1

Fiscal policy: making changes in tax rates and government spending (why there are deficits)
Monetary policy: changing interest rates and changing the amount of money in the economy
Y = C + I + G + NE
Y = total economy
C = consumption
I = investments
G = government spending
NE = net exports
Keynes focused on the short-term: on unemployment and lost production
During the 1970s and 1980s, macroeconomists became more concerned with the long-term:
inflation and economic growth
Every business cycle has 2 phases:
1. Recession: a period during which real GDP decreases for at least 2 successive quarters
2. Expansion: a period during which real GDP increases
And 2 turning points:
1. A peak
2. A trough
Gross domestic product (GDP): market value of all final goods and services produced in a
country in a given time period
GDP is a market value – goods and services are valued at their market prices
GDP is the value of final goods and services produced
Final good: an item bought by its final user during a specified time period
Intermediate good: an item that is produced by one firm, bought by another firm, and used as
a component of a final good or service
Primary good: material in a raw or unprocessed state
GDP measures production within a country and the value of production in a given time period
GDP measures the value of production, which also equals total expenditure on final goods and
total income
The equality of income and output shows the link between productivity and living standards
The circular flow diagram shows the transactions among:
1. Households
2. Firms
3. Governments
4. The rest of the world
 2

Households sell and firms buy the service of labour, capital, and land in factor markets
Firms sell and households buy consumer goods and services in the goods market. The total
payment for these goods and services is consumption expenditure
When a firm adds unsold output of inventory, we can think of the firm as buying goods from
itself. The purchase of new plant, equipment, and buildings and the additions to inventories are
investment
Governments buy goods and services from firms and their expenditure on goods and services is
called government expenditure
Firms in Canada sell goods and services to the rest of the world – exports – and buy goods and
services from the rest of the world – imports.
The value of exports minus the value of imports is called net exports
GDP can be measured in 2 ways:
1. The expenditure approach: the sum of consumption expenditure (C) investment (I) and
government expenditure on goods and services (X-M)
2. The income approach: summing the incomes that firms pay households for the factors
of production they hire
Investment is financed from 3 sources:
1. Private savings (S)
2. Government budget surplus (T-G)
3. Borrowing from the rest of the world (M-X)
Gross means before accounting for the depreciation of capital. The opposite of gross is net
Flow: a quantity per unit of time
Stock: a quantity that exists at a point in time
Depreciation (Capital consumption): the decrease in the capital stock that results from wear
and tear, and obsolescence
Gross profits and GDP include depreciation
2 adjustments must be made to get GDP:
1. Indirect taxes minus subsidies are added to get from factor cost to market prices
2. Depreciation (or capital consumption) is added to get from net domestic product to
gross domestic product
Real GDP: the value of final goods and services produced in a given year when valued at
constant prices
Calculating real GDP: the first step is to calculate nominal GDP, which is the value of goods and
services produced during a given year valued at the prices that prevailed in that same year
The new method of calculating real GDP, which is called the chain-weighted output index
method, uses the prices of two adjacent years to calculate the real GDP growth rate
 3

This calculation has 4 steps:

1. Value last year’s production and this year’s production at last years prices and then
calculate the growth rate of this number from last year to this year
2. Value last years production and this years production at this years prices and then
calculate the growth rate of this number from last year to this year
3. Calculate the average of the 2 growth rates. This is the growth rate of real GDP from last
year to this year
The average level of prices is called the price level
One measure of the price level is the GDP deflator, which is an average of the prices of the
goods in GDP in the current year expressed as a percentage of the base year prices
Nominal GDP also increases because prices rise
Real GDP is adjusted for inflation whereas nominal is not
We use real GDP to calculate the economic growth rate
The economic growth rate is the % change in the quantity of goods and services produced from
one year to the next
We measure economic growth so we can make:
- Economic welfare comparisons
- International welfare comparisons
- Business cycle forecasts
Economic welfare measures the nation’s overall state of well-being
Real GDP is not a perfect measure of economic welfare for 7 reasons:
1. Quality improvements tend to be neglected in calculating real GDP so the inflation rate
is overstated and real GDP understated
2. Real GDP does not include household production, that is productive activities done in
and around the house by members of the household
3. Real GDP, as measured, omits the underground economy, which is illegal economic
activity or legal economic activity that goes unreported for tax avoidance reasons
4. Health and life expectancy are not directly included in real GDP
5. Leisure time, a valuable component of an individual’s welfare is not included in real GDP
6. Environmental damage is not deducted
7. Political freedom and social justice are not included
Real GDP is used to compare economic welfare in one country with that in another
Two special problems arise in making these comparisons
- Real GDP of one country must be converted into the same currency units as the real
GDP of the other country, so an exchange rate must be used
- The same prices should be used to value the goods and services in the countries being
compared but often are not
 4

