-year car loan is 10 percent, and the annual rate of inflation for the next five years is 9 percent. (b) The lowest interest rate you can find on a five-year car loan is 6 percent, and the annual rate of inflation for the next five years is 1 percent.

Question: Under which scenario—(a) or (b)—will you pay less, in real income, for your car loan?

Answer: Although the nominal interest rate is much lower under scenario (a), you should base your decision on the real interest rate. Of course, you will not know what the actual rate of inflation will be in the future, but if the rate of inflation is 9 percent annually, the real rate of interest on your car loan will be only 1 percent. Under scenario (b), if the annual rate of inflation is 1 percent over the duration of your loan the real rate of interest will be 5 percent. You will pay less in real income under scenario (a) even though the nominal interest rate is much higher than it is under scenario (b).

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles Brief Chapter Summary and Learning Objectives 6.1

Long-Run Economic Growth (pages 151-157) Discuss the importance of long-run economic growth.

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6.2

The Canadian economy has experienced both long-run economic growth and short-run periods of expansion and recession. Long-run economic growth results from rising productivity and leads to increases in the average standard of living.

Saving, Investment, and the Financial System (pages 157-165) Discuss the role of the financial system in facilitating long-run economic growth.

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6.3

Financial markets and financial intermediaries together comprise the financial system. A well-functioning financial system is an important determinant of economic growth.

The Business Cycle (pages 165-169) Explain what happens during the business cycle.

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A business cycle consists of alternating periods of economic expansion and contraction.

During the expansion phase of a business cycle, production, employment, and income are increasing.

Following the business cycle peak, production, employment, and income decline during the recession phase of the cycle.

Key Terms Business cycle, p. 151. Alternating periods of economic expansion and economic recession.

Capital, p. 154. Manufactured goods that are used to produce other goods and services.

Crowding out, p. 163. A decline in private investment expenditures as a result of an increase in government purchases.

Expansion, p. 151. The period of a business cycle during which total production and total employment are increasing.

insurance companies, that borrow funds from savers and lend them to borrowers.

Financial markets, p. 157. Markets where financial securities, such as stocks and bonds, are bought and sold.

Financial system, p. 157. The system of financial markets and financial intermediaries through which firms acquire funds from households.

Labour productivity, p. 154. The quantity of goods and services that can be produced by one worker or by one hour of work.

Financial intermediaries, p. 158. Firms, such as banks, mutual funds, pension funds, and .

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles Long-run economic growth, p. 151. The process by which rising productivity increases the average standard of living.

Potential GDP, p. 156. The level of real GDP attained when all firms are producing at capacity.

Market for loanable funds, p. 160. The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged.

Recession, p. 151. The period of a business cycle during which total production and total employment are decreasing.

Chapter Outline Economic Growth and the Business Cycle at Bombardier Bombardier is a Canadian producer of snowmobiles and Ski-Doos. In 1974 the firm entered the train industry, and in 1986 they began producing the Canadair Regional Jet. Since then the CRJ has become the world’s most successful regional aircraft program. In 2011, however, as a result in declining demand during the great recession, Bombardier announced that it would slow production of its jets. Demand had not recovered sufficiently to resume previous levels of output. In October 2015, Bombardier received a $1 billion bail-out from the government of Quebec. In February 2017, the federal government added another $372.5 million in bailout funds. Bombardier’s C-Series jets, designed to serve the growing global shorthaul air travel market, have been hit with two problems. The first is that the C-Series project has encountered delays and cost overruns, which means Bombardier is only now starting to deliver the planes to buyers. The second is the slow recovery from the global recession in many markets.

6.1

Long-Run Economic Growth (pages 151-157) Learning Objective: Discuss the importance of long-run economic growth.

A successful economy is capable of increasing production of goods and services faster than the growth in population. The Canadian economy has experienced periods of expanding production and employment followed by periods of recession, during which production and employment decline. The business cycle refers to alternating periods of economic expansion and economic recession. Each period of expansion is not the same length nor is each period of recession.

Most people in Canada, the United States, Western Europe, Japan, and other advanced countries expect that, over time, their standard of living will improve. Long-run economic growth is the process by which rising productivity increases the average standard of living. The best measure of the standard of living is real GDP per capita. We measure long-run economic growth by increases in real GDP per capita over long periods of time.

A. Calculating Growth Rates and the Rule of 70 The growth rate of real GDP or real GDP per capita during a particular year is equal to the percentage change from the previous year. We can judge how rapidly an economic variable is growing by calculating how many years it would take to double. One easy way to calculate how many years it will take real GDP per capita to double is to use the rule of 70. The formula for the rule is Number of years to double =

70 .

Growth rate

Small differences in growth rates can have large effects on how rapidly the standard of living in a country .

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles increases.

B. What Determines the Rate of Long-Run Growth?

Increases in real GDP per capita depend on increases in labour productivity, which is the quantity of goods and services that can be produced by one worker or by one hour of work. Economists usually measure labour productivity as output per hour of work in order to avoid fluctuations in the length of the workday and in the fraction of the population employed. Economists believe two key factors determine labour productivity: the quantity of capital per hour worked and the level of technology. Capital refers to manufactured goods that are used to produce other goods and services. The total amount of physical capital (such as computers, factory buildings, and trucks) available in a country is known as the country’s capital stock. As the capital stock per hour worked increases, worker productivity increases. Human capital refers to the accumulated knowledge and skills workers acquire from education and training or from their life experiences. Increases in human capital stimulate economic growth. Economic growth depends more on technological change than on increases in capital per hour worked. Technology refers to the processes a firm uses to turn inputs into outputs of goods and services. Technological change is an increase in the quantity of output firms can produce using a given quantity of inputs. Most technological change is embodied in new machinery, equipment, or software.

In implementing technological change, entrepreneurs are important because they make the crucial decisions about whether to introduce new technology to produce better or lower-cost products.

Entrepreneurs also decide whether to allocate the firm’s resources to research and development that can result in new technologies. A key requirement for economic growth is that the government must provide secure rights to private property. In addition, the government can help the market system work and aid economic growth by establishing an independent court system that enforces contracts between private individuals. The government also has a role in facilitating the development of an efficient financial system, as well as systems of education, transportation, and communication.

C. Potential GDP Potential GDP is the level of real GDP attained when all firms are producing at capacity. Potential GDP will increase over time as the labour force grows, new factories and office buildings are built, new machinery and equipment are installed, and technological change takes place. The Bank of Canada estimates the “output gap”—the difference between actual and potential GDP. A negative output gap occurs when actual real GDP is less than potential real GDP. Economic activity is insufficient to make use of all available resources. Major deviations of actual GDP from potential GDP occur during recessions.

Extra Apply the What Explains Rapid Economic Growth in Botswana?

Concept Economic growth in much of sub-Saharan Africa has historically been very slow. As desperately poor as most of these countries were in 1960, some are even poorer today. The growth rate in one country in this region stands out, however, as being exceptionally rapid. The graph below shows the average annual growth rate in real GDP per capita between 1960 and 2009 for Botswana and the six most populous subSaharan countries. Botswana’s average annual growth rate over this 49-year period was three times as great as that of Tanzania and South Africa, which were the second and third-fastest-growing countries in the group. Botswana may seem an unlikely country to experience rapid growth because it has been hard

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles hit by the HIV epidemic. But Botswana’s relatively rapid growth pushed per capita GDP in 2016 to about $16,900, which places it among the world’s middle-income countries.

Note: Data for Democratic Republic of Congo are for 1970–2004.

Source: Textbook authors’ calculations from data in Alan Heston, Robert Summers, and Bettina Aten, Penn World Table, Version 7.0, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, June 3, 2011 and the CIA Factbook.

What explains Botswana’s rapid growth rate? Several factors have been important. Botswana avoided the civil wars that plagued other African countries during these years. The country also benefited from earnings from diamond exports. But many economists believe the pro-growth policies of Botswana’s government are the most important reason for the country’s success. Economists Shantayanan Devarajan of the World Bank, William Easterly of New York University, and Howard Pack of the University of Pennsylvania summarized these policies as follows: The government [of Botswana] made it clear it would protect private property rights. It was a “government of cattlemen” who were attuned to commercial interests…relative political stability and relatively low corruption also made Botswana a favorable location for investment.

Botswana’s relatively high level of press freedom and democracy (continuing a pre-colonial tradition that held chiefs responsible to tribal members) held the government responsible for any economic policy mistakes.

These policies—protecting private property, avoiding political instability and corruption, and allowing press freedom and democracy—may seem a straightforward recipe for providing an environment in which economic growth can occur. However, in practice, these are policies many countries do not implement.

Sources: International Monetary Fund, World Economic Outlook Database, September 2011; and Shantayanan Devarajan, William Easterly, and Howard Pack, “Low Investment Is Not the Constraint on African Development,” Economic Development and Cultural Change, Vol. 51, No. 3, April 2003, pp. 547–571.

Question If the keys to Botswana’s rapid economic growth seem obvious, why have other countries in the region had so much difficulty following them?

Answer

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles Many countries in sub-Saharan Africa have faced difficulties in successfully implementing policies that boost economic growth, such as protecting private property and avoiding political instability and corruption. In some countries, those in power have been unwilling to share power with rivals. They may retain power through corruption or military might. They assume—probably correctly—that the establishment of legal rights enforced by courts might end both their power and the wealth that comes with that power.

Extra Solved Problem 6.1 Explaining Economic Growth in Singapore Between 1960 and 1995, real GDP per capita in Singapore grew at an average annual rate of 6.2 percent.

This very rapid growth rate results in the level of real GDP per capita doubling about every 11.3 years. In 1995, Alwyn Young of the London School of Economics published an article in which he argued that Singapore’s growth depended more on increases in capital per hour worked, increases in the labour force participation rate, and the transfer of workers from agricultural to nonagricultural jobs than on technological change. If Young’s analysis was correct, predict what was likely to happen to Singapore’s growth rate in the years after 1995.

Solving the Problem Step 1:

Review the chapter material.

This problem is about what determines the rate of long-run growth, so you may want to review the section “What Determines the Rate of Long-Run Growth?” which begins on page 154 in the textbook.

Step 2:

Predict what happened to the growth rate in Singapore after 1995.

As countries begin to develop, they often experience an increase in the labour force participation rate, as workers who are not part of the paid labour force respond to rising wage rates. Many workers also leave the agricultural sector—where output per hour worked is often low—for the nonagricultural sector. These changes increase real GDP per capita, but they are “one-shot” changes that eventually come to an end, as the labour force participation rate and the fraction of the labour force outside agriculture both approach the levels found in high-income countries. Similarly, as we already noted, increases in capital per hour worked cannot sustain high rates of economic growth unless they are accompanied by technological change.

We can conclude that Singapore was unlikely to sustain its high growth rates in the years after 1995. In fact, from 1996 to 2012, the growth of real GDP per capita slowed to an average rate of 3.0 percent per year. Although this growth rate is comparable to rates experienced in high-income countries, such as the United States, it leads to a doubling of real GDP per capita only about every 23 years rather than about every 11 years.

Sources: Alwyn Young, “The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience,” Quarterly Journal of Economics, Vol. 110, No. 3, August 1995, pp. 641–680; and International Monetary Fund, World Economic Outlook Database, April 2013.

Question An article in the Economist magazine compares Panama to Singapore. It quotes Panama’s president as saying: “We copy a lot from Singapore and we need to copy more.” The article observes that: “Panama is not even one-fifth as rich as its Asian model on a per-person basis. But Singapore would envy its growth: .

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles from 2005 to 2010 its economy expanded by more than 8% a year, the fastest rate in the Americas.”

Judging from the experience of Singapore, if Panama is to maintain these high growth rates, what needs to be true about the sources of Panama’s growth?

Source: “A Singapore for Central America?” Economist, July 14, 2011.

Answer Over the long run, Panama cannot sustain high rates of growth by shifting workers from agricultural to nonagricultural industries or by increasing capital per hour worked. If Panama is to maintain high growth rates, the sources of growth need to include technological change.

6.2

Saving, Investment, and the Financial System (pages 157-165) Learning Objective: Discuss the role of the financial system in facilitating long-run economic growth.

Economic growth depends on the ability of firms to expand their operations. Firms can finance their expansion from retained earnings, through financial markets, and through financial intermediaries. The financial system is the system of financial markets and financial intermediaries through which firms acquire funds from households.

A. An Overview of the Financial System Financial markets are markets where financial securities, such as stocks and bonds, are bought and sold. A financial security is a document that states the terms under which funds pass from the buyer of the security to the seller. Stocks are financial securities that represent partial ownership of a firm. Bonds are financial securities that represent promises to repay a fixed amount of funds.

Financial intermediaries are firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers. No country has been able to sustain high levels of economic growth without a well-developed financial system. The financial system provides three key services for savers and borrowers: a. Risk sharing. Risk is the chance that the value of a financial security will change relative to what you expect. The financial system provides risk sharing by allowing savers to spread their money among many financial assets b. Liquidity. This is the ease with which a financial asset can be exchanged for money. c. Information, or facts about borrowers and expectations about returns on financial securities.

Financial markets incorporate information into prices of stocks, bonds, and other financial securities.

B. The Macroeconomics of Saving and Investment The total value of saving in the economy must equal the total value of investment. There are two categories of saving in the economy: private saving by households and public saving by the government.

We can use some relationships from national income accounting to understand why total saving must equal total investment. We begin with the relationships between GDP (Y) and its components, consumption (C), investment (I), government purchases (G), and net exports (NX): Y = C + I + G + NX.

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles In an open economy, there is interaction with other economies in terms of both trading of goods and services and borrowing and lending. In a closed economy, there is no trading or borrowing and lending with other economies. For simplicity, we develop the relationship between saving and investment for a closed economy. Net exports are zero, so we can rewrite the relationship between GDP and its components as Y = C + I + G. If we rearrange this relationship, we have an expression for investment in terms of the other variables: I = Y – C – G. We can also derive an expression for total saving. Private saving is equal to what households retain of their income after purchasing goods and services (C) and paying taxes (T). Households earn income for supplying the factors of production to firms (Y) and from government in the form of transfer payments (TR). We can write an expression for private saving (SPrivate): SPrivate = Y + TR – C – T. Public saving (SPublic) equals the amount of tax revenue the government retains after paying for government purchases and making transfer payments to households: SPublic = T – G – TR. Total saving in the economy (S) is equal to S = SPrivate + SPublic , or S = (Y + TR – C – T) + (T – G – TR), or S = Y – C – G. We can conclude that total saving must equal total investment: S = I. When the government spends the same amount that it collects in taxes, there is a balanced budget. When the government spends more than it collects in taxes, there is a budget deficit, which means that public saving is negative. When the government runs a budget deficit, the Bank of Canada, on behalf of the Minister of Finance, sells government bonds to borrow the money necessary to fund the gap between taxes and spending. With less saving, investment must be lower.

When the government spends less than it collects in taxes, there is a budget surplus. A budget surplus increases public saving and the total level of saving in the economy. A higher level of saving results in a higher level of investment spending.

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C. The Market for Loanable Funds The market for loanable funds refers to the interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged. The demand for loanable funds is determined by the willingness of firms to borrow money and to engage in new investment projects. The lower the interest rate, the more investment projects a firm can profitably undertake. The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving. The higher the interest rate, the greater the reward for saving and the larger the amount of funds households will save. Because both borrowers and lenders are interested in the real interest rate they will receive or pay, equilibrium in the market for loanable funds determines the real interest rate.

We draw the demand curve for loanable funds by holding constant all factors, other than the interest rate, that affect the willingness of borrowers to demand funds. We draw the supply curve by holding constant all factors, other than the interest rate, that affect the willingness of lenders to supply funds. An increase in the demand for loanable funds increases the equilibrium interest rate. As a result, the equilibrium quantity of loanable funds increases. We can use the market for loanable funds to examine the impact of a government deficit. Running a deficit reduces the level of total saving in the economy and, by increasing the interest rate, reduces the level of investment by firms. By borrowing the money to finance its budget deficit, the government will have crowded out some firms that would otherwise have been able to borrow to finance investment. Crowding out is a decline in private investment expenditures as a result of an increase in government purchases. A government budget surplus has the opposite effect of a deficit. In practice, the effect of government budget deficits and surpluses on the equilibrium interest rate is small, partly because of the importance of global saving in determining the interest rate. Paying off the debt in the future may, however, require higher taxes, which can depress economic growth.

Extra Solved Problem 6.2 How Would a Consumption Tax Affect Saving, Investment, the Interest Rate, and Economic Growth?

Some economists and policymakers have suggested that the federal government shift from relying on an income tax to relying on a consumption tax. Under the income tax, households pay taxes on all income earned. Under a consumption tax, households pay taxes only on the income they spend. Households would pay taxes on saved income only if they spend the money at a later time. Use the market for loanable funds model to analyze the effect on saving, investment, the interest rate, and economic growth of switching from an income tax to a consumption tax.

Solving the Problem Step 1:

Review the chapter material.

This problem is about applying the market for loanable funds model, so you may want to review the section “Explaining Movements in Saving, Investment, and the Interest Rate,” which begins on page 161 in the textbook.

Step 2:

Explain the effect of switching from an income tax to a consumption tax.

Households are interested in the return they receive from saving after they have paid their taxes. For example, consider someone who puts his savings in a certificate of deposit at an interest rate of 4 percent and whose tax rate is 25 percent. Under an income tax, this person’s after-tax return to saving is 3 percent [= 4 – (4  0.25)]. Under a consumption tax, income that is saved is not taxed, so the return rises to 4 percent. We can conclude that moving from

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles an income tax to a consumption tax would increase the return to saving, causing the supply of loanable funds to increase.

Step 3:

Draw a graph of the market for loanable funds to illustrate your answer.

The supply curve for loanable funds will shift to the right as the after-tax return to saving increases under the consumption tax. The equilibrium interest rate will fall, and the levels of saving and investment will both increase. Because investment increases, the capital stock and the quantity of capital per hour worked will grow, and the rate of economic growth should increase. Note that the size of the fall in the interest rate and the size of the increase in loanable funds shown in the following graph are larger than the effects that most economists expect would actually result from the replacement of the income tax with a consumption tax.

6.3

The Business Cycle (pages 165-169) Learning Objective: Explain what happens during the business cycle.

Although there has been a tremendous increase in the standard of living of the average Canadian over the past 50-plus years, real GDP per capita did not increase every year.

A. Some Basic Business Cycle Definitions Since Confederation, the Canadian economy has experienced business cycles that consist of alternating periods of expanding and contracting economic activity. During the expansion phase of a business cycle, production, employment, and income are increasing. The period of expansion ends with a business cycle peak. Following the business cycle peak, production, employment, and income decline during the recession phase of the cycle. The recession comes to an end with a business cycle trough, after which another period of expansion begins.

B. How Do We Know When the Economy Is in a Recession?

The federal government does not officially decide when a recession begins and when it ends. Statistics Canada produces many statistics that make it possible to monitor the economy. Statistics Canada does not

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles officially decide when a recession begins or when it ends. In Canada, there is no official beginning or end to a recession. However, elabourating on our earlier definition, there is general agreement that a recession is defined as two consecutive quarters of negative real GDP growth.

C. What Happens during the Business Cycle?

Although each business cycle is different, most business cycles share certain characteristics. Near the end of an expansion, interest rates are usually rising, and the wages of workers are usually rising faster than prices. As a result, profits of firms are falling. Typically, toward the end of an expansion, both households and firms will have substantially increased their debts.

A recession will often begin with a decline in spending by firms on capital goods or by households on housing and consumer durables. As sales decline, firms cut back on production and begin to lay off workers. As the recession continues, economic conditions gradually improve. Declines in spending eventually end, households and firms reduce their debt, and firms begin to increase their spending on capital goods as they anticipate additional production during the next expansion. Household spending on consumer durables and business spending on capital goods will bring the recession to an end.

An important fact about the business cycle is that during economic expansions the inflation rate usually increases, and during recessions the inflation rate usually decreases. Recessions cause the unemployment rate to rise. The unemployment rate continued to rise after the recessions of 1981, 1991 and 2007/2008 had ended. This pattern is due to two factors. First, though employment begins to increase as the recession ends, it may increase more slowly than the increase in the labour force from population growth. Second, some firms continue to operate well below their capacity even after a recession has ended and production has begun to increase. Firms may not hire back all the workers they had laid off and may continue to lay off more workers for a while.

Extra Solved Problem 6.3 Leading Indicators and the Business Cycle People often ask economists for predictions about the future of the macroeconomy. Forecasts about the economy’s future, even from experts, are not unlike a sports writer’s prediction of who will play in the next Stanley Cup. The prediction can seem well-reasoned and logical, but it is hardly foolproof. Certain statistical series tend to move in similar ways through all business cycles. Knowledge of these series and their tendencies can provide some insight into future business cycle movements. Statistics Canada and the Conference Board of Canada publish monthly updates called, respectively, the “composite leading index” and the “consumer sentiment index.” The index is a weighted average of ten statistical series that usually lead, or begin turning upward and downward, before the overall economy does. Because not all components of the index turn before the business cycle hits a peak or a trough, movements in the index are more reliable than the movement in any one of its components.

Among the most reliable of the leading indicators is an index of prices for 300 common stocks. Investors will want to buy stock shares when the prices are relatively low and sell shares when prices are relatively high. During a recession, stock prices fall due to sluggish sales and profits. Interest rates are relatively low during the last months of a recession because of reduced demand for investment. In choosing between buying bonds and stocks, investors will favour stocks when (a) stock prices have fallen to a point where there is a strong possibility of future capital gains and (b) the opportunity cost of buying stocks—the interest rate on bonds—is low. Therefore, prices of common stocks will usually begin to rise during the late stages of a business cycle, before a business expansion begins. As the economy moves near to full employment during an expansion, the situation is reversed. Strong demand for consumer goods and .

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles investment will drive prices and interest rates upward. At some point, investors sell stocks to realize capital gains and buy bonds, rather than stocks, to take advantage of high interest rates. The downward movement in stock prices will usually begin before a recession begins. a. Scientists make accurate predictions of the movement of asteroids and comets. Why can’t economists make accurate predictions of business cycle movements? b. Assume that the Canadian economy is in a recession. Mild weather results in lower demand for energy and a reduction in the price of oil. Investors interpret this as positive news for firms because their costs of production will be lowered. An increase in stock prices results. Will an economic expansion follow?

Solving the Problem Step 1:

Review the chapter material.

This problem is about the business cycle, so you may want to review the section “The Business Cycle,” which begins on page 165 in the textbook.

Step 2:

Answer part (a) by considering why economists have difficulty making accurate predictions of business cycle movements.

The movement of heavenly bodies, unlike human bodies, can be accurately explained by mathematical formulas. Economists are social scientists who attempt to describe and predict the behaviour of people. People do not behave as predictably as comets.

Step 3:

Answer part (b) by discussing whether an economic expansion will follow an increase in stock prices.

Stock prices can rise and fall over days or weeks many times before the next turning point in the business cycle occurs. A sustained rise in stock prices and upward movement in other leading indicators will increase the probability of an expansion, but remember that economic forecasts, like Stanley Cup forecasts, are certain only after the fact.

Extra Apply the The Business Cycle and the 2008 United States Election Concept Was the US economy in a recession during the 2008 presidential election? Less than one week before election day in 2008, the US Bureau of Economic Analysis announced its preliminary estimate that real GDP had declined during the third quarter of 2008. However, the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), a private research group located in Cambridge, Massachusetts, that determines when recessions begin, did not announce that a recession began in December 2007 until its meeting in late November, several weeks after the election.

The NBER is fairly slow in announcing business-cycle dates because it takes time to gather and analyze economic statistics. It is not unusual for the NBER to announce that the economy is in a recession only well after the recession has begun. Whether or not the NBER has declared that a recession is underway, does the state of the economy affect which presidential candidate voters choose?

There is substantial evidence that in some elections, the state of the economy can be of decisive importance. For instance, Herbert Hoover was elected president with a large majority in the 1928 presidential election. When the Great Depression began shortly after Hoover took office, his popularity rapidly faded and he was soundly defeated for re-election by Franklin Roosevelt in 1932. Similarly, George H. W. Bush was elected with 53 percent of the popular vote in 1988, but when the US economy

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by Bill Clinton. Even in elections that do not take place during or shortly after recessions, the state of the economy can influence voting. A careful analysis of the 2004 presidential election by Jeffrey S. DeSimone and Courtney LaFountain of the University of Texas, Austin, showed that voters who had experienced a financial decline between 2000 and 2004 were significantly less likely to vote to re-elect President George W. Bush.

During the summer of 2008, some opinion polls showed that John McCain, the candidate of the incumbent Republican party, had a lead among likely presidential voters. But in the fall, as real GDP began to decline and unemployment began to rise, McCain’s fortunes faded, and Barack Obama ultimately won the election by a margin in the popular vote of 53 percent to 46 percent.

The evidence on the political business cycle is more prevalent for the United States, where elections are held every four years, typically on the first Tuesday of November (after November 1). Evidence of the business cycle’s effect on politics in Canada has been reported by J. Stephen Ferris in “Electoral politics and monetary policy: Does the Bank of Canada contribute to a political business cycle?” Public Choice (2008) vol. 135, pp. 449-468 and J. Stephen Ferris, “Do business cycle peaks predict election calls in Canada?” European Journal of Political Economy (2013) vol. 29 pp. 102–118.

Sources: NBER Reporter, Fall 2001, and Jeffrey S. DeSimone and Courtney LaFountain, “It’s Still the Economy, Stupid: Economic Voting in the 2004 Presidential Election,” NBER Working Paper No. 13549, October 2007.

Question: Many researchers who have studied presidential elections believe that the state of the economy often plays a large role in the outcome of the election. In particular, presidents who run for reelection during a year when real GDP is declining and unemployment is increasing are usually defeated.

Is the current state of the economy a good reason for voting for or against an incumbent president running for re-election? Briefly explain your argument.

Answer: Voters base their decisions on a variety of issues. Some voters always vote for the candidate of the party they have registered with, while some Republican, Democratic, and independent voters base their decisions on various economic and non-economic issues that are important to them. It is often said that sitting presidents get too much credit when there is low unemployment and low inflation and too much blame when there is high unemployment and high inflation. The influence of a president’s actions have a limited effect on the economy’s performance. But it is not unreasonable for people to “vote their pocketbooks” since decisions made by the president and Congress can affect the growth of income and employment. One presidential advisor quipped that it is best to “get your recession out of the way early.”

For example, Ronald Reagan was president during a severe recession during 1981 and 1982. However, by the time he ran for re-election in 1984, the US economy was growing and unemployment was falling.

President Reagan was easily re-elected.

Extra Apply the Can a Recession Be a Good Time For a Business to Expand?

Concept During a recession, business managers have to quickly make many decisions, such as whether to reduce production, cut prices, close stores or other facilities, or lay off workers. In addition to making decisions aimed at dealing with the immediate effects of the recession, managers have to consider how to prepare for the expansion that will follow. Managers know that every recession, even one as severe as the recession of 2007–2009, will be followed by an expansion during which demand for their products is

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CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles likely to increase. But it can be difficult to commit resources to future expansion when current conditions are bleak and when the end of the recession is difficult to predict.

However, the payoff to preparing for future growth can be very large. For example, at the end of World War II in 1945, many economists and business managers expected that the U.S. economy would enter a severe recession. Sears and Montgomery Ward were the two largest department store chains in the country. Robert Wood, CEO of Sears, expected continued prosperity and moved to open new stores across the country. Sewell Avery, CEO of Montgomery Ward, expected falling incomes and rising unemployment and refused to authorize any new stores and closed a number of existing ones. As a result, when strong economic growth occurred during the late 1940s, Sears rapidly gained market share at Montgomery Ward’s expense.

Following the September 11, 2001, terrorist attacks in the United States, the managers of many hotels expected a prolonged period of reduced travel. They responded by laying off workers and postponing or canceling new construction. Isadore Sharp, the chairman and CEO of Four Seasons Hotels, decided that although the recession would severely hurt the hotel industry, the effects would be short-lived. He decided to finish construction of 18 hotels and begin construction of 10 more. By his own account: “We maintained or enhanced our market share in most regions, contrary to the predictions of various industry experts.” In a letter to his shareholders in March 2002, he wrote: “We are well positioned for the economic recovery expected later this year.”

During the severe recession of 2007–2009, managers had similar decisions to make. Based in Greensboro, North Carolina, VF Corporation is the largest apparel maker in the world. Among its brands are North Face, Timberland, and Wrangler. While many firms, such as J.Crew, Anne Klein, and Liz Claiborne, were closing stores or postponing opening new ones, Eric Wiseman, CEO of VF, pushed ahead, opening 89 stores in 2008 and 70 in 2009. One retail analyst was quoted as saying, “Unfortunately, many companies pull in the reins in a downturn, but these are often the best opportunities to grow.” Similarly, Intel, the computer chip manufacturer, decided in early 2009 to proceed with a $7 billion expansion of its factories in the United States, while many rival firms were reducing their spending on new factories as computer sales declined. Paul Otellini, CEO of Intel, was quoted as saying, “I thought it was important for a company like Intel to stand up and say we have confidence.” Heavy equipment manufacturer Caterpillar, Inc., announced that it would build several new facilities and expand some existing ones “to meet the expected increase in customer demand.”

By 2015, the recovery from the 2007–2009 recession was well underway, although it was slower than a typical recovery. VF’s decision to expand appeared to have been a good one as sales and profits continued to increase and its stock price was near an all-time high. The company continued to open new stores and was operating nearly 1,500 stores worldwide. The verdict for Caterpillar and Intel was more mixed, although both firms remained profitable. Intel’s announcement in mid-2015 that technical problems would delay its latest generation of computer chips until late 2017 might represent a temporary setback, or it could indicate that it was beginning to fall behind rival chipmakers. Caterpillar was being hurt by declining prices for coal, iron ore, oil, and other commodities, which reduced demand for equipment used for mining and oil exploration. Still, Caterpillar’s CEO expected that sales would increase in the future as growth in the world economy caused a turnaround in commodity prices.

Over the long run, betting on the future of the U.S. economy has paid off for most firms.

Sources: Lisa Beilfuss, “VF Corp. Tops Expectations on Strength in Outdoor Sales,” Wall Street Journal, July 24, 2015; Tiernan Ray, “Is Intel in Trouble?” Barrons, July 18, 2015; James R. Hagerty, “Caterpillar Resists Calls to Slash Spending,” Wall Street Journal, July 23, 2015; Robert Sobel, When Giants Stumble, Paramus, NJ: Prentice Hall, 1999; Isadore Sharp, Four Seasons: The Story of a Business Philosophy, New York: Portfolio, 2009; Bob Tita, “Caterpillar to Expand Kansas Plant,” Wall Street Journal, August 18, 2011; Rachel Dodes, “VF Dresses Up Its Operations, Bucking Recession,” Wall Street Journal, March 31, 2009; and Don Clark, “Intel to Spend Heavily on U.S. Plants,” Wall Street Journal, February 10, 2009.

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Extra Economics in Your Life and Career: Will Productivity Growth Prevent You from Getting a Job? In a September 2009 speech, economist Robert J. Gordon, a member of the Business Cycle Dating Committee at the US National Bureau of Economic Research, predicted that the committee would ultimately determine that the trough of the 2007–2009 recession would be in June 2009, and that the economic recovery from the recession would be characterized by strong gains in productivity but weak growth in employment.

Question: In this chapter the textbook argues that productivity growth increases a nation’s average standard of living, but Robert Gordon suggests that productivity growth inhibits growth in employment.

Does productivity growth help or harm people who are looking for jobs?

Answer: Productivity growth—increases in the quantity of goods and services that can be produced by one worker or one hour of work—must occur in order for a nation to experience an increase in the average standard of living, but the textbook stresses that this is a characteristic of long-run economic growth. In the short run, increases in productivity mean that firms can increase their output of goods and services without increasing employment. So, productivity increases could make it more difficult for you to find employment as the economy recovers from a recession. In the long run, greater productivity growth will result in both greater employment and greater per capita incomes.

Source: Sudeep Reddy, “Is the Recession Over? Wait Until 2010 for NBER’s Answer,” Wall Street Journal, September 11, 2009.

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CHAPTER 7 | Long-Run Economic

Growth: Sources and Policies Brief Chapter Summary and Learning Objectives 7.1

Economic Growth over Time and around the World (pages 176-181) Define economic growth, calculate economic growth rates, and describe global trends in economic growth.

▪

7.2

Real GDP per capita is the best measure of a country’s standard of living. Economic growth occurs when real GDP per capita increases.

What Determines How Fast Economies Grow? (pages 181-188) Use the economic growth model to explain why growth rates differ across countries.

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7.3

Labour productivity increases if there is an increase in the amount of capital available to each worker or if there is an improvement in technology.

Economic Growth in Canada (pages 188-192) Discuss fluctuations in productivity growth in Canada.

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7.4

Productivity in Canada grew rapidly from the end of World War II until the mid-1970s, then slowed down for twenty years, then slowed again after 1995.

Why Isn’t the Whole World Rich? (pages 192-201) Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth.

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7.5

Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth.

Growth Policies (pages 201-204) Discuss government policies that foster economic growth.

▪

Governments can attempt to increase economic growth through policies that enhance property rights and the rule of law, improve health and education, subsidize research and development, and provide incentives for savings and investment.

Key Terms Catch-up, p. 192. The prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries.

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Economic growth model, p. 181. A model that explains growth rates in real GDP per capita over the long run.

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CHAPTER 7 | Long-Run Economic Growth: Sources and Policies Foreign direct investment (FDI), p. 201. The purchase or building by a corporation of a facility in a foreign country.

technological change is influenced by economic incentives and so is determined by the working of the market system.

Foreign portfolio investment, p. 201. The purchase by an individual or a firm of stocks or bonds issued in another country.

Patent, p. 187. The exclusive right to produce a product for a period of 20 years from the date the patent is applied for.

Globalization, p. 201. The process of countries becoming more open to foreign trade and investment.

Per-worker production function, p. 182. The relationship between real GDP per hour worked and capital per hour worked, holding the level of technology constant.

Human capital, p. 182. The accumulated knowledge and skills that workers acquire from education and training or from their life experiences.

Industrial Revolution, p. 176. The application of mechanical power to the production of goods, beginning in England around 1750.

Labour productivity, p. 181. The quantity of goods and services that can be produced by one worker or by one hour of work.

Property rights, p. 198. The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

Rule of law, p. 198. The ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts.

Technological change, p. 181. A change in the quantity of output a firm can produce using a given quantity of inputs.

New growth theory, p. 186. A model of longrun economic growth that emphasizes that

Chapter Outline What Explains Slow Growth in Mexico?

More than 2500 Canadian companies and more than 18,000 US companies (including Bombardier, ScotiaBank and many Fortune 500 firms) chose to locate production in Mexico. In the last couple of years, announcements by Canadian and US firms about moving operations to Mexico have received increased attention than they might have otherwise, because US economic relations with Mexico were a key part of the 2016 US presidential campaign. President Donald Trump vowed to renegotiate the North American Free Trade Agreement (NAFTA), the 1994 agreement among the governments of Canada, Mexico, and the United States that reduced barriers to trade in goods and services among the three countries. In particular, President Trump objected to the fact that NAFTA had made it easier for US firms to ship products to the United States from factories in Mexico. Even without pressure from the Trump administration, moving operations to Mexico could be risky for Canadian (and US) firms because of problems with organized crime and corruption. As a result of attacks on its employees, Coca-Cola suspended operations in Chilpancingo. Some local Mexican firms are reluctant to expand because they fear criminal gangs and corrupted government inspectors. These indicate that the Mexican government has failed to fully establish the rule of law, particularly with respect to the consistent enforcement of property rights. Without the rule of law, entrepreneurs cannot fulfill their role in the market system of bringing together the factors of production to produce goods and services.

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7.1

Economic Growth over Time and around the World (pages 176-181) Learning Objective: Define economic growth, calculate economic growth rates, and describe global trends in economic growth.

A. Economic Growth from 1 000 000 BCE to the Present No sustained economic growth occurred between 1 000 000 BCE and 1300 CE. Significant growth did not begin until the Industrial Revolution. The Industrial Revolution refers to the application of mechanical power to the production of goods, beginning in England around 1750. Before that time, production of goods had relied almost exclusively on human or animal power. First England, and then other countries such as Canada, the United States, France, and Germany, experienced long-run economic growth with sustained increases in real GDP per capita.

B. Small Differences in Growth Rates Are Important Because of compounding, in the long run small differences in economic growth rates result in big differences in living standards.

C. Why Do Growth Rates Matter?

Growth rates matter because an economy that grows too slowly fails to raise living standards. In some countries in Africa and Asia, very little economic growth has occurred in the past 50 years, resulting in severe poverty.

D. “The Rich Get Richer and …”

The world can be divided into two groups: the high-income countries (or the industrial countries) and the poorer countries (or developing countries). The high-income countries include the countries of Western Europe, Australia, Canada, Japan, New Zealand, and the United States. The developing countries include most of the countries of Africa, Asia, and Latin America. In the 1980s and 1990s, a small group of countries, mostly East Asian countries such as Singapore, South Korea, and Taiwan, experienced high growth rates and are referred to as the newly industrializing countries.

Extra Solved Problem 7.1 Economic Growth in the Canada since 1981 Figure 7.1 in the textbook shows that the world’s average annual growth rate of real GDP per capita was 1.3 percent in the period 1800 to 1900, 2.3 percent from 1900 to 2000 and 1.6 percent from 2000 to 2015.

Statistics Canada has estimated that the real gross domestic product (in 2007 prices) of Canada in 1981 was $789.8 billion. The table below shows what real GDP would be for 1982, assuming that the growth rate of real GDP was 1.3 percent, 2.3 percent, and 3.3 percent from 1981 to 1982. The estimated values for 1982 were obtained by multiplying $789.8 billion by 1.013, 1.023 and 1.033, respectively.

Estimated Real GDP for Canada for Various Growth Rates 1.3%

2.3%

3.3%

1982 $800.1 billion $808.0 billion $815.9 billion

The differences in estimated real GDP for 1982 seem small, but how different would GDP be if these growth rates continued through 2012? .

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CHAPTER 7 | Long-Run Economic Growth: Sources and Policies Estimate real GDP for Canada if, from 1982 to 2012, the economy grew at three different growth rates: (a) 1.3 percent annually, (b) 2.3 percent annually, and (c) 3.3 percent annually.

Source: Statistics Canada Table 380-0064.

Solving the Problem Step 1:

Review the chapter material.

This problem is about the importance of economic growth over time, so you may want to review the section “Economic Growth over Time and around the World,” which begins on page 176 in the textbook.

Step 2:

Answer the problem by estimating real GDP for Canada if, from 1982 to 2012, the economy grew at three different growth rates: (a) 1.3 percent, (b) 2.3 percent, and (c) 3.3 percent.

The table below shows what real GDP would be in 2012 if real GDP grew at the three different rates.

Estimated Real GDP for Canada for Various Growth Rates 1.3%

2.3%

3.3%

2012 $1,178.7 billion $1,598.3 billion $2,160.9 billion The actual real GDP for 2012 was $1,302 billion, which corresponds to approximately 1.6 percent growth rate. This is about 60% of the estimated real GDP when assuming a 3.3 percent rate of growth, and is 81% of the estimated real GDP assuming a 2.3 percent rate of growth. These calculations show how apparently small differences in growth rates, compounded for just 31 years, can result in very different levels of real GDP.

7.2

What Determines How Fast Economies Grow? (pages 181-188) Learning Objective: Use the economic growth model to explain why growth rates differ across countries.

