Exchange Rates and the BOP

FINALLY: EXCHANGE RATES AND THE BALANCE OF PAYMENTS!!!!!!!!!!!!!!

Okay- final bit, and then we can all write our exams and promptly forget everything we ever needed to know about economics! =D

What is a balance of payments? It's a summary account of all the receipts and payments in and out of Canada (or any other country) in relation to the rest of the world (including payments made for both goods and investments). It clocks Canadian money moving back and forth across the border. Receipts are money going into Canada, and payments are money going out of Canada.

The balance of payments includes both current and capital accounts. Because these two accounts always balance out, the balance of payments will always be 0. You'll see why in a little bit.

SOME TERMS

A SURPLUS
-There is more money going in than out
-This is favorable
-We also call this "credit"
-More receipts than payments

A DEFICIT
-There is more money leaving than entering the country
-This is unfavorable
-We also call this a debit
-More payments than receipts

When foreign consumers buy Canadian exports, this creates a receipt (money enters Canada from the outside)
When domestic consumers buy foreign imports, this creates a payment (money leaves Canada)

OFFICIAL RESERVES
-These are holdings held by the BoC
-It includes gold, foreign exchange, and SDRs
-SDRs are special drawing rights, and they are the IMFs substitute for gold

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SO WHAT COMPOSES THE BALANCE OF PAYMENTS?

Basically, a bunch of different sub-accounts which measure trade flows

1: The Current Account (The BOP for goods)
-This encompasses exports, imports, and investment incomes
-The Trade Account is a subcategory of the current account, and it includes an account for merchandise, and an account for services. This account stacks up exports and imports and measures the difference difference
-The Capital Service Account measures the net investment income and unilateral money transfers. This measures the difference between Canadian interest and dividends on foreign bonds and investments, and Foreign interest and dividents on Canadian bonds and investments

2: The Capital Account
-This encompasses money spend on long and short term capital investments, including stocks, bonds, realty, factories and other investment devices
-Financial capital imports are A CREDIT (this may be confusing)! This is when foreigners bring money into Canada in order to purchase Canadian assets. Subsequently, financial capital exports are capital outflows: when Canadians bring money out of Canada in order to purchase foreign assets.
-Finally, the Capital account also includes the official financial account, which measures receipts and payments of Canadian dollars due to the selling and buying of foreign exchange. Selling foreign exchange constitutes a receipt of Canadian dollars, and thus counts as a receipt on the balance of payments. Essentially, the official financial account balances out the other two accounts: when Canadians buy a whole lot of foreign goods and investments, for instance, the BoC accommodates this by selling off foreign exchange for Canadian dollars (which thus counteracts the account deficit caused by other categories)
-An increase in official receipts means that the Bank of Canada is selling Canadian dollars in order to buy foreign exchange. This creates a negative balance effect (it counts as a debit on the balance sheet)
-An decrease in official receipts means that the BoC is selling foreign exchange in order to buy Canadian dollars. This creates a positive balance effect (it counts as a credit on the balance sheet)

IN SUMMARY

Current accounts = X - M + Returns to Investments
Capital Accounts = Capital in - Capital out, + Official Financing Account (which is Can$ in - Can$ out)

As you can see, the OFA always balances out all other payments and receipts, so the Balance of Payments is always 0! Sometimes, news media will talk about exchange deficits or credits, and when they are doing this, they are usually omitting the OFA.

So... if there are more exports than imports, foreigners are short of Canadian dollars, so the BoC will sell Canadian currency to foreigners (and in doing so, increase its holdings of foreign currency). This counts as a negative entry in the OFA: in this way, the BoC provides the excess Canadian money that foreigners require to buy Canadian exports.

Okay?

-The BOP always balances
-BOP balances or deficits are balanced out by the OFA
-There is nothing inherently good or bad about balances. A deficit is not necessarily bad, and a surplus is not necessarily good!

THE FLOATING EXCHANGE RATE ACTS AS AN ECONOMIC SHOCK ABSORBER!

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Okay- foreign exchange can be seen as a marketable good, just like anything else. As such, we have the FOREIGN EXCHANGE MARKET

External Value is how much domestic currency is worth in foreign terms (the foreign price of domestic currency)

Exchange Rate is how much foreign currency is worth in domestic terms (the domestic price of foreign currency)

ER = 1/EV & EV = 1/ER

Depreciation means that the external value is going down
Appreciation means that the external value is going up

What determines external value (and by association, exchange rates)???

SUPPLY AND DEMAND!!!


Remember: People supply currency in order to purchase imports or to facilitate capital exports (domestic investiture into foreign markets) and people demand currency in order to purchase domestic exports, or to facilitate capital imports (foreign investiture into domestic markets)...

Basically, supply of any currency increases as that currency becomes valued more (because high valued currencies can buy more imports, and translate into larger foreign investments), while demand for any currency shrinks as that currency appreciates (because this makes exports from that country more expensive, and capital in-flows less effective)

As such, currency prices tend to settle at an equilibrium value!

Remember, however, that demand and supply can shift here to affect the equilibrium price level!
Supply of currency will increase if
-There is heightened demand for imports
-There is heightened domestic demand for investment in foreign markets
-Domestic prices are higher than foreign prices

Demand for currency will increase if
-There is a heightened demand for exports
-There is a heightened foreign demand for investment in domestic markets
-Foreign prices are higher than domestic prices

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Surpluses, Deficits, and the EV

For surpluses, exports are higher, imports are low, demand for domestic currency is high, supply of it is low, and thus the currency appreciations

For deficits, exports are lower, imports are high, demand for domestic currency is low, supply of it is high, and this the currency depreciates

You can verify this by moving the supply and demand curves around!

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PRICES AND EXCHANGE RATES: Exchange rates facilitate the rule of one world price!

Domestic Prices = the exchange rate * Foreign Prices

And this translates into a stabilization mechanism- I'll show you!

When external value is higher, domestic prices become cheaper for international goods (due to the above formula), and as such, exports decrease, imports increase, and we are left with a BOT deficit (which brings the EV back down again)

The reverse is true for when the domestic value is lowered.

As such, the balance of trades and the exchange rate are interdependent and cyclical!

YOU SHOULD UNDERSTAND HOW THIS CYCLE WORKS

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Trade Policy

This chapter looks at the policies which either facilitate or impede free trade in the world!

As economists, we usually are in favor of free trade. We recognize that free trade offers many benefits to different countries!

Why is free trade a good idea?
-The law of comparative advantage
-When there is regional specialization and trade, the world production of all products rises
-This maximizes the world's average standard of living (world GDP per capita)

On the other hand, some countries may attempt to instill protectionist policies (policies which counteract free trade in order to protect domestic firms from international competition). These can include both TARIFFS and NON TARIFF BARRIERS (NTBs, such as quotas, customs procedures, anti-dumping duties and countervailing duties).

Why might nation choose certain degrees of protectionism?

REASONS WHICH RELATE TO MAXIMIZING NATIONAL INCOME

1: To improve the terms of trade! If a country is large enough, it can force the world price downward for goods it imports by imposing a Tariff

2: Infant Industry Protection. Some countries may set up trade barriers in order to protect domestic firms from international competition, with the hopes that these industries will grow to the point where they can realize economies of scale. The idea here is that under protection, infant industries will eventually "grow up" to the point where they will be able to compete on the international market without need of protectionism. A problem with this is that not all industries develop to this level of competency while under protection. Canada's national policy of 1876 was an example of infant industry protection directed at improving Canadian manufacturing.

