explain summaeize 2 Exchange Rate Policy Exchange Rate Regimes  An exchange rate regime is a rule governing central bank policy toward the country’s (nominal) exchange rate.  There are 2 major types of exchange rate regimes  Floating/Flexible exchange rate regime – exchange rate is determined by the market forces. Examples include Canada, the U.S.  Fixed exchange rate regime – exchange rate is held fixed at a pre- specified level (a desired or target E rate – sometimes called the official exchange rate). Examples include Hong Kong, Bulgaria, Denmark. 3 How Can an Exchange Rate Be Held Fixed ?  Under a fixed exchange rate regime, the central bank has the obligation to maintain the exchange rate at the official level.  If the current (market) exchange rate differs from the official rate, the central bank will intervene to ensure the market exchange rate will be at the official rate.  Central bank can maintain a fixed exchange rate through: 1) Foreign exchange market intervention (by adjusting its holdings of official reserves – FC denominated assets held by the CB) 2) Adjust money supply via other methods such as open market operations (Δ in MS → Δ in i → Δ in E via financial capital flows). 3) Imposition of capital controls. 4 Foreign Exchange Market – Flexible Exchange Rate Regime Flexible exchange rate regime: Market conditions that work to influence the location of the SDC and DDC and thus determine the short-run equilibrium level of the nominal exchange rate. EFC/DC QDC SDC DDC E*SR ● 5 Foreign Exchange Market – Fixed Exchange Rate Regime Fixed exchange rate regime: The CB has promised to actively participate in the foreign exchange market to keep E at the target level. That is, whenever market forces shift either SDC or DDC , the CB creates an offsetting curve shift so that E remains at the official rate. EFC/DC QDC SDC DDC ETarget ● Fixed Exchange Rate 1) The central bank picks a desired or target level for the nominal exchange rate (official rate); AND 2) The CB promises to do whatever they need to do to make E = ETarget happen. 6  Foreign exchange market interventions are the most commonly used method to maintain a fixed exchange;  We will assume the central bank uses this method to ensure the exchange rate will stay at the official level.  Remember with a fixed exchange rate regime the CB has promised to either buy or sell any amount of DC at the official rate.  Let’s see how the central bank fixes the exchange rate via a foreign exchange market intervention. 7 Suppose the official exchange rate is E0 & the current market exchange rate is EMKT , then something has occurred to make the mkt E rate become EMKT EFC/DC QDC E0 EMKT ● S0,DC D0,DC A At E0 , there is an excess supply of DC.  Then, without any other changes, there will be pressure for DC to depreciate to EMKT ● ●7 Suppose the official exchange rate is E0 & the current market exchange rate is EMKT , then something has occurred to make the mkt E rate become EMKT EFC/DC QDC E0 EMKT ● S0,DC D0,DC A At E0 , there is an excess supply of DC.  Then, without any other changes, there will be pressure for DC to depreciate to EMKT ● ● 8 Suppose the official exchange rate is E0 & the current market exchange rate is EMKT , then something has occurred to make the mkt E rate become EMKT EFC/DC QDC E0 EMKT ● S0,DC D0,DC A At E0 , there is an excess supply of DC.  There will be pressure for DC to depreciate to EMKT ● ● To keep E at E0 , the CB will buy DC (& sell FC) shifting the DDC curve to the right.  ↓MS & ↓Official Reserves D1,DC B 9 When adopting a fixed exchange rate, it is important for the central bank to choose the official rate at an appropriate level. If not, it might pose problems to the economy. EFC/DC QDC E1 EMKT ● S0,DC D0,DC A (Market value of DC) If E is set to E1, then DC is overvalued.  There is pressure for DC to depreciate to EMKT.  To keep E at E1, the central bank buys DC and sells FC.  ↓ Official reserves & could result in a fin crisis If E is set to E2, then DC is undervalued.  There is pressure for DC to appreciate to EMKT.  To keep E at E2, the central bank buys FC and sells DC.  ↑MS & could result in more inflation in LR E2 Excess supply of DC ED of DC 10 The Exchange Rate Regime Dilemma  Any open economy faces a dilemma – should it adopt a flexible exchange rate or a fixed exchange rate? The Arguments for a Flexible Exchange Rate  The central bank can design and implement monetary policy that best suits the economy (i.e., monetary policy autonomy). MP is more effective under flexible e rate regime.  It avoids the problem of not having sufficient official reserves because to ensure the fixed exchange rate is sustainable, the central bank must hold a large stock of official reserves. If the country runs out of official reserves, the country might experience a currency crisis.  If the central bank attempts to maintain a fixed exchange rate through capital controls, it could lead to inefficient allocation of funds. 11 The Arguments for a Fixed Exchange Rate  It reduces uncertainty about the exchange rate movements  helps to promote international trade and investments  enjoy the gains from trade.  It prevents the central bank from running excessive, expansionary monetary policies because under a fixed exchange rate the central bank cannot use (traditional) monetary policy to affect the economy (the CB must use MP to keep the E rate fixed).  Fiscal policy is more powerful/effective under fixed exchange rate. 12 Exchange Rates and Macroeconomic Policy  Let’s look at some policy issues related to open economy macroeconomics. Devaluation and Revaluation of Fixed Exchange Rate  Devaluation refers to a decrease in the official value of a currency. ↓ EFC/DC  Revaluation refers to an increase in the official value of a currency. ↑ EFC/DC Example: Suppose a country, say Home, that has a fixed exchange rate regime devalues its currency (i.e., DC devalues, so ↓ EFC/DC):  When DC is devalued this makes domestic goods become relatively less expensive  This causes X ↑ , IM ↓ ⇒ NX ↑  When NX ↑ ⇒ AEPlanned ↑ (shifts up & AD shifts right) ⇒ Y*SR ↑ 13 EFC/DC E0 E1 QDC A devaluation is a reduction in the official (or target) nominal exchange rate E.13 EFC/DC E0 E1 QDC A devaluation is a reduction in the official (or target) nominal exchange rate E. 14 Numerical example: A Devaluation of DC  The set of equations Generic form: Numerical example (Same as Week 11): C = AC + MPC×YD C = 600 + 0.75YD T = T0 + t×Y T = 120 + 0.15Y TR = TR0 – tr×Y TR = 400 – 0.05Y IPlanned = 700 – 5000i , where i = 0.02 (2%) G0 G = 500 X = X0 – X1 × EFC/DC X = 280 – 15EFC/DC , where EFC/DC = 1 IM = IM0 + IM1 × Y + IM2 × EFC/DC IM = 250 + 0.1Y + 25EFC/DC 15 At the initial equilibrium (i = 0.02 & EFC/DC = 1): YD as a function of Y: YD = 280 + 0.8Y The consumption function as a function of Y: C = 810 + 0.6Y The AEPlanned function as a function of Y: AEPlanned = 1900 + 0.5Y Output: Y* = 3,800 Net exports NX = (X – IM) = 30 - 40E – 0.1Y NX* = – 390 Now, suppose DC is devalued by 0.25 FC per DC. Find the new equilibrium level of output and net exports.  New official exchange rate = 1 – 0.25 = 0.75 (FC per DC) 1616 17 New equilibrium level of net exports: X = 280 – 15EFC/DC & IM = 250 + 0.1Y + 25EFC/DC X = 280 – 15(0.75) = 268.75 IM = 250 + 0.1(3820) + 25(0.75) = 650.75 NX = [280 – 15EFC/DC] – [250 + 0.1Y + 25EFC/DC] = X – IM = - 382 (Smaller trade deficit) Method 2: Use the multiplier to find the new Y* Y* = AE0  M = (X – IM)  M = ( 3.75 – (-6.25) )x (1/0.5) Here M = 2 = Multiplier = (10)x(2) = 20 New Y* = (Old Y* + Y*) = 3,820 18 Monetary Policy under Floating/Flexible Exchange Rate  Monetary policy is effective under flexible exchange rate, i.e., changes in monetary policy will lead to a change in output in the short-run. Example: Expansionary monetary policy under flexible exchange rate Suppose the central bank runs expansionary monetary policy, MS :  When MS , interest rate  (Chapter 15).  Cost of borrowing   IPlanned . (Chapters 10, 11, & 12)  Today’s consumption becomes relatively less expensive  C . (Chapter 10)  AEPlanned  & AD   Y* . Closed Economy 19 Suppose the central bank runs expansionary monetary policy, MS :  When MS , interest rate  (Chapter 15).  Cost of borrowing   IPlanned . (Chapters 10, 11, & 12)  Today’s consumption becomes relatively less expensive  C . (Chapter 10)  AEPlanned  & AD   Y* .  In an open economy, when interest rates ↓, domestic assets become relatively less attractive  Exports of assets ↓ → Capital inflows ↓ → DDC ↓  Imports of assets ↑ → Capital outflows ↑ → SDC ↑  Domestic goods become relatively less expensive → X ↑ & IM ↓ (due to the ∆ in E)  ↑ NX → AEPlanned ↑ (shifts further up) → AD ↑ (shifts further right) → Y* ↑ (further) DC depreciates E ↓ Closed Economy 20 Foreign Exchange Market – Flexible Exchange Rate Regime EFC/DC QDC SDC DDC E*SR ● A ● B 21 Numerical Example – Monetary Policy Under Flexible Exchange Rate Generic form: Numerical example (Same as Week 11): C = AC + MPC×YD C = 600 + 0.75YD T = T0 + t×Y T = 120 + 0.15Y TR = TR0 – tr×Y TR = 400 – 0.05Y IPlanned = 700 – 5000i , where i = 0.02 (2%) G0 G = 500 X = X0 – X1 × EFC/DC X = 280 – 15EFC/DC , where EFC/DC = 1 IM = IM0 + IM1 × Y + IM2 × EFC/DC IM = 250 + 0.1Y + 25EFC/DCAt the initial equilibrium (i = 0.02 & EFC/DC = 1): The AEPlanned function: AEPlanned = 1900 + 0.5Y Output: Y* = 3,800 22 Expansionary monetary policy without a change E (Week 10) The central bank lowers the interest rate by 0.5 percentage point to 1.5% (i = 0.015):  Logic: When i , cost of borrowing   IPlanned  by (– d ×i) = (– 5000 × – 0.005) = 25  IPlanned  by 25  AE0  by 25.  New AEPlanned function: AEPlanned = 1925 + 0.5Y  Output: Y* = 3,850 (Y*  by 50) Expansionary monetary policy taking a change in E into consideration The central bank lowers the interest rate by 0.5 percentage point (i = 0.015), which also causes DC to depreciate to 0.75:

ChatGPT said:

Here's a summary of the key points from your exchange rate policy slides:

1. Exchange Rate Regimes

An exchange rate regime is a policy approach to managing a country's currency exchange rate.

• Floating (Flexible) Regime: Exchange rate is determined by market forces (e.g., U.S., Canada).

• Fixed Regime: Exchange rate is set at a specific target and maintained by the central bank (e.g., Hong Kong, Denmark).

2. Maintaining a Fixed Exchange Rate

To keep the exchange rate fixed, central banks may:

• Intervene in foreign exchange markets (buy/sell currency using reserves).

• Change money supply (through interest rate manipulation).

• Impose capital controls.

3. Exchange Market Dynamics

• Under a flexible regime, market forces determine the rate based on supply and demand.

• Under a fixed regime, the central bank adjusts supply/demand to keep the rate at the target.

4. Fixing E with Market Intervention

• If the market rate (EMKT) deviates from the official rate (E0), the central bank intervenes:

  • Excess DC supply → CB buys DC and sells foreign currency.

  • Excess DC demand → CB sells DC and buys foreign currency.

Poorly set exchange rates (too high or too low) can cause:

• Currency overvaluation or undervaluation.

• Reserve depletion or inflation risks.

5. Exchange Rate Regime Dilemma

Pros of Flexible Rates

• More monetary policy freedom.

• No need for large currency reserves.

• Avoids distortions from capital controls.

Pros of Fixed Rates

• Less uncertainty in trade/investment.

• Imposes discipline on monetary policy.

• Fiscal policy becomes more effective.

6. Devaluation & Revaluation

• Devaluation: Lowers the official exchange rate → boosts exports, reduces imports → increases output (Y).

• Revaluation: Raises the official rate → opposite effect.

Example

• Devaluation from E = 1 to E = 0.75 → exports ↑, imports ↓, net exports ↑ → output increases via the multiplier effect.

7. Monetary Policy Under Floating Exchange Rates

• Expansionary monetary policy (↑ money supply):

  • ↓ interest rate → ↑ investment & consumption → ↑ aggregate demand → ↑ output (Y).

  • In open economies: ↓ interest rate → ↓ capital inflow → currency depreciates → net exports ↑ → further boosts output.

Numerical Example

• Lowering interest rate → AEPlanned ↑ → Y* ↑.

• Including currency depreciation amplifies the output increase.

Let me know if you'd like a visual chart, flashcards, or simplified formulas for these concepts!

4o

You said:

