Macro Notes

Chapter 21 - The Simplest Short Run Macro Model

21.1 Desired Aggregate Expenditure
- Desired expenditure is not what people would spend under imaginary
conditions, it refers to what people desire to spend out of the resources
they actually have
- Expenditure decisions are broken up into 4 main groups which are domestic
households, firms, governments and foreign purchasers of domestically
produced commodities
- Formula is the exact same as the expenditure approach to GDP without the
subscript A’s
- In this section we only look at the idea of consumption (C) and investment
(I)

Autonomous Expenditure vs Induced Expenditure

- Autonomous = Elements of expenditure that DO NOT change with changes
to national income
- Induced = Components of expenditure that DO change with changes to
national income

Important Assumptions
1. There is no trade with other nations (closed economy)
2. There is no government (no taxes)
3. Price level is constant

Desired Consumption Expenditure

 - Disposable income is the amount of income household receive after
deducting tax, in this model because there is no tax and government
disposable income (Yd) is the same as national income (Y)
- There is only two things people can do with disposable income, consume or
save

The Consumption Function

- Relates the total desired consumption of all households to the several
factors that determine it
- Relationship between desired consumption expenditure and disposable
income
- Holding others things constant, an increase in disposable income is
assumed to lead to an increase in desired consumption
- The factors influencing desired consumption include
- Disposable income
- Wealth
- Interest rates
- Future expectations
- Both desired consumption and saving are assumed to rise as disposable
income rises

The Slope of the Consumption Function

- The slope of the function is the marginal propensity to consume
- Because the slope is positive, it shows the relationship that as disposable
income increases it leads to an increase in desired consumption

Break-Even Level of Income

- The 45* angle shows all the points where desired consumption equals
disposable income
- When desired consumption > disposable income = desired savings is
negative, houses spend from savings or borrowing money
- When desired consumption < disposable income = desired savings is
positive, houses are paying back debt and accumulating assets
 - At break even -> desired consumption = disposable income -> desired
savings is zero

Shifts of the Consumption Function

1. Changes in Household Wealth
a. Household Wealth Increase = Consumption Function Up
b. Household Wealth Decrease = Consumption Function Down
2. Changes in Interest Rates
a. Interest Rates Fall = Consumption Function Up
b. Interest Rates Rise = Consumption Function Down
3. Future Expectations
a. Future Optimism = Consumption Function Up
b. Future Pessimism = Consumption Function Down

Shifts of the Savings Function

- All disposable income is either consumed or saved, therefore there is a
savings function which is associated with the consumption function
- Any event that causes the consumption function to shift causes an equal
shift in the opposite direction of the desired savings function

Desired Investment Expenditure

- Categories of Investment
- Inventory accumulation
- Residential construction
- New plant and equipment

Shifts of the Desired Investment Expenditure Function

1. Interest Rates (Real interest rates reflect opportunity cost)
a. Interest Rates High = Opportunity Cost High = Investment Low
b. Interest Rates Low = Opportunity Cost Low = Investment High
 2. Changes in Sales
a. Sales Increase = Investment Up
b. Sales Decrease = Investment Down
3. Business Confidence
a. Business Optimism = Investment Up
b. Business Pessimism = Investment Down
The Aggregate Expenditure Function
- Adding the desired consumption and investment functions
- Slope is the marginal propensity to spend, in this chapter it is the same as
the marginal propensity to consume but changes in later chapters with
introduction of tax and international trade

21.2 Equilibrium National Income

- For any level of national income which desired aggregate expenditure >
actual income, there will be pressure for actual national income to rise
- For any level in which desired aggregate expenditure < national income,
there will be pressure for national income to fall

Equilibrium = Desired AE = Actual Y

- The equilibrium level of national income occurs when desired aggregate
expenditure equals actual national income
- AE = Y
- Condition when AE function intersects the 45* line on the graph

