## Chapter 7

Define recession and expansion. What are the beginning and ending points of a recession called? In postwar Canada, which have been longer on average, recessions or expansions?

Recession: Recession is the phase in the economy during which the economic activity declines. During this period, production, employment, income and all other economic activities falls below the normal level. A country generally experience negative economic growth during recession. Expansion- After recession, the economy slowly starts to recover and the expansion happens. Expansion is the economic period during which the country’s GDP starts to increase because of increased productivity, employment, real income and all other economic activity.

The beginning and ending point of a recession is called the peak and trough respectively. In postwar Canada, on average the expansion phase was longer than recession.Chapter 8

## An economy is described by the following equations:

Potential output Y* equals 580. By how much would government purchases have to change to eliminate any output gap? By how much would taxes have to change? Show the effects of these fiscal policy changes in a Keynesian cross diagram.

## First, finding the relation between output and aggregate expenditure

PAE = C + IP + G + NX

PAE = 40 + 0.8(Y–150) + 70 + 120 + 10

PAE = 120 + 0.8Y

As we know, Y = PAE,

PAE = 120 + 0.8Y

Y = 120 + 0.8Y

0.2Y = 120

Y = 600

Hence, the gap in output is Y*-Y = 580-600 = -20. So, we say that the gap of 20 is the expansionary gap.

This will help to know the economy multiplier. As we know, multiplier =1/1-c = 1/1-0.8 = 5.

Since the actual output is more than potential output by 20, the government must reduce its purchase by 4 i.e. G =116 to remove the gap in output.

When G = 116, we have

0.2Y = 116

Y = 580

However, tax change have different effect. If tax changes by ∆T, it does not affect the expenditure by ∆T. The reason behind this is that people do not spend all of the tax saving resulting from change in tax by ∆T. But, the tax change will cause the change in expenditure by c∆T, here c refers to the marginal propensity to consume.

As above, we have reduced expenditure by 4. This reduction can be done by changing the tax. If we increase the tax by 5, and c = 0.8.

Change in expenditure = c∆T = 0.8*5 = 4. So, change in tax by 5 will reduce the expenditure by 4.

PAE Y=PAE

## PAE1

PAE2

Y

580 600

Repeat part (a), assuming that Y* = 630.

If Y* = 630, the gap in output is Y*-Y = 630-600 = 30. So, we say that the gap of 30 is the recessionary gap. 5 is the multiplier. Since the actual output is more than potential output by 30, the government must increase its purchase by 6 i.e. G =126 to remove the gap in output.

When G = 126, we have

0.2Y = 126

Y = 630

If the tax is reduced by 7.5, then and c= 0.8

Change in expenditure = c∆T = 0.8*7.5 = 6. So, change in tax by 7.5 will increase the expenditure by 6.

## Chapter 10

How does the real interest rate affect planned aggregate expenditure in the Keynesian cross model underlying Figures 10.4 and 10.5? How does the explanation associated with Figures 10.4 and 10.5 compare with the Bank of Canada explanation associated with Figure 10.6?

Savers are rewarded when the real interest rate increases. So, people will tend to save more and consume less if the real interest rate is high. On the other hand, with the high interest rate, people find it difficult to borrow money as a result the spending on consumable duration will be reduced. Firms finds it difficult to invest in capital goods as the borrowing cost will be very high. So, both consumption and investment will be reduced because of high interest rate. Since investment and consumption are both the component of planned aggregate expenditure, the higher interest rate will reduce the aggregate expenditure. The explanation that is linked with the Keynesian cross model is very similar or is highly alike with the Bank of Canada.

Suppose that the overnight rate and the overnight rate target are at 4.5 percent. The interest rate spread between the overnight rate target and typical household and business borrowing is 2 percent. The effective lower bound is 0.25 percent. All of the above rates are in nominal terms and the inflation rate is 2 percent. You are the decision maker for the central bank, and you calculate that to achieve your monetary policy objective the real interest rate for household and business borrowing should be 2.5 percent. LO1, LO2, LO3

## The real rates will be

Overnight rate = 6.5%

Overnight rate target = 6.5%

Bank rate = 4%

## Then,

For the real interest rate or bank rate to be 2.5%, the overnight rate target must be 5%

All conditions remain the same as above, but the interest rate spread rises from 2 percent to 3.5 percent. To achieve the real interest rate of 2.5 percent, at what level should you now set the overnight rate target?