Using the exchange rate to compare GDP in one country with GDP in another is problematic
because prices of particular products in one country may be much less or more than the other
country
Real GDP is used to measure business cycle fluctuations
These fluctuations are probably accurately timed but the changes in real GDP probably
overstate the changes in total production and people’s welfare caused by business cycles
The business cycle is the periodic but irregular up-and-down movement in production and jobs
The population is divided into 2 groups:
1. Working age: 15 and older
2. People too young to work or in institutional care
The working age population is divided into 2 groups:
1. People in the labour force
2. People not in the labour force
The labour force is the sum of employed and unemployed workers
To be considered unemployed, a person must be in one of the following 3 categories:
1. Without work but has made specific efforts to find a job within the previous 4 weeks
2. Waiting to be called back to a job from which he or she has been laid off
3. Waiting to start a new job within 4 weeks
4 labour market indicators:
1. Unemployment rate: the % of the labour force that is unemployed
(# of people unemployed / labour force) X 100
reaches its peak during recessions
2. Involuntary part-time rate
3. Labour force participation rate: the % of the working age population that is in the
labour force
(labour force / working age population) X 100
falls during recessions as discouraged workers – people available and willing to work
but who have not made an effort to find work within the last 4 weeks – leave the labour
force
4. Employment-to-population ratio: the % of working-age people who have jobs
(# of people employed / working-age population) X 100
3 types of people are unemployed:
1. Job losers: workers who have been laid off or fired and are searching for new jobs
2. Job leavers: workers who have voluntarily quit their jobs to look for new ones (smallest
fraction of unemployment)
3. Entrants and re-entrant: people entering the labour force for the first time or returning
to the labour force and searching for work
People end a spell of unemployment for 2 reasons:
 5

1. Hired or recalled workers gain jobs

2. Discouraged unemployment workers withdraw from the labour force
There are 4 types of unemployment:
1. Frictional: unemployment that arises from normal labour market turnover
2. Structural: unemployment created by changes in technology and foreign competition
that change the match between the skills necessary to perform jobs and the locations of
jobs, and the skills and location of the labour force
3. Seasonal: unemployment that arises because the # of jobs available has decreased
because of the season
4. Cyclical: the fluctuation in unemployment caused by the business cycle
Full employment: occurs when there is no cyclical unemployment or, equivalently, when all
employment is frictional or structural
The unemployment rate at full employment is called the natural rate of unemployment
Potential GDP: the quantity of real GDP produced at full employment. It corresponds to the
capacity of the economy to produce output on a sustained basis; actual GDP fluctuates around
potential GDP with the business cycle
The consumer price index (CPI): measures the average level of the prices of goods and services
consumed by an urban family
The CPI is defined to equal 100 for the reference base period
The value of the CPI for any other period is calculated by taking the ratio of the current cost of a
market basket of goods to the cost of the same market basket of goods in the reference base
period and multiplying by 100
Constructing the CPI involves 3 stages:
- Selecting the CPI basket
- Conducting a monthly price survey
- Using the prices and the basket to calculate the CPI
The CPI basket is based on a consumer expenditure survey
Every month, statistics Canada employees check the prices of the goods and services in the CPI
basket in 64 urban areas
The CPI is calculated using the prices and the contents of the basket
CPI = (cost of basket in current period / cost of basket in base period) X 100
The main purpose of the CPI is to measure inflation
The inflation rate: % change in the price level from one year to the next
Inflation rate = [(CPI this year – CPI last year) / CPI last year] X 100
The CPI may overstate the true inflation for 4 reasons:
 6