Shifts of the Aggregate Expenditure Function

1. Consumption or Investment Increase = Aggregate Expenditure Up
a. Equilibrium National Income Increase
2. Consumption or Investment Decrease = Aggregate Expenditure Down
a. Equilibrium National Income Decrease
3. Marginal Propensity to Spend Increase = Aggregate Expenditure Steep
a. Equilibrium National Income Increase
4. Marginal Propensity to Spend Decrease = Aggregate Expenditure Flat
a. Equilibrium National Income Decrease
The Multiplier
- Measures the size of the change in the equilibrium, the magnitude of the
change is measured by the multiplier
- A change in autonomous expenditure changes the equilibrium national
income by a multiple of the initial change in autonomous expenditure
- Size of the multiplier depends on the slope of the AE function (Marginal
propensity to spend)
- The larger the propensity to spend, the steeper the AE function and this the
larger the simple multiplier
 Chapter 22 - Adding Government and Trade to the Simple Macro Model
22.1 Introducing Government
Government Purchases
- Autonomous spending
- Understand that transfer payments and subsidies do not impact
government expenditure
- Transfer payments have an indirect impact as they increase investment or
consumption expenditure

Net Tax Revenues

- Total tax revenue received by the government minus total transfer
payments made by the government
- Governments collect tax revenues and make transfer payments,
- Net tax revenue (T) does not represent expenditure on goods and services,
it is not included in the AE function, instead it will be included because of its
impact on disposable income/consumption function where Yd = Y - T

Budget Balance
- Difference between total government revenue and total government
expenditure
- Budget Balance = Net tax revenue (T) - Government purchases (G)
- T > G = Budget surplus
- T < G = Budget deficit

Provincial and Municipal Governments

- When measuring overall contributions of government purchases to desired
expenditure, all levels of government are included
 - Federal, provincial, territorial and municipal

22.2 Introducing Foreign Trade

- Aggregate expenditure is the desired expenditure on all domestically
produced products and services
- Exports (X) are purchases by foreigners of Canadian products and so are a
part of Aggregate expenditure
- Imports (IM) are expenditures by Canadians on goods and services
produced elsewhere and this need to be subtracted from total expenditure
to determine Aggregate expenditure

Net Exports
- Exports depend on spending decisions by foreign households and firms to
purchase Canadian products, meaning they will not change as a result of
Canadian national income changes so they are autonomous
- Canadian imports depend on spending decisions of Canadian households
and firms, hence if consumptions rise, imports will also rise
- And since consumption rises with national income rises there is a positive
relationship between imports and national income so imports are induced

Net Export Function

- Because exports are autonomous they are in a horizontal line
- Imports by themselves are a positive relationship
- But the net export function as a whole is negative sloping because you have
to subtract way imports

Shifts of the Net Export Function

1. Changes in Foreign Income
a. Foreign Income Increase = Exports Increase = Net Exports Up
b. Foreign Income Decrease = Exports Decrease = Net Exports Down
2. Changes in International Relative Pricing
a. Canadian Prices Increase = Exports Decrease = m Increase = IM rotate
Up -> Net Exports Down + Steeper
 b. Canadian Prices Decrease = Exports Increase = m Decrease = IM
rotate Down -> Net Exports Up + Flatter

The Multiplier with Taxes and Imports

- In the previous chapter, the multiplier was the amount at which real GDP
changed when autonomous expenditure changed
- Taxes and imports reduce the overall size of the simple multiplier
- An increase in national income also goes to taxes and imports, the induced
increase is smaller (the AE Curve is flatter because z is smaller), as a result
in response to a change in autonomous expenditure, the overall change in
equilibrium GDP is smaller

Net Exports Shifts

- Exports Increase by 1 = AE Function Up by 1 = Equilibrium National Income
Increase by 1 x multiplier
- Exports Decrease by 1 = AE Function Down by 1 = Equilibrium National
Income Decrease by 1 x multiplier
- Imports Increase = m Increase = AE Function is Flatter = Equilibrium
National Income Decrease
- Imports Decrease = m Decrease = AE Function is Steeper = Equilibrium
National Income Increase

