UWaterloo ECON 102 Notes
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Transcript of UWaterloo ECON 102 Notes
Lecture 1
Economics is a social scienceStudy of choices that are made coping with scarcity and incentivesMicroeconomics choices made by individuals and businesses, and the interaction of those choices in markets ("Why are people buying more ebooks and fewer hard copies?")Macroeconomics study of national and global economiesPeople have unlimited wants, but limited resources (time, income, wealth)More of one thing is less of another > Scarcity results in choicesCeteris Paribus assumption of nothing else changingPositive statement what IS (facts)Normative statement what SHOULD BE (opinion)Rational choice achieves greatest benefit over cost for decision makerOpportunity cost highest valued alternative that must be given upEconomic surplus benefit of taking action minus the cost
Lecture 2
Goods and services objects valued by people, produced to satisfy human wantsChoices end up determining "what, how, and for whom" goods and services are producedFactors of production:
1. Land gifts of nature2. Labour work time and effort (dependent on skill, known as human capital)3. Capital tools, instruments, machinery, buildings4. Entrepreneurship human resources that organize the above 3
Land earns rentLabour earns wagesCapital earns interestEntrepreneurship earns profitSelfinterest: choices good for youSocial interest: Best for society, based on efficiency and equityEfficiency: when available resources are used to produce goods at lowest possible price and greatest quantitiesEquity is fairnessDirect relationship: x moves with yInverse relationship: x moves against y
Lecture 3
Gross Domestic Product market value of all final goods and services produced in country in given time periodFinal good item bought by final user (e.g. car)Intermediate good item used in production (e.g. tires)Nominal GDP: Market Price * QuantityHouseholds sell and firms buy labor, capital and land in factor marketsFirms sell and households buy goods in the goods marketConsumption expenditure is total payment for consumer goodsFirms upgrade and buy new capital, also known as investmentGovernments buy goods from firms, called government expenditureNet exports: value of exports imports
Left side = right side... GDP = total expenditure = total incomeGDP = C + I + G + X M
Consumer spending + Investments + Government expenditure + exports importsDepreciation: decrease in value of firm's capital (from wear and tear)Gross investment: total amount spend on upgrades and new purchasesNet investment = Gross investment depreciationIncome includes wages and interest, rent, profit, etc.Adjust income with indirect tax to get to market priced net domestic income. Then add depreciation to get gross domestic incomeReal GDP: Value of goods and services when priced at a base yearWe prefer real GDP to remove any influences of rising prices and cost of livingVariable Growth: (NEW OLD) / OLDReal GDP per person: rGDP / Population tells us value of goods that average person can enjoyFactors not included in GDP:
Household productionSecondhand activitiesHealth / life expectancyLeisure timeEnvironmental qualityPolitical freedom / social justice
GDP comparison worldwide is hard due to currencies and different goods valuesPotential GDP: When all factors of income are being 100% usedReal GDP fluctuates: expansion and recession
Lecture 4
Unemployment results in:Lost incomes and production
Lost human capital (people lose skills)
To be unemployed, one must be:Without work, but have made specific efforts to find job within 4 weeksWaiting to be called back to a job from which one has been laid offWaiting to start a new job within 4 weeks
Labour Market Indicators:Unemployment rate
# Unemployed / Labor ForceInvoluntary P.T. Rate
# Involuntary P.T / Labor forceLabor force participation rate:
Labor force / Working Age Pop.Employment : Population ratio
# employed / Working Age Pop.Limitations:
Marginally attached worker: Neither looking nor working, but has indicated desire and availability for a jobDiscouraged worker: Has given up searching due to repeated failurePart time workers who want full time jobs
Officially partly unemployedTypes of unemployment:
Frictional Arises from workers wanting to switch jobs, creation and destruction of jobsCompletely normal
Structural created by changes in technology and foreign competitionCyclical As a result of expansions and recessionsNatural only frictional and structural
N.U. rate = # N.U / labor forceFull employment is when unemployment rate = N.U. rateOutput gap = Real GDP Potential GDPWhen output gap is negative, unemployment > N.U.