1. New goods bias: new goods that were not available in the base year appear and, if they
are more expensive than the goods they replace, the price level may be biased higher.
Similarly, if they are cheaper than the goods they replace, but not yet in the CPI basket,
they bias the CPI upward.
2. Quality change bias: quality improvements generally are neglected, so quality
improvement that lead to price hikes are considered purely inflationary
3. Commodity substitution bias: the market basket of goods used in calculating the CPI is
fixed and does not take into account consumers’ substitutions away from goods whose
relative prices increase
4. Outlet substitution bias: as the structure of retailing changes, people switch to buying
from cheaper sources, but the CPI, as measured, does not take account of this outlet
substitution
The bias of the CPI distorts private contracts increases government outlays (close to a third of
government outlays are linked to the CPI), and biases estimates of real earnings
To reduce the bias in the CPI, statistics Canada undertakes consumer expenditure surveys more
frequently and revises the CPI basket frequently
The aggregate quantity of goods and services supplied depends on three factors:
- The quantity of labour (L)
- The quantity of capital (K)
- The state of technology (T)
The aggregate production function shows how quantity of real GDP supplied, Y, depends on
labour, capital, and technology
The aggregate production function is written as the equation:
Y= F( L, K, T)
In words, the quantity of real GDP supplied depends on (is a function of) the quantity of labour
employed, the quantity of capital, and the state of technology
The larger is L, K, T, the greater is Y
At any given time, the quantity of capital and the state of technology are fixed but the quantity
of labour can vary
The higher the real wage rate, the smaller is the quantity of labour demanded and the greater is
the quantity of labour supplied
The wage rate that makes the quantity of labour demanded equal to the quantity supplied is
the equilibrium wage rate and at that wage the level of employment is the natural rate of
unemployment
The macroeconomic long run is a time frame that is sufficiently long for all adjustments to be
made so that real GDP equals potential GDP and there is full employment
 7

The long run aggregate supply curve (LAS) Is the relationship between the quantity of real GDP
supplied and the price level when real GDP equals potential GDP
The macroeconomic short run is a period during which real GDP has fallen below or risen above
potential GDP
At the same time, the unemployment rate has risen above or fallen below the natural
unemployment rate
The short-run aggregate supply curve (SAS) is the relationship between the quantity of real
GDP supplied and the price level in the short-run when the money wage rate, the prices of
other resources, and potential GDP remain constant
When potential GDP increases, both the LAS and SAS curves shift rightward
Potential GDP changes for 3 reasons:
1. Change in the full-employment quantity of labour
2. Change in the quantity of capital (physical or human)
3. Advance in technology
The quantity of real GDP demanded, Y, is the total amount of final goods and services
produced in Canada that people, businesses, governments, and foreigners plan to buy
The quantity is the sum of consumption expenditures, C, investment, I, government purchases,
G, and net exports, X-M. That is: Y=C+I+G+X-M
Buying plans depend on may factors and some of the main ones are:
- The price level
- Expectations
- Fiscal and monetary policy
- The world economy
Aggregate demand: the relationship between the quantity of real GDP demanded and the price
level
The aggregate demand (AD) curve plots the quantity of real GDP demanded against the price
level
Wealth effect: a rise in the price level, other things remaining the same, decreases the quantity
of real wealth (money, bonds, stocks, etc.)
To restore their real wealth, people increase saving and decrease spending, so the quantity of
real GDP demanded decreases
Similarly, a fall in the price level, other things remaining the same, increases the quantity of real
wealth
With more real wealth, people decrease saving and increase spending, so the quantity of real
GDP demanded increases
Intertemporal substitution effect: a rise in the price level, other things remaining the same,
decreases the real value of money and raises the interest rate
 8

Faced with a higher interest rate, people try to borrow and spend less so the quantity of real
GDP demanded decreases
Similarly, a fall in the price level increases the real value of money and lowers the interest rate
Faced with a lower interest rate, people borrow and spend more so the quantity of real GDP
demanded increases
International substitution effect: a rise in the price level other things remaining the same,
increases the price of domestic goods relative to foreign goods, so imports increase and exports
decrease, which decreases the quantity or real GDP demanded
Similarly, a fall in the price level, other things remaining the same, decreases the price of
domestic goods relative to foreign goods, so imports decrease and exports increase, which
increases the quantity of real GDP demanded
A change in any influence on buying plans other than the price level changes aggregate demand
The main influences on aggregate demand are:
- Expectations
- Fiscal and monetary policy
- The world economy
Expectations about future income, future inflation, and future profits change aggregate
demand
Increases in expected future income increase people’s consumption today and increases
aggregate demand
A rise in the expected inflation rate makes buying goods cheaper today and increases aggregate
demand
An increase in expected future profits boosts firms’ investment, which increases aggregate
demand
Fiscal policy: the government’s attempt to influence economic activity by changing its taxes,
spending, deficit, and debt policies
A tax cut or an increase in transfer payments increases households’ disposable income
(aggregate income minus taxes plus transfer payments)
An increase in disposable income increases consumption expenditure and increases aggregate
demand
Because government purchases of goods and services are one component of aggregate
demands, an increase in government purchases increases aggregate demand
Monetary policy: changes in the interest rate and quantity of money
An increase in the quantity of money increases buying power and increases aggregate demand
A cut in the interest rate increases expenditure and increases aggregate demand
The world economy influences aggregate demand in two ways:
 9

