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Chapter 20: Measuring GDP and EconomicGrowth

Gross Domestic Product (or GDP) is the market value o all !nal goods andservices produced in a countr" in a given time period#

$his de!nition has % parts:

• Market value• &inal goods and services• Produced within a countr"• 'n a given time period

Market alue

GDP values items at market value goods and services are valued at their marketprices# $here ore* total production is measure as the summation o each good orservice produced at market price#

&inal Goods and +ervices• GDP is the value o the fnal goods and services produced• , fnal good (or service) is an item -ought -" its !nal user during a speci!ed

time period• , !nal good contrasts with an intermediate good * which is an item that is

produced -" one !rm* -ought -" another !rm* and used as a component o a!nal good or service#

o E.cluding the value o intermediate goods and services avoidscounting the same value more than once (double-counting ). $he !nalgood alread" contains the values o the intermediate goods that make the!nal good (e#g#* a tire or truck* a chip in an iPad)

o +ome goods can -e an intermediate group in some situations and a!nal good in other situations

o +ome items that people -u" are neither !nal goods nor intermediategoods and the" are not part o GDP#

• E.amples:&inancial ,ssets (+tocks* /onds)+econdhand Goods ( sed cars or e.isting homes)

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• Note : , secondhand good was part o the GDP inthe "ear in which it was produced* -ut not in the GDP in

ollowing "ears

Produced 1ithin a Countr"

GDP measures production within a countr" domestic production

• 'n other words* onl" goods and services that are produced within a countr"counts as part o that countr" s GDP

'n a Given $ime Period

GDP measures production during a speci!c time period* normall" a "ear or a 3uartero a "ear#

• 4uarter o a 5ear is called the 3uarterl" GDP data• , ull "ear is called annual GDP data

GDP measures not onl" the value o total production -ut also total income ande.penditure

• $he e3ualit" -etween the value o total production and total income isimportant -ecause it shows the direct link -etween productivity and livingstandards

• 6ising incomes and a rising value o production go togethero $he" are two aspects o the same phenomenon: increasing

productivity

GDP and the Circular &low o E.penditure and 'ncome

GDP measures the value o production* which also e3uals total e.penditure on !nalgoods and total income#

7ouseholds and &irms

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• 7ouseholds sell and !rms -u" the services o la-our* capital* and land inactor marketso &or these actor services* !rms pa" income to households:

• 1ages or la-our services• 'nterest or the use o capital•

6ent or the use o land• Entrepreneurship receives pro!t• &irm s retained earnings pro!ts that are not distri-uted to households are

part o the household sector s incomeo 6etained Earnings can -e thought o as income that households save

and lend -ack to !rms• Aggregate Income : total income received -" households* including retained

earnings• Consumption Expenditures : total pa"ment or consumer goods and

services (goods and services that !rms sell and households -u")o E.amples: +kates* haircut

• Investments : $he purchase o new plant* e3uipment* and -uildings and theadditions to inventories

Government

• Governments -u" goods and services rom !rmso Government Expenditure : e.penditure o goods and services o the

government• Government !nance their e.penditure with taxes

o $a.es are not part o the circular 8ow o e.penditure and income• Government also make !nancial trans ers to households* such as social

securit" -ene!ts and unemplo"ment -ene!ts* and pa" su-sidies to !rmso $hese !nancial trans ers* like ta.es* are not part o the circular 8ow o

e.penditure and income

6est o the 1orld

• Exports : Goods and services sold rom the countr" o origin* to the rest othe world (9)

• Imports : Goods and services -ought -" the countr" o origin* rom the rest o the world (M)

• et E.ports ( 9) ; 9 Mo ' net e.ports are positive * the net 8ow o goods and services is rom

the !rms o the countr" o origin (Canada) to the rest o the worldo ' the net e.ports are negative * the net 8ow o goods and services is

rom the rest o the world to the !rms o the countr" o origin (Canada)

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$he circular 8ow shows two wa"s o measuring GDP#

GDP ; $otal (,ggregate) E.penditure ; $otal (,ggregate) 'ncome

$otal e.penditure on !nal goods and services e3uals GDP:

GDP ; C < ' < G < 9 = M#

$otal income e3uals the total amount paid or the use o actors o production:wages*

interest* rent* and pro!t#

&irms pa" out all their receipts rom the sale o !nal goods* so income e3ualse.penditure*

5 ; C < ' < G < (9 = M)#

1h" >Domestic? and 1h" >Gross?@

Domestic

• Domestic product is production within a countr"#• 't contrasts with national product* which is the value o goods and services

produced an"where in the world -" the residents o a nation#

Gross

• Gross means -e ore deducting the depreciation o capital#• $he opposite o gross is net* which means a ter deducting the depreciation o

capital#

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Depreciation is the decrease in the value o a !rmAs capital that results rom wearand

tear and o-solescence#

Gross investment is the total amount spent on purchases o new capital and on

replacing depreciated capital#

Net investment is the increase in the value o the !rmAs capital#

et investment ; Gross investment Depreciation

Gross investment is one o the e.penditures included in the e.penditure approachto

measuring GDP#

+o total product is a gross measure#

Gross proft * which is a !rmAs pro!t -e ore su-tracting depreciation* is one o the

incomes included in the income approach to measuring GDP#

+o total product is a gross measure#

Measuring Canadian GDP

+tatistics Canada uses two approaches to measure GDP:

B $he e.penditure approach

B $he income approach

$he E.penditure ,pproach

$he e.penditure approach measures GDP as the sum o consumption e.penditure*

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investment* government e.penditure on goods and services* and net e.ports#

GDP ; C < ' < G < (9 M)

$he e.penditure approach with data (in -illions) or 20 2:

GDP ; *00 < 2*0F2 < F*0 H H

; *% I -illion

$he 'ncome ,pproach

$he income approach measures GDP -" summing the incomes that !rms pa"

households or the actors o production the" hire J wages or la-or* interest orcapital*

rent or land* and pro!t or entrepreneurship#

'ncomes in the National Income and Expenditure ccounts are divided into two-road categories:

1ages* salaries* and supplementar" la-our incomea $he pa"ment or la-our services

- 'ncludes gross wages plus -ene!ts such as pension contri-utions2 Kther actor incomesa 'ncludes corporate pro!ts* interests* armers income* and income rom

non arm unincorporated -usinessesi $hese incomes are a mi.ture o interest* rent* and pro!t and include

some la-our income rom sel emplo"ment

Indirect Tax : ta. that is paid -" consumers when the" -u" goods and services

• 'ndirect ta. makes the market price e.ceed actor cost

Direct Tax : a ta. on income#

Subsidy : pa"ment -" the government to a producer

• &actor cost e.ceeds market price

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Note : $o get rom actor cost to market price* we add indirect ta.es and subtract su-sidies#

• Making this adLustment -rings us to Net !omestic Income at "arket #rices

Note : $o get rom net income to gross income* we add depreciation#

+tatistical Discrepanc": the gap -etween the e.penditure approach and the incomeapproach

• 't is calculated as the GDP e.penditure total minus GDP income total• Note : $he discrepanc" is never large#

ominal GDP and 6eal GDP

Nominal GDP is the value o !nal goods and services produced during a given "ear

valued at the prices that prevailed in that same "ear#

eal GDP is the value o !nal goods and services produced in a given "ear when

valued at the prices o a re erence -ase "ear#

Currentl"* the re erence -ase "ear is 200 and we descri-e real GDP as measured in

200 dollars#

$he ses o 6eal GDP

Economists use estimates o real GDP or two main purposes:

$o compare the standard o living2 $o compare the standard o living across countries

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$he +tandard o iving Kver $ime

6eal GDP per person is 6eal GDP divided -" the population#

/" using real GDP * we remove an" in8uence that rising prices and a rising cost oliving might have had on our comparison

6eal GDP per person tells us the value o goods and services that the averageperson can enLo"

$wo eatures o our e.panding living standard:

• $he growth o potential GDP per persono Potential GDP is a N-enchmarkN or how much goods each individual

can consume#• &luctuations o real GDP

Potential GDP : $he value o real GDP when all the econom" s la-our* capital* land*and entrepreneurial a-ilit" are ull" emplo"ed

• 'n other words* it is the ma.imum level o real GDP that can -e producedwhile avoiding shortages o la-our* capital* land* and entrepreneurial a-ilit"that would -ring rising in8ation

• Ideal scenario : Potential GDP ; 6eal GDP• Potential GDP per person does not grow at a constant pace

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1hat a-out the Growth 6ates (as opposed to the evel) o 6eal GDP perCapita@

1e calculate the annual percentage change o real GDP per person:

; Growth 6ate o 6eal GDPOGrowth 6ate o the Population

N6eal GDP per person grows onl" i real GDP grows !aster than the populationgrows#N

Note : $he ule o! "# states that the num-er o "ear its takes or the level o avaria-le to dou-le is appro.imatel" 0 divided -" the annual percentage growth

rate o the varia-le#

N't s ok to -e poor* as long as "ou re growing at an increasing rate* and are a-le tocatch upN

Productivit" Growth +lowdown

•

$he growth rate o real GDP per person slowed a ter 0

7ow Costl" was that slowdown@

$ucas %edge : the dollar value o the accumulated gap -etween what real GDPwould have -een i the H0s growth rate had persisted and what real GDP turnedout to -e#

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/usiness C"cle

&usiness Cycle : a periodic -ut irregular up and down movement o totalproduction and other measures o economic activit"#

Ever" C"cle has two phases:

E.pansion2 6ecession

,nd two turning points:

Pea' : highest point o the -usiness c"cle2 Troug( : lowest point o the -usiness c"cle