3: Learning by doing. This sort of goes along with infant industry protection, but along with protecting developing industries from international competitors, protectionism can also simply give those industries time to operate, which gives personnel time to gain mastery over certain procedures. In this way, countries can turn comparative disadvantages into comparative advantages.

PROBLEM! Not every industry which gets chosen for protection will ultimately grow up to be an international "winner", so each time the government placed an industry under protection, they are effectively gambling (as protectionism exacts economic costs) on their choice. If governments do this frequently, statistically, they are likely to choose more losers than winners, which would be quite costly.

=(

4: Protectionism can allow certain key industries to earn economic profits and thus innovate more. As such, Canada has strategic trade policy in place with regards to Bombardier (if you remember, they're the company which made the olympic torches)

OTHER REASONS

1: There are advantages from diversification. Countries which are only specialized in a narrow range of products may use protectionism in order to diversify their economies (which gives local firms a "safe space" to expand into new industries, thus increasing the range of products produced domestically). This can be useful in that it buffers the volatility and risk posed by price changes and new technologies by spreading production to several different sectors. The idea here is not to "put all of your eggs in one basket" (although, often, this is more of a political argument than an economic argument)

2: Protectionism lets governments protect favored groups! In Canada, competitive advantage favors skilled labour over unskilled labour, and as a result, free trade may lower the wages of unskilled laborers (who are now competing with wage slaves from overseas). Here, protectionism can redistribute income to certain productive groups, but at the expense of the collective standard of GDP. There is a deadweight loss!

USUALLY, HOWEVER, PROTECTIONISM IS FOR POLITICAL OR FALLACIOUS ECONOMIC REASONS!!!!!!!!! >=(

HERE ARE SOME FAULTY ARGUMENTS WHICH PEOPLE WILL OFTEN POSE IN ORDER TO SUPPORT PROTECTIONISM!

1: "We've got to keep our money at home"
The Premise: If I buy a domestic good, by country will have both the good AND the money used to buy that good
Why it's incorrect: Domestic money is only useful for buying domestic goods. If you are buying foreign products, the money you spend on those products eventually gets used to buy Canadian products- it flows between the two trading countries

2: "We've got to protect ourselves from low-cost foreign labour"
The Premise: Low wage foreign goods will eliminate domestic goods from the market, and thus lower the domestic standard of living.
Why it's incorrect: This goes against the law of comparative advantage. Even if a foreign country can produce all goods at a lower cost than Canada, it would still be advantageous to trade, as trade will lower the opportunity cost of having certain products.

3: "Exports are good, and imports are bad"
The Premise: Exports add to domestic GDP, while imports take away from domestic GDP
Why it's incorrect: Standard of living is dependent on consumption, not production. If a country exports a lot of goods, but derives its comparative advantage by paying its workers very low salaries, then those workers will not be able to consume very many products, on average, and thus that country's standard of living will probably be quite low.

4: "Protectionism creates local jobs"
The Premise: Protecting the domestic market can help save local jobs, and thus combat unemployment
Why it's incorrect: Protectionism reduces employment in other sectors which may have local comparative advantages, and thus, while it may increase employment in one sector, the overall economic effect is inefficient.

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METHODS OF PROTECTIONISM

TARIFFS: Import Duties- these are a tax on imports. They increase costs for domestic consumers, but benefit domestic producers (who can sell at higher than the world price) and the government (who receives tax revenue). Tariffs create a deadweight social loss for the economy as a whole.


Originally, at the world price, Canada will import 1500 units of this product, and domestic producers will supply the other 500 units needed to satisfy demand.

Once the tariff raises the prices, Canada only imports 500 units of the product, and domestic producers supply the other 1000 units needed to satisfy domestic demand (as you can see, demand has decreased due to the higher price).

Consumer lose surplus represented by sections C, D, E, & F due to the Tariff
Producers gain surplus represented by section C due to the Tariff (the increase in price times the increase in production, minus the costs incurred by increasing production)
The government gains section E due to the Tariff (the quantity of foreign imports at the Tariff price, multiplied by the amount of the Tariff)

SECTIONS D & F REPRESENT A DEADWEIGHT SOCIAL LOSS, HOWEVER! (tragic, isn't it!?)

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QUOTAS AND VOLUNTARY EXPORT RESTRICTIONS (VERs)
An import quota is like a quantity ceiling- it restricts the quantity of products which a country will import
With a voluntary export restriction, the exporter agrees to limit the amount of exports it will send to any one country.
This incurs costs for domestic consumers, but benefits domestic producers
The net result is a deadweight social loss which is greater than that which results from a Tariff!



At the world price, Canada will import Q4 - Q1, and domestic producers will supply Q1
Let's say that a quota restricts domestic imports to Q3 - Q2. If this happens, then the domestic price must rise to P1, where the quota exactly satisfies the excess demand which domestic producers cannot meet.

Consumers lose surplus equal to E, F, G, H, & I due to the quota,
Producers gain surplus equal to E due to the quota
Since there is no taxation here, the higher price on the quota goods causes foreign producers to gain surplus equal to G & H

THERE IS A DEADWEIGHT LOSS EQUAL TO SECTIONS F & I due to the quota! >=(

Usually, in trade barrier situations, exporters prefer a quota (so they can gain the extra revenue section) while importing governments prefer a tariff (so they can gain the extra revenue section).

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NON-TARIFF BARRIERS

1: Antidumping Duties
-Dumping is the practice of selling a good in a foreign country at a price below domestic prices at a reason other than costs
-This is like price discrimination (remember from micro) but on an international level
-Usually, it is only temporary, in order to sell off excess supply, or to weaken local industries and force reliance on foreign imports
-It is seen as anti-competitive, and many people believe that it is an unfair form of competition
-Antidumping duties (taxes to bring "dumped" imports back up to the domestic price level) are often used to compensate for this
-Recently, however, these have been abused and used as a non-trade barrier
-When Antidumping Duties are used, the domestic price becomes the price floor, regardless of the foreign price (which can lead to an inflexibility in domestic prices compared to the world price)
-As such, if the world price falls below the average costs for domestic producers, they are protected
-Often, the system requires foreign accusers to prove that dumping is occurring in order for antidumping duties to be instated

2: Countervailing duties: a tariff imposed as a trade remedy to counteract foreign governments subsidizing their industries
-Governments wishing to impose countervailing duties must prove that there is a foreign subsidy being used to bolster a certain foreign industry, and that it is significantly harming the prospects of domestic producers
-The U.S. is currently placing countervailing duties on Canadian softwood lumber.