## For this, the overnight rate target must be 4%

The interest rate spread remains at 3.5 percent but the inflation rate falls to zero. To achieve the real interest rate of 2.5 percent, at what level should you now set the overnight rate target? Do you have a problem?

The overnight rate target will be 5.5%. No, there will not be any problem.

## Here is another set of equations describing an economy: LO4

Find a numerical equation relating planned aggregate expenditure to output and to the real interest rate.

Planned aggregate expenditure (PAE) is

PAE = C+Ip+G+NX

PAE = [14,400+0.5(Y-8000)-40000r]+(8000-20000r)+7000-1800

PAE = 23,600-60000r+0.5Y

At what value should the Bank of Canada set the real interest rate to eliminate any output gap? (Hint: Set output Y equal to the value of potential output given above in the equation you found in part (a). Then solve for the real interest rate that also sets planned aggregate expenditure equal to potential output.)

So,

40,000 = 23,600 - 60000r +0.5Y

16,400 = 60,000r+0.5*40,000

-3,600 = 60,000r

r = 0.06

## So, the interest rate must be 6%.

Chapter 11

Suppose you had $1000 in cash in a base year and the price level increased by 10 percent. What would happen to the real value of your cash?

If the price level increases by 10%, then we have to spend additional 10% to purchase a product. For example, if a product cost $100 today, then I have to pay $110 to buy same product next year. So, the real value of the cash decreases.

Suppose policy-makers are faced with an economy with an actual rate of unemployment above the natural rate. Use the expectations-augmented Phillips curve model to analyze two alternatives: a) policy-makers implement expansionary macroeconomic policy to move the actual rate to the natural rate and b) policy-makers allow the economy to self-correct.

In the case of high unemployment in the economy, the policy of expansionary nature or laissez-affaire nature could minimize the unemployment rate. If an economy is facing heavy unemployment, an expansionary policy could be implemented to remove unemployment or laissez-affaire could be followed by leaving the economy to correct on its own.

(a) In the expansionary policy, the money injected in the economy will boost the growth thereby increasing employment.

(b) If laissez-affaire policy adopted, then the economy could improve itself as explained below. High unemployment causes demand and price level to fall. As a result, inflation can fall and people can be better off. The fall in the price will eventually increase the demand thereby increasing the production and employment.

## Chapter 12

In macroeconomics, Aggregate Demand (AD) refers to the relationship between the output in short run output and the rate of inflation. Since the level of output in short run will be equivalent to the spending in the economy, AD curve is also related to the planned spending. As the inflation increases in the economy, the planned spending of consumers decreases due to high prices and the aggregate demand will also fall which creates a downward slopping demand curve.

## The inflation adjusted Aggregate Demand (AD) model will be explained with a figure below:

The diagram suggests the Aggregate Demand curve shifts to new demand curve at AD1 and the economy adjusts to the inflationary pressure. In the initial equilibrium E with aggregate output Y0, the Phillips curve demonstrates the inflation adjustment and its affect in the economy.

In the Philips curve, the X-axis measures unemployment rate and Y-axis measures the inflation rate. Suppose, the initial inflation rate equilibrium is 3%, an increase in inflation rate creates Ad curve to shift to AD1 and the rate rises to 6%. And the supply curve would also shift upwards due to increase in production cost. Thus, this will again bring the inflation rate to 3% after the shift in supply as shown in the figure. Finally, this suggests that long run Philips curve is a vertical line as a result of the inflation cutting back to initial position when both Aggregate demand and supply curve shifts.

