How to Classical and Keynesian Economists View Business Cycles? (2)

1) Classical economists say it is a beneficial way of defending against disturbances

2) Keynesian say they are not very useful since prices and wages adjust slowly

What are the characteristics of Business Cycles? (5)

What are Expansions and Contractions and what are the movements?

How is a Business Cycle displayed on a graph?

1) Fluctuating aggregate economy - based on GDP

2) Expansions and contractions - has peaks and troughs

3) Co-movement of all variables

4) Recurrent but not periodical

5) Persistence

An expansion is when aggregate economy is high.

A contraction is when aggregate economy is low

A peak is a high point on an expansion

A trough is a low point on a contraction

A peak to a trough is a business cycle

What are the key Macroeconomic Variables about Business Cycles? (2) Also list their sub-categories? (3) (3)

Give some common examples of variables? (3)

1) Direction

1) Pro-cyclical - same direction

2) Counter-cyclical - opposite direction

3) A-cyclical - direction not known

2) Timing

1) Leading - occur before cycle

2) Coincident - occur around the same time as cycle

3) Lagging - occur after the cycle

1) Production - coincident/pro-cylical

2) Expenditure - coincident/pro-cylical

3) Investment - leading/pro-cylical

1) Shocks - supply shocks like wars, terrorism and government policies

2) Model - IS-LM-FE = Aggregate Demand (AD)

What are some Factors that shift the FE line rightwards in a closed economy? (3)

What are some Factors that shift the IS curve in a closed economy? (6)

1) Beneficial supply shock

2) Increase in labor supply

3) Increase in capital stock

1) Expected future output

2) Wealth

3) Gov. expenditure

4) Taxes (always to the left or no change if anticipate)

5) MPK^f

6) Tax rate on capital (left)

(anything besides tax shifts right)

1) Money supply and demand (right/left)

2) Price level (left)

3) Expected inflation

4) Nominal interest on money

How is the price of a non-monetary asset related to interest rates?

What are some Factors that shift the LM curve? (2)

The higher the price, the lower the nominal interest rate

Inflation is inversely related to both of these.

1) Changes in money supply relative to money demand

2) Changes in money demand relative to money supply

What does a temporary supply shock do? Which curves does it shift?

What does Monetary expansion do? Which curves does it shift in short run?

It causes temporary increase in inflation, the FE curve shifts left and the LM curve then shifts to the new equilibrium

Monetary expansion results in AD increasing which triggers production and output to increase. LM curve shifts right in the short run.

What does the adjustment of price level do? What curves does it shift?

What does fiscal expansion do? What curves does it shift?

Money supply is affected and money growth is altered. LM curve shifts to the left

AD is increased which results in more production in output, IS curve shifts to the right

What influences results from short run adjustments? (2)

What are some questions about the IS-LM-FE that are debated between Classical and Keynesian? (2)

1) Multiplier effect - changes in government purchases has multi-round effects on output

2) Crowding out effect - increase in government purchases raise interest rate crowding out private investment

1) How rapidly does the economy reach general equilibrium

2) What are the effects of monetary policy on the economy

What is a Stabilization policy? 

What are some assumptions for the policies? (2)

What is money neutrality?

It is when government uses fiscal and monetary policies to shift the IS and LM curves into favorable positions

1) Closed economy

2) No expectations

When a change in money supply changes the price level proportionately but has no effect on real variables 

What does the Aggregate Demand curve show?

What are some Factors that cause the AD curve to shift? (3)

Shows the relationship between (C^d + I^d + G) and P

1) For constant price level, any factor that changes the aggregate demand for output causes AD to shift

2) For constant price level, any factor that causes the equilibrium of IS and LM to shift causes AD to shift

3) Monetary and Fiscal policies

In the IS-LM-FE Model

What happens when there is an increase in the price of oil? List all effects. (10)

1) Production goes down

2) Full employment labour goes down

3) Unemployment rises

4) Output goes down

5) FE line shifts to the left 

6) Prices go up

7) Money supply goes down

8) LM curve shifts up and left

9) Real interest rate rises as a result of the shift

10) Inflation increases temporarily

In the IS-LM-FE Model.

What happens when there is a monetary expansion?

List all effects (8)

1) Money supply increases

2) LM curve shifts down and to the right

3) Real interest rate falls as a result

4) Aggregate demand for goods increases

5) Output rises as a result

6) Prices rise

7) Money supply falls

8) The LM curve shifts back to where it was before

In the IS-LM-FE Model

What happens when there is a Fiscal Expansion?