Expansion : a period during which GDP increases rom a trough to a peak

ecession : a period which real GDP decreases its growth rate is negative or atleast two successive 3uarters

$he +tandard iving ,cross Countries $wo pro-lems arise in using real GDP to compare living standards across countries:

$he real GDP o one countr" must -e converted into the same currenc" units asthe real GDP o the other countr"

2 $he goods and services in -oth countries must -e valued at the same prices

Purc(asing Po)er Parity (PPP prices): the same prices or -oth countries (-eingassessed)

imitations o 6eal GDP

6eal GDP measures the value o goods and services that are -ought in markets#

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+ome o the actors that in8uence the standard o living and that are not o part oGDP are:

• 7ousehold Production ; ND'5 ,ctivitiesN or on market activitieso $he omission o household production rom GDP means that GDP

underestimates total productiono Growth rate o GDP overestimates the growth rate o total production

• $he reason is that some o the growth rate o market production(included in GDP) is a replacement or home production# $here ore*part o the increase in GDP arises rom a decrease in homeproduction

• nderground Economic ,ctivit" ; N+hallow Economic ,ctivit"N ;Q 'llegaltrades (/lack Market)

o 't is economic activit" hidden rom the view o the government to avoidta.es and regulations or -ecause the activit" is illegal

o /ecause it is unreported* it is omitted rom GDP• 7ealth and i e E.pectanc"• eisure $ime ; N,n economic good that contri-utes to our well -eing and the

standard o livingNo Kther things remaining the same* the more leisure we have* the -etter

oR we areo 1orking time is valued as a part o GDP* -ut leisure time is noto eisure time must -e at least as valua-le to individuals as the wage

that is earned or the last hour worked# Ktherwise* we would work insteado taking leisure#

• Environmental 4ualit"o Economic activit" directl" in8uences the 3ualit" o the environmento 6esources used to protect the environment are valued as part o the

GDP• Political &reedom and +ocial Sustice ; 7uman 6ights issues

Note : GDP is onl" a t"pe o measure### $here is no per ect measure in the world#

T(e &ottom $ine

•

Do we get an inaccurate a-out the level and growth o economic well -eingand the standard o living -" looking at the level and growth o real GDP@• $he in8uences omitted rom 6eal GDP are pro-a-l" large• 't is possi-le to construct -order measures that com-ine the man" in8uences

that contri-ute to human happiness• Descri-e all the alternatives* real GDP per person remains the most widel"

used indicator o economic well -eing

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Chapter 2 : Monitoring So-s and 'n8ationEmplo"ment and nemplo"ment

1h" nemplo"ment is a Pro-lem

nemplo"ment results in:

• ost incomes and productiono $he loss o Lo-s -rings a loss o income and lost production#o ost production means lower consumption and a lower investment in

capital* which lowers the living standard in -oth the present and the uture• ost human capital

o 'n Canada* an Employment Insurance e.istsT however* "ou mustwork around 00 to 00 hours -e ore receiving these -ene!ts ( alues andre3uirements ma" var" -ased on location)# Giving a limited time period toclaim these -ene!ts creates an incentive to work harder in !nding a Lo-#Ktherwise* individuals ma" -ecome dependent on the emplo"mentinsurance#

• ,mount received is not ver" muchT a raction o what waspreviousl" earned#

o

$he cost o lost human capital is particularl" acute or older workerso Governments make strenuous eRorts to measure unemplo"mentaccuratel" and to adopt policies to moderate its level and ease the pain

a-or &orce +urve"

+tatistics Canada conducts a monthl" la-or orce surve" to determine the status othe Canadian la-or orce

$he population is divided into two groups:

$he working-age population the num-er o people aged "ears and olderwho are not in Lail* hospital* or some other institution

2 People too "oung to work (under "ears o age) or those who live ininstitutions

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$he working-age population is divided into two groups

People in the la-our orce2 People not in the la-our orce

$he labor !orce is the sum o emplo"ed and unemplo"ed workers#

• $he emplo"ed are either ull time or part time workers• Part time workers are either voluntar" or involuntar" part time workers#

$o -e counted as unemplo"ed* a person must -e availa-le or work and must -e inone o the ollowing three categories:

1ithout work -ut has made speci!c eRorts to !nd a Lo- within the previous ourweeks

2 Kn temporar" la"oR with an e.pectation o recallF 7as a new Lo- within our weeks

&our a-or Market 'ndicators$he unemplo"ment rate

2 $he involuntar" part time rateF $he la-or orce participation rate% $he emplo"ment to population rate

$he unemployment rate is the percentage o the la-or orce that is unemplo"ed#

a-or &orce ; um-er o people emplo"ed < um-er o people unemplo"ed

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Involuntary Part*Time ate : the percentage o the people in the la-or orce whowork part time -ut want ull time Lo-s

$abor +orce Participation ate : the percentage o the working age populationwho are mem-ers o the la-our orce

Employment*to*Population atio : the percentage o the working agepopulation who have Lo-s

,t(er Defnitions o! -nemployment

$he purpose o the unemplo"ment rate is to measure the underutiliUation o thela-or resources#

+tatistics Canada -elieves that the unemplo"ment rate gives a correct measure#

/ut the oVcial measure is an imper ect measure -ecause it e.cludes three t"pes ounderemployed la-our:

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• Discouraged searchers• ong term uture starts• 'nvoluntar" part timers

Discouraged %or'er.Searc(er : a person who is currentl" neither working norlooking or work -ut has indicated that he or she wants or is availa-le or a Lo- andhas looked or work sometime in the recent past -ut has stopped looking -ecause o repeated ailure#

• $he oVcial unemplo"ment measure e.cludes discouraged searchers -ecausethe" haven t made speci!c eRorts to !nd a Lo- within the past our weeks# 'n allother aspects* the" are unemplo"ed

$ong*term +uture Starts : , person with a Lo- to start in more than our weeks isnot counted as part o the la-or orce#

• $he economic diRerence -etween someone who starts a new Lo- within ourweeks and someone who starts arther in the uture is slight and is a potentialsource o underestimating the true amount o unemplo"ment

/Involuntary0 Part*time %or'ers : 'ndividuals who would like ull time Lo-s andcan t !nd them are not counted as unemplo"ed#

• $he individuals are part time workers who would like ull time Lo-s -ut can t!nd them

1ost Costly -nemployment

,ll unemplo"ment is costl"* -ut the most costl" is long term unemplo"ment thatresults rom 2ob loss

• $he unemplo"ment rate does not distinguish among the diRerent lengths ounemplo"ment spells

• ' most unemplo"ment is long term* the situation is worse than i most areshort term Lo- searchers

-nemployment and +ull Employment

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nemplo"ment can -e classi!ed into three t"pes:

• &rictional unemplo"ment• +tructural unemplo"ment• C"clical unemplo"ment

+rictional -nemployment : unemplo"ment that arises rom normal la-or marketturnover (i#e#* people entering and leaving the la-our orce and rom the creationand destruction o Lo-s)

• $he creation and destruction o Lo-s re3uires that unemplo"ed workerssearch or new Lo-s and or -usiness to search or workers

• &rictional nemplo"ment is a permanent and health" phenomenon in ad"namic* growing econom"

&actors that ma" in8uence the siUe o rictional unemplo"ment:

• 'ncreases in the num-er o people entering and re entering the la-our orce• 'n ormational availa-ilit"• GovernmentOpu-lic policies:

o 'ncreases in unemplo"ment -ene!ts raise rictional unemplo"ment• $he more generous the policies are* the longer the rictional

unemplo"ment will last### on working individuals (who are eligi-leor Emplo"ment /ene!ts) are motivated to continue to rel" on the

-ene!ts* thus losing motivation to re enter the work orce#o 6egulations

Structural -nemployment : unemplo"ment created -" changes in technolog" andinternational competition that change the skills needed to per orm Lo-s or thelocation o Lo-s#

•

NMarket 'nnovationN• +tructural unemplo"ment lasts longer than &rictional unemplo"ment -ecauseworkers must retrain and possi-l" relocate to !nd a Lo-

• , growingOprosperous econom" must consider this t"pe o emplo"ment# $here is alwa"s a chance that the econom" ma" shi t due to the continualgrowth and development in technolog"Ocompetition

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• +tructural nemplo"ment is pain ul* especiall" or older workers or whom the-est availa-le option might -e to retire earl" or take lower skilled* lower pa"ing

Lo-s• E.amples: $a.is vs# -er* 6etail /ook +tores vs# Knline /ookstores vs# E

6eaders* $"pewriters vs# Computers

Cyclical -nemployment : the higher than normal unemplo"ment at a -usinessc"cle trough and lower than normal unemplo"ment at a -usiness c"cle peak#

• E.ample: worker who is laid oR -ecause the econom" is in a recession and isthen rehired when the e.pansion -egins e.perience c"clical unemplo"ment#

3Natural3 -nemployment

Natural -nemployment : the unemplo"ment that arises rom rictions andstructural change when there is no c"clical unemplo"ment

• atural unemplo"ment is all rictional and structural unemplo"ment• Natural -nemployment ate : natural unemplo"ment as a percentage o

the la-our orce

+ull Employment : the situation in which the unemplo"ment rate e4uals the

natural unemplo"ment rate#

• 1hen the econom" is at ull emplo"ment* there is no c"clical unemplo"mentor* e3uivalentl"* all unemplo"ment is rictional and structural#

$he natural unemplo"ment rate changes over time and is in8uenced -" man"actors#

$ey %actors :

• $he age distri-ution o the populationo ,n econom" with a "oung population has a large num-er o new Lo-

seekers ever" "ear and has a (ig( level o! !rictional unemploymento ,n econom" with an aging population has ewer new Lo- seekers and a

lo) level o! !rictional unemployment• $he scale o structural change

o $he scale o structural change is sometimes small* -ut sometimesthere is tec(nological up(eaval