The economic growth model explains growth rates in real GDP per capita over the long run. This model focuses on the causes of long-run increases in labour productivity, which is the quantity of goods and services that can be produced by one worker or by one hour of work. Economists believe that two key factors determine labour productivity: the quantity of capital available to workers and the level of technology. Technological change is a change in the quantity of output a firm can produce using a given quantity of inputs. There are three main sources of technological change: 1. Better machinery and equipment, such as the steam engine and computers.

2. Increases in human capital, which is the accumulated knowledge and skills that workers acquire from education and training or from their life experiences.

3. Better means of organizing and managing production, such as the just-in-time system that involves assembling goods from parts that arrive at the factory at the exact time needed.

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CHAPTER 7 | Long-Run Economic Growth: Sources and Policies A country’s standard of living will be higher the more capital workers have available on their jobs, the better the capital, the more human capital workers have, and the better job business managers do in organizing production.

A. The Per-Worker Production Function The economic growth model can be illustrated by using the per-worker production function, the relationship between real GDP per hour worked and capital per hour worked, holding the level of technology constant. Increases in the quantity of capital per hour worked result in movements up the perworker production function, increasing the quantity of output each worker produces. Equal increases in the amount of capital per hour worked lead to diminishing increases in output per hour worked. This effect results from the law of diminishing returns: The addition of one more unit of one input to a fixed quantity of another input makes output increase by smaller additional amounts.

B. Which Is More Important for Economic Growth: More Capital or Technological Change?

Technological change helps economies avoid diminishing returns to capital.

C. Technological Change: The Key to Sustaining Economic Growth Technological change shifts up the production function and allows an economy to produce more real GDP per hour worked with the same quantity of capital per hour worked. In the long run, a country will experience an increasing standard of living only if it experiences continuing technological change.

D. New Growth Theory The new growth theory is a model of long-run economic growth that emphasizes that technological change is influenced by economic incentives and so is determined by the working of the market system.

Paul Romer, who developed the new growth theory, argues that the rate of technological change is influenced by how individuals and firms respond to economic incentives. Firms add to an economy’s stock of knowledge capital when they engage in research and development or otherwise contribute to technological change. Romer argues that the accumulation of knowledge capital is subject to diminishing returns at the firm level, but at the level of the entire economy, knowledge capital is subject to increasing returns. The use of knowledge capital is nonrival because one firm’s use of that knowledge does not prevent another firm from using it. Romer points out that firms are unlikely to engage in research and development up to the point where the marginal cost of the research equals the marginal return from the knowledge gained because other firms will gain much of the marginal return. Government policy can help increase the accumulation of knowledge capital in three ways: 1. Protecting intellectual property with patents and copyrights. A patent is the exclusive right to produce a new product for a period of twenty years from the date the patent is applied for.

2. Supporting research and development. Government can conduct research directly, can subsidize research in universities, and can provide tax credit to firms that invest in R&D. 3. Subsidizing education.

These policies can bring the accumulation of knowledge capital closer to the optimal level.

E. Joseph Schumpeter and Creative Destruction The new growth theory has revived interest in the ideas of Joseph Schumpeter. Schumpeter developed a model of growth that emphasized his view that new products drive older products—and the firms that produce them—out of the market. For Schumpeter, the key to rising living standards is not small changes

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CHAPTER 7 | Long-Run Economic Growth: Sources and Policies in existing products but new products that meet consumer wants in qualitatively different ways. The entrepreneur is central to economic growth. Successful entrepreneurs can use their profits to finance the development of new products.

7.3

Economic Growth in Canada (pages 188-192) Learning Objective: Discuss fluctuations in productivity growth in Canada.

The economic growth model can help us understand the record of growth in Canada.

A. Economic Growth in Canada since 1950 Productivity in Canada grew rapidly from the end of World War II until the mid-1970s. Growth then slowed down for 20 years. Beginning in the mid-1990s, the growth rate declined again, though it remained at roughly the same rate as for the 1973 to 1994 period.

B. Is Canada Headed for a Long Period Slow Growth?

1. Economists have not reached a consensus. Economists’ views fall into two camps 2. The optimistic view: Although productivity has become more difficult to measure, in the long run rates of productivity will remain high.

3. The pessimistic view: Productivity growth entered a long-run decline in the mid-1970s, partly overcome for a brief period of time by the initial effects of the revolution in information technology.

Some economists argue that the development of information technology caused the productivity growth that began in the mid-1990s. As computers become more accessible, they made it possible for people and organizations to communicate and process data more efficiently. Faster data processing has had a major effect on nearly every firm. Developments in IT have significantly increased labour productivity.

Despite this, productivity growth since 1995 is similar to productivity growth from mid-1970s to the mid1990s. Is IT not a productivity booster, or are the data not capturing some of the IT’s benefits? Some argue that developments in IT have improved the delivery of services to both consumers and firms in ways the GDP statistics fail to capture. Others doubt that the unmeasured benefits of the IT revolution are any greater than the unmeasured benefits of earlier innovations.

Extra Solved Problem 7.3 Canadian Productivity Growth and Employment The textbook describes the productivity slowdown from 1974 to 1995 in which the annual growth rate of real GDP per hour worked in Canada was more than 1 percentage points per year lower than during the 1950 to 1973 period. Although the reasons for this anemic growth are still not certain, the economic growth picked up again to an annual average rate of 2.4 percent from 1996 to 2005. Many economists argued that the effects of the revolution in information technology (IT), including increased use of computers, software, cell phones, and related innovations, were causing a return to higher rate of long-run growth. But then, beginning in 2006, growth again slowed. The economic expansion that began after the 2001 recession was frequently referred to as a “jobless recovery” in newspaper and magazine articles.

Some observers argued that faster productivity growth allowed employers to increase production without increasing employment. Although employment growth subsequently increased, the concern expressed for workers’ jobs highlights two different views of productivity. In the US Federal Reserve Bank of San Francisco’s Economic Letter, Carl Walsh wrote,

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CHAPTER 7 | Long-Run Economic Growth: Sources and Policies If higher productivity allows firms to shed workers, how can it raise wages and living standards? If productivity does lead to improved wages and living standards, why do so many feel the recent productivity growth has left workers behind?

Walsh notes that productivity growth and changes in technology cause structural changes that result in increased production and employment in some industries and reductions in production and employment in other industries. For example, the growth in demand for word processors and personal computers resulted in a decline in the demand for typewriters and some types of office workers. Small changes in overall employment mask what often are large increases in employment and unemployment in individual industries. In other words, the negative effect of productivity on employment occurs in the short run, while the positive effect of productivity on employment occurs in the long run.

Source: Carl E. Walsh, “The Productivity and Jobs Connection: The Long and the Short of It.” FRBSF Economic Letter. July 16, 2004.

The average annual growth rate of real GDP per hour worked from 1950 to 1973 was 2.7 percent.

Examine the fluctuations in the annual unemployment rate for this period in Figure 7.5 in the textbook. Is the behaviour of the unemployment rate consistent with Carl Walsh’s explanation of the effect of productivity growth on employment when we look at Canadian data?

Solving the Problem Step 1:

Review the chapter material.

This problem is about fluctuations in productivity growth, so you may want to review the section “Economic Growth in Canada,” which begins on page 188 in the textbook.

Step 2:

Answer the problem by explaining whether the behaviour of the unemployment rate is consistent with Carl Walsh’s explanation of the effect of productivity growth on employment.

Yes, Walsh’s explanation is consistent with the behaviour of unemployment. Despite the relatively large increases in productivity from 1950 to 1973, the rate of unemployment did not have an upward trend. Most of the fluctuation in the unemployment rate occurred as a result of business cycle fluctuations. This observation is consistent with the argument that increases in productivity lead to increased employment in the long run by raising the real wage workers receive. Other data are needed to show how much total employment changed and which industries experienced job gains and job losses.

Extra Productivity Gains Help Make US Manufacturers More Apply the Competitive Concept It’s a story all too familiar to many Americans: Caterpillar, the world’s largest manufacturer of construction and industrial mining equipment, tried to persuade workers at one of the company’s North American locomotive-assembly plants to accept lower wages in order to reduce its wage and benefit costs, which were much higher than they were at a Caterpillar plant in another country. What was different about the story was the location of the two plants: Wage and benefit costs at Caterpillar’s railequipment plant in LaGrange, Illinois, were less than half of those at the company’s locomotive-assembly plant in Ontario. Navistar International Corp., formerly the International Harvester Company, manufactures diesel engines, buses, and other business equipment. Navistar also sought to lower costs at its plant in Ontario. After failing to reach an acceptable agreement for more-flexible work rules and lower wage costs with the Canadian Auto Workers, the company decided to relocate the plant to Springfield, Ohio. Navistar’s Chief Executive Dan Ustian commented, “I am a firm believer that North America and .

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CHAPTER 7 | Long-Run Economic Growth: Sources and Policies the US can be very competitive in manufacturing, especially when it is a technical kind of job.”

Bridgestone Corp. of Japan spent over $1 billion to expand a plant in South Carolina that makes radial tires. Gary Garfield, CEO of Bridgestone’s Americas unit, explained that the higher productivity of US workers trumped lower labour costs in other potential plant locations in Mexico or other Latin American countries.

What has made US manufacturers more efficient and more competitive in recent years? The recession of 2007–2009 slowed the growth of wages, and many firms have incorporated flexible work practices and increased automation in order to increase productivity. As a result, US productivity in 2010 grew by more than 4 percent and averaged over 2.5 percent over the previous ten years. Labour costs actually decreased by 13 percent among US manufacturers from 2000 to 2010. Over this same period, unit labour costs rose in Germany (by 2.3 percent), in Canada (by 18 percent), and in South Korea (by 15 percent). Other factors that contributed to holding down US manufacturing costs include lower energy prices, due mostly to increased production of natural gas from shale, and a lower exchange rate for the dollar.

A report by the Conference Board of Canada suggests that Canada’s lower productivity, relative to the United States is a result of lower levels of innovation in this country as well as lower levels of investment in both human and physical capital particularly with respect to STEM subjects and information and communications technology.

Sources: James R. Haberty and Kate Linebaugh, “In U.S., a Cheaper Labor Pool,” Wall Street Journal, January 6, 2012; Erik Brynjolfsson, “Not All the Economic News is Bad,” digitopoly.org, October 27, 2011, and “Labour Productivity Growth” The Conference Board of Canada 2013.

7.4

Why Isn’t the Whole World Rich? (pages 192-201) Learning Objective: Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth.

The economic growth model tells us that economies grow when the quantity of capital per hour worked increases and when technological change occurs. The profitability of using additional capital or better technology is generally greater in a developing country than in a high-income country. The economic growth model predicts that poor countries will grow faster than rich countries. Catch-up is the prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries. The paradox is that lower-income industrial countries have been catching up to the higherincome industrial countries, but the developing countries as a group have not been catching up to the high-income countries as a group.

A. Catch-up: Sometimes but Not Always You can use a graph to illustrate whether catch-up is happening. The initial level of GDP per capita is measured along the horizontal axis and the vertical axis shows the rate at which GDP per capita is growing. Low-income countries should be in the upper-left part of the graph and high-income countries should be in the lower-right part of the graph. Some countries that had low levels of real GDP per capita in 1960, such as Niger and the Democratic Republic of the Congo, had lower levels of real GDP per capita in 2014 than in 1960. Other countries that started with low levels of real GDP per capita, such as Malaysia and China, grew rapidly. In the textbook, see Figure 7.7 and Figure 7.8.

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B. Why Haven’t Most Western European Countries, Canada, and Japan Caught Up to the United States?

Over the past 20 years, other high-income countries have fallen further behind the United States. Real GDP per capita in Canada, Japan, and the five largest countries in Western Europe increased relative to the United States between 1960 and 1990, but none of these countries has experienced catch-up since 1990. Many economists believe there are two explanations for the failure of these countries to catch-up with the United States: The greater flexibility of US labour markets and the greater efficiency of the US financial system. The US financial system suffered severe problems between 2007 and 2009. But, over the long run, it has succeeded in efficiently allocating investment funds.

C. Why Don’t More Low-Income Countries Experience Rapid Growth?

Some poor countries do not experience rapid growth for four main reasons: 1. Failure to enforce the rule of law, which is the ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts 2. Wars and revolutions 3. Poor public education and health 4. Low rates of saving and investment Property rights are the rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

D. The Benefits of Globalization One way for a developing country to break out of the vicious cycle of low saving and investment and low growth is through foreign investment. Foreign direct investment (FDI) is the purchase or building by a corporation of a facility in a foreign country. Foreign portfolio investment is the purchase by an individual or a firm of stock or bonds issued in another country. Globalization is the process of countries becoming more open to foreign trade and investment.

7.5

Growth Policies (pages 201-204) Learning Objective: Discuss government policies that foster economic growth.

A. Enhancing Property Rights and the Rule of Law A market system cannot work well unless property rights are enforced. Entrepreneurs are unlikely to risk their own funds, and investors are unlikely to lend their funds to entrepreneurs, unless property is safe from being arbitrarily seized. In many developing countries, the rule of law and property rights are undermined by corruption. Research has shown that countries where corruption is most widespread grow much more slowly than countries where corruption is less of a problem.

B. Improving Health and Education As people’s health improves and they became stronger, and less susceptible to disease, they also become more productive. Many economists believe that government subsidies to education have played an important role in promoting economic growth.

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CHAPTER 7 | Long-Run Economic Growth: Sources and Policies The rising incomes that result from economic growth can help developing countries deal with brain drain.

Brain drain refers to highly educated and successful individuals leaving developing countries for highincome countries.

C. Policies That Promote Technological Change Government policies that facilitate access to technology are crucial for low-income countries. The easiest way for developing countries to gain access to technology is through foreign direct investment. In highincome countries, government policies can aid the growth of technology by subsidizing research and development.

D. Policies That Promote Saving and Investment Governments can increase incentives for firms to engage in investment in physical capital by using investment tax credits. These credits allow firms to deduct from their taxes some fraction of the funds they have spent on investment.

E. Is Economic Growth Good or Bad? The arguments against further economic growth tend to be motivated either by concern about the effects of growth on the environment or by concern about the effects of the globalization process that has accompanied economic growth in recent years. Economic analysis can contribute to the debate over the consequences of economic growth, but it cannot resolve the issue.

Extra Solved Problem 7.5 What Is the Proper Role for Government in Promoting Growth?

One popular explanation for the persistent poverty of developing nations is a lack of natural resources.

But Hong Kong and Japan have relatively few natural resources, yet both experienced more rapid economic growth in recent decades than nations with abundant supplies of resources. Economist Paul Romer has argued that it is ideas, not natural resources, that poor countries lack most: “If a poor nation invests in education and does not destroy the incentives for its citizens to acquire ideas from the rest of the world, it can rapidly take advantage of the publicly available part of . . . knowledge.”

In Canada and developed countries most economists support three government policies that encourage the production and dissemination of new knowledge: ▪ ▪ ▪

Subsidies for education Competitive grants for basic research Patents and copyrights

Romer warns that it is important to limit government’s power over economic policy. He states that most economists favour government subsidies for education and private research, but if government officials have power over economic policy, they may use that power to divert the results of research to narrow special interests.

Source: Paul M. Romer, “Economic Growth,” The Concise Encyclopedia of Economics. https://www.econlib.org/library/Enc1/EconomicGrowth.html

a. Why do economists believe that government should subsidize education and basic research? b. Paul Romer warns that government officials may use their power to divert the results of research to narrow special interests. Explain Romer’s concern.

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CHAPTER 7 | Long-Run Economic Growth: Sources and Policies

Solving the Problem Step 1:

Review the chapter material.

This problem is about policies that can foster economic growth, so you may want to review the section “Growth Policies,” which begins on page 201 in the textbook.

Step 2:

Answer part (a) by explaining why economists believe that government should subsidize education and basic research.

Private firms have little incentive to invest resources in activities that, if successful, are not profitable. The social returns to investment in education and basic research are significant, but these returns are spread throughout the economy. Therefore, firms may not undertake research that would increase economic growth and benefit the whole economy because the research would not be profitable for the firms. A government subsidy may be necessary to provide firms with the incentive to invest in basic research.

Step 3:

Answer part (b) by explaining Paul Romer’s concern that government officials may use their power to divert the results of research to narrow special interests.

Elected officials are likely to favour projects that are located in their own provinces or districts rather than projects that have the greatest social returns. For example, politicians from Quebec are apt to favour subsidies for milk and cheese production because the subsidy benefits dairy farmers in their province.

Extra The Role of Local Government in Promoting Economic Apply the Growth in China Concept For over two decades, economic growth in China has been among the highest of any nation, often exceeding 7 to 9 percent annually. A key to achieving economic growth in a market economy is protection of rights to private property. However, China has a relatively weak judicial system and a poor property rights environment. An explanation for China’s success in attracting private investment despite a poor track record in protecting property rights is offered by X. Zhang, who argues that local Chinese governments engage in vigorous competition for investment that benefits their own jurisdictions. The uncertainty of doing business is very high, and as a result, the cost of completing contracts is high as well.

To overcome these obstacles, businesses often partner with local government officials who work hard to provide a stable environment for these businesses and provide protection from local government regulations. The result is strong protection for investors within a weak system of protection of property rights for rural landowners. Farmers and other Chinese citizens are often forced to sell their rights to land for allegedly “public purposes”—that is, for new private businesses. Although this system has produced considerable prosperity for China, it has come at the expense of increased social tension, especially among current and former landowners. It may be difficult to sustain China’s high rate of economic growth far into the future without addressing this potential source of social conflict.

Source: Karol Boudreaux and Paul Dragos Aligica, “Legislation and creation by fiat,” in Paths to Property (London: The Institute of Economic Affairs, 2007), pp. 65–66.

Extra Economics in Your Life and Career: Can Economic Growth in China Have an Impact on You? Question: China has been enjoying higher economic growth for the past decade than has Canada. How can China’s rapid economic growth affect your welfare (assuming you live in Canada)?

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CHAPTER 7 | Long-Run Economic Growth: Sources and Policies Answer: The fact that China is experiencing rapid economic growth allows firms located in China to manufacture more products at a lower cost. So consumers in Canada are able to buy lower-priced imports from China, while growing prosperity in China will encourage consumers and firms to buy more products from other countries, including Canada. Of course, some firms and workers in Canada will be made worse off if these firms close as a result of competition from Chinese firms.

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run Brief Chapter Summary and Learning Objectives The Keynesian income-expenditure approach (the “45°-line diagram” or “Keynesian cross”) is useful for introducing students to the short-run relationship between spending and production. Many instructors, however, prefer to omit this material. Therefore, the textbook uses the 45°-line diagram only in Chapter 8: Aggregate Expenditure and Output in the Short Run. The discussion of monetary and fiscal policy in later chapters uses only the AD-AS model, making it possible for instructors to skip Chapter 9.

8.1

The Aggregate Expenditure Model (pages 214-218) Understand how macroeconomic equilibrium is determined in the aggregate expenditure model.

▪

8.2

The aggregate expenditure model focuses on the relationship between total spending and real GDP in the short run, assuming the price level is constant.

Determining the Level of Aggregate Expenditure in the Economy (pages 218-231) Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save.

▪

8.3

The most important determinant of consumption is the current disposable income of households. Investment spending, unlike consumption, does not follow a smooth upward trend.

Graphing Macroeconomic Equilibrium (pages 231-237) Use a 45-line diagram to illustrate macroeconomic equilibrium.

▪

8.4

The 45°-line diagram shows all the points where aggregate expenditure equals real GDP. On the 45°-line diagram, macroeconomic equilibrium occurs where the line representing the aggregate expenditure function crosses the 45° line.

The Multiplier Effect (pages 237-243) Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. ▪

.

An autonomous change in expenditure will cause rounds of induced changes in expenditure. Therefore, an autonomous change in expenditure will have a multiplier effect on equilibrium GDP.

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

8.5

The Aggregate Demand Curve (pages 243-245) Understand the relationship between the aggregate demand curve and aggregate expenditure.

▪

The aggregate demand curve shows the relationship between the price level and the level of aggregate expenditure, holding constant all factors that affect aggregate expenditure other than the price level.

Appendix: The Algebra of Macroeconomic Equilibrium (252-253) Apply the algebra of macroeconomic equilibrium.

Key Terms Aggregate demand (AD) curve, p. 245. A curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure.

Aggregate expenditure (AE), p. 214. Total spending in the economy: the sum of consumption, planned investment, government purchases, and net exports.

Aggregate expenditure model, p. 215. A macroeconomic model that focuses on the shortrun relationship between total spending and real GDP, assuming that the price level is constant.

Consumption function, p. 222. The relationship between consumption spending and disposable income.

Inventories, p. 216. Goods that have been produced but not yet sold.

Liability, p. 219. Anything owed by a person or a firm.

Marginal propensity to consume (MPC), p. 222. The slope of the consumption function: The amount by which consumption spending changes when disposable income changes.

Asset, p. 219. Anything of value owned by a person or a firm.

Marginal propensity to save (MPS), p. 225.

The amount by which saving changes when disposable income changes.

Autonomous consumption, p. 222. The level of consumption that occurs no matter what disposable income is.

Multiplier, p. 238. The increase in equilibrium real GDP divided by the increase in autonomous expenditure.

Autonomous expenditure, p. 237. An expenditure that does not depend on the level of GDP.

Multiplier effect, p. 238. The process by which an increase in autonomous expenditure leads to a larger increase in real GDP.

Cash flow, p. 227. The difference between the cash revenues received by a firm and the cash spending by a firm.

Nominal interest rate, p. 220. The stated interest rate on a loan.

Real interest rate, p. 220. The nominal interest rate minus the inflation rate.

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

Chapter Outline Fluctuating Demand at Tim Hortons Tim Hortons coffee is part of Canadian culture. There is a Tim Hortons outlet in just about every small town in the country, and it’s hard to go to a rink or a mall and not see someone taking a sip from that famous brown paper cup. Just like most other businesses, Tim Hortons outlets have to worry about the wider economy. When people lose their jobs or are worried about their financial future, they tend to cut back on spending. Tim Hortons has seen its sales fall in many of the small Canadian towns where the area’s main employer has shut down or scaled back operations due to the sluggish Canadian and American economies. Tim Hortons and other firms experience swings in sales and revenue as a result of fluctuations in total amount of spending, or aggregate expenditure, in the economy.

8.1

The Aggregate Expenditure Model (pages 214-218) Learning Objective: Understand how macroeconomic equilibrium is determined in the aggregate expenditure model.

We begin exploring the causes of the business cycle by examining the effect of changes in total spending on real GDP. Aggregate expenditure (AE) is total spending in the economy: the sum of consumption, planned investment, government purchases, and net exports. The aggregate expenditure model is a macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant. The key idea of the model is that in any particular year, the level of GDP is determined mainly by the level of aggregate expenditure.

A. Aggregate Expenditure In 1936, the English economist John Maynard Keynes published a book, The General Theory of Employment, Interest, and Money, that analyzed the relationship between changes in aggregate expenditure and changes in GDP. Keynes identified four components of aggregate expenditure that together equal GDP: •

Consumption (C). Spending by households on goods and services.

•

Planned Investment (I). Planned spending by firms on capital goods and by households on new homes.

•

Government Purchases (G). Spending by local, state, and federal governments on goods and services.

•

Net Exports (NX). Spending by foreign firms and households on goods and services produced in Canada minus spending by Canadian firms and households on goods and services produced in other countries.

We can write Aggregate expenditure = Consumption + Planned Investment + Government purchases + Net exports or AE = C + I + G + NX.

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

B. The Difference between Planned Investment and Actual Investment Inventories are goods that have been produced but not yet sold. For the economy as a whole, we can say that actual investment spending will be greater than planned investment spending when there is an unplanned increase in inventories. Actual investment spending will be less than planned investment spending when there is an unplanned decrease in inventories. Actual investment will equal planned investment only when there is no unplanned change in inventories.

C. Macroeconomic Equilibrium For the economy as a whole, macroeconomic equilibrium occurs where total spending, or planned aggregate expenditure, equals total production, or GDP: Planned aggregate expenditure = GDP.

D. Getting to Macroeconomic Equilibrium When aggregate expenditure is greater than GDP, inventories will decline, and GDP and total employment will increase. When aggregate expenditure is less than GDP, inventories will increase, and GDP and total employment will decrease. Only when aggregate expenditure equals GDP will firms sell what they expected to sell. In this case, their inventories will be unchanged, and they will not have an incentive to increase or decrease production. The economy will be in macroeconomic equilibrium. When economists forecast that aggregate expenditure is likely to decline, the federal and provincial governments may implement macroeconomic policies in an attempt to head off the fall in expenditure and keep the economy from falling into recession.

Teaching Tips Table 8.1 summarizes the important relationship between aggregate expenditure and GDP. It will help your students understand macroeconomic equilibrium if you briefly review how equilibrium is achieved in a market for a good or service. Remind students how price adjusts to return a market to equilibrium if there is a shortage or surplus in a market. In contrast, in the aggregate expenditure model, prices are constant and changes in inventories adjust to return the macro economy to equilibrium.

Extra Changes in Inventory Spending Offer Preview Apply the of Future GDP Growth Concept Changes in inventories are a small part of total gross domestic product. In 2014, for example, the real value of changes in private inventories equaled $68.0 billion, less than one-half of one percent of GDP. Nevertheless, inventory changes are often an important indicator of the future direction of GDP. In all recessions, as consumer spending slows, firms become reluctant to order new goods, so they sell from their inventories. With consumer demand uncertain, inventories fell for six straight quarters during the 2007–2009 recession, the longest such decline in the United States since 1948. Spending on inventories finally began to rise in the first quarter of 2010. (See table below.) Analysts interpreted the increase in inventory spending as a sign that companies would eventually begin to hire more workers.

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run Change in Inventories (billions of dollars, seasonally adjusted at annual rates) 2009 I II III IV I −179.5 −200.5 −197.1 −66.1 44.3

2010 II III 78.1 106.7

IV 38.7

2011 I II III 62.0 53.6 0.8

As workers earn more income, they spend more, leading to an increase in consumption, which is the largest component of GDP. “That’s how recoveries become self-sustaining,” says Dean Maki, chief U.S. economist at Barclays Capital. In fact, growth of real GDP began to increase in the third quarter of 2009, though only at a meagre 1.7 percent. (See table that follows.) The recession of 2007–2009 officially ended in June 2009, so the third quarter of 2009 marked the beginning of the business cycle expansion that followed.

Percentage Change in Real GDP (seasonally adjusted at annual rates) 2009 2010 2011 I II III IV I II III IV I II III 1.7 3.8 3.9 3.8 2.5 2.3 0.4 1.3 1.8 −6.7 −0.7 Data from U.S. Bureau of Economic Analysis The increase in inventories that continued through the third quarter of 2011 coincided with increases in the growth rate of real GDP, as analysts had expected. But GDP growth stalled in 2011, rising only 0.4 percent in the first quarter, leading some to wonder if the economy was heading to another recession.

These fears faded in the second half of 2011 as GDP growth rose, though still by less than 2 percent.

Analysts were encouraged by the fact that spending on inventories did not decrease. This was consistent with firmness in consumer spending in the third quarter, and a sign that that GDP growth in the near future could be stronger.

Sources: Kelly Evans, “After the Tape: Don’t Ignore the Inventory Effect on GDP,” Wall Street Journal, January 29, 2010; Lucia Mutikani, “Third-Quarter Growth Cut on Weak Inventories,” Reuters, November 22, 2011; and U.S. Bureau of Economic Analysis.

The situation in Canada was similar.

Canadian Data 2009 I

–2,364

II

2010 III

–7,779 –5,464

IV

I

II

III

–4,807 2,663 –2,508 4,841

IV

I

2011 II

III

–6,805 8,965 12,153 6,462

Statistics Canada Table 380-0069 (millions of dollars) Chained (2007) prices. Seasonally adjusted.

Percentage Change in Real GDP (seasonally adjusted at annual rates) 2009 2010 2011 I II III IV I II III IV I II III 0.5 -0.2 1.5 −2.2 −0.9 0.5 1.3 1.4 0.7 0.5 1.1 Data from Statistics Canada Table 380 0064

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

Extra Solved Problem 8.1 Ace Computers and Aggregate Expenditure Suppose that Ace Computers, Inc., produces $500 million of new computers in Canada for 2019. Ace sells computers to households, private firms, and local and provincial government agencies in Canada.

Some of Ace’s sales are to households, firms, and government agencies in the United States. The following table represents three different scenarios for Ace Computers’ sales.

Sales to:

Scenario 1

Scenario 2

Scenario 3

Households

$200 million

$250 million

$300 million

Private firms

50 million

50 million

50 million

Government

100 million

100 million

100 million

United States

100 million

100 million

100 million

Total sales

$450 million

$500 million

$550 million

a. What is the contribution of Ace Computers to Canadian GDP for 2019 under each of the three scenarios? b. Based on the sales figures, predict how Ace Computers would change its rate of output in 2020 in each of the three scenarios. c. Use this example to describe how macroeconomic equilibrium is achieved in the aggregate expenditure model.

Solving the Problem Step 1:

Review the chapter material.

This problem is about aggregate expenditure, so you may want to review the section “The Aggregate Expenditure Model,” which begins on page 214 in the textbook.

Step 2:

Explain Ace Computer’s contribution to GDP for 2019 under each of the scenarios.

Ace Computers’ sales contribute to consumption (C, sales to households), planned investment (I, sales to private firms), government purchases (G), and net exports (NX). In addition, unplanned investment (I) occurs when there are changes in inventories.

Scenario 1 C

Scenario 2

Scenario 3

$200 million $250 million

$300 million

I

50 million

50 million

50 million

G

100 million

100 million

100 million

NX

100 million

100 million

100 million

$450 million $500 million

$550 million

Total expenditures

Change in inventories +$50 million Contribution to GDP

$0 million −$50 million

$500 million $500 million

$500 million

Total expenditures on Ace Computers are $450 million, $500 million, and $550 million in Scenarios 1, 2, and 3, respectively. The contribution of Ace Computers to Canadian GDP in 2019 is equal to $500 million in each scenario.

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

Step 3:

Use the sales figures to predict how Ace Computers would change its rate of output in 2020 in each of the three scenarios.

In Scenario 1, Ace will likely decrease its rate of output in 2020 because sales were only $450 million. The firm may want to sell the $50 million of computers produced, but not sold, before producing more computers in 2020. In Scenario 2, there is no reason why Ace would change its rate of output from 2019 to 2020 because Ace sold exactly what it produced. In Scenario 3, the sales of Ace Computers exceeded what was produced in 2019 (sales in 2019 included $50 million worth of computers produced in 2018), so it will likely increase its rate of output in 2020.

Step 4:

Use the Ace Computers example to describe how macroeconomic equilibrium is achieved in the aggregate expenditure model.

When for a given time period total spending, or aggregate expenditure, for the entire economy equals total production, or GDP, macroeconomic equilibrium is achieved. There is no unplanned change in investment in inventories, and firms will not change their rates of output in the future. This is consistent with Scenario 2.

8.2

Determining the Level of Aggregate Expenditure in the Economy (pages 218-231) Learning Objective: Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save.

There are four components of aggregate expenditure. Each component is measured in real terms.

Consumption is the largest component of aggregate expenditure.

A. Consumption The following are the five most important variables that determine the level of consumption: current disposable income, household wealth, expected future income, the price level, and the interest rate.

The consumption function is the relationship between consumption spending and disposable income.

Autonomous consumption refers to the level of consumption that occurs no matter what disposable income is. The marginal propensity to consume (MPC) is the slope of the consumption function: The amount by which consumption spending changes when disposable income changes. We can write the expression for the MPC as MPC =

Change in consumption C . = Change in disposable income YD

B. The Relationship between Consumption and National Income Consumption spending by households depends on disposable income, but we want to focus on the relationship between consumption spending and GDP. The difference between GDP and national income is small and can be ignored. Disposable income is equal to national income plus transfer payments minus taxes. Taxes minus government transfer payments are equal to net taxes so we can write Disposable income = National income – Net taxes.

This equation can be rearranged as National income = GDP = Disposable income + Net taxes.

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

C. Income, Consumption, and Saving For the economy as a whole, National income = Consumption + Saving + Taxes.

When national income increases, there must be a combination of increases in consumption, saving, and taxes: Change in national income = Change in consumption + Change in saving + Change in taxes.

Using symbols, where Y represents national income (and GDP), C represents consumption, S represents saving, and T represents taxes, we can write: Y = C + S + T, and ΔY = ΔC + ΔS + ΔT. To simplify, we can assume that taxes are always a constant amount, so the following is also true: ΔY = ΔC + ΔS. We can define the marginal propensity to save (MPS) as the amount by which saving changes when disposable income changes. If we divide the previous equation by ΔY, we get

Y C S = + , Y Y Y or 1 = MPC + MPS. This equation tells us that when taxes are constant, the marginal propensity to consume plus the marginal propensity to save must always equal 1.

Consumption depends in part on the wealth of households. A household’s wealth is the value of its assets minus the value of its liabilities. An asset is anything of value owned by a person or a firm, and a liability is any debt or obligation owed by a person or firm. A recent estimate of the effect of changes in wealth on consumption spending indicates for a permanent $1 increase in household wealth, consumption spending increases by 4 to 5 cents per year.

D. Planned Investment The four most important variables that determine the level of investment are as follows: 1. Expectations of future profitability: The optimism or pessimism of firms is an important determinant of investment spending.

2. The interest rate: A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending. The nominal interest rate is the stated interest

.

8-8

CHAPTER 8 | Aggregate Expenditure and Output in the Short Run rate on a loan or a financial asset such as a bond. The real interest rate corrects the nominal interest rate for the impact of inflation and is equal to the nominal interest rate minus the inflation rate.

3. Taxes: Federal and provincial governments impose a corporate income tax on the profits corporations earn, including profits from the new buildings, equipment, and other investment goods they purchase. A reduction in the corporate income tax increases the after-tax profitability of investment spending. Investment tax incentives also increase investment spending.

4. Cash flow: Cash flow is the difference between the cash revenues received by a firm and the cash spending by the firm. The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment.

E. Government Purchases Total government purchases include all spending by federal, provincial, and local governments for goods and services.

F. Net Exports Net exports equal exports minus imports. The three most important variables that determine the level of net exports are as follows: 1. The price level in Canada relative to the price levels in other countries.

2. The growth rate of GDP in Canada relative to the growth rates of GDP in other countries.

3. The exchange rate between the dollar and other currencies.

Extra Apply the Intel Moves into Tablets and Perceptual Computing Concept Intel has a large market share in microprocessors that companies such as Apple and Dell use in their computers. Spending on durable goods, such as computers, follows the business cycle. During recessions, firms and households reduce spending on computers because they can often continue for a while to use their existing computers rather than purchase new computers. As the following graph shows, purchases of information processing equipment and software declined 8 percent during the 2001 recession and 9 percent during the 2007–2009 recession.

Paul Otellini, chief executive officer of Intel until his retirement in 2013, remained optimistic about the future demand for computers, and even during the 2007–2009 recession, he began a $7 billion expansion of Intel factories in the United States. But Otellini was also concerned that Intel’s dependence on sales of microprocessors to companies like Apple and Dell made it vulnerable to sharp declines in sales during recessions. To decrease this vulnerability, Intel began to develop memory chips that could be used in portable consumer electronic devices, such as tablets and smartphones. Intel developed the Clover Trail version of its Atom microprocessor, which is a chip used in tablets that run the Windows operating system. These tablets had about a 7 percent market share in 2013. That same year, Samsung announced that it would begin using Intel chips in its tablets that use the Android operating system. Because Android tablets have more than a 40 percent market share, Intel was hoping to substantially increase its market share in chips used in tablets.

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

Intel also encouraged hardware and software developers with innovations in perceptual computing, which allows users to interact with computers through speaking, gesturing with hands and fingers, or changing facial expressions. Intel entered a partnership with Creative Technologies to develop a 3-D camera that was available in late 2013 and helped support perceptual computing. It also started a $100 million fund, which one Intel executive described as an attempt to “find companies that have those kinds of innovative breakthroughs and help get them to work.”

Whether perceptual computing will be enough to revive sales of desktop and laptop computers—and Intel chips—remains to be seen. In providing chips for tablets and smartphones, Intel faces stiff competition from existing chip suppliers, such as Qualcomm, Texas Instruments, and NVIDIA, as it attempts to become less dependent on sales of personal computers.

Sources: Eva Dou, “Intel to Invest $100 Million in Voice, Gesture Technologies,” Wall Street Journal, June 4, 2013; Claire Jim, “Intel Claims It’s Not Getting Completely Clobbered in the Table Market Anymore,” Reuters.com, June 4, 2013; Dylan McGrath, “Intel Rapidly Gaining Market Share in Tablets,” www.eetimes.com, April 29, 2013; and Jack Hough, “Intel’s Share Price Could Double,” Wall Street Journal, June 8, 2013.

Question We saw that Intel hopes to increase sales of microprocessors used in tablets and smartphones. During a recession, why would spending on these products be more stable than spending on computers?

Answer Tablets and smartphones sell at lower prices than do computers, and the quantity of these items produced and sold is much larger than the quantity of computers. During a recession, consumers would be more willing to buy lower-priced items, or upgrade these items, than they would more expensive items like computers. Computers are considered durable goods, and sales of durable goods generally decline during a recession. Many consumers consider less expensive items such as tablets and smartphones nondurable goods. During a recession, sales of nondurable goods often do not decline or do not decline by nearly as much as sales of durable goods. In addition, during recessions firms often postpone buying new computers because they can typically use older computers with only a small loss of productivity.

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8.3

Graphing Macroeconomic Equilibrium (pages 231-237) Learning Objective: Use a 45-line diagram to illustrate macroeconomic equilibrium.

We can use a 45°-line diagram to illustrate macroeconomic equilibrium. In this graph, the line represents all the points that are equal distances from both axes. Since macroeconomic equilibrium occurs where planned aggregate expenditure equals GDP, we know that all points of macroeconomic equilibrium must lie along the 45° line. Only one of the points on the 45° line will represent the actual level of equilibrium real GDP, given the actual level of planned real expenditure. To determine this point, we draw a line on the graph to show the aggregate expenditure function. For simplicity, we assume that the variables that determine the planned investment, government purchases, and net exports all remain constant, as well as the variables other than GDP that affect consumption. Where the aggregate expenditure (AE) line crosses the 45° line, planned aggregate expenditure is equal to GDP, and the economy is in macroeconomic equilibrium.

A. Showing a Recession on the 45-Line Diagram At potential GDP, firms will be operating at their normal level of capacity, and the economy will be at the natural rate of unemployment, or full employment. Planned aggregate expenditure must be high enough for equilibrium to occur at the level of potential GDP. If there is insufficient spending, equilibrium will occur at a lower level of GDP and the unemployment rate will be above the natural rate of unemployment. The shortfall in planned aggregate expenditure that leads to a recession can be measured by the vertical distance between the AE line and the 45° line at the level of potential GDP. The shortfall in aggregate expenditures is equal to the unplanned increase in inventories that would occur if the economy was initially producing a level of output equal to potential GDP. The economy will remain at a level of output less than potential GDP until there is an increase in one or more of the components of aggregate expenditure.

B. The Important Role of Inventories Whenever planned aggregate expenditure is less than real GDP, some firms will experience an unplanned increase in inventories. If firms accumulate excess inventories, then even if spending quickly returns to its normal levels, firms will have to sell these excess inventories before they can return to producing at normal levels.

C. A Numerical Example of Macroeconomic Equilibrium In forecasting real GDP, economists rely on quantitative models of the economy. Table 8.3 shows several hypothetical combinations of real GDP and planned aggregate expenditure. Macroeconomic equilibrium occurs when the sum of consumption, planned investment, government purchases, and net exports equals GDP.