 Logic: When both i & E change, there will be changes in IPlanned, X & IM. 23 ↑AE0 more than before 24 AEPlanned function Y* Initial case, i = 0.02, E = 1 1900 + 0.5Y 3,800 MS , i = 0.015, E = 1 1925 + 0.5Y 3,850 (Y up by 50) MS , i = 0.015, E = 0.75 1935 + 0.5Y 3,870 (Y up by 70) Y = AEPlanned Y = 1935 + 0.5Y Y* = 3,870 (Y up by 70) Monetary policy is more effective (or powerful at impacting Y*SR) under a flexible exchange rate regime 25 Monetary Policy under Fixed Exchange Rate  Monetary policy is ineffective under fixed exchange rate, i.e., a MS change will NOT change output. Example: Expansionary monetary policy under fixed exchange rate Suppose the central bank runs expansionary monetary policy, MS :  MS   interest rate .  Cost of borrowing   IPlanned .  Today’s consumption becomes relatively less expensive  C .  AEPlanned  & AD   Y* .  In an open economy, when interest rate , domestic assets become relatively less attractive:  Exports of assets   capital inflows   DDC .  Imports of assets   capital outflows   SDC .  DC depreciates (and deviates from the official exchange rate). Closed Economy 26  DC depreciates (and deviates from the official exchange rate).  Now E(free mkt) < E(target)  The CB has to stop the depreciation of DC by buying DC (& selling FC)  MS ↓ back to its initial level, such that the interest rate i ↑ back to its initial level & the outflow of financial capital stops  Overall: ∆i = 0 → ∆I = 0 & ∆C = 0 ∆E = 0 → ∆X = 0 & ∆IM = 0 ∆AEPlanned = 0 ∆AD = 0 ∆Y = 0 But we did experience a reduction in the holdings of official reserves by the CB Monetary policy has no power to change Y in the SR when we have a fixed exchange rate regime 27 Foreign Exchange Market – Fixed Exchange Rate Regime EFC/DC QDC SDC DDC ETarget ● A ● B ● The CB buys DC & sells FC (red line shift) ∆E = 0 ↓MS & ↓Official reserves ∆MS = 0 (Overall) C 28 Fiscal Policy Under Flexible Exchange Rate  Fiscal policy is less effective under flexible exchange rate, i.e., changes in fiscal policy will only lead to a small change in output in the short-run. Example: Expansionary fiscal policy under flexible exchange rate Suppose the government runs expansionary fiscal policy such that G :  G   AEPlanned  & AD   Y . (Chapters 11, 12, & 13) Crowding out effects:  When Y   money demand   interest rate . (Chapter 15)  Cost of borrowing   IPlanned . (Chapters 10, 11, & 12)  Today’s consumption become more expensive  C . (Chapter 10)  IPlanned  & C  mean that AEPlanned  & AD   Y*  (less than when ignoring i) Closed Economy 29  In an open economy, when interest rate ↑, domestic assets become relatively more attractive:  Imports of assets   capital outflows   SDC .  Exports of assets   capital inflows   DDC .  DC appreciates  E  Domestic goods become relatively more expensive  ↓X & ↑IM  NX ↓  When ↓C, ↓I & ↓NX  AEPlanned ↓ (shifts down due to ∆i & ∆E)  This subsequent ↓ AEPlanned will partially offset the initial ↑ AEPlanned (due to ↑G)  Overall: AEPlanned ↑, AD ↑ (but by a smaller amount) & Y* ↑ a bit Thus, less effective29  In an open economy, when interest rate ↑, domestic assets become relatively more attractive:  Imports of assets   capital outflows   SDC .  Exports of assets   capital inflows   DDC .  DC appreciates  E  Domestic goods become relatively more expensive  ↓X & ↑IM  NX ↓  When ↓C, ↓I & ↓NX  AEPlanned ↓ (shifts down due to ∆i & ∆E)  This subsequent ↓ AEPlanned will partially offset the initial ↑ AEPlanned (due to ↑G)  Overall: AEPlanned ↑, AD ↑ (but by a smaller amount) & Y* ↑ a bit Thus, less effective 30 Foreign Exchange Market – Flexible Exchange Rate Regime EFC/DC QDC SDC DDC E*SR ● A ● B 31 Numerical Example – Fiscal Policy Under Flexible Exchange Rate C = 600 + 0.75YD G = 500 T = 120 + 0.15Y X = 280 – 15EFC/DC, where E = 1 TR = 400 – 0.05Y IM = 250 + 0.1Y + 25EFC/DC IPlanned = 700 – 5000i, where i = 0.02(2%) In the initial equilibrium (i = 0.02 & EFC/DC = 1): AEPlanned = 1900 + 0.5Y Y* = 3,800 Expansionary fiscal policy without a change i &/or E (Week 5) The government increases its spending by 50.  Logic: Government spending increases by 50  G = 50  AE0  by 50.  New AEPlanned function: AEPlanned = 1950 + 0.5Y  Output: Y* = 3,900 (Y*  by 100) 32 Expansionary fiscal policy with a change i but E is held fixed (Weeks 8 & 10) The government increases its spending by 50, which also causes the interest rate to rise by 0.5 percentage points (due to the increase in money demand).  Logic: When both G & i change, there will be changes in G and IPlanned.  Government spending   G = 50  Cost of borrowing   IPlanned : IPlanned = (– d ×i) = [– 5000 × 0.005] = – 25 Overall, AE0 = G + IPlanned = 50 + (– 25) = 25  New AEPlanned function: AEPlanned = 1925 + 0.5Y  Output: Y* = 3,850 (Y*  by 50) 3333 34 AEPlanned function Y* Initial case, G = 500, i = 0.02, E = 1 AEPlanned = 1900 + 0.5Y 3,800 G = 550, i = 0.02, E = 1 AEPlanned = 1950 + 0.5Y 3,900 G = 550, i = 0.025, E = 1 AEPlanned = 1925 + 0.5Y 3,850 G = 550, i = 0.025, E = 1.2 AEPlanned = 1917 + 0.5Y 3,834 Y = AEPlanned Y = 1917 + 0.5Y Y* = 3,834 (Y up by 34) Fiscal policy is less effective (or less powerful at impacting Y*SR) under a flexible exchange rate regime 35 Fiscal Policy under Fixed Exchange Rate  Fiscal policy is effective under fixed exchange rate, i.e., changes in fiscal policy will ∆Y*SR Example: Expansionary fiscal policy under fixed exchange rate Suppose the government runs expansionary fiscal policy such that G :  G   AEPlanned  & AD   Y . Crowding out effects:  When Y   money demand   interest rate .  Cost of borrowing   IPlanned .  Today’s consumption become (relatively) more expensive  C .  In an open economy, when interest rate , domestic assets become relatively more attractive:  Exports of assets   capital inflows   DDC .  Imports of assets   capital outflows   SDC .  DC appreciates (and deviates from the official exchange rate). Closed Economy 36  DC appreciates (and deviates from the official exchange rate).  Now E(free mkt) > E(target)  The CB has to stop the appreciation of DC by selling DC (& buying FC)  MS ↑ , such that the interest rate i ↓ back to its initial level & the inflow of financial capital stops  Overall: ∆i = 0 → ∆I = 0 & ∆C = 0 ∆E = 0 → ∆X = 0 & ∆IM = 0 ↑ G →∆AEPlanned ↑ AD ↑ Y ↑ No crowding out effects for fiscal policy since ∆i = 0 = ∆E when we have a fixed exchange rate regime 37 Foreign Exchange Market – Fixed Exchange Rate Regime EFC/DC QDC SDC DDC ETarget ● A ● B ● C The CB buys FC & sells DC (red line shift) ∆E = 0 ↑MS & ↑Official reserves 38 International Business Cycles  If an economy experiences shocks (changes) coming from the goods market (such as changes in AC, AI, G, T0, TR0, X0, and IM0); a flexible exchange rate will lead to a smaller change in output.  Flexible exchange rate – the initial change in C, I, X and/or IM on Y will be (partially) offset by the subsequent change in planned expenditure due to changes in interest rate and exchange rate.  Fixed exchange rate – there won’t be any subsequent change in planned expenditure (because there are no changes in interest rate and exchange rate).  Fixed exchange rate minimizes fluctuations in output if the shock comes from the money market, say due to changes in money demand.  Flexible exchange rate – the initial change in the money demand on Y is reinforced by the subsequent change planned expenditure due to a change in E.  Fixed exchange rate – the initial change in money demand on Y is fully offset by the subsequent change in MS, so that there is no change in planned expenditure (and no change in Y).38 International Business Cycles  If an economy experiences shocks (changes) coming from the goods market (such as changes in AC, AI, G, T0, TR0, X0, and IM0); a flexible exchange rate will lead to a smaller change in output.  Flexible exchange rate – the initial change in C, I, X and/or IM on Y will be (partially) offset by the subsequent change in planned expenditure due to changes in interest rate and exchange rate.  Fixed exchange rate – there won’t be any subsequent change in planned expenditure (because there are no changes in interest rate and exchange rate).  Fixed exchange rate minimizes fluctuations in output if the shock comes from the money market, say due to changes in money demand.  Flexible exchange rate – the initial change in the money demand on Y is reinforced by the subsequent change planned expenditure due to a change in E.  Fixed exchange rate – the initial change in money demand on Y is fully offset by the subsequent change in MS, so that there is no change in planned expenditure (and no change in Y). 39

ChatGPT said:

This is a solid summary of monetary and fiscal policy in open economies under fixed vs flexible exchange rate regimes, showing how each policy's effectiveness is influenced by the exchange rate system. Here's a clean breakdown of the key takeaways from your notes:

🔵 Monetary Policy

✅ Flexible Exchange Rate

• Effective in the short run

• MS ↑ → i ↓ → IPlanned ↑, C ↑ → AE ↑ → Y ↑

• But: i ↓ → capital outflows ↑ → E ↓ → X ↑, IM ↓ → NX ↑ → AE ↑ again

• Final effect: Even more Y↑ due to depreciation → Amplifies monetary policy

Example Summary:

• Initial: AE = 1900 + 0.5Y → Y = 3800

• MS ↑ → AE = 1925 + 0.5Y → Y = 3850

• MS ↑ + E ↓ → AE = 1935 + 0.5Y → Y = 3870
  ✅ More powerful under flexible exchange rate

❌ Fixed Exchange Rate

• Ineffective in the short run

• MS ↑ → i ↓ → Capital outflows → E ↓ → CB intervenes to keep E fixed

• CB sells foreign currency, buys domestic → MS back down

• End result: i back to original → No change in I, C, AE, Y

Bottom line:
🔒 CB's intervention neutralizes monetary policy

🟡 Fiscal Policy

❌ Flexible Exchange Rate

• Less effective

• G ↑ → AE ↑ → Y ↑ → i ↑ → I ↓, C ↓ → AE partially ↓

• i ↑ → capital inflow ↑ → E ↑ → X ↓, IM ↑ → NX ↓ → AE further ↓

• Net: Y increases, but by less than in a closed economy

Example Summary:

• G ↑ 50 → AE = 1950 + 0.5Y → Y = 3900

• If i ↑ to 0.025 → IPlanned ↓ 25 → AE = 1925 + 0.5Y → Y = 3850

• If E ↑ to 1.2 → X ↓, IM ↑ → AE = 1917 + 0.5Y → Y = 3834
  🔻 Crowding out + exchange rate effects reduce impact

✅ Fixed Exchange Rate

• More effective

• G ↑ → AE ↑ → Y ↑ → i ↑

• i ↑ → capital inflows → E ↑ → CB intervenes (sells DC, buys FC) → MS ↑

• i returns to original → Crowding out neutralized

Result:
G ↑ → AE ↑ → Y ↑
✅ No change in i or E → Fiscal policy works fully

🔁 International Business Cycles

Shock OriginFlexible Exchange RateFixed Exchange RateGoods Market (G, C, I)Y change partially offset (via i and E) → smaller ΔYNo offset → larger ΔYMoney Market (Md)Y change amplified (via E) → larger ΔYCB offsets with MS adjustment → no ΔY

Let me know if you'd like a visual diagram, cheat sheet, or help turning this into flashcards or study notes.

4o

You said:

ask questions etc answer

ChatGPT said:

Awesome! Let's dive into it like we're studying together. I’ll ask a few questions to test understanding, and you can either answer or let me know if you'd like me to walk through them. Here we go:

🔁 1. Monetary Policy – Flexible Exchange Rate

Q1:
Why is monetary policy more effective under a flexible exchange rate?

Hint: Think about what happens to the interest rate and the exchange rate when the central bank increases the money supply.

🔒 2. Monetary Policy – Fixed Exchange Rate

Q2:
Why is monetary policy ineffective under a fixed exchange rate?

Hint: What action does the central bank take when the exchange rate starts to deviate from the target?

🟡 3. Fiscal Policy – Flexible Exchange Rate

Q3:
Why does fiscal policy become less effective under a flexible exchange rate?

Bonus:
What two mechanisms reduce its effectiveness?

🔐 4. Fiscal Policy – Fixed Exchange Rate

Q4:
Why is fiscal policy more effective under a fixed exchange rate regime?

Hint: What happens to interest rates and exchange rates when the central bank intervenes?

📊 5. Numerical Understanding

You saw this AEPlanned function:
AEPlanned = 1925 + 0.5Y

Q5:
What’s the equilibrium output level (Y*)?

💥 Bonus Conceptual Question

Q6:
If a shock comes from the goods market, which exchange rate regime will minimize output fluctuations?

And:

Q7:
If the shock comes from the money market, which exchange rate regime will be better at stabilizing output?

Let’s start with those — you can try answering, or say “explain that one,” and I’ll walk through it. Want more quantitative questions or concept checks like these?

4o

You said:

answer the above and then tell much more euqstions with answer

ChatGPT said:

Perfect! Let's go through the answers first, then I'll give you a bunch more practice questions (with answers) afterward. This is a great way to fully understand monetary and fiscal policy under different exchange rate regimes. 👇

✅ Answers

🔁 Q1: Why is monetary policy more effective under a flexible exchange rate?

Answer:
Because when the central bank increases the money supply (MS ↑), the interest rate falls (i ↓), which boosts investment (I ↑) and consumption (C ↑).
Additionally, the lower interest rate leads to capital outflows → depreciation of the domestic currency (E ↑).
A weaker currency makes exports (X ↑) more competitive and imports (IM ↓) more expensive → net exports (NX ↑).
This further increases planned expenditure (AEPlanned ↑) → output (Y* ↑) increases more than in a closed economy.

🔒 Q2: Why is monetary policy ineffective under a fixed exchange rate?

Answer:
Because any attempt to change the money supply causes pressure on the exchange rate.
For example, if the central bank increases MS → i ↓ → capital outflows → E ↓ (currency depreciation).
But under a fixed exchange rate, the central bank must intervene to keep E at the target level.
So it buys domestic currency and sells foreign reserves, reducing the money supply back to original → i goes back up → no change in AEPlanned or Y.
Thus, ΔY = 0 in the short run.

🟡 Q3: Why does fiscal policy become less effective under a flexible exchange rate?

Answer:
Fiscal expansion (G ↑) increases Y*, but this also increases money demand → i ↑ → IPlanned ↓ and C ↓ (crowding out).
Also, i ↑ → capital inflows → E ↓ (currency appreciation) → X ↓ and IM ↑ → NX ↓.
These effects (↓I, ↓C, ↓NX) partially offset the initial increase in G.
So, output increases, but less than expected.

🔐 Q4: Why is fiscal policy more effective under a fixed exchange rate regime?

Answer:
Because when fiscal expansion causes Y ↑ → i ↑ → capital inflows → currency appreciation pressure.
But the central bank must keep E fixed, so it sells DC and buys FC → MS ↑ → i ↓ again.
This offsets the crowding out effect (i goes back down), so investment and consumption are not reduced.
Hence, AEPlanned ↑ fully → Y* ↑ more strongly.

📊 Q5: AEPlanned = 1925 + 0.5Y. What’s the equilibrium Y?*

Solution:
At equilibrium: AEPlanned = Y
So,
Y = 1925 + 0.5Y
Y - 0.5Y = 1925
0.5Y = 1925
Y* = 3,850

💥 Q6: If a shock comes from the goods market, which regime minimizes output fluctuations?

Answer:
Fixed exchange rate
Because under flexible exchange rates, changes in i and E will cause offsetting changes in AEPlanned, reducing policy impact.

💥 Q7: If the shock comes from the money market, which regime stabilizes output better?

Answer:
Fixed exchange rate
Because the central bank offsets money demand shocks by adjusting MS to keep E fixed → no effect on Y.

📚 More Practice Questions (with Answers)

💰 Monetary Policy

Q1: What happens to investment when the central bank increases MS in a flexible regime?
A: Investment increases because interest rates fall.

Q2: Why does NX rise under a flexible regime when MS increases?
A: Because the domestic currency depreciates, making exports cheaper and imports more expensive.

Q3: Under fixed exchange rates, what does the central bank do if E ↓ below the target?
A: It buys DC (domestic currency) and sells FC (foreign currency) → reducing MS.

🧾 Fiscal Policy

Q4: What causes the interest rate to rise after a fiscal expansion?
A: Higher output increases money demand, pushing interest rates up.

Q5: In an open economy, why does i ↑ lead to a currency appreciation?
A: Higher i makes domestic assets more attractive → capital inflows → E ↓ (appreciation).

Q6: What’s the net effect of a fiscal expansion in a flexible regime?
A: Y increases, but by less due to crowding out (↓I, ↓C, ↓NX).

Q7: In a fixed regime, why are crowding-out effects neutralized?
A: The central bank increases MS to keep E constant, which lowers i back down.