Fiscal Policy: Government Spending and Taxation

- Actual GDP = Y
- Potential GDP = Y*
- When Y < Y* = Factor incomes low and unemployment of factors is high
- When Y > Y* = Rising costs creates inflationary pressures
- Stabilization Policy = Closing the gap between actual and potential GDP,
reduce the cyclical fluctuations and stabilize national income

Shifts from Fiscal Policy

1. Changes in Government Purchases
 a. Government Purchases Increase = AE Shift Up = Equilibrium National
Income Increase x Multiplier
b. Government Purchases Decrease = AE Shift Down = Equilibrium
National Income Decrease x Multiplier
2. Changes in Net Tax Rate (Changes z/slope = rotates the curve)
a. Net Tax Rate Decrease = z Increase = Rotate Up = Equilibrium
National Income Increase
b. Net Tax Rate Increase = z Decrease = Rotate Down = Equilibrium
National Income Decrease

Demand-Determined Output
- Our simple model of national income determination is assumed to have a
given price level (constant price level)
- Output may be demand determined in two situations
- There are unemployed resources
- Firms are price setters
 Chapter 23 - Real GDP and the Price Level in the Short Run
23.1 The Demand Side of the Economy
Exogenous Changes in the Price Level
1. Changes in Consumption
a. Price Level Increase = Public Sector Wealth Decrease = Desired
Consumption Decrease = AE Shift Down
b. Price Level Decrease = Public Sector Wealth Increase = Desired
Consumption Increase = AE Shift Up
2. Changes in Net Exports
a. Domestic Price Level Rise = Net Exports Decrease = AE Shift Down
b. Domestic Price Level Fall = Net Exports Increase = AE Shift Up

Changes in the Equilibrium GDP

- Changes in the Label
- Chapter 21 and 22 the x axis was labeled as “Actual National Income”
- Now we change it to Real GDP but it means the same thing as “Actual
National Income”
- It is “real” because the price level is changing from now on

The Aggregate Demand Curve

- Price level and real GDP are negatively related to each-other and this
relationship is shown with the aggregate demand curve
- Aggregate demand is a curve showing the combinations of real GDP and the
price level that make desired aggregate expenditure equal to actual
national income
- On the AE function, real GDP was the x axis and desired aggregate
expenditure was the y axis
 - Now price varies and the function keeps track of various equilibrium points
that occur as the AE curve shifts
- AD Curve is the relationship between the price level and equilibrium level
of real GDP
- For any given price level (price level varies)

Shifts ALONG the Aggregate Demand Curve

1. Price Level Rise = AE Shift Down = Left Along AD Curve = Equilibrium GDP
Fall
2. Price Level Fall = AE Shift Up = Right Along AD Curve = Equilibrium GDP Rise

Shifts of the Aggregate Demand Curve (Given Price Level but changes in C, G, I)
- Autonomous Aggregate Expenditure Increase = AE Shift Up and AD Shift
Right
- Autonomous Aggregate Expenditure Decrease = AE Shift Down and AD Shift
Left
- These are known as Aggregate Demand Shocks because they shift the AD
curve

The Multiplier and the AD Curve

- Measures the side of the horizontal shift of the AD curve in response to a
change in autonomous expenditure

23.2 The Supply Side of the Economy

The Aggregate Supply Curve
- Refers to the total output of goods and services that firms would like to sell
- Relates the price level to the quantity of output would like to produce
- State of technology and price of factors of production must be
constant
- At their current level of production, firms are incurring costs per unit of
output called unit costs
- Remember the law of diminishing marginal returns for supply
 - Producing more output increases price (this shows the positive correlation
for the aggregate supply curve) - this logic applies to both price taking and
price setting firms. Units costs generally rise with output means that firms
only increase their production only if they are able to receive higher prices

Shifts of the Aggregate Supply Curve

1. Changes in Input Prices
a. Price Increase = AS Shift Left
b. Price Decrease = AS Shift Right
2. Changes in Technology
a. Technology Deteriorates = AS Shift Left
b. Technology Improves = AS Shift Right
- These are known are Aggregate Supply Shocks because they shift aggregate
supply due to exogenous forces

23.3 Macroeconomic Equilibrium

- At the combination of real GDP and price level given by the intersection
between AS and AD curves