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IMPORTANT ORGANIZATIONS AND TERMS

GATT- The general agreement on trades and tariffs: an effort to reduce international protectionism

The Uruguay Round- reduced tariffs by 40%, but failed to deal with European and Canadian agricultural subsidies (eventually, they ended quotas, but replaced them with Tariffs in a process called Tariffication)

WTO- World trade organization- it has 148 members, it is a global organization which deals with the rules of trade, and it endeavors to lower trade and non-trade barriers. It also includes a formal dispute settlement mechanism

Doha Round- tried to reduce agricultural subsidies

The Battle for Seattle- People protested that human, labour, and environmental rights were not being addressed by the WTO. Interestingly, 3rd world countries often argue against considering these in trade deals

MAI- Multilateral agreement on investment: similar to WTO, but for investments

Free trade Area- Goods and services may move freely among member countries, but each member nation still sets barriers against foreign imports on an individual basis (like NAFTA) PROBLEM: Certain Tariffs have grandfather clauses, and thus persist despite agreements.

Customs Union- A free trade area, but with a common set of barriers against foreign imports (like Mercosur: Brazil, Uruguay, Paraguay, and Argentina)

Common Market- A customs union in which factors of production (i.e., workers) may move freely among member nations (like the EU)

THAT'S ALMOST ALL!!!

Unemployment

Okay- I'm really behind in these online notes, but I'm going to catch up as much as I possibly can tonight.

Unemployment is scary stuff! Here we go!

CHANGES IN UNEMPLOYMENT:
-In the long run, increases in the labor force should be matched by changes in employment (so as the population grows, more people should get hired for more jobs)
-In the short run, changes in the labor force may not match population growth

In Canada, the supply of labour has increased because of increases in the population (probably due to immigration), an increased rate of labor force participation, and an increase in education. Demand for labor has also increased due to new technology and economic growth. In most years, new jobs are created to replace old jobs and provide new jobs for the growing labor force.

In a typical year in Canada, employment increases by 1/4 million jobs.

CHANGES IN UNEMPLOYMENT

-In Canada U was 12% in 1980, and 8% in 2008
-During booms, unemployment falls, and during recessions, unemployment rises. Doh
-In Canada, employment is rising, BUT the labor force is growing at a FASTER RATE, so in Canada, the unemployment rate has increased
-The proportion of employment in the service sector has increased (it is now about 75%)
-The proportion of employment in the goods sector has decreased

RECENT DEVELOPMENTS
-According to Naomi Klein, North America produces "brands, no products"
-A lot of labour is outsourced these days
-There is a rise in the amount of low-skill service labor these days (i.e., McJobs)
-There is greater transience in the workforce: people move from job to job more
-Schedules are crappier, and employees receive fewer benefits
-There is less company loyalty, so quality suffers (the Wal-mart greeter makes about $11,000 working full time, so you can bet your ass she's not really that happy to see you)
-The best way to operate here is to see yourself as a movable asset: "Me Inc." sell yourself and you will be happy- attach yourself to any one company and you will not be happy

What are some reasons for these negative changes?
-Low ability levels
-The entry level for better jobs has significantly increased
-Flexible hours are now the norm
-Part-time workers have less legal protection (and are thus preferred)

LABOR FLOWS
-The labor market can be seen in terms of flows in about of unemployment, rather than as a simple unemployment rate
-We should examine gross rather than net flows (because this gives us more information about the nature of the labor market)

THE EFFECTS OF UNEMPLOYMENT
-Voluntary vs. Involuntary: Technically, voluntary unemployment does not exist, as that individual has technically left the workforce.
-Not all unemployment is bad!

Unemployment: All individuals who are willing and able to work at the going rate, but are unable to find a job

When there is a great deal of involuntary unemployment, we end up with something like the great depression:
-On a small scale, this causes personal hardship and psychological suffering for those who lose their jobs
-On a large scale, this decreases national output per capita, and by association, the standard of living- there is a loss in potential output

GAP UNEMPLOYMENT

Why does it happen? It happens because there is a recessionary gap! (doh)

If Y = Y*, U =0
If Y < Y*, U > U*

Cyclical Unemployment is unemployment in exess of frictional and structural unemployment!

We could see the labour market as any other market where there is supply and demand for labour at different prices.
Demand = the willingness of firms to hire at any given wage rate
Supply = willingness of workers to work at any given wage rate
The price of labor is the real wage rate (w)

As the graph should demonstrate, labor markets are pretty flexible, because wages can shift upward and downward. With wage flexibility, real wages and employment change with economic cycles.



This graph shows that eventually, employment reaches an equilibrium! In other words, there should be no involuntary or cyclical unemployment in the long run...

There are two theories which examine gap unemployment

1: THE NEO-CLASSICAL THEORY OF LABOR MARKETS
2: THE NEO-KEYNESIAN THEORY OF LABOR MARKETS

NEO CLASSICAL LABOR MARKETS:
-We assume here that markets are flexible and that they will eventually clear
-This theory predicts that there will be no cyclical unemployment (but they're wrong! There is cyclical unemployment!)

Here's the logic: since wages are flexible, the labor market will always reach an equilibrium where the amount of labour supplied equals the labor demanded at the going wage rate. Here, no one is involuntarily unemployed, and thus, there is no cyclical unemployment. There are only people who are voluntarily unemployed (i.e., frictional and structural unemployment)

NAIRU, here, can occur due to

Exogenous demand shocks
-Changes in technology or tastes
-Changes in the demand for labour

Exogenous supply shocks
-Changes in the willingness to work
-Changes in the supply of labour

In this model, it is the NAIRU which fluctuates, since the unemployment rate is alwats the NAIRU

NOTE* Real wages ARE flexible and markets DO eventually clear, so this model isn't entirely wrong...

But there are PROBLEMS:
-According to this theory, real wages should change rapidly with the business cycle. This does not happen. Real wages remain relatively constant even as the economy fluctuates
-An unemployed person would be shocked to learn that economists veiw him or her as "voluntarily" unemployed
-This model seems to show that there is no need for stabilization policy, but in reality, we know that there IS!

thankfully, we have...

NEO-KEYNESIAN LABOUR MARKETS (aka, how they actually work)
-Here, labour markets are inflexible and do not clear... at least not in the short run
-This is because of STICKY WAGES! The wage rate does not change fast enough to equate the supply and demand of labour (because wages are not perfectly flexible), as a result, we get unemployment in slumps, and labour shortages in booms.
-Only when the supply and demand of labour are equal is there no involuntary unemployment: it is here that the market clears!

IN A SLUMP:
-Demand for labor decreases
-Wages want to fall to their new equilibrium level
-But wages stick at a higher level than the equilibrium
-So there is excess supply of labour, and thus unemployment

IN A BOOM:
-Demand for labor increases
-Wages want to rise to a new equilibrium level
-But wages will not immediately increase to that new equilibrium level: it takes time for that to happen
-In the meantime, there will be excess demand, and therefore a labor shortage

We know that wages are much more likely to be "sticky downward" (they take longer to fall than to rise). Why is this?

-Long-term employment contracts: workers and employers respond to other factors like job security by creating long term contracts: here, wages are planned over the long-term and are thus insulated from short term fluctuations. The fringe benefits of these contractual agreements can be mutually beneficial, as they give employees long term stability, and ensure employers that they will have trained employees invested in the company over a longer period of time

-Menu costs: Changing wages in any way invokes administrative costs

-Efficiency wages: this is when employers pay employees higher wages than the equilibrium wage necessary to hire them, because they believe that the higher wages will act as a motivator, and cause workers to become more efficient

-Unions: unions negotiate on behalf of workers who are already embedded in the workforce, and thus often make it difficult to negotiate for higher wages

-Psychological factors: people find it psychologically difficult to give up wages (even if the price level is dropping, so real wages are effectively still the same)

OKAY!