Teaching Tips As noted previously, your students may better understand macroeconomic equilibrium, as shown in Figure 8.10, if you compare it to equilibrium in a market for a good or service. In each case, quantities adjust when a market, or an economy, is not in equilibrium.

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

8.4

The Multiplier Effect (pages 237-243) Learning Objective: Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP.

An increase in planned investment spending has a multiplied effect on equilibrium real GDP. In fact, any increase in autonomous expenditure will shift up the aggregate expenditure function and lead to a multiplied increase in equilibrium real GDP. Autonomous expenditure is an expenditure that does not depend on the level of GDP. In the aggregate expenditure model, planned investment spending, government spending, and net exports are all autonomous expenditures. Consumption has an autonomous component and a nonautonomous (also known as induced) component that does depend on the level of GDP. The multiplier is the increase in equilibrium real GDP divided by the increase in autonomous expenditure. The multiplier effect is the process by which an increase in autonomous expenditure leads to a larger increase in real GDP.

A. A Formula for the Multiplier The general formula for the multiplier is Multiplier =

Change in equilibrium real GDP 1 . = Change in autonomous expenditure 1 − MPC

B. Summarizing the Multiplier Effect There are four key points about the multiplier effect: 1. The multiplier effect occurs both when autonomous expenditure increases and when it decreases.

2. The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be.

3. The larger the MPC, the larger the value of the multiplier.

4. The formula for the multiplier is oversimplified because it ignores real-world complications, such as the effect that increasing GDP can have on imports, inflation, interest rates, and income taxes.

C. The Paradox of Thrift In the short run, if households save more of their income and spend less of it, aggregate expenditure and real GDP will decline. John Maynard Keynes argued that if many households decide at the same time to increase their saving and reduce their spending, they make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a recession. The lower incomes in the recession might mean that total saving does not increase, despite the attempts by many individuals to increase their saving. Keynes referred to this outcome as the paradox of thrift.

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run

8.5

The Aggregate Demand Curve (pages 243-245) Learning Objective: Understand the relationship between the aggregate demand curve and aggregate expenditure.

We expect that an increase or decrease in aggregate expenditure would affect both real GDP and the price level. There are three reasons why there is an inverse relationship between changes in the price level and changes in aggregate expenditure.

1. A rising price level decreases consumption by decreasing the real value of household wealth; a falling price level has the reverse effect.

2. If the price level in Canada rises relative to the price levels in other countries, Canadian exports will become relatively more expensive, and foreign imports will become relatively less expensive, causing net exports to fall. A falling price level in Canada will have the reverse effect.

3. When prices rise, firms and households need more money to finance buying and selling. If the money supply does not increase, the result will be an increase in the interest rate. A higher interest rate will reduce investment spending. A falling price level has the reverse effect.

The aggregate demand (AD) curve is a curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure.

Extra Solved Problem 8.5 Do Price Changes Affect Aggregate Expenditure?

When studying demand and supply, you learn that a price change is considered the most important determinant of the quantity demanded for a good or service. It may seem odd that in discussing the determinants of total spending or aggregate expenditure, the textbook states that the most important determinant of consumption is the current disposable income of households. If changes in price are important determinants of consumption in individual markets, why aren’t they important in determining total consumption expenditures? The key to answering this question is to understand the difference between a relative price change and a change in the price level, or the average of all prices. In microeconomics, a change in the price of a good or service is a relative price change. For example, if the price of bottled water falls, it is assumed that the prices of other goods and services do not change.

Because bottled water becomes less expensive compared to other items, the quantity demanded of water will increase. In macroeconomics, the focus is not on changes in prices and quantities in individual markets but changes in the economy as a whole. Therefore, when there is a change in the price level this does not refer to a change in one market but in all markets. An increase in the price level of 10 percent means there is no change in the relative price of bottled water, because all other prices have increased by 10 percent as well. But if current disposable income were to increase by 10 percent, then consumers have more income to spend on all goods and services. Economists consider this type of change to be most important in determining consumption.

Changes in aggregate expenditure do have important effects on the price level. Economists use an aggregate demand (AD) curve to analyze this relationship. This curve shows the relationship between the level of planned expenditure and the price level, holding constant other factors such as interest rates and wealth that affect aggregate expenditure. The textbook shows the aggregate demand curve as a

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run downward-sloping line, just as the demand curve for a single good or service is drawn as a downwardsloping line.

If the price level were to fall, the AD curve shows there will be an increase in planned aggregate expenditure or real GDP. One reason for this will be an increase in consumption. If relative prices do not fall as the price level falls, what would explain the increase in consumption?

Solving the Problem Step 1:

Review the chapter material.

This problem is about the relationship between the aggregate demand curve and aggregate expenditure, so you may want to review the section “The Aggregate Demand Curve,” which begins on page 243 in the textbook.

Step 2:

Answer the question by explaining why, if relative prices do not fall as the price level falls, there is an increase in consumption.

The increase in consumption can be explained by the increase in purchasing power consumers experience as a result of a lower price level. (Note that a decline in the price level, or deflation, rarely occurs over a period as long as a year. If the rate of increase in the price level is less in one year than in the previous year, this is called disinflation.) A fixed amount of wealth in the form of homes, stocks, bonds, savings accounts, and other assets will have more purchasing power as the price level falls. Consumers will use some of this increased wealth to buy goods and services.

Extra Making the “Made in China” (and the United States) Connection The following refers to trade between the two largest economies on the planet, the United States and China. The sentiments are common to all countries that think they are losing jobs as a result of imports.

Canada’s biggest trading partners as of 2018 are the United States (75% of exports and 52% of imports), China, the United Kingdom and Japan. (Source: http://www.worldstopexports.com/canadas-top-import-partners/.)

In recent years many American politicians, business managers, and ordinary citizens have expressed concern about the increasing amounts of goods sold in the United States with a “Made in China” label.

This concern has led to calls for restrictions on Chinese imports in order to boost sales of competing U.S. products. Other things being equal, spending on imports does reduce U.S. GDP and China moved ahead of Japan, Canada, and Mexico as the number one source of imports into the United States in 2010. But fears of lost sales and jobs to overseas markets ignore several other important facts: Fact # 1: Many U.S. firms export to China From 1990 to 2016, China rose from the eighteenth to the third largest market for U.S. exports, including goods such as semiconductors, aircraft, industrial machinery, copper, and chemicals. The Paulson Manufacturing Corp., a maker of facial safety equipment, saw its sales of sporting goods fall due to competition from China in the 1980s. The manufacturer responded by promoting exports of equipment for firemen and steel workers. Now, “We enjoy nice sales to China,” explains Roy Paulson, president of the company. Some of his overseas customers “don’t want to buy the quality of the products that are made in their country.”

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run Welch Allyn, Inc., a producer of medical devices, has a substantial export business with European customers and views China as an opportunity to substantially expand its overseas sales. CEO Julie Shimer explains: “They have a multibillion-dollar commitment to improving community health care. . . . We see that as an opportunity.”

Fact # 2: Chinese imports are a small percentage of U.S. GDP Galina Hale and Bart Hobijn, economists at the Federal Reserve Bank of San Francisco, found that imports accounted for 16 percent of U.S. GDP in 2010. Imports from China amounted to 2.5 percent of U.S. GDP. About 88.5 percent of consumer spending on goods and services is on items produced in the United States. Over time, a greater percentage of spending by American consumers has been for services, and a lower percentage of spending has been for goods. Almost all services are produced domestically.

Fact # 3: A significant fraction of spending for Chinese imports benefits U.S. companies Hale and Hobijn estimate that 55 cents of every dollar spent on an item with a “Made in China” label is spent on services—transportation, wholesale, and retail activities—produced in the United States. This is higher than the percentage of the price U.S. consumers pay for such services for all goods imported into the United States (36 percent).

Sources: Sudeep Reddy, “Export Shift Turns Rivals Into Allies,” Wall Street Journal, February 12, 2011; and Galina Hale and Bart Hobijn, “The U.S. Content of ‘Made in China,’” FRBSF Economic Letter, August 8, 2011; and Lisa Mahapatra, “US Exports To China Have Grown 294% Over the Past Decade,” International Business Times, December 2013.

Extra Economics in Your Life and Career: Will Lower Net Exports Jeopardize Your Job? Question: Suppose you are a customer service representative of a large computer company and you read the following headline in your newspaper: “Canadian exports in July increased less than Canadian imports.” Should you be concerned about losing your job?

Answer: If Canadian exports increase less than Canadian imports, then net exports fall. Your job could be at risk if net exports continue to decrease, especially in the service sector. However, net exports have usually decreased when the Canadian economy is expanding, which should lead to an increase in the number of jobs overall in the Canadian economy. If you do lose your job, you may be able to find employment in another industry.

Appendix: The Algebra of Macroeconomic Equilibrium (252-253) Learning Objective: Apply the algebra of macroeconomic equilibrium.

Graphs and tables are alternative means to illustrate the aggregate expenditure model of short-run real GDP. Graphs help us understand economic change qualitatively. We make it easier to make quantitative estimates when we write down an economic model using equations. When economists forecast future movements in GDP, they often rely on econometric models. An econometric model is an economic model written in the form of equations, where each equation has been statistically estimated. The following equations are based on the example from Table 8.3.

1. C = 1,000 + 0.65Y

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Consumption function

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CHAPTER 8 | Aggregate Expenditure and Output in the Short Run 2.

3.

4.

5.

I = 1,500 G = 1,500 NX = −500 Y = C + I + G + NX

Planned investment function Government spending function Net export function Equilibrium condition

The parameters of the functions—such as the value of autonomous consumption and the value of the MPC in the consumption function—would be estimated statistically using data for the values of each variable over a period of years. To calculate equilibrium, we substitute equations 1 through 4 into equation 5. This gives us the following: Y = 1,000 + 0.65Y + 1,500 + 1,500 – 500.

This equation can be solved for Y to find equilibrium GDP: Y = 10,000.

To make this result more general, we can replace particular values with general values represented by letters:

C = C + MPC (Y ) 2. I = I 3. G = G 4. NX = NX 1.

Consumption function

5. Y = C + I + G + NX

Planned investment function Government spending function Net export function Equilibrium condition

The letters with bars over them represent fixed, or autonomous, values.

Solving for equilibrium Y:

Y =

C + I + G + NX .

1 − MPC

All four variables in the numerator of the equation represent autonomous expenditure. An alternative expression for equilibrium GDP is Equilibrium GDP = Autonomous expenditure × Multiplier.

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

CHAPTER 9 | Aggregate Demand and

Aggregate Supply Analysis Brief Chapter Summary and Learning Objectives This book takes a fresh approach to the standard aggregate demand and aggregate supply model. There is no good, simple alternative to using the AD-AS model when explaining movements in the price level and real GDP. But many instructors are dissatisfied with relying exclusively on the AD-AS model. The key problem, of course, is that AD-AS is a static model that attempts to account for dynamic changes in real GDP and the price level. The authors’ approach retains the basics of the AD-AS model but makes it more accurate and useful by making it more dynamic. The authors emphasize two points: 1.

Changes in the position of the short-run (upward-sloping) aggregate supply curve depend mainly on the state of expectations of the inflation rate.

2.

The existence of growth in the economy means that the long-run (vertical) aggregate supply curve shifts to the right every year.

This “dynamic” AD-AS model provides students with a more accurate understanding of the causes and consequences of fluctuations in real GDP and the price level. The authors introduce this model in Chapter 9 and use it to discuss monetary policy in Chapter 11 and fiscal policy in Chapter 12. Note, though, the sections on the dynamic AD-AS model are self-contained in one section each of Chapters 9, 11, and 12, so you can omit these sections without any loss of continuity in the discussion of macroeconomic theory and policy.

9.1

Aggregate Demand (pages 255-263) Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve.

▪ ▪

9.2

The aggregate demand curve (AD) shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.

If any variable other than the price level changes, the aggregate demand curve will shift.

The variables that cause the aggregate demand curve to shift are changes in government policies, changes in the expectations of households and firms, and changes in foreign variables.

Aggregate Supply (pages 264-268) Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve.

▪

.

The long-run aggregate supply curve is a vertical line because, in the long run, real GDP is always at its potential level and is unaffected by the price level. The short-run aggregate supply curve slopes upward because workers and firms often fail to predict accurately the future price level.

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

9.3

Macroeconomic Equilibrium in the Long Run and the Short Run (pages 269-273) Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium.

▪

9.4

In long-run macroeconomic equilibrium, the aggregate demand and short-run aggregate supply curves intersect at a point on the long-run aggregate supply curve. In short-run macroeconomic equilibrium, the aggregate demand and short-run aggregate supply curves often intersect at a point away from the long-run aggregate supply curve.

A Dynamic Aggregate Demand and Aggregate Supply Model (pages 273-278) Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions.

▪

To make the aggregate demand and aggregate supply model dynamic, we assume that 1. Potential real GDP increases continually, shifting the long-run aggregate supply curve to the right.

2. During most years, aggregate demand will shift to the right.

3. Except during periods when workers and firms expect high rates of inflation, the aggregate supply curve will shift to the right.

Appendix: Macroeconomic Schools of Thought (pages 285-287) Understand macroeconomic schools of thought.

Key Terms Aggregate demand and aggregate supply model, p. 256. A model that explains short-run fluctuations in real GDP and the price level.

Aggregate demand (AD) curve, p. 256. A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.

Fiscal policy, p. 259. Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives.

Long-run aggregate supply (LRAS) curve, p. 264. A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied.

Menu costs, p. 266. The costs to firms of changing prices.

Monetary policy, p. 258. The actions the Bank of Canada takes to manage the money supply and .

interest rates to pursue macroeconomic policy goals.

Potential GDP, p. 264. The level of real GDP attained when all firms are producing at capacity.

Price level, p. 256. A measure of the average prices of goods and services in the economy.

Short-run aggregate supply (SRAS) curve, p. 256. A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.

Stagflation, p. 272. A combination of inflation and recession, usually resulting from a supply shock.

Supply shock, p. 267. An unexpected event that causes the short-run aggregate supply curve to shift

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

Key Terms—Appendix Keynesian revolution, p. 285. The name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes’s macroeconomic model.

Monetarism, p. 286. The macroeconomic theories of Milton Friedman and his followers, particularly the idea that the quantity of money should be increased at a constant rate.

Monetary growth rule, p. 285. A plan for increasing the quantity of money at a fixed rate

that does not respond to changes in economic conditions.

New classical macroeconomics, p. 286. The macroeconomic theories of Robert Lucas and others, particularly the idea that workers and firms have rational expectations.

Real business cycle model, p. 286. A macroeconomic model that focuses on real, rather than monetary, causes of the business cycle.

Chapter Outline Canadian National Railway and the Business Cycle Canadian National Railway (CN) was formed in 1919 by the federal government from the remains of several failed Canadian railway companies. CN was returned to the private sector in 1995. Now Canada’s largest freight railway, CN moved more than 2,700,000 carloads of freight with worth in excess of $250 billion in 2017. Despite its size, CN is subject to the business cycle just like other firms. During recessions, as demand for goods falls, CN handles less cargo on its network. When the economy is expanding, CN handles more cargo and, often, longer trains. When the price of oil or labour rises, CN often has to increase its price and firms find it more expensive to get their goods to market. Increases in the price of a key good or service, such as transportation, tend to reduce the supply of goods and services in all parts of the economy. To understand the relationship between the business cycle and firms such as CN, we need to explore how production, employment, and prices interact throughout the business cycle.

9.1

Aggregate Demand (pages 255-263) Learning Objective: Identify the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the curve.

The aggregate demand and aggregate supply model explains short-run fluctuations in real GDP and the price level. The aggregate demand (AD) curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government. The short-run aggregate supply (SRAS) curve shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms. In the short run, real GDP and the price level are determined by the interaction of the aggregate demand curve and the short-run aggregate supply curve.

A. Why Is the Aggregate Demand Curve Downward Sloping?

We saw in Chapter 4 that GDP has four components: consumption (C), investment (I), government purchases (G), and net exports (NX). If we let Y stand for GDP, we can write

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis Y = C + I + G + NX. The aggregate demand curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded. Current income is the most important variable determining consumption by households. But consumption also depends on household wealth, which is the difference between the value of a household’s assets and the value of its debts. When the price level rises, the real value of household wealth declines, and so will consumption and the demand for goods and services. The effect of the price level on consumption is called the wealth effect and is one reason the aggregate demand curve is downward sloping.

When prices rise, households and firms need more money to finance buying and selling. Therefore, when the price level rises, households and firms will try to increase the amount of money they hold by withdrawing funds from banks, borrowing from banks, or selling assets. These actions drive up the interest rate. So, because a higher price level increases the interest rate and reduces investment spending, it also reduces the quantity of goods and services demanded. The effect of the price level on investment is known as the interest rate effect and is a second reason why the aggregate demand curve is downward sloping If the price level rises in Canada relative to the price levels in other countries, Canadian exports will become relatively more expensive, and foreign imports will become relatively less expensive. Canadian exports will fall and Canadian imports will rise, causing net exports to fall. The effect of the price level on net exports is known as the international-trade effect and is a third reason why the aggregate demand curve is downward sloping.

B. Shifts of the Aggregate Demand Curve versus Movements along It The aggregate demand curve tells us the relationship between the price level and the quantity of real GDP demanded, holding everything else constant. If the price level changes but other variables that affect the willingness of households, firms, and the government to spend are unchanged, the economy will move up or down a stationary aggregate demand curve. If any variable changes other than the price level, the aggregate demand curve will shift.

C. The Variables That Shift the Aggregate Demand Curve Three variables shift the aggregate demand curve: 1. Changes in government policies. The federal government uses monetary policy and fiscal policy to shift the aggregate demand curve. Monetary policy refers to the actions the Bank of Canada takes to manage the money supply and interest rates to pursue macroeconomic policy goals. Fiscal policy refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives.

2. Changes in the expectations of households and firms. If households become more optimistic about their future incomes, they are likely to increase their consumption. This increased consumption will shift the aggregate demand curve to the right. If firms become more optimistic about the future profitability of investment spending, the aggregate demand curve will shift to the right.

3. Changes in foreign variables. If firms and households in other countries buy fewer Canadian goods, or if firms and households in Canada buy more foreign goods, net exports will fall and the aggregate demand curve will shift to the left.

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

Extra In a Global Economy, How Can You Tell the Imports Apply the from the Domestic Goods?

Concept Some US firms appeal to the patriotism of US consumers by urging them to buy products made in the United States. For example, an executive vice president of Ford Motor Company was quoted as saying, “Americans really do want to buy American brands. We will compete vigorously to be America’s car company.” What could be more all-American than the Lincoln? And what is more obviously an import than the Toyota Sienna minivan? After all, Toyota’s headquarters are in Japan, and competition from cars made by Toyota, Honda, and Nissan has helped cause plummeting employment and production at Ford and the other US “Big Three” automakers. But things are not so simple in the modern global economy.

Ford’s Lincoln MKX is assembled in Oakville, Ontario, and Toyota’s Sienna is not assembled in Japan but in Princeton, Indiana. What’s more, most firms that sell products that have many parts, such as automobiles, purchase those parts from suppliers that may be located anywhere in the world. In fact, according to the US National Highway Traffic Safety Administration, 60 percent of the content of the Lincoln MKX was produced by Ford itself or by firms located in the United States or Canada. The other 40 percent of the content was imported from firms located in other countries. By contrast, 75 percent of the content of the Toyota Sienna is produced in the United States or Canada, and only 25 percent is imported from firms located in other countries. So a consumer in Canada or the United States who buys a Toyota Sienna actually contributes more to increasing Canadian/American aggregate demand than does a consumer purchasing a Ford Lincoln MKX. Statistics Canada, which gathers data on imports as well as the other components of aggregate demand, is well aware of this complication. StatsCan is careful to include in the category of imports the parts purchased by Canadian-based firms from foreign suppliers even when the final product being sold is mainly composed of Canadian-made parts.

Source: Jathon Sapsford and Norihiko Shirouzu, “Mom, Apple Pie and . . . Toyota?” Wall Street Journal, May 11, 2006.

Question: Suppose that a consumer in Germany buys a Lincoln MKX for a price of $40,000. Do Canadian exports increase by $40,000? Briefly explain.

Answer: Canadian exports will increase by less than $40,000 because less than 100 percent of the content in a Lincoln MKX is produced by firms located in Canada.

Aggregate Supply (pages 264-268) 9.2

Learning Objective: Identify the determinants of aggregate supply and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve.

Because the impact of changes in the price level on aggregate supply is very different in the short run as compared with the long run, we use two aggregate supply curves: one for the long run and one for the short run.

A. The Long-Run Aggregate Supply Curve Because changes in the price level do not affect the number of workers, the capital stock, or technology in the long run, changes in the price level do not affect the level of real GDP. The level of real GDP in the long run is called potential GDP or full-employment GDP. At potential GDP, firms operate at their normal level of capacity, and everyone who wants a job will have one, except for the structurally and frictionally unemployed. The long-run aggregate supply (LRAS) curve shows the relationship in the .

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis long run between the price level and the quantity of real GDP supplied. The LRAS curve is a vertical line.

Because potential GDP increases each year, the long-run aggregate supply curve shifts to the right each year.

B. The Short-Run Aggregate Supply Curve The short-run aggregate supply curve is upward sloping because, over the short run, as the price level increases, the quantity of goods and services firms are willing to supply increases. The main reason firms behave this way is that as the prices of goods and services rise, prices of inputs rise more slowly. Most economists believe that some firms and workers fail to accurately predict changes in the price level. This failure results in an upward-sloping short-run aggregate supply curve. The reasons for this include the following: 1. Contracts make some wages and prices “sticky.”

2. Firms are often slow to adjust wages.

3. Menu costs, the costs to firms of changing prices, make some prices sticky.

C. Shifts of the Short-Run Aggregate Supply Curve versus Movements along It If the price level changes but other variables are unchanged, the economy will move up or down a stationary aggregate supply curve. If any variable other than the price level changes, the aggregate supply curve will shift.

D. Variables That Shift the Short-Run Aggregate Supply Curve The most important variables that cause the short-run aggregate supply curve to shift are • • • • •

Increases in the labour force and in the capital stock Technological change Expected changes in the future price level Adjustments of workers and firms to errors in past expectations about the price level Unexpected changes in the price of an important natural resource

A supply shock is an unexpected event that causes the short-run aggregate supply curve to shift. Supply shocks are often caused by unexpected increases or decreases in the prices of important natural resources such as oil.

Extra Solved Problem 9.2 Sticky Prices and Wages The aggregate supply curve plots the relationship between the price level and quantity of real GDP supplied by firms. Because price level changes do not affect the factors that cause potential GDP to change (for example, increases in the labour force or the capital stock), the long-run aggregate supply curve is drawn as a vertical line. Changes in real GDP occur in response to price level changes over short periods of time when input prices rise more slowly than output prices. Because real GDP responds to changes in the price level in the short run, the short-run aggregate supply curve is upward sloping.

Economists use the phrases “sticky wages” and “sticky prices” to refer to the slow response of wages and other input prices, as well as some output prices, to price level changes. To help understand why prices and wages may be sticky, let’s use the example of “Bill’s Glue Emporium,” a firm that sells other adhesives to businesses. Assume the price level increases by 10 percent in 2018. Bill does not plan to buy new equipment or tools during the year and the wages of Bill’s workers will not be adjusted until the end of the year. Explain why Bill would choose each of the following alternative responses to the price level change.

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9-6

CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis a. Bill increases the price and output of glue during 2018 but reduces output to its previous (2017) level in 2019. b. Bill does not raise the price of glue but does increase the output of glue in 2018. In 2019, he raises glue prices and reduces the production of glue to its former (2017) level.

Solving the problem Step 1:

Review the chapter material.

This problem is about the short-run aggregate supply curve, so you may want to review the section “Aggregate Supply,” which begins on page 265 in the textbook.

Step 2:

Answer part (a) by explaining why Bill might increase the price and output of glue during 2018 but reduce the output of glue to its previous (2017) level in 2019.

The price level increase means that other output prices have risen. As a result, suppose that Bill believes that he will sell more glue, even at a higher price. If this price increase sticks (pun intended), then his profits will increase in 2018 because his capital and labour costs will not rise. But his workers will probably demand a wage increase in 2019 to compensate for the reduction in real income caused by the price level increase. Sellers of capital goods will also want to raise their prices. If Bill’s input prices rise by the same amount as prices have risen, he will decide in 2019 to reduce his output of glue to its former (2017) level.

Step 3:

Answer part (b) by explaining why Bill might choose not to raise the price of glue during 2018 but would increase the output of glue during 2018 and reduce the production of glue to its former (2017) level in 2019.

Bill might choose this option if he is not sure if the increase in the price level will be sustained. If he raises prices in 2018, he risks losing customers to other glue sellers. In addition, if he raises his prices only to lower them later in the year, he will have incurred menu costs twice—costs that he can avoid by not raising his prices in the first place. Because his labour and capital costs will not rise in 2018, he can earn a profit from selling a higher output of glue even without raising his prices. In 2019, his workers and capital goods suppliers will likely demand higher wages and prices to compensate for the reduction in real income caused by the price level increase. Bill will raise his prices and reduce his output of glue to its former (2017) level.

Extra Wages Stay Sticky Apply the Despite Shortage Concept Over the next decade, the mining industry is going to need 80,000 workers. Such is the situation in Canada. According to Benefits Canada, To, Canada should follow Alberta’s example and recruit American workers to alleviate its skills shortage in a competitive global talent market. United Steelworkers economist, Erin Weir, says companies should be offering better wages. Across the country there is a shortage of skilled workers. When there is a shortage, prices are supposed to rise to alleviate the shortage. Why then, are wages not rising? Sticky wages. Labour demand in parts of the country is increasing faster than the economy as a whole. Under these circumstances, firms may not expect the increased demand for their goods and service to be permanent. If the demand is expected to return to its former level, firms will not be able to pay the higher wage rate in the future. Without higher wages, new workers have little or no incentive to retrain, and the supply of labour is stagnant. The shortage persists.

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis If wages for skilled workers are lower in the United States than they are in Canada, it may be possible to temporarily allow foreign workers into the country. The supply of labour would increase and the shortage would disappear. This strategy would work if the increased demand was a temporary phenomenon. If the increase in demand is permanent, and firms come to expect that it will be permanent, then wage rates will rise and the SRAS will shift left until a new equilibrium is reached at full employment.

Sources: Does Canada have a skilled labour shortage? CBC News, Apr. 13, 2013. http://www.cbc.ca/news/canada/does-canada-reallyhave-a-skilled-labour-shortage-1.1342392.

To reduce talent shortage, Canada should hire U.S. workers. Benefits Canada, Oct 4, 2013. https://www.benefitscanada.com/news/to-reduce-talent-shortage-canada-should-hire-u-s-workers-44813.

9.3

Macroeconomic Equilibrium in the Long Run and the Short Run (pages 269-273) Learning Objective: Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium.

We can use the aggregate demand and aggregate supply model to analyze changes in real GDP and the price level. In the long run, the short-run aggregate supply curve and the aggregate demand curve intersect at a point on the long-run aggregate supply curve, and the economy produces its potential level of real GDP. At this point, firms are operating at their normal level of capacity, and everyone who wants a job will have one, except for the structurally and frictionally unemployed.

A. Recessions, Expansions, and Supply Shocks We begin with a simplified case, using two assumptions: 1. The economy has not been experiencing any inflation. The price level is expected to stay at that level.

2. The economy is not experiencing any long-run growth.

Though unrealistic, these assumptions allow us to focus on the key ideas of the aggregate demand and aggregate supply model. Assume that rising interest rates reduce investment and cause the aggregate demand curve to shift to the left, resulting in a recession. The recession will eventually end because there are forces that push the economy back to potential GDP in the long run. The shift in aggregate demand lowers the price level. Workers will be willing to accept lower wages, and firms will be willing to accept lower prices. This causes the SRAS curve to shift to the right. It may take the economy several years to return to potential GDP. Economists refer to this adjustment process as an automatic mechanism because it occurs without any actions by the government. An alternative to waiting for the automatic mechanism to work is for the government to use monetary and fiscal policy to shift the AD curve to the right and restore potential GDP more quickly.

Suppose that many firms become more optimistic about the future profitability of new investment. The resulting increase in investment shifts the AD curve to the right. Firms will operate beyond their normal capacity, and some workers who would ordinarily be structurally or frictionally unemployed are employed. An automatic mechanism will bring the economy back from a short-run equilibrium beyond potential GDP. Workers will push for higher wages, and firms will charge higher prices. As a result, the SRAS curve will shift to the left. The process of returning to potential GDP may stretch out for more than a year.

Suppose oil prices increase substantially. This will increase many firms’ costs and cause the SRAS curve to shift to the left. The price level is higher in short-run equilibrium, but real GDP is lower. This result is

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis called stagflation, which is a combination of inflation and recession, usually resulting from a supply shock. The recession eventually results in workers being willing to accept lower wages and firms being willing to accept lower prices. As this occurs, the SRAS curve will shift to the right. The economy returns to potential GDP at the original price level. It may take the economy several years for this process to be completed. Alternatively, the government can use monetary and fiscal policy to restore potential GDP more quickly, but this would result in a permanently higher price level.

Extra Solved Problem 9.3: Short-Run and Long-Run Equilibrium The following graph illustrates an economy in long-run equilibrium at a price level of 123 and real GDP of $1.6 trillion. Assume that an increase in real estate prices raises household wealth.

a. What two assumptions are used when the economy is said to be in initial long-run equilibrium at a price level of 123 and real GDP equal to $1.6 trillion? b. Use a graph to describe the changes in aggregate demand and aggregate supply that result in a short-run and a long-run equilibrium following the increase in household wealth.

Solving the Problem Step 1:

Review the chapter material.

This problem is about the relationship between short-run and long-run macroeconomic equilibrium, so you may want to review the section “Macroeconomic Equilibrium in the Long Run and the Short Run,” which begins on page 269 in the textbook.

Step 2:

Answer part (a) by explaining the two assumptions used when the economy is said to be in initial long-run equilibrium.

The first assumption is that the economy has not been experiencing any inflation, as the price level is 123 and is expected to remain at this level. The second assumption is that potential GDP equals 1.6 trillion and will remain at this level.

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

Step 3:

Answer part (b) by using a graph to describe the changes in aggregate demand and aggregate supply that result in a short-run and a long-run equilibrium following the increase in household wealth.

The increase in wealth will increase consumption. This increase will cause a shift in aggregate demand to the right from AD1 to AD2. The economy will reach short-run equilibrium at a higher real GDP (1.64 trillion) and a higher price level (126). Workers and firms will eventually adjust to the price level being higher than they had expected. Workers will push for higher wages—because each dollar of wages will buy fewer goods and services—and firms will charge higher prices. In addition, the low levels of unemployment resulting from the expansion will make it easier for workers to negotiate for higher wages, and the increase in demand will make it easier for firms to charge higher prices. As a result, the SRAS curve will shift to the left from SRAS1 to SRAS2. At this point, the economy will be back in long-run equilibrium. The economy’s new long-run equilibrium will have a higher price level, but the same level of real GDP as before the increase in wealth occurred.

9.4

A Dynamic Aggregate Demand and Aggregate Supply Model (pages 273-278) Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze macroeconomic conditions.

The difficulty with the basic aggregate demand and aggregate supply model is that it leads to some misleading results. This difficulty arises from the assumptions that (1) the economy does not experience continuing inflation, and (2) the economy does not experience long-run growth. We can create a dynamic aggregate demand and aggregate supply model by making changes to the basic model based on the following macroeconomic facts: • Potential real GDP increases continually, shifting the long-run aggregate supply curve to the right.

• During most years, the aggregate demand curve shifts to the right.

• Except during periods when workers and firms expect high rates of inflation, the short-run aggregate supply curve shifts to the right. .

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

A. What Is the Usual Cause of Inflation?

The dynamic aggregate demand and aggregate supply model provides a more accurate explanation than the basic model of the source of most inflation. If total spending in the economy grows faster than total production, prices rise. Inflation can also result when there is a shift to the left of the short-run aggregate supply curve.

Teaching Tips Because the dynamic aggregate demand and aggregate supply model is more complicated than the basic model, you may need to spend some extra class time explaining it. The dynamic model provides a much more realistic account of macroeconomic events. The dynamic model avoids the unrealistic result of the basic model, where a decline in aggregate demand leads to a fall in the price level. Because the graphs of the dynamic model contain six curves (as opposed to three in the basic model), it is important to help students identify the movement from one short-run macroeconomic equilibrium to another. Review with your students Figure 9.8, which shows the dynamic aggregate demand and aggregate supply model.

Figures 9.9 and 9.10 show the effects of changes in equilibrium using the dynamic model.

Extra Economics in Your Life and Career: How Will Immigration and an Aging Labour Force Affect You? Question: Suppose that the friends you made on an international trip are thinking of immigrating to Canada. The number of immigrants living in Canada totals 7.5 million, according to data from the Statistics Canada’s National Household Survey. Approximately 1.2 million arrived between 2011 and 2016. At the same time, the percentage of the Canadian population over 65 increased by 16.9 percent, which was double the rate of increase of the country’s population as a whole. How will the increased immigration and the aging of Canada affect your standard of living?

(Source: Statistics Canada, Focus on Geography Series, 2016 Census and 2016 Census topic: Age and sex.)

Answer: Increased immigration over time leads to a larger supply of labour. Although many believe that immigration can hurt Canada in the short run, in the long run immigration will cause the aggregate supply curve to shift to the right. Increased immigration will cause the equilibrium real GDP to increase and the equilibrium price level to decrease. As a larger percentage of the population leaves the labour force because of retirement or illness, the aggregate supply curve will shift to the left. The aging of Canada, taken by itself, will cause the equilibrium real GDP to fall and the price level to increase. Overall, it is hard to predict which of the two effects on aggregate supply will be greater.

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CHAPTER 9 | Aggregate Demand and Aggregate Supply Analysis

Appendix Macroeconomic Schools of Thought (pages 285-287) Learning Objective: Understand macroeconomic schools of thought.

Macroeconomics became a separate field of economics in 1936, with the publication of John Maynard Keynes’s book The General Theory of Employment, Interest and Money. The Keynesian revolution is the name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes’s macroeconomic model. The aggregate demand and aggregate supply model developed by Keynes remains the most widely accepted approach to analyzing macroeconomic issues. Because the model has been modified from Keynes’s day, many economists who use the model today refer to themselves as new Keynesians. A significant number of economists, however, dispute whether using the aggregate demand and aggregate supply model is the best way to analyze macroeconomic issues. Three alternative schools of thought use models that differ significantly from the standard aggregate demand and aggregate supply model: 1. The monetarist model 2. The new classical model 3. The real business cycle model

The Monetarist Model In the 1940s, Milton Friedman, an economist at the University of Chicago, developed the monetarist model—also known as the neo-Quantity Theory of Money model. Friedman argued that the Keynesian approach overstates the amount of macroeconomic instability in the economy. Friedman recommended that central banks in general, and the US Federal Reserve in particular, which is responsible for managing the quantity of money, should adopt a monetary growth rule, which is a plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions. Monetarism refers to the macroeconomic theories of Milton Friedman and his followers, particularly the idea that the quantity of money should be increased at a constant rate. Friedman’s ideas attracted significant support during the 1970s and early 1980s, when the economy experienced high rates of unemployment and inflation.

The New Classical Model New classical macroeconomics refers to the macroeconomic theories of Robert Lucas and others, particularly the idea that workers and firms have rational expectations. This means that workers and firms form their expectations of the future values of economic variables by making use of all available information. Some of the views held by the new classical macroeconomists are similar to those held by economists before the Great Depression. Supporters of the new classical model agree with supporters of the monetarist model that central banks, including the Bank of Canada, should adopt a monetary growth rule.

The Real Business Cycle Model The real business cycle model is a macroeconomic model that focuses on real, rather than monetary, causes of the business cycle. Proponents of this model argue that fluctuations in real GDP are caused by temporary shocks to productivity.

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CHAPTER 10 | Money, Banks, and the Bank of Canada

CHAPTER 10 | Money, Banks, and the Bank of Canada Brief Chapter Summary 10.1 What Is Money, and Why Do We Need It? (pages 290-293) Define money and discuss the four functions of money.

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Money is anything that people are generally willing to accept in exchange for goods or services or in payment of debts. Money has four functions: a medium of exchange, a unit of account, a store of value, and a standard of deferred payment.

10.2 How Is Money Measured in the Canada Today? (pages 293-298) Discuss the definitions of the money supply used in the Canada today.

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The narrowest definition of the money supply in the Canada today is M1+: The sum of currency in circulation, chequable deposits at chartered banks, trust and mortgage loan companies (TMLs), and credit unions and caisses populaires (CUCPs). M2 is a broader definition of the money supply. It includes currency outside banks and personal deposits at chartered banks, non-personal demand and notice deposits at chartered banks, and fixed-term deposits.

10.3 How Do Banks Create Money? (pages 298-306) Explain how banks create money.

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The key role that banks play in the economy is to accept deposits and make loans. In performing this function, banks create chequing account deposits.

10.4 The Bank of Canada (pages 306-314) Discuss the policy tools the Bank of Canada uses to manage the money supply.

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The Bank of Canada is the central bank of Canada. Today its main role is to conduct monetary policy by managing interest rates and the money supply. The Bank of Canada’s two monetary policy tools are open market buyback operations and loans to financial institutions.

10.5 The Quantity Theory of Money (pages 314-318) Explain the quantity theory of money and use it to explain how high rates of inflation occur.

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The quantity theory of money provides insight into the long-run relationship between the money supply and inflation: In the long run, inflation results from the money supply growing at a faster rate than real GDP.

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CHAPTER 10 | Money, Banks, and the Bank of Canada

Key Terms Advances to banks, p. 308. Loans the Bank of Canada makes to banks.

Asset, p. 290. Anything of value owned by a person or a firm.

Bank of Canada, p. 292. The central bank of Canada.

Bank panic, p. 307. A situation in which many banks experience runs at the same time.

Bank rate, p. 308. The interest rate the Bank of Canada charges on loans (advances) to banks.

Fractional reserve banking system, p. 306. A banking system in which banks keep less than 100 percent of deposits as reserves.

Governing council (of the Bank of Canada), p. 307. A council with six members (including the governor) that is responsible for the management of the Bank of Canada.

Key policy rate, p. 308. The Bank of Canada’s target for the overnight interest rate.

Bank run, p. 307. A situation in which many depositors simultaneously decide to withdraw money from a bank.

M1+, p. 294. The narrowest definition of the money supply: It includes currency and other assets that have cheque writing features—all chequable deposits at chartered banks, TMLs, and CUCPs.

Board of directors (of the Bank of Canada), p. 307. A board with 15 members (including the governor) that is responsible for the management of the Bank of Canada.

M1++, p. 294. This broader definition of the money supply includes everything that is in M1+ as well as all non-chequable deposits at chartered banks, TMLs, and CUCPs.

Collateralized transactions, p. 308.

Transactions that involve property being pledged to the lender to guarantee payment in the event that the borrower is unable to make debt payments.

M2, p. 294. A monetary aggregate that includes currency outside banks and personal deposits at chartered banks, non-personal demand and notice deposits at chartered banks, and fixed-term deposits.

Commodity money, p. 290. A good used as money that also has value independent of its use as money.

M2+, p. 294. A broader monetary aggregate that includes everything that is in M2 plus deposits at TMLs, deposits at CUCPs, life insurance company individual annuities, personal deposits at government-owned savings institutions, and money market mutual funds.

Desired reserve ratio, p. 299. The minimum fraction of deposits banks desire to keep as reserves.