We saw in Chapter 10 that short-run equilibrium output falls when the Bank of Canada raises the real interest rate. Suppose the relationship between short-run equilibrium output Y and the real interest rate r set by the Bank of Canada is given by

Suppose also that the Bank of Canada's monetary policy rule is the one shown in Table 12.1. For whole number inflation rates between zero and 4 percent, find the real interest rate set by the Bank of Canada and the resulting short-run equilibrium output. Graph the aggregate demand curve numerically. LO1

We have to calculate the equilibrium output in short run for each inflation value using Y = 1000 – 1000r.

## The aggregate demand curve illustrated below shows the existing relation between the inflation rate and the output in short run.

Inflation

0.04

0.03

0.02

0.01 ADI

Y

940 950 960 970

## An economy's aggregate demand curve (the relationship between short-run equilibrium output and inflation) is described by the equation

Initially, the inflation rate is 4 percent, or π = 0.04. Potential output Y* equals 12 000. LO3

## Find inflation and output in short-run equilibrium.

The intersection of AS and AD curve gives the equilibrium inflation rate in the short run. So, equilibrium in short run is obtained by putting the value of current inflation into the equation of AD. We have:

## Find inflation and output in long-run equilibrium.

The intersection of AD and LRAS curve gives the equilibrium inflation rate as well as output level in the long run. So, equilibrium in long run is obtained by putting the value of potential output into the equation of AD. We have

## Chapter 13

Why do Canadian households and firms supply dollars to the foreign exchange market? Why do foreigners demand dollars in the foreign exchange market?

Canadian households and firms supply dollars to the foreign exchange market for number of reasons. They supply dollars so that the foreigners who want to purchase the goods and services from Canada can purchase it. When Canadian peoples and companies wants or needs to acquire the foreign currency, they supply Canadian dollar in foreign market to get foreign currency. Some people supply dollars for speculative purpose.

Foreigners demand dollars in the foreign exchange market to purchase the goods, services, assets or nay other things from Canada. To purchase the goods from Canada, one need to pay for it in Canadian dollars so foreigners demand dollars in the foreign exchange market.

## The demand for and supply of shekels in the foreign exchange market is

where the nominal exchange rate is expressed as Canadian dollars per shekel.LO2, LO3

## What is the market equilibrium value of the shekel?

First, we find the equilibrium rate by equating demand and supply

30000-8000e = 25000+12000e

20,000e = 5000

e = 0.25 dollars/shekels

The shekel is fixed at 0.30 Canadian dollars. Is the shekel overvalued, undervalued, or neither? Find the balance-of-payments deficit or surplus in both shekels and dollars. What happens to the country's international reserves over time?

The shekel is overvalued as it is priced as $0.30 while its real price is $0.25.

## When, price is 0.30,

Demand = 30000-8000*0.30

Demand = 27,600

Supply = 25000+12000*0.30 = 28,600

So, balance of payments deficit = 28600-27600 = 1000 shekel

The government will have to pay $300 i.e. 1000*$0.30 = $300 to purchase the excess of 1000 shekels. Hence, the country’s international reserve will decrease overtime.

Repeat (b) for the case in which the shekel is fixed at 0.20 Canadian dollars.

The shekel will be undervalued as it is priced as $0.20 while its real price is $0.25.

## When, price is 0.20,

Demand = 30000-8000*0.20

Demand = 28,400

Supply = 25000+12000*0.20 = 27,400

So, balance of payments surplus = 28400-27400 = 1000 shekel

The government will have to make additional 1000 shekel to sell it in international market and earn the foreign currency equal to 1000*$0.20 = $200. Hence, the country’s international reserve will increase overtime.

A British-made automobile is priced at £20 000 (20 000 British pounds). A comparable U.S.-made car costs US$26 000. One pound trades for US$2 in the foreign exchange market. Which country's cars are more competitively priced?

Given: £1 = $2

£ 20,000 = $ 40,000

## So, a British-made automobile will be sold for $40,000.

Then, the real exchange rate is $26,000/$40,000 = 0.50. This clearly shows that the US-made car cost relatively less than the British-made car. Hence, US-made car is more competitively priced.