In summary, Neo-Keynesians assume that markets may not clear, and thus there CAN be involuntary unemployment

NOW LET'S BRING THESE TWO THEORIES TOGETHER!

In the short run, the Neo-Keynesian are correct: sticky wages can create excess supply or demand of labour... HOWEVER, all of the factors which contribute to sticky wages will not persist in the long run, so eventually, the labour market DOES clear, and wage flexibility eliminates involuntary unemployment. Thus, in the long run, both Classical and Keynesian theories predict that unemployment will be at U*

(The only differences is that for classical economists, there is no short run- that time frame is not taken into account)

LET'S COMPARE THESE TWO THEORIES ONE LAST TIME

NEO-CLASSICAL:
-Wages are flexible, so the labour market will always clear
-U is always at U* and there is no gap unemployment (no involuntary unemployment)
-Aggregate demand shocks will have no effect on unemployment, because aggregate supply reacts

NEO-KEYNESIAN:
-Wages are sticky, and markets will not clear immediately
-U is not always at U*, so there can be gap unemployment (involuntary unemployment)
-Aggregate supply and demand shocks cause gaps

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The Non-Accelerating-Inflationary-Rate of Unemployment (NAIRU)

There are 2 components to NAIRU: Frictional and Structural Unemployment

FRICTIONAL UNEMPLOYMENT (Job turnover, or search unemployment)
-This refers to the length of time it takes someone to either find their first job or a new job

STRUCTURAL UNEMPLOYMENT (Mismatching of supply and demand of labour)
-It can be supply-side (ie: a worker's skills are needed in an economy, but in a different city, persay)
-It can be demand-side (ie: there are jobs available, but they require more training than the current workforce has accumulated)

WHAT'S THE DIFFERENCE BETWEEN THE TWO?
-Structural Unemployment may just be long run frictional unemployment
-Both are similar in that the number of unfilled jobs is equal to the number of people looking for work

NAIRU = The Non-Accelerating-Inflationary-Rate of Unemployment
-This is the rate on unemployment when inflation does not accelerate
-In other words, this is the normal, or natural rate of unemployment
-Here, we only have frictional and structural unemployment
-There is no cyclical unemployment at U*
-But "there is always some unemployment at full employment"
-This is the rate of unemployment when the supply and demand of labour are equal
-This is the rate of unemployment at Y*, or Yfe

NEWSFLASH: NAIRU can change over time! How does this happen???

1: Demographic Changes
-Baby boomers and shadow baby boomers, for example, entered the labour market and created a larger flow of voluntary unemployment, thus increasing NAIRU
-Historically, increased female participation in the workforce (where females historically have had a higher unemployment rate than men) will increase NAIRU
-Immigration may affect this as well

2: Labour Market Flexibility
-The speed at which wages adjust to supply and demand changes is slowing down over time
-It is more costly for firms to hire new workers these days, and due to unions and legal issues, it often takes them a longer amount of time to commit to hiring or laying off workers
-Unions and the psychology of concessions also play a role here

3: Government Policy
-Any government policy that reduces labour market flexibility will increase the NAIRU
-EI decreases search costs (the opportunity cost of searching for a new job) and will therefore increase average job search times, thus contributing more to NAIRU
-Severance Pay increases the cost of firing a worker, but at the same time, also makes companies less willing to hire new workers in the first place (its a higher risk, so firms must be more discerning)

4: Globalization and Technological Changes
-Rightsizing, restructuring, retooling, and rationalizing, global competition, and freer trade have increased structural unemployment, many would argue (mature industrial nations such as Canada are expected to provide high level services and technology, while countries with cheaper labour are expected to provide lower level manufacturing and production, but this can often lead to a mismatch between available worker skills and desired potential employee assets)

5: Hysteresis (A lagged effect)
-This theory suggests that the future NAIRU is a function of the current actual rate of unemployment
-This is seen more in European countries with an insider-outsider model to the workforce: in these countries, people who are already employed use their insider power to keep outsiders out
-Recessions prevent on-the-job training and thus reduce the amount of "learning by doing" which can occur, and as a result, when a recession is over, the group of people who would otherwise have gained skills due to simply being employed are left without employable skills, and may thus continue to struggle to find employment

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MEASURING NAIRU

OKUN's LAW!!!!!!!!!!!!!!!!!!!!!!!!!!

A 1% Change in the cyclical unemployment rate is associated with a 2% change in the recessionary gap!

So... if the economy goes into a recession and is producing output at 12% below its potential level, than we know that cyclical unemployment has risen by 6%. Similarly, if cyclical unemployment were in increase by 3%, we could predict that output would decrease to 6% below Y*

HOW TO ESTIMATE NAIRU: You need to know Y*, the current output level, and the actual unemployment rate

1: Find Y* (potential output level)
2: Calculate the recessionary gap as a percentage of Y*: (Y-Y*)/Y* multiplied by 100
3: Take 1/2 of the recessionary gap you just calculated. This is the cyclical unemployment rate
4: Subtract the cyclical unemployment rate from the actual unemployment rate. The difference is the normal U-rate, or NAIRU!

=D

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WHAT ARE SOME WAYS THAT WE COULD REDUCE UNEMPLOYMENT?

Reducing Frictional Unemployment:
-Here, the goal is to decrease turnover time
-Governments could create giant posting boards to match potential employers with potential workers (i.e., Canada Manpower, workopolis, craigslist)

Reducing Structural Unemployment
-The goal here is to make the supply and demand of labour match
-Government initiatives to retrain and relocate workers can help here
-Eliminating resistance to change (i.e., tariffs and subsidies) can help, as these instruments perpetuate the status quo, and may deter people from getting the skills needed to operate in the new global labor market (i.e., if a tariff is supporting a failing industry, then that tariff is also going to deter people employed in that industry from getting the retraining they require to become employed once that industry inevitably topples)
-Aiding change is key here

Reducing Cyclical Unemployment
-The goal here is to bring Y back to Y* by increasing aggregate demand
-This accomplished using fiscal and monetary policy
-YAY! Gap-busting! =D =D

That's all for unemployment. I hope all of you who read this are successful at avoiding summer employment....

Demand Shocks and Accelerating Inflation

INFLATIONARY DEMAND SHOCKS AND INFLATION
-An increase in consumption, investment, government expenditures, and net exports causes an increase in aggregate expenditure, a rightward shift in aggregate demand, and an increase in the equilibrium price level.

IF THE GOVERNMENT DOES NOT VALIDATE INFLATION CAUSED BY AN ISOLATED DEMAND SHOCK
Aggregate demand will shift to the right as a result of this demand shock. Y is now greater than Y*, and thus we have an inflationary gap. however, wages adjust: excess demand for labour increases wages, which in turn increases firm costs. As a result, short run aggregate supply shifts to the left, and output returns to its original level, but at a higher price level. This is one-shot inflation. The price level is now at a higher equilibrium level, but since the demand shock is isolated, inflation will not be sustained.