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o $he amount o structural unemplo"ment 8uctuates with the pace andvolume o technological change and the change driven -" !erceinternational competition* especiall" rom ast changing ,sian economies

• $he real wage rateo $he natural unemplo"ment rate is in8uenced -" the level o the real

wage rate• Nominal : $he W o dollars "ou receive per hour• eal : $he W o goods and services that "ou can reall" get out

the amount o dollars "ou earn per hour

Note : ,n individual ma" -e rich in nominal terms* -ut can -e poor in real terms#

o 6eal wage rate that -ring unemplo"ment are minimum )age ande5ciency )age

• E5ciency %age : a wage set above the going market wage to ena-le!rms to attract the most productive workers* get them to work hard*and discourage them rom 3uitting

• nemplo"ment -ene!tso nemplo"ment -ene!ts increase the natural unemplo"ment rate -"

lowering the opportunit" cost o Lo- searcho E.tending unemplo"ment -ene!ts increases the natural

unemplo"ment rate

eal GDP and -nemployment ,ver t(e Cycle

Potential GDP : the 3uantit" o real GDP produced at ull emplo"ment

• Potential GDP corresponds to the capacit" o the econom" to produce outputon a sustained -asis

,utput Gap : the gap -etween real GDP and potential GDP

6eal GDP Potential GDP ; K $P $ G,P

Note : Kver the -usiness c"cle* the output gap 8uctuates and the

unemplo"ment rate 8uctuates around the natural unemplo"ment rate#

Conditions or Kutput Gap

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• 1hen the econom" is at !ull employment * the unemplo"ment rate e3ualsthe natural unemplo"ment rate and real GDP e3uals potential GDP * so theoutput gap is 6ero

• 1hen the unemplo"ment rate is less than the natural unemplo"ment rate*real GDP is greater than potential GDP and the output gap is positive

• 1hen the unemplo"ment rate is greater than the natural unemplo"mentrate* real GDP is less than potential GDP and the output gap is negative

Summary7

nemplo"ment 6ate ; aturalnemplo"ment 6ate

(&ull Emplo"ment)

6eal GDP ; PotentialGDP

Kutput Gap is8ero

nemplo"ment 6ate X aturalnemplo"ment 6ate

6eal GDP Q PotentialGDP

Kutput Gap isPositive

nemplo"ment 6ate Q aturalnemplo"ment 6ate

6eal GDP X PotentialGDP

Kutput Gap isNegative

Price $evel9 In:ation9 De:ation

$he price level tells "ou a-out the value o the mone" in "our pocket#

1e are interested in the price level -ecause we want to:

Measure the annual percentage change o the price level in8ation rate or thede8ation rate

2 Distinguish -etween mone" values and real values o economic varia-les

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In:ation is a persistent rise in the level o prices

De:ation is a persistent all in the level o prices

%(y In:ation and De:ation Are Problems

ow* stead"* and anticipated in8ation or de8ation is NnotN a pro-lem

npredicta-le in8ation or period o de8ation is a pro-lem -ecause it:

• 6edistri-utes incomeo 1orkers are worse oR with an une.pected -urst o in8ation -ecause

their wages -u" less than the" -argained or and emplo"ers are -etter oR-ecause their pro!ts rise

o ,n une.pected period o de8ation has the opposite side eRect:• 1orkers are -etter oR with an une.pected -urst o de8ation

-ecause their !.ed wages -u" more than the" -argained or andemplo"ers are worse oR with lower pro!ts

• 6edistri-utes wealtho 1ith an une.pected -urst o in8ation* the mone" that the -orrowers

repa" to the lenders -u"s is less than the mone" originall" loaned• $he -u"er wins and the lender loses• $he interest paid on the loan does not compensate the lender

or the loss in the value o the mone" loanedo 1ith an une.pected -urst o de8ation* the mone" that the -orrowerrepa"s to the lender -u"s more than the mone" originall" loaned

• $he -orrower loses and the lender wins• owers real GDP and emplo"ment

o ne.pected in8ation that raises !rms pro!ts -rings a rise ininvestment and a -oom in production and emplo"ment

• 6eal GDP e.ceeds Potential GDP• nemplo"ment 6ate alls -elow atural nemplo"ment 6ate• /ut the situation is temporary

Pro!ta-le investment dries up+pending alls

6eal GDP alls -elow potential GDPnemplo"ment 6ate rises

Note : ,voiding these swings in production and Lo-s means avoiding une.pectedswings in the in8ation rate#

o ,n une.pected de8ation has even greater conse3uences or real GDP and Lo-s#

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• /usinesses and households that are in de-t (-orrowers) are worse oRand the" cut their spending#

• , all in total spending -rings a recession and rising unemplo"ment#• Diverts resources rom production

o npredicta-le in8ation or de8ation turns the econom" into a casino

and diverts resources rom productive activities to orecasting in8ation• 't can -ecome more pro!ta-le to orecast the in8ation rate orde8ation rate correctl" than to invent a new product

• Pro essionals (i#e#* doctors* accountants* law"ers) stopspecialiUing and spend more time -ecoming in8ation orecasters andmanaging their investments

&rom a social perspective* the diversion o talent thatresults rom unpredicta-le in8ation is like throwing scarceresources onto a pile o gar-age

7ow a-out ,nticipated or E.pected 'n8ation@ ,n" Costs@

Cost o! Expected In:ation

• +hoe leather Costo , metaphoro $ime spent taking trips to the -ank

• 4uite costl"T "ou spend at the same rate as "ou have in "ourwallet# $his causes us to visit -anks more re3uentl" to take outmone"#

o 1hen the nominal interest rate is high* what would "ou do@o Nominal Interest ate : $he Nopportunit" costN o holding cash Yin"ou walletZ

• Menu Costo $he cost o Nre printingN "our catalogueo $he change o prices such as that o a menuO8"ero $he change in prices can cause con usion to consumers

• $a. Distortionso 1hen individuals are pa"ing ta.es when the" shouldn t -e#### /ecause

the" are neither gaining or losingo $a. rates are not adLusted properl" or changes in in8ation YratesZ

• Mone" 'llusiono

, con usion o nominal and real terms (Price Change relative toincrease in wage rates causes the con usion o prices o goods toincrease### 5et* aRorda-ilit" is still the same#)

,n" /ene!ts@

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;yperin:ation : an in8ation rate o 0 percent a month or higher that grinds theeconom" to a halt and causes a societ" to collapse

• 't is a situation where the price increases are so out o! control that theconcept o in8ation is meaningless

• 7"perin8ation is rare

$he Consumer Price 'nde. (CP')

CPI measures the average o the prices paid -" ur-an consumers or a N!.edN-asket o consumer goods and services#

eading t(e CPI Numbers

$he CP' is de!ned to e3ual 00 in the re!erence base period

• Currentl"* the re erence -ase period is 2002• $hat is* or the average o the 2 months o 2002* the CP' e3uals 00

'n Sune 20 %* the CP' was 2 #H#

• $his num-er tells us that the average o the prices paid -" ur-an consumersor a !.ed -asket o goods and services was 2 #H percent higher in Sune 20 %

than it was on average during 2002#

Constructing t(e CPI

Constructing the CP' involves three stages:

• +electing the CP' -asket• Conducting a monthl" price surve"• Calculating the CP'

$he CP' -asket is -ased on a consumer e.penditure surve"* which is undertakenin re3uentl"#

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• $he CP' -asket toda" is -ased on surve" data collected in 20 #• Each month* +tatistics Canada emplo"ees check the prices o the goods and

services in the CP' -asket in the maLor cities#

Calculating t(e CPI

&ind the cost o the CP' -asket at -ase period prices#2 &ind the cost o the CP' -asket at current period prices#F Calculate the CP' or the current period

$he idea is* CP' tells us the cost o -asket in the current period relative to the -aseperiod:

1easuring t(e In:ation ate

• , maLor purpose o the CP' is to measure changes in the cost o living and in

the value o mone"• 't is also used to measure in8ation

In:ation ate : the percentage change in the price level rom one "ear to the ne.t#

&ormula:

T(e &iased CPI

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$he CP' might overstate the true in8ation rate or our reasons:

• Commodit" +u-stitution /ias• ew Goods /ias• 4ualit" Change /ias•

Kutlet +u-stitution /ias

Commodity Substitution &ias

$he market -asket o goods used in calculating the CP' is !.ed and does not takeinto account consumersA su-stitutions awa" rom goods whose relative pricesincrease#

Ne) Goods &ias

ew goods that were not availa-le in the -ase "ear appear and* the" might -e moree.pensive than the goods the" replace#

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T(e 1agnitude o! &ias

Estimates sa" that the CP' overstates the in8ation -" 0#H percentage points per"ear

Some Conse4uences o! t(e &ias

• Distorts private contracts• 'ncreases government outla"s (close to a third o ederal government outla"s

are linked to the CP')

, -ias o 0#H percent is small* -ut over a decade adds up to -illions o dollars oadditional e.penditure

Alternative Price Indexes

,lternative measures o the price level are:

• Chained Price 'nde. &or Consumption (CP'C)o ,n inde. o the prices o all the items included in consumption

e.penditure in GDPo 's the ratio o nominal consumption e.penditure to real consumption

e.penditureo /ecause the CP'C uses current period and previous period 3uantities

rather than !.ed 3uantities rom an earlier period* it incorporatessu-stitution eRects and new goods and overcomes the sources o -ias inthe CP'