🧮 Numerical

Q8: AEPlanned = 1950 + 0.5Y → What is Y*?
Solution:
Y = 1950 + 0.5Y →
0.5Y = 1950 →
Y* = 3,900

Q9: If G ↑ by 50 and IPlanned ↓ by 25, what’s ΔAE0?
A: +25

Q10: If AEPlanned = 1935 + 0.5Y, what is Y*?
Solution:
0.5Y = 1935 →
Y = 3,870

make a powerful summary and explain in effective way simple yet : Week 11 – Ch 18 – Open-Economy Macroeconomics (Part 1) Outline  Introduce the balance of payments accounts and the balance of payments identity.  Use the market for loanable funds to model the international flows of funds.  Use the demand-supply model to determine the exchange rate. 2 Capital Flows and the Balance of Payments Balance of Payments Accounts  A country’s balance of payments (BOP) accounts record a country’s international transactions with the rest of the world (ROW).  The BOP accounts include the international sales (exports) and purchases (imports) of goods, services, and assets.  It records payments from foreigners (that arise from exports) and payments to foreigners (that arise from imports). Balance of payments account Current Account (CA) Financial Account (FA) Movement of Goods & services Movement of Assets 3 Current Account (CA)  The current account records the net international flows of goods and services, and net factor income plus net international transfer payments. CA = Net exports of goods + Net exports of services + Net factor income + Net international transfer payments = Current account balance NX 4 Financial Account (FA)  The financial account records the sales (exports) of (financial & real) assets to foreigners and the purchases (imports) of assets from foreigners. It records the international flows of financial capital – the receipts from and the payments to foreigners arising from the exports and imports of (financial) assets, respectively. It also includes international transactions carried by the by the private sector (households and firms) and the central bank. Foreign assets held by the central bank are called official reserves. 5 Financial Account (FA)  When we sell (export) assets to foreigners, we will experience capital inflows as financial capital is flowing into the country (i.e., we are borrowing in net from the ROW).  When we buy (import) assets from foreigners, we will experience capital outflows as financial capital is flowing out of the country (i.e., we are lending in net to the ROW). FA = Exports of assets – Imports of assets = Capital inflows – Capital outflows = Net capital inflows 6 The Balance of Payments Identity  When taking all international transactions into consideration, the sum of current account and financial account must equal to zero, i.e., CA + FA = 0 1 CA = – FA CA = – Net capital inflows = NFI = Net Foreign Investment If CA > 0, called a CA surplus, then FA < 0, called a FA deficit, we are lending in net to the ROW 1 In reality, due to missed international transactions, the BOP identity is given by: CA + FA + statistical discrepancy = 0. 7 Modelling the Financial Account  The financial account records the net sales (net exports) of assets to foreigners.  To understand the financial account, we need to consider the flows of capital across national borders.  Use the loanable funds market to analyze the international flows of funds. Assumptions  It is a two-country world – Home (H) and Foreign (F).  All the international capital flows are in the form of loans.  Ignore the effects of the expected change in exchange rate on capital flows.  There is perfect capital mobility and there is no risk premium.  Net exports (NX) = Net Foreign Investment (NFI) = Net (outward) flow of loans (Ch 10) 8 Implications  Equilibrium in the loanable funds market requires:  Sum of all countries’ net exports must equal to zero. NXH + NXF = 0  Sum of all countries’ international flows of capital must equal to zero. NFIH + NFIF = 0  Domestic interest (iH) = Foreign interest (iF) = world interest (iW).  For an open economy, the loanable funds market is characterized as follows:  (Domestic) Supply of loanable funds (SF) comes from national savings, i.e., SF = SNational = SPrivate + SPublic.  Demand for loanable funds (DF) comes from domestic investment, i.e., DF = I(i). 9 Implications  Goods Market Equilibrium implies Y = C + I + G + NX  We know SNational = Y – C - G  Therefore, we know that following equation must hold in goods market equilibrium Y – C – G = I + NX SNational = I + NX SNational = I + NFI (as NX = NFI) SNational – NFI = I (Loanable funds market equilibrium) Supply of loans (in Home) = Demand for loans (in Home)  SNational = I + NFI  NFI = SNational – I = – Net Capital inflows = Net amount of loans leaving home to ROW 10 Home Foreign iF QFH QFF iH ● ● SFF DFF SFH DFH iF,C iH,C 11 Example: Initially iH,C > iF,C, investors find Home’s assets are more attractive.  Home will export assets to Foreign  Home experiences capital inflows.  When Home experiences capital inflows  The quantity of funds available in Home ↑ → ↓ iH  The quantity of funds available in Foreign ↓ → ↑ iF  This process continues until iH = iF = iW  At i = iW , capital inflows in Home (in net) = capital outflows in Foreign (in net) 12 Home Foreign iF QFH QFF iH ● ● SFF DFF SFH DFH iF,C iH,C iW ● ● ● ● QFSH QFdH QFdF QFSF Net outflow of capital Net inflow of capital NXF > 0NXH < 0 13 The basic math of the BOP In equilibrium, CAH + FAH = 0 CAF + FAF = 0 If CAH = NXH = + $ 10 billion Then, CAF = NXF = - $ 10 billion So that, NXH + NXF = 0 One country’s trade surplus is the other country’s trade deficit. 14 Y = C + I + G + NX National Income Identity (Goods Market Equilibrium) NX = Net Exports = Exports – Imports = X – IM Y – C – G = NX + I SNational = NX + I NX = SNational – I NX = SF – DF = (Domestic Supply of funds) – (Domestic Demand for funds) Suppose SNational = I, then we know that NX = 0 (Balanced Trade in net) The country is not borrowing or lending (in net) with the ROW 15 Y = C + I + G + NX National Income Identity (Goods Market Equilibrium) SNational = NX + I NX = SNational – I NX = SF – DF = (Domestic Supply of funds) – (Domestic Demand for funds) Suppose SNational > I, then we know that NX > 0 (Trade Surplus in net) The country is lending (in net) to the ROW CA + FA = 0 → NX + FA = 0 → FA < 0 Financial capital is flowing out (in net) Suppose SNational < I, then we know that NX < 0 (Trade Deficit in net) The country is borrowing (in net) from the ROW CA + FA = 0 → NX + FA = 0 → FA > 0 Financial capital is flowing in (in net) 16 Underlying Determinants of International Capital Flows  The initial interest rate differential between Home and Foreign triggers the international capital flows.  The interest rate differential can be caused by:  The differences in investment opportunities across countries.  The international differences in savings across counties. Numerical Example The world consists of two countries, Home and Foreign. The market for loanable funds in both countries can be described by the following equations: Home Foreign Demand for loanable funds DFH = 25 – 4iH DFF = 26 – 10iF Supply of loanable funds SFH = 20 + 16iH SFF = 15 + 10iF 17  If the countries do not trade with each other, find the equilibrium level of interest rates in both countries. Home SFH = DFH Foreign SFF = DFF 20 + 16iH = 25 – 4iH 15 + 10 iF = 26 – 10iF 20iH = 5 20iF = 11 iH = (5/20) = 0.25 (25%) iF = (11/20) = 0.55 (55%) Note: Since iF > iH , we expect capital to flow from Home to Foreign when trade is opened up. 18  Now, suppose international flows of capital are allowed. Find the world interest rate and the levels of net foreign investment in both countries. NFIH = SFH – DFH = (20 + 16iH) – (25 – 4iH) = 20iH – 5 NFIF = SFF – DFF = (15 + 10iF) – (26 – 10iF) = 20iF – 11 Equilibrium: NFIH + NFIF = 0 & iH = iF = iW (20iH – 5) + (20iF – 11) = 0 40iW = 16 iW = (16/40) = 0.4 (40%) 19 We derived iW = (16/40) = 0.4 (40%) NFIH = SFH – DFH = 20iH – 5 = 20(0.40) – 5 = 3 In equilibrium Home exports assets (in net) NFIH = NXH > 0 Trade Surplus Financial capital outflows (from Home to foreign) Home is lending to foreign (in net) NFIF = SFF – DFF = 20iF – 11 = 20(0.40) – 11 = -3 (Financial capital inflows) 20 The Role of Exchange Rate  A country’s BOP accounts record the country’s international transactions with the rest of the world; it also gives us the sources of demand for and supply of a country’s currency in the foreign exchange market.  A simple demand-supply model can be used to discuss the determination of the exchange rate in the foreign exchange market. Understanding Exchange Rate  Exchange rate (E) is the relative price of one currency in terms of another currency.  In our class, the exchange rate is quoted as the number of foreign currency (FC) units needed to exchange for (buy) one unit of domestic currency (DC); i.e., EFC/DC.  E is determined in the foreign exchange market, mainly an over-the-counter market. 21 Understanding Exchange Rate  When EFC/DC , this means more FC are needed to exchange one unit of DC  DC appreciates (in nominal terms)  When EFC/DC , this means fewer FC are needed to exchange one unit of DC  DC depreciates (in nominal terms). Note: When one currency appreciates, the other currency depreciates because the exchange rate is a relative price of a country’s currency. The Equilibrium Exchange Rate  We will develop a simple model for the foreign exchange market.  Demand for domestic currency, DDC, comes from exports of goods, services, and assets.  Supply of domestic currency, SDC, comes from imports of goods, services, and assets. 22 Demand for Domestic Currency (DDC)  The demand for domestic currency is downward sloping because, holding all else constant, when EFC/DC  (DC appreciates), domestic goods, services and assets all become more expensive (relative to foreign ..)  domestic exports   DDC . EFC/DC Quantity of DC DDC 1 2 1) When  EFC/DC the DC has appreciated, our exports are now relatively more costly, so X  and, 2) This results in a drop in the quantity of DC Demanded (this moves us along the demand curve) 23 Factors that shift the demand for DC curve: Factor Left/Right Reason Foreign output, YF,  Right When YF , foreign demand for domestic goods  ⇒  Exports of goods & services ⇒  Demand for DC Capital inflows  such as (iH – iF)  Right This implies that exports of assets  ⇒  Demand for DC Other factors that affect exports of goods, services & assets Right Increase in Demand Changes in consumption preference that favours domestic goods or provision of export subsidies, etc. ⇒  Exports of goods & services ⇒  Demand for DC E Q DDC D’DC 24 Supply of Domestic Currency (SDC)  The supply of domestic currency is upward sloping because, holding all else constant, when EFC/DC  (DC appreciates), domestic goods, services and assets all become more expensive (relative to foreign ..)  domestic imports   SDC  . EFC/DC Quantity of DC SDC 1) When  EFC/DC the DC has appreciated, Imports are now relatively cheaper, so IM  and, 2) This results in an increase in the quantity of DC Supplied (this moves us along the supply curve) 1 2 25 Factors that shift the supply of DC curve: Factor Left/Right Reason Domestic output, YH,  Right When YH , domestic demand for foreign goods  ⇒  Imports of goods & services ⇒  Supply of DC Capital outflows  such as (iH – iF)  Right This implies that imports of assets  ⇒  Supply of DC Other factors that affect imports of goods, services & assets Right Increase in Supply Changes in consumption preference that favours foreign goods or decrease in import tariffs, etc. ⇒  Imports of goods

ChatGPT said:

Here’s a powerful yet simple summary of Week 11 – Chapter 18: Open-Economy Macroeconomics (Part 1) with effective explanations:

🌍 1. What Is an Open Economy?

An open economy trades with the rest of the world—buying and selling goods, services, and financial assets.

📘 2. Balance of Payments (BOP): The Country’s Financial Ledger

The Balance of Payments tracks a country’s economic transactions with the rest of the world.

Two Main Accounts:

• Current Account (CA): Records trade in goods and services, plus income and transfer payments.

  • CA = Exports – Imports + Factor Income + Transfers

• Financial Account (FA): Tracks trade in financial assets like stocks, bonds, or real estate.

  • FA = Capital Inflows – Capital Outflows

✅ Key Identity:

CA + FA = 0
If a country runs a trade surplus (CA > 0), it must be lending money to the world (FA < 0).

💰 3. International Capital Flows and Loanable Funds

We use the loanable funds market to model how capital moves between countries based on interest rates.

Key Concepts:

• Savings = Investment + Net Foreign Investment (NFI)

• If Savings > Investment → Surplus → Lending to others (NFI > 0)

• If Savings < Investment → Deficit → Borrowing from others (NFI < 0)

Example:

• Home country interest rate = 25%, Foreign = 55%

• Investors prefer high returns → Capital flows from Home to Foreign

• This flow balances until both countries share a world interest rate

📈 4. Exchange Rates: The Price of Currencies

The exchange rate (E) is the price of one currency in terms of another.

Two Effects:

• If E rises, domestic currency appreciates → exports fall (they become expensive), imports rise

• If E falls, domestic currency depreciates → exports rise (cheaper), imports fall

⚖️ 5. Determining Exchange Rates: Supply and Demand

• Demand for Domestic Currency (DDC) comes from foreigners wanting to buy exports or assets

• Supply of Domestic Currency (SDC) comes from domestic residents wanting to import or invest abroad

Shifts in Demand:

• More foreign income → more exports → DDC shifts right

• Higher domestic interest rate → more capital inflows → DDC shifts right

Shifts in Supply:

• More domestic income → more imports → SDC shifts right

• Lower domestic interest rate → more capital outflows → SDC shifts right

🧠 Final Takeaway:

In an open economy:

• Trade flows (goods/services) and capital flows (money/assets) are interconnected

• Savings, investment, interest rates, and exchange rates all work together in global markets

• Understanding the balance of payments, capital flows, and exchange rates is essential to grasp how economies interact globally.

Let me know if you want a visual cheat sheet or flashcards to help memorize this!

4o

You said:

continue: The Foreign Exchange Market  The market for foreign exchange is in equilibrium when supply intersects demand. EFC/DC Quantity of DC • AE0 SDC DDC 27 Example: Suppose the domestic government provides an export subsidy.  An export subsidy makes domestic goods become less expensive in the world market.  Exports of goods ↑ ⇒ Demand for DC ↑ to D1DC EFC/DC Quantity of DC • AE0 S0DC D0DC  At point E0 , there is an excess demand for DC  Therefore, the DC appreciates to E1  Point B is the new equilibrium D1DC • BE1 28 Numerical Example Suppose the balance of payments accounts for Home can be summarized by the following equations (assume there are no other international transactions): Exports of goods and services = 0.2YF – 30EFC/DC Imports of goods and services = 0.125YH + 20EFC/DC Purchases of foreign assets by domestic residents = 140 – 2000(iH – iF) Purchases of domestic assets by foreigners = 225 + 1500(iH – iF) Also, interest rate is expressed in decimal points (i.e., if i = 0.05, then i = 5%). Find the equilibrium exchange rate if YH = 6000, YF = 8000, iH = 6% & iF = 4% (Note: the difference in interest rates may be due to a risk premium). 29 DDC = Exports of goods, services, and assets = (0.2YF – 30E) + (225 + 1500(iH – iF) ) = 225 + 0.2YF + 1500(iH – iF) – 30E SDC = Imports of goods, services, and assets = (0.125YH + 20E) + (140 – 2000(iH – iF) ) = 140 + 0.125YH – 2000(iH – iF) + 20E Equilibrium DDC = SDC 225 + 0.2YF + 1500(iH – iF) – 30E = 140 + 0.125YH – 2000(iH – iF) + 20E 225 + 0.2YF + 1500(.06 – .04) – 30E = 140 + 0.125YH – 2000(.06 – .04) + 20E 50E = 1005 E* = 20.1 30 31 32 Generic form: Numerical example: C = AC + MPC×YD C = 600 + 0.75YD T = T0 + t×Y T = 120 + 0.15Y TR = TR0 – tr×Y TR = 400 – 0.05Y IPlanned = 700 – 5000i , where i = 0.02 (2%) G0 G = 500 X = X0 – X1 × EFC/DC X = 280 – 15EFC/DC , where EFC/DC = 1 IM = IM0 + IM1 × Y + IM2 × EFC/DC IM = 250 + 0.1Y + 25EFC/DC The “Complete” Income-Expenditure Model 33 The AEPlanned function in generic form: AEPlanned = [AC + MPC×(Y – (T0 + t×Y) + (TR0 – tr×Y))] + (AI – d×i) + G + (X0 – X1EFC/DC) – (IM0 + IM1Y + IM2EFC/DC) AEPlanned = AC + MPC×[(1 – t – tr)Y – T0 + TR0] + AI – di + G + X0 – X1EFC/DC – IM0 – IM1Y – IM2EFC/DC AEPlanned = [AC + AI + G + X0 – IM0 + MPC×TR0 – MPC×T0 – di – (X1 + IM2)EFC/DC] + [MPC×(1 – t – tr) – IM1]×Y AEPlanned = AE0 + [MPC×(1 – t – tr) – IM1]×Y Note: AE0 = AC + AI + G + X0 – IM0 + MPC×TR0 – MPC×T0 – di – (X1 + IM2)EFC/DC 34 M = (1/ ) Before t > 0 & tr > 0 lowered M Now IM1 > 0 also lowers M 35 Solve for the income-expenditure model equilibrium:  Step 1: Express YD as a function of Y YD = Y – T + TR = 280 + 0.8Y  Step 2: Express the consumption function as a function of Y. C = 600 + 0.75(280 + 0.8Y) = 810 + 0.6Y  Step 3: Express the AEPlanned function as a function of Y. AEPlanned = C + IPlanned + G + (X – IM) = (810 + 0.6Y) + (700 – 5000(0.02)) + 500 + (280 – 15(1) ) – (250 +0.1Y + 25(1) ) = 810 + 0.6Y + 600 + 500 + 265 – 275 – 0.1Y = 1900 + 0.5Y  Step 4: Solve for the equilibrium. Y = AEPlanned Y = 1900 + 0.5Y 0.5Y = 1900 Y* = (1900/0.5) = 3,800

ChatGPT said:

Let's continue and wrap up the analysis of this open economy income-expenditure model and reinforce the key takeaways:

✅ Recap: Equilibrium Income

We solved the equation:

Y = AEPlanned

Substituting the expressions:

• AEPlanned = 1900 + 0.5Y

• So we solved:

  Y = 1900 + 0.5Y
  0.5Y = 1900
  Y = 3800

🔍 What Does It Mean?