IF THE GOVERNMENT DOES VALIDATE INFLATION CAUSED BY ISOLATED DEMAND SHOCKS
Aggregate demand will shift to the right as a result of this supply shock. In response to this, SRAS shifts to the left due to wage adjustment. However, if the government tries to validate this change in supply by increasing the money supply (which lowers interest rates, and ultimately shifts AD to the right), this puts NEW INFLATIONARY PRESSURES on an economy: basically, the natural chain and anchor mechanism is fighting against government policy here, and the result is sustained inflation within an inflationary gap. The SRAS want to return output to Y*, but the government continues to artificially increase AD through monetary policy. As both AD and SRAS continue to shift right and left, respectively, the price level will continuously climb. =(

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WHAT ABOUT ACCELERATING INFLATION?
-We know that in most cases, demand shocks cause wage adjustment, and that if governments are not crafty, they may follow this up with monetary validation. If we look at this graphically, we can say that the inflation rate (the change in the price level divided by the original price level) could be graphically represented by the vertical distance between the original price point and the new price point.
-When AD and AS both shift up, the inflationary gap will persist.
-Graphically, we know that inflation is accelerating if the arrow between the price points gets longer and longer.

SO... two questions we need to answer are:

1) What creates persistent inflation (what causes inflation to hang around, instead of being a one-off)?

The answer: Validation

and

2) When is the inflation at a constant rate, and when is it at an accelerating rate (what causes inflation to get worse and worse)?

The answer: Expectations

ACCELERATION HYPOTHESIS
-If the economy is running an inflationary gap caused by either increased aggregate demand (for an example, demand resulting from China's increased demand for raw materials) or increased aggregate supply (for an example, increase supply due to lower world prices of raw materials)...
-AND if the central bank wants to maintain the "good time" (aka: it uses monetary policy to validate this inflationary gap, and tries to keep the gap from being closed)...
-THEN, inflation will persist, and be accelerating.

In summary, if the BoC maintains a constant inflationary gap, then the actual inflation rate will persist and accelerate (the economy will continue to inflate at progressively larger rates over time).

WHY?

1) EXPECTATION EFFECTS (remember, actual inflation is a combined result of gap inflation, expectation inflation, and supply shock inflation)
-An increase in aggregate demand causes an inflationary gap, and as we know, this ultimately causes prices to rise due to the wage change mechanism
-As a result, expectations are formed: workers demand that their wages rise at a similar rate over the next year to account for predicted inflation (for an example, let's say that they expect inflation to be 2%, then they will demand a 2% wage increase).
-If the BoC adds inflationary pressures by maintaining the gap, then this will create extra gap inflation of 2%, which stacks on top of the expectation inflation for a combined actual 4% rate of inflation.
-This overall 4% rate of inflation informs new expectations for the next year: workers will demand 4% wage increases, and those new expectation pressures stack onto persistent gap inflation for a total of 6% total inflation over the next year
-This continues on for quite a while, generating an inflationary spiral.

AS LONG AS THE BoC VALIDATES THE GAP, EXPECTATIONS ARE ALWAYS BEING REVISED UPWARDS (worker expect higher and higher inflation, and demand higher and higher wage increases). People come to expect this inflation, and build it into their wage demands.

2) MORE RAPID MONETARY VALIDATION IS REQUIRED
-If the BoC wants to maintain output above Y*, it has to increase the rate of growth in the money supply.
-This is because the inflation rate is accelerating, and therefore, to accommodate for increase transaction demands due to higher prices, the BoC must accelerate the growth of money (basically, it must print a larger and larger quantity of money each year)
-This validation becomes more and more dramatic as time goes on

Let's summarize what we know!

We have an isolated shock ---> There will be no gap in the long run
We have have a repeated AS shock ---> There will be a persistent gap
We have a repeated AD shock ---> There will be a persistent gap

At Y*, persistent inflation will consist of only expectation inflation
With a Gap, there will be accelerating inflation, due to the gap inflation on top of expectation inflation

Cost push inflation from Y* lead to a recessionary gap
Demand pull inflation from Y* leads to an inflationary gap

AGAIN: Is monetary validation a good idea?
Yes, because monetary validation can eliminate recessions more quickly than simply letting "nature take its course"
No, because it causes inflation

Additionally, as we now know, monetary validation can create expected inflation to increase over time, creating a wage-price spiral. Some economists argue that the disadvantages of these increased expectations could be avoided if the BoC never validated gaps in the first place!

The Gap Effect, and the Expectation Effect

THE WONDERFUL WORLD OF INFLATION:

People talk about inflation a LOT, so its probably a good idea know what it is. If you've survived macroeconomics without knowing what inflation is up until this point, congratulations, you live a seriously charmed life.

For the rest of us, lets reiterate:

Inflation is any rise in the general price level (P)

Inflation can be temporary/transitory (the price level increases to a new equilibrium price level, where it stays put for a while) or it can be sustained/persistant (the price level rises continuously over time)

In classical economics, aggregate demand shocks and aggregate supply shocks cause TEMPORARY inflation (one-time jumps in the price level) as a side effect of gap inflation. In this chapter, we are more concerned with exploring the causes of sustained inflation (which, as we will learn, is affected by people's expectations). We're also going to look at what causes accelerating inflation.

On a very basic level, prices can rise for two different reasons
1) There is a decrease in supply (this is called cost-push inflation)
2) There is an increase in demand (this is called demand-pull inflation)

HERE IS A LIST OF TERRIBLY IMPORTANT DEFINITIONS WHICH WE SHOULD ALL PROBABLY LEARN IF WE WANT TO DO WELL IN MACROECONOMICS:
Inflation - A rise in the consumer price index
Inflation Rate - The percentage change in the consumer price index
Zero Inflation - A situation where there is no percentage change in the consumer price index
Stable Inflation - A situation where the inflation rate remains relatively constant over time (ie: inflation is 2% for seven years in a row)
Accelerating Inflation - The inflation rate increases over time (ie: inflation is 2% in 1991, 4% in 1992, 8% in 1993, and 13% in 1994)
Disinflation - The inflation rate decrease over time (ie: inflation is 16% in 1991, 9% in 1992, 5% in 1993, and 3% in 1994)
Deflation - A negative rate of inflation: the consumer price index goes down (so goods end up costing less)

Low inflation: 1-3%
Medium inflation: 3-6%
High inflation: Over 6%
Hyperinflation: Over 20%

Why are we concerned with inflation? Because too much inflation inflicts a bunch of costs on society. Here are some of them:
-It decreases the purchasing power of people who are on fixed incomes (both contractually and in terms of pensionary incomes)
-It can arbitrarily redistribute income
-It undermines the efficiency of the price system by distorting relative prices (so its harder for consumers to tell if they are getting a good deal or if they are getting ripped off if the general price level is continuously in flux)

---------------------------------------

One last important concept is NAIRU, which is the non-accelerating inflationary rate of unemployment. Basically, this is the rate of unemployment present in an economy when there are no inflationary or recessionary gaps (when Y is at Y*). This does not mean that there is no unemployment- only that there is no GAP unemployment (there can still be frictional and structural unemployment). NAIRU is also sometimes called "full employment," or U*.

We're going to look at why NAIRU is called NAIRU in this chapter

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INFLATION AND WAGE CHANGES:

Okay... why do people's wages change?