• GDP De8atoro ,n inde. o the prices o all the items included in GDPo 's the ratio o nominal GDP to real GDPo /ecause real GDP includes consumption e.penditure* investment*

government e.penditure* and net e.ports* the GDP de8ator is an inde. othe prices o all these items

$he CP'C e3uals:

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Note : PCE (Personal Consumption E.penditure) De:ator is a -roader measure othe price level than the CP' -ecause it includes all consumption e.penditures

$he GDP De8ator e3uals:

Note : GDP De8ator is like the PCE De8ator e.cept it includes the prices o all goods

and services that are counted in GDP

Core In:ation ate : the CP' in8ation rate e.cluding the volatile elements (o oodand uel)

T(e eal =ariables in 1acroeconomics

1e can use the de8ator to de8ate nominal varia-les to !nd their real values

&or e.ample*

/ut this is not the real interest rate[ 't is diRerent#

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Chapter 2F: &inance* +aving* and 'nvestment+inancial 1ar'ets

Saving is the source o the unds that are used to !nance investment

$hese unds are supplied and demanded in three t"pes o !nancial markets:

• oan marketso /usinesses o ten want short term !nance to -u" inventories or to

e.tend credit to their customerso 7ouseholds o ten want !nance to purchase -ig ticket items* such as

automo-iles or household urnishings* and appliances• $he" get -ank loans in the orm o outstanding credit card

-alanceso 7ouseholds also get !nance to -u" new homes (E.penditures on new

homes is counted as a part o investment)• $hese unds are usuall" o-tained as a loan that is secured -" a

mortgage a legal contract that gives ownership o a home to thelender in the event that the -orrower ails to meet the agreed loanpa"ments (repa"ment and interest)

• /ond marketso , bond is a promise to make speci!ed pa"ments on speci!ed dates#o &ond 1ar'et : where -onds issued -" corporations and governments

are tradedo

$erm o a /ond• ong (Decades)• +hort (Lust a month or two)

o 1ortgage*&ac'ed Security : entitles its holder to the income rom apackage o mortgages

• Mortgage lenders create mortgage -acked securities• $he holder o a mortgage -acked securit" is entitled to receive

pa"ments that derive rom the pa"ments received -" the mortgagelender rom the home -u"er -orrower

• +tock markets

,stoc'

is a certi!cate o ownership and claim to the !rm s pro!ts, stoc' mar'et is a !nancial market in which shares o stocks ocorporations are traded#

+inancial Institutions

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$he" are a -orrower in one market and a lender in another# 't is a !rm that operateson -oth sides o the markets or !nancial capital

• /ankso /anks accept deposits and use the unds to -u" government -onds

and other securities and to make loanso % domestic -anks and FF oreign -anks operate in Canada

• $rust and oan Companieso ,ccepts deposits and make personal loans and mortgage loanso ,lso administers estates* trusts* and pension plans

• Credit nions and Caisses Populaireso /anks that are owned and controlled -" their depositors and -orrowerso 6egulated -" provincial ruleso Kperate onl" inside their own provincial -oundarieso arge in num-er* small in siUe

• Pension &undso 6eceive the pension contri-utions o !rms and workerso Pension Contri-utions that are used to -u" diversi!ed port olios o

-onds and stocks (investments) that the" e.pect to generate an incomethat -alances risk and return

o $he income is used to pa" pension -ene!tso Can -e ver" large and pla" an active role in the !rms whose stock the"

hold• 'nsurance Companies

o Provide risk sharing serviceso $he" enter into agreements with households and !rms to provide

compensation in the event o an accident* the t* !re* and a host o othermis ortunes

o Make pa"ments against claimso 6eceivesOGains premiums rom customerso 'nsurance companies use the unds the" have received -ut not paid

out as claims to -u" -onds and stocks on which the" earn an interestincome

Net %ort( (o a &inancial 'nstitution) ; Market alue o 1hat it has ent Marketalue o 1hat is has /orrowed

• ' net worth is positive (

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Illi4uid : when a !rms has made long term loans with -orrowed unds and is acedwith a sudden demand to repa" more o what it has -orrowed than its availa-lecash

T(e $oanable +unds 1ar'et

$he market or loana-le unds is the aggregate o all the individual markets

&unds come rom three sources:

7ousehold saving* +2 Government -udget surplus* ($=G)F /orrowing rom the rest o the world* (M=9)

Net Taxes : the ta.es paid to governments minus the cash trans ers received romgovernment (such as social securities and unemplo"ment -ene!ts)

National Saving : the sum o private saving* +* and government saving* ($ G)

$he nominal interest rate is the num-er o dollars that a -orrower pa"s and a

lender receives in interest in a "ear e.pressed as a percentage o the num-er odollars -orrowed and lent#

• E.ample: i the annual interest paid on a 00 loan is 2 * the nominalinterest rate is percent per "ear#

$he real interest rate is the nominal interest rate adLusted to remove the eRectso in8ation on the -u"ing power o mone"#

real interest rate \ ( nominal interest rate in8ation rate )

E.ample: i the nominal interest rate is percent a "ear and the in8ation rate is 2percent a "ear* the real interest rate is F percent a "ear

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Note : $he real interest rate is the opportunity cost o loanable !unds

Note : $he real interest paid on -orrowed unds is the opportunity cost o borro)ing

Note : $he real interest &oregone when unds are used either to -u" consumptiongoods and services or to invest in new capital goods is the opportunity cost o not saving or lending t(ose !unds

T(e Demand !or $oanable +unds

$he 'uantity o& loanable &unds demanded is the total 3uantit" o unds demanded to!nance investment* the government -udget de!cit* and international investment orlending during a given period

$he 'uantity o& loanable &unds demanded depends on:

$he real interest rate2 E.pected pro!t

NKther things remaining the same* the (ig(er the real interest rate* the smaller isthe 3uantit" o loana-le unds demandedT and the lo)er the real interest rate* the

greater the 3uantit" o loana-le unds demandedN

T(e Demand !or $oanable +unds Curve

$he demand or loana-le unds is the relationship -etween the 4uantity o!loanable !unds demanded and the real interest rate when all other in8uenceson -orrowing plans remain the same#

• /usiness investment is the main item that makes up the demand or loana-leunds#

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C(anges in t(e Demand !or $oanable +unds

• 1hen the e.pected pro!t changes* the demand or loana-le unds changes• 1ith other things remaining the same* the greater the e.pected pro!t rom

new capital * the greater is the amount o investment and the greater thedemand or loana-le unds ( s(i!ts in the curve)

E.pected Pro!ts:

• 6ises during a -usiness c"cle e.pansion• &alls during a recession• 6ises when technological changes creates pro!ta-le new products• 6ises as growing population -rings increased demand or goods and services•

&luctuates with contagious swings o optimism and pessimism

T(e Supply o! $oanable +unds

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$he 3uantit" o loana-le unds supplies is the total unds availa-le rom privatesaving* the government -udget surplus* and international -orrowing during a givenperiod#

&or now* let us ocus on private saving #

7ow do "ou decide how much o "our income to save and suppl" in the loana-leunds market@

$he 3uantit" o loana-le unds supplied depends on

# $he real interest rate (Movement , K G the oana-le &unds +uppliedCurve)

o Kther things remaining the same* the higher the real interest rate* thegreater is the 3uantit" o loana-le unds suppliedT and the lower the realinterest rate* the smaller is the 3uantit" o loana-le unds supplied

2# Disposa-le income

o 'ncome Earned et $a.eso 1hen disposa-le income increases* other things remaining the same*

consumption e.penditures increase -ut -" less than the increase inincome (+ome o the increase in income is saved)

o $he greater a household s disposa-le income* other things remaining thesame* the greater is its saving

F# E.pected uture income

o $he (ig(er a household s e.pected uture income* other things remainingthe same* the smaller is its saving toda"

%# 1ealth

o $he higher a household s wealth* other things remaining the same* thesmaller is its savings

# De ault risk

o $he risk that a loan will not -e repaido $he greater the risk* the (ig(er is the interest rate needed to induce a

person to lend and the smaller is the suppl" o loana-le unds

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T(e Supply o! $oanable +unds Curve

• $he suppl" o loana-le unds is the relationship -etween the 4uantity o!loanable !unds supplied and the real interest rate when all otherin8uences on lending plans remain the same#

• +aving is the main item that makes up the suppl" o loana-le unds

C(anges in t(e Supply o! $oanable +unds

• , change in disposa-le income* e.pected uture income* wealth* or de ault

risk changes the suppl" o loana-le unds (shi t in the curve)#• ,n increase in disposa-le income* a decrease in e.pected uture income* adecrease in wealth* or a all in de ault risk increases saving and increases thesuppl" o loana-le unds#

E4uilibrium in t(e $oanable +unds 1ar'et

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$he loana-le unds market is in e3uili-rium at the real interest rate at which the3uantit" o loana-le unds

demanded e3uals the 3uantit" o loana-le unds supplied#

• ,t percent a "ear* there is a surplus o unds and the real interest rate alls#• ,t percent a "ear* there is a shortage o unds and the real interest rate

rises#• E3uili-rium occurs at a real interest rate o H percent a "ear#

C(anges in Demand

• ,n increase in e.pected pro!ts increases the demand or unds toda"#• $he real interest rate rises#• +aving and 3uantit" o unds supplied increases#

C(anges in Supply

• ' one o the in8uences on saving plans changes and saving increases* thesuppl" o unds increases#

• $he real interest rate alls#• 'nvestment increases#

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Government in t(e $oanable +unds 1ar'et

Government enters the loana-le unds market when it has a -udget surplus orde!cit#

• , government -udget surplus increases the supply o unds#o Contri-utes to !nancing investment

• , government -udget defcit increases the demand or undso Competes with -usinesses or unds