Desired reserves, p. 299. Reserves that a bank desires to hold, based on its chequing account deposits.

Excess reserves, p. 299. Reserves that banks hold over and above the desired amounts.

Fiat money, p. 292. Money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money.

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M2++, p. 294. The broadest definition of the money supply: It includes everything that is in M2+ as well as Canada Savings Bonds and other retail instruments, and non-money market mutual funds.

M3, p. 294. A category within the money supply that includes everything that is in M2 plus non-personal term deposits at chartered banks and foreign currency deposits of residents at chartered banks.

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CHAPTER 10 | Money, Banks, and the Bank of Canada Monetary base, p. 309. The sum of the Bank of Canada’s monetary liabilities (i.e., paper money in circulation and bank settlement balances) and the Canadian Mint’s coins outstanding (i.e., coins in circulation).

Monetary policy, p. 307. The actions the Bank of Canada takes to manage the money supply and interest rates to pursue macroeconomic policy objectives.

Quantity theory of money, p. 315. A theory about the connection between money and prices that assumes that the velocity of money is constant.

Reserves, p. 298. Deposits that a bank keeps as cash in its vault or on deposit with the Bank of Canada.

Money, p. 290. Assets that people are generally willing to accept in exchange for goods and services or for payment of debts.

Sale and Repurchase Agreements (SRAs), p. 309. The Bank of Canada’s sale of government securities to primary dealers (i.e., banks or securities brokers/dealers), with an agreement to repurchase them later.

Open market buyback operations, p. 309.

Agreements in which the Bank of Canada, or another party, purchase securities with the understanding that the seller will repurchase them in a short period of time, usually less than a week.

Securitization, p. 312. The process of transforming loans or other financial assets into securities.

Open market operations, p. 309. The buying and selling of government securities by the Bank of Canada in order to control the money supply.

Operating band, p. 308. The Bank of Canada’s 50-basis-point range for the overnight interest rate.

Overnight interest rate, p. 308. The interest rate banks charge each other for overnight loans.

Purchase and Resale Agreements (PRAs), p. 309. The Bank of Canada’s purchase of government securities from primary dealers (i.e., banks or securities brokers/dealers), with an agreement to resell them later.

Security, p. 312. A financial asset—such as a stock or a bond—that can be bought and sold in a financial market.

Settlement balances, p. 308. Deposits held by banks in their accounts at the Bank of Canada.

Simple deposit multiplier, p. 302. The ratio of the amount of deposits created by banks to the amount of new reserves.

Standing liquidity facilities, p. 308. The Bank of Canada’s readiness to lend to or borrow from a bank.

Velocity of money, p. 314. The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

Chapter Outline Does India Need Paper Currency?

Many people in India remain impoverished, with the country’s GDP per capita being barely more than 10 percent that of the United States. So it may seem surprising that in 2017 more than 225 million people in India made some or all of their purchases using a mobile wallet rather than cash. With a mobile wallet, consumers can use a smartphone, smartwatch, or tablet to make payments. This unexpected use of cutting-edge technology in India was the result of two developments: (1) the spread of smartphone usage even among people with low incomes and (2) the sudden decision by the Indian government in late November 2016 to withdraw from circulation all existing 500- and 1000-rupee paper currency.

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CHAPTER 10 | Money, Banks, and the Bank of Canada At the end of 2016, the government stopped accepting the old currency and also stopped exchanging it for newly printed currency. The government enacted this drastic policy in an attempt to push the Indian economy away from a heavy reliance on cash transactions. Policymakers hoped to reduce the size of the country’s large underground economy, and to reduce corruption by making it more difficult for government officials to receive cash bribes.

The Indian firm Paytm benefited from consumers who needed an alternative to using cash to make payments. Paytm was founded in 2010 by Vijay Shekhar Sharma, India’s youngest billionaire. Paytm is an app that allows users to make payments at retail stores or online after transferring funds from a bank account, credit card, or debit card or depositing cash at designated banks or stores. Paytm provides stores with a sticker that customers scan with their smartphone cameras when making a payment. Paytm confirms each payment with a text message and collects a fee of 1 to 3 percent from the store. Paytm’s success has attracted competitors, including MobiKwik, FreeCharge, and Samsung Pay, which have also gained millions of users in India.

SOURCES: Corinne Abrams and Newley Purnell, “Mobile Wallet Paytm Hits Pay Dirt Amid India’s Cash Crackdown,” Wall Street Journal, May 31, 2017; Raymond Zhong, “India to Replace Largest Bank Notes,” Wall Street Journal, November 9, 2016; and “India Online,” Economist, March 5, 2016.

What Is Money, and Why Do We Need It? (pages 290-293) 10.1 Learning Objective: Define money and discuss the four functions of money.

Money refers to assets that people are generally willing to accept in exchange for goods and services or for payment of debts. An asset is anything of value owned by a person or a firm.

A. Barter and the Invention of Money Economies where goods and services are traded directly for other goods and services are called barter economies. For a barter trade to take place between two people, each person must want what the other one has, known as a double coincidence of wants. A good used as money that also has value independent of its use as money is called commodity money. The high income levels in modern economies are based on the specialization that money makes possible. By making exchange easier, money allows for specialization and greater productivity.

B. The Functions of Money Anything used as money should fulfill the following four functions: 1. Medium of exchange: Sellers are willing to accept it in exchange for goods or services 2. Unit of account: Each good has a price in terms of money.

3. Store of value: Money allows value to be stored easily. Money has liquidity, which is the ease with which an asset can be converted into a medium of exchange.

4. Standard of deferred payment: Money can facilitate exchange over time.

C. What Can Serve as Money?

There are five criteria that make a good suitable for use as a medium of exchange: 1. It must be acceptable to most people.

2. It should be of standardized quality so that any two units are identical.

3. It should be durable so that value is not lost by quickly wearing out.

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CHAPTER 10 | Money, Banks, and the Bank of Canada 4. It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported.

5. The medium of exchange should be divisible so that it can be used in purchases of both low-priced and high-priced goods..

Dollar bills meet all of these criteria. Commodity money—gold, for example—has a significant problem: its value depends on its purity. Another problem with using gold as money is that the money supply is difficult to control because it depends partly on unpredictable discoveries of new gold fields.

Paper money is generally issued by a central bank. The Bank of Canada is the central bank of Canada.

Paper currency has no value unless it is used as money, so it’s not a commodity money. Fiat money is money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money.

Extra Solved Problem 10.1 Money in the Eighteenth Century Canadians use paper money because it meets the five criteria that make any good suitable as a medium of exchange. Paper money is 1.

2.

3.

4.

5.

Acceptable to most people Of standardized quality Durable Valuable relative to its weight Divisible

Other commodities have served as money, including animal skins. The following is a list of prices for goods supplied to a tribe in the Iroquois-dominated region of what is now upstate New York in 1703: Item One yard of broadcloth Two yards of cotton Five pecks of corn Two pints of powder Ten pounds of pork One hat with hatband One shirt One sword blade Six knives

Price 3 beaver skins 1 beaver skin 1 beaver skin 1 beaver skin 1 beaver skin 3 beaver skins 1 beaver skin 1 ½ beaver skins 1 beaver skin

Source: Hudson Historical Bureau.

a. What function of money does this list demonstrate? .

b. Why were animal skins used as money in the eighteenth century?

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CHAPTER 10 | Money, Banks, and the Bank of Canada

Solving the Problem Step 1:

Review the chapter material.

This problem is about the definition and functions of money, so you may want to review the section “What Is Money, and Why Do We Need It?” which begins on page 290 in the textbook.

Step 2:

Answer part (a) by explaining what function of money the list demonstrates.

The list of prices demonstrates the use of beaver skins as a unit of account, or a way of measuring value in terms of money.

Step 3:

Answer part (b) by explaining why animal skins were used as money in the eighteenth century.

It is important to consider this question in the context of the alternatives that were available to serve as money in the early eighteenth century. There was no central bank that could issue and regulate the supply of money, and trading was much less sophisticated than it is today.

Individuals developed a system that was suitable to their purposes. Animal skins were recognized as valuable commodities by both First Nations people and colonial settlers. We can infer that both groups of traders found the skins acceptable. Relative to other goods, skins were relatively durable—they would not melt or spoil in hot weather and were not harmed by cold weather—and easily transported. Individual pelts were similar to each other (standardized) and fairly small so that divisibility was not a serious problem. An additional attribute was that the supply of skins could not be increased without cost. Animals had to be hunted, and skins were difficult to counterfeit. This natural limitation on the supply of skins enhanced their acceptability among traders. In addition, in a period before the availability of inexpensive clothing made from cotton and wool, animal skins could be made into coats, hats, blankets, rugs, and other useful items. Therefore, animal skins were a type of commodity money.

Extra Apply the Apple Didn’t Want My Cash!

Concept If the US Federal Reserve Notes are legal tender, doesn’t that mean that everyone in the United States, including every business, has to accept paper money? The answer to this question is “no,” as a woman in California found out when she went to an Apple store in Palo Alto and tried to buy an iPad using $600 in currency. The store refused to sell her the iPad for cash. At that time, the iPad had just been released, and Apple did not want to sell large numbers to people who were buying them to resell on eBay, Craigslist, or elsewhere. So, a customer wanting to buy an iPad had to pay with either a credit card or a debit card, which would make it easier for Apple to keep track of anyone attempting to buy more than the limit of two per customer.

Because the US Federal Reserve Notes are legal tender, creditors must accept them in payment of debts, and the government will accept them in payment of taxes. However, as this incident demonstrates, firms do not have to accept cash as payment for goods and services. As the U.S. Treasury Department explains on its Web site: There is … no Federal statute mandating that a private business, a person or an organization must accept currency or coins as payment for goods and/or services. … For example, a bus line may prohibit payment of fares in pennies or dollar bills. In addition, movie theaters, convenience stores

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CHAPTER 10 | Money, Banks, and the Bank of Canada and gas stations may refuse to accept large denomination currency (usually notes above $20) as a matter of policy.

The woman who tried to buy an iPad for cash was disabled and on a limited income, so the incident led to negative publicity for Apple. As a result, Apple decided to lift its ban on paying for iPads with cash, provided that the customer was willing to set up an Apple account at the time of purchase. In addition, Apple presented a free iPad to the customer who was originally turned down when she tried to pay with cash.

Sources: Michael Winter, “Apple Ends No-Cash Policy and California Woman Gets Free iPad,” www.usatoday.com, May 20, 2010; and U.S. Treasury, “FAQs: Currency,” www.treasury.gov/resource-center/faqs/Currency/Pages/edu_faq_currency_index2.aspx

How Is Money Measured in Canada Today? (pages 293-298) 10.2 Learning Objective: Discuss the definitions of the money supply used in Canada today.

A. M1+ and M1++: The Narrowest Definitions of the Money Supply ▪ ▪

M1+ is the narrowest definition of the money supply: The sum of currency in circulation, plus chequable deposits at chartered banks, trust and mortgage loan companies (TMLs), and credit unions and caisses populaires (CUCPs).

M1++ includes everything that is in M1+ as well as all non-chequable deposits at chartered banks, TMLs, and CUCPs.

B. M2, M2+ and M2++: A Broader Definition of Money ▪ ▪ ▪

M2 is a broader definition of the money supply: It includes currency outside banks and personal deposits at chartered banks, non-personal demand and notice deposits at chartered banks, and fixed-term deposits.

M2+ includes currency outside banks and personal deposits at chartered banks, non-personal demand and notice deposits at chartered banks, and fixed-term deposits.

M2++ The broadest definition of the money supply: It includes everything that is in M2+ as well as Canada Savings Bonds and other retail instruments, and non-money market mutual funds.

C. The M3 Definition of the Money Supply ▪

M3 A category within the money supply that includes everything that is in M2 plus non-personal term deposits at chartered banks and foreign currency deposits of residents at chartered banks.

There are two key points about the money supply: 1. The money supply consists of both currency and chequing and non-chequing account deposits.

2. Because balances in chequing and non-chequing account deposits are included in the money supply, banks play an important role in the way the money supply increases and decreases.

D. What about Credit Cards and Debit Cards?

Credit cards are not included in the definitions of the money supply because they are considered loans from banks that issue the cards. With a debit card, the funds to make a purchase are taken directly from a chequing account. Neither credit cards nor debit cards themselves represent money.

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CHAPTER 10 | Money, Banks, and the Bank of Canada

How Do Banks Create Money? (pages 298-306) 10.3 Learning Objective: Explain how banks create money.

The key role that banks play in the economy is to accept deposits and make loans. By taking these actions, banks fulfill a key function in the money supply process by which central banks control the money supply.

A. Bank Balance Sheets The key assets on a bank’s balance sheet are its reserves, loans, and securities, such as Canada Bonds.

Reserves are deposits that a bank keeps as cash in its vault or on deposit with the Bank of Canada.

Desired reserves are reserves that a bank desires to hold, based on its chequing account deposits. The desired reserve ratio is the minimum fraction of deposits banks desire to keep as reserves. Excess reserves are reserves that banks hold over and above the desired amounts. Banks make consumer loans to households and commercial loans to businesses. A loan is an asset to a bank because it represents a promise by the person taking out the loan to make specified payments to the bank. A bank’s reserves and its holding of securities are also assets. Deposits are a typical bank’s largest liability, which include chequing accounts, savings accounts, and certificates of deposit.

B. Using T-Accounts to Show How a Bank Can Create Money A T-account is a stripped-down version of a balance sheet that shows how a transaction changes a bank’s balance sheet. When a bank accepts a deposit, it keeps only a fraction of the funds as reserves and lends out the remainder. In making a loan, banks increase the chequing account balance of the borrower. When the borrower uses a cheque to buy something with the funds the bank has lent, the seller will deposit the cheque in his bank. The seller’s bank will keep part of the deposit as reserves and lend out the remainder.

This process will continue until no banks have excess reserves. In this way, the process of banks making new loans increases the volume of chequing account balances and the money supply.

C. The Simple Deposit Multiplier The simple deposit multiplier is the ratio of the amount of deposits created by banks to the amount of new reserves. The formula for the simple deposit multiplier is Simple deposit multiplier =

,

where rd is the desired reserve ratio. We can use this formula to calculate the total increase in chequing account deposits from an increase in bank reserves due, for instance, to currency being deposited in a bank:

Change in chequing account deposits = Change in bank reserves x

.

D. The Simple Deposit Multiplier versus the Real-World Deposit Multiplier The explanation for the way an increase in reserves in the banking system leads to the creation of new deposits and an increase in the money supply is simplified in two ways. First, we assumed that banks keep no excess reserves. In reality, banks often keep some excess reserves to guard against many depositors simultaneously making withdrawals from their accounts. (During the financial crisis that began in 2007, banks held large quantities of excess reserves.) Second, we assumed that the whole amount of every cheque is deposited in a bank. In reality, households and firms keep roughly constant the amount of currency they hold relative to the value of their chequing account balances. The effect of these two factors is to reduce the real-world multiplier during normal times.

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We can summarize two important conclusions: 1. Whenever banks gain reserves, they make new loans, and the money supply expands.

2. Whenever banks lose reserves, they reduce their loans, and the money supply contracts.

Extra Apply the Banks Create Money—Who Prints Money?

Concept When economists describe how “banks create money,” they don’t mean that banks literally print money—currency—but that by lending reserves, banks create new deposits that become part of the money supply. The Bank of Canada does not print money either, though each bill is engraved with the phrase “Bank of Canada.” Canadian currency is printed by two private sector security printing companies on behalf of the Bank of Canada. These firms also print other documents such as postage stamps, passports, drivers’ licenses, and Canadian Tire Money. The private sector printers ship bundles of notes to the Bank of Canada for distribution to the commercial banks. Commercial banks ship old, torn bills to the Bank of Canada, where they are shredded and destroyed. Coins are minted by the Royal Canadian Mint, another department of the federal government.

Source: Bank of Canada

The Bank of Canada (pages 306-314) 10.4 Learning Objective: Discuss the policy tools the Bank of Canada uses to manage the money supply.

In a fractional reserve banking system, banks keep less than 100 percent of deposits as reserves. When people deposit money in a bank, the bank lends most of the money to someone else. On a typical day, about as much money is deposited in a bank as is withdrawn. A bank run is a situation in which many depositors simultaneously decide to withdraw money from a bank. A bank panic is a situation in which many banks experience runs at the same time. It is possible for one bank to handle a run by borrowing from other banks. A central bank, like the Bank of Canada, can help stop a bank panic by acting as a lender of last resort. In this case, a central bank makes loans to banks that cannot borrow funds elsewhere.

The bank can use these loans to pay off depositors. When the panic ends and the depositors put their money back in their accounts, the bank can repay the loan to the central bank.

A. The Establishment of the Bank of Canada After a Royal Commission in 1933, the Bank of Canada was created by the Bank of Canada Act in 1934 and began operations in 1935. The overall responsibility for the operation of the Bank of Canada rests with a board of directors, which consists of 15 members—the governor, the senior deputy governor, the deputy minister of finance, and 12 outside directors. The Governing council (of the Bank of Canada) is a council with six members (including the governor) that is responsible for the management of the Bank of Canada. The Bank of Canada is responsible for monetary policy in Canada, but the objectives of monetary policy are determined jointly by the Bank of Canada and the minister of finance, with the latter acting on behalf of the federal government.

B. The Bank of Canada’s Operating Band for the Overnight Interest Rate The Bank of Canada signals its stance on monetary policy by announcing a target for the overnight interest rate. The target for the overnight interest rate, known as the key policy rate (or policy rate, for

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CHAPTER 10 | Money, Banks, and the Bank of Canada short), is the Bank of Canada’s main tool for conducting monetary policy. The Bank of Canada’s operational objective is to keep the overnight interest rate within an operating band of 50 basis points.

The upper limit of the operating band defines the bank rate, the interest rate the Bank of Canada charges financial institutions that require an overdraft loan to cover negative settlement balances on the Bank of Canada’s books at the end of the banking day. The lower limit of the operating band is the rate the Bank of Canada pays to financial institutions with positive settlement balances at the end of the day.

C. How the Bank of Canada implements Money Supply Monetary policy refers to the actions the Bank of Canada takes to manage the money supply and interest rates to pursue macroeconomic policy objectives. To manage the money supply, the Bank of Canada uses two monetary policy tools: 1. Open market buyback operations 2. Lending to financial institutions The Bank of Canada’s policy tools are aimed at affecting interest rates and bank reserves. Open market operations are the buying and selling of government securities by the Bank of Canada in order to control the money supply. The Bank of Canada’s most common open market operations have been repurchase transactions, a special type of open market operation. In particular, the Bank of Canada uses Purchase and Resale Agreements (PRAs) as a tool to reduce undesired upward pressure on the overnight interest rate, and Sale and Repurchase Agreements (SRAs) as a tool to reduce undesired downward pressure on the overnight interest rate.

D. The Bank of Canada’s Approach to Monetary Policy The goal of the Bank of Canada’s current monetary policy is to keep the inflation rate within a target range of 1 percent to 3 percent, with the midpoint of the inflation target range, 2 percent, being the most desirable outcome. The Bank of Canada implements monetary policy by changing the policy rate in order to influence other short-term interest rates, the exchange rate, and the level of economic activity.

E. The “Shadow Banking System” and the Global Financial Crisis of 2007–2009 In the past 25 years, two important developments have occurred in the financial system: 1. Banks have begun to resell many of their loans rather than keep them until they are paid off.

2. Financial firms other than commercial banks have become sources of credit to businesses.

Traditionally, when a bank made a residential mortgage loan to a household to buy a home or made a commercial loan to a business, the bank would keep the loan and collect the payments until the loan was paid off. A financial asset—such as a stock or a bond—that can be bought and sold in a financial market is a security. When a financial asset is first sold, the sale takes place in a primary market. Subsequent sales take place in a secondary market. After 1970, loans began to be securitized. Securitization is the process of transforming loans or other financial assets into securities.

The financial system was also transformed in the 1990s and 2000s by the increasing importance of nonbank financial firms, such as investments banks, money market mutual funds, and hedge funds.

Investment banks concentrate on providing advice to firms issuing stocks and bonds and considering mergers with other firms. In the 1990s, investment banks began bundling large numbers of their mortgages and reselling them to investors. Mortgage-backed securities became popular because they often paid higher interest rates than similar securities. Money market mutual funds sell shares to investors and use the money to buy short-term securities. Hedge funds raise money from wealthy investors and use sophisticated investment strategies that often involve significant risk. By raising money from individual

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CHAPTER 10 | Money, Banks, and the Bank of Canada investors and providing it directly or indirectly to firms and households, investment banks, money market mutual funds, hedge funds, and other financial firms—the “shadow banking system”—were carrying out a function that at one time was almost exclusively the domain of commercial banks.

The firms in the shadow banking system differed from commercial banks in two ways: First, the government agencies that regulated the commercial banking system—including the Office of the Superintendent of Financial Institutions Canada (OSFI) and the Bank of Canada—did not regulate these firms. Second, these firms were more highly leveraged than were commercial banks. Chartered banks have rarely experienced bank runs since the federal government established the Canada Deposit Insurance Corporation (CDIC) in 1967 to insure deposits (currently up to $100,000) with all federally chartered banks and near banks. It turned out that in 2007, firms in the shadow banking system were quite vulnerable to bank runs. As housing prices began to fall in the United States, some borrowers began to default on their mortgages, which caused mortgage-backed securities to lose value. Investment banks and other financial firms that had borrowed short term and invested the funds long term were in trouble. In the fall of 2008, the process of securitization had ground to a halt. The resulting credit crunch significantly worsened the recession that had begun in December 2007.

Teaching Tips The Web site of the Bank of Canada has the latest information on monetary policy and regulation: https://www.bankofcanada.ca/core-functions/monetary-policy/.

Extra Solved Problem 10.4 Open Market Operations and Changes in the Supply of Money Suppose that the Bank of Canada would like to increase the money supply by $500,000. How can the Bank of Canada use open market operations to accomplish this goal? Assume the desired reserve ratio is 10 percent.

SOLVING THE PROBLEM Step 1:

Review the chapter material.

This problem is about the Bank of Canada’s use of open market operations, so you may want to review the section “The Bank of Canada,” which begins on page 306 in the textbook.

Step 2:

Determine the level of deposits that can be created from the excess reserves.

When the Bank of Canada uses open market operations to increase the supply of money, the Bank of Canada buys securities from the public. When the public deposits the proceeds from these sales in their banks, the level of deposits and the level of reserves in the banking system increase. Because banks want to keep only a fraction of the deposits they receive as reserves, the level of excess reserves will increase. Assume that ΔD is the change in deposits, ΔR is the change in reserves, and rd is the desired reserve ratio. The total amount of deposits that can be created from these excess reserves is determined by the formula: 1 D = R . rd

Step 3:

Calculate the change in reserves.

If the Bank of Canada would like to increase the money supply by $500,000, it needs to increase deposits by $500,000. Using the 10 percent desired reserve ratio (rd = 0.10), the formula for determining the change in deposits is

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CHAPTER 10 | Money, Banks, and the Bank of Canada 1 1 R = R. rd 0.10 Solving this equation for ΔR results in a value of ΔR = $50,000. If the Bank of Canada buys $50,000 of securities from the public, reserves will increase by $50,000. As banks create new loans based on these new reserves, the quantity of bank loans and deposits will increase. $500 000 =

Extra Paying Interest on Reserves Apply the Gives Fed a New Tool Concept The financial crisis that led to the recession of 2007–2009 caused the Federal Reserve (the Fed) to take extreme measures to stabilize the U.S. economy. While it did not make headlines, the U.S. Congress gave the Fed a new tool that may allow it to help mitigate the effects of future crises. This new tool, already used by the Bank of Canada, and the Central Banks of Australia, England, Japan, New Zealand, Norway and Sweden, is the ability of the Fed to pay interest on reserves that banks have on deposit with the Fed. Many analysts believe that this tool will allow the central bank to have greater control over the federal funds rate and to better manage bank reserves. Michael Feroli, a J.P. Morgan Chase economist, believes “[i]t’s incredibly important that they have this tool.” Because of the recession and actions taken by the Fed and U.S. Treasury in 2008, banks had historically high levels of excess reserves in early 2012, around $1.5 trillion. As demand for loans picks up during the economic expansion, those reserves have the potential to cause a massive increase in the money supply and, eventually, high rates of inflation. To slow the growth of the money supply, the Fed can pay banks a higher interest rate on their reserves, which will result in banks lending less to other banks via the federal funds market. Federal Reserve chairman Ben Bernanke commented on the importance of the new policy in comments he made to Congress. “Raising the rate of interest paid on reserve balances will give us substantial leverage over the federal funds rate . . . banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve.”

Sources: Michael S. Derby, “Interest on Reserves Seen as Key Fed Tool,” Wall Street Journal, September 11, 2009; David Wessel, “Fed Paying Interest on Reserves: A Primer,” Wall Street Journal, September 16, 2009.

Extra Apply the The 2001 Bank Panic in Argentina Concept Argentina suffered a bank panic in 2001. Some unusual aspects of the Argentine banking system made it very difficult for the Argentine central bank to act as a lender of last resort. As an alternative policy to stop the bank panic, the Argentine government limited the amount of Argentine currency that depositors could withdraw to $1000 per account per month. Consumers cut back on their spending because much of the money in their bank accounts could not be withdrawn. Firms like McDonald’s experienced declining sales as the country’s recession worsened.

The inability of the Argentine central bank to act as a lender of last resort resulted from a decision made by the Argentine government in 1991 to fix the value of the Argentine peso relative to the U.S. dollar at one to one. This policy was meant to restore public faith in the ability of the Argentine currency to retain its value. Argentina had suffered through several periods of high inflation. In 1990, for example, the inflation rate had been a staggering 2300 percent. These inflationary episodes caused the purchasing power of the currency to decline rapidly. Although the policy of fixing the value of the peso against the

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CHAPTER 10 | Money, Banks, and the Bank of Canada dollar was successful in greatly reducing inflation, it ultimately placed the banking system in an awkward situation. After 1991, Argentine banks were encouraged to take in U.S. dollar deposits and to make U.S. dollar loans, and U.S. dollars were legally recognized as a means of payment within Argentina. By 1994, 60 percent of time deposits and 50 percent of loans were in U.S. dollars. The Argentine central bank was allowed to issue pesos only in exchange for dollars, which limited its ability to provide pesos to banks experiencing a bank run.

By 2000, many observers had begun to doubt the ability of the Argentine government to maintain the one-to-one exchange rate. As a result, Argentine households and firms, as well as foreign investors, began moving funds out of pesos and into dollars. By late 2001, fully 80 percent of time deposits in Argentine banks were in dollars rather than in pesos. In addition, many depositors began withdrawing money from their accounts. Forty-seven of the top 50 Argentine banks had experienced major withdrawals by December 2001. In January 2002, the crisis was ended when the government abandoned its commitment to the one-to-one exchange rate between the peso and the dollar and decreed that dollar deposits in banks would be converted to peso deposits at a rate of 1.4 pesos to the dollar. Although some financial stability was restored, the damage to the banking system from the crisis contributed to a decline in real GDP of 11.5 percent during 2002.

Source: Kathryn M. E. Dominguez and Linda Tesar, “International Borrowing and Macroeconomic Performance in Argentina,” in Sebastian Edwards, ed., Capital Controls and Capital Flows in Emerging Economies: Policies, Practices, and Consequences (Chicago: University of Chicago Press, 2007).

Question: Argentina suffered a severe bank panic in 2001. The United States has not suffered a bank panic since the 1930s. What differences between the Argentine and U.S. financial systems can account for their differing vulnerability to bank panics?

Answer: One significant difference between the U.S. and Argentine financial systems that accounted for the bank panic in 2001 was the inability of the Argentine central bank to act as lender of last resort. This was due to a 1991 decision by the Argentine government to fix the value of the Argentine peso to the U.S. dollar at a ratio of one to one. After 1991, Argentine banks were encouraged to take in U.S. dollar deposits and to make U.S. dollar loans. By 1994, 60 percent of time deposits and 50 percent of loans were in U.S. dollars. The Argentine central bank was allowed to issue pesos only in exchange for dollars, which limited its ability to provide pesos to banks experiencing a bank run.

The Quantity Theory of Money (pages 314-318) 10.5 Learning Objective: Explain the quantity theory of money and use it to explain how high rates of inflation occur.

A. Connecting Money and Prices: The Quantity Equation In the early twentieth century, Irving Fisher, an economist at Yale, formalized the connection between money and prices using the quantity equation. The equation states that the money supply (M) multiplied by the velocity of money (V) equals the price level (P) multiplied by real output (Y): M × V = P × Y. The velocity of money is the average number of times each dollar in the money supply is used to purchase goods and services included in GDP. Rewriting the original equation by dividing both sides by M, we have the equation for velocity:

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CHAPTER 10 | Money, Banks, and the Bank of Canada

V=

P Y .

M

The left side of this equation must equal the right side. Irving Fisher turned the quantity equation into the quantity theory of money by asserting that the velocity of money was constant. The quantity theory of money is a theory about the connection between money and prices that assumes that the velocity of money is constant.

B. The Quantity Theory Explanation of Inflation We can use a mathematical rule that states that an equation where variables are multiplied together is equal to an equation where the growth rates of the variables are added together. Therefore, the quantity equation can be transformed to Growth rate of the money supply + growth rate of velocity = Growth rate of the price level + Growth rate of output.

The growth rate of the price level is the inflation rate, so we can rewrite the quantity equation to help understand the factors that determine inflation: Inflation rate = Growth in the money supply + Growth of velocity – Growth rate of real output.

If velocity is constant, then the growth rate of velocity is zero. This allows us to rewrite the equation as Inflation rate = Growth in the money supply – Growth rate of real output.

This equation leads to the following predictions: 1. If the money supply grows at a faster rate than real GDP, there will be inflation.

2. If the money supply grows at a slower rate than real GDP, there will be deflation.

3. If the money supply grows at the same rate as real GDP, the price level will be stable, and there will be neither inflation nor deflation.

We can draw the important conclusion that in the long run, inflation results from the money supply growing at a faster rate than real GDP.

C. How Accurate Are Estimates of Inflation Based on the Quantity Theory?

If velocity is not constant, then there may not be a tight link between increases in the money supply and increases in the price level. Because velocity can move erratically in the short run, the quantity equation can’t be expected to provide good forecasts of inflation. Over the long run, there is a strong link between changes in the money supply and inflation.

D. High Rates of Inflation Very high rates of inflation are known as hyperinflation. It is caused by central banks increasing the money supply at a rate far in excess of the growth rate of real GDP. A high rate of inflation causes money to lose its value so rapidly that households and firms avoid holding it. Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession. Why do governments cause it by expanding the money supply so rapidly? The main reason is that governments often want to spend more than they are able to raise through taxes.

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CHAPTER 10 | Money, Banks, and the Bank of Canada

Extra Solved Problem 10.5 Growth in the Money Supply and the Inflation Rate Suppose that during a particular year, the money supply grows at a rate of 20 percent, velocity grows at a rate of 5 percent, and real GDP grows at a rate of 1 percent. Calculate the resulting inflation rate.

Solving the Problem Step 1:

Review the chapter material.

This problem is about the link between increases in the money supply and the inflation rate, so you may want to review the section “The Quantity Theory of Money,” which begins on page 314 in the textbook.

Step 2:

Use the quantity equation to state the relationship between the inflation rate and the other variables given.

As the textbook shows on page 315, we can rewrite the quantity equation to give us the following relationship between the inflation rate and the other variables given: Inflation rate = Growth rate of the money supply + Growth rate of velocity – Growth rate of real output.

Step 3:

Calculate the inflation rate.

Substituting the numbers from the problem into the equation given in Step 2, we have Inflation rate = 20% + 5% – 1% = 24%.

Extra Economics in Your Life and Career: If We Never Used Cash, How Much Money Could Banks Create?

Question: Suppose you live in a society where people never withdraw cash from their banks. In this case, how much money could the banking system create? What might limit deposit creation in this case?

Answer: If there were never any withdrawals of cash, the banking system could potentially have unlimited potential to create money. This situation could develop if we were successful in becoming a cashless society where all transactions were paid via cheque or credit card. This is one possibility. If the banking system did have an unlimited ability to create money, it could create money only if there were a demand for loans. Another limiting factor can be the fact that banks could not lend out more than their excess reserves.

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CHAPTER 11 | Monetary Policy

CHAPTER 11 | Monetary Policy Brief Chapter Summary and Learning Objectives The authors use the dynamic aggregate demand-aggregate model to discuss monetary policy in section 4 of this chapter. This section is self-contained so you can omit it without any loss of continuity in your discussion of monetary policy.

11.1 What Is Monetary Policy? (pages 327-329) Define monetary policy and describe the Bank of Canada’s monetary policy goals.

▪

The Bank of Canada has four monetary policy goals: price stability, high employment, stability of financial markets, and institutions and economic growth.

11.2 The Money Market and the Bank of Canada’s Choice of Monetary Policy Targets (pages 329-335) Describe the Bank of Canada’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate.

▪

The two main monetary policy targets are the money supply and the interest rate. The Bank of Canada typically uses the overnight interest rate as its policy target.

11.3 Monetary Policy and Economic Activity (pages 336-341) Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level.

▪

We can use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level.

11.4 Monetary Policy in the Dynamic Aggregate Demand and Aggregate Supply Model (pages 342-346) Use the dynamic aggregate demand and aggregate supply model to analyze monetary policy.

▪

The dynamic aggregate demand and aggregate supply model can account for the economy experiencing inflation and increases in potential GDP each year.

11.5 A Closer Look at the Bank of Canada’s Setting of Monetary Policy Targets (pages 346-351) Discuss the Bank of Canada’s setting of monetary policy targets.

▪ ▪

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Some economists argue that the Bank of Canada should use the money supply, rather than an interest rate, as its monetary target.

The Taylor rule links the Bank of Canada’s target for the overnight interest rate to economic variables. Many economists and central bankers have proposed using inflation targeting as a framework for monetary policy.

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11.6 Central Bank Policies during the 2007–2009 Global Financial Crisis (pages 352-358) Discuss the policies central banks used during the 2007–2009 global financial crisis.

▪

In addition to the policies it typically uses during recessions, the US Federal Reserve Board used new policies to combat the financial crisis that accompanied the global financial crisis of 2007–2009.

Key Terms Contractionary monetary policy, p. 338. The Bank of Canada’s increasing interest rates to reduce inflation.

Expansionary monetary policy, p. 337. The Bank of Canada’s decreasing interest rates to increase real GDP. Flexible inflation targeting, p. 328. Conducting monetary policy that does not rely on mechanical rules to achieve its inflation target, but tries to meet the inflation target over some time horizon (typically a two-year horizon).

Governing council (of the Bank of Canada), p. 343. A council with six members (including the governor) that is responsible for the management of the Bank of Canada.

Inflation targeting, p. 328. Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

Monetary growth rule, p. 347. A plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions.

Monetary policy, p. 327. The actions the Bank of Canada takes to manage the money supply

and interest rates to pursue macroeconomic policy goals.

Open market buyback operations, p. 336.

Agreements in which the Bank of Canada, or another party, purchase securities with the understanding that the seller will repurchase them in a short period of time, usually less than a week.

Operating band, p. 334. The Bank of Canada’s 50-basis-point range for the overnight interest rate.

Overnight interest rate, p. 334. The interest rate banks charge each other for overnight loans.

Symmetric inflation targeting, p. 328.

Conducting monetary policy based on equal concern about inflation rising above its target as about inflation falling below its target.

Taylor principle, p. 348. The principle that the central bank should raise the nominal interest rate by more than the increase in the inflation rate so that the real interest rate also increases.

Taylor rule, p. 348. A rule developed by John Taylor that links the central bank’s target for the overnight interest rate to economic variables.

Chapter Outline Why Would a Bank Pay a Negative Interest Rate?

Central banks, including the Bank of Canada, had driven interest rates to historically low levels as they tried to pull their economies out of the severe worldwide recession of 2007–2009. In 2015, some banks in Europe were in an unusual situation: They were receiving negative nominal interest rates on loans. Banks

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CHAPTER 11 | Monetary Policy had to make interest payments to borrowers rather than receive interest payments from borrowers. Why would a bank pay someone to borrow money? The answer is that the interest rates on these loans were not fixed but were instead adjusted based on changes in short-term interest rates that depend on the actions of central banks in Europe. When some of these interest rates became negative, banks had to automatically make the interest rates on some of their mortgage loans negative as well. European banks paying negative interest rates on loans is a striking example of how central bank policy can affect households.

Homebuilders and manufacturers that sell durable goods are also directly affected by changes in interest rates because their customers frequently borrow money to buy these goods. Other businesses will be affected indirectly because changes in interest rates cause changes in aggregate demand.

What Is Monetary Policy? (pages 327-329) 11.1 Learning Objective: Define monetary policy and describe the Bank of Canada’s monetary policy goals.

The devastation of the Great Depression was fundamentally important to the creation of the Bank of Canada. Because the depth of the Great Depression was blamed on the operation of the country’s financial system, the federal Conservative government established the Royal Commission on Banking and Currency in 1933 to study the country’s banking and monetary system. Based on the commission’s recommendation, Parliament passed the Bank of Canada Act in 1934, and the newly founded Bank of Canada started operations on March 11, 1935. The main responsibility of the Bank of Canada is to conduct monetary policy “in the best interests of the economic life of the nation.” Since World War II, the Bank of Canada has carried out an active monetary policy. Monetary policy refers to the actions the Bank of Canada takes to manage supply and interest rates to pursue its macroeconomic policy goals.

A.

The Goals of Monetary Policy

The Bank of Canada has four monetary policy goals that are intended to promote a well-functioning economy: 1. Price stability. Rising prices erode the value of money as a medium of exchange and a store of value.

2. High employment (or a low rate of unemployment). Unemployed workers and underused factories and office buildings reduce GDP below its potential level.

3. Stability of financial markets and institutions. Resources are lost when financial markets are not efficient in matching savers and borrowers.

4. Economic growth. Policymakers aim to encourage stable economic growth because stable growth allows households and firms to better plan their spending and saving decisions and encourages longrun investment.

Extra Solved Problem 11.1 Monetary Policy and Economic Growth The textbook lists the Bank of Canada’s four monetary policy goals: (1) price stability, (2) employment, (3) stability of financial markets and institutions, and (4) economic growth. The control the Bank of Canada has over the supply of money and interest rates is the source of its ability to achieve goals (1) and (3), but how much control does the Bank of Canada have over real variables such as employment and economic growth? The textbook argues that increases in per capita real GDP are the result of the growth of labour productivity. In turn, increases in labour productivity are caused by increases in the quantity of capital per hour worked and the level of technology, not changes in the money supply. The Bank of

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CHAPTER 11 | Monetary Policy Canada’s explanation of monetary policy states that “central banks choose to focus on maintaining low and relatively stable inflation for two reasons. First, low inflation is beneficial for the operation of the economy. Second, both theory and evidence suggest that monetary policy cannot have a systematic and sustained effect on macroeconomic variables other than the inflation rate.”

Source: Bank of Canada, “Why Monetary Policy Matters: A Canadian Perspective,” http://www.bankofcanada.ca/monetary-policy-introduction/why-monetary-policy-matters/1-economy/.

Why does the Bank of Canada correctly state that central banks cannot affect output (or economic growth) and employment?

Solving the Problem Step 1:

Review the chapter material.

This problem is about monetary policy, so you may want to review the section “What Is Monetary Policy?” which begins on page 327 in the textbook.

Step 2:

Explain why the Bank of Canada is correct in stating that central banks cannot affect output (or economic growth) and employment.