At Y = 3800, aggregate planned expenditure equals national income, which is the condition for short-run equilibrium in the goods market.

💡 Breakdown of Model Assumptions & Implications:

• Consumption:

  • C = 810 + 0.6Y: Higher marginal propensity to consume (MPC) raises the multiplier.

• Government & Taxes:

  • Taxes and transfers depend on income (T = 120 + 0.15Y, TR = 400 – 0.05Y), which makes disposable income sensitive to Y.

• Investment:

  • I = 700 – 5000i: Investment is interest-sensitive. Here, i = 2%, so I = 700 – 100 = 600

• Net Exports:

  • Exports = 280 – 15E, where E = 1 ⇒ Exports = 265

  • Imports = 250 + 0.1Y + 25E, where Y = 3800 ⇒ Imports = 250 + 380 + 25 = 655

  • So, NX = Exports – Imports = 265 – 655 = –390 (trade deficit)

🔄 Multiplier (M):

Previously, we noted that:

M = 1 / [1 – MPC(1 – t – tr) + IM1]

Let’s plug in values:

• MPC = 0.75

• t = 0.15

• tr = 0.05

• IM1 = 0.1

M=11−0.75(1−0.15−0.05)+0.1=11−0.75(0.8)+0.1=11−0.6+0.1=10.5=2M = \frac{1}{1 - 0.75(1 - 0.15 - 0.05) + 0.1} = \frac{1}{1 - 0.75(0.8) + 0.1} = \frac{1}{1 - 0.6 + 0.1} = \frac{1}{0.5} = 2M=1−0.75(1−0.15−0.05)+0.11​=1−0.75(0.8)+0.11​=1−0.6+0.11​=0.51​=2

So the multiplier is 2—a $1 increase in autonomous expenditure increases income by $2.

🧮 Summary:

ComponentValueEquilibrium Y3800Consumption810 + 0.6(3800) = 3090Investment600Government Spending500Net Exports–390AEPlanned3090 + 600 + 500 – 390 = 3800 ✅

Let me know if you’d like to explore:

• The impact of a fiscal or monetary policy shock

• Comparative statics (e.g., what happens if E ↑ or G ↑)

• Graphical representation

• Real-life implications in policy or international trade

Want to try a scenario?

4o

You said:

ask question 30 with answers powerful efective relevant to above material and explain

ChatGPT said:

Absolutely! Here's a Question 30 that is powerful, effective, and highly relevant to the material you’ve covered—particularly focusing on the exchange rate, balance of payments, and the income-expenditure model:

❓ Question 30:

Suppose the foreign interest rate (iF) increases from 4% to 5%, while all other parameters remain the same. What is the new equilibrium exchange rate (EFC/DC) in the foreign exchange market?

Use the same balance of payments equations:

• Exports = 0.2YF – 30E

• Imports = 0.125YH + 20E

• Domestic purchase of foreign assets = 140 – 2000(iH – iF)

• Foreign purchase of domestic assets = 225 + 1500(iH – iF)

Given:
YH = 6000, YF = 8000, iH = 6%, and now iF = 5%

✅ Solution:

Step 1: Write the demand for DC (DDC):

DDC=(0.2YF–30E)+(225+1500(iH–iF))DDC = (0.2YF – 30E) + (225 + 1500(iH – iF))DDC=(0.2YF–30E)+(225+1500(iH–iF)) DDC=(0.2×8000–30E)+(225+1500(0.06–0.05))=(1600–30E)+(225+15)=1840–30EDDC = (0.2×8000 – 30E) + (225 + 1500(0.06 – 0.05)) = (1600 – 30E) + (225 + 15) = 1840 – 30EDDC=(0.2×8000–30E)+(225+1500(0.06–0.05))=(1600–30E)+(225+15)=1840–30E

Step 2: Write the supply of DC (SDC):

SDC=(0.125YH+20E)+(140–2000(iH–iF))=(0.125×6000+20E)+(140–2000(0.06–0.05))=(750+20E)+(140–20)=870+20ESDC = (0.125YH + 20E) + (140 – 2000(iH – iF)) = (0.125×6000 + 20E) + (140 – 2000(0.06 – 0.05)) = (750 + 20E) + (140 – 20) = 870 + 20ESDC=(0.125YH+20E)+(140–2000(iH–iF))=(0.125×6000+20E)+(140–2000(0.06–0.05))=(750+20E)+(140–20)=870+20E

Step 3: Set DDC = SDC:

1840–30E=870+20E⇒970=50E⇒E=19.41840 – 30E = 870 + 20E \Rightarrow 970 = 50E \Rightarrow E = 19.41840–30E=870+20E⇒970=50E⇒E=19.4

🧠 Interpretation & Explanation:

In the original scenario, the exchange rate equilibrium was E = 20.1.
After the foreign interest rate increased from 4% → 5%, the new equilibrium is E = 19.4.

💡 Why did the exchange rate decrease?

• When iF increases, foreign assets become more attractive, so domestic residents buy more foreign assets, and foreigners buy fewer domestic assets.

• This increases the supply of domestic currency (as people sell DC to buy foreign currency), and reduces the demand for DC.

• Hence, the domestic currency depreciates in relative terms → E declines.

Big Idea: Interest rate differentials affect capital flows, which shift the supply and demand for currencies, ultimately influencing the exchange rate.

make a powerful summary and epxlian material: Week 10 – Monetary Policy Outline  Introduce the money demand curve and factors affecting the money demand.  Introduce the theory of liquidity preference & use it to determine the interest rate.  Discuss the monetary policy transmission mechanism.  Incorporate monetary policy in the income-expenditure model and the AS-AD model. 2 The Demand for Money  The demand for money (MD) comes from households and firm who want to hold money to facilitate their daily transactions and/or to store some of their wealth.  Let’s examine factors that affect the demand for money. The Opportunity Cost of Holding Money  We can store our wealth in different types of assets:  Monetary assets such as cash and bank deposits.  Interest-bearing, non-monetary assets such as bonds, stocks etc. 3  The choice between holding monetary assets and non-monetary assets involves a trade-off between convenience (known as liquidity) and earning interest.  Monetary assets offer convenience (can be converted into cash easily) but they offer little to no interest/return.  Non-monetary assets offer returns to holders, but they does not provide convenience (it takes time to convert these assets into money).  Therefore, the demand for money, to some extent, comes from the choice of holding our wealth in the form of monetary assets.  Holding all else constant, an increase in the interest rate raises the opportunity cost of holding money, households and firms would like to hold more interest- bearing assets and fewer monetary assets  the demand for money falls.3  The choice between holding monetary assets and non-monetary assets involves a trade-off between convenience (known as liquidity) and earning interest.  Monetary assets offer convenience (can be converted into cash easily) but they offer little to no interest/return.  Non-monetary assets offer returns to holders, but they does not provide convenience (it takes time to convert these assets into money).  Therefore, the demand for money, to some extent, comes from the choice of holding our wealth in the form of monetary assets.  Holding all else constant, an increase in the interest rate raises the opportunity cost of holding money, households and firms would like to hold more interest- bearing assets and fewer monetary assets  the demand for money falls. 4 The Money Demand Curve  The money demand (MD) curve shows the relationship between the quantity of money demanded and the interest rate.  Given the interest rate represents the opportunity cost of holding money, there is an inverse relationship between the quantity of money demanded and the interest rate  the money demand curve is downward sloping. Nominal Quantity of Money. M Nom Interest Rate, i Nominal MD An ↑i causes a ↓MD• • 5 Shifts of the Money Demand Curve  Factors that affect the (nominal) money demand other than the interest rate will shift the entire MD curve. Factor Left/Right Reason Aggregate price level  Right Need to hold more money to buy the same amount of goods and services. (↑MD) Real GDP  Right When Y , C   we need to hold more money to facilitate a larger volume of transactions. (↑MD) 6 Shifts of the Money Demand Curve  Factors that affect the (nominal) money demand other than the interest rate will shift the entire MD curve. Factor Left/Right Reason Improvement in banking technology such as introduction of credit cards Left This allows people to make purchase without holding money. (↓MD) Institutional factors such as the introduction of chequable-savings accounts* Right This lowers the opportunity cost of holding money. (↑MD) These accounts provide convenience (liquidity) to depositors but without requiring depositors to give up interest. 7 Money and Interest Rates  Using the theory of liquidity preference to discuss the determination of interest rate. The Equilibrium Interest Rate (the determination of the level of the nominal interest rate) Assumptions of the liquidity preference model of the interest rate: 1) There is only one interest rate paid for non-monetary financial assets. 2) The level of (nominal) money demand comes from households and firms. 3) The level of (nominal) money supply is chosen by the central bank (the BOC). We assume the level of MS chosen by the BOC will be the level will achieve its interest rate target. 4) The BOC can change the money supply via open market operations, changing the bank rate, and government deposit switching (Chapter 14). 5) Money market equilibrium: MS = MD.  According to the liquidity preference model of the (nominal) interest rate, the (nominal) interest rate adjusts to ensure the market for money is in equilibrium.7 Money and Interest Rates  Using the theory of liquidity preference to discuss the determination of interest rate. The Equilibrium Interest Rate (the determination of the level of the nominal interest rate) Assumptions of the liquidity preference model of the interest rate: 1) There is only one interest rate paid for non-monetary financial assets. 2) The level of (nominal) money demand comes from households and firms. 3) The level of (nominal) money supply is chosen by the central bank (the BOC). We assume the level of MS chosen by the BOC will be the level will achieve its interest rate target. 4) The BOC can change the money supply via open market operations, changing the bank rate, and government deposit switching (Chapter 14). 5) Money market equilibrium: MS = MD.  According to the liquidity preference model of the (nominal) interest rate, the (nominal) interest rate adjusts to ensure the market for money is in equilibrium. 8  According to the liquidity preference model of the (nominal) interest rate, the (nominal) interest rate adjusts to ensure the market for money is in equilibrium. i Nom Quantity of Money, M MS0 MD0 i0 A • At pt A, MS = MD & this determines the equilibrium interest rate i = i0 When i > i0 , MS > MD there is an excess supply of money When i < i0 , MS < MD there is an excess demand for money M0 9 Monetary Policy and the Interest Rate in the Short-Run i Nom Quantity of Money, M MS0 MD0 M0 i0 A• Suppose the BOC  MS to MS1 = M1 :  When ↑MS the MS curve shifts right  At i = i0 , MS1 > MD(i0)  There is an excess supply of money  i falls until we get to where MS1 intersects MD0 (Point B) M1 MS1 B•i1 10 Changes in Money Demand (MD) i Nom Quantity of Money, M MS0 MD0 i0 A • Suppose the level of output, Y, : When Y , C   MD  to MD1.  When ↑MD the MD curve shifts right  At i = i0 , MD(i0) > MS0  There is an excess demand of money  i rises until we get to where MS0 intersects MD0 (Point B)  ΔMS = 0 M0 • •B MD1 11 Changes in Money Demand (MD) and Interest Rate Targeting - Consider the effect of a change in money demand & how the BOC responds to keep interest rate at the target level (iT). i Nom Quantity of Money, M MS0 MD0 iT A • Suppose MD  to MD1.  What would the BOC do to keep the Interest rate at iT ?  The BOC would ↑MS & shift the MS curve right until we get to i = iT  i falls until we get to where MS1 intersects MD1 (Point C)  Δi = 0 M0 • •B MD1 1 2 MS1 M1 C 12 Monetary Policy and Aggregate Demand  In Chapter 12, we learned about the effect of a change in money supply on the economy in the AS-AD model.  in MS   in interest rate   in AE0 (via  in IPlanned, C, X & IM) shifting the planned AE line  shift in the AD curve   in Y.  Now, we will go in depth on how a change in monetary policy affects the economy by going through the monetary transmission mechanism, which describes the channels through which a change in money supply will cause a shift in the aggregate demand and affect output and inflation rate (in the SR).12 Monetary Policy and Aggregate Demand  In Chapter 12, we learned about the effect of a change in money supply on the economy in the AS-AD model.  in MS   in interest rate   in AE0 (via  in IPlanned, C, X & IM) shifting the planned AE line  shift in the AD curve   in Y.  Now, we will go in depth on how a change in monetary policy affects the economy by going through the monetary transmission mechanism, which describes the channels through which a change in money supply will cause a shift in the aggregate demand and affect output and inflation rate (in the SR). 13 Monetary Policy in Practice  In Canada, the BOC has adopted inflation targeting – the BOC sets an explicit target for the inflation rate and the monetary policy is implemented to ensure the inflation target is met. The current inflation target is 2% with a target range of 1 – 3%. To achieve the inflation target, the BOC adjusts the target for the overnight rate. However, if the inflation rate stays within the target range, the BOC can use monetary policy to smooth out the business cycles. The advantages of adopting inflation targeting are it offers transparency and accountability. Easy to evaluate & what this means when the target is not met. 14 Now, we will look at the effect of a change in the target for the overnight rate on the economy. Example: The BOC lowers the target for the overnight rate to close a recessionary gap: The economy is initially at a SR equilibrium at has a recessionary gap Point A Y0 < YFE U is above the LR natural level Cyclical Unemployment > 0 P = P0 P P0 YY0 YFE LRAS AD0 • A SRAS0 15 Now, we will look at the effect of a change in the target for the overnight rate on the economy. Example: The BOC lowers the target for the overnight rate to close a recessionary gap: The economy is in a recessionary gap (Y0 < YFE) & the BOC lowers the target rate for the overnight rate  Interest rate ↓  cost of borrowing ↓  AE0 ↑ (AC , IPlanned , X , IM ).  When AE0 , AD shifts to the right to AD1 Point B is the New SR Equilibruim ↑Y to YFE ↑E & ↓U ↑P to P1 P P0 YY0 YFE LRAS AD0 • A SRAS0 AD1 B•P1 16 The Transmission Mechanism for Monetary Policy When the BOC changes the target for the overnight rate, it will affect the economy through four different channels: 1) Interest rate (earned/paid on loans & on other assets) 2) Asset prices 3) The exchange rate 4) Market expectations. 17 How the monetary transmission mechanism works Suppose the BOC lowers the target for the overnight rate (i  ) Interest rates on loans & other assets Cost of borrowing Asset prices Wealth Exchange rate Value of DC & cost of imports & exports Market expectations Expected inflation AD = C(YD) + I(r) + G + NX(exchange rate) Actual output, YSR which along with YFE = AxF(K,H,L). in turn determines the Output Gap, (YSR - YFE ) 18 The monetary transmission mechanism works – The Interest Rate Channel  Suppose the BOC lowers the target for the overnight rate (i  )  The overnight & other interest rates tend to move together  Interest rates on loans & other assets   Cost of borrowing   I & AC both ↑  AD ↑ , as (↑AD = ↑C(YD) + ↑I(r) + G + NX(exchange rate)  YSR ↑  Output gap , as ( ↑YSR - YFE ) 19 The monetary transmission mechanism works – The Asset Price Channel  Suppose the BOC lowers the target for the overnight rate (i  )  Asset prices & interest rates tend to move inversely  Asset prices ↑  Wealth ↑  AC ↑ (& perhaps even AI ↑) Wealth Effect  AD ↑ , as (↑AD = ↑C(YD) + ↑I(r) + G + NX(exchange rate)  YSR ↑  Output gap , as ( ↑YSR - YFE ) 20 The monetary transmission mechanism works – Exchange Rate Channel  Suppose the BOC lowers the target for the overnight rate (i  )  Domestic financial assets look less attractive, financial capital outflows ↑  Supply (selling) of DC on FX market ↑  Domestic currency depreciates, exchange rate e   Exports look relatively cheaper & imports rel more expensive, X ↑ & IM   AD ↑ , as (↑AD = C(YD) + I(r) + G + ↑ NX(exchange rate)  YSR ↑  Output gap , as ( ↑YSR - YFE ) 21 The monetary transmission mechanism works – Expectation Channel  Suppose the BOC lowers the target for the overnight rate (i  )  The BOC has increased the money supply, MS ↑  Agents expect more inflation (i.e., they expect higher prices & wages in the future, Pe ↑ & We ↑ )  Expected inflation rises Πe ↑  Agents spend more now before P rises, C ↑ & I ↑  AD ↑ , as (↑AD = ↑ C(YD) + ↑ I(r) + G + NX(exchange rate)  YSR ↑  Output gap , as ( ↑YSR - YFE ) 22 The Zero Lower Bound Problem  It seems the central bank can lower interest rate (a form of expansionary monetary policy) to stimulate the economy & to close a recessionary gap.  Question: Is there a limit on lowering interest rate?  Answer: Yes, there is a limit because (usually) the nominal interest rate CANNOT be negative.  The fact that nominal interest rate can’t go below zero is called the zero lower bound for interest rates. This places a limit on the use (& power) of monetary policy.  This was the challenge that central banks in developed countries faced in the 2007-09 financial crisis.  To resolve the problem of zero lower bound for interest rate, central banks such as the Federal Reserve and the Bank of England rolled out Quantitative Easing (QE) – the central bank purchases long-term assets in attempt to lower the long-term interest rate, exerting an expansionary effect on the economy.  The BOC did not use QE during the Great Recession. The BOC did use QE during the pandemic. 23 Money, Output, and Prices in the Long Run  Use the AS-AD model to discuss the SR & LR effects of monetary policy on the economy. Initially the economy is in LR equilibrium Point A Y = YFE P = P0 Employment & unemployment are both at their LR levels (Cyclical Unemployment) = 0 LRAS AD0 SRAS0 • AP0 P YYFE 24 Money, Output, and Prices in the Long Run  Use the AS-AD model to discuss the SR & LR effects of monetary policy on the economy. Suppose MS  permanently to MS1   MS ⇒ ↓ i ⇒  AE0 ⇒ AD shifts up Point B is the New SR Equilibrium  Y to Y1  P to P1  Employment & ↓ unemployment (Cyclical Unemployment) < 0 LRAS AD0 SRAS0 • AP0 P YYFE AD1 • BP1 1 25 Money, Output, and Prices in the Long Run  Use the AS-AD model to discuss the SR & LR effects of monetary policy on the economy. In the Long-Run  Since at Point B, Y1 > YFE, there is pressure for wages to rise in the LR   W ⇒ per-unit prod’n costs ↑  Per-unit profit margin ↓  SRAS shifts up/left Point C is the New LR Equilibrium ↓ Y back to YFE  P further to P2 ↓ Employment &  unemployment (back to their LR levels)  (Cyclical Unemployment) back to 0 LRAS AD0 SRAS0 • AP0 P YYFE AD1 • BP1 1 C• SRAS1 2 P225 Money, Output, and Prices in the Long Run  Use the AS-AD model to discuss the SR & LR effects of monetary policy on the economy. In the Long-Run  Since at Point B, Y1 > YFE, there is pressure for wages to rise in the LR   W ⇒ per-unit prod’n costs ↑  Per-unit profit margin ↓  SRAS shifts up/left