E>ect o! a Government &udget Surplus

• , government -udget surplus increases the supply o unds#• $he real interest rate !alls #• Private saving decreases #• 'nvestment increases #

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E>ect o! a Government &udget Defcit

• , government -udget de!cit increases the demand or unds#•

$he real interest rate rises #• Private saving increases #• 'nvestment decreases Jis crowded out

Special Case7 T(e icardo*&arro E>ect

• , -udget de!cit increases the demand or unds#• 6ational ta.pa"ers increase saving* which increases the suppl" o unds#• 'ncreased private saving !nances the de!cit#• Crowding out is avoided#

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Chapter 2%: 1hat is Mone"@1oney is an" commodit" or token that is generall" accepta-le as a means opa"ment#

• , means o! payment is method o settling a de-to 1hen a pa"ment has -een made* there is no remaining o-ligation

-etween the parties to a transaction

Mone" has three other unctions:

• Medium o e.change• nit o account• +tore o value

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Medium o E.change

, medium of exchange is an o-Lect that is generall" accepted in e.change orgoods and services#

• 'n the a-sence o mone"* people would need to e.change goods and servicesdirectl" or other goods and services* which is called barter #

o /arter re3uires a dou-le coincidence o wants* which is rare* so -arteris costl"

• , medium o e.change overcomes the needs or a dou-le coincidence owants

• Mone" acts as a medium o e.change -ecause people with something to sellwill alwa"s accept mone" in e.change or it#

Commodity 1oney : mone" whose value comes rom a commodit" o which it ismade (E.ample: Gold* +ilver)

+iat 1oney : does not have an" value* it does not have an" inherent or intrinsicvalueT it is onl" used or e.change

nit o ,ccount

, unit of account is an agreed measure or stating the prices o goods andservices

• NDollars and CentsN

+tore o alue

,s a store of value * mone" can -e held or a time and later e.changed or goodsand services

• ' mone" were not at store o value* it could not serve as a means o pa"ment• $he more sta-le the value o a commodit" or token* the -etter it can act as a

store o value and the more use ul it is as mone"• o store o value has a completel" sta-le value• 'n8ation lowers the value o mone" and the values o other commodities and

tokens that are used as mone"

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o $o make mone" as use ul as possi-le as a store o value* a low in8ationrate is needed#

Mone" in Canada $oda"Mone" in Canada consists o :

• Currenc" Q otes and coins held -" households and !rmso otes and coins inside -anks are not counted as currenc" -ecause

the" are not held -" individuals and -usinesseso Currenc" is convenient or settling small de-ts and -u"ing low priced

items• Deposits o individuals and -usinesses at -anks and other depositor"

institutionso E.amples: $rust and mortgage companies* credit unions* caisses

populaireso Deposits are mone" -ecause the owners o the deposits can use them

to make pa"mentso Deposits owned -" the Government o Canada are not counted as

mone" -ecause the" are not held -" individuals and -usinesses

Currency : the notes and coins held -" households and !rms

Note : Deposits are mone" -ecause owners o the deposit can use them to make

pa"ments

KVcial Measures o Mone"

$he two main oVcial measures o mone" in Canada are M and M2#

• 1? consists o currenc" and che3uing deposits held -" individuals and-usinesses

• 1@ consists o M plus all other deposits non che3ua-le deposits and !.ed

term deposits held -" individuals and -usinessesNote : M is more li3uid

,re M and M2 6eall" Mone"@

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• ,ll the items in M are means o pa"ment# $he" are money #• +ome components o M2 can easil" -e converted into a means o pa"ment

without loss in value# $he" are called li3uid assets#• $i4uidity is the propert" o -eing instantl" converti-le into a means o

pa"ment with little loss o value#•

/ecause the deposits in M2 can -e 3uickl" and easil" converted into a meanso pa"ment* the" are counted as mone"#

Deposits are Mone" -ut Che3ues ,re ot

• 'n de!ning mone"* we include* along with currenc"* deposits at -anks andother depositor" institutions#

• /ut we do not count the che3ues that people write as mone"#• , che3ue is an instruction to a -ank to trans er mone"#

Credit Cards ,re ot Mone"

• Credits cards are not mone"• , credit card is an 'D card that allows an individual to take out a loan at an

instant "ou -u" somethingo , credit card ena-les the user (or holder) to o-tain a loan* -ut it must

-e repaid with mone"

, depository institution is a !rm that takes deposits rom households and !rmsand makes loans to other households and !rms#

$"pes o Depositor" 'nstitutions:

• Chartered /anks• Credit nions and Caisses Populaires• $rust and Mortgage oan Companies

Chartered /anks

, c(artered ban' is a private !rm* chartered under the /ank ,ct o toreceive deposits and make loans

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• /" ar* chartered -anks are the largest institutions in the -anking s"stem andconduct all t"pes o -anking and !nancial -usiness

Credit nions and Caisses Populaires, credit union is a cooperative organiUation that operates under the CooperativeCredit ,ssociation ,ct o and that receives deposits rom and makes loans toits mem-ers#

• , caisse populaire is a similar t"pe o institution that operates in 4ue-ec#

$rust and Mortgage oan Companies

, trust and mortgage loan company is a privatel" owned depositor" institutionthat operates under the $rust and oan Companies ,ct o

• $hese institutions receive deposits* make loans* and act as a trustee orpension unds and or estates

1hat Depositor" 'nstitutions Do

Depositor" institutions provide service such as che3ue clearing* accountmanagement* credit cards* and 'nternet -anking (all o which provide an income

rom service ees)

$he goal o an" -ank is to ma.imiUe the wealth o its owners#

• $o achieve this o-Lective* the interest rate at which it lends exceeds theinterest rate it pa"s on deposits#

/ut the -anks must -alance pro!t and prudence:

• oans generate pro!t#• Depositors must -e a-le to o-tain their unds when the" want them#

, Chartered /ank puts the depositors unds into our t"pes o assets:

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• eserves Jnotes and coins in its vault or its deposit at the /ank o Canadao $hese unds are used to meet depositors currenc" withdrawals and to

make pa"ments to other -ankso Note : , -ank keeps a-out a hal o percent o deposits as reserves

• $i4uid Assets JCanadian Government $reasur" -ills and commercial -illso

$hese assets are the -anks !rst line o de ence i the" need reserveso i3uid assets can -e sold and instantl" converted into reserves withvirtuall" no risk o loss (earns a low interest rate)

• Securities Jlonger=term Canadian government -onds and other -onds suchas mortgage -acked securities

o $hese assets can -e converted into reserves -ut at prices that8uctuate

• /ecause the prices 8uctuate* these assets are riskier than li3uidassets* -ut also have a higher interest rate

• $oans Jcommitments o !.ed amounts o mone" or agreed upon periods otime

o /anks make loans to corporations to !nance the purchase o capitalo 6iskiest assets o a -ank

• $he" cannot -e converted into reserves until the" are due to -erepaid

• +ome -orrowers de ault and never repa"o $hese assets earn the highest interest rate

Economic /ene!ts Provided -" Depositor" 'nstitutions

Depositor" institutions make a pro!t rom the spread -etween the interest rate the"pa" on their deposits and the interest rate the" charge on their loans

Deposit 'nstitutions provide our -ene!ts:

• Credit i3uidit"o Created -" -orrowing short and lending long taking deposits and

standing read" to repa" them on short notice or on demand and makingloan commitments that run or terms o man" "ears

• Pool 6isko , loan might not -e repaid a de!ault #

• ower the cost o -orrowing• ower the cost o monitoring -orrowers

o /" monitoring -orrowers* a lender can encourage good decisions thatprevent de aults

• $his activit" is costl"#

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7ow Depositor" 'nstitutions ,re 6egulated

• $he goal o !nancial regulation is to identi "* evaluate* and lessen theconse3uences o !nancial risk

• Depositor" institutions engage in risk" -usiness#• $o make the risk o ailure small* depositor" institutions are re3uired to hold

levels o reserves and ownersA capital e3ual to or that surpass the ratios laiddown -" regulation#

• ' a Canadian -ank ails* deposits are guaranteed up to 00*000 perdepositor per -ank -" the Canada Deposit 'nsurance Corporation#

• Provincial government agencies regulate credit unions and caisses populaires

/ank o Canada

•

Central /ank the pu-lic authorit" that supervises other -anks and !nancialinstitutions* !nancial markets and the pa"ment s"stem* and conductsmonetar" polic"

• Esta-lished in F• Management +tructure

o $he /ank o Canada is:• +ole issuer o -ank notes

$he /ank o Canada is the onl" -ank that is permitted toissue -ank notes# $he /ank o Canada has a monopol" on thisactivit"#

• /anker to the -anks and government $he /ank o Canada has a restricted list o customers

• Chartered /anks• Credit nions• Caisses Populaires• $rust and Mortgage oan Companies that make up

the -anking s"stem• Government o Canada• Central /ank o other countries

$he /ank o Canada accepts deposits rom depositor"institutions that make up the pa"ments s"stem and thegovernment o Canada#

• ender o last resort $his means that it stands read" to make loans when the

-anking s"stem as a whole is short o reserves#

$he /ank o Canada s /alance +heet

$he /ank o Canada has two main assets:

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Government +ecuritiesa $reasur" /ills -ought in the -ills market

2 oans to Depositor" 'nstitutions

'ts lia-ilities are:

/ank o Canada notesa Dollar -ills that we use in our dail" transactions- +ome o the notes are held -" individuals and -usinessesT other are in the

tills and vaults o -anks and other depositor" institutions2 Depositor" 'nstitution Deposits

Monetar" /ase

• $he lia-ilities o the /ank o Canada (plus coins issued -" the Canadian Mint)orm the monetar" -ase