Lecture 5
Price level: average level of prices and value of moneyInflation and deflation are problematic because they:
Redistribute income and wealthLower real GDP and employmentDivert resources from production
Consumer Price Index: measures average of prices paid by urban consumers for "fixed" basket of goodsCalculating CPI:
1. Find cost of CPI basket at base year prices2. Find cost of CPI basket at current year prices3. CPI = (Current Year / Base Year) * 100
Inflation Rate: Plug CPI into growth formula((CPICurrent CPIPrevious) / CPIPrevious) * 100
CPI Biased due to:New goods bias goods not available in base year. If they are more expensive than what they're replacing, they upwardly bias the CPIQuality bias sometimes price goes up due to quality improvement, not inflationCommodity substitution bias fixed basket does not take into account substitutions away from higher priced goodsOutlet substitution people buy from cheaper places
Alternative Price Indexes:GDP Deflator
(NominalGDP / RealGDP) * 100Broader than CPI as it includes all factors of GDPToo broad for cost of living
Chained price index for consumption(Nominal consumption expenditure / real consumption expenditure) * 100
These both are period based, so they overcome 4 sources of bias aboveCore inflation inflation of all goods excluding volatile elements (food, fuel)
Attempts to reveal underlying inflation trendCommonly measured with core CPI inflation rate
To find real variable, just do: Nominal variable / GDP deflatorDon't do this for interest
Lecture 7
A market is anywhere an economic exchange occursCompetitive market has many buyers and sellers, so no one entity can influence the priceMoney price amount of money needed to purchase goodRelative price ratio of money price to money price of next best alternative good... the opportunity cost of the goodFactor market any place where resources are bought and soldProduct market where products are bought and soldQuantity demanded amount that consumers plan to buy during particular time and priceLaw of Demand: higher the price, lower the quantity demanded, and vice versa
Results from:Substitution effect when people seek lower priced alternatives, demand for original dropsIncome effect when price increases relative to income, it can no longer be afforded
Demand curve: X>Quantity Y>PriceAlso known as willingness and ability to pay curve
Market demand sum of individual demandsIf price changes, there is a movement along the demand curveIf anything else changes, there is a change in demand (the curve moves)Six demand changing factors:
1. Price of related goods2. Expected future prices3. Income4. Expected future income and credit5. Population6. Preferences
PriceSubstitute good that can be used in place of anotherComplement a good used in conjunction with another
Expected future priceIf price is expected to go up, current demand increases
IncomeNormal good: demand increases as income increasesInferior good: demand decreases and income increases
Expected future incomeDemand increases if more money is a potential
PopulationLarger population means larger demand
PreferencesPeople with same income have different preferences, thus different demands
Quantity supplied amount that producers plan to sell during given time at particular priceLaw of Supply: Higher the price, higher quantity supplied, and vice versaSupply curves double as minimumsupplyprice curvesMarket supply sum of individual suppliesPrice change: movement along supply curveOther factor change: movement of supply curveSix supply changing factors:
Prices of factors of productionPrices of related goodsExpected future pricesNumber of suppliersTechnologyState of nature
If production becomes expensive, supply decreasesIf substitute goods become cheaper, supply increasesIf complement goods become cheaper, supply decreasesIf prices are expected to go up, supply decreases until prices do go upIf number of suppliers go up, overall supply increasesAdvances in technology increase supplyBad states of nature decrease supply (hurricanes, etc.)