(increase in fiscal policy)

List all effects (10)

What is the multiplier equation?

1) Government expenditure rises

2) Savings decreases

3) The IS curve shifts up and to the right

4) Real interest rate rises as a result

5) Output rises by the multiplier amount

6) Price levels rises because AD exceeds output

7) Money supply falls

8) LM curve shifts up and left

9) This results in real interest rate increasing

10) Investment falls which is a crowding out effect

Change in y/Change in G = 1/1-MPC

What is the multiplier effect?

What is the equation?

What is the crowding out effect?

The multiplier effect takes place when an increase in G causes Y to increase by a multiplied amount

Change in y/Change in G = 1/1-MPC

MPC + MPS = 1 

Keep in mind that Y = C + I + G in this case

The crowding out effect is when G increases and people want to save more, this means that they want to sell investments which results in investment being crowded out.

What are the exchange rate systems? (2)

What is the formula for the real exchange rate?

1) Flexible (floating) regime

2) Fixed (pegged) regime 

r = (i * P / P_foreign)

What is appreciation and depreciation and what do they do?

What are they associated with?

Appreciation - under nominal, nominal exch. rate rises and dollar rises in value, can buy more foreign currency

Depreciation - under nominal, can buy less foreign currency

Both are associated with flexible exchange rate regimes

What is Purchasing Power Parity and what does it imply?

Does PPP hold in short run?

Why or why not? (4)

What is the relative purchasing power parity equation?

It states that all goods, foreign or domestic should have a term where they can have same currency

It implies, i = (P_foreign / P)

where i = nominal exchange rate

It does not.

1) Transportation costs

2) Diff. characteristics

3) Production costs

4) Taxes

Change in i / i = foreign inflation - domestic inflation

What is the relationship between real interest rate and net exports?

What are the reasons to demand CAD? (2)

What are the reasons to supply CAD? (2)

Inverse relationship, as one increases the other falls

1) Buy Canadian goods

2) Buy Canadian real and financial assets

1) To buy foreign goods

2) To buy real and financial assets from foreign countries

What are the effects of a change in output (income)? (3)

What are the effects of a change in export quality? (1)

What are the effects of a change in real interest rate? (4)

1) Domestic currency depreciation -> exch. rate falls

2) foreign output increase -> net exports rise

3) domestic currency appreciations -> exch. rate rises

1) Quality of Canadian goods increase, foreigners demand more and demand for CAD rises

1) Country's real and fin. asset (investment) rises

2) Demand for currency goes up, exch rate appreciates

3) After domestic real int. rate goes up, appreciation makes net exports get reduced

4) If foreign country's real int. rate rises, demand for currency and exch. rate fall and net exports rise

What is Interest rate parity?

What are the sources of gain? (2)

If you have two investments that are domestic and foreign, they should have the same returns given that they have the same risk and liquidity.

1) Interest rates

2) Appreciation of foreign currency

What is the interest rate parity condition equation?

What is the gross expected return condition equation?

(i / i_future) * (1 - i_foreign) = 1 + i

(1 + i_foreign) * (i/i_future)

i_future = the expected future value of i

In an open economy, what does the addition of NX do?

What is the goods market equilibrium (IS) in the IS-LM-FE model in an open economy?

Changes in NX shift the IS curve.

S^d - I^d = NX

1) Any factors that change real interest rate that clears the goods market at a constant level of output (G, T, etc.)

2) Any factors that changes NX, given Y

What is the Mundel-Flemming model?

What are the effects in the entire model? (6) 

It is a model based around fiscal expansion in the IS-LM-FE model with a flexible exchange rate.

1) Increase in G = crowds out NX

2) Shifts IS to the right

3) since r increases, demand for CAD rises

4) i increases and NX falls

5) IS curve shifts left back to where it was

6) No change in Y and P, crowding out effect of NX

What are the effects of a Monetary expansion in SR? (4)

What are the effects of a Monetary expansion in LR? (5)

*LR continues from SR

1) Increase in M, LM curve shifts right

2) since r decreases, demand for CAD decreases

3) i decreases and NX rises

4) IS curve shifts right

1) Since Y is higher, P increases

2) LM shifts left

3) Since r increases, demand for CAD increases

4) i increases and NX falls

5) IS curve shifts left

Keynesian and Classical both agree that fiscal policies change nothing in LR or SR

Keynesian says that in LR, monetary expansions raise the price level (p)

What is the idea behind fixed exchange regime and how is it valued?