• $he monetar" -ase is the sum o /ank o Canada notes* coins* and depositor"institution deposits at the /ank o Canada

$he Conduct o Monetar" Polic"

$he /ank o Canada s Polic" $ools

$o achieve its o-Lectives* the /KC uses two main polic" tools:

• Kpen Market Kperationso 'nLects mone" or li3uidit" into the market

• /ank 6ateo 'nterest rate that is charged to commercial -anks rom the Central

/anko Central /ank is the N ast 6esortN

• $here ore* Commercial /anks tr" to minimiUe their loans romthe Central /ank# 6ather* the" would -orrow rom other commercial-anks when the" are short o unds

,n open mar'et operation is the purchase or sale o government securities -"the /ank o Canada rom or to a chartered -ank or the pu-lic#

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• 1hen the /ank o Canada buys securities* it pa"s or them with newl"created reserves held -" the -anks#

• 1hen the /ank o Canada sells securities* the" are paid or with reservesheld -" -anks#

+o open market operations in8uence -anksA reserves#

$he /ank o Canada makes short term loans* t"picall" one da" loans* to maLordepositor" institutions when the -anking s"stem is short o reserves#

• $he interest rate on these loans is ban' rate #o $he interest rate the /ank o Canada charges to commercial -anks or

loanso $he -enchmark o other interest rates

• &an' rate acts as an anchor or other short term interest rates and is closel"related to the /ankAs target or the overnight loans rate#

Note : an open market purchase increases -ank reserves

Note : an open market sale decreases -ank reserves

7ow (CharteredOCommercial) /anks Create Mone"

6ecall:

1oney Currency B Deposits

1 C B D

Creating Deposits -" Making oans

/anks create deposits when the" make loans and the new deposits created are newmone"

$he 3uantit" o deposits that -anks can create is limited -" three actors:

• $he Monetar" /ase (Controlled -" /KC)

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o N7igh poweredN mone"o $he siUe o the monetar" -ase limits the total 3uantit" o mone" that

the -anking s"stem can create• eason : /anks have a desired level o reserves* households and

!rms have a desired holding o currenc"* and -oth o these desiredholdings o the monetar" -ase depend on the 3uantit" o deposits#

• Desired 6eserves (Controlled -" Commercial /anks)• Desired Currenc" 7olding (Controlled -" individuals)

$he Monetar" /ase

$he monetary base is the sum o /KC notes and coins* and -anks deposits at the/KC

1& C B

Desired 6eserves

• , -ank s actual reserves consists o notes and coins in its vault and itsdeposit at the /KC

• DiRerent rom re'uired reserves * which is the minimum 3uantit" o reservesthat a -ank must hold#

• $he desired reserve ratio is the ratio o the -ank s reserves to totaldeposits that a -ank plans to hold

o $he desired reserve ratio e.ceeds the re3uired reserve ratio -" theamount that the -ank determines to -e prudent or its dail" -usiness

• $he" can hold more reserves* -ut not less than the re3uiredreserves#

Desired Currenc" 7olding

• People hold some raction o their mone" as currenc"o +o when the total 3uantit" o mone" increases* so does the 3uantit" o

currenc" that people plan to hold• ' -ank deposits increase* desired currenc" holding also increases

o $hus* when -anks make loans that increase deposits* some currenc"leaves the -anks

• $he leakage o -ank reserves into currenc" is called currency draino $he ratio o currenc" to deposits is the currency drain ratio

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$he Mone" Creation Process and the Mone" Multiplier

$he mone" creation process -egins with an increase in the monetar" -ase#

• Kccurs i the /ank o Canada conducts an open market operation in which it

-u"s securities rom -anks and other institutions

+uppose that the /KC conducts an open market operation in which it -u"ssecurities rom a -ank (sa"* Premier /ank)#

• $he /KC pa"s or the securities with newl" created -ank reserves#• Premier /ank now has more reserves ( 00) -ut the same amount o

deposits* so the" have e.cess reserves#• 'nstead o keeping the 00 in their vault or deposit at the /KC* suppose that

Premier /ank decided to loan all o it to an individual and the individual in turndeposit the 00 to /ank ,#

E.cess reserves ; ,ctual reserves = Desired reserves#

]]] ,ssume that the desired reserve ratio is 0# 0 and the currenc" deposit ratio is 0]]]

/ank , will now !nd itsel with a 00 deposit# 1hat to do with it@

• 0 o which needs to -e kept in reserve and 0 can -e loaned out#• /ank , decided to loan the 0 to another individual and the individual in

turn deposit the 0 to /ank /#

/ank / now has a 0 deposit: need to keep in reserve and loan the remainingI #

1hen the -anks make loans and create deposits* the e.tra deposits lower e.cessreserves or two reasons:

$he increase in deposits increases desired reserves2 , currenc" drain decreases total reserves

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Process o E.cess 6eserves

/anks have excess reserves2 /anks lend e.cess reservesF $he 3uantit" o mone" increases% ew mone" is used to make pa"ments

+ome o the new mone" remains on depositH +ome o the new mone" is a currency drain

Desired reserves increase -ecause deposits have increasedI E.cess reserves decrease

Note : ' the /ank o Canada sells securities in an open market operation* then-anks have negative excess reserves the" are short o reserves

• 1hen the -anks are short o reserves* loans and deposits decrease and theNProcess o E.cess 6eservesN (listed a-ove) works in a downward direction untildesired reserves plus desired currenc" holding has decreased -" an amounte3ual to the decrease in monetar" -ase

De!ne:

• Mone" as the sum o currenc" and che3ua-le deposits: M ; C < D•

Monetar" -ase as the sum o currenc" and reserves: M/ ; C < 6

$ake the ratio: MOM/ ; (C < D) O (C < 6)

Divide -oth numerator and denominator o the right hand side -" D:

1.1& /C.D B ?0 . /C.D B .D0

1here: COD is the currenc" deposit ratio or currenc" drain ratio

6OD is reserve deposit ratio or desired reserve ratio

$here ore* M ; M/ ] Y (COD < ) O (COD < 6OD) Z

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$he money multiplier * m is (COD < ) O (COD < 6OD)#

$he money multiplier is the ratio o the change in the 3uantit" o mone" to thechange in the monetar" -ase#

&or e.ample* i the /KC increases the monetar" -ase -" 00*000 and the 3uantit"o mone" increases -" 2 0*000* the mone" multiplier is 2# #

'n general* the 3uantit" o mone" created depends on the desired reserve ratio and

the currenc" drain ratio#

$he smaller these ratios* the larger is the mone" multiplier#

$he Mone" Market

7ow much mone" do people want to hold@

• $he 'uantity o& money demanded is the inventor" o mone" that people planto hold on an" given da"#

o Mone" in our wallets and our deposit accounts in our -anks

$he 'n8uence o Mone" 7olding

$he 3uantit" o mone" that people plan to hold depends on our main actors:

• $he Price evel• $he Nominal 'nterest 6ate• 6eal GDP• &inancial 'nnovation

$he Price evel

• ominal mone" is the amount o mone" measured in dollars#• 6eal mone" e3uals nominal mone" ^ price level#

o 't is the 3uantit" o mone" measured in terms o what it will -u"o $he 3uantit" o real mone" demanded is independent o the price level

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• $he 3uantit" o nominal mone" demanded is proportional to the price levelJa 0 percent rise in the price level increases the 3uantit" o nominal mone"demanded -" 0 percent#

$he Nominal Interest ate

$he nominal interest rate is the opportunit" cost o holding wealth in the orm omone"

• $he higher the opportunit" cost o holding mone"* other things remaining thesame* the smaller is the 3uantit" o real mone" demanded#

• $he nominal interest rate on other assets minus the nominal interest rate onmone" is the opportunit" cost o holding mone"#

o $he interest rate that is earned on currenc" and che3ua-le deposits is6ero * so the opportunit" cost o holding these items is the nominalinterest rate on other assets such as a savings -ond or $reasur" /ill#

o /" holding mone" instead* the interest that otherwise would have -eenreceived ( rom holding currenc" and che3ua-le deposits) is oregone

6eal GDP

,n increase in real GDP increases the volume o e.penditure* which increases the3uantit" o real mone" that people plan to hold

&inancial 'nnovation

$echnological changes and the arrival o new !nancial products in8uence the3uantit" o mone" held#

$"pes o &inancial 'nnovation:

• Dail" interest che3ua-le deposits• ,utomatic trans ers -etween che3ua-le and saving deposits• ,utomatic teller machines• Credit cards and de-it cards• 'nternet -anking and -ill pa"ing

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Note : &inancial 'nnovation that lowers the cost o switching -etween mone" andinterest -earing assets decreases the 3uantit" o real mone" that people plan tohold

T(e Demand or 1oney

$he demand !or money is the relationship -etween the 3uantit" o real mone"demanded and the nominal interest rate when all other in8uences on the amount o mone" that people wish to hold remain the same#

• , rise in the interest rate -rings a decrease in the 3uantit" o real mone"demanded

• , !all in the interest rate -rings an increase in the 3uantit" o real mone"demanded

+hi ts in the Demand or Mone" Curve

• , decrease in real GDP or a !nancial innovation decreases the demand ormone" and shi ts the demand curve le!t)ard #

• ,n increase in real GDP increases the demand or mone" and shi ts thedemand curve rig(t)ard #

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Mone" Market E3uili-rium

Mone" market e3uili-rium occurs when the 3uantit" o mone" demanded e3uals the3uantit" o mone" supplied#

• ,dLustments that occur to -ring a-out mone" market e3uili-rium areundamentall" diRerent in the short run and the long run#