Lecture 8
Surplus is when demand < supplyShortage is when demand > supplyEquilibrium is when demand = supplySurplus forces price down, so that consumers will buyShortage forces price up, causing consumers to buy less and making it more worthwhile for suppliers
Lecture 9
Study of finance looks at how households and firms use financial resources
Study of money looks at how it is used by households and firms, how much is held, how banks create and manage it, how quantity influences economyPhysical capital items already produced used in production such as tools and machinesFinancial capital funds used by firms to buy physical capitalWealth value of all things that people ownSavings non taxed income that is not used for consumptionSavings increase wealthWealth increases when market value of assets rises (capital gains), and decreases when it falls (capital losses)Savings are used to fund 3 financial markets:
Bond marketStock marketLoan market
Financial institution firm that operates on both sides of financial capital markets as a borrower and lenderCommercial banksGovernment mortgage lendersPension fundsInsurance companies
Net worth: Lent BorrowedIf positive, solvent institution can remain in businessNegative, insolvent institution must shut down
Interest rate is interest received expressed as percentage of asset priceNOMINAL I.R. = (interest / asset price) * 100
Market for loanable funds Aggregate of all 3 financial marketsFinance investment is funded from
Household SavingsGovernment budget surplus
Borrowing from rested of worldHousehold income is comprised of Consumtion, Savings and TaxesGDP = C + I + G + (XM) = Household incomeInvestment = S + (TG) + (MX)Real Interest Rate = Nominal rate inflation rate
Opportunity cost of borrowingNominal interest rate in each country:
i = r + 3.14i = nominal, r = real, 3.14 = expected inflation
Quantity of loanable funds demanded depends on:Real interest rateExpected profit
As real interest increases, quantity demanded for loanable funds decreasesAs expected profit from new capital increases, amount of investment is greater, and so demand for loanable funds increasesQuantity of loanable funds supplied depends on:
Real interest rateDisposable incomeExpected future incomeWealthDefault risk
As real interest increases, funds supplied increasesSupply of funds increases when:
Expected future income decreasesWealth decreasesDefault risk falls
Government budget surplus increases supply of funds, and deficit increases demandLoanable funds market is globalLenders want to earn the highest interest rateBorrowers want to pay the lowest possible interest rateFunds flow in to the country with the highest interest rate, and out of the country with the lowest interest rateLoanable funds are tied with net exportsNegative net exports means that world supplies funds to this country
Quantity of loanable funds is greater than national savingPositive net exports means country supplies funds to rest of world
Quantity of loanable funds in this country is less than national savingInterest rate differentials:
Time preferences for consumptionRiskExpected inflation
r = r* + I + RPr = nominal interest rater* = real interest rateIP = inflation rateRP = risk premium
Lecture 11
Money any commodity or token generally acceptable as method of settling debtAlso functions as a:
Medium of exchangeObject generally accepted in exchange for goods and servicesAbsence of this would require barter, which is rare due to the need of two people wanting the same thing
Unit of accountAgreed measure to state prices of goods and services
Store of valueCan be held for a time and still be used for exchange
Money consists of:Currency the notes and coins held by individuals and businessesDeposits at banks and other depository institutions
Official measures in Canada are:M1 consists of currency and chequable deposits held by individuals and businesses
Basically coins, notes, and things like savings and chequing accountsM2 M1 plus all other deposits (nonchequable and fixed term)
Everything in M1 is a means of payment, thus is moneySome things in M2 are liquid assets
Assets that can be easily converted without losing valueCheques are not money, simply an instruction to transfer moneyCredit cards are not money, simply loans that must be repaid with money
Banking system consists of:Depository institutionsThe Bank of Canada
Depository institutions take deposits from and loan to households and firmsChartered banks (CIBC, TD, Scotia, RBC)Credit unions (Meridian)Trust and mortgage loan companies
They maximize wealth by having a loan interest > savings interestChartered bank assets are:
Reserves currency in bank vault, and money at Bank of CanadaLiquid assets Treasury and commerical billsSecurities long term government bonds and other bondsLoans commitments of fixed amounts of money for agreed upon periods of time
Depository institutions are beneficial because they:Create liquidityPool riskLower borrowing costLowering cost of monitoring borrowers
Bank of Canada regulates Canada's depository institutions and control quantity of moneyIt is:
Banker to the banks and governmentAccept deposits from banks
Lender of last resortCan loan to banks if they are short of reserves
Sole issuer of bank notesThe currency notes that are used
Assets include: (what they have)Government securitiesLast resort loans to banks
Liabilities are: (things they use, but don't "own")Bank of Canada notesDeposits of banks and governments
Monetary base includes:Liabilities of Bank of Canada (plus coins from the Mint)Notes outside the BoC, deposits at the BoC, coins
The base is changed through an open market operationOpen Market Purchase:
When the BoC buys government securities, it buys from the banks. BoC pays banks by adding money to their reservesOpen Market Sale:
BoC sells securities to banks, and takes money from their reservesQuantity of deposits that can be created by a bank is limited by:
Monetary baseDesired reservesDesired currency holding
Actual reserves notes and coins in vault, and deposits at BoCDesired reserves notes and coins in vault, planned deposits at BoC
Desired reserve ratio Bank's reserves : total planned deposits that bank will hold
Required reserves notes and coins in vault, required deposits at BoCRequired reserve ratio Bank's reserves : required deposits
Excess reserves = Actual reserves desired reservesDesired currency holding people hold some fraction of their money. As total quantity of money increases, quantity of currency held increasesCurrency drain ratio: Currency : Deposits (C/D)Money Creation Process:
1. BoC conducts open market purchase2. Banks now have excess reserves, so they loan this out3. Deposits increase; money quantity increases, new money is used to make payments, some of the new money remains on deposit, some is currency drain