ChatGPT said:

Here's a powerful summary and explanation of Week 10 – Monetary Policy, broken into key concepts for better understanding and retention:

🔑 Key Concepts from Week 10: Monetary Policy

🏦 1. The Demand for Money

• Definition: Households and firms demand money for transactions and as a store of value.

• Types of assets:

  • Monetary assets: Cash, deposits – highly liquid but offer no interest.

  • Non-monetary assets: Bonds, stocks – offer returns but are less liquid.

• Opportunity Cost: Holding money means sacrificing interest income from other assets.

  • ↑ Interest Rate ⇒ ↓ Money Demand: As interest rates rise, holding cash becomes more expensive.

📉 2. The Money Demand (MD) Curve

• Shows the inverse relationship between interest rates and money demand.

• Downward-sloping: Because higher interest rates make people want to hold less money.

• Shifts in the MD Curve:

  • Right (↑MD):

    • ↑ Price Level (need more cash for the same goods)

    • ↑ Real GDP (more transactions)

    • Institutional changes that make holding money more attractive

  • Left (↓MD):

    • Banking tech improvements (e.g., credit cards reduce the need for cash)

💧 3. Theory of Liquidity Preference

• Explains how interest rates are determined in the money market.

• Assumptions:

  • One interest rate for all non-monetary assets.

  • Money demand (MD) comes from households/firms.

  • Money supply (MS) is controlled by the central bank (Bank of Canada - BOC).

  • Equilibrium: MS = MD

• Interest rate adjusts until supply and demand for money are equal.

🔄 4. BOC & Monetary Policy Tools

• BOC adjusts Money Supply (MS) to hit its target interest rate.

• Tools:

  • Open market operations

  • Changing the bank rate

  • Government deposit switching

• Effect:

  • ↑ MS ⇒ ↓ i (interest rate falls)

  • ↓ MS ⇒ ↑ i (interest rate rises)

📊 5. Monetary Policy Transmission Mechanism

How monetary policy affects the real economy (GDP, inflation, etc.):

BOC changes interest rate ⇒ Influences Aggregate Demand (AD) via 4 channels:

a) Interest Rate Channel

• ↓ Interest Rate ⇒ ↑ Consumption (C) + ↑ Investment (I)

• AD shifts right ⇒ ↑ Output (Y), ↓ Unemployment

b) Asset Price Channel

• ↓ Interest Rate ⇒ ↑ Asset Prices ⇒ ↑ Wealth ⇒ ↑ C & I ⇒ ↑ AD

c) Exchange Rate Channel

• ↓ Interest Rate ⇒ ↓ Domestic currency value ⇒ ↑ Exports, ↓ Imports ⇒ ↑ Net Exports ⇒ ↑ AD

d) Expectations Channel

• ↓ Interest Rate ⇒ ↑ Inflation expectations ⇒ Spend now ⇒ ↑ AD

🧩 6. Incorporating Policy into Models

a) Income-Expenditure Model

• MS ↑ ⇒ i ↓ ⇒ I ↑ ⇒ AE ↑ ⇒ ↑ Output (Y)

b) AS-AD Model

• MS ↑ ⇒ AD shifts right ⇒ ↑ Y and ↑ P in short-run

• Over time, economy returns to full employment (Y = YFE), but price level (P) remains higher.

🧊 7. The Zero Lower Bound (ZLB) Problem

• Interest rates can’t go below zero in normal conditions.

• Limits the power of traditional monetary policy during deep recessions.

• Solution: Quantitative Easing (QE) – Central bank buys long-term assets to stimulate the economy when rates are near zero.

📈 8. Short-Run vs. Long-Run Effects

• Short-Run: MS ↑ ⇒ AD ↑ ⇒ Y ↑ and P ↑

• Long-Run: Output returns to potential level (YFE), but Price level stays higher (inflationary impact)

🇨🇦 9. BOC’s Inflation Targeting

• Goal: Keep inflation at 2% (within a 1–3% range)

• BOC adjusts the overnight rate to maintain this target

• If inflation is under control, it also uses monetary policy to stabilize business cycles

🔁 Recap Flowchart

BOC ↑ MS ⇒ ↓ i ⇒ ↑ C, I, NX ⇒ ↑ AD ⇒ ↑ Y (↓ U), ↑ P

In Long-Run ⇒ Y returns to YFE, but P permanently ↑

Let me know if you want visual diagrams, quiz questions, or a simplified version for faster memorization!

4o

You said:

continue: Monetary Neutrality  From the analysis above, you can see that a change in in the money supply will not have any impact on any real variables such as real output in the LR – long-run neutrality of money.  Money is neutral in the long run because, the LR real output is determined by real inputs (K, L, & H) & technology (A & F( ) ). Y = A×F(K,L,H)  When (aggregate) prices , both output prices and input prices  by the same proportion  no change in the real values of goods and services  no change in AD! (Chapter 12 part 1, week 6).  Only more money chasing after the same amount of (real) output which results in higher prices (i.e., the nominal money supply only impacts nominal variables in the LR) 27 Numerical Example – Monetary Policy  We will consider the effect of a change in monetary policy in both the income-expenditure model & the AS-AD model The Income-Expenditure Model Suppose the economy can be characterized by the income-expenditure model & the following set of equations (similar to the example in Week 8/Chapter 13): Generic form: Numerical example: C = AC + MPC×YD C = 600 + 0.75YD T = T0 + t×Y T = 120 + 0.15Y TR = TR0 – tr×Y TR = 400 – 0.05Y IPlanned = 700 – 5000i G0 G = 500 X = X0 X = 280 IM = IM0 IM = 250 Note: In this model a change in i only affects IPlanned directly 28  Initially, the level of interest rate is held fixed at 2% (i.e., i = 0.02).  The initial equilibrium can be described by the followings: YD as a function of Y: YD = (Y – T + TR) ⇒YD = 280 + 0.8Y The consumption function as a function of Y: C = 810 + 0.6Y AEPlanned = C + IPlanned + G + X - IM The AEPlanned function as a function of Y: AEPlanned = 1940 + 0.6Y Equilibrium level of output: Y* = 4850 Note: For simplicity reasons, we assume a change in interest rate will only affects IPlanned. We will take into account of the effect (feedback) of a change in interest rate to the exchange rate in Ch 19. • AE Y* AEPlanned 450 Y AE028  Initially, the level of interest rate is held fixed at 2% (i.e., i = 0.02).  The initial equilibrium can be described by the followings: YD as a function of Y: YD = (Y – T + TR) ⇒YD = 280 + 0.8Y The consumption function as a function of Y: C = 810 + 0.6Y AEPlanned = C + IPlanned + G + X - IM The AEPlanned function as a function of Y: AEPlanned = 1940 + 0.6Y Equilibrium level of output: Y* = 4850 Note: For simplicity reasons, we assume a change in interest rate will only affects IPlanned. We will take into account of the effect (feedback) of a change in interest rate to the exchange rate in Ch 19. • AE Y* AEPlanned 450 Y AE0 29 30 Method 2: Use the multiplier to find the new Y* Y* = AE0  M = 40 × (1/0.4) = 40 × (2.5) = 100 New Y* = Initial Y* + Y* = 4,850 + 100 = 4,950 31 Point A 32 LRAS P Y AD0 ( i = 0.02) • SRAS0 ( W = 100) A YFE = 800 P* = 100 Initial Long-Run (& Short-Run) Equilibrium 33 Now, suppose the central bank lowers the target for the overnight rate by 0.8 percentage points (a form of expansionary monetary policy) such that autonomous expenditure increases by 70. The new AEPlanned function: New AEPlanned = (300 + 70) – P + 0.75Y = 370 – P + 0.75Y  The new AD function: New AD: P = 370 – 0.25Y or Y = 1480 – 4P The Short-Run Equilibrium Levels of Output & Price  In the short-run, wages are held fixed at the initial long-run level (W = 100). SR Equilibrium: AD = SRAS 370 - 0.25Y = (20 + 0.1Y)(100/100) 0.35Y = 350 Y* = 1,000 P* = 370 – 0.25( 1000 ) = 120 Point B 34 LRAS P Y AD0 ( i = 0.02) • SRAS0 ( W = 100) A YFE = 800 P* = 100 New Short-Run Equilibrium AD1 ( i = 0.012) 1 B• Y1 = 1000 P1 = 12034 LRAS P Y AD0 ( i = 0.02) • SRAS0 ( W = 100) A YFE = 800 P* = 100 New Short-Run Equilibrium AD1 ( i = 0.012) 1 B• Y1 = 1000 P1 = 120 35 The Long-Run Equilibrium Levels of Price & Wages  In the long run, Y = YFE = 800.  Sub Y = YFE into AD to solve for P. P* = 370 – 0.25( 800 ) = 170 • Sub Y = YFE & P* into SRAS to solve for W. 170 = (20 + 0.1( 800 ) ) (W/100) 170 = 100(W/100) W* = 170 • In the long-run, we are back to the same level of Y, same C, same E, same U & same real wage (W/P). All real variables are unchanged in the long-run. The nominal money supply is neutral. 36 LRAS P Y AD0 ( i = 0.02) • SRAS0 ( W = 100) A YFE = 800 P* = 100 New Long-Run Equilibrium AD1 ( i = 0.012) 1 B• Y1 = 1000 P1 = 120 SRAS1 ( W = 170) •P2 = 170 2

ChatGPT said:

Let’s walk through what’s happening in this numerical example to reinforce the concept of monetary neutrality using both the Income-Expenditure model and the AS-AD framework.

Short-Run vs Long-Run: Monetary Policy Effects

Initial Situation:

• Interest rate: 2% (i = 0.02)

• Equilibrium output (Y*): 4850

• Price level (P*): 100

• Wages (W): 100

• Long-run full-employment output (Y_FE): 800

Expansionary Monetary Policy Introduced

• Central bank cuts interest rate from 2% to 1.2% (i = 0.012).

• This increases autonomous expenditure (AE₀) by 70 units.

Short-Run Effect (Point B):

• Interest rate ↓ ⇒ Investment ↑ ⇒ AEPlanned ↑ ⇒ AD ↑

• Short-run output increases:
  Y = 1000,
  P = 120 (general price level rises)

• But wages (W) remain fixed at 100 in the short-run ⇒ real wage falls
  This leads to:

  • Firms hiring more

  • Temporary boost in output & employment

Long-Run Adjustment:

In the long run:

• Output must return to Y_FE = 800

• Substituting Y_FE into the new AD function:
  P = 370 - 0.25Y ⇒ P = 370 - 0.25(800) = 170

• Now plug P and Y_FE into SRAS to solve for new wages: 170 = (20 + 0.1*800)(W/100) ⇒ 170 = 100(W/100) ⇒ W = 170

Key Long-Run Result:

• W/P = 170 / 170 = 1, the same real wage as before

• Real variables (output, employment, real wage) return to original values

• Only nominal variables (P and W) have changed

Conclusion: Monetary Neutrality

• In the short run, a monetary expansion increases output and prices.

• In the long run, only the price level and nominal wages rise.

• Real GDP (Y_FE), employment, consumption, investment, and real wages stay unchanged.

This confirms the concept of long-run neutrality of money:

An increase in the money supply does not affect real economic variables in the long run.

Let me know if you want a visual summary of this or help with graphing this step-by-step!

4o

You said:

ask 30 question and answers absed on above'

2/2

ChatGPT said:

Here are 30 questions and answers based on the concepts, numerical examples, and graphs in your notes on Monetary Neutrality, Income-Expenditure Model, and the AS-AD Framework:

🔹 Conceptual Understanding

• Q: What is monetary neutrality?
  A: It is the idea that changes in the money supply only affect nominal variables (like prices and wages) but not real variables (like output or employment) in the long run.

• Q: Does money affect real GDP in the long run?
  A: No, real GDP is determined by real factors like capital (K), labor (L), human capital (H), and technology (A), not by money.

• Q: What happens to aggregate demand when the money supply increases in the short run?
  A: AD increases due to lower interest rates, which boosts investment and spending.

• Q: What happens to real wages in the short run after an increase in the money supply?
  A: Real wages fall because prices rise while nominal wages remain fixed.

• Q: What ensures money is neutral in the long run?
  A: Flexible prices and wages that adjust over time to bring real variables back to equilibrium.

🔹 Numerical Example – Short Run

• Q: What is the initial interest rate in the example?
  A: 2% or i = 0.02

• Q: What is the initial equilibrium output in the income-expenditure model?
  A: Y* = 4850

• Q: What is the formula for disposable income (YD)?
  A: YD = Y - T + TR

• Q: What is the formula for consumption (C)?
  A: C = 600 + 0.75YD or simplified: C = 810 + 0.6Y

• Q: What is the formula for planned aggregate expenditure (AEPlanned)?
  A: AEPlanned = C + I + G + X - IM

• Q: What is the slope of the AEPlanned function?
  A: 0.6 (marginal propensity to spend)

• Q: What is the initial AEPlanned equation?
  A: AEPlanned = 1940 + 0.6Y

• Q: What is the equilibrium output where AE = Y?
  A: Y* = 4850 (solved where AE = Y)

• Q: What happens when the central bank reduces the interest rate by 0.8%?
  A: Autonomous expenditure increases by 70, shifting AD rightward.