Changes in Macroeconomic Equilibrium

- Positive AD and AS shocks increase equilibrium
- Negative AD and AS shocks decrease equilibrium

Aggregate Demand Shocks

- AD Shifts Right = Increase Equilibrium Real GDP and Price (Positive Shock)
- AD Shift Left = Decrease Equilibrium Real GDP and Price (Negative Shock)

Aggregate Supply Shocks

- AS Shifts Left = Decrease Equilibrium and Increase Price (Negative Shock)
- AS Shift Right = Increase Equilibrium and Decrease Price (Positive Shock)
Chapter 24 - From the Short Run to the Long Run: The Adjustment of Factor Prices
24.1 The Macroeconomic States
1. The Short Run
a. Factor prices are assumed to be exogenous, they may change but any
change is not represented in the model
b. Technology and factor supplies are assumed to be constant
(therefore potential GDP is constant)
c. Equilibrium is the intersection between AS and AD, they are both
subject to shocks which cause real GDP to fluctuate around constant
potential output
2. The Adjustment of Factor Prices - takes the economy from short run to the
long run
a. Factor prices are assumed to adjust in response to output gaps
b. Technology and factor supplies are assumed to be constant
(potential output is constant)
c. Brings GDP back to potential
3. The Long Run
a. Factor prices are assumed to have fully adjusted to any output gap
b. Technology and factor prices are assumed to be changing

24.2 The Adjustment Process

Potential Output and the Output Gap
- Potential output - the total output that can be produced when all
productive resources including land, labour and capital are fully employed
- When actual output diverges from potential output, it is called the output
gap
Factor Prices and the Output Gap
- Output ABOVE Potential or Y > Y* (Inflationary Gap)
- The boom is associated with an excess demand for factors that tends
to cause wages (and other factor prices) to rise
- Causes AS to shift to the left, to the point where the output gap is
closed
- Output BELOW Potential or Y < Y* (Recessionary Gap)
- The slump is associated with an excess supply of factors that causes
wages (and other factor prices) to fall
- Causes AS to shift to the right, to the point where the the output gap
is closed

24.3 Aggregate Demand and Supply Shocks

Aggregate Demand Shocks
1. Positive AD Shocks (Inflationary gap opens)
a. Autonomous Expenditure Increase = AD Right -> Positive AD Shock
b. Factor Price Increase = AS shifts to the left until the gap is closed
c. Overall impact is the price level is increased but real GDP is
unchanged
2. Negative AD Shocks (Recessionary gap opens)
a. Autonomous Expenditure Decrease = AD Left -> Negative AD Shock
b. Factor Prices Decrease
i. Flexible Wages - Wages fall quickly = AS Shifts right quickly
ii. Sticky Wages - Wages fall slowly = AS Shifts right slowly
Aggregate Supply Shocks
1. Exogenous changes in input prices causes AS to shift, creating an output
gap
2. The adjustment process then reverses the initial AS shift bringing it back to
the initial price level and potential output

Long-Run Equilibrium
 - Following the AD/AS shocks the adjustment process brings the market back
to where real GDP is equal to Y*
- Long run equilibrium is when the adjustment process is complete (no
output gap)
- Long run equilibrium is where AS and AD intersect at Y*
- Y* is dependent on the labour force, capital stock and level of technology
and it is independent from the price level
- The vertical line is often called the long-run aggregate supply curve (the
relationship between the price level and amount of output supplied by
firms after all factor prices have been adjusted to output gaps)
- Sometimes called the classical aggregate supply curve

The Basic Theory of Fiscal Stabilization

1. Closing a Recessionary Gap
a. Method 1 - Adjustment Process
i. Excess Supply -> Factor Prices Fall -> AS shift right -> Gap closes
b. Method 2
i. Because of downward stickiness, the government may use an
expansionary policy
ii. Shift AD Right through reducing tax rates, increasing transfers
and levels of government spending
2. Closing an Inflationary Gap
a. Method 1 - Adjustment Process
i. Excess Demand -> Factor Prices Rise -> AS shift left -> Gap
closes
b. Method 2
i. Government use contractionary policy
ii. Shift AD Left through increasing tax rates, decreasing transfers
and reducing levels of government spending
 Chapter 25 - Long Run Economic Growth
25.1 - The Nature of Economic Growth
Economic Growth - Sustained, long-run increases in the level of real GDP