1. A fall in the foreign exchange rate lowers the price of domestic goods and services
relative to foreign goods and services, increases exports, decreases imports, and
increases aggregate demand
2. An increase in foreign income increases the demand for Canadian exports and increases
aggregate demand
Short-run macroeconomic equilibrium: occurs when the quantity of real GDP demanded
equals the quantity of real GDP supplied at the point of intersection of the AD curve and the
SAS curve
Increase in LAS brings economic growth
Bigger increase in AD than in LAS brings inflation
The business cycle occurs because aggregate demand and the short-run aggregate supply
fluctuate but the money wage does not change rapidly enough to keep real GDP at potential
GDP
The components of aggregate expenditure sum to real GDP. That is:
Y=C+I+G+X-M
Two of the components of aggregate expenditure, consumption and imports, are influenced by
real GDP
So there is a two way link or feedback loop between aggregate expenditure and real GDP
The two-way link between aggregate expenditure and real GDP:
- An increase in real GDP increases aggregate expenditure
- An increase in aggregate expenditure increases real GDP
Consumption expenditure is influenced by many factors, but the most direct one is disposable
income
Disposable income is aggregate income or real GDP, Y, minus net taxes, NT
Call disposable income YD
The equation for disposable income is:
YD = Y – NT
Disposable income is either spent on consumption goods and services, C, or saved, S
That is: YD = C + S
The relationship between consumption expenditure and disposable income, other things
remaining the same, is the consumption function
The relationship between saving and disposable income, other things remaining the same, is
the saving function
Marginal propensity to consume (MPC) is the fraction a change in disposable income spent on
consumption
 10

It is calculated as the change in consumption expenditure divided by the change in disposable

income
That is: MPS = S /YD
The MPC plus the MPS equals one
To see why, note that,
C + S = YD
Divide this equation by YD to obtain
C / YD + S / YD = YD /YD
Our influences on consumption expenditure saving
When an influence other than disposable income changes – real interest rate, wealth, expected
future income – consumption function and seeing function shift
Consumption as a function of real GDP
Disposable income changes when either real GDP changes or when net taxes change
The tax rates don’t change, real GDP is the only influence on disposable income, so
Consumption expenditure is a function of real GDP
We use the relationship to determine equilibrium expenditure
In the short run, Canadian imports are influenced primarily by Canadian real GDP
The marginal propensity to import is the fraction of an increase in real GDP spent on imports
In recent years, NAFTA and increased integration in the global economy have increased
Canadian imports
Removing the effects of these influences, the Canadian marginal propensity to import is
probably about 0.3
Y = C + I + G + NE when one thing increases, it increases Y
Import function
In the short run, Canadian imports are influences primarily by Canadian real GDP
The Marginal propensity to import is the fraction of an increase in real GDP spent on imports
In recent years, NAFTA an increased integration in the global economy have increased Canadian
imports
Removing the effects of these influences, the Canadian marginal propensity to import is
probably about 0.3
Fixed prices have 2 implications for the economy as a whole:
1 Because each firm’s price is fixed, the price level is fixed
2 Because demand determines the quantities that each firm sells, aggregate demand
determines the aggregate quantity of goods and services sold, which equals real GDP
 11

To understand how real GDP is determined when the price level is fixed, we must understand
how aggregate demand is determined
Aggregate demand is determined by aggregate expenditure plans
Aggregate planned expenditure is planned consumption expenditure plus planned investment
plus planned government expenditures plus planned exports minus planned imports
We’ve seen that planned consumption expenditure and planned imports are influenced by real
GDP
When real GDP increases, planned consumption expenditure and planned imports increase
Planned investment plus planned government expenditures plus planned exports are not
influenced by real GDP
We’re going to study the aggregate expenditure model that explains how equilibrium
expenditure is determined
The relationship between aggregate planned expenditure and real GDP can be described by an
aggregate expenditure schedule, which lists the level of aggregate expenditure planned at each
level of real GDP
The relationship can also be described by an aggregate expenditure curve which is a graph of
the expenditure’s schedule
Consumption expenditure minus imports, which varies with real GDP, is induced expenditure
The sum of investment, government purchases, and exports, which does not vary with GDP, is
autonomous expenditure
(consumption expenditure and imports can have an autonomous component)
Actual expenditure is always equal to real GDP
Aggregate planned expenditure may differ from actual aggregate expenditure because firms
can have unplanned changes in inventories
Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate
planned expenditure equals real GDP
The multiplier is the amount by which a change in autonomous expenditure is magnified or
multiplied to determine the change in equilibrium expenditure and real GDP
An increase in investment (or any other component of autonomous expenditure) increases
aggregate expenditure and real GDP and the increase in real GDP leads to an increase in
induced expenditure
The increase in induced expenditure leads to a further increase in aggregate expenditure and
real GDP
So real GDP increases by more than the initial increase in autonomous expenditure
The multiplier is greater than 1 because an increase in autonomous expenditure induces further
increase in expenditure
 12