What control does the government have under valuation? (3)

If i (enom) is higher then what is determined by markets then it is overvalued

If overvalued:

1) Devalue its nominal fixed exch. rate

(bring it down)

2) Restrict international transactions

(make its currency non-convertible)

3) Buy back its currency in foreign markets

(buy surplus = deplete official reserves for local currency)

What is a Speculative turn?

What effects does a Monetary policy have in a fixed exchange rate regime? (2)

Is a Monetary policy effective?

What effects does a Fiscal policy have in a fixed exchange rate regime? (3)

What are the results on econ. variables in the Fiscal Policy during LR?

1) Increase in M, shifts LM right

2) r is below, exchange rate overvalued

*Opposite for decrease in M

*Can't use Monetary policy for Macro stabilization goals

1) Increase in G, shifts IS right

2) r is above, exchange rate is undervalued

3) Monetary policy can be used to offset, LM curve will shift to the right as a result.

*Opposite for decrease in G

1) P increases

2) i increases 

3) NX falls -> Crowded out

What is the supply of money affected by? (3)

How does the government convince people that paper money has value?

1) Central banks

2) Depository institutions

3) The public

By offering a legal tender meaning that people are required to accept it in settlements of debts

What are the types of reserve banking? (2)

What is the positive from the second type?

1) 100% reserve - bank reserves = deposits

2) Fractional-reserve - only a fraction of the deposits are in reserves

Positive from fractional is that the value will be higher due to the multiplier, money will accrue more money.

What is a Bank Run

What is a Bank Panic

When everyone wants to withdraw their money but the bank is not capable of withdrawing

(perhaps fractional reserves?)

When all the banks are facing a bank run

What is the money supply equal to when there is no currency held by the public?

What is the currency-deposit ratio?

What is the multiplier that affects money supply? (Equation)

M = DEP = BASE/res

where, DEP = deposits, res = RES/DEP and RES = reserves

M/BASE = [(CU/DEP) + 1 / (CU/DEP) + (RES/DEP)]

M = [(cu + 1) / (cu + res)] * BASE

What is the prime rate?

What are the functions of a bank? (2)

The interest rate that commercial banks charge their most credit-worthy customers

1) Hold money

2) Make loans

What are the functions of the Bank of Canada? (5)

What assets does the Bank of Canada have? (2)

What liabilities? (1)

1) 'Bankers' bank

2) Issue currency (fiat money)

3) Fiscal agent

4) Supervising chartered banks

5) Regulate supply of money (policy)

1) Securities

2) Advances to chartered banks

1) Reserves

What are the goals of Monetary policy? (3)

What are the tools of Monetary policy? (2)

1) Keep inflation low, stable and predictable so we can moderate business cycles, keep FE and sustained growth

2) Altering money supply to influence interest rates

3) Inflation rate target of 1-3% annually

1) Open market operations (buy/sell assets)

2) Bank of Canada buying bonds from chartered banks

What happens when the Bank of Canada buys bonds from chartered banks?

What is the Bank rate?

What is the Overnight lending rate?

Chartered banks have more reserves, banks increase in lending and thus money supply increases

The bank rate is the rate that the bank of Canada charges to chartered banks

The overnight lending rate is the upper end of the bank rate given for one day if necessary

What happens in an Expansionary Monetary policy (easy money policy)? (6)

When should this type of policy be used?

1) Bank of Canada sells securities

2) Increase money supply

3) Decreases interest rates

4) Consumption and Investment increase

5) AD increases

6) NX increases so AD increases even more

During a recession or when trying to lower target for overnight lending

What happens during a Restrictive Monetary policy (tight money policy)? (3)

When should this be used?

1) Bank of Canada sell securities

2) Increase money supply

3) Decrease interest rates

When trying to control inflation

Who supports having rules for Banks? Why? (2)

Who doesn't support banks having rules? Why?

Classical and Monetarists support having rules

1) More credibility for the bank

2) More credibility for when they use policies

Keynesian says that it reduces flexibility and makes things risky

i = π + 0.02 + 0.5y + 0.5(π - 0.02)

i = nominal overnight interest rate

π = rate of inflation from past 4 quarters

y = (Y - Ybar) * Ybar = percentage of deviation from FE Y

What are the advantages that Monetary has over Fiscal policy? (2)

What are the problems and complications with Monetary policy? (2)

1) Speed and flexibility

2) Isolation from political pressure

1) Lags

2) Cyclical asymmetry and liquidity trap

(Liquidity trap is when money supply increases but prices level and inflation remain unchanged)

What is the Net Exports effect?

What is an Operational Twist?