Benefits of Economic Growth

- Rising Average Living Standards
- Improval of living standards
- Environmental benefits
- Overall better well-being
- Addressing Poverty and Income Inequality
- Redistribution of national income

Costs of Economic Growth (read again page 613)

- Forgone Consumption
- Economic growth, which promises more goods and services
tomorrow, is achieved by consuming fewer goods today
- This sacrifice in consumption is an important cost of growth
- Social Costs
- The process of economic growth renders some machines obsolete
and also leaves the skills of some workers obsolete as a result

Sources of Economic Growth

1. Growth of the labour force - Growth in population or fraction that chooses
to work
2. Growth in human capital - growth in the set of skills workers have, it can
increase through education or training
 3. Growth in physical capital - Physical capital (factories, machines
transportation communication) grows through investment
4. Technological improvement - Innovation brings new products, new ways of
production and new forms of organizing economic activity

25.2 Economic Growth: Basic Relationships

Shifts of the National Saving Curve
- Consumption or Government Spending Falls = National Savings Shift Right =
Interest Rates Fall
- Technological Improvements/Increased productivity of investment
goods/government tax investment to incentivise investment increase =
Increased Investment Demand Shift Right and interest rates increase

The “Neoclassical” Growth Model

 Chapter 26 - Money and Banking
26.1 The Nature of Money
What is Money?
- Money is any generally accepted medium of changes, which means
anything widely accepted in society in exchange for goods and services

Medium of Exchange Role of Money

1. Money as a Medium of Exchange
a. If there was no money, products would be exchanged by barter, a
system where goods and services are exchanged for each other
b. The issue is that for a barter to happen each person would need to
find someone willing to exchange services (double coincidence).
Money solves this because people can sell what they need to sell and
use that money to buy what they need
c. Facilitates transactions, however it needs to be easily recognizable
and readily acceptable, it must also be divisible so smaller
transactions can be made
2. Money as a Store of Value
a. Convenient way of storing purchasing power, goods may be sold
today and the money can be stored until the future purchase
b. Purchasing power must be relatively stable over time
3. Money as a Unit of Account
a. Money is also used for accounting, and its use for such purpose does
not rely on its physical form
b. All records from business, government and houses are expressed in
dollars without physical currency
 c. Expenditure receipts and deficits and surpluses are computed in
dollar value without the physical presence of money

The Origins of Money

1. Metallic Money - Carrying around amounts of silver and gold were needed
before the idea of coins coming around with predetermined amounts of
value. Metals came to circulate as money because it was easily divisible,
recognized and did not wear out, they were precious.
2. Paper Money - Paper currency, paper money was a promise which back in
the day represented a promise to pay the gold from the blacksmith needed
to complete a transaction
3. Fiat Money - Currency converted into gold at a fixed rate = gold standard
a. All currency today can be seen as fiat money

26.2 The Canadian Banking System

The Bank of Canada
- Central Bank = A bank that acts as a banker to the commercial banking
system and often the government as well. Usually a government-owned
institution that is the sole money-issuing authority
- They were initially prove, profit making institutions that provided services
to ordinary banks, but their importance made them develop ties with
ordinary banks
- The Bank of England, one of the world’s oldest and most famous central
banks began to operate as the central bank of England in the 17th century
and got taken over by the government in 1947

Basic Functions of the Bank of Canada

1. Banker to the Commercial Banks
a. The central bank accepts deposits from commercial banks and will,
on order transfer them to the accounts of another bank
b. Allows other banks to settle debts to other banks
2. Banker to the Federal Government
 a. Governments also need to hold their funds in an account into which
they can make deposits and on which they can write cheques
3. Regulator of the Money Supply
a. Through the liabilities (Promises to pay) which can be seen as the
currency circulation + reserves which are household deposits