The size of the multiplier is the change in equilibrium expenditure divided by the change in
autonomous expenditure
The slope of the AE curve determines the magnitude of the multiplier
Multiplier = 1 / (1- Slope of AE curve)
To see why the multiplier is equal to this, begin with the fact that
Y = N + A
But
Slope of AE curve = N + Y
So,
N = Slope of AE curve x Y
and
Y = Slope of AE curve x Y + A
when there are no income taxes and no imports, the slope of the AE curve equals the marginal
propensity to consume so
multiplier = 1/ (1 – MPC)
but 1 – MPC = MPS so the multiplier is also
multiplier = 1 / MPS
turning points in the business cycle – peaks and troughs – occur when autonomous expenditure
changes
an increase in autonomous expenditure brings an unplanned decrease in inventories, which
triggers an expansion
a decrease in autonomous expenditure brings an unplanned increase in inventories, which
triggers a recession
in the equilibrium expenditure model, the price level is constant, but real firms don’t hold their
prices constant for long. When they have an unplanned change in inventories, they change
production and prices, and the price level changes when firms change prices
the aggregate supply – aggregate demand model explains the simultaneous determination of
real GDP and the price level. The two models are related
the aggregate expenditure curve is the relationship between aggregate planned expenditure
and real GDP, with all other influences on aggregate planned expenditure remaining the same
the aggregate demand curve is the relationship between the quantity of real GDP demanded
and the price level, with all other influences on aggregate demand remaining the same
when the price level changes, a wealth effect and substitution effect change aggregate planned
expenditure and change the quantity of real GDP demanded
 13

The federal budget is the annual statement of the federal government’s expenditure and tax
revenues
A provincial budget is the annual statement of a provincial government’s expenditures and tax
revenues
Fiscal policy: the use of the federal budget to achieve macroeconomic objectives, such as full
employment, sustained long-term economic growth, and price level stability
The federal government and Parliament make fiscal policy
The budget process begins with long drawn-out meetings between the Minister of Finance,
Department of Finance officials, provincial government, business, labour, and consumer groups
A budget plan is presented to Parliament, which Parliament eventually approves and passes
Highlights of the 2008 budget
The projected fiscal 2008 federal budget has revenues of $242 billion, outlays of $240 billion,
and a projected deficit of $2 billion
Revenues come from personal income taxes, corporate income taxes, indirect taxes, and
investment income
Personal income taxes are the largest revenue sources
Outlays are transfer payments, expenditure on goods and services, and debt interest
Transfer payments are the largest item of outlays
The federal government’s budget balance equals tax revenue minus expenditure
If tax revenues exceed expenditures, the government has a budget surplus
If expenditures exceed tax revenues, the government has a budget deficit
If tax revenues equal expenditures, the government has a balanced budget
Automatic fiscal policy: a change in fiscal policy triggered by the state of the economy
Discretionary fiscal policy: a policy action that is initiated by an act of Congress
To enable us to focus on the principles of fiscal policy multipliers, we first study discretionary
fiscal policy in a model economy that has only autonomous taxes
Autonomous taxes: taxes that do not vary with real GDP
The government purchases multiplier: the magnification effect of a change in government
purchases of goods and services on equilibrium aggregate expenditure and real GDP
A multiplier exists because government purchases are a component of aggregate expenditure;
an increase in government purchases increases aggregate income, which induces additional
consumption expenditure
The amount by which tax increase lowers consumption expenditure is determined by the MPC
 14

