Productivity: is the quantity of goods and services that a worker can produce for each

unit of a worker’s time

- (usually an hour)

4 components of productivity
- Physical capital
- Equipment and structures
- Human Capital
- Knowledge and skills that worker acquire
- Natural resources
- Inputs into production the re provided by nature
- Technological knowledge
- Society’s understanding of the best ways to produce goods and services

The Production Function

Y = A* F(L, K, H, N)

Y = output
L = physical capital
H = human capital
N = natural resources
A = technology

Diminishing Returns
- Phenomenon whereby output increases at a decreasing rate
- Due to diminishing returns, an increase in the savings rate leads to a higher growth of
productivity but only for a while
- benefits of additional capital become smaller over time, if growth of other inputs do not
keep up

Forms of Investment:
- Foreign investment
- Education
-> Form of investment in human capital
- Health and Nutrition
-> investment in human capital
- Property rights
-> if there are no property rights
- Research and Development
-> Patents incentivize innovation

Canadian Financial Institutions

- Financial markets involve two types of consumers savers and borrowers
- savers supply their money to the financial system with the expectation that they will
get it back with interest at a later date.
- Borrowers demand money from the financial system with the knowledge that they will
be required to pay it back with interest at a later date.

The Bond Market

- Bonds: certificated of indebtedness that specifies the obligations of the borrower and
the holder of the bond.
- the buyer of a bond gives their money to the issuer of a bond in exchange for the
promise of payment of interest and the principal.
-> the buyer can hold the bond to maturity or sell it.

The Stock Market

- Stock: represents ownership in a firm. Owners of stock can claim to a share of the
profits that a firm makes.

Financial Intermediaries
- Banks serve as financial intermediaries - institutions whereby savers can indirectly
provide funds to borrowers.
- primary job of banks is to take deposits from people who want to save, and use these
deposits to make loans to people who want to borrow.

Saving and Investment in National income accounting

Y=C+I+G
 -> GDP is the sum of consumptions, investment, and government purchases

Y-C-G=I
-> the income left over after consumption and government purchases
-> Y - C - G = national saving → Y - C - G = S
-> Savings = Investments

T = amount the gov’t collects in taxes minus the amount payed to households in transfer
payments
-> S = Y - C - G - T + T
-> S = (Y - T - C) + (T - G)

- Private saving: amount of income that households have left after paying their
consumption and taxes
- Public Saving: amount of tax revenue that gov’t has left over after paying government
expenditures

Budget surplus → T > G

Budget Deficit → T < G

***
T = Taxes collected - amount payed in transfer payments(CCP and EIP)
G = Gov’t purchases

The Market for Loanable Funds

- Supply: derived from savings
-> comes directly from the bond or stock market, or .
indirectly through banks
- Demand: derived from investment
-> mortgages to buy new homes, firms borrowing to by .
new tech
- Higher Interest rates mean the quantity of loanable funds demanded is lower
-> demand is downward sloping
- Higher interest rates mean the quantity of loanable funds supplied is higher
-> supply is upward-sloping
 - Policies such as savings incentives, investment incentives, or government
budgets and surpluses casechanges and shifts in the supply or demand curves.

Savings Incentives

- Taxes on income reduce future payoff of current

savings, reducing the incentive for people to save
- Changes in tax law that encourage savings shifts
supply of loanable funds to the right
- Interest rate is lower
- Quantity demanded of investments increases
- Eqm loanable funds is $160b

Investment Incentives
 • An investment tax credit gives a tax
advantage to any firm building a new factory
or buying equipment, etc.
• Firms are encouraged to invest more
• Demand for loanable funds increases
• Eqm interest rates rise, as well as eqm
quantity of loanable funds

Government Deficits and Surpluses

- “Crowing out” is a decrease in I that

results from government borrowing
(G)

Minimum-Wage Laws
Theory of Efficiency wages
- According to the theory of efficiency wages, firms operate more efficiently if wages
are above th equilibrium level
→ It may be profitable for firms to keep wages high, even in the presence of a
labour surplus

Theory 1: Worker Health

- Better paid workers may have more positive health outcomes, and this may lead to an
increase in productivity
→ wages should reflect what is needed for workers to maintain an adequate and
healthy diet

Theory 2: Worker Turnover

- It is costly for firms to deal with turnover - in some cases, more so than paying above
the market wage
→ Paying higher wages may be profitable

Theory 3: Worker Effort

- Higher wages maker workers more eager to keep their job/scared to lose their job,
incentivizing harder work
- Harder work increases efficiency and profits