An important phrase was left out of the bank’s comments: “. . . monetary policy cannot influence real variables—such as output and employment—in the long run [except via the contribution of price stability to living standards].” Because prices in many markets are “sticky,” shocks to the economy can lead to persistent departures from full employment. This means there is potential for monetary policy to smooth business cycles. In other words, monetary policy can affect output and employment—but only in the short run. In the long run, a country’s economic growth is determined by real factors such as investment in capital and the level of technology, not by monetary policy.

Extra Apply the The Bank of Canada’s Monetary Policy Goals Concept In its publication “Monetary Policy: The Framework,” the Bank of Canada offers a detailed description of the operations of the central bank. The following is a passage from that publication describing the Bank of Canada’s monetary policy goals.

Inflation-control targeting has been the cornerstone of monetary policy in Canada since its introduction in 1991. At present the target range is 1 to 3 per cent, with the Bank’s monetary policy aimed at keeping inflation at the 2 per cent target midpoint.

The inflation-control target has helped to make the Bank’s monetary policy actions more readily understandable to financial markets and the public. The target also provides a clear measure of the effectiveness of monetary policy. One of the most important benefits of a clear inflation target is its role in anchoring expectations of future inflation. This, in turn, leads to the kind of economic decision making—by individuals, businesses, and governments—that brings about non-inflationary growth in the economy.

Beyond influencing the level of prices and the level of output in the near term, the Bank of Canada can contribute to financial stability and better economic performance by acting to contain financial disruptions and to prevent further problems outside of the financial sector. Modern financial systems are highly complex and interdependent and may be vulnerable to systemic disruptions, such as those that can occur as a result of a sudden plunge in stock prices. The Bank of Canada can enhance the financial .

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CHAPTER 11 | Monetary Policy system’s resilience to such shocks through its regulatory policies. If a disturbance develops, the Bank of Canada can also cushion the negative effect on financial markets and the economy by reducing the target for the overnight interest rate.

Source: The Bank of Canada, “Monetary Policy: The Framework,” http://www.bankofcanada.ca/monetary-policyintroduction/framework/inflation-control-target/.

11.2

The Money Market and the Bank of Canada’s Choice of Monetary Policy Targets (pages 329-335) Learning Objective: Describe the Bank of Canada’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate.

A. Monetary Policy Targets The Bank of Canada can’t affect employment and inflation rates directly. The Bank of Canada uses variables called monetary policy targets to influence real GDP, inflation and employment. The two main monetary policy targets are the money supply and the interest rate. The Bank of Canada typically uses the overnight interest rate as its policy target. The Bank of Canada was forced to develop new policy tools during the global financial crisis.

B. The Demand for Money The demand curve for money slopes downward because a lower interest rate causes households and firms to switch from financial assets, such as Canada bonds, to money. When interest rates on Canada bonds and other financial assets are low, the opportunity cost of holding money is low, so the quantity of money demanded by households and firms will be high. The opportunity cost of holding money is the interest rate.

C. Shifts in the Money Demand Curve The two most important variables that cause the money demand curve to shift are real GDP and the price level. An increase in real GDP means that the amount of buying and selling of goods and services has increased, which increases the quantity of money demanded at each interest rate, shifting the money demand curve to the right. A decrease in real GDP decreases the quantity of money demanded at each interest rate, shifting the money demand curve to the left. An increase in the price level increases the quantity demanded of money at each interest rate, shifting the demand curve for money to the right. A decrease in the price level decreases the quantity demanded of money at each interest rate, shifting the money demand curve to the left.

D. How the Bank of Canada Manages the Money Supply: A Quick Review If the Bank of Canada decides to increase the money supply, it purchases government of Canada securities. The sellers of these securities deposit the funds they receive from the Bank of Canada in banks, which increases their reserves. In normal times, banks lend out most of their reserves, which creates new chequing account deposits and expands the money supply. If the Bank of Canada decides to decrease the money supply, it sells government of Canada securities, which decreases banks’ reserves and contracts the money supply.

E. Equilibrium in the Money Market For simplicity, we assume that the Bank of Canada can fix the money supply. Therefore, the money supply curve is a vertical line and changes in the interest rate have no effect on the quantity of money supplied. Equilibrium in the money market occurs where the money demand curve crosses the money supply curve. When the Bank of Canada increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money.

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F. A Tale of Two Interest Rates We need two models of the interest rate. The loanable funds model is concerned with the long-term real rate of interest, and the money-market model is concerned with the short-term nominal rate of interest.

The long-run real rate of interest is the interest rate that is relevant when savers consider purchasing a long-term financial investment such as a corporate bond. When conducting monetary policy, however, the short-term nominal interest rate is the most relevant interest rate because it is the interest rate most affected by increases and decreases in the money supply.

G. Choosing a Monetary Policy Target The Bank of Canada chooses the money supply or the interest rate as its monetary policy target. The Bank of Canada has generally focused more on the interest rate than on the money supply. There are many interest rates in the economy but for purposes of monetary policy, the Bank of Canada has targeted the interest rate known as the overnight interest rate.

H. The Importance of the Overnight Interest Rate The Bank of Canada pays banks a low interest rate on their reserve deposits, so banks have an incentive to invest reserves above the desired amount. As the financial crisis that began in 2007 deepened during 2008, bank reserves soared (especially in the US) as banks attempted to meet an increase in deposit withdrawals and as they became reluctant to lend to borrowers except those with the most flawless credit histories. In normal times, banks keep few excess reserves. When banks need additional reserves, they borrow in the overnight funds market from banks that have reserves available. The overnight interest rate is the interest rate banks charge each other for overnight loans. The Bank of Canada does not set the overnight interest rate. Instead, the overnight interest rate is determined by the supply of reserves relative to the demand for them. The Bank of Canada operates under a system in which it announces the target for the overnight interest rate on eight “fixed” dates throughout the year. Changes in the overnight interest rate usually result in changes in interest rates on other short-term financial assets, such as Canada bonds, and changes in interest rates on long-term financial assets, such as corporate bonds and mortgages.

Extra Solved Problem 11.2 Should the Bank of Canada Have a Different Target?

Questions about the mandate of a central bank are frequently raised. Should a central bank only focus on inflation or should it also target other variables such as the unemployment rate or the nominal GDP. In August 2016, John Williams, head of the San Francisco Fed, suggest that central banks should rethink on what they aim for. James W. Dean, an emeritus professor of economics at Simon Fraser says that in fact some central banks worldwide are targeting economics variables not covered by their mandate.

Especially after the 2007 – 2009 recession, the mandate of the Bank of Canada mandate was questioned.

“Bank of Canada Governor Stephen Poloz emphasized weak inflation and growth as top concerns on Wednesday and signaled he differed with the Organisation of Economic Co-operation and Development’s suggestion that he should start raising interest rates as soon as late 2014.” As suggested by this quote from Reuters (November 20, 2013), not everyone agrees with the mandate of the Bank of Canada.

In 2013, a growing number of economists, including some at the OECD viewed a stubbornly high rate of unemployment more than four years after the end of the 2007–2009 recession as evidence that the Bank of Canada should do more to promote its goal of “maximum employment.” Rather than target the interest rate or the money supply, these economists suggest a different target: nominal gross domestic product (NGDP). NGDP increases whenever real GDP or the rate of inflation rises, so an NGDP target would call

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CHAPTER 11 | Monetary Policy for the Bank of Canada to increase the growth of the money supply by buying Canada bonds whenever NGDP, or the growth rate of NGDP, fell below the target.

The same issue has arisen in the United States and was addressed by the president of the Chicago Fed. Although he did not call for a new monetary policy target, Charles Evans, president of the Federal Reserve Bank of Chicago, expressed his support for a more aggressive monetary policy in a 2011 speech: “Given how badly we [the Fed] are doing with our employment mandate, we need to be willing to take a risk on inflation going modestly higher in the short run.” In 2012, the Fed stated its intention to use open market operations to maintain the federal funds rate, the interest rate banks charge each other for overnight loans, in a range from 0 to 1/4 percent through at least late 2014. Some NGDP target advocates recommended a more aggressive policy that would keep interest rates near zero through at least 2016.

Those who oppose NGDP targeting believe the Fed would risk failing to attain another of its goals: price stability. Richard Fisher, president of the Federal Reserve Bank of Dallas, said, “It would not break my . . . heart if we had a single mandate” to focus solely on inflation. In fact, the many central banks, including those of Canada and the European countries that use the euro, have only one mandate: to promote stable prices.

There is no consensus on what should the mandate of a central bank be. However, economists are actively researching this question.

Sources: Louise Egan, “Canadian inflation lower than central bank would like—Poloz,” Reuters, November 20, 2013; “OECD calls for Bank of Canada’s interest rate to more than double by end of 2015”, CTV News, November 19, 2013; Wall Street Journal, October 27, 2011; Kelly Evans, “Inflated Expectations for an Economic Fix,” Wall Street Journal, October 24, 2011; Board of Governors of the Federal Reserve System, “Minutes of the Federal Open Market Committee,” November 28 and December 13, 2011, James Dean, “Central banks worldwide need more tools to co-ordinate policy,” The Globe and Mail, December 24, 2016 “When 2% is not enough,” The Economist, August 27, 2016. Garín, Julio, Robert Lester, and Eric Sims. "On the desirability of nominal GDP targeting." Journal of Economic Dynamics and Control 69 (2016): 21-44.

a. Can the Bank of Canada’s Board of Directors change the Bank’s monetary policy goals, for example, to have a dual mandate to maintain stable prices and minimize unemployment as some other central banks have? b. Can the Bank of Canada’s Board of Directors change the Bank’s monetary policy target, for example, from the interest rate to NGDP?

Solving the Problem Step 1:

Review the chapter material.

This problem is about how the Bank of Canada uses targets to conduct monetary policy and affect interest rates, so you may want to review the section “The Money Market and the Bank of Canada’s Choice of Monetary Policy Targets,” which begins on page 329 in the textbook.

Step 2:

Answer part (a) by explaining whether the Bank of Canada’s Board of Directors can change the Bank’s monetary policy goals.

The mandate of the Bank of Canada is spelled out in the latest Bank of Canada Act. Parliament would have to amend the Act again in order to change the Bank’s monetary policy goals. The Governing Council is responsible for the implementation of monetary policy.

Step 3:

Answer part (b) by explaining whether the Bank of Canada’s Governing Council can change the Bank’s monetary policy target.

Nothing in the Bank of Canada Act keeps the Governing Council from changing the Bank’s monetary policy target. Such changes have been made in the past. For example, when the Bank of Canada began to target the interest rate rather than the money supply. However,

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CHAPTER 11 | Monetary Policy changing the monetary policy target from the interest rate to NGDP would likely be met by opposition from some members of the Board of Directors.

Extra Why Did the Fed’s Monetary Policy Fail during the Apply the Great Depression?

Concept Many economists criticize the US Federal Reserve for its monetary policy decision-making during the Great Depression. Instead of pursuing an expansionary monetary policy, as the US Federal Reserve typically does now during recessions, the Fed “sat on its hands.” Allan H. Meltzer of Carnegie Mellon University has written two volumes of A History of the Federal Reserve in which he studies why the Federal Reserve acted as it did. In an interview that appeared in The Region, a magazine published by the Federal Reserve Bank of Minneapolis, Professor Meltzer was asked about the Fed’s behaviour during the Great Depression.

Region: [In your book] you clearly . . . describe the Fed’s early failures to do precisely what it was intended [to do]: stabilize the economy. . . . Why were policymakers unable to see what was happening during the Great Depression and implement the right tools?

Meltzer: . . . They did what many so-called sensible people at the time would have done. . . . the Federal Reserve Act was written to create a passive institution. . . . They were not supposed to engage in countercyclical policy. . . . They didn’t think that was their responsibility [and] the authors of the Federal Reserve Act relied on the gold standard to maintain stability . . . . The strong belief was that . . . when banks want to borrow, we’ll be there to lend. But until they want to borrow then it’s wrong to increase reserves . . . their idea of inflation was not that prices were rising—because during 1929 . . . prices were falling. But they worried about inflation.

Source: Douglas Clement, “An Interview with Allan H. Meltzer,” The Region, Federal Reserve Bank of Minneapolis, September 2003.

The Bank of Canada was created in 1934 as a result of the Great Depression.

Monetary Policy and Economic Activity (pages 336-341) 11.3 Learning Objective: Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level.

The ability of the Bank of Canada to use monetary policy to affect economic variables depends on its ability to affect real interest rates. Because the overnight interest rate is a short-run nominal interest rate, the Bank of Canada sometimes has difficulty affecting long-term interest rates. The Bank of Canada can, however, use buyback operations to affect long-term real interest rates by selectively buying securities of a longer maturity.

A. How Interest Rates Affect Aggregate Demand Changes in interest rates affect aggregate demand, which is the total level of spending in the economy.

Changes in interest rates will not affect government purchases, but will affect consumption, investment, and net exports in the following ways: 1. Consumption: Lower interest rates lead to increased spending on durables and reduce the return to saving, leading households to save less and spend more. .

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CHAPTER 11 | Monetary Policy 2. Investment: Lower interest rates make it less expensive for firms to borrow, so they will undertake more investment projects. Lower interest rates can also increase investment through their effect on stock prices. Spending by households on new homes falls when interest rates rise. Spending by households on new homes increases when interest rates fall.

3. Net exports: If interest rates in Canada rise relative to interest rates in other countries, investing in Canadian financial assets will become more desirable, causing foreign investors to increase their demand for dollars, which will increase the value of the dollar. As the value of the dollar increases, net exports will fall.

B. The Effects of Monetary Policy on Real GDP and the Price Level The Bank of Canada’s decreasing interest rates to increase real GDP is called expansionary monetary policy. The Bank of Canada can also use monetary policy to keep aggregate demand from expanding so rapidly that the inflation rate begins to increase. Contractionary monetary policy refers to the Bank of Canada’s increasing interest rates to reduce inflation. The Bank of Canada can use monetary policy to affect the price level and, in the short run, the level of real GDP, allowing it to attain its policy goals of high employment and price stability.

C. Can the Bank of Canada Eliminate Recessions?

Keeping recessions shorter and milder than they would otherwise be is usually the best the Bank of Canada can do. To be successful, the Bank of Canada needs to be able to recognize the need for a change in monetary policy. If the Bank of Canada acts too late, it may destabilize the economy. Failing to react until well after a recession has begun or ended can be a serious problem for the Bank of Canada. In the case of the 2007–2009 recession, the Bank of Canada did promptly cut the target overnight rate in response to the beginning of the financial crisis, even though a recession did not actually begin until some months later.

D. A Summary of How Monetary Policy Works A contractionary monetary policy does not cause the price level to fall, but causes it to rise by less than it would have without the policy. An expansionary monetary policy is sometimes called a loose or easy policy. A contractionary policy is sometimes called a tight policy.

Extra Why Do Financial Markets Care Apply the about Monetary Policy?

Concept You may have seen newspaper headlines similar to these: ▪ ▪ ▪

“Bank Rate Cut Fuels Stock Gains” “Stocks Fall in Anticipation of Bank Rate Increase” “Worries of Bank Rate Increase Send Stocks Lower”

Before most meetings of the Governing Council, newspapers report stock traders’ predictions of possible Bank actions and whether those actions will cause stock prices to increase or decrease. Some Bay Street analysts attempt to forecast future changes in the target for the overnight rate. Why do changes in the overnight rate affect the stock market? There are two main explanations. In thinking about both explanations, remember that changes in the overnight rate usually cause changes in other interest rates.

The first reason that stock prices react to the Bank raising or lowering interest rates is that changes in interest rates affect the economy. As we have seen, lower interest rates usually result in increases in real GDP. The value of a share of stock depends on the profitability of the firm that issued the stock. When real GDP is increasing, the profitability of many firms is also increasing. Stock prices tend to rise when .

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CHAPTER 11 | Monetary Policy investors expect that the Bank will be lowering interest rates to stimulate the economy. When investors expect that the Bank will be raising interest rates to slow down an economy at risk of rising inflation, stock prices tend to fall.

The second reason that stock prices react to changes in interest rates is that changes in interest rates make it more or less attractive for people to invest in stocks rather than in other financial assets. Investors look for the highest return possible on their investments, holding constant the risk level of the investments. If the interest rates on Canada bonds, term deposits, and corporate bonds are all low, an investment in stocks will be more attractive. When interest rates are high, an investment in stocks will be less attractive.

Question: Why would stock prices increase if investors believe that the Bank of Canada will not be raising interest rates and may even be cutting them?

Answer: Two reasons why stock prices rise if investors believe that the Bank will not raise interest rates or will even cut them are (1) lower interest rates lead to increases in aggregate demand and, therefore, real GDP, and (2) lower interest rates make stocks more attractive than bonds or other interest-paying financial assets.

Extra The US Federal Reserve Responds Apply the to the Terrorist Attacks Concept of September 11, 2001 When the US Federal Reserve (the Fed) was founded, its main purpose was to make discount loans to banks suffering from deposit withdrawals. Today, discount loans have become relatively less important in the operations of the Fed. For example, the average weekly amount of discount loans outstanding in 2001 through September 11 was only $34 million.

Still, discount loans remain an effective way for the Fed to make funds quickly available to banks in an emergency. The banks can use these funds to provide cash or loans to households and firms. The day after the terrorist attacks of September 11, 2001 in New York, Washington, D.C., and Pennsylvania, the Fed made massive discount loans to banks. Discount loans rose from $99 million on September 5 to $45.5 billion on September 12, or to 500 times their normal level. In the end, households and firms did not withdraw excessive amounts from their bank accounts following the attacks, and the volume of discount loans returned to normal levels very quickly. By September 19, discount loans had fallen to $2.6 billion, and by September 26, they had fallen to only $20 million. The Fed also relied on discount loans to cushion the banking and financial systems from potential instability during the subprime mortgage crisis of 2007 and 2008.

Although the modern Fed concentrates on its objectives for inflation and economic growth, which it implements through open market operations, it still retains its original purpose of dealing with potential financial panics. For this purpose, discount loans are an effective tool.

Source: Federal Reserve Board of Governors, Statistical Release H.4.1, various weekly issues.

Question: Some economists and members of the US government have argued that because of deposit insurance, bank runs and bank panics no longer occur, and the Fed no longer needs to act as a lender of last resort. Therefore, the Federal Reserve Act should be amended to eliminate the ability of the Fed to make discount loans. Briefly evaluate this argument. Does the same argument hold true with respect to the Bank of Canada?

Answer: Discount loans are an effective way for the Fed to make funds available to banks in an emergency, and therefore, they remain an important tool for the Fed to deal with potential financial panics

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CHAPTER 11 | Monetary Policy arising from unexpected events, such as the September 11, 2001, terrorist attacks. The Bank of Canada stands ready to make loans to commercial banks at the Bank Rate, 25 basis points above the target overnight rate.

11.4

Monetary Policy in the Dynamic Aggregate Demand and Aggregate Supply Model (pages 342-346) Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze monetary policy.

In Chapter 9, we developed a dynamic aggregate demand and aggregate supply model to take account of the following facts: (1) The economy experiences continuing inflation, and (2) the economy experiences long-term growth, with the LRAS curve shifting to the right every year.

A. The Effects of Monetary Policy on Real GDP and the Price Level: A More Complete Account During some periods, aggregate demand (AD) does not increase enough to keep the economy at potential GDP. For example, the collapse of the US housing bubble and the financial crisis had a negative effect on AD during the 2007–2009 recession. Economists at the Bank of Canada closely monitor the economy and continually update forecasts of real GDP and the price level. When these economists forecast that aggregate demand is not growing fast enough to allow the economy to remain at full employment, they present their findings to the Bank of Canada’s governing council, which decides whether circumstances require a change in monetary policy.

B. Using Monetary Policy to Fight Inflation The Bank of Canada can also use a contractionary monetary policy to keep AD from expanding so rapidly that the inflation rate begins to increase above 3 percent. During 2006 and 2007, the economy was at equilibrium at potential GDP, but the Bank of Canada’s economists and governing council were concerned that the continuing boom in the commodities sector could increase inflation. Between January 2006 and July 2007, the target for the overnight interest rate rose from 3.25 percent to 4.5 percent as the Bank of Canada tried to slow the increase in prices. Because the Bank of Canada kept AD from increasing as much as it otherwise would have, equilibrium occurred at potential GDP, and the price level in 2006 rose to only 103.2, keeping the inflation rate at 3.2 percent, instead of an inflation rate of 4.5 percent if the Bank of Canada took no action.

Extra Apply the Trading with the Bank of Canada Concept The textbook describes how the Bank of Canada uses the overnight interest rate as a monetary policy target. The Bank of Canada sells securities in order to raise the interest rate on overnight funds or to buy securities in order to lower the overnight funds rate. This is typically done using open market buybacks.

Visitors to the trading desk (which is really a room) who expect to see shouting traders crowded around each other may be disappointed. Trading takes place quietly via computer and phone calls. Those who sell securities to the Bank of Canada are represented by dealers who trade on their behalf. Only a small number of firms—called primary dealers—engage in trades of government treasury bills with the Bank of Canada. As of September 2019, the primary dealers included the following companies:

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CHAPTER 11 | Monetary Policy 1.

2.

3.

4.

5.

Bank of Montreal Canadian Imperial Bank of Commerce Desjardins Securities Inc. HSBC Bank Canada Laurentian Bank Securities Inc.

6. Merrill Lynch Canada Inc. 7. National Bank Financial Inc. 8. RBC Dominion Securities Inc. 9. Scotia Capital Inc. 10. The Toronto-Dominion Bank

In addition, the Bank of Canada provides Large Value Transfer System (LVTS) advances, which are collateralized overnight loans to direct participants in the LVTS. The sixteen members of the LVTS, as of September 2019, are as follows:

1. Alberta Treasury Branches 2. Bank of America, National Association 3. Bank of Canada 4. Bank of Montreal 5. Bank of Nova Scotia 6. BNP Paribas (Canada) 7. Canadian Imperial Bank of Commerce 8. Central 1 Credit Union

9. Fédération des caisses Desjardins du Quebec 10. HSBC Bank Canada 11. ICICI Bank Canada 12. Laurentian Bank of Canada 13. National Bank of Canada 14. Royal Bank of Canada 15. State Street 16. Toronto-Dominion Bank

Source: Bank of Canada

11.5

A Closer Look at the Bank of Canada’s Setting of Monetary Policy Targets (pages 346-351) Learning Objective: Discuss the Bank of Canada’s setting of monetary policy targets.

A. Should the Bank of Canada Target the Money Supply?

Some economists have argued that rather than using an interest rate as its monetary policy target, the Bank of Canada should use the money supply. These economists belong to a school of thought known as monetarism. Followers of monetarism favour replacing monetary policy with a monetary growth rule.

Under current Bank of Canada policy, when the economy is in recession, the Bank of Canada reduces interest rates, and when inflation is increasing, the Bank of Canada raises interest rates. A monetary growth rule, in contrast, is a plan for increasing the money supply at a constant rate that does not change in response to economic conditions. By keeping the money supply growing at a constant rate, the monetarists claim, the Bank of Canada would greatly increase economic stability.

B. Why Doesn’t the Bank of Canada Target Both the Money Supply and the Interest Rate?

Most economists believe that an interest rate is the best monetary policy target. The Bank of Canada can’t target both the interest rate and the money supply at the same time. The Bank of Canada controls the money supply, but it does not control money demand. Money demand is determined by decisions of households and firms as they weigh the trade-off between money, with its low interest rate, and bonds and other financial assets.

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CHAPTER 11 | Monetary Policy

C. The Taylor Rule The Taylor rule is a rule developed by John Taylor that links the Bank of Canada’s target for the overnight interest rate to economic variables. According to the Taylor rule, the Bank of Canada should set the target for the overnight interest rate so that it is equal to the sum of the inflation rate, the equilibrium real overnight interest rate, and two additional terms.

1. The inflation gap: the difference between current inflation and a target rate.

2. The output gap: the percentage difference between real GDP and potential real GDP. The inflation gap and output gap are each given “weights” that reflect their influence on the overnight interest target rate. With weights of 1/2 for both gaps, we have the following Taylor rule: Overnight interest rate target = Current inflation rate + Real equilibrium overnight interest rate + ((½)×Inflation gap + (½)×Output gap).

11.6

Central Bank Policies during the 2007–2009 Global Financial Crisis (pages 352-358) Learning Objective: Discuss the policies central banks used during the 2007–2009 recession.

The severity of the recession of 2007–2009 complicated the job of the Federal Reserve in the United States, the world’s largest central bank.

A. The Inflation and Deflation of the Housing Market Bubble The US Federal Reserve lowered the target for its federal funds rate during the 2001 recession to stimulate the demand for housing. The policy was successful, but by 2005 many economists argued that a “bubble” had formed in the housing market. The price of a house should reflect the value of the housing services the house provides. By 2005, some economists believed that in some cities prices had risen so much that monthly mortgage payments were far above the rent on comparable homes. During 2006 and 2007, the air was escaping from the housing bubble. Prices of new and existing homes in most markets were declining. When lenders foreclosed on some mortgage loans, those lenders then sold the homes, causing prices to fall further. Subprime loans are loans granted to borrowers with flawed credit histories.

Mortgage lenders that had concentrated on making subprime loans suffered heavy losses. Most other banks and other lenders tightened the requirements for borrowers. This credit crunch made it more difficult for potential homeowners to obtain mortgages.

The decline in the housing market affected other markets such as furniture, appliances, and home improvements.

B. The Changing Mortgage Market in the United States Until the 1970s, the commercial banks and savings and loans that granted mortgages kept the loans until the borrowers paid them off. Many politicians in the United States believed that home ownership could be increased by creating a secondary market in mortgages. If a bank granted a mortgage and then resold it to an investor, the bank could use the funds to grant another mortgage. In this way, financial institutions could grant more mortgages because they would no longer depend only on deposits for the funds needed for the loans. However, most investors were unwilling to buy mortgages because they were afraid of losing money if borrowers defaulted on their loans.

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CHAPTER 11 | Monetary Policy To reassure investors, the US government used two government-sponsored enterprises (GSEs): the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) the equivalent of Canada’s Canada Mortgage and Housing Corporation (CMHC). By the 1990s, a large secondary market existed in mortgages, with funds flowing from investors through Fannie Mae and Freddie Mac to banks and, ultimately, to individuals and families borrowing money to buy houses.

C. The Role of Investment Banks By the 2000s, further changes had taken place in the mortgage market. First, investment banks became significant participants in the secondary market for mortgages. Investments banks bought mortgages, bundled large numbers of them together as bonds known as mortgage-backed securities, and resold them to investors. Mortgage-backed securities became popular with investors because they paid higher interest rates than other securities with comparable default risk.

Second, by the height of the housing bubble of 2005 and early 2006, lenders had loosened the standards for obtaining a mortgage loan. By 2005, many mortgages were being issued to subprime borrowers with flawed credit histories. Lenders created new types of adjustable-rate mortgages that allowed borrowers to pay a very low interest rate for the first few years of the mortgage and a higher rate in later years. Both borrowers and lenders anticipated that housing prices would continue to rise. Unfortunately, the decline in housing prices led to rising defaults and the value of mortgage-backed securities declined sharply. Many commercial and investment banks owned mortgage-backed securities, so the decline in the value of these securities caused these banks to suffer heavy losses. By mid-2007, the decline in the value of mortgagebacked securities and the large losses suffered by commercial and investment banks began to cause turmoil in the financial system.

D. Why Didn’t Canada Have a Housing Bubble and Banking Crisis in 2008?

One reason the Canadian economy and banks have done much better than their US and European counterparts is that Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), has been more conservative than banking regulators in other countries. As a result, Canadian banks have lower leverage and more conservative lending and acquisition practices. In fact, in the aftermath of the subprime recession, Canada’s conservative lending system has been viewed as the soundest in the world, with many countries considering Canadian-style reforms of their financial markets.

E. The US Federal Reserve and the US Treasury Department Respond The US Federal Reserve entered into an unusual partnership with the US Treasury Department to develop new policies. Although the Federal Reserve traditionally made loans only to commercial banks, in March 2008 it announced that it would temporarily make discount loans to primary dealers, firms that participate in regular open market transactions with the Federal Reserve. Also in March, the Federal Reserve announced that it would lend up to $200 billion of Treasury securities in exchange for mortgagebacked securities. This made it possible for primary dealers that owned mortgage-backed securities that were difficult to sell to have access to Treasury securities that could be used as collateral for short-term loans. In March, the Federal Reserve and Treasury also helped JPMorgan Chase acquire the investment bank Bear Stearns, which was close to failing. The Federal Reserve agreed that if JPMorgan Chase would acquire Bear Stearns, the Federal Reserve would guarantee any losses JPMorgan Chase suffered on Bear Stearn’s holdings of mortgage-backed securities, up to $29 billion. Finally, in September 2008, the Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac. The firms were placed under the supervision of the Federal Housing Finance Agency.

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CHAPTER 11 | Monetary Policy The decision by the Federal Reserve and the Treasury to help arrange the sale of Bear Stearns was criticized. The main concern was with a moral hazard problem. This is the possibility that managers of firms might make riskier investments if they believe the federal government will save them from bankruptcy. In September 2008, when the investment bank Lehman Brothers was near bankruptcy, the Federal Reserve and the Treasury had to weigh the moral hazard problem against the possibility that the failure of Lehman Brothers would lead to further declines in asset prices and endanger the financial positions of other firms.

The Federal Reserve and the Treasury did not intervene to save Lehman Brothers from bankruptcy. The adverse reaction to Lehman’s failure led the Federal Reserve to provide an $85 billion loan to the insurance company American International Group (AIG) in exchange for an 80 percent ownership stake, effectively giving the government control of the company. The Treasury announced a plan to provide insurance for deposits in money market mutual funds. The Federal Reserve announced that it would lend directly through the Commercial Paper Lending Facility by purchasing three-month commercial paper issued by nonfinancial corporations. Finally, in October 2008, Congress passed the Troubled Asset Relief Program (TARP), under which the Treasury attempted to stabilize the commercial banking system by providing funds in exchange for stock. It remains to be seen whether these new approaches represent a permanent increase in the federal government’s involvement in US financial markets or whether the end of the recession will see policy return to more traditional approaches.

F. The US Federal Reserve Adopts Flexible Inflation Targeting Over the past decade, many economists in the United States had proposed using inflation targeting as a framework for conducting monetary policy in that country. With inflation targeting, the central bank commits to achieving a publicly announced inflation target of, for example, 2 percent. Inflation targeting does not impose an inflexible rule on the central bank. Although Ben Bernanke’s appointment as chair of the Federal Reserve in January 2006 signaled that the Federal Reserve would likely adopt a policy of inflation targeting, the necessity of dealing with the recession of 2007–2009 temporarily pushed the issue off the Federal Reserve’s agenda. In 2011, however, the Federal Reserve adopted flexible inflation targeting, a strategy that has been practised for over 20 years by other central banks around the world.

Extra Solved Problem 11.6 The Fed Uses New Policy Tools to Respond to Financial Crisis Canada’s financial system escaped relatively unscathed by the 2007–2009 financial crisis. The US was not as lucky, and the policy response in the US was far more dramatic that the policy response in Canada.

Ben Bernanke, chair of the Board of Governors of the US Federal Reserve System, explained how the Federal Reserve used new policy tools to respond to the financial crisis and recession that occurred between 2007 and 2009. The following are excerpts from a speech Bernanke gave at the London School of Economics in January 2009: The Federal Reserve has responded aggressively to the crisis since . . . the summer of 2007. . . . One important tool is communication. . . . The Committee should be able to influence longer-term interest rates by informing the public’s expectations about the future course of monetary policy. . . . The Federal Reserve . . . [has used other] policy tools . . . [that] all make use of the asset side of the Federal Reserve’s balance sheet . . . .

The first set of tools . . . involve the provision of short-term liquidity to sound financial institutions . . . . These actions include creating new facilities for auctioning credit and making primary securities dealers, as well as banks, eligible to borrow at the Fed’s discount window. . . . .

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CHAPTER 11 | Monetary Policy [To] address instability . . . in critical nonbank markets . . . the Federal Reserve has developed a second set of policy tools. . . . We have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds. . . . the Federal Reserve and the Treasury have jointly announced a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. . . .

The Federal Reserve’s third set of policy tools . . . involves the purchase of longer-term securities for the Fed’s portfolio. . . .

Some observers have expressed concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed’s lending activities have indeed resulted in a large increase in excess reserves held by banks. . . .

However, banks are choosing to leave the great bulk of their excess reserves idle. . . .

As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline, implying a reduction in excess reserves. . . . The Federal Reserve will be able to return to its traditional means of making monetary policy—namely, by setting a target for the federal funds rate. a. How did the policies the Federal Reserve used to respond to the financial crisis and the recession of 2007–2009 differ from policies it used during earlier recessions? b. What risk did the Federal Reserve take by “responding aggressively” to the economic crisis of 2007–2009?

Source: Board of Governors of the Federal Reserve System, “The Crisis and the Policy Response”; http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm.

Solving the Problem Step 1:

Review the chapter material.

This problem is about the policies the Federal Reserve used during the 2007–2009 recession so you may want to review the section “Central Bank Policies during the 2007–2009 Global Financial Crisis” which begins on page 352 in the textbook.

Step 2:

Answer part (a) by explaining how the policies the Federal Reserve used to respond to the financial crisis differed from policies it used during earlier recessions.

The Federal Reserve (a) allowed primary securities dealers (broker-dealers that trade in Treasury securities with the Federal Reserve Bank of New York) to borrow from the Fed’s “discount window;” (b) purchased commercial paper (short-term loans made between firms) and provided backup liquidity for money market mutual funds; (c) with the Treasury Department, made loans against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration; and (d) purchased longer-term securities for its asset portfolio. (The Fed typically buys and sells Treasury bills, with maturities of less than one year, when it conducts open market operations).

Step 3:

Answer part (b) by discussing the risk the Federal Reserve took by “responding aggressively” to the economic crisis of 2007–2009.

Most of the actions Ben Bernanke described caused an increase in bank reserves. There was a large increase in banks’ excess reserves, which can be used to expand deposits and the money supply. So, the Fed was risking an increase in the inflation rate.

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CHAPTER 11 | Monetary Policy

Extra Economics in Your Life and Career: Should You Hold Bonds or Savings/Chequing Accounts?

Question: Suppose most of your savings are in bonds and, according to an article in the Financial Post, the Bank of Canada announces that it will carry out a contractionary monetary policy. What should you do? Should you continue to hold your bonds or should you move your funds into bank accounts?

Answer: Holding bonds has several advantages. Their prices may rise. In addition, they pay interest that is greater than you are likely to receive on savings or chequing accounts. Let’s assume that some firms produce beyond their normal capacity and the unemployment rate is very low. In this case, wages and prices are increasing. To reach its goal of price stability, the Bank of Canada needs to carry out a contractionary monetary policy by decreasing the money supply and increasing interest rates. Higher interest rates will cause a decline in the selling price of bonds. So, you will be better off if you sell your bonds before interest rates begin to rise and move your funds into bank accounts. Of course, by the time you read the news in the Financial Post, it may be too late and bond prices may already have declined.

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CHAPTER 12 | Fiscal Policy

CHAPTER 12 | Fiscal Policy Brief Chapter Summary and Learning Objectives The authors use the dynamic aggregate demand and aggregate supply model to discuss fiscal policy in section 12.3 of this chapter. This section is self-contained so you can omit it without any loss of continuity in your discussion of fiscal policy.

12.1 What Is Fiscal Policy? (pages 367-373) Define fiscal policy.

▪

Fiscal policy involves changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives.

12.2 The Effects of Fiscal Policy on Real GDP and the Price Level (pages 373-375) Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy.

▪

To fight recessions, governments can increase purchases or cut taxes. To fight rising inflation, governments can decrease purchases or raise taxes.

12.3 Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model (pages 375-376) Use the dynamic aggregate demand and aggregate supply model to analyze fiscal policy.

▪

The dynamic model allows for a more complete understanding of fiscal policy because it recognizes that the price level rises every year and the LRAS curve shifts to the right every year.

12.4 The Government Purchases and Tax Multipliers (pages 376-382) Explain how the government purchases and tax multipliers work.

▪

The multiplier effect refers to the fact that an increase in government purchases or a cut in taxes will cause equilibrium real GDP to increase by a multiple of the increase in government purchases or cut in taxes.

12.5 The Limits of Fiscal Policy as a Stimulus (pages 382-385) Discuss the difficulties that can arise in implementing fiscal policy.

▪

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Obtaining approval from the prime minister and a majority of parliament for a new fiscal policy can be a long process, and it can take months for an increase in authorized spending to actually take place.

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CHAPTER 12 | Fiscal Policy

12.6 Deficits, Surpluses, and Federal Government Debt (pages 385-390) Define federal budget deficit and federal government debt and explain how the federal budget can serve as an automatic stabilizer.

▪

A budget deficit occurs when the federal government’s expenditures are greater than its tax revenues. A budget surplus occurs when the federal government’s expenditures are less than its tax revenues.

12.7 The Effects of Fiscal Policy in the Long Run (pages 391-394) Discuss the effects of fiscal policy in the long run.

▪

Some fiscal policy actions have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth.

Appendix: A Closer Look at the Multiplier (pages 402-406) Apply the multiplier formula.

Key Terms Automatic stabilizers, p. 368. Government spending and taxes that automatically increase or decrease along with the business cycle.

Federal government debt, p. 389. The total value of bonds outstanding, which is equal to the sum of past budget deficits, net of surpluses.

Budget deficit, p. 385. The situation in which the government’s current expenditures are greater than its current tax revenue.

Fiscal policy, p. 367. Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives.

Budget surplus, p. 385. The situation in which the government’s current expenditures are less than its current tax revenue.

Multiplier effect, p. 377. The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

Crowding out, p. 383. A decline in private expenditures as a result of an increase in government purchases.

Tax wedge, p. 391. The difference between the pretax and posttax return to an economic activity.

Cyclically adjusted budget deficit or surplus, p. 387. The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

Chapter Outline Fiscal Policy as a 2019 Canadian Election Issue Fiscal policy is almost always an election issue in Canada. Government spending and taxation, as well as promises to balance the federal budget, featured prominently in the 2019 federal election. The same issues played a key role in the 2015 election. Two of the three main federal parties consistently campaign on the

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CHAPTER 12 | Fiscal Policy idea of increasing government spending in order to “boost” the economy. Most politicians and many economists believe that changes in government spending and taxation can be used to manage the overall level of macroeconomic activity in a country. Fiscal policy is not only used to stabilize the economy. It is also used to encourage investment and savings. Economists and, more recently, politicians have also begun to worry about long-term deficit spending. When a government constantly spends more than it collects in taxes and other forms of revenue, more and more of its budget must be devoted to paying interest on past borrowing. The federal government has to attempt to balance its desire to stimulate the economy and foster economic growth with costs of borrowing to do so. If economic growth is slower than the government predicted, it becomes very difficult for a government to return to a balanced budget.

What Is Fiscal Policy? (pages 367-373) 12.1 Learning Objective: Define fiscal policy.

Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives are called fiscal policy.

A. What Fiscal Policy Is and What It Isn’t Provincial, territorial, and local governments sometimes change their taxing and spending policies to aid their local economies, but these are not fiscal policy actions because they are not intended to affect the national economy. Some of the decisions the federal government makes about taxes and spending are not fiscal policy actions because they are not intended to achieve macroeconomic policy goals.

B. Automatic Stabilizers versus Discretionary Fiscal Policy Automatic stabilizers are government spending and taxes that automatically increase or decrease along with the business cycle. The word automatic refers to the fact that changes in these types of spending and taxes happen without actions by the government. For example, when the economy is expanding and employment is increasing, government spending on Employment Insurance payments to workers who have lost their jobs will automatically decrease. With discretionary fiscal policy, the government takes actions to change spending or taxes.