The net exports effect is what helps strengthen Monetary policies in both types and Fiscal policies. NX affects the IS and AD curves to make it shift a little extra forward or backwards.

An operation twist is when you sell short term bonds for long terms bonds to increase real interest rates.

(can be risky)

During Revenue-Spending, how is the Government Budget classified? (2)

What does the Built-in Stabilizer do?

1) If less then 0 then there is a budget surplus

2) If more then 0 there is a deficit

In our taxation system, it causes increases and decreases in the government budget so it can correct itself

What does the open economy Trilemma state that a country can have? (3)

How many can be applied to a country?

What contributes to unemployment? (2)

What is labor hoarding? What is it used to defend?

1) Fixed exchange rate

2) Free capital flow

3) Independent monetary policy

You can only have 2 out of the 3

1) All workers are the same

2) Skills, different skills (mismatch b/w workers and firm)

Keeping workers during a recession, it is used to defend against the claim of pro-cyclical labor productivity (prices are sticky so they can't be pro-cyclical unless hoarding)

What are the factors that play in on Monetary policies? (2)

Explain them in great detail.

In the Real Business Cycle theory, what causes business cycles? What types? (4)

1) Causality - anticipated Md to increase, this puts downward pressure on price (P), Money supply rises

2) Misperception theory - we have rational expectations = informed and intelligent -> if something we don't expect happens then the price level (P) and aggregate supply level (AS) are higher then normal

Real shocks cause business cycles

1) Production function

2) Size of labor force

3) Real quantity of government purchases

4) Spending and saving decisions of consumers

What does a real shock do?

What does a nominal shock do?

What kinds of shocks affect the economy?

What is the Solow Residual equal to?

Real shocks shift the FE, LM and IS curves

Nominal shocks shift only the LM curve

Only productivity shocks affect the economy and cause recessions, etc.

Solow Residual = A * (U_k^α * U_n^1-α)

Where U_k = use of capital, U_n = use of labor, A represents the residual in terms of productivity

What are some rational expectations about anticipated and unanticipated monetary policy? (3)

What is the difference between an unanticipated and anticipated increase in money supply on a graph?

What is a Propagation mechanism?

1) Expectations adjust quickly

2) Prices will change quickly

3) Only unanticipated policies will have an effect

On the AD-AS graph, during an unanticipated change only the AD curve will shift during the short run. In an anticipated change both the SRAS and AD curve will shift in the short run. The SRAS will shift in the unanticipated in the long run. There is an extra shift in long run for unanticipated.

It is a mechanism that allows short-lived shocks to have long-lasting effects on the economy

What is the Keynesian approach to business cycles?

In terms of SRAS and labour contracts what needs to be emphasized? (3)

Why are wages sticky?

Emphasize prices (wages as well, W/P = w) are sticky

1) Uses nominal wages, not real wage

2) Contracts specify employment conditions and nominal wages for an extended period

3) Nominal wages are committed to for 1 to 3 years

(future state of economy is not known)

Since wages are committed to for a couple of years, firms won't just decrease wages. Instead they get rid of workers, the wages only adjust after the period is over

1) If affects the ND/NS curves on the N vs Wage graph

2) The SRAS and LRAS curve on the Y vs Price graph

(wages = prices basically)

1) Shifts AD right, P rises

2) Real wages fall, Money supply rises due to anticipation (this is the monetary policy)

3) LM curve shifts up and left, r decreases

4) Prices rise again, SRAS shifts to the left

5) Money supply falls, LM shifts back to original point

What is the difference between anticipated and unanticipated monetary policy using a Keynesian approach?

What is the difference between Classical and Keynesian approaches in monetary policy?

There are no real effects in anticipated monetary policy, in an unanticipated monetary policy price stickiness does have some effect in short run.

They are somewhat similar, Keynesian say that money is not neutral in SR but it is neutral in LR, Classical say that money is neutral in both SR and LR. 

What happens during an expansionary fiscal policy in terms of a Keynesian approach? (6)

What is the difference between anticipated and unanticipated in terms of a Keynesian approach?

1) Gov. purchases increase, AD curve shifts right

2) Increase in P causes real wage to fall, IS curve shifts right and upwards

3) LM curve also shifts slightly left because of price increase

4) Since LM shifted, r increases slightly, P increases more

5) SRAS shifts left since P is adjusting

6) Real money supply decreases and LM shifts to the left into equilibrium

In anticipated, it does nothing. In unanticipated it increases unemployment, r and output in SR, and crowds out investment and consumption in long run as well as increasing r and P.

What are Fiscal and Monetary policies referred to as?