S(ort* un E4uilibrium

+uppose that the /ank o Canada wants the interest rate to -e percent a "ear#

• $he /ank adLusts the 3uantit" o mone" each da" so that the 3uantit" o realmone" is I00 -illion#

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' the interest rate e.ceeds the percent a "ear* _

• $he 3uantit" o mone" that people are willing to hold is less than the 3uantit"supplied#

$he" tr" to get rid o their >e.cess? mone" the" are holding -" buying bonds andbidding up prices #

• $his action lowers the interest rate#

' the interest rate is -elow percent a "ear* _

• $he 3uantit" o mone" that people want to hold e.ceeds the 3uantit"supplied#

$he" tr" to get more mone" -" selling bonds and bid do)n prices #

• $his action raises the interest rate#

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$he +hort 6un ERect o a Change in the 4uantit" o Mone"

• 'nitiall"* the interest rate is percent a "ear#• ' the /KC increases the 3uantit" o mone"* people will -e holding more

mone" than the 3uantit" demanded#• +o the" -u" some -onds#• $he increased demand or -onds raises the -ond price and lowers the interest

rate#

'nitiall"* the interest rate is percent a "ear#

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' the /KC decreases the 3uantit" o mone"* people will -e holding less mone" thanthe 3uantit" demanded#

+o the" sell -onds#

$he increased suppl" o -onds lowers the -ond price and raises the interest rate#

$ong* un E4uilibrium

• 'n the long run* the loana-le unds market determines the real interest rate#• $he nominal interest rate e3uals the e3uili-rium real interest rate plus the

e.pected in8ation rate#• 'n the long run* real GDP e3uals potential GDP* so the onl" varia-le le t to

adLust in the long run is the price level #• $he price level adLusts to make the 3uantit" o real mone" supplied e3ual to

the 3uantit" demanded#• ' in long run e3uili-rium* the /KC increases the 3uantit" o mone"* the price

level changes to move the mone" market to a new long run e3uili-rium#• 'n the long run* nothing real has changed#• 6eal GDP* emplo"ment* 3uantit" o real mone"* and the real interest rate are

unchanged#• 'n the long run* the price level rises -" the same percentage as the increase

in the 3uantit" o mone"#

$he 4uantit" $heor" o Mone"

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$he 4uantity t(eory o! money is the proposition that* in the long run* an increasein the 3uantit" o mone" -rings an e3ual percentage increase in the price level#

• $he 3uantit" theor" o mone" is -ased on the velocit" o circulation and thee3uation o e.change#

o $he velocity o! circulation is the average num-er o times in a "eara dollar is used to purchase goods and services in GDP#

Denote the velocit" o circulation as * the price level P* real GDP 5* and the3uantit" o mone" M:

= P 1

$he e3uation o e.change states that M ; P5#

$he e3uation o e.change -ecomes the 3uantit" theor" o mone" i M does notin8uence or 5#

+o in the long run* the change in P is proportional to the change in M#

1= P

E.pressing the e3uation o e.change in growth rates:1oney gro)t( rate B gro)t( rate o! velocity In:ation rate B eal GDP

gro)t(

6earranging:

In:ation rate 1oney gro)t( rate B Gro)t( rate o! velocity * eal GDPgro)t(

'n the long run* velocit" does not change* so

In:ation rate 1oney gro)t( rate * eal GDP gro)t(

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'n the long run* with the econom" at ull emplo"ment* real GDP e3uals potentialGDP* so the real GDP growth rate e3uals the potential GDP growth rate# 4uantit"

$heor" assumes that the growth rate is Uero* so

In:ation ate 1oney Gro)t( ate

Chapter 2 : $he E.change 6ate $he &oreign E.change Market

• $o -u" goods and services produced in another countr" we need mone" othat countr"

• &oreign -ank notes* coins* and -ank deposits are called !oreign currency• $he !oreign exc(ange mar'et is the market in which the currenc" o one

countr" is e.changed or the currenc" o anothero $he oreign e.change market is made up o thousands o people

importers and e.porters* -anks* international investors and speculators*international travellers* and specialist traders called &oreign exchangebrokers

E.change 6ates

+oreign exc(ange rate is the price at which one currenc" e.changes or another#

• ike all prices* an e.change rate is determined in a marketJthe oreigne.change market# 1ith man" traders and no restrictions* the oreign e.changemarket is a competitive market #

• $he e.change rate 8uctuates* i#e#* sometimes it rises and sometimes it alls

1e will -e consistentl" using the e.change rate as the units o oreign currenc" perone Canadian dollar or e.ample:

• , all in the value o one currenc" in terms o another currenc" is calledcurrenc" depreciation #

• , rise in value o one currenc" in terms o another currenc" is called currenc"appreciation #

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&or e.ample* the dollar appreciates against the "en when the e.change raterises rom I0 to 0 "en per dollar#

Demand in the &oreign Market $he 3uantit" o Canadian dollars that traders plan to -u" in the oreign e.changemarket during a given period depends on:

# $he e.change rate

2# 1orld demand or Canadian e.ports

F# 'nterest rates in Canada and other countries

%# $he e.pected uture e.change rate

$he aw o Demand or &oreign E.change

People -u" Canadian dollars so that the" can -u" Canadian produced goods andservices or Canadian assets#

Kther things remaining the same* the (ig(er the e.change rate* the smaller is the3uantit" o Canadian dollars demanded in the oreign e.change market#

$he e.change rate in8uences the 3uantit" o Canadian dollars demanded or tworeasons:

• E.ports eRect• E.pected pro!t eRect

E.ports ERect

• $he larger the value o Canadian e.ports* the greater is the 3uantit" oCanadian dollars demanded on the oreign e.change market#

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• $he lower the e.change rate* the lower are the prices o Canadian producedgoods and services to oreigners and the greater is the value o CanadianE.ports* so the greater is the 3uantit" o Canadian dollars demanded

' the e.change rate !alls (and other in8uences remaining the same)* the 3uantit"o Canadian dollars demanded in the oreign e.change market increases #

E.ample: Me.ican Peso P 2 ; C and -ottle o Canadian Maple +"rup ; C 2 (orP2%)

+uppose the Canadian Dollar depreciate: P 0 ; C

$he price o Canadian Maple +"rup alls rom 2% Me.ican Pesos to 20 Me.icanPesos# Me.ico would -e a-le purchase Maple +"rup at a lower e.change rate* or ahigher value#

E.pected Pro!t ERect

•

$he larger the e.pected pro!t rom holding Canadian dollars* the greater isthe 3uantit" o Canadian dollars demanded toda"#o /ut e.pected pro!t depends on the e.change rate#

• $he lower toda"As e.change rate* other things remaining the same* the largeris the e.pected pro!t rom -u"ing Canadian dollars and the greater is the3uantit" o Canadian dollars demanded toda"#

Demand Curve or Canadian Dollars

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+uppl" in the &oreign E.change Market

1h" do people sell C and -u" other services@

i /u" oreign produced goods and services (Canadian imports)ii /u" oreign assets

iii 7old part o their mone" in -ank deposits denominated in oreign currenc"

$he 3uantit" o Canadian dollars supplied in the oreign e.change market is theamount that traders plan to sell during a given time period at a given e.changerate#

$his 3uantit" depends on man" actors -ut the main ones are:

# $he e.change rate

2# Canadian demand or imports

F# 'nterest rates in Canada and other countries

%# $he e.pected uture e.change rate

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$he aw o +uppl" o &oreign E.change

Kther things remaining the same* the higher the e.change rate* the greater is the3uantit" o Canadian dollars supplied in the oreign e.change market#

$he e.change rate in8uences the 3uantit" o Canadian dollars supplied or tworeasons:

• 'mports eRect• E.pected pro!t eRect

'mports ERect

• $he larger the value o Canadian imports* the larger is the 3uantit" oCanadian dollars supplied on the oreign e.change market#

• $he higher the e.change rate* the lower are the prices o oreign producedgoods and services* the greater is the volume o Canadian imports* and so thegreater is the 3uantit" o Canadian dollars supplied in the oreign e.changemarket

E.pected Pro!t ERect

&or a given e.pected uture Canadian dollar e.change rate* the lower the currente.change rate* the greater is the e.pected pro!t rom holding Canadian dollars* andthe smaller is the 3uantit" o Canadian dollars supplied on the oreign e.changemarket#

Kn the other side* the higher the e.change rate toda"* other things remaining thesame* the larger is the e.pected pro!t rom selling Canadian dollars today andholding oreign currencies* so the greater is the 3uantit" o Canadian dollarssupplied in the oreign e.change market#

+uppl" Curve or Canadian Dollars

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Market E3uili-rium

• ' the e.change rate is too high* a surplus o Canadian dollars drives it down#• ' the e.change rate is too low* a shortage o Canadian dollars drives it up#• $he market is pulled (3uickl") to the e3uili-rium e.change rate at which there

is neither a shortage nor a surplus#

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E.change 6ate &luctuations

C(anges in t(e Demand !or Canadian Dollars

$he demand or Canadian dollars in the oreign e.change market changes when

there is a change in:• 1orld demand or Canadian e.ports• Canadian interest rate relative to the oreign interest rate• $he e.pected uture e.change rate

1orld Demand or Canadian E.ports

,t a given e.change rate* i world demand or Canadian e.ports increases* the

demand or Canadian dollars increases and the demand curve or Canadian dollarsshi ts rig(t)ard #

Canadian 'nterest 6ate 6elative to the &oreign 'nterest 6ate

• $he higher the interest rate that people can make on Canadian assetscompared with oreign assets* the more Canadian assets the" -u"#

• $he Canadian interest rate minus the oreign interest rate is called theCanadian interest rate di>erential #