4. Deposits have increased, so desired reserves increase5. Excess reserves decrease, but are still positive. Repeat.
Money multiplier ratio of change in quantity of money to change in monetary baseDepends on desired reserve ratio and currency drain ratioSmaller rations > larger money multiplier
Money multiplier = (1 + C/D) / (C/D + R/D)Where C/D = currency drain ratio, R/D = desired reserve ratio
Lecture 12
Demand for money is the relationship between quantity of real money demanded and the nominal interest rateMoney demand depends on:
Price levelNominal interest rateReal GDPFinancial Innovation
Price level increase increases the quantity of nominal money but not real moneyNominal money amount of money measured in $Real money Nominal money / price level
Quantity of nominal money proportional to price levelNominal interest rate is opportunity cost of holding wealth as money rather than as interest earning assetRise in nominal interest rate causes money demand to decreaseReal GDP increase increases expenditure, increasing quantity of real money heldFinancial innovations that help lower cost of switching assets to money will decrease demand for real moneyNominal interest rate causes the quantity demanded to change, but changes in GDP or financial innovations cause the demand to shiftMoney supply is set by BoC, independent of interest rate (vertical line)In the short run:
BoC decreases money supply, so there is shortage of moneyPeople sell bonds, increasing the interest rate
BoC increases money supply, so there is excess moneyPeople buy bonds, interest rate falls
HAVE SOME SHORT/LONG RUN STUFFQuantity Theory of Money:
In long run, increase in quantity of money brings equal percentage increase in price levelVelocity of circulation: average number of times in a year dollar is used to purchase goods and services in GDPV = PY / M
where V is velocity of circulation, P is price level, Y is real GDP, M is quantity of moneyEquation of exchange states that MV = PYEquation of exchange becomes quantity theory of money if M does not influence V or Y (i.e the long run)In the long run:
Inflation rate = Money growth rate real GDP growth
Lecture 13
We get foreign currency in the foreign exchange marketThe price of exchange is called the foreign exchange rateThe foreign exchange market is competitiveWhen the value of a currency rises in terms of another, it appreciates, otherwise it depreciatesFactors of demand for once currency affect the supply of another currencyCanadian dollar demand depends on:
The exchange rate (movement along curve)Foreign demand for Canadian exports (shift)Canadian and foreign interest rates (shift)Expected future exchange rate (shift)
Canadian dollar supply depends on:The exchange rateCanadian demand for foreign importsCanadian and foreign interest rates
Expected future exchangeCanadian interest rate differential: Canadian interest rate foreign interest rate
Lecture 14
Interest rate parity: equal rates of return on two currenciesPurchasing power parity: when two currencies can buy the same goods with the same quantity of moneyReal exchange rate = (Nominal Exchange Rate * Domestic Price Level) / Foreign Price LevelLong Run: Exchange Rate = N.E.R * (F.P.L / D.P.L)Flexible exchange rate determined by demand and supply with no intervention from bankFixed exchange rate active intervention from bank by buying and selling Canadian dollarsCrawling peg is similar to fixed, except the target value changes
Used to avoid running out of reserves, as can happen with fixedCurrent Account:
Exports and importsNet interest paid abroadNet transfers (e.g. foreign aid payments)Balance = Exports Imports + Net Interest Income + Net Transfers
Government Sector = Taxes Government SpendingPrivate Sector = Savings InvestmentsNX = (TG) + (SI)Capital and Financial Account:
Foreign investment in Canada Canadian investment abroadOfficial settlements account = change in Canadian official reserves (government holding of foreign currency)Official Settlements = 1 * (Current + Capital and Financial)Net borrower country that borrows from worldNet lender country that lends to worldCreditor nation nation that has lent for its entire historyDebtor nation nation that has borrowed for its entire history
Lecture 15
Real GDP = Consumer Expenditure + Firm Investments + Government Spending + Net ExportsY = C + I + G + X MAggregate demand depends on:
The price levelExpectationsFiscal and monetary policyWorld economy