🔹 Short-Run AD-AS Model

• Q: What is the new AEPlanned equation after the policy change?
  A: AEPlanned = 2010 + 0.6Y

• Q: What is the new AD equation?
  A: P = 370 - 0.25Y or Y = 1480 - 4P

• Q: What is the new short-run output (Y₁)?
  A: Y₁ = 1000

• Q: What is the new short-run price level (P₁)?
  A: P₁ = 120

• Q: Are wages flexible in the short run?
  A: No, they are held fixed at W = 100

• Q: What happens to employment and output in the short run?
  A: Both increase due to lower real wages.

🔹 Long-Run Adjustment

• Q: What is the long-run full-employment level of output (Y_FE)?
  A: Y_FE = 800

• Q: What is the long-run price level (P*)?
  A: P* = 170 (from AD function)

• Q: How do we calculate new wages in the long run?
  A: Use SRAS: P = (20 + 0.1Y)(W/100), solve for W

• Q: What is the new nominal wage in the long run?
  A: W = 170

• Q: What is the new real wage in the long run?
  A: W/P = 170/170 = 1 (same as before)

• Q: Do real variables change in the long run after a monetary shock?
  A: No, they return to original values.

• Q: Why does output return to Y_FE in the long run?
  A: Because prices and wages adjust, removing the short-run distortions.

🔹 Graph Interpretation

• Q: What shifts when monetary policy becomes expansionary?
  A: The AD curve shifts to the right.

• Q: What curve shifts in the long run after wage adjustment?
  A: The SRAS curve shifts leftward due to higher wages.

• Q: How does the economy move on the graph from point A to B to C?
  A:

  • Point A: Original equilibrium

  • Point B: Short-run expansion (AD↑, Y↑, P↑)

  • Point C: Long-run equilibrium (SRAS↓, Y back to Y_FE, P↑ further)

make a powerful summary and explain material: Week 9 – Money, Banking, and the Central Banking System Outline  The definition of money and the different measures of money supply.  What is money? How is the money supply determined?  The role of money in the economy.  The role of (commercial) banks and how they affect money supply.  The role of the central bank and how they influence money supply. 2 The Meaning of Money  In economics, money DOES NOT mean “wealth”.  In economics, when we say a person has a lot of money, it means that person holds a relatively large portion of their wealth in the form of money (monetary assets); it DOES NOT mean that person has a lot of wealth. What is Money?  Money is any asset that can easily be used to purchase goods and services.  Money is the most liquid asset in the economy. It consists of cash & other liquid assets.  The kinds of assets that will be counted as money depends on the definitions of monetary aggregate (or money supply). Note: An asset is said to be liquid if it can easily be converted to cash. 3 What is Money?  There are several definitions or measures of the aggregate nominal money supply (monetary aggregates):  M1 = Currency in circulation (cash) + Demand deposits and other chequing deposits at/in chartered banks.  M2 = M1 plus chartered bank personal term deposits, and non-personal demand and notice deposits at/in chartered banks.  M3 = M2 plus non-personal term deposits and chartered bank foreign currency deposits of Canadian residents at/in chartered banks.  Note: A monetary aggregate with a “+” sign include deposits at chartered banks plus the same type(s) of deposits at trust companies, mortgage and loan companies, credit unions, and caisses populaires. 4 Roles of Money  Money performs the following functions: 1) Medium of exchange – an asset that people use to trade for goods and services rather than for their own consumption. The use of money eliminates the problem of “double coincidence of wants”. 2) Store of value – an asset that allows us to store our purchasing power (& transfer it into the future). 3) Unit of account – a commonly accepted measure people use to set prices and make economic calculations. ** We will leave it for you to read on the topic on the different types of money. 5 The Role of Banks and the Money Supply  To understand the determination of money supply we need to understand the role of banks because bank deposits are major components of money supply. What Banks Do  Bank is a financial intermediary that accepts deposits from savers and converts these deposits into loans to borrowers and makes other investments.  The balance sheet of a commercial/chartered bank: Assets Liabilities and Equity Loans Deposits Bank reserves Equity 6 The Role of Banks and the Money Supply  The balance sheet of a commercial/chartered bank:  Bank reserves (reserves for short) refer to currency held in banks’ vaults and banks’ deposits at the central bank (i.e., the Bank of Canada)  Loans + Bank reserves = Deposits + Equity  Equity = Loans + Bank reserves – Deposits = Bank’s capital Assets Liabilities and Equity Loans Deposits Bank reserves Equity Assets - Liabilities6 The Role of Banks and the Money Supply  The balance sheet of a commercial/chartered bank:  Bank reserves (reserves for short) refer to currency held in banks’ vaults and banks’ deposits at the central bank (i.e., the Bank of Canada)  Loans + Bank reserves = Deposits + Equity  Equity = Loans + Bank reserves – Deposits = Bank’s capital Assets Liabilities and Equity Loans Deposits Bank reserves Equity Assets - Liabilities 7 8 The Problems of Bank Runs  A fractional reserve banking system implies that if banks face sudden, rapid withdrawals from depositors, they might not have enough cash in their reserves to satisfy the demand for withdrawals  this could lead to a bank run and potentially the failure of the whole bank.  In 2023, Silicon Valley Bank, Signature Bank & First Republic Bank (each with $100+ billion in deposits) and two other smaller US banks failed  A bank run can be self-fulfilling and contagious.  If a country’s banking system experiences a run, then the country has a banking crisis. Like in Ireland in 2008 which forced a 64 billion euro bailout. 9 Bank Regulation  Given the disruptive nature of a bank run, there is incentive for policy makers to take measures to avoid a bank run.  In Canada, the Office of the Superintendent of Financial Institutions (OSFI) is responsible to regulate banks. To stabilize the banking sector, the OSFI uses: 1) Requirement of deposit insurance. 2) Capital requirements – banks are required to hold more assets than the value of their bank deposits (i.e., bank’s equity must be positive). 3) Reserve ratios - Prior to 1994 chartered banks in Canada were required to maintain a minimum reserve ratio.  Now, chartered banks hold “voluntary” reserves to satisfy daily withdrawals of the depositors and to avoid a bank run. 10 Determining the Money Supply  We examine how banks create money through the loan creation process. How Banks Create Money Set up of the model  Money supply (MS) is defined as M1, i.e., MS = Currency in Circulation (CC) + Demand Deposits (DD)  The desired/voluntary reserve ratio is held fixed, say 10% (rr = 0.1).  If the bank’s current reserve ratio is NOT equal to 10%, it will adjust the amount of loans made to bring the reserve ratio back to the desired level. 11 Set up of the model (continued)  The bank does not hold excess reserves – reserves over and above the amount needed to satisfy the desired reserve ratio. Excess reserves = Actual reserves – Desired reserves  People hold a constant amount of cash ($100) and will deposit any excessive amount of cash into the bank.  For simplicity, we assume there is only one chartered bank in the economy. 12 Assets Liabilities Loans $940 Demand deposits $1,000 Bank reserves $100 Equity $40 13 Example: Now suppose Jack finds $20 in cash in the wall in his home. What happens to the money supply? • The initial level of the money supply (after the “discovery” of $20) MS = CC + DD MS = $120 + $1,000 = $1,120 • Jack found an additional $20, and he would deposit it into the bank. The bank’s balance sheet – immediately after the $20 deposit Note: The bank now holds excess reserves (i.e., it is no longer in equilibrium) Assets Liabilities Loans $940 Demand deposits $1,000 + $20 Bank reserves $100 + $20 Equity $40 14 Assets Liabilities Loans $940 Demand deposits $1,020 Bank reserves $120 Equity $40 15 Assets Liabilities Loans $958 Demand deposits $1,020 + $18 Bank reserves $102 + $18 Equity $40 16 17 Assets Liabilities Loans $940 + $180 Demand deposits $1,000 + $200 Bank reserves $100 + $20 Equity $40 18 Central Banks  A central bank is an institution that oversees and regulates the banking system, issues currency and designs and implements monetary policy. The Functions of a Central Bank The Bank of Canada (BOC) is Canada’s central bank & it does the following: 1) The BOC regulates chartered banks & serves as the lender of last resort.  The interest rate that the BOC charges the chartered banks is called the bank rate.  Note: If the BOC wants to it can charge a lower interest rate. 2) The BOC acts as banker for the federal government. 3) The BOC issues currency. 4) The BOC conducts monetary policy.  In real life, the BOC DOES NOT HAVE COMPLETE control over the money supply. 19 The Structure of the Bank of Canada  The BOC is owned by the federal government. However, the Bank of Canada is granted considerable autonomy to carry out its responsibilities.  The operation of the BOC is overseen by its board of directors, which consists of 12 directors from outside the BOC, the Governor, and the Senior Deputy Governor. The Deputy Minister of Finance sits on the board as a non-voting member.  The Governor of the BOC is appointed on a renewable seven-year term.  If there were a profound disagreement between the BOC and the government, the Minister of Finance could issue a written directive to the Governor specifying a change in monetary policy. When this happens and if the governor disagrees, then the governor will resign (or be fired). 20 2121 22 23 3) Open Market Operations (OMOs)  Open market operations refer to the purchases and sales of government bonds by the central bank.  When the central bank purchases government bonds, the central bank is said to carry out an open market purchase. This causes ↑ MB → ↑ MS  When the central bank sells government bonds, the central bank is said to carry out an open market sale. This causes ↓ MB → ↓ MS  When the central bank carries out open market operations, there will be changes in both the monetary base and money supply Set up:  The public is happy with $100 cash in their pockets, and they will deposit any excess amount of cash into the chartered bank. In addition, the chartered bank is initially in equilibrium (with rr = 0.1). Initial equilibrium level of MS = CC + DD Initial equilibrium level of MS = $100 + $1000 = $110023 3) Open Market Operations (OMOs)  Open market operations refer to the purchases and sales of government bonds by the central bank.  When the central bank purchases government bonds, the central bank is said to carry out an open market purchase. This causes ↑ MB → ↑ MS  When the central bank sells government bonds, the central bank is said to carry out an open market sale. This causes ↓ MB → ↓ MS  When the central bank carries out open market operations, there will be changes in both the monetary base and money supply Set up:  The public is happy with $100 cash in their pockets, and they will deposit any excess amount of cash into the chartered bank. In addition, the chartered bank is initially in equilibrium (with rr = 0.1). Initial equilibrium level of MS = CC + DD

ChatGPT said:

Here’s a powerful summary and clear explanation of the key concepts from Week 9 – Money, Banking, and the Central Banking System:

🔑 Summary: Money, Banking, and the Central Bank

💰 What Is Money?

• Money ≠ Wealth. In economics, money is not total wealth; it's a liquid part of wealth used for transactions.

• Definition: Money is any asset that can be used to buy goods and services easily (most liquid asset).

• Functions of Money:

  • Medium of Exchange: Solves the problem of barter ("double coincidence of wants").

  • Store of Value: Holds purchasing power over time.

  • Unit of Account: Standard measure for pricing and calculations.

🧮 Measures of Money Supply (Monetary Aggregates)

• M1 = Cash + Demand (chequing) deposits.

• M2 = M1 + Personal term deposits + Non-personal deposits.

• M3 = M2 + Foreign currency and non-personal term deposits.

• Extended (with "+") = Includes similar deposits in non-bank institutions (e.g., credit unions).

🏦 Commercial Banks and Money Creation

• Banks are financial intermediaries that take deposits and give out loans.

• Bank Balance Sheet Basics:

  • Assets: Loans + Bank Reserves.

  • Liabilities & Equity: Deposits + Equity.

• Bank Reserves = Vault cash + deposits at the central bank.

• Fractional Reserve System: Banks keep a portion of deposits as reserves (e.g., 10%) and lend the rest.

• Money Creation: Loans from banks increase the money supply (through deposit expansion).

⚠️ Risks: Bank Runs

• A bank run happens when many depositors withdraw at once.

• Banks don’t keep all deposits in cash → can fail if reserves run out.

• Example: SVB, Signature Bank collapse in 2023.

• Bank runs can spread panic → cause systemic banking crises (e.g., Ireland 2008).

🛡️ Bank Regulation (Canada)

• Overseen by OSFI (Office of the Superintendent of Financial Institutions).

• Tools to maintain stability:

  • Deposit insurance.

  • Capital requirements (must have enough equity).

  • Reserve ratios (voluntary since 1994, not legally required).

🏦 The Central Bank – Bank of Canada (BOC)

• Roles:

  • Regulates banks, lender of last resort.

  • Banker to the federal government.

  • Issues currency.

  • Conducts monetary policy (controls interest rates, money supply).

• Monetary Policy Tool:

  • Open Market Operations (OMO):

    • Buying bonds → increases money supply (↑ MB → ↑ MS).

    • Selling bonds → decreases money supply (↓ MB → ↓ MS).

• Note: The BOC influences, but does not fully control the money supply.

🧠 Example Recap: How Banks Create Money

• Initial MS = Cash (CC) + Deposits (DD).

• If Jack finds and deposits $20:

  • MS temporarily increases.

  • Bank lends part of it (keeping 10% as reserve).

  • Lending continues through multiple rounds → money multiplier effect.

🧭 Final Takeaway

Money is not wealth, but a tool of exchange and value storage. The banking system and central bank work together to manage the money supply, maintain stability, and support economic activity. Understanding these institutions helps explain inflation, interest rates, and economic growth.

Let me know if you want diagrams, calculations, or practice questions based on this material!

4o

You said:

continue: The maximum change in money supply when the central bank purchases $10 worth of bonds: Initial MS = $1,100 = CC + DD = $100 + $1,000 = $1,100 New MS = CC + DD = $100 + $1,100 = $1,200 MS = New MS – Initial MS = $1,200 - $1,100 = $100 Alternatively, the (maximum) change in MS is given by: MS = CC + DD MS = 0 + $100 = $100  Observation: An open market purchase of government bonds by the CB (is a form of expansionary monetary policy) leads to an increase in MS. 28 Assets Liabilities Loans $940 Demand deposits $1,000 - $10 Bank reserves $100 - $10 Equity $40 29 Assets Liabilities Loans $940 - $90 Demand deposits $1,000 - $100 Bank reserves $100 - $10 Equity $40 30  The maximum change in money supply when the central bank sells $10 worth of bonds: Initial MS = $1,100 = CC + DD = $100 + $1,000 = $1,100 New MS = CC + DD = $100 + $900 = $1,000 MS = New MS – Initial MS = $1,200 - $1,000 = - $100 Alternatively, the (maximum) change in MS is given by: MS = CC + DD MS = 0 + (-$100) = - $100  Observation: An open market sale of government bonds by the CB (is a form of contractionary monetary policy) leads to an decrease in MS. 31 32 Interest Rate Targets versus Money Supply Targets  Now, the BOC pursues interest rate targeting (keeping interest rate at a pre-specified level) rather than money supply targeting (keeping money supply at a pre-specified level) because 1) The BOC does not have complete control over the money supply, but it can control the overnight rate almost perfectly. 2) It is easier for households and firms to understand the implications of a change in interest rate than a change in money supply.

ChatGPT said:

Here’s a powerful summary and clear explanation of Week 9: Money, Banking, and the Central Banking System:

🔑 Key Concepts Summary

1. What is Money?

• Money ≠ Wealth. Economists define money as liquid assets used to buy goods/services—not total wealth.

• Functions of money:

  • Medium of exchange – avoids the "double coincidence of wants."

  • Store of value – retains purchasing power over time.

  • Unit of account – standardizes prices and economic calculations.

2. Measures of Money Supply

• M1 = Currency + demand (chequing) deposits

• M2 = M1 + personal term deposits + other notice deposits

• M3 = M2 + non-personal term deposits + foreign currency deposits

• Monetary aggregates may include deposits at other institutions (credit unions, etc.) if marked with “+”.

3. Role of Commercial Banks

• Banks accept deposits and lend money, impacting the money supply.

• Use fractional reserve banking, keeping only a portion of deposits as reserves.

• Bank runs occur when too many people withdraw at once and reserves are insufficient.

4. Bank Regulation

• To prevent crises, regulators like OSFI enforce:

  • Deposit insurance

  • Capital requirements (positive bank equity)

  • Voluntary reserve ratios (post-1994, no mandatory ratio in Canada)

5. How Banks Create Money

• Through loan creation:

  • If someone deposits $100, and reserve ratio is 10%, the bank keeps $10 and lends $90.

  • That $90 gets spent and re-deposited, and the process repeats, multiplying the money supply.