Theory 4: Worker Quality

- When a firm offers a higher wage, in theory, it demands a better applicant pool

The Monetary System

- Money: the set of assets in the economy that regularly use to buy goods and services
- Money serves 3 functions
1. It acts as a medium of exchange
2. It acts as a unit of account
3. It acts as a store value

1. Medium of exchange
- a medium of exchange is an item that buyers give to sellers when they want to
purchase a good or service

2. Unit of Account
- The yardstick people use to post prices and record debts
- You don’t go to a store and see the price of a sandwich as “4 coffees”
→ you would see it reflected it dollar values

3. Store of Value
- an item that people can use to transfer power from the present to the future

Fiat vs. Commodity Money

- Money can either have intrinsic value or no intrinsic value
- money without intrinsic value is called fiat money
- the value of fiat money is based on the value the gov’t assigns to it
- Commodity money does have intrinsic value
- ex. Gold
- Money is backed by gold or convertible to gold on demand is operating under a
gold standard

The Bank of Canada

- The BoC is Canada’s central bank
- Role: to regulate the quantity of money in the economy

BoC’s Core Functions

 1. Monetary policy: BoC aims to keep inflation low, stable and predictable
2. Financial System: BoC promotes safe, sound and efficient financial systems wihtin
Canada and internationally
3. Currency: BoC designs, issues and distributes Canada’s bank notes
4. Funds management: BoC acts as a fiscal agant for the Gov’t of Canada, managing its
public debt programs and foreign exchange reserves

The BoC’s 4 Jobs

1. Issues currency
2. Is the banker to commercial banks
3. Is a banker to the Canadian government
4. Controls the money supply in Canada through monetary policy

Monetary Policy
- Monetary policy is the setting of the money supply by policymakers in the central
bank
- BoC does this inorder to keep inflation low, stable and predictable.

Money multiplier
- The amount of money that the banking system generates with each dollar of reserves
is called the money multiplier

1
𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 𝑟𝑎𝑡𝑖𝑜

The BoC Toolkit

1. open-market operations
2. changes in reserve requirements
3. changes in the overnight lending rate

- If a commercial bank does not have enough in its deposits to cover reserves, it can borrow
from the BoC
- BoC doesn’t provide loans for free - it charges interest
- That interest rate is called the bank rate
- If commercial banks have a positive balance in their account with the BoC, the BoC pays
the commercial bank the bank rate minus 50 basis points (pre-2020)
- This is also called the deposit rate

The Opertating Band pre-2020

- The “50 basis-point” span is called the operating band
- The overnight rate is the rate of interest on very short-term loans between
commercial banks
- tends to stay very close to the centre of the operating band

The operating band post-2020

- the operating band is one-quate of a percentage point wide
- the deposit rate is currently equal to the target overnight rate
- this is called a floor system

1. Open-Market Operations
- Central banks can also increase the supply of money by purchasing things in the
markets
- they can decrease by selling things
- the BoC can reasonably buy or sell anything, but tends to operate in the government
bonds market

2. Changing Reserve Requirements

- Some central banks regulate the amount of deposits that banks must retain in
reserves.
- an increase in the reserve requirements lowers the money multiplier, and decreases
the money supply
- The BoC does not use the reserve ratio requirements b/c some financial institutions
are not bound by these ratio req. - which may give unfair advantages in open market

Inflation in a classical context

- Inflation: increase in price level in an economy
- let P = price level in the economy
-> P measures the number of dollars to buy basket of goods and services
- quantity of goods and services that $1 can buy is 1/P

Monetary Equilibrium
- Money supply → $ given by BoC
- Money Demand → The quantity of $ that people want to hold in liquid form
- “liquid form”: money we can use to make a purchase
Effects of an increase in Money supply

- Decreasing the value of money

- increasing the equilibrium price levels

The Quantity Theory of Money

- States that the quanity of money in an economy influences the value of money, and
growth in the quantity of money is the primary cause of inflation

Monetary
- Real variables are variables that are measured in physical units
- the price of a tonne of cone is 2 tonnes of wheat, this is now a relative
price and is a real variable
 - Nominal variables are measures in monetary units
- Corn is $200 per tonne and wheat is $100 per tonne
- Influnced by monetary system
*** Prices are nominal, while relative prices are real ***

Monetary Neutrality
- In a classical context, changes in money supply affect nominal variables but not
real variables

Velocity of Money and the Quantity Equation

Velocity of money
V = (P * Y)/M
- Velocity of money is measured by dividing nominal GDP by the quantity of money