Is the relationship between real GDP demanded and the price levelFiscal policy is the changing of taxes, transfer payment and purchases by the governmentMonetary policy is the change in interest rate and quantity of money
Lecture 16
Long run aggregate supply = vertical line at potential GDPShort run aggregate supply is affected by price level, money wage rate, and other factors of productionWhen potential GDP changes, both LAS and SAS shift in the same direction
Caused by full employment quantity changeChange in capital (physical or human)Technological advances
When short run shifts, due to money wage rate change or other factor price changes, LAS doesn't moveShort run macroeconomic equilibrium real GDP demand = real GDP supply
Intersection of AD and SASLong run equilibrium is when real GDP = potential GDP
Intersection of AD and LASAbove full employment equilibrium: real GDP > potential GDP
Inflationary gapFull employment equilibrium: real GDP = potential GDPBelow full employment equilibrium: real GDP < potential GDP
Recessionary gapStagflation when real GDP decreases and price level increasesClassical Thought: economy is self regulatingKeynesian Though: help is required from fiscal and monetary policyMonetarist Thought: self regulating, provided monetary policy is sound
Lecture 17
Demand Pull Inflation
Begins with any factor that increases aggregate demandAD curve shifts rightwardPrice level rises, GDP increases, inflationary gap occursSAS moves left to compensate, process repeats, causing increase in price level
Cost Push InflationStarts with an increase in production costSAS shifts leftward due to increased cost, GDP decreases, price level increasesThis price level increase is one time only because:BoC stimulates aggregate demand by creating more moneyAD curve shifts right, but firms try to keep relative prices high, so process repeats
Rising price level and decreasing GDP is called stagflationIf inflation is expected, inflation proceeds as it does in the long run, along LAS lineRational expectations are the best, most informed forecasts of inflationCorrect forecast leads to full employment economyIf AD grows faster, then inflationary gap occurs, and demand pull inflationAD grows slower, recessionary gap, cost push inflation
Lecture 19
Keynesian model describes short run, fixed pricesAggregate expenditure = Real GDP
Y = C+I+G+XMConsumption and imports are influenced by real GDPIncrease in real GDP increases aggregate expenditureIncrease in aggregate expenditure increases real GDPDisposable income = aggregate income net taxes
YD = YTYD = Consumption + Savings
Consumption function: relation between consumption expenditure and disposable incomeC = a+b(YT)Net taxes are equal to autonomous taxes plus induced taxes, which vary with income (Ta and tY)C = A bTa + b(1t)Y
Saving function: relation between saving and disposable incomeMarginal propensity to consume: fraction of change in disposable income spent on consumption
delta C / delta YD = slope of consumption functionMarginal propensity to save: fraction of a change in disposable income that is saved
delta S / delta YD = slope of saving function = 1MPCMarginal propensity to import: fraction of an increase in real GDP spent on imports
M = mY, where m = propensity, Y = change in GDP, M = change in importsAggregate planned expenditure: planned variablesInduced expenditure: consumption expenditure minus imports
Varies with real GDPAutonomous expenditure = investment + government expenditure + exports
A = I + G + XDoesn't vary with real GDP
Actual aggregate expenditure = real GDPAggregate planned expenditure can differ from actual A.E. because firms can have unplanned canges in inventoriesEquilibrium expenditure = level of aggregate expenditure that occurs when A.P.E = real GDPEquilibrium occurs when AE curve crosses 45 degreesIf AE curve is above 45 degree line:
There is an unplanned decrease in inventoriesFirms hire workers and increase production, increasing real GDP
If AE curve is below 45 degree line:Unplanned increase in inventoriesFirms fire workers and decrease production, decreasing real GDP
Lecture 20
Induced expenditures: those influenced by real GDPConsumer expenditureImports
Autonomous expenditures: those independent of real GDPInvestmentsGovernment expenditureExports
Consumption function: C = a+b(YT)b = marginal propensity to consume
Saving function: S = a + (1b)(YT)(1b) = marginal propensity to save
MPS + MPC = 1Consumption Shift Factors:
Expected future incomeIncrease in expected income > increase in consumption
WealthIncrease in wealth increases consumption
Real interest rateIncreased rates reduce consumptionThis is the net effect of 1) seeing that savings yield a higher return and 2) less money needs to be saved to yield the same amount
Determinants of Investment:Interest rate
Capital expenditures are usually financed, and should be sensitive to the cost of financing (the interest rate)Profit expectations
Cost of financing vs. expected returns from new capitalImports
M = mYm = marginal propensity to import
ExportsThought to be determined by the economy of buying nation
When autonomous expenditure changes, so does equilibrium expenditure and real GDPChange in equilibrium expenditure is larger than change in autonomous expenditureMultiplier is amount by which a change in autonoumous expenditure is multiplied to determine change in equilibrium expenditure and real GDPWhy we have a multiplier:
1. Increase in an autonomous component increases A.E. and real GDP (AE = C+I+G+XM)2. Increase in real GDP affects the induced variables (C, M)3. Increase in induced variables increases AE and GDP4. GDP has increased more than the increase in autonomous expenditure
An increase in autonomous expenditure moves the aggregate expenditure line up, causing an increase in equilibrium GDPMultiplier = 1 / (1 Slope of AE curve)The price level changes because firms change production and pricesAn increase in price level means the AE curve shifts upward, and AD rightward, by an amount equal to change investment multiplied by multiplierLong run multiplier is 0
Lecture 21
Federal budget annual statement of federal outlays and revenuesFiscal policy the use of federal budget to achieve full employment, growth and price level stabilitySurplus: revenue exceeds outlaysDeficit: outlays exceed revenueBalance: revenue = outlaysGovernment debt: total amount gov't is borrowingIncome tax changes full employment and potential GDP
Gap between beforetax and aftertax wage rates is the tax wedgeTaxes on consumption expenditure also add to tax wedge
Income tax = 25%Tax on expenditure = 10%Tax wedge = 35%One dollar can only buy 65 cents worth of G&S
Tax on capital income lowers quantity of saving / investment and slows real GDP growth rateInterest rate that influences saving and investment is called the real aftertax interest rate
Subtracts income tax from real interestTaxes depend on nominal interest rate. True tax on interest income depends on inflation rate.Tax decreases the supply of loanable fundsAutomatic fiscal policy: triggered by state of economy, no gov't actionDiscretionary fiscal policy: policy action initiated by ParliamentTax revenues and transfer payments change automatically in response to state of economyParliament sets tax rates, but tax revenues depend on real GDP (because income depends on GDP)Transfer payments are things such as E.I.Structural surplus / deficit: budget balance that would occur at full employment and real GDP = potential GDPCyclical surplus / deficit: actual surplus / deficitGovernment expenditure and multiplier: effect of a change in gov't expenditure on real GDPCrowding out: increased gov't expenditure raises borrowing price, decreasing investmentIt is said that crowding out > multiplier, thus multiplier < 1Tax multiplier: quantity effect of change in taxes on aggregate demandRecognition lag: time taken to figure out that action is neededLawmaking lag: Parliament law passing timeImpact lag: time from law being passed to effects being felt
Lecture 22
Monetary policy instrument: variable that the BOC can directly control / closely target1. Quantity of money (monetary base)
2. Exchange rate3. Short term interest rate
Monetary Base Exchange Rate Interest Rate
Decrease Increase Increase
Increase Decrease Decrease
Bank prefers interest rate, and targets the overnight loans rateTools used to achieve this:
Operating BandOpen market operations
Operating band = overnight rate +/ 0.25BOC sets big bank interest rate on loans to overnight + 0.25Sets interest rate on reserves to OLR 0.25When the Bank of Canada lowers the overnight loans rate:
1. Other shortterm interest rates and the exchange rate fall.2. The quantity of money and the supply of loanable funds increase.3. The longterm real interest rate falls.4. Consumption expenditure, investment, and net exports increase.5. Aggregate demand increases6. Real GDP growth and inflation rate increase