• ' the Canadian 'nterest 6ate rises and the &oreign 'nterest 6ate remainsconstant* the Canadian 'nterest 6ate DiRerential increases

o ' the Canadian interest diRerential rises* the demand or Canadiandollars increases and the demand curve or Canadian dollars shi tsrightward#

$he E.pected &uture E.change 6ate

,t a given current e.change rate* i the e.pected uture e.change rate or Canadiandollars rises* the demand or Canadian dollars increases and the demand curve or

dollars shi ts rightward#

7ow the demand curve or Canadian dollars shi ts in response to changes in

• Canadian e.ports• $he Canadian interest rate diRerential

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• $he e.pected uture e.change rate

C(ange in t(e Supply o! Canadian Dollars

, change in an" in8uence on the 3uantit" o Canadian dollars that people plan tosell* other than the e.change rate* -rings a change in the suppl" o dollars#

$hese other in8uences are:

• Canadian demand or imports• Canadian interest rates relative to the oreign interest rate• $he e.pected uture e.change rate

Canadian Demand or 'mports

,t a given e.change rate* i the Canadian demand or imports increases* the suppl"o Canadian dollars on the oreign e.change market increases and the suppl" curveo Canadian dollars shi ts rig(t)ard #

Canadian 'nterest 6ate 6elative to the &oreign 'nterest 6ate

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' the Canadian interest diRerential rises* the suppl" o Canadian dollars decreasesand the suppl" curve o Canadian dollars shi ts le!t)ard #

• 1ith a higher Canadian interest rate diRerential* people decide to keep moreo their unds in Canadian dollar assets and less in oreign currenc" assets

o $he" -u" a smaller 3uantit" o oreign currenc" and sell a smaller3uantit" o Canadian dollars

+o a rise in Canadian interest rate* other things remaining the same* decreases thesuppl" o Canadian dollars in the oreign e.change market#

$he E.pected &uture E.change 6ate

,t a given current e.change rate* i the e.pected uture e.change rate or Canadiandollars rises* the suppl" o Canadian dollars decreases and the suppl" curve oCanadian dollars shi ts le!t)ard #

• +uppliers o Canadian currenc" could make a pro!t i the e.change rate is(ig( compared to other oreign currencies (a higher value o a oreign currenc"per one Canadian dollar)# $here ore* i e.pected uture currenc" ratesdecreases* a higher amount o pro!t would -e made with the currente.change rateT thus* suppliers would increase the suppl" o Canadian dollars inthe &oreign E.change Market#

7ow the suppl" curve o Canadian dollars shi ts in response to changes in

• Canadian demand or imports• $he Canadian interest rate diRerential• $he e.pected uture e.change rate

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Changes in the E.change 6ate

• ' demand or Canadian dollars increases and suppl" does not change* thee.change rate rises#

• ' demand or Canadian dollars decreases and suppl" does not change* thee.change rate alls#

• ' suppl" o Canadian dollars increases and demand does not change* thee.change rate alls#

•

' suppl" o Canadian dollars decreases and demand does not change* thee.change rate rises#

+ummar":

• , rise in the Canadian 'nterest 6ate DiRerential or a rise in the E.pected&uture E.change 6ate increases demand* decreases suppl"* and raises thee.change rate #

• , !all in the Canadian 'nterest 6ate DiRerential or a !all in the E.pected&uture E.change 6ate decreases demand* increases suppl"* and lo)ers thee.change rate

&undamentals* E.pectations* and ,r-itrage

$he e.change rate changes when it is e.pected to change#

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/ut* what causes this change in e.pectation@

• $he" are driven -" deeper orces

,r-itrage:

$he simultaneous purchase and sale o an asset in order to pro!t rom a diRerencein the price# 't is a trade that pro!ts -" e.ploiting price diRerences o identical orsimilar !nancial instruments* on diRerent markets or in diRerent orms# ,r-itragee.ists as a result o market ineVcienciesT it provides a mechanism to ensure pricesdo not deviate su-stantiall" rom air value or long periods o time#

• 'n simpler terms* it is the practice o seeking to pro!t -" -u"ing in one marketand selling or a higher price in another market#

,r-itrage activities can lead to:

• aw o Kne Priceo N' an item is traded in more than one place* the price will -e the same

in all locationsN•

o 6ound $rip Pro!to , round trip is using currenc" , to -u" currenc" /* and then using / to

-u" ,# , round trip might involve more stages* using / to -u" C and thenusing C to -u" ,

o ,r-itrage removes pro!t rom all transactions o this t"pe• ,n" 8eeting pro!t is taken* and the changes in suppl" and

demand induce -" the momentaril" availa-le pro!t snaps thee.change rate -ack to levels that remove the pro!t#

• 'nterest 6ate Parit"• Purchasing Power Parit"

'nterest 6ate Parit" ('6P)

$he rates o returns on two currencies are e3ual#

• &or risk ree transactions* there is no gain rom choosing one currenc" overanother

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+uppose that -ank deposit earns ` a "ear in $ok"o and F` a "ear in ew 5ork#

$he return on a currenc" is the interest rate on that currenc" plus the e.pected rateo appreciation over a given period#

1hen the rates o returns on two currencies are e3ual* interest rate parityprevails#

'nterest rate parit" means e3ual interest rates when e.change rate changes aretaken into account#

Market orces achieve interest rate parit" ver" 3uickl"#

$he law o one price states that i an item can -e traded in more the one place* theprice will -e the same in all locations

Purchasing Power Parit" (PPP)

• Kne Canadian dollar (or a unit o an" currenc") can -u" the same 3uantit" ogoods and services in an" countries#

•

E3ual purchasing power or e'ual value o& money

Conditions:

• ' most goods and services cost more in one countr" than another* thecurrenc" o the !rst countr" is said to -e overvalued

o , depreciation o the currenc" would restore PPP• $he currenc" o the countr" with the lower prices is said to -e undervalued

o ,n appreciation o that currenc" would restore the PPP•

1hen goods and services cost the same in two countries* their currencies aresaid to -e at their PPP levels

Speculation

+peculation is trading on the expectation o making a pro!t

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• 't contrasts with ar-itrage* which is trading on the certainty o making a pro!t• Most oreign e.change transactions are -ased on speculation

$he 6eal E.change 6ate $he real e.change rate (6E6) is the relative price o Canadian produced goods andservices to oreign produced goods and services#

• 't measures the 3uantit" o real GDP o other countries that a unit oCanadian real GDP -u"s#

E.ample: +uppose a -ushel o Canadian wheat sells or 00* and a -ushel oMe.ican wheat sells or 00 pesos#

1hat is the 6eal E.change 6ate -etween Canadian and Me.ican wheat@

• se the nominal e.change rate to convert the prices into a common currenc"#• +uppose the e.change rate is 0 pesos per dollar#• $he price o Canadian wheat o 00 per -ushel is e3uivalent to 000 pesos

per -ushel#

$here ore*

2 -ushel o Me.ican wheat per -ushel o Canadian wheat (2: )

$he e3uation that links the nominal e.change rate (E) and real e.change rate (6E6)is

6E6; (E . P)OP]

where P is the Canadian price level and P] is the Me.ican (or oreign) price level#

' -oth countries produce identical goods* then the price levels e.pressed in thesame currenc" would -e the same and 6E6 would e3ual #

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$he +hort 6un

'n the short run* the e3uation determines 6E6#

E /E x P0.P

'n the short run* i the nominal e.change rate changes* P and P] do not change andthe change in E -rings an e3uivalent change in 6E6#

$he ong 6un

'n the long run* 6E6 is determined -" the real orces o demand and suppl" in themarkets or goods and services#

+o in the long run* E is determined -" 6E6 and the price levels# $hat is*

E E x /P .P0

• , rise in the Sapanese price level P] -rings an appreciation o the Canadiandollar in the long run#

• , rise in the Canadian price level P -rings a depreciation o the Canadiandollar in the long run#

E.change 6ate Polic"

$hree possi-le e.change rate policies are

• &le.i-le e.change rate• &i.ed e.change rate• Crawling peg

, :exible exc(ange rate policy is one that permits the e.change rate to -edetermined -" demand and suppl" in the oreign e.change market* with no directintervention in the oreign e.change market -" the central -ank#

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, fxed exc(ange rate policy is one that pegs the e.change rate at a valuedecided -" the government or central -ank and is achieved -" direct intervention inthe oreign e.change market to -lock unregulated orces o demand and suppl"#

, !.ed e.change rate re3uires active intervention in the oreign e.change market#

7ow the /KC can intervene in the oreign e.change market to keep the e.changerate close to a target rate#

+uppose that the target is 00 "en per Canadian dollar#

• ' the demand or Canadian dollars increases* the /KC sells Canadian dollarsto increase suppl"#

, cra)ling peg is an e.change rate that ollows a path determined -" a decision o the government or the central -ank and is achieved -" active intervention in themarket#

• China is a countr" that operates a crawling peg#• , crawling peg works like a !.ed e.change rate e.cept that the target value

changes#• $he ideal crawling peg sets a target or the e.change rate e3ual to the

e3uili-rium e.change rate on average#

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$he idea -ehind a crawling peg is to avoid wild swings in the e.change rate thatmight happen i e.pectations -ecame volatile and to avoid the pro-lem o runningout o reserves* which can happen with a !.ed e.change rate#

, crawling peg departs rom the ideal i * as o ten happens with a !.ed e.changerate* the target rate departs rom the e3uili-rium e.change rate or too long#

• 1hen this occurs* the countr" either runs out o reserves or piles up reserves

Net &orro)er : a countr" that is -orrowing more rom the rest o the world than it islending to the rest o the world

Net $ender : a countr" that is lending more to the rest o the world than it is