$1 tax increases lower consumption expenditure by $1 X MPC, and this amount gets multiplied
by the standard autonomous expenditures multiplier
the autonomous tax multiplier is –MPC/(1-MPC)
it is negative because an increase in autonomous taxes decreases equilibrium expenditure
taxes that vary with real GDP are called induced taxes
most transfer payments are entitlement spending, which also vary with real GDP
During a recession, induced taxes fall and entitlement spending rises; and during an expansion,
induced taxes rise and entitlement spending fall
Both effects diminish the size of the government purchases and autonomous tax multipliers
The extent to which induced taxes and entitlement spending decrease the multiplier depends
on the marginal tax rate, which is the fraction of an additional dollar of real GDP that flows to
the government in net taxes
The higher the marginal tax rate, the larger is the fraction of an additional dollar of income that
flows to the government and the smaller is the induced change in consumption expenditure
The smaller the induced change in consumption expenditure, the smaller are the government
purchases and autonomous tax multipliers
Imports decrease the fiscal policy multipliers
The larger the marginal propensity to import, the smaller is the magnitude of the government
purchases and autonomous tax multipliers
Automatic stabilizers: mechanisms that stabilize real GDP without explicit action by the
government
Income taxes and transfer payments are automatic stabilizers
Because income taxes and transfer payments change with the business cycle, the government’s
budget deficit also varies with this cycle
In a recession, taxes fall, transfer payments rise, and the deficit grows. In an expansion, taxes
rise, transfers fall, and deficit shrinks
The autonomous tax multiplier is the magnification effect a change in autonomous taxes on
equilibrium aggregate expenditure and real GDP
An increase in autonomous taxes decreases disposable income, which decreases consumption
expenditure and decreases aggregate expenditure and real GDP
The structural surplus or deficit is the surplus or deficit that would occur if the economy were
at full employment and real GDP were equal to potential GDP
The cyclical surplus or deficit: the actual surplus or deficit minus the structural surplus or
deficit, that is, it is the surplus or deficit that occurs purely because real GDP does not equal
potential GDP
 15

Fiscal policy doesn’t help us with net exports, but it can increase consumption, investment, and
government spending
An increase in government expenditures has a multiplier effect that increases aggregate
demand and shifts the AD curve rightward
Expansionary fiscal policy, an increase in government expenditures or a decrease in tax
revenues, shifts the AD curve rightward
Contractionary fiscal policy, a decrease in government expenditures or an increase in tax
revenues, shifts the AD curve leftward
In the long run, fiscal policy multipliers are zero because real GDP equals potential GDP and a
change in aggregate demand changes the money wage rate, the SAS curve, and the price level
Because the short-run fiscal policy multipliers are not zero, fiscal policy can be used to help
stabilize the economy, but in practice, fiscal policy is hard to use because the legislative process
is too slow to permit policy actions to be implemented when they are needed
Potential GDP is hard to estimate, so too much fiscal stimulation might be applied too close to
full employment
If people have to pay higher income taxes, they are going to work less
Fiscal policy has a large effect on AD and a small supply-side effect
Money: any commodity or token that is generally acceptable as a means of payment
A means of payment is a method of settling a debt
Money has three other functions:
 medium of exchange
 unit of account
 store of value
Medium of exchange
A medium of exchange is an object that is generally accepted in exchange for goods and
services
In the absence of money, people would need to exchange goods and services directly, which is
called barter
Barter requires a double coincidence of wants, which is rare, so barter is costly
Unit of account
A unit of account is an agreed measure for stating the prices of goods and services
Store of value
As a store of value, money can be held for a time and later exchanged for goods and services
Money in Canada consists of
 Currency
 16

 Deposits at banks and other financial institutions

Currency is the general term for bills and coins
The two main official measures of money in Canada are M1 and M2+
M1 consists of currency outside banks and demand deposits at chartered banks that are owned
by individuals and businesses
M2+ consists of M1 plus personal savings deposits at chartered banks, non-personal notice
deposits at chartered banks, deposits at trust and mortgage loan companies, deposits at credit
unions and caisses populaires, and deposits at other financial institutions
We can only have inflation if there is too much money in the economy
The items in M1 clearly meet the definition of money; the items in M2 do not do so quite so
clearly but still are quite liquid
Liquidity is the property of being instantly convertible into a means of payment with little loss
of value
Checkable deposits are money, but checks are not—checks are instructions to banks to transfer
money
Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but the loan
must be repaid with money
A depository institution is a firm that accepts deposits from households and firms
The deposits of three types of depository institution make up Canada’s money:
 Chartered banks
 Credit unions and caisses populaires
 Trust and mortgage loan companies
A chartered bank is a private firm that is licensed to receive deposits and make loans
A chartered bank’s balance sheet summarizes its business and lists the bank’s assets, liabilities,
and net worth
The objective of a chartered bank is to maximize the net worth of its stockholders
To achieve its objective, a bank makes risky loans at an interest rate higher than that paid on
deposits
But the banks must balance profit and prudence; loans generate profit, but depositors must be
able to obtain their funds when they want them
So banks divide their funds into two parts: reserves and loans
Reserves are the cash in a bank’s vault and deposits at the Bank of Canada
Bank lending takes the form of liquid assets, investment securities, and loans
Depository institutions make a profit from the spread between the interest rate they pay on
their deposits and the interest rate they charge on their loans
 17