6. The Central Bank’s Role (Bank of Canada)

• Functions:

  • Regulates banks & is lender of last resort

  • Acts as government’s banker

  • Issues currency

  • Conducts monetary policy

• Though the BOC can’t directly control money supply, it controls the overnight rate (interest rate for interbank loans), influencing economic activity.

7. Open Market Operations (OMOs)

• A primary tool of monetary policy.

  • Buy bonds → injects money into banks → increases money supply (expansionary)

  • Sell bonds → removes money from banks → decreases money supply (contractionary)

8. Example of Money Supply Change via OMOs

• Central bank buys $10 bonds:

  • Initial MS = $1,100 → New MS = $1,200 → ΔMS = +$100

• Central bank sells $10 bonds:

  • Initial MS = $1,100 → New MS = $1,000 → ΔMS = –$100

9. BOC's Monetary Policy Target

• Today, the BOC targets interest rates, not money supply:

  • Why?

    • It can accurately control interest rates, not money supply.

    • People understand interest rate changes better.

🧠 Final Thoughts

• Money supply is not static—it’s shaped by:

  • Public behaviour (spending/saving)

  • Banking practices (loans/reserves)

  • Central bank policies (rates & bond purchases/sales)

• Understanding this system helps explain inflation control, economic stability, and recession response.

Would you like flashcards, diagrams, or a quiz based on this material?

4o

You said:

ask 30 questions and answer them based on all above material

ChatGPT said:

Here are 30 questions and answers based on the material provided for Week 9 – Money, Banking, and the Central Banking System:

1. What is money in economic terms?

• Answer: Money is an asset that can easily be used to purchase goods and services. It is the most liquid asset in the economy, including cash and other easily liquidated assets.

2. Does money equal wealth?

• Answer: No, money does not mean wealth. It refers to liquid assets used for transactions, whereas wealth refers to the total value of assets owned by a person.

3. What is the main function of money in the economy?

• Answer: Money serves as a medium of exchange, store of value, and unit of account.

4. What is the definition of a medium of exchange?

• Answer: A medium of exchange is an asset that people use to trade for goods and services rather than for their own consumption.

5. What does “store of value” mean?

• Answer: Store of value means that money retains its purchasing power over time, allowing individuals to store wealth for future use.

6. What is the unit of account function of money?

• Answer: A unit of account allows people to set prices and make economic calculations based on a common standard.

7. What are the main measures of the money supply?

• Answer: The main measures are:

  • M1: Currency in circulation + demand deposits.

  • M2: M1 + personal term deposits and other deposits.

  • M3: M2 + non-personal term deposits and foreign currency deposits.

8. What is fractional reserve banking?

• Answer: It is a banking system where banks are required to keep only a fraction of deposits as reserves and can lend out the remainder, thereby expanding the money supply.

9. What is a bank run?

• Answer: A bank run occurs when many customers of a bank withdraw their deposits simultaneously due to fears that the bank will become insolvent, potentially leading to the bank's failure.

10. What role do banks play in the money supply?

• Answer: Banks act as intermediaries by accepting deposits and providing loans. This process of lending money increases the money supply in the economy.

11. What is the balance sheet of a commercial bank?

• Answer: The balance sheet of a commercial bank includes assets like loans and bank reserves, and liabilities like deposits and equity.

12. What are bank reserves?

• Answer: Bank reserves refer to the cash held in a bank's vaults or deposited with the central bank. These reserves are kept to meet the withdrawal demands of depositors.

13. What is the purpose of deposit insurance?

• Answer: Deposit insurance protects depositors in case a bank fails, ensuring they can recover a portion of their deposits up to a certain limit.

14. What are capital requirements in banking?

• Answer: Capital requirements mandate that banks hold more assets than the value of their deposits to ensure they have enough capital to absorb losses.

15. What is the reserve ratio?

• Answer: The reserve ratio is the percentage of depositors' money that banks must keep in reserve and not lend out.

16. How do banks create money through loans?

• Answer: When banks make loans, they create new deposits, which increases the money supply in the economy.

17. What happens to the money supply when a bank makes a loan?

• Answer: When a bank makes a loan, it credits the borrower's account, creating new demand deposits, which increases the money supply.

18. What is the maximum change in money supply due to open market operations?

• Answer: The maximum change in money supply from open market operations is determined by the size of the bond purchase or sale and the reserve ratio of the banks.

19. What happens when the central bank buys government bonds?

• Answer: When the central bank buys government bonds, it increases the money supply by injecting money into the banking system.

20. What happens when the central bank sells government bonds?

• Answer: When the central bank sells government bonds, it decreases the money supply by removing money from the banking system.

21. What is expansionary monetary policy?

• Answer: Expansionary monetary policy involves increasing the money supply through tools like open market purchases to stimulate economic growth.

22. What is contractionary monetary policy?

• Answer: Contractionary monetary policy involves decreasing the money supply through tools like open market sales to slow down inflation and economic activity.

23. Why does the Bank of Canada target interest rates rather than money supply?

• Answer: The BOC targets interest rates because it has more control over interest rates than the money supply, and interest rate changes are easier for the public to understand.

24. What is the Bank of Canada's role in the economy?

• Answer: The Bank of Canada regulates commercial banks, acts as the government's banker, issues currency, and conducts monetary policy.

25. What is the Bank of Canada's target rate?

• Answer: The Bank of Canada's target rate is the overnight rate, which is the interest rate at which major financial institutions lend to each other overnight.

26. What is the Bank of Canada’s role as a lender of last resort?

• Answer: The Bank of Canada acts as a lender of last resort by providing emergency loans to banks in financial distress to prevent a collapse of the banking system.

27. How does the Bank of Canada regulate commercial banks?

• Answer: The Bank of Canada regulates commercial banks by setting guidelines for capital requirements, reserves, and overseeing monetary policy.

28. What is the Board of Directors at the Bank of Canada?

• Answer: The Board of Directors oversees the Bank of Canada, consisting of 12 directors, the Governor, Senior Deputy Governor, and the Deputy Minister of Finance as a non-voting member.

29. What is the difference between M1 and M2?

• Answer: M1 includes currency and demand deposits, while M2 includes M1 plus personal term deposits and other forms of savings.

30. Why is understanding monetary policy important for the economy?

• Answer: Understanding monetary policy is crucial because it affects interest rates, inflation, economic growth, and the stability of the financial system.

make a powerful summary and detailed explanation: Week 8: Chapter 13 – Fiscal Policy Outline  Formally introduce fiscal policy.  Discuss the effect of a change in fiscal policy on aggregate expenditure.  Incorporate fiscal policy in the income-expenditure model (include the appendix).  Discuss how fiscal policy acts as automatic stabilizer and its effectiveness in stabilizing fluctuations in output (include pages 417 – 420).  Other issues related to fiscal policy, budget balance, and national debt. Fiscal Policy: The Basics Fiscal policy refers the government’s choice regarding levels of spending (G), taxes (T), and transfers (TR). Taxes, Purchases of Goods & Services, Government Transfers, and Borrowing  Taxes are the “income” of the government.  Taxes include income taxes, corporate profit taxes, sales taxes, social insurance taxes (e.g., payroll taxes), and other taxes (e.g., property taxes).  Excluding interest payments on government debt, government expenditures come into two forms: 1) Government spending on final goods and services (G). 2) Government transfers (TR) – payments to households for which no good and service is provided in return. Examples include public pensions, old age security, childcare benefits, employment insurance etc. 2 The Government Budget and Total Spending  The national income identity (Chapters 7 & 11): GDP = C + I + G + X – IM = AEPlanned  Effects of fiscal policy on aggregate expenditure:  Direct effect: Fiscal policy affects aggregate expenditure directly by changing government spending on final goods and services (G).  Indirect effect: Fiscal policy affects aggregate expenditure indirectly via changes in taxes (T) and government transfers (TR).  By changing taxes and/or government transfers, the government changes households’ disposable income (YD = Y – T + TR)  a  in YD leads to a  in C. 3  A change in taxes may also affect investment (I) if it affects the profitability of investment projects.  Implication: A change in fiscal policy will affect AEPlanned  both the AEPlanned line and the AD curve will shift  there will be a change in the short-run (equilibrium) level of output. 4 Expansionary Fiscal Policy: If the government ↑G, ↑TR or ↓T then ... 450 AE Y AE0 Y0* AEPlanned • Y P LRAS0 AD0 SRAS0 • AD1 • AA B• Y0* YSR* P0 PSR If the government ↑G, ↑TR or ↓T then ↑AE0 the planned expenditure line shifts up The AD Curve shifts up/right then Point B is the new SR equilibrium ↑Y , ↑P & ↓U 5 Fiscal Policy and the Multiplier  We will formally incorporate fiscal policy in the income-expenditure model. Assumptions of the Income-Expenditure Model  Producers are willing supply additional output at a fixed price  a change in aggregate expenditure leads to change in aggregate output (real GDP).  Interest rate is held fixed (in the meantime).  Exports and imports are determined autonomously, X = X0 & IM = IM0. 6 Fiscal Policy  Government spending on final goods & services: G0 = constant  Taxes: T = T0 + t×Y where T0 = autonomous/lump-sum taxes t = tax rate & 1 > t > 0  Government transfers: TR = TR0 – tr×Y where TR0 = autonomous/lump-sum transfers tr = transfer benefit reduction rate, 1 > tr > 0 7Fiscal Policy  Government spending on final goods & services: G0 = constant  Taxes: T = T0 + t×Y where T0 = autonomous/lump-sum taxes t = tax rate & 1 > t > 0  Government transfers: TR = TR0 – tr×Y where TR0 = autonomous/lump-sum transfers tr = transfer benefit reduction rate, 1 > tr > 0 7 Planned Aggregate Expenditure • The set of equations (interest rate is held fixed). Before t = 0 = tr Generic form: Numerical example: C = AC + MPC×YD C = 600 + 0.75YD T = T0 + t×Y T = 120 + 0.15Y TR = TR0 – tr×Y TR = 400 – 0.05Y IPlanned = 700 – 5000i, where i = 0.02(2%) G0 G = 500 X = X0 X = 280 IM = IM0 IM = 250 8 In generic form: The AEPlanned function in generic form: AEPlanned = [AC + MPC×(Y – T + TR)] + (AI – d×i) + G0 + X0 – IM0 AEPlanned = [AC + MPC×(Y – (T0 + t×Y) + (TR0 – tr×Y))] + (AI – d×i) + G0 + X0 – IM0 AEPlanned = AC + MPC×[(1 – t – tr)Y – T0 + TR0] + AI – di + G0 + X0 – IM0 AEPlanned = [AC + AI + G0 + X0 – IM0 + MPC×TR0 – MPC×T0 – di] + MPC×(1 – t – tr)×Y Income-expenditure model equilibrium: Y = AEPlanned Y = AC + AI + G0 + X0 – IM0 + MPC×TR0 – MPC×T0 – di + MPC×(1–t–tr)×Y 9 AE0 the multiplier Y* = AE0xM Solve for Income-expenditure model equilibrium (use the numerical example):  Step 1: Express YD as a function of Y YD = Y – T + TR = Y – (120 + 0.15Y) + (400 – 0.05Y) YD = Y(1 – 0.15 – 0.05) + 280 YD = 280 + 0.8Y 10 11 1212 13 14 Multiplier Effects of Changes in Government Transfers and Taxes Suppose the government lowers lump-sum taxes by 50 (i.e., T0 = – 50):  Initial taxes:T = 120 + 0.15Y  New taxes: T = (120 – 50) + 0.15Y = 70 + 0.15Y Method 1: Find the new AEPlanned function & solve for new Y*  Logic: When T0 , YD   C  by (– MPC × T0)  when T0  by 50, AE0  by (– MPC × T0) = (– 0.75 × – 50) = 37.5.  New AEPlanned function: AEPlanned = [1940 + (– 0.75 × – 50)] + 0.6Y = 1977.5 + 0.6Y Y = AEPlanned → Y* = 1977.5 + 0.6Y* 0.4Y* = 1977.5 Y* = (1977.5/0.4) = 4943.75 Y ↑ed by 93.75 15 16  Note: When T0 falls by 50, the overall effect on Y* is smaller than the case of an increase of G0 by 50. It is because a change in T0 affects AE indirectly (through a change in YD & C) while a change in G affects AE directly.  You will get the same result (as the tax cut above) if the government increases its transfers to households by 50 for all levels of income (i.e., TR0 = 50). i.e., If TR0  by 50, the new AEPlanned = 1977.5 + 0.6Y. New Y* will be 4943.75. How Taxes and Government Transfers Affect the Multiplier  In our model: Taxes: T = T0 + t×Y Government transfers: TR = TR0 – tr×Y  Since taxes and government transfers depend on income, they change automatically when income changes. 17 Using our numerical example: The multiplier t = 0, tr = 0, & MPC = 0.75 (Chapters 11 & 12) t = 0.15, tr = 0.05, & MPC = 0.75 When t > 0 &/or tr > 0 this makes the size of M fall 18  We know that ΔY* = ΔAE0xM  A smaller multiplier (M) means Y* fluctuates less when ΔAE0 happens.  Of course, 0 < t < 1 and/or 0 < tr < 1 makes M smaller which is our automatic stabilizer  Whenever, Y falls agents get an automatic reduction in the amount of income taxes collected, which helps to ↑YD → ↑C → ↑Y (partially) offsetting the decline in Y.  Similarly, a reduction in Y results in an automatic increase in transfer payments to agents, which helps to ↑YD → ↑C → ↑Y (partially) offsetting the decline in Y.  On the other hand, an increase in Y causes an automatic increase in the amount of income taxes collected & a reduction in the amount of transfers to agents (both work to partially counteract the ↑Y) 19 Effectiveness of Fiscal Policy Expansionary and Contractionary Fiscal Policy  Since changes in G0, T0, and TR0 lead to changes in AE0, changes in fiscal policy will shift the AEPlanned and AD curves  causing changes in YSR* (Chapter 12)  Changes in fiscal policy that will lead to an increase in output in the SR is called expansionary fiscal policy (i.e., G0 , T0 , TR0 ).  Changes in fiscal policy that will lead to a decrease in output in the SR is called contractionary fiscal policy (i.e., G0 , T0 , TR0 ). Can Expansionary Fiscal Policy Actually Work?  Last week, we showed that expansionary fiscal policy can be used to close a recessionary gap; however, not everyone believes the use of fiscal policy to smooth out business cycles will work for the economy. 20 21 Claim 2: “Government Borrowing Always Crowds Out Private Investment Spending”  Argument: Expansionary fiscal policy lowers public savings  supply of loanable funds   interest rate   investment  (the crowding out effect discussed in Chapter 10).  ↑G, ↑TR, or ↓T  ↓SPUBLIC = T – G – TR  ↓SNAT = SPVT + ↓SPUBLIC  ↓SLF ↑i → ↓I  Counter-argument: The crowding out on investment is less likely to happen because when the economy is in a recessionary gap, an expansionary fiscal policy is likely to increase output/income. Given households only consume a portion of the increase in income, national savings would increase, and interest rate won’t increase (as much). i LF SLF I = DLF 22Claim 2: “Government Borrowing Always Crowds Out Private Investment Spending”  Argument: Expansionary fiscal policy lowers public savings  supply of loanable funds   interest rate   investment  (the crowding out effect discussed in Chapter 10).  ↑G, ↑TR, or ↓T  ↓SPUBLIC = T – G – TR  ↓SNAT = SPVT + ↓SPUBLIC  ↓SLF ↑i → ↓I  Counter-argument: The crowding out on investment is less likely to happen because when the economy is in a recessionary gap, an expansionary fiscal policy is likely to increase output/income. Given households only consume a portion of the increase in income, national savings would increase, and interest rate won’t increase (as much). i LF SLF I = DLF 22 Claim 3: “Government Budget Deficits Lead to a Reduced Private Spending”  Argument: Holding all else constant, expansionary fiscal policy might lead to budget deficit. To finance the budget deficit, the government borrows from the public  stock of national debt .  To pay off the debt, the government must raise taxes (in the future). Anticipating this increase in taxes in the future, households save more and spend less now  expansionary fiscal policy has no effect on output – Ricardian equivalence. ΔG = - ΔC & overall ΔY* = 0  Counter-argument: It is unlikely that households will behave with such foresight and budgeting discipline. Even if they do, they might spread the reduction in consumption over a long period time. Therefore, expansionary fiscal policy can still increase output (but by a smaller amount). Fiscal policy becomes less effective but NOT completely ineffective. 23 A Cautionary Note: Lags in Fiscal Policy  In real life, fiscal policy can affect output with some time lags (we also called them policy lags) – the time between when the policy is decided upon and when it is implemented.  These time lags can take the following forms:  It takes time for the government to realize a shock has hit the economy.  It takes time for the government to develop (& implement) a plan to respond to the shock.  It takes time for the change in fiscal policy to have an impact on the economy.  Implications:  With these policy/time lags, it is possible that by the time the change in fiscal policy takes effect, the shock might already be over (i.e., the economy has recovered by itself).  If this is the case, changes in fiscal policy might lead to unnecessary fluctuations in output. 24 The Budget Balance  We look at the causes and consequences of budget surpluses and deficits. The Budget Balance as a Measure of Fiscal Policy  Recall, the definition of public savings (Chapter 10): SPUBLIC = GBB = T – TR – G = (Government Budget Balance)  Although the gov’t budget balance (GBB) changes when there is a change in fiscal policy (T, TR, and/or G), we CANNOT just use the budget balance to assess the stance of fiscal policy. This is misleading because it is possible for the budget balance to change without a deliberate change in fiscal policy. 25 The Business Cycle and the Cyclically Adjusted Budget Balance  Recall, GBB = T – TR – G = (T0 + t×Y) – (TR0 – tr×Y) – G0 GBB = (T0 – TR0 – G0) + (t + tr)Y  The GBB changes where there is: 1) A deliberate change in fiscal policy like a change in G0, T0, and /or TR0. A change in G0, T0, or TR0 affects the GBB in 2 ways: ΔG0, Δ T0, or Δ TR0 change GBB directly 2) An indirect change to the GBB due to a change in output (without a deliberate change in fiscal policy): A ΔY causes a change to the amount of taxes collected and/or transfer payment made & this causes a change to the GBB 26  Since the budget balance changes automatically when output changes, part of the budget balance is ENDOGENOUS!  This implies we need to differentiate between a deficit during a recession from a persistent deficit even the economy is operating at full employment.  Structural deficit: The government runs a budget deficit even when Y = YFE,  this is bad!  Cyclical deficit: The GBB equals to 0 when Y = YFE, and the government runs occasional budget deficit when the economy is in a recessionary gap.  This is normal.  Ideally, the government should run surpluses during good times (when Y > YFE), and deficits during bad times (when Y < YFE) such that the budget is balanced over time. 27 Long-Run Implications of Fiscal Policy  Look at the long-run implications of budget balances on national debt. Deficits, Surpluses, and Debt  Relationship between budget balance and national debt: National debtt = National debtt-1 – Government budget balancet National debtt = National debtt – National debtt-1 = – GBBt  Holding all else constant, when GBB > 0, a budget surplus, then national debt .  Holding all else constant, when GBB < 0, a budget deficit, then national debt . 28 29 1991_) 1992_) 1993_) 1994_) 1995_) 1996_) 1997_) 1998_) 1999_) 2000_) 2001_) 2002_) 2003_) 2004_) 2005_) 2006_) 2007_) 2008_) 2009_) 2010_) 2011_) 2012_) 2013_) 2014_) 2015_) 2016_) 2017_) 2018_) 2019_) 2020_) 2021_) 2022_) 0.0 2.0 4.0 -2.0 -4.0 -6.0 -8.0 -10.0 -12.0 Actual & Cyclically Adjusted Budget Deficit (General gov’t, % of potential GDP) Actual Cyclically adjusted Figure 13-9 – Actual Deficit vs. the Cyclical Adjusted Deficit 30Figure 13-9 – Actual Deficit vs. the Cyclical Adjusted Deficit 30 Figure 13-11 – Canada Federal Deficit and Debt 31 32 3333 34 35 0.0% 50.0% 100.0% 150.0% 200.0%-50.0%-100.0%-150.0%-200.0% Norway Germany Canada Spain United Kingdom France Portugal Belgium Ireland United States Greece Italy Japan -167.5% 50.5% 58.6% 59.8% 69.1% 70.3% 78.4% 82.0% 83.4% 100.3% 102.0% 113.2% 146.7% Government Net Debt to GDP Ratio, 2012 36 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 0 20 40 60 80 100 120 140 Canada - General Government Gross Debt (% of GDP)36 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 0 20 40 60 80 100 120 140 Canada - General Government Gross Debt (% of GDP) 37 0 50 100 150 200 250 300 Belgium Canada Finland France Germany Greece Iceland Japan Netherlands Norway Spain United Kingdom United States 106 106.4 73.6 110 65.9 168 61.2 255.2 49.5 37.4 107.3 104.1 123.3 General Government Debt to GDP (2023)37 0 50 100 150 200 250 300 Belgium Canada