Commercial Banks in Canada

- All private sector banks in Canada are referred to as commercial banks
- Privately owned, profit-seeking institutions that provide a variety of
financing activities (services), such as accepting deposits from customers or
making loans and other investments

The Provision of Credit

- They are financial intermediaries
- Banks borrow (accept deposits) from households and firms that have
money that they do not need at the moment and they lend that money
(provide credit) to others households and firms that need credit to achieve
things

Interbank Activities
- Sharing bank loans
- Credit card systems
- Cheque clearing and collection
- Clearing house, seeing the difference between deposits and inflows
between backs to transfer the money accordingly

Banks as Profit Seekers

- Commercial banks attract depositor by paying interest and providing
services but they earn money by lending and investing money deposited
with them for more than they pay their depositors in terms of interest and
other services provided
Commercial Banks’ Reserves
- Commercial banks keep sufficient cash on hand to be able to meet
depositor’s day to day cash requirements
- Only a small fraction of total deposits will be withdrawn in cash at any one
time
- Bank run, depositors rush to withdraw their money from banks
- Canada’s banks hold reserves against their deposit liabilities for the simple
reason that they want to avoid situations in which they cannot satisfy their
depositors demands for cash and it is costly for them to borrow from other
banks or the Bank of Canada when they are short of reserves
 Chapter 27 - Money, Interest Rates and Economic Activity
27.1 Understanding Bonds
- Financial wealth is assumed to be 2 categories, money and bonds
- Money -> all assets that serve as a medium of exchange such as paper
money, coins and back deposits
- Bonds -> all other forms of financial wealth

Present Value and the Interest Rate

- A bond is a financial asset that promises to make one or more payments at
specific dates in the future
- The Present Value (PV) of any asset refers to the value now of the future
payments that the asset offers
- Higher the interest rate, the lower the present value

Note
- Present value has a negative relationship with the market interest rate

Two Key Relationships

1. The present value of any given bond is negatively related to the market
interest rate
2. A bond’s equilibrium market price will be equal to its present value

*An increase in the market interest rate leads to a fall in the price of any given
bond. A decrease in the market interest rate leads to an increase in the price of
any given bond*
*An increase in the market interest rate will reduce bond prices and increase
bond yields. A reduction in the market interest rate will increase bond prices and
reduce bond yields. Therefore, market interest rates and bond yields tend to
move together.

Money Demand
- The amount of money that everyone total wants to hold at any given time
is called the demand for money
- Three reasons to hold money, transaction demand, precautionary demand
and speculative demand
- The determinants of money demand are the interest rate, level of real GDP
and the price level

The Interest Rate

- The Interest Rate and the demand for money are negatively related

Real GDP
- The demand for money is assumed to be positively related to real GDP
- When GDP rises, Md curve shifts to the right

Price Level
- The demand for money is assumed to be positively related to the price level
- When price level increase, Md shifts to the right

Monetary Equilibrium
- Ms and Md is called a money market
- Ms is a vertical line
- Ms shifts to the right when the central bank increases reserves
- Ms shifts to the left when the central bank decreases reserves
- Md is downward sloping indicating that firms and households decide to
hold more money when interest rates fall
 - Monetary equilibrium occurs when quantity of money demanded is equal
to the quantity of money supplied

The Monetary Transmission Mechanism

- The connection between changes in the demand and supply of money and
the level of aggregate demand is called the monetary transmission
mechanism (shifts of MS and MD which cause AD to shift)
Monetary Transmission Mechanism Works in 3 stages
1. Changed in the demand for money or the supply of money cause a change
in the equilibrium interest rate
2. The change in the equilibrium interest rate leads to a change in desired
investment and consumption expenditure (and net exports in an open
economy). Desired aggregate expenditure changes
3. The desired expenditure change causes a shift of the AD curve and this to
short run changes in real GDP and price level
 Chapter 28 - Monetary Policy in Canada
- The monetary transmission mechanism describes how changes in the
demand and supply of money changes the interest rate which change
aggregate demand, real GDP and the price level
- The money supply is the sum of the currency in circulation and total bank
deposits
- Monetary policy is either by changing the supply or money or by changing
the interest rates but not both and for a given Md curve

Why the Bank of Canada Does Not Target the Money Supply?
1. The Bank of Canada cannot control the process of deposit creation
2. There is uncertainty regarding the slope of the Md curve
3. There is uncertainty regarding the position of the Md curve

Why the Bank of Canada Targets the Interest Rate?