C. An Overview of Government Spending and Taxes Over the past 38 years, the federal government’s share of total government spending has been declining, as Figure 12.1 shows. There are two reasons for this decline: The federal government has been delegating the administration of certain responsibilities to provincial and territorial agencies (e.g., the regulation of interprovincial and international highway traffic, and the management of forestry and natural resources), and the importance of health care in the budgets of other levels of government has grown. The federal government supports provincial health care spending through the Canada Health Transfer, a payment system that provides money to provincial and territorial governments to pay for health care. In 2018, the Canada Health Transfer accounted for roughly 11 percent of federal government spending.

Figure 12.4 on p. 370 illustrates where federal government spending went in 2018. Figure 12.5 on p. 371 illustrates where federal government spending came from in 2018.

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Extra Solved Problem 12.1 Fiscal Policy and Deficits Fiscal policy refers to changes in federal taxes and spending that are intended to achieve macroeconomic policy objectives. One implication of fiscal policy is that the federal government’s budget should not always be balanced. For example, a budget deficit will stimulate spending and employment in a recession because federal government spending exceeds tax revenue. But some economists express concern that the Canadian and American governments’ budgets have been in deficit when the economy is not in recession.

The Concord Coalition is a grassroots organization that advocates fiscal responsibility. The late Edward Gramlich, who was an economist at the University of Michigan and a Federal Reserve Board Governor, expressed his concern about US fiscal policy and the health of the US economy at a Concord Coalition policy forum in 2004: Fiscal policy can have important long-run effects on the health of the economy. . . . When the government runs deficits, it siphons off private savings . . . leaving less available for capital investment. With less capital investment, less new equipment is provided to workers . . . future productivity growth rates and levels are lower.

Source: “Why is Fiscal Responsibility Important?” The Concord Coalition, https://www.concordcoalition.org/

The US federal government’s budget deficit in fiscal year 2016 was about $584.6 billion. The budget for national defence in fiscal year 2016 was about $587.5 billion.

Discuss whether the defence budget should be cut in order to reduce the deficit and promote future productivity growth.

Solving the Problem Step 1:

Review the chapter material.

This problem is about the definition of fiscal policy, so you may want to review the section “What is Fiscal Policy?” which begins on page 367 of the textbook.

Step 2:

Answer the question by discussing whether the defence budget should be cut in order to reduce the deficit and promote future productivity growth.

Critics of government spending can find examples of wasteful spending in most programs, including national defence. But as the textbook notes, not all government decisions regarding spending and taxes are fiscal policy actions “because they are not intended to achieve macroeconomic policy goals.” The size of the budget for national defence should be based on the nation’s long-term security goals, not on a desire to reduce the deficit or promote future productivity growth.

12.2

The Effects of Fiscal Policy on Real GDP and the Price Level (pages 373-375) Learning Objective: Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy.

The federal government uses macroeconomic policies to offset the effects of the business cycle on the economy. When the economy is in recession, increases in government purchases or decreases in taxes will increase aggregate demand. Decreasing government purchases or raising taxes will slow the growth of aggregate demand and reduce the inflation rate.

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A. Expansionary and Contractionary Fiscal Policy Expansionary fiscal policy involves increasing government purchases or decreasing taxes. An increase in government purchases will increase aggregate demand directly. A cut in taxes has an indirect effect on aggregate demand. Cutting the individual income tax will increase household disposable income and consumption spending. Cutting taxes on business income can increase aggregate demand by increasing business investment. The goal of both expansionary monetary policy and expansionary fiscal policy is to increase aggregate demand relative to what it would have been without the policy.

Contractionary fiscal policy involves decreasing government purchases or increasing taxes. Policymakers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation.

B. A Summary of How Fiscal Policy Affects Aggregate Demand The impact of fiscal policy assumes that monetary policy and all other factors affecting the variables involved are held constant. A contractionary fiscal policy does not cause the price level to fall. A contractionary fiscal policy causes the price level to rise less than it would have without the policy.

Extra Solved Problem 12.2 Fiscal Policy and Aggregate Demand The following graph illustrates the basic version of the aggregate demand and aggregate supply model for an economy with a potential GDP equal to $1.7 trillion. The long-run aggregate supply curve (LRAS) is a vertical line at this level of output. The economy is in a recession with aggregate demand (AD1) intersecting short-run aggregate supply (SRAS) at an output equal to $1.65 trillion (real GDP) and a price level equal to 120.

a. How can fiscal policy be used to allow the economy to reach equilibrium at potential GDP? b. Draw a graph that illustrates the effect of this fiscal policy.

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CHAPTER 12 | Fiscal Policy

c. What two facts does the basic version of the aggregate demand and aggregate supply model ignore?

Solving the Problem Step 1:

Review the chapter material.

This problem is about the use of fiscal policy, so you may want to review the section “The Effects of Fiscal Policy on Real GDP and the Price Level,” which begins on page 373 in the textbook.

Step 2:

Answer part (a) by explaining how fiscal policy can be used to allow the economy to reach equilibrium at potential GDP. Increasing government purchases or decreasing taxes will increase aggregate demand.

Government purchases increase aggregate demand directly, while changes in taxes affect spending indirectly through changes in income, so in dollar terms the tax reduction would have to be greater than an increase in government purchases to achieve the same increase in aggregate demand.

Step 3:

Answer part (b) by drawing a graph that illustrates the effect of this fiscal policy.

The following graph shows the effect of a change in purchases or taxes that shifts aggregate demand from AD1 to AD2. The increase in aggregate demand increases the price level from 120 to 122, and increases real GDP from $1.65 trillion to $1.7 trillion.

Step 4:

Answer part (c) by identifying the two facts that the basic version of the aggregate demand and aggregate supply model ignores.

In reality, the economy experiences (1) continuing inflation, with the price level rising every year, and (2) long-run growth, which shifts the LRAS curve to the right every year.

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Extra Two Canadian Economists Answer the Question: Apply the Can the United States Continue to Finance Its Debt?

Concept Dramatic increases in the federal government’s deficit as a result of expansionary fiscal policy and the 2007–2009 recession caused concern about the government’s ability to finance its debt. James Dean and Richard Lipsey, professors emeritus at Simon Fraser University, have placed the US deficit in perspective. Although the United States began the recession with the largest deficit in world history, relative to national income it was not as large as the deficit Great Britain ran after the Napoleonic wars or Japan’s recent deficit, which is equal to almost 200 percent of its GDP. Dean and Lipsey explain that US deficits can be financed in several ways: 1. By selling Treasury bonds to the Federal Reserve. “This puts zero upward pressure on interest rates . . . . But it does increase the money supply. . . . If this money is not re-absorbed when full employment is restored, we will witness inflation. . . .”

2. By selling Treasury bonds to foreign buyers. Despite foreign buyers already holding large amounts of US debt, the demand for dollar-denominated liquid assets is still substantial, and there are no other financial assets that are as liquid and safe as Treasury securities. Canadian debt is as safe, but not as liquid due to the relative small amount available on global financial markets.

3. By selling Treasury bonds to commercial banks. If there were strong demand for bank loans from the private sector, Treasury bond sales to banks would crowd out private consumption and investment.

However, during the 2007–2009 recession and the years that followed, the demand for credit was weak, which reduced the risk of crowding out.

4. By selling Treasury bonds to firms and households. Though crowding out could result, because of the recession, firms were sitting on large cash reserves and consumers had increased their savings. In the fourth quarter of 2013, Apple Inc. (AAPL) was holding over $40 billion on its balance sheet. Dean and Lipsey concluded that fears of crowding out, while the US economy continued to have substantial unemployed resources, were unfounded.

Source: James W. Dean and Richard Lipsey, “Will stimulus spending stifle recovery?” Financial Times, May 21, 2009.

12.3

Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model (pages 375-376) Learning Objective: Use the dynamic aggregate demand and aggregate supply model to analyze fiscal policy.

In Chapter 9, we developed a dynamic aggregate demand and aggregate supply model to account for two important facts about the economy: (1) The economy experiences continuing inflation, with the price level rising every year, and (2) the economy experiences long-run growth, with the long-run aggregate supply curve shifting to the right every year. The factors that cause the long-run aggregate supply curve to shift also cause firms to supply more goods and services at any given price level in the short run, which is shown by shifting the short-run aggregate supply curve to the right. During most years, the aggregate demand curve shifts to the right, indicating that aggregate expenditure is higher at every price level.

The goal of both expansionary monetary policy and expansionary fiscal policy is to increase aggregate demand relative to what it would have been without the policy. Contractionary fiscal policy involves decreasing government purchases or increasing taxes. Policymakers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation. .

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CHAPTER 12 | Fiscal Policy

Extra Solved Problem 12.3 Fiscal Policy in a Dynamic Aggregate Demand and Aggregate Demand Model The following graph illustrates the dynamic version of an aggregate demand and aggregate supply model for an economy with a potential GDP equal to $1.7 trillion. The initial long-run aggregate supply curve (LRAS1) is a vertical line at this level of output. Without an expansionary fiscal policy, aggregate demand will shift from AD1 to AD2 (without policy). The long-run aggregate supply curve will shift (to LRAS2) to reflect the increase in potential GDP (to $1.8 trillion) as a result of increases in the labour force, capital stock, and technology. The factors that shift LRAS will also shift short-run aggregate supply, from SRAS1 to SRAS2. Because the shift in LRAS is greater than the shift in AD, the equilibrium output will be only $1.75 trillion, and the equilibrium price level will equal 122. The economy is in a recession. a. How can fiscal policy be used so that the economy reaches equilibrium at potential GDP? b. Draw a graph that illustrates the effect of this fiscal policy.

Solving the Problem Step 1:

Review the chapter material.

This problem is about the use of fiscal policy, so you may want to review the section “Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model,” which begins on page 375 in the textbook.

Step 2:

Answer part (a) by explaining how fiscal policy can be used so that the economy reaches equilibrium at potential GDP. Increasing government purchases or decreasing taxes will increase aggregate demand.

Government spending is a direct increase in aggregate demand, whereas changes in taxes affect spending indirectly through changes in disposable income, so the dollar value of a tax reduction would have to be greater than a government spending increase to achieve the same increase in aggregate demand.

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CHAPTER 12 | Fiscal Policy

Step 3:

Answer part (b) by drawing a graph that illustrates the effect of this fiscal policy.

The following graph shows the effect of a change in spending or taxes that shifts aggregate demand from to AD2 (without policy) to AD3 (with policy). The increase in aggregate demand increases the price level from 122 to 125 and increases real GDP from $1.75 trillion to $1.8 trillion.

Extra Despite Credit Downgrade, US Treasury Securities Apply the Offer Investors a Safe Haven Concept Standard & Poor’s (S&P), Moody’s, and Fitch issue credit ratings for public and private debt. In August 2011, S&P lowered the rating of the long-term debt of the U.S government from its top grade of AAA to AA+. Although record federal budget deficits had increased the total public debt to over $15 trillion, nearly equal to the total US GDP for the previous year, S&P explained that the credit downgrade “reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened.” In other words, the size of the debt was less significant than the inability of Congress and the administration to agree on a plan to deal with the debt. The credit downgrade and political gridlock appeared to have little effect on the market for new Treasury securities in the months that followed. In January 2012, for example, the US Treasury sold over $20 billion of ten-year notes at a record low yield of 1.90 percent and the bid-to-cover ratio—a measure of the demand for the amount of securities offered for sale—was a robust 3.29.

An important reason for the continuing strong demand for Treasury debt was the lack of other good alternatives for investors’ cash. The European debt crisis made traders nervous throughout 2011, so many

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CHAPTER 12 | Fiscal Policy considered the US Treasury market a safe haven. Thomas Connor, president and head of trading at Pierpont Securities in Stamford, Connecticut, explained: “The expectation is for Europe to have a rough six months.” There were also concerns about the debt incurred in recent years by the Chinese government, which had a lower credit rating than the United States and was widely suspected of understating its debt problems in order to avoid scrutiny from international investors. Dominic Konstam, interest-rate strategist at Credit Suisse in New York, noted that the Treasury market “is in some fundamental sense much more liquid than European markets because the dollar is still by far the global reserve currency . . . although there has been some diversification . . . at the end of the day [foreign investors] are still beholden to U.S. markets.”

Sources: Binyamin Appelbaum and Eric Dash, “S&P Downgrades Debt Rating of U.S. for the First Time,” New York Times, August 5, 2011; Susanne Walker, “Treasury Sells 10-year Notes at Record Yield on Refuge Demand,” Bloomberg News, January 11, 2012; Gordon Chang, “China’s Looming Debt Disaster,” The Daily Beast, August 23, 2011; Michael Casey, “Treasury Sales Smash Record,” Wall Street Journal, October 30, 2009.

The Government Purchases and Tax Multipliers (pages 376-382) 12.4 Learning Objective: Explain how the government purchases and tax multipliers work.

If the federal government decides to use discretionary fiscal policy to increase aggregate demand by, for example, spending $10 billion on expanding the Caldecott Tunnel and similar projects, the initial increase in aggregate demand should lead to additional increases in income and spending. Economists refer to the initial increase in government purchases as autonomous because it is not directly caused by changes in the level of real GDP. The increases in consumption spending that result from the initial increase in autonomous expenditures are induced. The multiplier effect is the series of induced increases in consumption spending that result from an initial increase in autonomous expenditures. The ratio of the change in equilibrium real GDP to the initial change in government purchases is known as the government purchases multiplier:

Government purchases multiplier =

Change in equilibrium real GDP .

Change in government purchases

Tax cuts also have a multiplier effect. The expression for the tax multiplier is

Tax multiplier =

Change in equilibrium real GDP .

Change in taxes

The tax multiplier is a negative number because changes in taxes and changes in real GDP move in opposite directions: An increase in taxes reduces disposable income, consumption, and real GDP. A decrease in taxes raises disposable income, consumption, and real GDP.

A. The Effect of Changes in Tax Rates A cut in tax rates has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount. The higher the tax rate, the smaller the amount of any increase in income that households have available to spend, and the smaller the multiplier effect. A cut in tax rates affects equilibrium real GDP through two channels: 1. A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending.

2. A cut in tax rates increases the size of the multiplier effect.

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B. Taking into Account the Effects of Aggregate Supply We know that when the AD curve shifts to the right, the price level will rise. However, the SRAS curve is upward sloping. As a result of the rise in the price level, equilibrium real GDP will not increase by the full amount the multiplier indicates.

C. The Multipliers Work in Both Directions Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP. Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP, but in this case the effect is negative.

The Limits of Fiscal Policy as a stimulus (pages 382-385) 12.5 Learning Objective: Discuss the difficulties that can arise in implementing fiscal policy.

Poorly timed fiscal policy, like poorly time monetary policy, can do more harm than good. Getting the timing right can be more difficult for fiscal policy. Control over monetary policy is concentrated in the hands of the Bank of Canada, which can change monetary policy at any of its meetings. By contrast, the prime minister and a majority of the members of Parliament have to agree on a change in fiscal policy.

Even after a fiscal policy decision has been approved, it takes time to implement the policy. Delays may push spending beyond the end of the recession the spending was supposed to fight.

A. Does Government Spending Reduce Private Spending?

Using government purchases to increase aggregate demand poses another problem. The size of the multiplier effect may be limited if the increase in government purchases causes consumption, investment, or net exports to fall. Crowding out is a decline in private expenditures as a result of an increase in government purchases.

B. Crowding Out in the Short Run The greater the sensitivity of consumption, investment, and net exports to changes in interest rates, the more crowding out will occur. In a deep recession, many firms may be so pessimistic about the future and have so much excess capacity that investment spending falls to very low levels and is unlikely to fall much further, even if interest rates rise. In this case, crowding out is unlikely to be a problem. If the economy is close to potential GDP, however, and firms are optimistic about the future, an increase in interest rates may result in a significant decline in investment spending.

C. Crowding Out in the Long Run Most economists agree that in the short run, an increase in government spending results in partial crowding out. The long-run effect of a permanent increase in government spending is complete crowding out. In the long run, the decline in investment, consumption, and net exports exactly offsets the increase in government purchases, and aggregate demand remains unchanged. Recall from Chapter 9 that in the long run, the economy returns to potential GDP.

Extra Solved Problem 12.5 Fiscal Policy Lags As we’ve seen, government can increase government purchases and reduce taxes to increase aggregate demand either to avoid or at least to reduce the effects and duration of a recession. The federal government used both tax cuts and an increase in government purchases to try to offset the impact of the 2007–2009 global recession on the Canadian economy. The specific initiatives of “Canada’s Economic

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CHAPTER 12 | Fiscal Policy Action Plan” are presented at the program’s website: http://actionplan.gc.ca. The goal of the two-year $62-billion plan was to help offset the fall in demand caused by the global recession.

The Canadian economy started to contract in 2008. The federal government responded to this contraction in the 2009–2010 budget, dramatically increasing government purchases and reducing taxes. As a result, the government’s budget deficit (i.e., the difference between the spending of the government and the revenue it takes in) rose from $5.8 billion for the 2008–2009 fiscal year to $53.8 billion in the 2009–2010 fiscal year.

Discretionary fiscal policy is often associated with Keynesian Economics. John Maynard Keynes advocated discretionary fiscal policy as a response to a severe recession, such as the Great Depression of the 1930s.

Why would discretionary fiscal policies be more effective during the Great Depression or the 2007–2009 recession than during other recessions of the post–World War II era?

Solving the Problem Step 1:

Review the chapter material.

This problem is about the limitations of fiscal policy, so you may want to review the section “The Limits of Fiscal Policy as a Stimulus,” which begins on page 382 of the textbook.

Step 2:

Answer the question by discussing why discretionary fiscal policies might be more effective during the Great Depression or the 2007–2009 recession than during other recessions of the post–World War II era.

In Canada and the United States, the Great Depression refers to the period following the business cycle peak in August 1929. The contraction that followed lasted for more than three years, from August 1929 to early 1933. Although a recovery followed this contraction, the economy operated well below its potential throughout the 1930s. Even with lags in recognizing and reacting to a severe contraction such as the Great Depression, fiscal policy can increase aggregate demand well before a recovery begins. Also, interest rates during the Great Depression were very low. Monetary policy is relatively ineffective in this environment because it relies on reducing interest rates to increase spending by firms on factories, office buildings, and machinery and by households on new housing. In the post–World War II era, recessions have been shorter and much less severe. Shorter recessions increase the likelihood that a contraction would actually have ended before the expansionary fiscal policy can affect the economy. During the 2007–2009 recession, as in the 1930s, short-term interest rates had fallen to low levels, which limited the ability of the Bank of Canada to increase aggregate demand by lowering interest rates further. In future years, economists will be evaluating the effectiveness of the Economic Action Plan in aiding in the recovery from the 2007–2009 recession.

Deficits, Surpluses, and Federal Government Debt (pages 385-390) 12.6 Learning Objective: Define federal budget deficit and federal government debt and explain how the federal budget can serve as an automatic stabilizer.

A budget deficit is the situation in which the government’s expenditures are greater than its tax revenue.

A budget surplus is the situation in which the government’s expenditures are less than its tax revenue.

As with other macroeconomic variables, it is useful to consider the size of the surplus or deficit relative to the size of the overall economy. In the early 1990s, the federal budget deficit averaged 5 percent of GDP. In the late 1990s the federal government began to run surpluses for the first time in decades. The global

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CHAPTER 12 | Fiscal Policy financial crisis drove the budget back into deficit in 2009. The federal budget returned to balance briefly in 2015. Since 2015 the federal government has run a deficit in every year.

A. How the Federal Budget Can Serve as an Automatic Stabilizer Discretionary fiscal policy actions can increase the federal budget deficit during recessions, but most of the increase in the deficit during a typical recession takes place without the federal government taking any action. Deficits occur automatically for two reasons: First, during a recession wages and profits fall, causing tax revenues to fall. Second, the government automatically increases its spending on transfer payments when the economy moves into recession. Because budget deficits automatically increase during recessions and decrease during expansions, economists often look at the cyclically adjusted budget deficit or surplus. The cyclically adjusted budget deficit or surplus is the deficit or surplus in the federal government’s budget if the economy were at potential GDP. Automatic budget surpluses and deficits can help to stabilize the economy.

B. Should the Federal Budget Always Be Balanced?

Few economists believe that the federal government should have a balanced budget every year unless the economy is operating at potential. Some economists argue that the federal government should normally run a deficit, even at potential GDP. When the federal budget is in deficit, the government sells bonds to raise the funds necessary to pay the government’s bills. Borrowing may be a bad idea when the bills are for current expenses, but it is not a bad policy if the bills are for long-lived capital goods.

C. The Federal Government Debt When the federal government runs a budget deficit, the government must borrow funds from investors by selling Treasury securities. When the federal government runs a surplus, the government pays off some existing bonds. The total value of bonds outstanding is referred to as the federal government debt or the national debt.

D. Is Government Debt a Problem?

The federal government is in no danger of defaulting on its debt. The government can raise the funds it needs by taxing households and firms to pay interest on its debt. However, if the debt becomes large relative to the economy, the government may have to raise taxes to very high levels or cut back on other types of spending to make interest payments on the debt. In the long run, a debt that increases in size relative to GDP can pose a problem. Crowding out of investment spending can occur if an increasing debt drives up interest rates. Lower investment spending means a lower capital stock in the future and a lower capacity of the economy to produce goods and services. This effect is somewhat offset if some of the government debt was incurred to finance improvements in infrastructure, such as bridges, roads, and ports; to finance education; or to finance research and development.

The Effects of Fiscal Policy in the Long Run (pages 391-394) 12.7 Learning Objective: Discuss the effects of fiscal policy in the long run.

Some fiscal policy actions are intended to meet short-run goals of stabilizing the economy. Other fiscal policy actions are intended to have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. Actions that have long-run effects are sometimes referred to as supply-side economics.

A. The Long-Run Effects of Tax Policy The tax wedge is the difference between the pretax and posttax return to an economic activity. The tax wedge applies to the marginal tax rate, which is the fraction of each additional dollar of income that must be paid in taxes. Here is how tax cuts affect aggregate supply: .

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• •

•

Individual income tax. Reducing marginal tax rates on individual income will reduce the tax wedge faced by workers, thereby increasing the quantity of labour supplied. Cutting individual income tax rates also raises the return to entrepreneurship and the return to saving.

Corporate income tax. Reducing the marginal corporate income tax rate would encourage investment spending by increasing the return that corporations receive from new investments in equipment, factories, and office buildings. Cutting the corporate income tax rate can potentially increase the pace of technological change.

Taxes on dividends and capital gains. Reducing the tax rates on dividends and capital gains increases the supply of loanable funds from households to firms, increasing saving and investment and lowering the equilibrium real interest rate. (Only half of dividend and capital gains are taxed, and they are taxed in the same way as other income.)

B. Tax Simplification If the tax code were greatly simplified, the economic resources currently used by the tax preparation industry would be available to produce other goods and services. In addition to wasting resources, the complexity of the tax code may also distort the decisions made by households and firms. A simplified tax code would increase economic efficiency by reducing the number of decisions made by households and firms solely to reduce their tax payments.

C. The Economic Effect of Tax Reform If tax reduction and simplification are effective, the economy will experience increases in labour supply, saving, investment, and the formation of new firms. Economic efficiency will also be improved.

Together, these factors will result in an increase in the quantity of real GDP supplied at every price level.

A successful policy of tax reductions and simplifications will benefit the economy by increasing output and employment and, at the same time, may result in smaller increases in the price level.

D. How Large Are Supply-Side Effects?

Most economists agree that there are supply-side effects to reducing taxes: Decreasing marginal income tax rates will increase the quantity of labour supplied; decreasing the corporate income tax will increase investment spending and so on. The magnitude of the effects is subject to considerable debate. The size of the supply-side effects of tax policy can be determined only by careful study of the effects of differences in tax rates on labour supply and saving and investment decisions.

Extra Solved Problem 12.7 Are Foreign Countries Holding Too Much US Debt?

As the public debt of the United States climbed to over $20 trillion in 2017, budget hawks were concerned with a related problem: the growing amount of debt held by foreign investors, including foreign governments. The following table shows that as of October 2017, foreign holdings of U.S. Treasury securities totaled $6,349.4 billion, or over $6.3 trillion.

Foreign Holdings of U.S. Treasury Securities October 2017 China $1,189.2 billion Japan 1,093.9 billion Ireland 312.4 billion Brazil 270.0 billion Cayman Islands 269.9 billion

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CHAPTER 12 | Fiscal Policy Switzerland All others Total

254.0 billion 2,960.0 billion $ 6,349.4 billion

The following table shows the total debt that month was over $20 trillion, about $5.7 trillion of which was held in the Social Security trust fund and other federal government accounts. Foreign holdings of debt amounted to about 43 percent of the debt held by the public.

Total Public Debt of the United States October 2017 Debt held by the public $14,751.4 billion Federal government holdings 5,691.0 billion Total public debt outstanding $20,442.5 billion Sources: Department of the Treasury/Federal Reserve Board; and The Bureau of the Public Debt

Selling Treasury debt to foreign investors keeps interest rates lower than they would be if all the debt had to be financed in the United States. But what if foreign investors used their creditor positions as leverage against the United States? One ominous scenario: What if the Chinese government were to sell large amounts of Treasury securities and thereby send the exchange rate of the dollar downward and interest rates upward?

How likely is it that foreign investors would sell large amounts of US Treasury securities in an attempt to influence US economic and foreign policy decisions?

Solving the Problem Step 1:

Review the chapter material.

This problem is about the long-run effects of fiscal policy, so you may want to review the section “The Effects of Fiscal Policy in the Long Run,” which begins on page 391 in the textbook.

Step 2:

Answer the question by discussing how likely it is that foreign investors would sell large amounts of US Treasury securities in an attempt to influence US economic and foreign policy decisions.

Michael Pakko, an economist at the Federal Reserve of St. Louis, commented on this scenario: “Such a sudden and disruptive strategy is unlikely to be successful. Even the largest foreign holdings of US government debt are smaller than the daily volume of trade in Treasury securities. If such a strategy did disrupt the markets, the resulting decline in the value of US Treasury securities would generate substantial losses to all debt holders, including those in the country attempting to use their debt holdings as political leverage. . . .

The more grave risk is that investors in US Treasury debt, foreign or domestic, would lose faith in the ability of the US government to meet its obligations in the face of unsustainable, long-run structural deficits.”

Source: Michael Pakko, “Deficits, Debt and Looming Disaster,” The Regional Economist, January 2009, http://www.stlouisfed.org.

Extra Apply the Should Canada Adopt a “Flat Tax”?

Concept In thinking about fundamental tax reform, some economists and policymakers have advocated .

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CHAPTER 12 | Fiscal Policy simplifying the individual income tax by adopting a “flat tax.” A flat tax would replace the current individual income tax system, with its many tax brackets, exemptions, and deductions, with a new system containing a single tax rate and few, or perhaps no, deductions and exemptions.

In 1994, Estonia became the first country to adopt a flat tax when it began imposing a single tax rate of 26 percent on individual income. As the table below shows, a number of other countries in Eastern Europe have followed Estonia’s lead. Although all these countries have a flat tax rate on income, they vary in the amount of annual income they allow to be exempt from the tax and on which income is taxable. For example, Estonia does not tax corporate profits directly, although it does tax dividends paid by corporations to shareholders.

Country Estonia

Year Flat Tax Flat Tax Rate (%) Was Introduced 26 1994

Lithuania

33

1994

Latvia

25

1995

Russia

13

2001

Serbia

14

2003

Ukraine

13

2004

Slovakia

19

2004

Georgia

12

2005

Romania

16

2005

Governments in Eastern Europe are attracted by the simplicity of the flat tax. It is easy for taxpayers to understand and easy for the government to administer. The result has been greater compliance with the tax code. A study of the effects of Russia moving to a flat tax found that, before tax reform, Russians whose incomes had placed them in the two highest tax brackets had, on average, been reporting only 52 percent of their income to the government. In 2001, with the new single 13 percent tax bracket in place, these high-income groups on average reported 68 percent of their income to the government.

In North America and western Europe, proponents of the flat tax have focused on the reduction in paperwork and compliance costs and the potential increases in labour supply, saving, and investment that would result from a lower marginal tax rate. Opponents of the flat tax believe it has two key weaknesses.

First, they point out that many of the provisions that make the current tax code so complex were enacted for good reasons. For example, currently taxpayers are allowed to deduct tuition from their taxes, making school cheaper and thereby aiding the government’s goal of increasing the skills of Canadians. These and other deductions would be eliminated under most flat tax proposals, thereby reducing the ability of the government to pursue some policy goals. Second, opponents of the flat tax believe that it would make the distribution of income more unequal by reducing the marginal tax rate on high-income taxpayers.

Because high-income taxpayers now can sometimes use the intricacies of the tax code to shelter some of their income from taxes, it is unclear whether the amount of taxes paid by high-income people actually would decrease under a flat tax.

Sources: Susan Saulny, “A Candidate Writing His Own Campaign Rules,” New York Times, October 5, 2011; “The Case for Flat Taxes,” Economist, April 14, 2005; and Juan Carlos Conesa and Dirk Krueger, “On the Optimal Progressivity of the Income Tax Code,” Journal of Monetary Economics, Vol. 53, No. 7, October 2006, pp. 1425–1450.

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Extra Economics in Your Life and Career: Does a Cut in My Income Tax Rate Lower Government Revenue?

Question: Suppose that the government decides to cut income taxes. Does this reduction in your income tax rate necessarily reduce the government’s tax revenues?

Answer: One effect of a cut in tax rates is a reduction in tax collections from the same amount of income. But lower income tax rates also increase consumption, which causes equilibrium national income to increase and may cause tax receipts also to increase because more income is taxed at the new lower rates. So, it is possible that your income tax rate cut could lead to higher tax revenues. Typically, though, a lower tax rate leads to the government collecting less tax revenue.

Appendix: A Closer Look at the Multiplier (pages 402-406) Learning Objective: Apply the multiplier formula.

When economists forecast the effect of a change in spending or taxes, they often rely on econometric models.

An Expression for Equilibrium Real GDP We can write a set of equations that includes the key macroeconomic relationships we studied in this and previous chapters. We assume that taxes, T, do not depend on the level of real GDP, Y. There are no government transfer payments to households, and there are no exports or imports. The numbers represents billions of dollars.

(1) (2) (3) (4) (5)

C = 1000 + 0.8(Y – T) I = 125 G = 125 T = 100 Y=C+I+G

Consumption function Planned investment function Government purchases function Tax function Equilibrium condition

To calculate a value for equilibrium real GDP we need to substitute equations (1) through (4) into (5).

To make the result more general, we can replace particular values with general values represented by letters.

C = C + MPC (Y − T ) Consumption function I =I Planned investment function Government spending function G=G T =T Tax function Y=C+I+G Equilibrium condition Solving for equilibrium: Y=

.

C − ( MPC  T ) + I + G .

1 − MPC

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A Formula for the Government Purchases Multiplier To find a formula for the government purchases multiplier, rewrite the last equation for changes in each variable, rather than levels: ΔY =

C − ( MPC  T ) + I + G .

1 − MPC

If we hold constant the changes in autonomous consumption spending, planned investment spending, and taxes, we can find a formula for the government spending multiplier, which is the ratio of the change in equilibrium real GDP to the change in government purchases:

Y 1 . = G 1 − MPC

A Formula for the Tax Multiplier We can find a formula for the tax multiplier. We start with the equation ΔY =

C − ( MPC  T ) + I + G .

1 − MPC

We hold constant the values of autonomous consumption spending, planned investment, and government purchases, but allow the value of taxes to change: ΔY =

− MPC  T .

1 − MPC

Or The tax multiplier =

Y − MPC = . T 1 − MPC

The tax multiplier is a negative number because an increase in taxes causes a decrease in equilibrium real GDP, and a decrease in taxes causes an increase in equilibrium real GDP.

The “Balanced Budget” Multiplier We can use the formulas for the government purchases multiplier and the tax multiplier to calculate the net effect of increasing government purchases by the same amount as taxes are increased.

The government purchases multiplier is larger (in absolute value) than the tax multiplier. Equal dollar increases and decreases in government purchases and taxes lead to the same dollar increase in real GDP in the short run.

Balanced Budget Multiplier = (1 – MPC)/(1 – MPC) = 1.

The Effects of Changes in Tax Rates on the Multiplier We consider the effect of a change in the tax rate, as opposed to a change in a fixed amount of taxes.

Changing the tax rate changes the value of the multiplier. In general, an increase in income can be .

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CHAPTER 12 | Fiscal Policy multiplied by (1 – t) to find the change in disposable income, where t is the tax rate. We can rewrite the consumption function as

C = C + MPC (1 − t )Y .

We can use this equation to find an expression for the government purchases multiplier: Government Purchases Multiplier =

Y 1 = . G 1 − MPC (1 − t )

The Multiplier in an Open Economy We can consider the case of an open economy by including net exports in our analysis. We assume that exports are autonomous.

Exports = Exports Imports will increase as real GDP increases because households will spend some portion of an increase in income on imports. The marginal propensity to import (MPI) is the fraction of an increase in income that is spent on imports: Imports = MPI × Y. We can substitute our expressions for exports and imports into the expressions derived previously for equilibrium real GDP: Y = C + MPC (1 − t )Y + I + G + [ Exports − (MPI  Y )] .

We can now find an expression for the government purchases multiplier: Government Purchases Multiplier =

Y 1 = . G 1 − [ MPC (1 − t ) − MPI ]

The multiplier is a short-run effect that assumes that the economy is below the level of potential GDP. In the long run, the economy is at potential real GDP, so an increase in government purchases causes a decline in the nongovernmental components of real GDP but leaves the level of real GDP unchanged.

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CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy

CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy Brief Chapter Summary and Learning Objectives 13.1 The Discovery of the Short-Run Trade-off between Unemployment and Inflation (pages 410-415) Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation.

▪

The Phillips curve illustrates the short-run trade-off between the unemployment rate and the inflation rate.

13.2 The Short-Run and Long-Run Phillips Curves (pages 415-420) Explain the relationship between the short-run and long-run Phillips curves.

▪

It is not possible to buy a permanently lower unemployment rate at the cost of a permanently higher inflation rate.

13.3 Expectations of the Inflation Rate and Monetary Policy (pages 420-423) Discuss how expectations of the inflation rate affect monetary policy.

▪ ▪

Workers and firms tend to have adaptive expectations when the inflation rate is stable.

Robert Lucas and Thomas Sargent argued that workers and firms would have rational expectations, formed by using all available information about an economic variable.

13.4 Bank of Canada Policy from the 1970s to the Present (pages 423-430) Use a Phillips curve graph to show how the Bank of Canada can permanently lower the inflation rate.

▪

The Bank of Canada uses contractionary monetary policy to reduce inflation, which pushes the economy down a short-run Phillips curve.

Key Terms Disinflation, p. 425. A significant reduction in the inflation rate.

Leverage, p. 429. A measure of how much debt an investor assumes in making an investment.

Natural rate of unemployment, p. 413. The unemployment rate that exists when the economy is at potential GDP.

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Nonaccelerating inflation rate of unemployment (NAIRU), p. 418. The unemployment rate at which the inflation rate has no tendency to increase or decrease.

Phillips curve, p. 410. A curve showing the short-run relationship between the unemployment rate and the inflation rate.

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CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy Rational expectations, p. 420. Expectations formed by using all available information about an economic variable.

Structural relationship, p. 412. A relationship that depends on the basic behaviour of consumers and firms and that remains unchanged over long periods.

Real business cycle models, p. 423. Models that focus on real rather than monetary explanations of fluctuations in real GDP.

Chapter Outline The Bank of Canada Tries for a “Soft Landing” The Bank of Canada is continually balancing the risks in the Canadian economy. A contractionary monetary policy that would help rein in inflation risks pushing the economy into recession. An expansionary monetary policy that can reduce the effects of recession risks increasing inflation and spilling over into asset price bubbles that can be damaging later on. In regards to the housing market, which the Bank of Canada calls the most important risk to financial stability in Canada, in the aftermath of the global financial crisis, the Department of Finance tightened several regulations for real estate lending six times (in July 2008, February 2010, January 2011, June 2012, December 2015, and October 2017). In addition, Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), has placed a loan-to-value limit of 65 percent on borrowing against home equity. Monetary policy is not the only tool policymakers have at their disposal to reduce risks. The Bank of Canada has indicated that monetary policy should be coordinated with sound macroprudential regulation (policies that seek to maintain system-wide financial stability) to reduce the risks that arise from the spread of leverage cycles over time and from one sector to another, and the development of asset-price bubbles. In fact, Canada has a tradition of sound macroprudential regulation that has been recognized throughout the world as having allowed it to emerge relatively unscathed from the global financial crisis of 2008.

13.1

The Discovery of the Short-Run Trade-off between Unemployment and Inflation (pages 410-415) Learning Objective: Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation.

There is a short-run trade-off between unemployment and inflation: Higher unemployment is usually accompanied by lower inflation, and lower unemployment is usually accompanied by higher inflation.

This trade-off exists in the short run but disappears in the long run. Today, the short-run trade-off between unemployment and inflation plays a role in the Bank of Canada’s monetary policy decisions, but the trade-off was not widely recognized until the 1950s. Since that time, a curve showing the short-run relationship between the unemployment rate and the inflation rate has been called a Phillips curve.

During years when the unemployment rate is low, the inflation rate tends to be high, and during years when the unemployment rate is high, the inflation rate tends to be low.

A. Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves The inverse relationship between unemployment and inflation is consistent with the aggregate demand and aggregate supply (AD-AS) analysis we developed in Chapter 9. The AD-AS model indicates that slow growth in aggregate demand leads both to higher unemployment and lower inflation when compared to high growth in aggregate demand. The AD-AS model and the Phillips curve are different ways of Copyright © 2021Pearson Canada Inc.

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CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy illustrating the same events. The Phillips curve has an advantage over the AD-AS model when we want to analyze changes explicitly in the inflation and unemployment rates.

B. Is the Phillips Curve a Policy Menu?

Some economists argued during the 1960s that the Phillips curve represented a structural relationship in the economy that represented a permanent trade-off between inflation and unemployment. A structural relationship is a relationship that depends on the basic behaviour of consumers and firms and that remains unchanged over long periods. If the Phillips curve were a structural relationship, it would present policymakers with a reliable menu of combinations of unemployment and inflation. They could use contractionary monetary and fiscal policies to choose a point that had lower inflation and higher unemployment. However, economists have come to realize that the Phillips curve did not represent a permanent trade-off between unemployment and inflation.

C. Is the Short-Run Phillips Curve Stable?

In his 1968 presidential address to the American Economic Association, Milton Friedman of the University of Chicago argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation. Edmund Phelps published a paper that made a similar argument. Friedman and Phelps noted that economists had come to agree that the long-run aggregate supply curve was vertical. If this were true, the Phillips curve could not be downward sloping in the long run. Friedman and Phelps argued, in essence, that there is no trade-off between unemployment and inflation in the long run.

D. The Long-Run Phillips Curve At potential real GDP, firms operate at their normal level of capacity, and everyone who wants a job will have one, except the structurally and frictionally unemployed. Friedman defined the natural rate of unemployment as the unemployment rate that exists when the economy is at potential GDP. The actual unemployment rate will fluctuate in the short run but will always come back to the natural rate in the long run. In the long run, a higher or lower price level has no effect on real GDP because real GDP is always at its potential level. In the long run, a higher or lower rate of inflation will have no effect on the unemployment rate because the unemployment rate is always equal to the natural rate in the long run.