This spread exists because depository institutions”

 Create liquidity
 Minimize the cost of obtaining funds
 Minimize the cost of monitoring borrowers
 Pool risk
The fraction of a bank’s total deposits held as reserves is the reserve ratio
The required reserve ratio is the fraction that banks are required, by regulation, to keep as
reserves. Required reserves are the total amount of reserves that banks are required to keep
Excess reserves equal actual reserves minus required reserves
When a bank receives a deposit of currency, its reserves increase by the amount deposited, but
its required reserves increase by only a fraction (determined by the required reserve ratio) of
the amount deposited
The bank has excess reserves, which it loans. These loans can only end up as deposits in our one
and only bank, where they boost deposits without changing total reserves, which creates
money
The deposit multiplier is the amount by which an increase in bank reserves is multiplied to
calculate the increase in bank deposits
The deposit multiplier = 1/ required reserve ratio
With many banks, one bank lending out its excess reserves cannot expect its deposits to
increase by the full amount loaned; some of the loaned reserves end up in other banks
But then the other banks have excess reserves, which they loan
Ultimately, the effect in the banking system is the same as if there was only one bank, so long
as all loans are deposited in banks
The quantity of money that people plan to hold depends on four main factors
 The price level
 The interest rate
 Real GDP
 Financial innovation
A rise in the price level increases the nominal quantity of money but doesn’t change the real
quantity of money that people plan to hold
Nominal money is the amount of money measured in dollars
The interest rate is the opportunity cost of holding wealth in the form of money rather than an
interest-bearing asset
A rise in the interest rate decreases the quantity of money that people plan to hold
An increase in real GDP increases the volume of expenditure, which increases the quantity of
real money that people plan to hold
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Financial innovation that lowers the cost of switching between money and interest-bearing
assets decreases the quantity of money that people plan to hold
The demand for money curve is the relationship between the quantity of real money
demanded (M/P) and the interest rate when all other influences on the amount of money that
people wish to hold remain the same
The demand for money changes and the demand for money curve shifts if real GDP changes or
if financial innovation occurs
Like to have a positive inflation rate typically between 1 and 2 %.
An interest rate is the percentage yield on a financial security such as a bond or stock the price
of a bond and the interest rate are inversely related
If the price of a bond falls, the interest rate of the bond rises.
If the price of the bond rises, the interest rate on the bond falls. We can study the forces that
determine the interest rate in the market for money.
The Fed determines the quantity of money supplied and on any given day that quantity is fixed.
The supply of money curve is vertical at the given quantity of money supplied Money market
equilibrium determines the interest rates.
The exchange rate is the price at which the Canadian dollar exchanges for another country.
The exchange rate is determined by demand and supply in the global foreign exchange market.
A rise in the Canadian interest rate increases the demand for the Canadian dollar and the
exchange rate rise.
A fall in the Canadian interest rate decreases the demand for the Canadian dollar and the
exchange rate fall.
The nominal interest rate is the percentage return on an asset such as a bond expressed in
terms of money.
The Real interest rate is the percentage return on an asset such as a bond expressed in terms
of what money will buy. The two interest rates are linked by the inflation rate in the following
wat:
Real interest rate = nominal interest rate – inflation rate
The nominal interest rate is the opportunity cost of holding money and so influences the
quantity of money demanded…
The real interest rate is the opportunity cost of spending.
Two components of aggregate expenditure influenced by the real interest rate are
- Consumption expenditure
- Investments
Other things remaining the same, the lower the real interest rate, the greater is the amount of
consumption expenditure and the smaller is the amount of saving
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The interest rate effect on consumption expenditure influences autonomous consumption