There are two factors which can explain why people's wages change
1) The gap effect
2) The expectation effect

THE GAP EFFECT
-Basically, this is demand-pull inflation caused by excess demand in the labour market.
-In an inflationary gap, we get GAP INFLATION. Y is larger than Y*, U is smaller than U*, and there is an excess demand for labour. As a result, firms are forced to raise wages in order to keep employees. The result of this rise in wages is that average costs rise (which, in turn, causes the short run aggregate supply to shift to the left, correcting the inflationary gap).
-In a recessionary gap, we get GAP DEFLATION. Y is smaller than Y*, U is greater than U*, and there is an excess supply of labour. As a result, firms can safely lower employee wages without the risk of losing employees (its better to have a low-paying job than no job at all). This, in turn, causes average costs to fall, which shifts short run aggregate supply to the right, correcting the inflationary gap.
-When there is no gap, there is NO INFLATION. Y equals Y*, U equal U*, demand and supply of labour are equal, wages remain constant, average costs remain constant, and the short run aggregate supply remains constant (as do prices).

The Phillips Curve shows the inverse relation between the unemployment rate and the rate of changes in nominal wages.

Basically, as unemployment gets higher, wage increases get smaller and smaller, and eventually, turn into wage decreases (salary cuts).

Classical economists ONLY considered the gap effect to be a source of inflation, and believed that gaps would only create a temporary period of inflation. They also believed that if there was no gap, that there would be no increase in wages...

They were entirely correct... there is also...

THE EXPECTATION EFFECT
-Here, expected inflation is taken into account when employees are negotiating wage demands with their employers
-Here, inflation is like a "self fulfilling prophecy". If employees believe that there will be inflation of a certain level over the next year, they will negotiate for higher wages to account for that inflation. This, in turn, increases firms' average costs, which shifts the SRAD curve to the left, effecting CAUSING an increase in prices in-step with what employees predicted. In other words, preemptively adjusting wages for expected inflation can MANUFACTURE real inflation!

Causes of expectation inflation:
-Expectation inflation can be caused by backward-looking, where people assume that past rates in inflation will continue into the future (people believe that history repeats itself)
-At the same time, if an economy has an extremely volatile inflation rate, it may take time for people to develop a psychological trend to respond to inflation- it takes a while to figure out how the pattern works and predict accurately for the future.
-Expectation inflation can also be forward-looking. Workers could look at governments' macroeconomic policies to predict what future changes may be in store (they can prognosticate).
-The main thing to remember is that in economics, we assume that people are RATIONAL BEINGS with their own best interests at heart. People try to use all available information to the best of their ability, and for the most part, they are correct. People can adjust rapidly to changes.

The TOTAL EFFECT: Changes in money wages are a combination of the gap effect and the expectation effect
-In this way, we can decompose an increase in the rate of wage changes into the gap effect (excess demand for labour) and the expectation effect (psychology)
-We can think of the expectation effect as the "cake" and the gap effect as the "icing", which causes increased wages changes on top of expected changes
-The total effect can be either positive or negative.

The Demand & Supply for Money

The Liquidity Preference Function: This shows people's preference to hold money (cash balances) rather than bonds (interest bearing assets)

-People have a choice between holding their wealth in one of two ways: bonds or money
-Money pays no returns, and bonds do pay a return
-The opportunity cost of holding money is the interest rate one earns on a bond
-People only want to hold money when it provides benefits which at least equal the cost of forgoing bond interest

3 REASONS WHY PEOPLE HOLD MONEY

1: TRANSACTION DEMANDS FOR MONEY
-People hold money so that they can make transactions

2: PRECAUTIONARY DEMAND FOR MONEY:
-People hold money in case they experience an emergency where money would is required
-There is uncertainty sometimes about the timing of receipts and payments, so it can be strategic to have a buffer of cash savings to "tide yourself over"

3: SPECULATIVE DEMAND FOR MONEY:
-People hold money because they believe it will be more strategic to buy bonds in the near future than in the immediate present (if the interest rate is really low, for interest, waiting for the interest raise to rise before buying bonds will be more financially strategic)

The transaction and precautionary demands for money account for the distance between the money demand curve and the Y-axis. When the demand for money shifts to the left or right, this is usually due to a change in transaction demands (for an example, if GDP increases or prices increase, consumers will have higher transaction demands)

The speculative demand for money explains why the liquidity preference curve is downward sloping: the opportunity cost of holding money increases as interest rates increase, so the higher the interest rates, the lower the demand for money (this is dependent on nominal interest rates, rather than real interest rates, as this is a PSYCHOLOGICAL, rather than an accounting effect)

Income, Prices, and The Nominal Interest Rate Affect Demand for Money!

The higher income is, the more transactions there are within an economy, so the higher demand for money will be
+ Positive Relation

The higher the nominal interest rate, the lower the demand for money will be, for reasons related to opportunity cost
- Negative Relation

The higher the price level is, the higher demand for money will be (this is called inflationary demand for money), because a greater monetary value of transaction will be required to facilitate the same amount of real spending: households need more money to carry out their transactions.
+ Positive Relation

Note* when interest rates are very very very high, the only demand for money is transaction demands (so this is the space between the liquidity preference function's asymptote and the Y axis)

THE SUPPLY OF MONEY

-The money multiplier is relatively constant
-The currency ration and and reserve ratio only change during times of uncertainty (usually, they both increase when the future is murky)
-The money supply is independent from the interest rate (although it affects the interest rate)
-In our model, we say that the money supply is a constant, and that it is perfectly inelastic: it is represented by a straight line on our graph
-The real money supply is M/P: this describes money's purchasing power in terms of goods and services


PUTTING SUPPLY AND DEMAND TOGETHER: MONETARY EQUILIBRIUM
(This is also called liquidity preference theory of interest, or the portfolio balance theory)
-This is a short run analysis of how interest rates are affected by the money supply- it is very different than the long run analysis we talked about earlier

Okay: So..
-The supply of money is perfectly inelastic (a vertical line)
-The demand for money varies inversely with the interest rate (it is a downward sloping curve)

Equilibrium occurs when demand and supply for money intersect: M = L

Notice that because the demand for money is downward sloping, the money supply affects equilibrium interest rates: a higher money supply renders lower interest rates, while a lower money supply renders higher interest rates

Monetary equilibrium is a stable equilibrium: if there is higher demand for money than money supplied, then a large number of people will begin to sell-off their bonds to generate some extra money. Because of an excess influx of bonds being sold on the market, the price of bonds will fall, while their relative yields will increase. This, in turn, causes the interest rate to rise, and it will rise until the money market is in equilibrium. A similar mechanism returns interest rates to an equilibrium level when there is an excess supply of money.

That's all for now!

MONEY MONEY MONEY

Money Money Money!