Therefore, the long-run aggregate supply curve is a vertical line at potential GDP and the long-run Phillips curve is a vertical line at the natural rate of unemployment.

E. The Role of Expectations of Future Inflation Friedman argued that the experience of the 1950s and 1960s, which showed a stable trade-off between unemployment and inflation, actually showed only a short-run trade-off. The short-run trade-off existed only because workers and firms sometimes expected the inflation rate to be either higher or lower than it turned out to be. Differences between the expected inflation rate and the actual inflation rate could lead the unemployment rate to rise above or dip below the natural rate. If actual inflation is higher than expected inflation, actual real wages in the economy will be lower than expected real wages, and many firms will hire more workers than they planned to hire. The unemployment rate will fall. If actual inflation is lower than expected inflation, actual real wages will be higher than expected, so many firms will hire fewer workers than they had planned to hire, and the unemployment rate will rise. Friedman and Phelps concluded that an increase in the inflation rate increases employment (and decreases unemployment) only if the increase in the inflation rate is unexpected.

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Extra Solved Problem 13.1 The Policy Menu View of the Phillips Curve In 1960, Paul Samuelson and Robert Solow wrote the first article using the Phillips curve model to explain the relationship between unemployment and inflation in the United States. They concluded that price stability is seen to involve about 5½ percent unemployment; whereas . . . 3 percent unemployment is seen to involve a price rise of about 4½ percent per annum. We rather expect that the tug of war of politics will end us up in the next few years somewhere in between these selected points.

Source: Paul A. Samuelson and Robert M. Solow, “Analytical Aspects of Anti-Inflation Policy,” American Economic Review, Vol. 50, No. 2, May 1960, pp. 192–193.

a. What did Samuelson and Solow mean by “price stability”? b. What does the “tug of war of politics” have to do with what happens to the unemployment and inflation rates?

Solving the Problem Step 1:

Review the chapter material.

This problem is about how the Phillips curve was understood in the 1960s, so you may want to review the section “Is the Phillips Curve a Policy Menu?” which is on page 412 in the textbook.

Step 2:

Answer part (a) by explaining what Samuelson and Solow meant by “price stability.”

When prices are stable, the price level does not change. So, price stability is another term for zero inflation.

Step 3:

Answer part (b) by explaining what the “tug of war of politics” has to do with what happens to the unemployment and inflation rates.

By the “tug of war of politics,” Samuelson and Solow were referring to the policy menu view of the Phillips curve. Some politicians prefer expansionary policies that would result in very low unemployment at the cost of higher inflation. Others prefer low inflation at the cost of higher unemployment. Political compromise would result in the economy ending up somewhere in between. Although the policy menu view of the Phillips curve was popular among economists and policymakers during the 1960s, most economist now believe that it is mistaken.

The Short-Run and Long-Run Phillips Curves (pages 415-420) 13.2 Learning Objective: Explain the relationship between the short-run and long-run Phillips curves.

A. Shifts in the Short-Run Phillips Curve A new, higher expected inflation rate can become embedded in the economy, meaning that workers, firms, consumers, and the government all take the inflation rate into account when making decisions.

There is a short-run Phillips curve for every level of expected inflation. The short-run trade-off between unemployment and inflation now takes place from this higher, less favourable level.

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B. How Does a Vertical Long-Run Phillips Curve Affect Monetary Policy?

By the 1970s, most economists accepted the argument that the long-run Phillips curve is vertical and realized that the common view of the 1960s had been wrong: It was not possible to buy a permanently lower unemployment rate at the cost of a permanently higher inflation rate. In the long run, there is no trade-off between unemployment and inflation: The unemployment rate always returns to the natural rate, no matter what the inflation rate is. The natural rate of unemployment is sometimes called the nonaccelerating inflation rate of unemployment (NAIRU). In the long run, the Bank of Canada can affect the inflation rate but not the unemployment rate.

Expectations of the Inflation Rate and Monetary Policy (pages 420-423) 13.3 Learning Objective: Discuss how expectations of the inflation rate affect monetary policy.

The amount of time an economy can remain on a short-run Phillips curve but off of the long-run Phillips curve depends on how quickly workers and firms adjust their expectations of future inflation to changes in current inflation. There are three possibilities: 1. Low inflation. When the inflation rate is low, workers and firms tend to ignore it.

2. Moderate, but stable inflation. People are said to have adaptive expectations of inflation if they assume that future rates of inflation will follow the pattern of rates of inflation in the past.

3. High and unstable inflation. Canada experienced inflation rates above 5 percent from 1973 to 1982.

Inflation was high and unstable. Workers and firms that failed to accurately anticipate the fluctuations in inflation during those years could experience substantial declines in real wages and profits.

Expectations formed by using all available information about an economic variable are called rational expectations.

A. The Implications of Rational Expectations on Monetary Policy Robert Lucas of the University of Chicago and Thomas Sargent of New York University pointed out an important consequence of rational expectations: An expansionary monetary policy would not work, and there might not be a trade-off between unemployment and inflation, even in the short run. By the mid1970s, most economists believed that expansionary monetary policy could cause the actual inflation rate to be higher than the expected rate. This gap would cause the actual real wage to fall below the expected real wage, and the unemployment rate would be below the natural rate. The economy’s short-run equilibrium would move up the short-run Phillips curve. Lucas and Sargent argued that this assumption requires workers and firms to ignore inflation or to use adaptive expectations in making their inflation forecasts. If workers and firms have rational expectations, they will use all available information, including knowledge of the effects of central bank policy. As a result, the short-run Phillips curve will be vertical.

B. Is the Short-Run Phillips Curve Really Vertical?

The claim by Lucas and Sargent that the short-run Phillips curve is vertical and that an expansionary monetary policy cannot reduce the unemployment rate below the natural rate surprised many economists.

The experience of the 1950s and 1960s seemed to show that the short-run Phillips curve was downward sloping. Lucas and Sargent explained that the apparent short-run trade-off was the result of unexpected changes in monetary policy. They argued that a policy that was announced ahead of time would not cause a change in unemployment. Many economists have remained skeptical of the argument that the short-run Phillips curve is vertical. These economists raise two main objections: 1. Workers and firms actually may not have rational expectations.

2. The rapid adjustment of wages and prices needed for the short-run Phillips curve to be vertical will not actually take place.

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C. Real Business Cycle Models During the 1980s, some economists argued that Lucas was correct in assuming that workers and firms formed their expectations rationally and that wages and prices adjust quickly but that he was wrong in assuming that fluctuations in real GDP are caused by changes in the money supply. They argued that fluctuations in “real” factors, particularly technology shocks, explained deviations of real GDP from its potential level. Technology shocks are changes to the economy that make it possible to produce either more output or less output with the same number of workers, machines, and other inputs. Real business cycle models focus on real rather than monetary explanations of fluctuations in real GDP.

Extra Solved Problem 13.3 Stagflation and the Short-run Phillips Curve Stagflation is the simultaneous increase in inflation and unemployment (or an increase in inflation and slower economic growth). Given the negative slope of the short-run Phillips curve, how is it possible for the inflation rate and the unemployment rate to increase at the same time?

Solving the Problem Step 1:

Review the chapter material.

This problem is about the role that changing expectations play in shifting the position of the short-run Phillips curve, so you may want to review the section “Expectations of the Inflation Rate and Monetary Policy,” which begins on page 420 in the textbook.

Step 2:

Illustrate the change in the inflation rate and the unemployment rate along a shortrun Phillips curve.

The short-run Phillips curve shows the short-run trade-off between inflation and unemployment. On any particular short-run Phillips curve, an increase in inflation will be accompanied by a decrease in unemployment. The movement from point A to point B in the following graph shows a decrease in the unemployment and an increase in the inflation rate.

Step 3:

Illustrate how an adverse supply shock can cause both the unemployment rate and the inflation rate to increase.

Periods of stagflation are often the result of adverse supply shocks, caused by rapid increases in the prices of resources, such as oil. An adverse supply shock that shifts the SRAS curve to

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CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy the left will also shift the short-run Phillips curve upward. This is shown in the following graph.

As the graph shows, a shift in the short-run Phillips curve creates the possibility of a simultaneous increase in inflation and unemployment. Stagflation is shown as a movement from point A to point B in the graph.

Extra Does the Federal Reserve Apply the Need a New Model of the Economy?

Concept The Great Depression and the period of “stagflation” in the 1970s led economists to develop new models to deal with these crises. These models influenced how policymakers would respond to future crises. The models developed to address stagflation were based on rational expectations. Consistent with the theory of rational expectations is the idea that markets are efficient. That is, the price of any financial security is based on all relevant information. Another financial crisis led to the recession of 2007–2009 and tested both existing economic models and the ability of policymakers to respond to the crisis. Could a new model developed in the wake of the events of 2007–2009 be used to influence monetary policy in the future? Some economists, including Yale University’s John Geanakoplos, believe so. Before starting his academic career, Professor Geanakoplos was head of fixed-income research at the brokerage house Kidder, Peabody & Co. and a partner in a hedge fund that specialized in mortgage-backed securities. He observed that there were not enough forms of collateral to back all of the debt securities that bankers wanted to create, so bankers had to find ways to “stretch” the available supply of collateral.

Mr. Geanakoplos reasons that when banks set low margins—lending more against a given amount of collateral—they have a powerful effect on what he refers to as “natural buyers.” Using large amounts of borrowed money—leverage—the natural buyers push up prices to levels far above what other investors consider rational. If bad economic news makes lenders more pessimistic about the future, they typically raise margins, which forces the natural buyers to sell. This can result in a chain reaction of falling prices and rising margins.

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CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy Professor Geanakoplos believes that his theory has important implications for the Federal Reserve, which currently uses interest rates as its monetary policy target. Could something else—lenders’ collateral or margin demands—be even more important than interest rates? The challenge for Geanakoplos, and other economists who believe that the “leverage cycle theory” is valid, is to develop a model that can be used to fashion new policymaking rules. The model could lead to a movement away from the efficient markets and rational expectations theories. “If that happens, that will be a change of enormous proportions,” says Martin Eichenbaum, a professor of economics at Northwestern University. (Source: Mark Whitehouse, “Crisis Compels Economists to Reach for New Paradigm,” Wall Street Journal, November 3, 2009.)

During the 2007 – 2009 recession, Finance Minister Jim Flaherty decided to give tax breaks to businesses that invest in R&D, and create the Tax Free Savings Account (TFSA). He also implemented other tax breaks and increased government spending on infrastructure (roads, airports, and water treatment). After the recession ended, he made plans to reduce spending and return the budget to balance.

Compare the situation in the United States viewed through the eyes of Mr. Geanakoplos with the policy reactions of Finance Minister Jim Flaherty.

Bank of Canada Policy from the 1970s to the Present (pages 423-430) 13.4 Learning Objective: Use a Phillips curve graph to show how the Bank of Canada can permanently lower the inflation rate.

A. The Effect of a Supply Shock on the Phillips Curve Following actions by the Organization of Petroleum Exporting Countries (OPEC), oil prices rose in 1974, which caused the short-run aggregate supply curve to shift to the left. The result was a higher price level and a lower level of real GDP. On a Phillips curve graph, the short-run Phillips curve shifted up, as both the inflation rate and the unemployment rate increased. The combination of rising unemployment and rising inflation placed the Bank of Canada in a difficult position. If the Bank of Canada used expansionary monetary policy to fight unemployment, the aggregate demand curve would shift to the right. Increasing real GDP would increase, but at the cost of higher inflation. If the Bank of Canada used a contractionary monetary policy, the aggregate demand curve would shift to the left, causing a movement down the short-run Phillips curve, leading to higher unemployment. In the end, the Bank of Canada decided to fight unemployment with expansionary monetary policy, even though this decision worsened the inflation rate.

B. The Canadian Disinflation, 1989–1993 By the late 1980s, the Bank of Canada had gone through a two-decade period of increasing the rate of growth of the money supply. In January 1988, newly appointed Bank of Canada Governor John Crow announced that the Bank of Canada would subsequently pursue an objective of price stability or zero inflation; “zero inflation” should be interpreted as a small positive rate of measured inflation. In this attempt at lowering inflation, the Bank of Canada followed a different strategy, by announcing explicit targets for its ultimate goal—the inflation rate—rather than for an intermediate variable such as money growth. In particular, in February 1991, the Bank of Canada’s governor and the minister of finance jointly announced a series of declining inflation targets, with a band of plus and minus one percentage point around them. The targets were 3 percent by the end of 1992, falling to 2 percent by the end of 1995, to remain within a range of 1 percent to 3 percent thereafter.

Under Crow’s leadership, the Bank of Canada had reduced the inflation rate from more than 5 percent to less than 2 percent. A significant reduction in the inflation rate is called disinflation. This episode is often

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CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy referred to as the “Canadian disinflation.” The disinflation had come at a very high price. The unemployment rate increased from 7.5 percent in 1989 to above 11 percent in 1993.

C. Inflation Targeting, 1989–Present The Bank of Canada was successful in achieving its inflation targets during the 1989–1993 disinflation.

In fact, it renewed its 1 to 3 percent target range for inflation in December 1995, in early 1998, in May 2001, in November 2006, in November 2011, and again in November 2016, to apply until the end of 2021. Clearly, inflation has fallen dramatically since the adoption of inflation targets, most of the time staying in the lower half of the target range. However, this decline was not without cost: Unemployment soared to above the 10 percent level from 1991 until 1993, but has since fallen.

Around the world, the 2007–2009 recession led many central banks (including the Bank of Canada) to move well beyond the short-term nominal interest rate as the focus of monetary policy. With the target overnight interest rate having been driven to the zero lower bound (the short-term nominal interest rate being zero or near zero) without much expansionary effect on the economy, some observers began to speak of a “crisis in monetary policy.”

In recent years the New Keynesian model, upon which the current approach to monetary policy is based, has also been extended to allow for interest rate channels (or corridors), and many central banks have changed the institutional structure within which monetary policy is conducted and now use a corridor system of monetary policy implementation.

In the aftermath of the global financial crisis, short-term interest rates have hardly moved and this has discredited the short-term nominal interest rate as an indicator of monetary policy. Because of these unconventional monetary policies, there is uncertainty about the future path of money growth and inflation.

Another problem with the current approach to monetary policy is that it ignores the role of leverage (or collateral rates). Leverage, l , is defined as

, where A denotes total assets and L liabilities other than net worth (equivalently, capital). Thus, leverage is the ratio of assets to capital and is a measure of how much debt an investor assumes in making an investment; the reciprocal of leverage, 1/ l , is known as the leverage ratio .

In fact, it is now widely recognized that leverage cycles (fluctuations in collateral rates) can have important effects on the level of economic activity.

Extra The Coyne Affair Apply the and Bank of Canada Independence Concept In 1961, after a battle of wills between then Prime Minister John Diefenbaker and Bank of Canada Governor James Coyne, the Bank of Canada Act was rewritten to ensure that the central bank’s decisions would not be influenced by politics, at least under normal circumstance.

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CHAPTER 13 | Inflation, Unemployment, and Bank of Canada Policy At the time, Prime Minister Diefenbaker wanted the Bank of Canada to stimulate the economy while Governor Coyne wanted to prevent inflationary pressures. The two policies are complete opposites of each other. The Prime Minister passed a bill in the Commons that essentially fired the Bank of Canada governor. That bill was blocked in the Senate. Nonetheless, Governor Coyne resigned shortly afterward.

Today, it would be very difficult for the government to directly influence the Bank of Canada. Louis Rasminsky, Mr. Coyne’s replacement, demanded that clear rules be set out before he accepted the job.

“It was a stroke of genius,” said Prof. Chris Ragan, in an interview with the Globe and Mail. “The last thing you want is the central bank being pressured to print money going into an election, but you also want it answerable to Parliament.”

If the government now has an issue with how the Bank of Canada conducts monetary policy, it is required to provide the Bank with a formal directive.

Source: Kevin Carmichael, “How the ‘Coyne Affair’ paved the way for Carney.” Globe and Mail, October 15, 2012.

Extra Economics in Your Life and Career: Would Your Job Be at Risk as a Result of an Expansionary Monetary Policy?

Question: Suppose you have rational expectations about future inflation. According to an article in the Globe and Mail, the Bank of Canada has decided to pursue an expansionary monetary policy. How would the Bank of Canada’s decision affect the rate of unemployment? Do you have to worry about losing your job?

Answer: If you and other workers have rational expectations, an expansionary monetary policy will cause the inflation rate to rise without any change in unemployment. If workers have contracts with their employers that keep wages and prices from adjusting quickly, then even if workers and firms have rational expectations, an expansionary monetary policy may still reduce the unemployment rate in the short run. So, in this case, you should not worry about losing your job.

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CHAPTER 14 | Macroeconomics in an Open Economy

CHAPTER 14 | Macroeconomics in an Open Economy Brief Chapter Summary and Learning Objectives 14.1 The Balance of Payments: Linking Canada to the International Economy (pages 437-442) Explain how the balance of payments is calculated.

▪

The balance of payments is the record of a country’s trade with other countries in goods, services, and assets.

14.2 The Foreign Exchange Market and Exchange Rates (pages 442-450) Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports.

▪

Exchange rates are determined in the foreign exchange market by the demand and supply of a country’s currency.

14.3 The International Sector and National Saving and Investment (pages 450-453) Explain the saving and investment equation.

▪

A current account deficit must be exactly offset by a financial account surplus.

14.4 The Effect of a Government Budget Deficit on Investment (pages 453-455) Explain the effect of a government budget deficit on investment in an open economy.

▪

When the government runs a budget deficit, national saving will decline unless private saving increases by the full amount of the budget deficit.

14.5 Monetary Policy and Fiscal Policy in an Open Economy (pages 456-457) Compare the effectiveness of monetary and fiscal policy in an open economy and in a closed economy.

▪

In a closed economy, the main effect of lower interest rates is on domestic investment spending and purchases of consumer durables. In an open economy, lower interest rates will also cause an increase in net exports.

Key Terms Balance of payments, p. 438. The record of a country’s trade with other countries in goods, services, and assets.

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Balance of trade, p. 439. The difference between the value of the goods a country exports and the value of the goods a country imports.

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CHAPTER 14 | Macroeconomics in an Open Economy Capital account, p. 440. The part of the balance of payments that records relatively minor transactions, such as migrants’ transfers and sales and purchases of nonproduced, nonfinancial assets.

Closed economy, p. 438. An economy that has no interactions in trade or finance with other countries.

Currency appreciation, p. 445. An increase in the market value of one currency relative to another currency.

Currency depreciation, p. 445. A decrease in the market value of one currency relative to another currency.

Current account, p. 438. The part of the balance of payments that records a country’s net exports, net income on investments, and net transfers.

Financial account, p. 439. The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country.

Net foreign investment, p. 440. The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment.

Nominal exchange rate, p. 442. The value of one country’s currency in terms of another country’s currency.

Open economy, p. 438. An economy that has interactions in trade or finance with other countries.

Real exchange rate, p. 450. The price of domestic goods in terms of foreign goods.

Saving and investment equation, p. 452. An equation that shows that national saving is equal to domestic investment plus net foreign investment.

Speculators, p. 445. Currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates.

Chapter Outline Amazon Deals with the Effects of a Strong Dollar By 2017, Amazon had 340,000 employees and revenue of $136 billion. Amazon’s success has not been confined to the United States. In 2017, about one-third of its sales were in foreign markets. In some years, converting foreign currencies into dollars yields fewer dollars than in other years. In 2016, Amazon’s global revenue was $550 million lower when measured in dollars than when measured in local currencies because the value of the dollar increased relative to most other currencies. Higher interest rates made financial investments in the United States more attractive to investors, which increased the demand for dollars and the exchange rate between the dollar and other currencies. But during the first half of 2017, the dollar lost about 6 percent of its value against other currencies.

14.1

The Balance of Payments: Linking Canada to the International Economy (pages 437-442) Learning Objective: Explain how the balance of payments is calculated.

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CHAPTER 14 | Macroeconomics in an Open Economy Nearly all economies are open economies. An open economy is an economy that has interactions in trade or finance with other countries. A closed economy is an economy that has no interactions in trade or finance with other countries. A good way to understand the interactions between one economy and other economies is through the balance of payments, which is the record of a country’s trade with other countries in goods, services, and assets. The balance of payments contains three accounts: 1. The current account 2. The financial account 3. The capital account

A. The Current Account The current account is the part of the balance of payments that records a country’s net exports, net income on investments, and net transfers. Any payments received by Canadian residents are positive numbers in the current account, and any payments made by Canadian residents are negative numbers in the current account. The balance of trade is the difference between the value of the goods a country exports and the value of the goods a country imports. If a country exports more than it imports, it has a trade surplus. If a country exports less than it imports, it has a trade deficit. Net exports is a component of aggregate expenditure. We can calculate net exports by adding together the balance of trade and the balance of services. The balance of services is the difference between the value of the services a country exports and the value of services a country imports. It is a convenient simplification to think of net exports as being equal to the current account balance.

B. The Financial Account The financial account is the part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country. The financial account records long-term flows of funds into and out of a country. There is a capital outflow from Canada when an investor in Canada buys a bond issued by a foreign company or government or when a Canadian firm builds a factory in another country. There is a capital inflow into the Canada when a foreign investor buys a bond issued by a Canadian firm or by the government or when a foreign firm builds a factory in Canada. The word capital applies not just to physical assets but also to financial assets. When firms build or buy facilities in foreign countries, they are engaging in foreign direct investment. When investors buy stock or bonds issued in another country, they are engaging in foreign portfolio investment. Net capital flows is the difference between capital inflows and capital outflows. Net foreign investment is the difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment. When net capital flows is positive, net foreign investment is negative; when net capital flows is negative, net foreign investment is positive.

C. The Capital Account The capital account is the part of the balance of payments that records less important transactions, such as migrants’ transfers and sales and purchases of nonproduced, nonfinancial assets.

D. Why Is the Balance of Payments Always Zero?

The sum of the current account balance, financial account balance, and the capital account balance equals the balance of payments. The balance of payments is always zero. To make the balance on the current account equal the balance on the financial account, the balance of payments includes an entry called the statistical discrepancy. Changes in foreign holdings of dollars are known as official reserve transactions.

Foreign investment in Canada and additions to foreign holdings of dollars both show up as positive entries in the Canadian financial account. Therefore, a current account deficit must be exactly offset by a financial account surplus, leaving the balance of payments equal to zero.

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Extra Apply the Just How Much Do We Owe? Concept Canada is a vast country with large quantities of natural resources and relatively few people. To take advantage of the abundant riches this country has to offer, Canada has long been an importer of foreign capital. Beginning in the 17th century, the fur trade was built using foreign capital from the English (Hudson’s Bay Company), French (North West Company), and the Dutch (West India Company). Today, these transactions would be recorded in Canada’s Financial Accounts. With such a long history of importing capital, could the solvency of the country be at risk?

A 2017 issue of Statistics Canada’ The Daily puts this history into perspective. While we continue to import capital, as the country has grown, we have become exporters of capital as well. The difference between what Canadians owe foreigners and what foreigners owe Canadians is known as our “net foreign debt” (excess of international liabilities over assets) or “net foreign assets” (excess of international assets over liabilities). The market value of our net foreign assets in the fourth quarter of 2016 amounted to $188.4 billion. While Canada’s assets now surpass liabilities, it is a recent state. Canada’s assets have surpassed liabilities only since the fourth quarter of 2014. In the mid-1990s when net foreign debt accounted for 44 percent of national income.

Sources: Statistics Canada, The Daily, March 14, 2017, http://www.statcan.gc.ca/daily-quotidien/170314/dq170314a-eng.htm. Statistics Canada.

Table 376-0142 - International investment position, book and market values, quarterly (dollars).

The Foreign Exchange Market and Exchange Rates (pages 442-450) 14.2 Learning Objective: Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports.

When firms make extensive use of foreign currencies, they must deal with fluctuations in the exchange rate. The nominal exchange rate is the value of one country’s currency in terms of another country’s currency. Economists also calculate the real exchange rate, which corrects the nominal exchange rate for changes in prices of goods and services. Every day the equivalent of $4 trillion worth of currency is traded in the foreign exchange market.

The market exchange rate is determined by the interaction of demand and supply. There are three sources of foreign currency demand for the Canadian dollar: 1. Foreign firms and households that want to buy goods and services produced in Canada.

2. Foreign firms and households that want to invest in Canada either through foreign direct investment—buying or building factories or other facilities in Canada—or through foreign portfolio investment—buying stocks and bonds issued in Canada.

3. Currency traders who believe that the value of the dollar in the future will be greater than its value today.

A. Equilibrium in the Market for Foreign Exchange The demand curve for dollars in exchange for a foreign currency has the normal downward slope, while the supply curve has the normal upward slope. Equilibrium occurs in the foreign exchange market where the quantity supplied equals the quantity demanded. Surpluses and shortages in the foreign exchange market are eliminated quickly because the volume of trading in major currencies such as the dollar and

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CHAPTER 14 | Macroeconomics in an Open Economy yen is very large, and currency traders are linked together by computer. Currency appreciation is an increase in the market value of one currency relative to another currency. Currency depreciation is a decrease in the market value of one currency relative to another currency.

B. How Do Shifts in Demand and Supply Affect the Exchange Rate?

Shifts in demand and supply curves cause the equilibrium exchange rate to change. Three main factors cause the demand and supply curves in the foreign exchange market to shift: 1. Changes in the demand for Canadian-produced goods and services and changes in the demand for foreign produced goods and services.

2. Changes in the desire to invest in Canada and changes in the desire to invest in foreign countries.

3. Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies.

Some buyers and sellers in the foreign exchange market are speculators, who are currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates. The demand curve for dollars shifts to the right when incomes in a foreign country rise, when interest rates in Canada rise, or when speculators decide that the value of the dollar will rise relative to the value of the foreign currency.

The factors affecting the supply curve for dollars are similar to those that affect the demand curve for dollars. A recession in Canada will decrease the demand for a foreign country’s products and cause the supply curve for dollars to shift to the left. A decrease in interest rates in a foreign country will make financial investments in that foreign country less attractive and cause the supply curve of dollars to shift to the left. The factors that affect the demand and supply for currencies are constantly changing. Whether the exchange rate increases or decreases depends on the direction of and size of the shifts in the demand curve and supply curve.

C. Some Exchange Rates Are Not Determined by the Market Some currencies have fixed exchange rates that do not change over long periods. For example, for more than 10 years, the value of the Chinese yuan was fixed against the US dollar at a rate of 8.28 yuan to the US dollar. A country’s central bank must intervene in the foreign exchange market to buy and sell its currency to keep the exchange rate fixed.

D. How Movements in the Exchange Rate Affect Exports and Imports A depreciation in the domestic currency will increase exports and decrease imports, thereby increasing net exports. An appreciation in the domestic currency will have the opposite effect: exports should fall and imports should rise, which will reduce net exports, aggregate demand, and real GDP.

E. The Real Exchange Rate The relative prices of two countries’ goods are determined by two factors: The relative price levels in the two countries, and the nominal exchange rate between the two countries’ currencies. Economists combine these two factors in the real exchange rate, which is the price of domestic goods in terms of foreign goods. We can calculate the real exchange rate between two currencies as

 Domestic price level  Real exchange rate = Nominal exchange rate   .  Foreign price level  Notice that both changes in the nominal exchange rate and changes in the relative price levels cause movements in the real exchange rate. Real exchange rates are reported as index numbers, with one year

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CHAPTER 14 | Macroeconomics in an Open Economy chosen as the base year. The main value of the real exchange rate is in tracking changes over time—in this case, changes in the relative prices of domestic goods in terms of foreign goods.

Extra Solved Problem 14.2 Subaru Benefits from a Weak Yen Today, most Japanese automobile companies have manufacturing plants in the United States. Honda, for example, exports from Japan only 21 percent of the cars it sells in the United States. Fuji Heavy Industries, whose main car brand is Subaru, is an exception in still producing most of its cars in Japan. An article in the Wall Street Journal observed that for Fuji Heavy Industries, “the plunging yen has turned a problem—a shortage of production in the U.S.—into an unexpected boon.” a. What does the article mean by a “plunging yen”? b. Why would a plunging yen be a boon for Fuji Heavy Industries? c. Briefly explain whether a plunging yen would help or hurt Honda.

Solving the Problem Step 1:

Review the chapter material.

This problem is about changes in the value of a currency, so you may want to review the section “How Movements in the Exchange Rate Affect Exports and Imports” on page 448.

Step 2:

Answer (a) by explaining what the article means by a “plunging yen.”

In this case, a plunging yen means a yen that is worth less in exchange for the U.S. dollar. With a plunging yen, a larger number of yen would be required to exchange for one U.S. dollar.

Step 3:

Answer (b) by explaining how a plunging yen would affect Fuji Heavy Industries.

When Fuji Heavy Industries manufactures cars in Japan, it pays production costs, including the salaries of its assembly-line workers and payments to its suppliers, with yen. With a falling value of the yen, the dollar price of cars Fuji sells in the United States decreases. As a result, Fuji will gain sales from other companies, particularly those that produce their cars in the United States. If Fuji had produced its cars in the United States, it would not have had this advantage.

Step 4:

Answer (c) by explaining how a plunging yen would help or hurt Honda.

Because most of the cars Honda sells in the United States are also produced here, most of the company’s production costs and most of the revenue it earns are in dollars. So, Honda will not be directly affected by fluctuations in the yen–dollar exchange rate. Honda will, though, likely lose some sales to Fuji as the dollar prices of Subarus declines.

Extra Credit: Managers at Honda, Toyota, and Nissan are aware that when the value of the yen declines against the dollar, they would be better off producing in Japan the cars they planned to sell in the United States. But, unlike the managers of Fuji, the managers of these firms decided that moving production to the United States would allow them to plan better and to stabilize their profits because their sales would no longer be affected as much by fluctuations in the exchange rate.

Source: Yoko Kubota, “Subaru Rides a Weaker Yen into the U.S.,” Wall Street Journal, November 15, 2014.

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Extra Apply the Japan Rides the Yen Roller Coaster Concept Bridgestone, headquartered in Tokyo, Japan, is the world’s largest tire manufacturer. A 2013 headline in the Wall Street Journal read: “Weak Yen Boosts Bridgestone Profits.” The headline was not unusual.

Many large Japanese firms, including Toyota, Sony, and Nintendo, rely heavily on sales in the United States and other foreign countries. As a result, their profits depend on the exchange rate between the yen and other currencies.

As the following figure shows, the long-run trend has been for the yen to gain value against the U.S. dollar. The value of the yen increased from ¥360 = $1 in 1971 to less than ¥100 = $1 in 2013. There have been substantial swings in the exchange rate around that long-run trend, however. For example, the U.S. dollar soared in value against the yen by more than 70 percent between 1995 and 1998. Between 2007 and 2011, the value of the U.S. dollar fell by 60 percent against the yen, before increasing by 25 percent between 2012 and 2013. As a result of these exchange rate movements, the late 1990s and 2012–2013 were good years for Japanese exporters, while 2007–2011 were bad years.

What explains these fluctuations in the yen–dollar exchange rate? We have seen that an increase in the demand by foreign investors for U.S. financial assets can increase the value of the U.S. dollar, and a decrease in the demand for U.S. financial assets can decrease the value of the U.S. dollar. The increase in the value of the U.S. dollar against the yen in the late 1990s was driven by strong demand by Japanese and other foreign investors for U.S. stocks and bonds, particularly U.S. Treasury securities. This increase in demand was not primarily due to higher U.S. interest rates but to problems in the international financial system that we will discuss in Chapter 15. Many investors considered U.S. financial assets a safe haven in times of financial problems because the investors believed the U.S. Treasury was unlikely to default on its bonds.

The decline in the value of the U.S. dollar against the yen in the years following 2007 began when the U.S. Fed started cutting the target for the federal funds rate in response to the beginning of the recession of 2007–2009. When U.S. interest rates are relatively low, investors are likely to buy Japanese and other foreign stocks and bonds rather than U.S. stocks and bonds, which depresses the demand for the U.S. dollars and lowers the exchange value of the U.S. dollar. By 2011, Bridgestone and other Japanese firms were complaining about the losses they were suffering due to the high value of the yen. Some Japanese manufacturers considered moving more of their production capacity out of Japan. The CEO of Nissan

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CHAPTER 14 | Macroeconomics in an Open Economy stated: “What’s taking place now is many projects are now basing their manufacturing outside of Japan because they just cannot survive with this 77 yen to the dollar.”

The decline in the value of the yen after 2012 occurred as a result of the Japanese central bank, the Bank of Japan, following an expansionary monetary policy. When Shinzo Abe was elected prime minister in late 2012, he appointed a new governor of the Bank of Japan who pledged to double the Bank’s holdings of Japanese government bonds and to buy other assets. Investors expected that the result would be lower nominal Japanese interest rates and a higher inflation rate, reducing the real return from owning Japanese financial assets. In response, investors sold Japanese financial assets and bought U.S. financial assets, causing the value of the yen to decline against the U.S. dollar.

The fall in the value of the yen was good news for Japanese firms, but fluctuations in the yen–dollar exchange rate are certain to continue as investors buy and sell currencies in response to changes in monetary policy and other factors.

Sources: Yoree Koh, “Weak Yen Boosts Bridgestone Profits,” Wall Street Journal, August 9, 2013; “Automakers May Flee Strong Yen,” Reuters, November 17, 2011; “Opening the Flood Gates,” Economist, April 13, 2013; and Federal Reserve Bank of St. Louis.

Questions An article in the Economist notes that gasoline prices in Japan were increasing “because of the government’s efforts to drive down the yen.” a. Why was the Japanese government trying to drive down the yen? b. What actions was the Japanese government taking to drive down the yen? c. Why would driving down the yen have increased gasoline prices in Japan?

Source: “Man with Plan,” Economist, July 20, 2013.

Answers a. The Japanese government was trying to drive down the yen to help Japanese exporters and stimulate the economy. b. The Bank of Japan was following an expansionary monetary policy to stimulate the economy, which reduced Japanese interest rates. The lower interest rates reduced the demand for Japanese financial assets, decreasing the foreign exchange rate of the yen. c. Driving down the yen increases the prices of imports into Japan, which includes the price of imported crude oil that is refined into gasoline.

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14.3

The International Sector and National Saving and Investment (pages 450-453) Learning Objective: Explain the saving and investment equation.

A. Net Exports Equal Net Foreign Investment When a country imports more than it exports the country must finance the difference by selling assets or by borrowing. When a country sells more assets to foreigners than it buys from foreigners, or when it borrows more from foreigners than it lends to foreigners, the country experiences a net capital inflow and a financial account surplus. When imports are greater than exports, net exports are negative, and there will be net capital inflow as people in Canada sell assets and borrow to pay for the surplus of imports over exports. Therefore, net capital flows will be equal to net exports (but with the opposite sign), and net foreign investment will also be equal to net exports (and with the same sign).

In summary: Current account balance + Financial account balance = 0 or Current account balance = –Financial account balance or Net exports = Net foreign investment.

This equation tells us that countries that import more than they export must borrow more from abroad than they lend abroad. If net exports are negative, net foreign investment will also be negative by the same amount.

B. Domestic Saving, Domestic Investment, and Net Foreign Investment The total saving in any economy is equal to saving by the private sector plus saving by the government sector, which is called public saving. When the government runs a budget surplus by spending less than it receives in taxes, it is saving. When the government runs a budget deficit, public saving is negative, which is also known as dissaving. We can write the following equation for the level of saving in the economy: National saving = Private saving + Public saving or S = Sprivate + Spublic.

Private saving is equal to what households have left of their income after spending on consumption goods and paying taxes (assume that transfers are zero): Private saving = National income – Consumption – Taxes or Sprivate = Y – C – T.

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CHAPTER 14 | Macroeconomics in an Open Economy The basic macroeconomic equation for GDP or national income is Y = C + I + G + NX. We can now write the saving and investment equation, which shows that national saving is equal to domestic investment plus net foreign investment.

National saving = Domestic investment + Net foreign investment or S = I + NFI. This equation is an identity because it must always be true, given the definitions we used. The saving and investment equation tells us that a country’s saving will be invested either domestically or overseas. A country that has positive net foreign investment, such as Canada, must be saving more than it is investing domestically. To understand why, rewrite the saving and investment equation by moving domestic investment to the left side: S - I = NFI.

Extra Question: A current account deficit Apply the or a financial account surplus?

Concept Answer: Both Table 14.1 in the textbook shows that in 2017 Canada had a negative balance on its current account—the part of the balance of payments equal to net exports, plus net income on investments, plus net transfers— of $63.3 billion. This means that there was a surplus in the financial account. The surplus, $52.0 billion, plus the balance on the capital account and the statistical discrepancy equalled $63.3 billion, so the balance of payments netted out to zero. The current account has been in deficit since 2009. Some people have expressed concern that so long as this negative balance continues, the country is selling assets to foreigners, net of its purchases of foreign assets, in an amount equal to the deficit. Others offer an alternative view: Investors buy Canadian assets because they are sound investments.

Perhaps the argument should be that the deficit on the current account is the result of a financial account surplus, and not that the financial account surplus is the result of the current account deficit. As the demand by foreign investors for Canadian assets increases, the exchange rate of the dollar is greater than it would otherwise be. A stronger dollar reduces exports and increases imports, which results in a greater deficit in the current account.

Canadian investors have been very active in purchasing foreign assets in recent years. But foreign investors have been even more eager buyers of real and financial capital in Canada.

The challenge for Canada in the years to come will be to pursue prudent monetary and fiscal policies. The current account can then adjust over time without serious repercussions.

Source: Statistics Canada, CANSIM table 376-0101 and 376-0102.

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14.4

The Effect of a Government Budget Deficit on Investment (pages 453-455) Learning Objective: Explain the effect of a government budget deficit on investment in an open economy.

When the government runs a budget deficit, national saving will decline unless private saving increases by the amount of the budget deficit, which is unlikely. As the saving and investment equation shows, the result of a decline in national saving must be a decline in either domestic investment or net foreign investment.

If the federal government runs a budget deficit, the US Treasury must raise an amount equal to the deficit by selling bonds. To attract investors, the government may have to raise the interest rates on its bonds. As interest rates on government bonds rise, other interest rates, including those on corporate bonds and bank loans, will also rise. Higher interest rates will discourage some firms from borrowing funds to build new factories or to buy new equipment. Higher interest rates on financial assets in Canada will attract foreign investors, who will buy Canadian dollars in order to purchase bonds in Canada. The greater demand for dollars will increase their value relative to other currencies. Exports from Canada will fall, and imports to Canada will rise. Net exports and net foreign investment will fall.

When a government budget deficit leads to a decline in net exports, the result is sometimes referred to as the twin deficits, which refers to the possibility that a government budget deficit will also lead to a current account deficit. The twin deficits idea first became widely discussed in Canada during the early 1980s when the federal government ran a large budget deficit that resulted in high interest rates, a high exchange value of the dollar, and a large current account deficit.

The experience of Canada and other countries shows only mixed support for the twin deficits idea. The saving and investment equation shows that an increase in the government budget deficit will not lead to a current account deficit, provided that either private saving increases or domestic investment declines.

Extra Solved Problem 14.4 US Budget Deficits and Investment In a 2005 speech, Ben Bernanke, shortly before he became chair of the US Federal Reserve, offered an explanation for changes that had occurred in the federal budget and current account of the United States.