expenditure.
Other things remaining the same, the lower the real interest rate, the greater is the amount of
investment. The funds used to finance investment might be borrowed or the firm’s own
(retained earnings). Either way, the real interest rate is the opportunity cost of those funds.
Firms invest only if the expected rate of return on a project exceeds the real interest rate.
Net exports change when the real interest rate changes because:
 The exchange rate influences net exports—other things remaining the same, the higher
the exchange rate, the smaller are net exports, and
 The interest rate influences the exchange rate—other things remaining the same, the
higher the interest rate, the higher is the exchange rate
The interest-sensitive expenditure curve (the IE curve) shows the relationship between
aggregate planned expenditure and the real interest rate when all other influences on
expenditure plans remain the same
A central bank is the public authority that supervises financial institutions and markets and
conducts monetary policy
The bank of Canada was established in 1935
The governor of the Bank is appointed by the federal government
The current governor, who was appointed in 2001, is David Dodge
There are two possible models for the relationship between the central bank and government:
 Independent central bank
 Subordinate central bank
An independent central bank sets its own goals and makes its own decisions about how to
pursue those goals and might listen to the views of government but is not obliged to pay any
attention to those views
A subordinate central bank pursues goals set by the government and sometimes takes
directions from the government on how best to achieve those goals
The bank of Canada pursues inflation targets laid down by the government but makes its own
decisions on how best to achieve those goals
The bank of Canada’s assets are government securities and loans to banks (plus some other
small items)
The bank of Canada’s liabilities are its notes (the $5, $10, $20, $50, and $100 notes), banks
deposits, and government deposits
The monetary base is the sum of Bank of Canada notes outside the bank, chartered bank
deposits at the Bank of Canada, and coins held by households, firms, and banks
(Coins are issued by the government, not the Bank of Canada)
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Monetary policy making involves three elements:

 Monetary policy objectives
 Monetary policy Indicators
 Monetary policy tools
The objectives of monetary policy, as stated in the Bank of Canada Act, are to
… regulate credit and currency in the best interest of the economic life of the nation… and to
mitigate by its influence fluctuations in the general level of production, trade, prices and
employment, so far as may be possible within the scope of monetary action…
Current objective: keep inflation rate between 1% and 3% a year and smooth fluctuations as
much as possible
Monetary policy indicators are the current features of the economy that the Bank looks at to
determine whether it needs to apply the brake or the accelerator to influence future inflation,
real GDP, and unemployment
The indicators change as the Bank learns more about how the economy works
Currently, the overnight loans rate, the interest rate on large-scale loans that chartered banks
make to each other, is the main monetary policy indicator
The four monetary policy tools are:
 Required reserve ratio: right now in Canada, it is zero
 Bank rate and bankers’ deposit rate
 Open market operations
 Government deposit shifting
The Bank of Canada no longer requires chartered banks to hold a minimum level of reserves
Bank rate is the interest rate that the Bank of Canada charges the chartered banks on the
reserves it lends to them
The bankers’ deposit rate is the interest rate that the Bank of Canada pays to chartered banks
on their deposits at the bank
The bank of Canada sets the bankers’ deposit rate at bank rate minus half a percent
An open market operation is the purchase or sale of government of Canada securities by the
Bank of Canada in the open market
Government deposit shifting is the transfer of government funds by the bank of Canada from
the government’s account at the Bank to the government account at a chartered bank.
When the Bank of Canada conducts an open market operation by buying a government
security, it increases bank reserves
Banks loan the excess reserves. By making loans, they create money
The reverse occurs when the Bank of Canada sells a government security
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Although the details differ, the ultimate process of how an open market operation changes the
money supply is the same regardless of whether the Bank of Canada conducts its transactions
with a commercial bank or a member of the public
An open market operation that increases banks’ reserves also increases the monetary base
The money multiplier is the amount by which a change in the monetary base is multiplied to
calculate the final change in the money supply
An increase in currency held outside the banks is called a currency drain
Such a drain reduces the amount of banks’ reserves, thereby decreasing the amount that banks
can loan and reducing the money multiplier
The deposit multiplier shows how much a change in reserves affects deposits
The money multiplier shows how much a change in the monetary base affects the monetary
supply
When the Bank of Canada increases the monetary base, a sequence of nine events follows.
They are:
1. Banks have excess reserves
2. Banks lend excess reserves
3. Bank deposits increase
4. The quantity of money increases
5. New money is used to make payments
6. Some of the new money remains on deposit
7. Some of the new money is a currency drain
8. Desired reserves increase because deposits have increased
9. Excess reserves decrease but remain positive.
The Canadian money multiplier is the change in the quantity of money divided by the change in
the monetary base
Because there are two definitions of money, M1 and M2+
The M1 multiplier is about 2.2
The M2 multiplier is about 10
The Bank of Canada needs a combination of good judgment and good luck to achieve its
monetary policy goal of low and stable inflation and full employment
The Bank is handicapped by the fact that the ripple effect of its actions are long drawn out and
not entirely predictable.
Because the demand for monetary base fluctuates, the Bank of Canada prefers to target the
interest rate and change the quantity of money automatically if the demand for money changes
Inflation is a process in which the price level is rising and money is losing value
Inflation is a rise in the price level, not in the price of a particular commodity, and inflation is an
ongoing process, not a one-time jump in the price level