THE NATURE OF MONEY

-Classical economists arbitrarily divided economies into the real sector, and the monetary sector.
-The REAL SECTOR describes the allocation of resources to produce different goods
-Resource allocation (use of factors) is dependent on relative prices
-Relative prices affect output (so if wood is cheaper than brick, an economy will produce more wood houses than brick houses

-The MONETARY SECTOR encompasses changes in the money supply (how much money is circulating in an economy)
-Most economists believe that a change in the money supply would just change the absolute price level in the long run
-If relative prices do not change (ie: the price of both wood and brick rises proportionately), then this will not change the allocation resources
-This shows the NEUTRALITY OF MONEY (A change in the money supply can change the macroeconomic price level, but it will not change relative prices, or GDP)
-The amount of money circulating in an economy affects ABSOLUTE prices, but not relative prices (so while the price of wood will go up, so will the price of bricks, and consequently, the price of houses)

-In modern economic theories, money supply has no long run effect on GDP (it only affects the price level)
-In the short run, however, money supply can affect both price level and GDP

This is the exchange identity: MV = PY : The velocity of money (the size of the money supply multiplied by the amount of times money is used in an economy) is equal to the general price level multiplied by real output. In other words, what you give up (the amount of many people spend to get things) is equal to what you get (the value of the real goods produced by an economy)

THE DEFINITION OF MONEY: 3 ESSENTIAL CHARACTERISTICS

1: Money is a medium of exchange
-Barter requires the "double coincidence of wants" (you have to want what I have, and I have to want what you have)
-Because such situations rarely occur, money is an excellent "in-between" medium-of-exchange for facilitating trade

There are stipulations, however!
1: Money only works as a medium of exchange if people expect that others will accept their money as a legitimate form of payment
2: Money should have a generally high value relative to its weight (or else it will be awkward to exchange: can you imagine if sand or dirt were money, for instance!)
3: It must be divisible (you can divide a dollar in half. You cannot divide a live cow in half)
4: It must not be counterfeit-able (which explains the elaborate construction of dollar-bills)

2: Money is a method of storing wealth
-Earning and spending are not synchronized (ie: you may work on a Monday, but not wish to buy anything until a Saturday)
-Money has stable value which does not diminish over time
-It is a method of deferred payment (this is sometimes cited as the 4th role of money)

3: Money is a unit of account, or financial measurement
-We use money as a unit of measurement: we measure different transactions using dollars, thus it is a sort of accounting unit which facilitates accounting.

NOTE* Demand deposits (aka: deposits into an easily-accessible checking account) count as money, as they satisfy all of these conditions!

THE ORIGINS OF MONEY

1: Commodity Money
-Money was originally precious metals, such as gold
-These were generally recognized as valuable and accepted as payment in most places- they did not wear away or lose value over time, and they had a stable value

Problems:
-Originally, these metals were carried in bulk, so they would have to be weighed, and then stamped by a ruler, guaranteeing the weight of "face value"
-Clipping and shaving
-debasement led to inflation and Quantity Theory of Money

Gresham's Law:
-Bad money forces good money out of the system
-People will hang on to money with high intrinsic value (because it is a very good method for storing wealth)

2: Token Money
-To overcome the problems associated with commodity money, would was deposited at a goldsmith's vault for safekeeping. The goldsmith would give owners a receipt, and this receipt of ownership of the gold was exchanged, rather than the gold itself. Eventually, banks replaced goldsmiths, performing a similar function
-Bank notes were paper money, which were FULLY BACKED by gold (ie: convertible on demand)
-A country whose money is fully backed by gold is on the gold standard

3: Fractionally Backed Money
-Banks discovered that while some customers withdraw gold, and some customers deposit gold, most of their customers are simply trading indirectly using bank notes
-Thus, banks could issue more notes convertible to gold than they actually have gold in their vaults as reserves, and then charge interest on this lent money to generate profits.
-The fraction of money held in reserve affects the money supply: the higher the amount held in reserve, the lower the money supply (because money held in banks cannot be in circulation)

4: Fiat Money: Legal Tender
-Here, the state promises that a certain form of paper or coin currency is legally money, so it becomes money
-Over time, central banks took control of the note issuance: while it was originally backed by gold, it is now only fractionally backed
-Ultimately most of the money we deal with on a day to day basis is not backed by gold at all (for instance, if we went to the neighborhood bank, deposited a cheque, and asked for gold, the teller would probably think we were very strange)
-Most countries abandoned the gold standard by 1940 (WW2)

Legal Tender: The law requires that this be accepted to repay debts- refusal discharges debt.
-Fiat money is backed by the productive capacity of an economy
-Fiat money is valuable because it can purchase goods and pay debts (today's money is fiat money)

5: Bank Deposits (Modern Money)
-Money held by the public in the form of deposits withdrawn on demand from banks (no notice is required)
-(Checks and debit cards, however, are not considered money)
-Bank deposits function on a fractional reserve system: banks create money by granting more loans than deposits to cover them (so if a run on the banks were to occur, the banks would not actually have enough money on hand to pay everyone back.

THE CANADIAN BANKING SYSTEM:

Canada (and many other countries) has a central bank which controls the money supply (the bank of Canada, which a run by a "governor" of the bank of Canada)
-Although the Bank is owned and operated by the government, it operates separately from the cabinet on a day to day basis: it is ultimately held responsible the cabinet, however.

In Canada, our current governor of the Bank of Canada is Mike Carney (Monetary Policy) and our current minister of finance is Jim Flaherty (Fiscal Policy)

THE FUNCTIONS OF THE BANK OF CANDA

1: It is the Bankers' Bank
-It is a lender of last resort to Chartered Banks (they can lend money from the BoC if they have to)
-Chartered Banks have their checking accounts at the Bank of Canada (reserves)
-As of 2002, about $1.2 billion was actually held in asset form at the bank of Canada

2: It is the government's bank
-The government has a chequing account at the BoC
-The government replenishes this account from larger accounts at Chartered Banks
-The BoC's monetary tool is "switching" the location of government accounts (between the BoC and Chartered Banks)

3: It regulates the money supply
-It prints money (this is only done as a reaction in Canada)

4: It regulates financial markets
-It prevents panic and bank failures
-Financial intermediaries (chartered and commercial banks) borrow short term and loan long term from the BoC, so increases in the bank rate squeezes them, and makes the "overnight market" less attractive: basically the higher the BoC sets the bank rate, the higher Chartered Banks will set their prime rate in order to continue to profit, and the more money they will hold in reserve to avoid getting "dinged" with interest for borrowing from the government should a customer seek to withdraw money
-The BoC is concerned about the exchange rate

So, the money supply involves the government, central banks, and chartered banks

The Canadian System

Canada- few banks with many branches (the banking sector is much more like an oligopoly)
USA- many banks with fewer branches (the banking sector is much more like monopolistic competition)
The systems are a bit different, but they essentially function the same way

COMMERCIAL BANKS: Includes chartered banks (formed prior to 1980), smaller banks trusts and credit unions, and foreign banks
A commercial bank is a profit-maximizing private corporation

Chartered Banks
-They hold deposits (trust companies also do this)
-They transfer deposits by cheque (the post office also does this)
-They make loans (credit unions also do this)
-They invest in government securities (insurance companies also do this)
-The government used to require the chartered banks to old money on reserve, but this is no longer required after reforms to the Bank Act (1980)

Interbank Cooperation
-Several Banks can make pooled loans to large companies (which they all benefit from due to the interest paid)
-Charted Banks must now compete against credit card companies
-Debit Cards
-Cheque clearing distinguishes chartered banks (they will turn cheques into money!)
-A clearing house settles interbanks debts: the net difference is accomplished by change in deposits at the bank of Canada