What effects does a Fiscal policy have? (2)

Aggregate demand policies since they make the curve shift.

1) Multiplier effect - when it is working to expand output, arises because demand for goods go up and thus there are more transactions (money flowing to make more money)

2) Crowding out effect - works in opposite direction of multiplier effect, more transactions means holding more money so investment and consumption are reduced

What are some cons and criticisms about Nominal wage rigidity assumption? (3)

What are some sources to argue for price stickiness? (2)

1) Only 1/3 labor force is unionized and covered by labor contracts (does 1-3 year committed rule apply?)

2) Some contracts have cost of living adjustments (COLA) which adds to price/wage levels (different wages?)

3) According to model, predicts real wages to be counter-cyclical (output and real wage go in opposite directions?)

1) Monopolistic competition is more common then perfect competition, there is more stickiness since people are price setters

2) Menu costs are paying someone to change the label prices of goods, because it costs money firms are unwilling to change prices

What do Keynesian believe is the cause of business cycle fluctuations?

What are some policies to stabilize the economy? (2)

What are the cons of the policies? (2)

Unanticipated shocks in the Aggregate Demand curve (AD)

1) Government does nothing, let wages be sticky

2) Government policy of increase money supply and expenditures (both fiscal and monetary?)

1) Fiscal policies have lag in taking effect and are usually only used for big projects

2) Knowing where the economy is and how to effectively use monetary and fiscal policy together in order to change the economy

What did A.W Philip create? Explain what his creation does.

What is stagflation?

What did Friedman and Phelps say about the Philips curve?

He created the Philips curve, it shows a negative empirical relationship between inflation and unemployment (in %)

When unemployment and inflation are both rising

(not showing a negative relationship)

They questioned the negative relationship above.

They said that there is a negative relationship between unanticipated inflation and cyclical unemployment.

What is the difference between an anticipated and unanticipated change in inflation on the AD/AS curves?

What is the equation for the expectations-augmented Phillips curve?

An anticipated inflation means that money supply has risen and it has shifted AD by a certain amount and SRAS by the same amount. During an unanticipated inflation, the money supply increase causes AD to shift by a lot more since there is inflation attached that we don't know about. SRAS shifts by a lesser amount. (y isn't at full employment)

Π - Π^e = -h(u - ubar)

where, Π - Π^e, is the unanticipated inflation

u - ubar, is the cyclical unemployment

h, is a positive number that measure the relationship between the two

How is an increase in inflation shown on the Phillips curve?

How is an increase in unemployment shown on the Phillips curve?

How is stagflation shown on the Phillips curve?

It is shown when the curve shifts but the value of unemployment remains the same at the new level of inflation (inflation increases, u stays same = quasi-linear)

It is shown when the curve shifts but the value of inflation rate stays the same at the new level of unemployment

(quasi-linear)

It is shown when both the values of inflation and unemployment change and are no longer the same when the curve shifts

Give characteristics about the long run Phillips curve. (3)

What are the costs of Unemployment? (4)

1) It is a straight vertical line

2) Located at ubar (natural rate of unemployment)

3) Expected inflation equals actual inflation since we are at natural unemployment

1) Loss of output

2) Loss of taxes

3) Personal issues/conditions

4) Okun's law

What is Okun's law?

What else did Okun create?

What is hyperinflation?

What usually causes it?

Okun's law states that for every 1% increase in cyclical unemployment, real output (GDP) decreases by 2%

He also created the misery index and super misery index

Hyperinflation is when inflation is too high for a period of time. People are paid the same day since prices are always rising.

Something that could cause it is the gov's ability to collect taxes. If inflation starts, taxes become more and more worthless and the gov has no finances. Hyperinflation then ensues.

What are some of the costs of mild anticipated inflation? (2)

What are some costs of mild unanticipated inflation? (1)

1) Shoe-leather costs - cost of time and effort in trying to minimize your holdings of cash (not $, time/effort = getting rid of your currency, buying goods)

2) Menu costs - the cost of having to change prices

(new menu printed, pay a worker to change labels)

1) Transfer of wealth - winners: borrowers, firms, banks

losers: lenders, workers

vice versa if it is the other way around

(winners: lenders, workers)

1) Cold turkey - massive reduction in growth rate of money supply (anticipated) but could cause more unemployment

(Recommended by Classical)

2) Gradualism - Gradually decrease the money supply growth rate, less unemployment and more time to react

(Recommended by Keynesian)

3) Price and wage controls - could cause shortages (goods will get bought out fast), could be made effective with the use of monetary/fiscal policy but the banks shouldn't depend on it