Quantity Equation
M*V=P*Y
- Relates the quantity if money to the nominal value of output
Trade balance(Net exports): value of a nations exports minus value of imports
-> Imports and exports are influenced by tastes, prices, exchange rates, income,
cost of transportation, politics, etc

Trade Surplus: Exports > Imports

Trade Deficit: Imports > Exports
Blanced Trade: Exports = Imports

Net Capital Outflow = Purchase of foreign assets by domestic residents - Purchase of

domestic assets by foreign residents

*** NX = NCO ***

Y = C + I + G + NX
Y - C - G = NX + I
→Y - C - G: Savings

S = I + NX
→ NX = NCO
S = I + NCO → NCO = S - I

Trade Deficit Balanced Trade Trade Surplus

Exports < Imports Exports = Imports Exports > Imports

 NX < 0; (-) NX = 0 NX > 0; (+)

Y<C+I+G Y=C+I+G Y>C+I+G

Saving < Saving = Investment Saving > Investment

Investment

NCO < 0; (-) NCO = 0 NCO > 0; (+)

Exchange Rates
- Nominal Exchange Rate: the rate at which a person can trade the currency of
one country for the currency of another
- Real exchange rate: rate at which a person can trade with goods and services
of one country for the goods and services of another

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 × 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒

𝑟𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 = 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒

Purchasing-power parity: a theory that economists developed to explain how

currencies around the world appreciate and depreciate
- States that price of a good should stay the same regardless of location
- According to this the nominal exchange rates between 2 countries mus reflect diff
price levels in those countries
- P* → Price of foreign basket of goods
- e → nominal exchange rate
- P → Price level at home
- Purchasing power of $1 at home is 1/P
- Abroad $1 can be exchanged into e units of foreign currency ($1
has the purchasing power of e/p*)
1 𝑒 𝑒𝑃 𝑃*
𝑃
= 𝑃*
→ 1= 𝑃*
→ 𝑒 = 𝑃

Perfect capital mobility: people in a small open economy have access to the financial
markets of the rest of the world
- r = rW → interest rate parity

Small Open Economy - Three Important Assumptions

1. We take the economy’s GDP as given
2. We take the economy’s price level as given
3. We take the real interest rate as given

The Market for Loanable Funds in an Open Economy

S = I + NCO
or,
Saving = domestic investment + net capital outflow

rW > r
- world interest rates are higher than domestic interest rates
- Demand for I is less than supply of S
rW < r
- World interest rates are lower than domestic interest rates
- Demand for I > supply of S
- NCO is a negative number, indicating a net purchase of Canadian assets by
foreigners

Market for Foreign Currency Exchange

S = I + NX
Or,
S - I = NX

S - I → quantity of dollars supplied in the foreign currency exchange market to buy

foreign assets
NX → quantity of CAD $ demanded to buy Canadian net exports for goods and services
 - If real exchange rate was below equilibrium, quantity of dollars supplied would
be less than the quantity demanded
- Results in shortage, pushes the value of the dollar up
- If real exchange rate is above equilibrium level, quantity of dollars supplied
exceeds the quantity of dollars demanded
- Surplus of dollars, value of the dollar would be driven down
- At equilibrium, demand for dollars to buy net exports balances the supply of
dollars to be exchanged into other currencies

NCO is the link between the market for loanable funds and the market for foreign
currency exchange
 - NCO has decreased → supply of CAD in the foreign exchange market has
decreased
- This causes real exchange rate to increase → which means the CAD has
appreciated
- Net exports fall

Model of Aggregate Demand and Aggregate Supply

- There are fluctuations around the long-term mean of the economic activity
- Cause by several factors within and outside the economy
- Recession: a period of declining real income and rising unemployment.
- Period of negative economic growth
- Depression: severe recession

Properties of Economic Fluctuations

1. Economic fluctuations are largely unpredictable
2. Most observable macroeconomic variables fluctuate at he same time
3. A general trend emerges: as output falls, unemployment increases

AD/AS Model
1. Output of goods and services (real GDP)
- X-axis variable
2. Price levels (CPI or GDP Deflator)
 - Y-axis variable

The Aggregate Demand (AD) Curve

- Y = C + I + G + NX
- Each of these contributes to AD
- Assume that gov’t expenditures is fixed

Wealth effect: relationship between consumption and price levels

- Increase in price levels → consumers less wealthy
- Demand fewer goods and services
- Decrease in price levels → dollars has risen in value
- house holds demand more goods and services

Investment rate effect: relationship between investment and price levels

- Price level increase → demand to hold a larger quantity of money
- Things get more expensive → we need more $ to buy
- Price level fall → households tend to reduce their holdings of money
- Fall in price level
- Reduces interest rate
- Encourages more spending on investment goods
- Increased quantity of goods and services demanded