Chartered Banks are Profit-Maximizing Private Corporations:
-Their main asset is securities and loans
-Their main liability is deposits
-They make profits by borrowing money for less than they lend it for
-Competition is strong among different banks, which leads to competitive rates, which is good for consumers

The Big 5:
Royal
Toronto Dominion
Scotia
CIBC
BMO

Note* Our prof usually refers to chartered and commercial banks interchangeably

RESERVES
-Their purpose is to meet demands on deposits for chartered banks
-A RUN ON THE BANKS is when more depositors wish to withdraw more deposits than there are reserves

WAYS TO AVOID A RUN ON THE BANKS:

1: Reserves- the BoC can induce an INCREASE in reserves and avert a run on the banks by
-Loaning money directly to chartered banks
or
-Open Market Operations: buying securities from Chartered Banks

2: The Canadian Deposit Insurance Coporation
-A Federal Crown Corporation
-Insures deposits in any one account up to $100,000
-A problem is that this insurance is an incentive for banks to pursue riskier investment options "if this investment makes us money, the depositor wins- if it loses us money, then the taxpayer loses"

TYPES OF RESERVES:
1: A Reserve Ratio is the chartered bank's fraction of deposit liability held in Cash of BoC deposits

Actual reserves = reserves the Chartered Bank actually holds
Target reserves = reserves a Chartered Bank wishes to hold
Excess reserves = reserves a Charted Bank holds above target
Secondary reserves = liquid assets convertible to cash (ie: T-bills, and government bonds)

The old bank act required banks to hold reserves for stability and confidence in the system, and to regulate the money supply

Competition from intermediaries and international banks who were not required to hold reserves lead to the elimination of required reserves. Now, the BoC uses the "overnight target rate" (how much interest it charges target rates on overnight loans) to regulate reserves and control the money supply

Presently, actual reserves are about 0.5% of total Chartered Banks liabilities (so we are using a fractional reserve system)

THE FRACTIONAL RESERVE SYSTEM

The reserve ratio is much much less than 1, at about 0.5% of total liabilities. Chartered banks only hold a small portion of deposits on reserve, and the BoC will bail them out if reserves are too low to meet demands on deposits.

The Cost for chartered Banks of borrowing from the BoC (the Bank rate, or the "overnight rate") determines how much reserves banks will hold. An increase in the cost of borrowing will induce the Chartered Banks to hold more reserves

BANK RATE INCREASES ---> BANKS HOLD MORE IN RESERVES
BANK RATE DECREASES ---> BANKS HOLD LESS IN RESERVES

Target reserve ratios are now determined independently by Chartered Banks, but there is incentive for them to still hold some reserves on hand, in order to avoid losing money: the Bank rate determines the opportunity cost of the risk of loaning out more than is on reserve for Chartered Banks.

The Creation of Money!

Assume:
-There is a fixed reserve ratio
-There are no leakages or cash drains (this implies that a change in the money supply will manifest as a change in deposits)

2 Conditions are required for Banks to Make Money

1: The Public must be willing to use bank deposits as money

currency ratio = (public cash holdings/public bank deposits) or C/D

2: banks must be willing to use the fractional reserve system

reserve ratio = (reserve assets/deposit liabilities) or R/D

If the currency ratio is equal to 1, then there is no banking system
If the reserve ratio is equal to 1, there is no creation of money (there is just safety deposit boxes)

The Creation of Deposit Money

Assume:
-cr = 0 (all of the cash is deposited in banks)
-rr = 0.20 (banks loan out 80% of their deposits)

The creation of money is possible due to the fractional reserve system

Changes in the money supply are equal to deposits or withdrawals / The reserve ratio

The currency ratio acts as a cash drain, or leakage. The uncertainty of the banking system increases the currency ratio and decreases the multiple expansion of the money supply (the more cash people hold onto instead of converting into a bank deposit, the smaller the change in the money supply due to banks loaning out money)- we saw this sort of thing happen in 2008 with the US financial meltdown- people lost faith in the banks and wanted their money back, so the money supply in the United States suddenly decreased.

On the other hand, deposits are very convenient (thanks to debit cards), which decreases the currency ratio

High Powered Money (H) is "cash": a combination of cash held on reserve by banks, and cash in circulation within the public.
H = rr * D + cr * D

THE MONEY MULTIPLIER

Money Supply = M

M = D + C (bank deposits + money in circulation)

But, C = cr * D

so

M = (1 + cr)D

H = R + C

R = rr * D and C = cr * D

Therefore, H = (rr + cr)D

The money multiplier = Changes in M/Changes in H
= (1 + cr)/(rr + cr)

If the currency ratio = 0, then the money multiplier = 1/rr

If banks want to hold more money (the reserve ratio increases) or if the public wants to hold more cash (the currency ratio increases), then the money multiplier gets smaller: basically, the more loanable money which is held in banks, the higher the multiplier effect for money!

AN EXAMPLE OF THE MONEY MULTIPLIER

Assume:
-A constant reserve ration of 0.20
-cr = 0

Person 1 deposits $100 in the bank.
The bank loans out $80 to person 2
Person 2 deposits $80 in another bank
The bank loans out $64 to person 3
Etc...

With each transaction, the money supply increases by a decreasing amount (it works similarly to the expenditure multiplier effect)
So, let's do the math: 100 * the money multiplier = 100 *(1/0.20) = 500!

Monetary Base (H) = C + R - this is the amount of cash in an economy
Money Supply (M) = C + D - This is the amount of money in an economy (because not all money is cash!)

Variable reserve ratios make the the money multiplier equation complicated, but it still works

Cash Drains: Money creation is not automatic- it depends on public and bank behaviors
Public: Uncertainty causes the cr to increase, which makes it harder to create new money
Bank: Uncertainty causes the rr to increase, which makes it harder to create new money

TYPES OF DEPOSITS

Demand Deposit
-Can be withdrawn on demand (no notice required)
-Money can be transfered via cheque

Savings Deposit
-Notice of withdrawal required
-Non-transferable by cheque

Term Deposit
-Chequable savings accounts are now available, so the old distinction isn't as useful
-Today, "term deposit" distinguishes "notice accounts" from other accounts
-A deposit must be left in the account for a term: if withdrawn early, there is a reduced interest rate on that money (so the depositor gets less bang for their buck)

Definitions of the money supply
H = High Powered Money, or cash in public and cash in reserves
M1B = Cash in public + Demand Deposits (this emphasizes the exchange medium function of money)
M2 = M1B + savings deposits at chartered banks (emphasize money's wealth storage function)
M2+ = M2 + Deposits at other intermediaries, including credit unions, trust companies, insurance companies, and MMFs
M2++ = M2+ and all other mutual finds + Canada Savings Bonds

The BoC uses M2's to control inflation.

Near Money and Money Substitutes

There is debate over the definition of the money supply: if a medium of exchange is important, than M1B should define the money supply. If a storage of wealth is important, than deposits that pay higher returns but are not chequable (ie: the M2 series) should count as part of the money supply

Near Money is not a good medium of exchange, but it IS a good store of wealth (like Savings Bongs, Mutual Funds, and Money held in trust accounts)
Money Substitutes are good methods of exchange, but not good methods of storing wealth (like credit cards and debit cards)

Whew. That's all!