He explained that in the previous decade there had been a large increase in saving worldwide, which made up for a low level of saving the United States. In many foreign countries, aging populations and a strong motive for saving led many investors to seek investment opportunities in other countries. At the same time, many developing nations changed from being net users to net suppliers of saving to international capital markets. The increase in current account deficit of the United States from 1996 to 2004 was matched by an increase in the current account surplus of other countries, with much of the increase coming from developing countries, as shown in the table below. Bernanke explained that: “The development . . . of new technologies . . . rising productivity . . . [and] lower political risk . . . made the US economy exceptionally attractive to international investors. . . .” As investment flowed into the United States, stock prices and the exchange rate of the dollar rose.

Bernanke argued that the pattern of international capital flows he described—the developing world lending large amounts of saving to developed countries—has some benefits but could prove counterproductive if the pattern were to persist.

Global Account Balances

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Countries

(billions of dollars) 1996 2000

2004

Industrial

$41.5

−$331.5

−$400.3

United States

−120.2

−413.4

−665.9

Japan

65.7

119.6

171.8

European area

78.5

−71.7

53.0

Developing

–90.4

131.2

326.4

Source: Ben S. Bernanke. “The Global Savings Glut and the U.S. Current Account Deficit.” The Federal Reserve Board. April 14, 2005, http://www.federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm.

Why would it be better for the United States and developing countries if the pattern of capital flows Bernanke described is eventually reversed?

Solving the Problem Step 1:

Review the chapter material.

This problem is about the effect of a government budget deficit, so you may want to review the section “The Effect of a Government Budget Deficit on Investment,” which begins on page 453 in the textbook.

Step 2:

Discuss whether it would be better for the United States and developing countries if the pattern of capital flows Bernanke described is eventually reversed.

In the United States and other high-income countries, workers have large quantities of capital to work with. Population is growing slowly and workforces are aging. These countries have very good reasons to save to support their future retirees. In contrast, low-income countries have younger and more rapidly growing populations and offer relatively high returns to capital. Therefore, in the long run it would be more efficient for high-income countries to run current account surpluses and lend some of their savings to low-income countries.

14.5

Monetary Policy and Fiscal Policy in an Open Economy (pages 456-457) Learning Objective: Compare the effectiveness of monetary and fiscal policy in an open economy and in a closed economy.

Economists refer to the ways in which monetary and fiscal policy affect the domestic economy as policy channels. An open economy has more policy channels than does a closed economy.

A. Monetary Policy in an Open Economy When the Bank of Canada engages in an expansionary monetary policy, it buys government securities to lower interest rates and stimulate aggregate demand. In a closed economy, the main effect of lower interest rates is on domestic investment spending and consumer durables. In an open economy, lower interest rates will also affect the exchange rate between the dollar and foreign currencies. Lower interest rates will cause some investors in Canada and abroad to switch from investing in Canadian financial assets to investing in foreign financial assets. The result is a lower demand for the dollar relative to foreign currencies and a decline in the dollar’s value. This additional policy channel will increase the ability of an expansionary monetary policy to affect aggregate demand.

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CHAPTER 14 | Macroeconomics in an Open Economy When the Bank of Canada wants to reduce aggregate demand to reduce inflation, it engages in contractionary monetary policy. In a closed economy, the main effect is on domestic investment and purchases of durables. In an open economy, higher interest rates will lead to a higher exchange value of the dollar. Net exports will fall. The contractionary monetary policy will have a larger effect on aggregate demand. Monetary policy has a greater effect on aggregate demand in an open economy than in a closed economy.

B. Fiscal Policy in an Open Economy To engage in an expansionary fiscal policy, the federal government increases its purchases or cuts taxes.

Increases in government purchases directly increase aggregate demand. Tax cuts increase aggregate demand by increasing household disposable income and business income, which results in increased consumption spending and investment spending. An expansionary fiscal policy may result in higher interest rates. In a closed economy, the main effect of higher interest rates is to reduce investment spending and purchases of consumer durables. In an open economy, higher interest rates will also lead to an increase in the foreign exchange value of the dollar and a decrease in net exports. Therefore, in an open economy, an expansionary fiscal policy may be less effective because the crowding out effect may be larger. In a closed economy, only consumption and investment are crowded out by an expansionary fiscal policy. In an open economy, net exports may also be crowded out.

A contractionary fiscal policy cuts government purchases or raises taxes to reduce household income and consumption. Contractionary fiscal policy also reduces the federal budget deficit (or increases the surplus), which may lower interest rates. Lower rates increase domestic investment and purchases of consumer durables. In an open economy, lower interest rates will also reduce the foreign exchange rate of the dollar and increase net exports. In an open economy, a contractionary fiscal policy will have a smaller effect on aggregate demand that will be less effective in slowing down an economy. Fiscal policy has a smaller effect on aggregate demand in an open economy than in a closed economy.

Extra Solved Problem 14.5 Monetary and Fiscal Policy in a Recession Assume that Canada, an open economy, has slipped into a recession. Policymakers consider two different strategies for increasing aggregate demand. First, the Bank of Canada can lower the target overnight rate by 0.5 percent (50 basis points). Second, the government can pass legislation to cut income taxes. a. If Canada were a closed economy, would the Bank of Canada have to lower the target overnight rate by more or less than 50 basis points in order to have the same effect on aggregate demand as in an open economy? b. In an open economy, as national income or GDP increases, so will spending on imports. Define the marginal propensity to import (MPI) as the increase in imports divided by the increase in GDP. Assume two different values for the MPI for Canada: MPI = 0.10 and MPI = 0.20. For which value of the MPI would an income tax cut have a greater effect on aggregate demand?

Explain your answer.

Solving the Problem Step 1:

Review the chapter material.

This problem is about the effect of fiscal policy and monetary policy, so you may want to review the section “Monetary Policy and Fiscal Policy in an Open Economy,” which begins on page 456 in the textbook.

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Step 2:

Answer part (a) by explaining whether, if Canada had a closed economy, the Bank of Canada would have to lower the target overnight rate by more or less than 50 basis points in order to have the same effect on aggregate demand as in an open economy.

Because Canada has an open economy, open market operations that reduce the target overnight rate will cause some investors to switch from investing in Canadian financial assets to foreign assets that have higher yields. As investors sell dollars to buy foreign currencies, the value of the dollar will fall relative to other currencies. The depreciation of the dollar will eventually cause Canadian exports to rise. If Canada had a closed economy, lowering the target overnight rate would have no effect on the exchange rate or exports. Therefore, the Bank of Canada would have to lower the target overnight rate by more than 50 basis points to have the same effect on aggregate demand.

Step 3:

Answer part (b) by explaining for which value of the MPI, 0.10 or 0.20, an income tax cut would have the greater impact on aggregate demand.

In an open economy, the larger the value of the MPI the larger the increase in imports as GDP increases and the larger the decline in net exports and aggregate demand. Therefore, a given tax cut will have a greater effect on aggregate demand when the MPI equals 0.10 than when the MPI equals 0.20, because with the smaller MPI there will be a smaller decrease in net exports.

Extra Fiscal and Monetary Policy Face Apply the New Challenges after 2007–2009 Concept The financial crisis and the recession of 2007–2009 presented unprecedented challenges to the Federal Reserve and to a lesser extent, the Bank of Canada. It may take years before the Fed gets a final report card for its performance. As the United States economy began to show new life in late 2009, investors were uncertain about the future. “There has been a lot of disappointment with the way the US credit crisis was handled,” said Claire Dissaux, managing director of global economics and strategy for Millennium Global Investments Ltd. “The dollar’s loss of influence is a steady and long-term trend.” Additional uncertainty surrounded the fiscal policies enacted during the first term of the Obama administration, with annual deficits exceeding $1 trillion and the inability of Congress and the administration to agree on a plan to reduce them.

Famed investor Warren Buffett and bond investment firm Pimco made headlines when they publicly expressed fears that the government’s fiscal and monetary stimulus programs could result in higher inflation and a lower dollar exchange rate. Mr. Buffet expressed doubt that policymakers would be able to slow the growth of the debt. Pimco portfolio manager Curtis Mewbourne said that emerging economies have begun to reduce their holdings of the US dollar, which accounts for a large share of these countries’ foreign exchange reserves. “Investors should consider whether it makes sense to take advantage of any period of U.S. dollar strength to diversify their currency exposure.”

However, movement away from the dollar as a reserve currency seemed unlikely in the near future. For example, attempts by China to coax foreign companies to conduct transactions with yuan, rather than dollars, have yet to meet much success. Corporate executives said it is difficult to buy and sell in yuan because of the paperwork and bureaucracy involved in the required government registration process. And it still is easier to pay in dollars because most international business with China is done in US currency.

For many companies, the convenience of paying in dollars outweighs the potential cost of an unfavourable move in the yuan-dollar exchange rate.

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CHAPTER 14 | Macroeconomics in an Open Economy Source: Neil Shah, “As Budget Deficit Grows, So Do Doubts on Dollar,” Wall Street Journal August 26, 2009; and Chana R. Schoenberger, “U.S. Firms Pose Hurdle for Yuan,” Wall Street Journal, November 3, 2011.

Extra Economics in Your Life and Career: Should You Buy Euro Bonds?

Question: A friend of yours mentions he read about a European Commission’s proposal to sell euro-zone bonds. These bonds would replace some or all of the bonds offered by each of the nineteen euro-zone national governments. Assume that euro bonds are offered for sale to investors and that the yield on these bonds is greater than the yield on Canada bonds with the same maturity. Assume that there is no default risk on both types of bonds. Would the euro bonds be a better investment than Canada bonds?

Answer: Although the euro bonds offer a higher interest rate than Canada bonds, there is one other element of risk associated with buying euro bonds: exchange rate risk. To buy the euro bonds, you will have to convert dollars into euros. Any dividends and principal you receive from the bonds will be paid in euros. From the time you buy the bonds until you receive payments from them, the exchange rate of the dollar against the euro may rise or fall. When you convert euros into dollars, the value of the dollar may be greater or less than it was when you bought the bonds. When you decide whether to buy euro bonds, remember that there is no exchange rate risk when you buy Canada bonds.

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CHAPTER 15 | The International Financial System Brief Chapter Summary and Learning Objectives 15.1 Exchange Rate Systems (page 466) Understand how different exchange rate systems operate.

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A currency floats when its exchange rate is determined by demand and supply. Under a fixed exchange rate system, countries agree to keep their currencies’ exchange rates fixed.

15.2 The Current Exchange Rate System (pages 467-478) Discuss the three key features of the current exchange rate system.

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(1) The US dollar floats against other major currencies. (2) Most countries in Western Europe have adopted a common currency. (3) Some developing countries have fixed their currencies’ exchange rates against the dollar or another major currency.

15.3 International Capital Markets (pages 478-480) Discuss the growth of international capital markets.

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A key reason that exchange rates fluctuate is that investors seek out the best investments they can find anywhere in the world.

Key Terms Bretton Woods system, p. 466. An exchange rate system that lasted from 1944 to 1973, under which countries pledged to buy and sell their currencies at a fixed rate against the dollar.

Euro, p. 467. The common currency of many European countries.

Exchange rate system, p. 466. An agreement among countries about how exchange rates should be determined.

Fixed exchange rate system, p. 466. A system under which countries agree to keep the exchange rates among their currencies fixed for long periods.

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Floating currency, p. 466. The outcome of a country allowing its currency’s exchange rate to be determined by demand and supply.

Managed float exchange rate system, p. 466.

The current exchange rate system, under which the value of most currencies is determined by demand and supply, with occasional government intervention.

Pegging, p. 475. The decision by a country to keep the exchange rate fixed between its currency and another country’s currency.

Purchasing power parity, p. 468. The theory that, in the long run, exchange rates move to equalize the purchasing powers of different currencies.

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CHAPTER 15 | The International Financial System Quota, p. 469. A numerical limit that a government imposes on the quantity of a good that can be imported into the country.

Tariff, p. 469. A tax imposed by a government on imports.

Chapter Outline Bayer and the Great European Currency Experiment Most people know the German firm Bayer for its aspirin. Today, the company sells a variety of pharmaceuticals and other products. Because of the euro, Bayer and other German firms do not have to worry about fluctuations in exchange rates within most of Europe. Since the financial crisis of 2007–2009, there has been a debate about the future of the euro. While it seems likely to survive, this outcome is not certain. Although firms such as Bayer receive advantages from the euro, when they export outside Europe, they must deal with currency fluctuations. When the value of the euro increases, Bayer’s sales are hurt, but when the value of the euro falls it is good news for Bayer and other German exporters. Because Bayer receives revenue in many different currencies, as the exchange rates of those currencies change relative to the euro, the values of Bayer’s sales and profits change as well.

Exchange Rate Systems (page 466) 15.1 Learning Objective: Understand how different exchange rate systems operate.

Some countries allow the exchange rate to be determined by demand and supply, just as other prices are.

The result of this approach is a floating currency. An exchange rate system is an agreement among countries about how exchange rates should be determined. A managed float exchange rate system is the current exchange rate system, under which the value of most currencies is determined by demand and supply, with occasional government intervention. Historically, the two most important alternatives to the managed float exchange rate system were the gold standard and the Bretton Woods system. These were both fixed exchange rate systems. Under a fixed exchange rate system, countries agree to keep the exchange rates among their currencies fixed for long periods. Under the gold standard, exchange rates were determined by the relative amounts of gold in each country’s currency and the money supply was determined by the amount of gold available. The gold standard collapsed during the Great Depression of the 1930s.

A conference was held in Bretton Woods, New Hampshire, in 1944 to set up an exchange rate system in which the United States pledged to buy or sell gold at a fixed price of $35 per ounce. The central banks of all other members of the new Bretton Woods system pledged to buy and sell their currencies at a fixed rate against the dollar. Unlike the gold standard, neither the United States nor any other country was willing to redeem its paper currency for gold domestically. By the early 1970s, the difficulty of keeping exchange rates fixed led to the end of the Bretton Woods system.

Extra Solved Problem 15.1 To Some, Stones Are as Good as Gold In 1903, anthropologist William Henry Furness visited the tiny island of Yap in Micronesia. He wrote a book titled The Island of Stone. Famed economist Milton Friedman quoted passages from Furness’s work in his own book, Money Mischief, that described Yap’s unusual monetary system. Because the island had no

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CHAPTER 15 | The International Financial System metal to fashion coins, islanders used stone wheels called fei as their medium of exchange. The fei were too large to move easily, so the natives were content to merely acknowledge that ownership had been transferred after a transaction had been conducted, and the fei remained on the former owner’s premises.

Friedman recounted Furness’ explanation of how the German government, which took possession of Yap from Spain in 1898, used a “fine” to coax the natives to repair paths used for transportation between settlements. At first, the natives failed to act, believing the repairs were unnecessary. Eventually, a fine was imposed on the chiefs of the district simply by sending a man who used black paint to mark a certain number of the fei to indicate the stones were claimed by the government. The chiefs responded by repairing the paths. When the work was done, the government’s agents were dispatched once again, this time to erase the black paint marks. The “fine” was paid, and ownership of the stones reverted to the natives. The “stone standard” of Yap may seem odd, but Friedman explained that it was not very different from the gold standard of the modern world. In 1932–1933, the Bank of France requested that the Federal Reserve Bank of New York convert part of the dollar assets it had in the United States into gold. Federal Reserve officials responded by ordering one of its employees to enter its gold vault, place the required amount of gold ingots into drawers, and label them the property of the Bank of France.

Discuss the extent to which the Yap’s “stone standard” resembled the gold standard.

Solving the Problem Step 1:

Review the chapter material.

This problem is about different exchange rate systems, so you may want to review the section “Exchange Rate Systems,” which begins on page 466 in the textbook.

Step 2:

How were Yap’s “stone standard” and the gold standard similar?

Friedman explained the similarity between the two standards in the following passage from his book, Money Mischief: U.S. gold reserves were down, French gold reserves were up. . . . The so-called drain of gold by France from the United States was one of the factors that led to the banking panic of 1933. . . . The Yap islanders regarded as a concrete manifestation of their wealth stones . . . the civilized world regarded as a concrete manifestation of its wealth a metal dug from deep in the ground, refined at great labour . . . and buried again in elaborate vaults deep in the ground.

Source: Milton Friedman, “The Island of Stone Money,” in Money Mischief. (New York: Harcourt Brace Jovanovich, 1992) pp. 6–7.

Extra Apply the The Canadian Province of...Arizona?

Concept In 2011, there seemed to be a lot of Canadians buying houses in Phoenix and other cities in Arizona. For many years, some Canadians found buying a second home in Arizona or Florida a good way to avoid the harsh Canadian winters. The value of the U.S. dollar had been declining relative to the Canadian dollar.

Although the value of the U.S. dollar soared by more than 30 percent relative to the Canadian dollar during the height of the financial crisis in 2008, it declined during most of the period after the crisis ended. The falling value of the U.S. dollar was a great help to Canadian buyers of U.S. homes.

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CHAPTER 15 | The International Financial System In late 2001, it took 1.60 Canadian dollars to purchase 1 U.S. dollar. So, a Canadian purchasing a house in Phoenix priced at $125,000 would have had to pay $200,000 in Canadian dollars. In the summer of 2011, it took only 0.95 Canadian dollars to purchase 1 U.S. dollar. The stronger Canadian dollar meant that a Canadian could now purchase a house in Phoenix priced at $125,000 for only $118,750 in Canadian dollars. In other words, the decline in the value of the U.S. dollar resulted in a more than 40 percent reduction in the price of the house in Canadian dollars. As one Canadian who was buying a vacation home in Desert Ridge, Arizona, put it: “It’s purchasing power, plain and simple. In the days when our dollar was 60 or 65 [U.S.] cents, I wouldn’t even be talking to you. The strong Canadian dollar has created a lot of opportunities for Canadians.” In addition to the decline in the value of the U.S. dollar, many Canadians found Arizona to be an ideal place to buy a second home because overbuilding in the state during the housing bubble had resulted in many property owners being willing to accept sharply lower prices (in U.S. dollars). Little wonder that by 2011, restaurants and bars in Arizona began staging Canada Day celebrations to attract the growing Canadian population.

In addition to individual Canadians looking to buy second homes in Arizona, some Canadian investors bought multiple properties, hoping to resell them for a profit after local housing prices had risen and after the value of the U.S. dollar had increased relative to the Canadian dollar. Some Canadian manufacturers also shifted operations to the United States. For example, E.H. Price, a firm that produces ventilation systems for commercial buildings and is headquartered in Winnipeg, Canada, doubled the size of its operations in the United States, where nearly half of its sales were. The rising value of the Canadian dollar would have priced its products out of the U.S. market if it had continued manufacturing the products in Canada. Of course, further fluctuations in the value of the U.S. dollar could pose problems for Canadians buying and investing in the United States. For example, if the value of the U.S. dollar were to continue to decline, then Canadians who bought second homes in the United States or Canadian investors buying multiple U.S. homes would take a loss in terms of Canadian dollars should they decide to sell. An increase in the value of the U.S. dollar would be good news for Canadian owners of U.S. houses but bad news for Canadian manufacturers if they intended to export goods to Canada from their U.S. plants.

Sources: Chana R. Schoenberger, “Canadians Warm to Phoenix,” Wall Street Journal, October 8, 2011; Julie Schmit, “Foreign Buyers Lifting U.S. Home Sales,” USA Today, July 14, 2011; and Barrie McKenna, “For Canadian Manufacturers, Foreign Assets Tantalizingly Cheap,” (Toronto) Globe and Mail, June 12, 2011.

The Current Exchange Rate System (pages 467-478) 15.2 Learning Objective: Discuss the three key features of the current exchange rate system.

The current exchange rate system has three important aspects: 1. Canada allows the dollar to float against other major currencies 2. Nineteen countries in Europe have adopted a single currency, the euro.

3. Some developing countries have attempted to keep their currencies’ exchange rates fixed against the US dollar or another major currency.

A. The Floating Dollar Since 1973, the value of the dollar has fluctuated widely against other major currencies.

B. What Determines Exchange Rates in the Long Run? In the short run, the two most important causes of exchange rate movements are changes in interest rates and changes in investors’ expectations about the future values of currencies. The theory that exchange rates move to equalize the purchasing powers of different currencies in the long run is the theory of

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CHAPTER 15 | The International Financial System purchasing power parity. Three real-world complications keep purchasing power parity from being a complete explanation of exchange rates, even in the long run: 1. Not all products can be traded internationally.

2. Products and consumer preferences are different across countries.

3. Countries impose barriers to trade. A tariff is a tax imposed by a government on imports. A quota is a numerical limit a government imposes on the quantity of a good that can be imported into the country.

The four determinants of exchange rates in the long run are 1.

2.

3.

4.

Relative price levels Relative rates of productivity growth Preferences for domestic and foreign goods Tariffs and quotas

Because these four factors change over time, the value of one country’s currency can increase or decrease by substantial amounts over the long run. These changes in exchange rates can create problems for firms.

A decline in the value of a country’s currency lowers the foreign currency prices of the country’s exports and increases the prices of imports.

C. The Euro After World War II, many countries of Western Europe wanted to integrate their economies more closely.

In 1957, Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands established the European Economic Community. Over the years, other countries joined the European Economic Community, which was renamed the European Union (EU) in 1991. By 2017, 28 countries were members of the EU. EU members moved to a common currency beginning in 1999. On January 1, 2002, euro coins and paper currency were introduced. A new European Central Bank (ECB) was also established with responsibility for monetary policy and issuing currency. The ECB represents a unique experiment in allowing a multinational organization to control the domestic monetary policies of independent countries. At the end of 2017, 19 EU countries had adopted the euro as their currency. These countries are referred to as the euro zone.

D. Pegging against Another Currency Some developing countries have attempted to keep their exchange rates fixed against the US dollar or another major currency. When the exchange rate is fixed, business planning becomes much easier. In the 1980s and 1990s an additional reason developed for having fixed exchange rates. During those decades, the flow of foreign investment funds to developing countries increased substantially. It became possible for firms in some of these countries to borrow dollars directly from foreign investors or indirectly from foreign banks. In the 1980s and 1990s, some countries feared the inflationary consequences of a floating exchange rate.

Pegging refers to the decision by a country to keep the exchange rate fixed between its currency and another country’s currency. When a developing country has pegged the value of its currency against the dollar, the responsibility for maintaining the peg has been entirely with the developing country. Countries attempting to maintain a peg can run into problems. A currency pegged at a value above the market equilibrium exchange rate is said to be overvalued. A currency pegged at a value below the market equilibrium exchange rate is said to be undervalued. When investors make it more difficult to maintain a fixed exchange rate, it is referred to as destabilizing speculation. Most countries that continue to use

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CHAPTER 15 | The International Financial System pegged exchange rates are small and trade primarily with a single, much larger, country. Overall, the trend has been toward replacing pegged exchanges rates with managed floating exchange rates.

Extra Spain’s Economy Shows Benefits, Apply the Risks of the Euro Concept Adopting the euro as its currency resulted in low real interest rates and rapid economic growth in Spain in the first years of the twenty-first century. In fact, the short-term nominal interest rate in Spain, set by the European Central Bank (ECB) for all euro countries, was less than Spain’s rate of inflation. But with rapid growth came higher prices and wages. When the exchange rate for the euro rose relative to the U.S. dollar during the financial crisis and recession of 2007–2009, Spain experienced the downside of ceding control of its monetary policy to the ECB. Spain’s GDP fell in 2009 and unemployment soared to over 18 percent. Spain faced the reality of having to lower its wages and prices to become more competitive in international markets.

Spain’s experience underlined the downside of using a currency union that has a monetary policy that affects 17 countries, each of which has its own sovereign government and economy. While countries like Spain and Italy ran trade deficits, Germany and the Netherlands racked up large trade surpluses. “There is a serious risk that the growth prospects of struggling euro-zone economies will be handicapped for many years by their inflexibility and the external surpluses of other euro-zone member states,” noted Simon Tilford, chief economist at the Centre for European Reform. “If so, investors will lose confidence in the credit-worthiness of governments and firms in these countries, leading to a dramatic increase in their borrowing costs.”

Tilford added that there were three resolutions to the debt crisis: 1. The euro zone countries could move to a full political union.

2. The European countries with serious debt problems, such as Spain and Italy, could cease to use the euro as their currency, which would probably mean they would default on their national debts.

3. Stronger euro zone countries, such as Germany and France, could bail out the weaker countries.

Source: Thomas Catan, “Spain’s Struggles Illustrate Pitfalls of Europe’s Common Currency,” Wall Street Journal, September 14, 2009.

Extra Apply the Can the Euro Survive?

Concept The euro was first introduced as a currency in 2002. The period from then until the beginning of the global economic downturn in 2007 was one of relative economic stability in most of Europe. With low interest rates, low inflation rates, and expanding employment and production, the advantages of the euro seemed obvious. When trading with each other, the countries using the euro no longer had to deal with problems caused by fluctuating exchange rates. Having a common currency also reduces the costs to consumers and firms of buying and selling across borders. It is no longer necessary for someone in France to exchange francs for marks to do business in Germany. Some of the lower-income European countries, in particular, seemed to prosper under the euro. The Spanish economy grew at an annual rate of 3.9 percent between 1999 and 2007. The unemployment rate in Spain was nearly 20 percent in the mid-1990s but dropped to 7.9 percent in 2007. Ireland and Greece also experienced rapid growth during these years.

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CHAPTER 15 | The International Financial System By 2008, however, the global recession was gathering force, and some economists and policymakers questioned whether the euro was making the recession worse. The countries using the euro cannot pursue independent monetary policies because the ECB from its headquarters in Frankfurt, Germany, determines those policies. Countries that were particularly hard hit by the recession—for example, Spain, where the unemployment rate had more than doubled to 18 percent by 2009 and was nearly 27 percent in 2013— were unable to pursue a more expansionary policy than the ECB was willing to implement for the euro zone as a whole. Similarly, countries could not attempt to revive their exports by allowing their currencies to depreciate because (1) most of their exports were to other euro zone countries and (2) the value of the euro was determined by factors affecting the euro zone as a whole.

Problems in the euro zone were made worse by a sovereign debt crisis that developed in 2010. Sovereign debt refers to bonds issued by a government. The recession of 2007–2009 caused large increases in government spending and reductions in tax revenues in a number of European countries, particularly Greece, Ireland, Spain, Portugal, and Italy. Their governments paid for the resulting budget deficits by issuing government bonds. By the spring of 2010, many investors had come to doubt the ability of Greece, in particular, to make the interest payments on its bonds. If Greece defaulted and stopped making interest payments on its bonds, investors would be likely to stop buying bonds issued by several other European governments, and the euro would be jeopardized. The ECB helped Greece avoid a default by directly buying its bonds. The bank extended similar help to Spain, Ireland, and Italy. The International Monetary Fund and the European Union put together aid packages meant to keep Greece and other countries from defaulting. In exchange for the aid, these countries were required to cut government spending and raise taxes even though doing so resulted in significant protests from unions, students, and other groups. Although by late 2013 the worst of the sovereign debt crisis had passed, levels of sovereign debt remained very high in several countries, and some economists and policymakers believed that unless the euro zone began to experience stronger economic growth, sovereign debt problems might return.

Under the gold standard, countries couldn’t run expansionary monetary policies and were unable to have their currencies depreciate. During the Great Depression of the 1930s, these drawbacks to remaining on the gold standard led one country after another to abandon it, and by the mid-1930s, the gold standard had collapsed. In 2013, some economists and policymakers were predicting a similar abandonment of the euro. There were significant reasons, though, that no government had yet been willing to consider reverting from the euro to its own currency. Because many euro zone countries export a significant fraction of GDP to other euro zone countries, exchange rate stability has been important to their economic stability, making these countries reluctant to abandon the euro. In addition, some of the European countries hit hardest by the recession, particularly Spain and Ireland, were suffering from the bursting of housing bubbles. More expansionary monetary policies or depreciating exchange rates were unlikely to result in economic recovery until the effects of the collapse in residential construction had run its course.

It was unclear that the constraints imposed by the euro were holding back recovery in Europe. Finally, because so many contracts and agreements among households, firms, and governments in Europe were written in euros, abandoning the euro was likely to be disruptive to the financial system and to trade.

The ultimate fate of the euro will help to answer the question of whether independent countries with diverse economies can successfully maintain a joint monetary policy and a single currency.

Sources: Nina Adam, William Horobin, and Paul Hannon, “Euro Zone Returns to Growth but Malaise Lingers,” Wall Street Journal, August 14, 2013; “What Angela Isn’t Saying,” Economist, August 10, 2013; and Terence Roth, “Setting Up the Greek Default,” Wall Street Journal, October 11, 2011.

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CHAPTER 15 | The International Financial System Question Jordi Galí, an economist at the Universitat Pompeu Fabra in Spain, noted that the Spanish economy was in recession during the early 1990s, but that “in 1992 and 1993 a series of [exchange rate] devaluations got us out of trouble.” Was Spain able to use exchange rate devaluations to deal with the recession of 2007–2009? Briefly explain.

Source: “One Size Fits None,” Economist, June 11, 2009.

Answer Spain was not able to use exchange rate devaluations to deal with the recession of 2007–2009 because Spain now uses the euro as its currency. The value of the euro is determined by factors affecting the euro zone as a whole and not any one particular country. Also, because most of Spain’s exports are to other euro-zone countries, a devaluation of the euro would have little effect on Spain’s international trade.

Extra Apply the Why Did Iceland Recover So Quickly from the Financial Crisis?

Concept No country may have been more severely affected by the global financial crisis of 2007–2009 than Iceland. Although a country with a population of only 300,000 and a GDP smaller than that of Jamaica or Estonia, Iceland temporarily played an important role in the global financial system during the mid-2000s.

In 2006, at the height of the worldwide housing bubble, Iceland’s two largest banks began to accept online deposits from households and firms outside of the country. Having accepted billions of dollars in foreign deposits, Icelandic banks used them to make loans in Iceland and elsewhere in Europe, often to finance housing. By 2007, Icelandic banks had made loans equal to nine times the country’s GDP. Fueled by bank loans, the value of shares on the Icelandic stock market increased by a factor of nine between 2003 and 2007, while the value of real estate in the capital of Reykjavik more than tripled. Two factors caused the financial bubble resulting from this bank lending to burst. First, as in other countries, including the United States, banks in Iceland had made real estate loans to people with poor credit histories or who made very small down payments. When housing prices began to decline, many borrowers defaulted on their loans. Second, Icelandic banks held deposits that were far larger than the amounts available in deposit insurance funds and far larger than the resources available to the Icelandic central bank in its role as a lender of last resort. As a result, in 2008 the banks were subject to runs that forced them to close. The government of Iceland took over the banks but was faced with resolving the banks’ debts of about $100 billion—or more than $300,000 for each citizen of Iceland.

The following figure shows the results of the devastating financial collapse. Real GDP declined in Iceland by 13 percent between the third quarter of 2007 and the fourth quarter of 2010. The figure also shows real GDP for other European countries that were hit hard by the financial crisis: Greece, Ireland, Italy, and Spain. (To aid in comparing the countries, the values for real GDP in each country were set equal to 100 for the first quarter of 2007.) Note that although Iceland suffered a larger decline in real GDP than the other countries during the first two years of the downturn, by 2012 real GDP had returned to its precrisis level. In 2013, real GDP in the other four countries was still 5 percent or more lower than in 2007. The unemployment statistics tell a similar story: The unemployment rate in Iceland in early 2013 was only 4.1 percent, as compared to more than 10 percent in Ireland and Italy, and more than 20 percent in Greece and Spain.

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Why did Iceland recover more quickly than other European countries, despite the severity of its financial crisis? One reason is that, unlike the other countries, Iceland does not use the euro. Therefore, it was possible for the value of its currency, the krona, to decline versus the euro, thereby spurring Iceland’s exports. As the following figure shows, between the second quarter of 2007 and the fourth quarter of 2009, the value of the krona fell by more than 50 percent versus the euro. As a result, although Iceland’s exports fell during the first part of 2007, by 2012 the country’s exports had soared by more than 30 percent compared with precrisis levels. Rising exports were a key to Iceland’s recovery from the financial crisis. European countries using the euro were unable to gain the advantage of having the value of their currencies decline versus their major trading partners, because most of their major trading partners also use the euro.

As we have seen, there are advantages to countries using the euro, and in 2013 Iceland was still considering whether it should abandon the krona and enter the euro zone. But Iceland’s experience following the financial crisis shows that a flexible exchange rate can have important advantages.

Sources: R.A., “The Iceland Question,” Economist, July 2, 2012; OECD, Economic Surveys: Iceland 2011, June 2011; Michael Lewis, Boomerang: Travels in the New Third World, New York: W.W. Norton and Company, 2011; and Federal Reserve Bank of St. Louis.

Question A report from the Organization for Economic Cooperation and Development (OECD) notes that: “Iceland appears to have the smallest independent, floating currency in the world. Other countries the size of

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CHAPTER 15 | The International Financial System Iceland either do not have their own currency (Estonia, Luxembourg, Malta) or peg their currency to that of another country (Barbados, Bahamas, Belize, Brunei, Latvia, Lithuania, Maldives, the Netherlands Antilles).” a. Why might small countries decide to not allow their currencies to float? b. The report also noted that: “Joining the euro area would significantly lower the volatility of traded good prices and lower overall inflation volatility as nearly half of Iceland’s external trade is with countries in the euro area or pegged to it.” Why would joining the euro area have these effects? Are there any reasons why Iceland might not want to join the euro area?

Source: OECD, Economic Surveys: Iceland 2011, June 2011, p. 18.

Answer a. Small countries rely heavily on trade with other countries and fixed exchange rates reduce the uncertainty of buying, selling, and investing across borders. b. Movements in exchange rates cause volatility in the prices of traded goods and the prices of imported goods and services, which adds volatility to a country’s inflation rate. By joining the euro area, where all countries use the same currency, Iceland would be reducing the volatility in prices of nearly half of its overall trade with other countries. However, by joining the euro area, Iceland would forfeit the ability to conduct independent monetary policy and the ability to allow its currency to depreciate during economic downturns.

International Capital Markets (pages 478-480) 15.3 Learning Objective: Discuss the growth of international capital markets.

One important reason exchange rates fluctuate is that investors seek out the best investments they can find anywhere in the world. Shares of stock and long-term debt are bought and sold on capital markets. Before 1980, most Canadian investors rarely invested in foreign capital markets. In the 1980s and 1990s, European governments removed many restrictions on foreign investments in financial markets.

Improvements in communications and technology have now made it possible for US investors to receive better and more timely information about foreign firms and for foreign investors to receive better information about US firms.

Today there are large capital markets in Europe and Japan, and there are smaller markets in Latin America and East Asia. The three most important international financial centres are New York, London, and Tokyo. Beginning in the 1990s, the flow of foreign funds into Canadian stocks and bonds—portfolio investments —increased substantially. Foreign purchases of Canadian securities soared again after the global financial crisis, as fears that some European governments might default on their bonds lead to a flight to safety.

The globalization of financial markets has helped increase growth and efficiency in the world economy.

Now it is possible for firms in nearly every country to tap the savings of foreign households to gain the funds needed for expansion. But the globalization of financial markets also has a downside, as the events of 2007–2009 showed. Because financial securities issued in one country are held by investors and firms in many other countries, if those securities decline in value, the financial pain will be widely distributed.

For example, the sharp decline in the value of mortgage-backed securities issued in the United States hurt

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CHAPTER 15 | The International Financial System not only US investors and financial firms but investors and financial firms in many other countries as well, including Canada.

Extra Solved Problem 15.3 Gold Rush? Central Banks Stop Selling, Start Buying Gold Since the end of the Bretton Woods system in 1973, when the United States officially ceased to agree to exchange gold for dollars held by foreign governments and central banks, gold has not played a formal role in the international monetary system. However, governments and their central banks have continued to hold gold, along with foreign currencies and securities. From 1991 to 2009, central banks sold about 10 percent of their holdings of gold, which, unlike securities, earn no interest. But that trend changed in 2009 as India’s central bank bought $6.7 billion in gold from the International Monetary Fund, the largest purchase by a central bank in 30 years. Analysts speculated whether the next gold purchase would be from a Middle Eastern country, China, or some other country.

Most central banks hold a basket of foreign currencies, bonds, and other assets in order to make international payments or adjust the value of their domestic currencies. For many years, the US dollar was the primary reserve currency, but as the exchange rate for the dollar against most currencies declined in recent years, governments began to diversify. In a note to clients, Goldman Sachs’s analysts explained that India’s purchase “highlighted . . . the ongoing shift of central banks and governments from being net sellers of gold to net buyers, which we believe will likely continue to provide strong fundamental support for gold prices.”

Source: Carolyn Cui, “Central Banks Join in a New Gold Rush,” Wall Street Journal, November 11, 2009.

Gold that foreign governments and firms hold doesn’t earn any interest, while US Treasury securities do earn interest. So, why would central banks choose to buy gold rather than US Treasury securities?

Solving the Problem Step 1:

Review the chapter material.

This problem is about trading in international capital markets so you may want to review the section “International Capital Markets,” which begins on page 478 in the textbook.

Step 2:

Why would central banks choose to buy gold rather than US Treasury securities?

In 2009, the interest rates on Treasury securities were very low. If the exchange rate of the dollar declines over time, the value of the dollars received when the securities are sold will decline as well. In other words, the real interest rate on the securities could be negative.

Although gold doesn’t earn interest, its price has risen significantly in recent years. Buyers realize that the supply of gold cannot be increased by the actions of central banks. Any decline in the gold price would be the result of a decrease in demand, which many analysts believe will not occur in the near future.

Extra Apply the In Black Markets Traders Still Like Dollars Concept Although low interest rates and large government budget deficits in the United States have made the U.S. dollar less attractive to foreign investors in recent years, there is one market where the dollar has .

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CHAPTER 15 | The International Financial System maintained its popularity: black markets in developing countries. “The U.S. dollar is losing value, but not here in Vietnam,” said Vu Manh Quynh, who regularly exchanges dong for dollars in Hanoi. “Vietnamese people still keep U.S. dollars and gold.”

There are no official records of trading volume in the murky black market world, but an estimated $600 billion worth of U.S. notes is held outside the United States, much of it in countries that have tight currency controls. Households and firms in these countries hold dollars to protect against a loss of value in their home currencies through devaluation or inflation. Harvard University economist Kenneth Rogoff explains: “Typically, dollars are king in the black markets of the world…” One country where the dollar is still popular is Venezuela, where Arnaldo Morales, who drives a taxicab and also moonlights as a currency trader, buys dollars from people he drives from the airport and sells the dollars to Venezuelans.

Morales began the practice in 2003 when Hugo Chávez, who then was Venezuela’s president, imposed limits on the number of dollars citizens could purchase at the official rate of 2.15 bolivars per dollar.

The dollar is also still popular in Nigeria, where black-market traders even have their own trade group.

“The dollar still has dominance in Nigeria,” said Alhaji Farouk Suleman, the president of the group. “The exchange rate might not be good, but…you can use the dollar anywhere you go. I don’t see any real shift towards the pound or euro.”

Source: Nguyen Anh Thu, Darcy Crowe, and Will Connors, “Globally, the Greenback Remains King,” Wall Street Journal, October 29, 2009.

Extra Economics in Your Life and Career: Exchange Rates and Your Income Question: Suppose that you work for a computer company. Because the firm has an office in Germany, you are asked to move there and work for a two-year period. Your employer gives you the option to receive pay either in dollars or in euros. Which payment option is better for you? What factors should affect your decision?

Answer: Because you will be working in Germany for a two-year period, you will need euros to pay your bills, buy food, and cover your living expenses. Fluctuations in the exchange value of euros in terms of dollars will not affect your income. If you choose to be paid in dollars, your income will fluctuate based on the changes in the foreign exchange market. An increase in the value of the euro relative to the dollar means a reduction in your salary in terms of euros. A reduction in your salary in terms of euros reduces the purchasing power of your living in Germany. You might be better off to be paid in euros to avoid fluctuations in your income.

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