Real exchange rate effect: relationship between NXand price level

𝑒𝑃
- 𝑟𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 = 𝑃*
- P = price of Canadian basket goods
- P* = price of foreign basket goods
- e = nominal exchange rate

Why AD curve slope downward

1. Consumers are wealthier from drops in prices (in real terms)
2. Interest rates fall, which stimulates demand for investment goods
3. The exchange rate depreciates, which stimulates the demand for net exports

Shifts in Aggregate Demand

1. Changes in consumption:
- An event that makes consumers spend more at a given price level (tax cut, stock
market boom) shifts the AD curve to the right.
- An event that makes consumers spend less at a given price level (a tax hike, stock
market decline) shifts the AD curve to the left

2. Changes in investment:
- An event that makes firms invest more at a given price level (optimism about the
future, a fall in interest rates due to an increase in the money supply) shifts the
aggregate-demand curve to the right.
- An event that makes firms invest less at a given price level (pessimism about the
future, a rise in interest rates due to a decrease in the money supply) shifts the
aggregate-demand curve to the left.

3. Changes in government purchases:

- An increase in government purchases of goods and services (greater spending on
defence or highway construction) shifts the aggregate-demand curve to the right.
- A decrease in government purchases of goods and services (a cutback in defence
or highway spending) shifts the aggregate-demand curve to the left

4. Changes in net exports:

- An event that raises spending on net exports at a given price level (a boom
experienced by a major trading partner, an exchange-rate depreciation) shifts the
aggregate-demand curve to the right.
- An event that reduces spending on net exports at a given price level (a recession
experienced by a major trading partner, an exchange-rate appreciation) shifts the
aggregate-demand curve to the left.

The Aggregate Supply Curve

- Aggregate supply: the total quantity of goods and services that frims produce
and sell at any given price level
- In the long-run, aggregate supply is a vertical line
- In the short-run, aggregate supply is upward-sloping
Aggregate Supply in the Long-Run
- Output that the economy produces depends of the factors of production
- Labour
- Natural resources
- Cap`ital
- Technological knowledge

Shifts in the Long-Run AS

- LRAS is bound it shift if acted on by an outside force
- 4 channels for shifts in the LRAS curve
- 1. Labour: Any changes to the natural rate of unemployment will cause
the LRAS to shift
- 2. Capital: capital stock increases productivity in the long run
- 3. Natural resources: changes in amount of natural resources that and
economy has access to will inevitably shift the LRAS
- 4. Technological knowledge: improvement in tech increases productivity
Short-Run Aggregate Supply
- Upward sloping

Theory 1: Sticky Wage theory

- Nominal wages adjust slowly to economic conditions
- SRAS curve is upward sloping → nominal wages are based on expected prices
and don’t respond immediately when the actual price turns out to be different
than expected.

Theory 2: Sticky-Price Theory

- Prices of some goods and services adjust slowly to changes in economic
conditions
- Firms may lag behind accurately representing costs of their goods and
services

Theory 3: The Theory of Misperceptions

- Firms may be mislead about what is actually happening in the market for their
goods and services
- Matter of mistaking prices rising or falling with relative prices rising or
falling

The three theories are unified around the idea that output deviates from its natural level
when price level deviate from the price level that people expect.
 Quantity of output supplied = output (natural level) + a(ε)

Where

ε = actual price level - expected price level

And a is a coefficient measuring how much output responds to unexpected changes in

the price level

*** When people change their expectations of the price level, the SRAS curve shifts ***

Shifts in the SRAS curve

- Increase in the expected price level reduces the quantity of goods and services
supplied
- Shifts SRAS curve to the left
- A decrease in the expected price level raises the quantity of goods and services
provided
- Shifts SRAS curve to right

SRAS vs LRAS
- In short-run: expectations are fixed
- In long-run: people adjust expectations

Economic Fluctuations Caused by Shifts in AS/AD

1) Determine which curve is shifting (or both)
2) Determine which direction the shift is
3) Use a diagram to interpret what happens to Y and P in the short-run
4) Use a diagram to interpret what happens to Y and P in the long-run
Fiscal Policy: how government chooses overall purchases, or the level of taxation
- Increases G element of [Y = C + I + G + NX]

The Simple Multiplier - MPC

- The amount that households consume is calculated using the MPC (marginal
propensity to consume)

Calculating the Simple Multiplier

 1
Simple multiplier = 1 −𝑀𝑃𝐶