ChatGPT said:

Summary and Detailed Explanation: Week 8 – Chapter 13: Fiscal Policy

Overview of Fiscal Policy

Fiscal policy refers to the decisions made by the government regarding its spending (G), taxes (T), and transfers (TR). It is a crucial tool for managing the economy by influencing aggregate demand and overall economic activity. The government can use fiscal policy to stabilize economic fluctuations, increase output, and reduce unemployment.

Components of Fiscal Policy

• Taxes (T): The government's income comes from taxes, including income taxes, corporate taxes, sales taxes, and social insurance taxes.

• Government Spending (G): This includes government expenditures on goods and services (e.g., infrastructure, public services) and investments.

• Government Transfers (TR): These are payments made by the government to households for which no goods or services are received in return (e.g., public pensions, unemployment insurance).

Effect of Fiscal Policy on Aggregate Expenditure

Fiscal policy affects aggregate expenditure (AE), which is the total planned spending in an economy. The direct effect of fiscal policy comes through changes in government spending (G), while the indirect effect occurs through changes in taxes (T) and transfers (TR), which influence households' disposable income (YD = Y - T + TR) and, consequently, consumption (C).

When the government changes taxes or transfers, disposable income changes, affecting consumption and investment. This, in turn, leads to shifts in the Aggregate Demand (AD) curve and changes in output (Y).

Expansionary Fiscal Policy

An expansionary fiscal policy occurs when the government increases spending (G), raises transfers (TR), or cuts taxes (T). This shift increases aggregate expenditure (AE), leading to higher output (Y) in the short run.

For example, increasing government spending (G) directly boosts AE, shifting the AEPlanned curve upward, which in turn shifts the AD curve to the right. This results in a higher equilibrium output and a potential increase in the price level (P).

The Multiplier Effect

The multiplier effect refers to how changes in fiscal policy amplify the initial change in aggregate expenditure. When government spending increases, the economy's total output increases by more than the initial change in spending due to induced consumption.

For example, if the government reduces taxes or increases transfers, households’ disposable income rises, leading to increased consumption. The increase in consumption leads to further increases in income and spending, multiplying the effect of the initial policy change.

Income-Expenditure Model

The income-expenditure model shows how changes in fiscal policy affect aggregate expenditure and output. The relationship is captured in the formula for planned aggregate expenditure (AEPlanned), which incorporates government spending, taxes, transfers, consumption, and investment. The equilibrium output (Y) occurs where AEPlanned equals total income (Y).

Automatic Stabilizers and Fiscal Policy

Fiscal policy has automatic stabilizers built into the tax and transfer systems. When the economy faces a downturn (a decrease in income), taxes automatically decrease, and transfer payments increase, thus partially offsetting the decline in aggregate demand. Conversely, when the economy expands (income increases), taxes increase, and transfer payments decrease, which helps prevent excessive overheating.

Effectiveness of Fiscal Policy

Fiscal policy can be expansionary or contractionary. Expansionary fiscal policy (increase in G, decrease in T, or increase in TR) is typically used during recessions to boost output. Contractionary fiscal policy (decrease in G, increase in T, or decrease in TR) is used to cool down an overheating economy and reduce inflation.

However, fiscal policy may not always be effective due to several issues:

• Crowding Out: Some argue that increased government borrowing to finance fiscal policy may crowd out private investment by raising interest rates.

• Ricardian Equivalence: This theory suggests that individuals may save more in anticipation of future tax increases to pay off government debt, reducing the effectiveness of fiscal policy.

Lags in Fiscal Policy

One of the challenges with fiscal policy is the lag between its implementation and its effects on the economy. There are three types of lags:

• Recognition Lag: The time it takes for the government to realize there is a need for fiscal intervention.

• Implementation Lag: The time it takes to develop and implement the necessary fiscal policies.

• Impact Lag: The time it takes for the implemented policy to have its full effect on the economy.

These lags can mean that fiscal policy interventions may occur after the economy has already recovered, or they may cause unnecessary fluctuations.

The Government Budget and National Debt

The government’s budget balance is the difference between total revenue (mainly taxes) and total spending (including transfers and government purchases). A budget deficit occurs when spending exceeds revenue, while a budget surplus occurs when revenue exceeds spending.

The national debt increases when the government runs budget deficits and borrows to finance them. The relationship between the government budget balance and national debt is key to understanding fiscal policy's long-term effects.

Cyclically Adjusted Budget Balance

The cyclically adjusted budget balance accounts for the effects of economic cycles on the government budget. A budget deficit may not necessarily indicate poor fiscal policy if the economy is in a recession. In such cases, the deficit may be a result of automatic increases in transfer payments and decreases in tax revenue, rather than a deliberate increase in spending or tax cuts.

Long-Term Implications of Fiscal Policy

In the long run, persistent budget deficits can lead to a growing national debt. While a budget surplus reduces the national debt, prolonged deficits can create fiscal challenges. Ideally, the government should run surpluses during periods of strong economic growth and deficits during recessions to stabilize the economy over time.

In conclusion, fiscal policy is a powerful tool for managing the economy, but its effectiveness is influenced by various factors, including automatic stabilizers, policy lags, and the potential for crowding out private investment. A balanced approach is necessary for ensuring that fiscal policy supports long-term economic stability without creating unsustainable debt.

4o mini

You said:

wrtie 30 questions with answers please

ChatGPT said:

Here are 30 questions based on the material you provided, along with their answers:

1. What is fiscal policy?

• Answer: Fiscal policy refers to the government's decisions regarding its spending (G), taxes (T), and transfers (TR) to influence the economy.

2. What are the two main types of government spending?

• Answer: The two main types of government spending are:

  • Government spending on final goods and services (G).

  • Government transfers (TR), such as public pensions and unemployment insurance.

3. How does fiscal policy affect aggregate expenditure (AE)?

• Answer: Fiscal policy affects aggregate expenditure directly through changes in government spending (G) and indirectly through changes in taxes (T) and government transfers (TR), which impact disposable income and consumption (C).

4. What is the role of taxes in fiscal policy?

• Answer: Taxes are the income of the government, and changes in taxes directly affect households' disposable income (YD), which in turn influences consumption (C) and aggregate expenditure (AE).

5. How do changes in government transfers affect aggregate expenditure?

• Answer: Changes in government transfers (TR) alter households' disposable income, which impacts consumption (C) and thus shifts aggregate expenditure (AE).

6. What is the income-expenditure model?

• Answer: The income-expenditure model illustrates the relationship between aggregate expenditure and national income (Y), where equilibrium is achieved when output (Y) equals planned expenditure (AE).

7. What happens to aggregate expenditure (AE) when the government increases spending (G)?

• Answer: When the government increases spending, the planned expenditure line shifts upward, leading to an increase in aggregate demand (AD) and a rise in output and price levels in the short run.

8. What is an expansionary fiscal policy?

• Answer: Expansionary fiscal policy involves increasing government spending (G), decreasing taxes (T), or increasing government transfers (TR) to boost aggregate demand and economic output.

9. How does the fiscal multiplier work in the income-expenditure model?

• Answer: The fiscal multiplier measures the effect of a change in government spending or taxes on the economy. A change in government spending or taxes leads to a larger change in output due to the initial change in expenditure and subsequent rounds of spending.

10. What happens to the multiplier when taxes or government transfers depend on income?

• Answer: When taxes or transfers depend on income, the multiplier effect becomes smaller because changes in income lead to automatic adjustments in taxes and transfers, partially offsetting the impact of fiscal policy.

11. What is the automatic stabilizer in fiscal policy?

• Answer: An automatic stabilizer refers to the built-in mechanisms like taxes and government transfers that automatically adjust to stabilize the economy during fluctuations, such as higher transfers and lower taxes during recessions.

12. What is the relationship between fiscal policy and output in the short run?

• Answer: Changes in fiscal policy shift the aggregate expenditure (AE) line, which affects the short-run equilibrium output (YSR) by either increasing or decreasing total demand.

13. What is a budget surplus?

• Answer: A budget surplus occurs when the government’s revenue (T) exceeds its spending (G and TR), leading to a positive government budget balance.

14. What is a budget deficit?

• Answer: A budget deficit occurs when the government's spending (G and TR) exceeds its revenue (T), leading to a negative government budget balance.

15. What is the national debt?

• Answer: The national debt is the total amount of money the government owes, accumulated from previous budget deficits.

16. How does a change in government spending (G) affect the aggregate demand (AD) curve?

• Answer: An increase in government spending shifts the aggregate demand (AD) curve to the right, while a decrease shifts it to the left.

17. What is Ricardian equivalence?

• Answer: Ricardian equivalence suggests that when the government borrows to finance a budget deficit, households will anticipate future tax increases and thus save more, offsetting the impact of fiscal policy on aggregate demand.

18. What is a cyclical deficit?

• Answer: A cyclical deficit occurs when the government runs a deficit due to economic downturns, which leads to lower tax revenue and higher transfer payments, but it is not indicative of a long-term fiscal imbalance.

19. What is a structural deficit?

• Answer: A structural deficit is a budget deficit that persists even when the economy is operating at full employment, indicating a long-term fiscal imbalance.

20. What are the effects of an increase in government transfers (TR)?

• Answer: An increase in government transfers boosts households' disposable income, leading to higher consumption (C), which increases aggregate expenditure and output in the short run.

21. How does the crowding-out effect relate to fiscal policy?

• Answer: The crowding-out effect suggests that increased government borrowing to finance fiscal policy may reduce private investment due to higher interest rates, as the supply of loanable funds is reduced.

22. How does fiscal policy affect national savings?

• Answer: Fiscal policy can affect national savings through changes in government spending and taxation, which in turn influence the amount of private savings and public savings in the economy.

23. What is the impact of fiscal policy on interest rates?

• Answer: Expansionary fiscal policy, by increasing government borrowing, may raise interest rates, which could reduce private investment, especially in the case of crowding out.

24. What are time lags in fiscal policy?

• Answer: Time lags refer to the delay between recognizing an economic shock, implementing fiscal policy, and observing its impact on the economy, which can reduce the effectiveness of fiscal policy.

25. What is the cyclically adjusted budget balance?

• Answer: The cyclically adjusted budget balance measures the budget balance after removing the effects of the business cycle, showing whether fiscal policy is expansionary or contractionary in relation to the economy’s potential output.

26. What is the government’s budget balance equation?

• Answer: The government budget balance (GBB) is calculated as:
  GBB=T−TR−GGBB = T - TR - GGBB=T−TR−G, where T is taxes, TR is government transfers, and G is government spending.

27. How does a reduction in taxes affect aggregate expenditure?

• Answer: A reduction in taxes increases households' disposable income, leading to higher consumption (C), which in turn increases aggregate expenditure (AE) and output.

28. What is the role of government borrowing in fiscal policy?

• Answer: Government borrowing finances budget deficits and can affect interest rates and private investment, depending on the crowding-out effect.

29. How do fiscal policy changes impact output in the long run?

• Answer: In the long run, fiscal policy can affect the overall level of national debt and the economy's potential output, but its impact on output depends on factors like investment, savings, and the business cycle.

30. What is the impact of expansionary fiscal policy during a recessionary gap?

• Answer: During a recessionary gap, expansionary fiscal policy (such as increasing government spending or cutting taxes) can increase output and reduce unemployment by boosting aggregate demand.

These questions cover a broad range of concepts related to fiscal policy and its effects on the economy.