1. The Bank of Canada is able to control a particular interest rate
2. Uncertainty about the slope and the position of the Md curve does not
prevent the Bank of Canada from establishing its desired interest rate
3. The Bank of Canada can easily communicate its interest rate policy to the
general public

The Bank of Canada and the Overnight Interest Rate

- Bank of Canada would prefer to implement monetary policy to target the
interest rate rather than targeting the money supply
 - In Canada the interest rate corresponding to the shortest period of
borrowing or lending is called the overnight interest rate, which is the
interest rate that commercial banks charge one another for overnight loans
- The Bank of Canada exercises enormous influence over the overnight
interest rate, as the rate falls or rises, all of the other rates in the economy
rise or fall as well which can impact consumption and investment
expenditure
- The target, actually overnight interest rate is within a 0.5 range from the
center half split on either side (0.25) of the target rate (this is after a bank
announces a target rate and is it announced eight times per team called
fixed amount dates or FAD’s)

The Money Supply Is Endogenous

- When the Bank of Canada changes its target for the overnight interest rate,
the change in the actual overnight interest happens almost instantly
- The other interests rates for mortgages and government securities etc
change but a little slower
- As the rates adjust firms and households begin to make adjustments to
their borrowing behaviours
- As the demand for new loans changes with the adjusting interest rates,
commercial banks often find themselves in need of more cash reserves with
which to make new loans
- When this happens, banks can sell off their government securities to the
Bank of Canada in exchange for cash or electronic reserves and then use
the cash to extend the new loans
- Open-market operations, the purchase or sale of government securities on
the open market by the central bank
- The new currency arrives to the banks as cash reserves which expands the
money supply
- Money supply is often called endogenous, the money supply is the sum of
all bank deposits and currency in circulation. The amount of bank deposits
is not controlled by the Bank of Canada but is is determined by the
economic decisions made by households, firm and commercial banks
Expansionary and Contractionary Monetary Policies
- If the Bank of Canada wants to stimulate aggregate demand, it will reduce
the target overnight interest rate, this is an expansionary government
monetary policy because lower interest rates will increase aggregate
demand
- Increasing the target interest rates lowers aggregate demand which is
known as a contractionary government monetary policy
- Monetary transmission mechanism, how the interest rates impact desired
investment and consumption do in the end impact AE and this AD which
overall impact the price level and real GDP

28.2 Inflation Targeting

Why Target Inflation
- Remember the cost associated with high inflation as well as the ultimate
cause of sustained inflation

1. High Inflation is Costly

a. Inflation erodes the real purchasing power of people financial
investments and income especially those who earn from pensions
and other fixed forms of income
b. High inflation also undermines the ability of the price system to
provide accurate signals of changes in relative scarcity through
changes in relative price levels because of this both consumers and
producers make mistakes regarding their own production and
consumptions decisions
c. Inflation creates uncertainty due to its volatility creating problems
with price determination
2. Monetary Policy is the Cause of Sustained Inflation
a. Shocks unrelated to monetary policy cause shifts to AD and AS which
cause temporary inflation
b. Sustained inflation however is caused by monetary policy
 c. Most economists and central banks accept the idea that the
monetary policy is the most important determinant of a countries
long-run rate of inflation

Inflation Targeting and the Output Gap

- Banks recognize that monetary policy has the potential to influence real
GDP, it simultaneously has the potential to alter the size of the output gap
- In an recessionary gap when inflation is below 2%, the bank will use
expansionary policy to bring it close to 2%
- In a inflationary gap when inflation is above 2%, the bank will use
contractionary policy to bring it close to 2%

28.3 Long and Variable Lags