BUSINESS ECONOMICS Part II: Macroeconomics, 5th Edition

SOLUTIONS TO END-OF-CHAPTER PROBLEMS Dr. Kenneth Matziorinis 6.1 i) U = (L - N) = 17,576,000 - 16,501,000 = 1,075,000 persons in 2006

ii) UR = (U / L) x 100 = 1,075,000 / 17,576,000 x 100 = 6.1%

iii) NR = (N / CP) x 100 = 16,501,000 / 26,155,000 x 100 = 63.1%

iv) NGR = N t - N t-1 / N t-1 x 100 = 16,501,000 - 16,137,000 / 16,137,000 x 100 = 2.25% growth in employment (people with jobs) from 2005 to 2006

v) LGR = L t - L t-1 / L t-1 x 100 = 17,576,000 - 17,324,000 / 17,324,000 x 100 =

1.45% growth in the country�s labour force in 2006

vi) Labour force (L) is the total number of persons of working age (i.e. 15 years and over) who are able and willing to work. Who offer their labour services to the economy

vii) POPGR = POP t - POP t-1 / POP t-1 x 100 = 32,524,000 - 32,197,000 /

32,197,000 x 100 = 1.0% growth in Canada�s population between 2005 and 2006

viii) PR = (L / CP) x 100 = 17,576,000 / 26,155,000 x 100 = 67.2% The participation rate shows the proportion of persons who are of working age and able to work who are interested or willing to work.

ix) The "full-employment" unemployment rate in Canada is presently considered to

be around 6%.

x) Three types of unemployment:

Frictional Unemployment: Here people are unemployed because they voluntarily decided to quit their job so that they can get a better job, move to another part of the country, go back to school, give birth to a child etc. It reflects personal factors which have nothing to say about the state of labour markets or the economy.

Structural Unemployment: Here people lose their job against their will. The reason has to do with the fact that their job skill is no longer current or in demand by employers because the skill has been superceded by machines or the market is no longer interested in the product that skill is used to make. Structural unemployment is concentrated in specific job skill areas and industries so it tends to be localized.

Cyclical Unemployment: Here people lose their job because the state of the overall economy is bad. When total demand for goods and services falls, employers cut down on production which results in lay-offs for a portion of the workforce. Cyclical unemployment is easy to detect since it affects the vast majority of industries and spreads across all regions of the economy.

6.2 You divide the unemployment rate by the seasonality factor: i.e. UR / SF = S.A.U.R.:

Seasonally Seasonality Seasonally Month Unadjusted Factor Adjusted

Jan 13.7 1.105 12.4 Feb 13.6 1.088 12.5 Mar 14.0 1.120 12.5 Apr 13.2 1.065 12.4 May 12.2 0.992 12.3 Jun 11.7 0.967 12.1 Jul 11.2 0.941 11.9 Aug 10.9 0.940 11.6 Sep 10.4 0.920 11.3 Oct 10.3 0.920 11.2 Nov 10.7 0.964 11.1 Dec 11.1 1.000 11.1 _______________________________________________________________

UNADJUSTED AND SEASONALLY-ADJUSTED UNEMPLOYMENT RATE IN CANADA, BY MONTH

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec9

10

11

12

13

14

15Percent (%) UR

9

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Unadjusted Seasonally Adjusted

6.3 You are given the following annual inflation data for Canada for the 1969-82 period: Year Rate of Inflation CPI 1969 4.8 94.3 1970 3.0 97.1 1971 3.0 100.0 1972 4.8 104.8 1973 7.8 113.0 1974 11.0 125.4 1975 10.7 138.8 1976 7.2 148.8 1977 8.0 160.7 1978 8.9 175.0 1979 9.3 191.3 1980 10.0 210.4 1981 12.5 236.7 1982 10.9 262.5 _________________________________________________________________

a) See table above: Eg.: 100 x 1.048 = 104.8; 104.8 x 1.078 = 113.0; 113.0 x 1.1= 125.4 Eg.: 100 / 103.0 = 97.1; 97.1 / 103.0 = 94.3 b) The CPI is a measure of cumulative inflation over time in goods and services

bought at the retail level by households only, i.e. consumer goods and services only. The IPI is a measure of cumulative inflation over time in the price of all goods and services sold in the economy, i.e. consumer, producer, government and export prices, and is the broadest or economy-wide measure of inflation available, for this reason it is used as the GDP price deflator in the calculation of real GDP.

c) The federal government in conjunction with the Bank of Canada have set a target

for annual inflation at 2%, within a band of 1% - 3% over time. d) Headline inflation is the all-items number reported every month by Statistics

Canada which makes the headlines in newspapers. The core inflation strips out volatile components of the index such as food and energy prices that can swing up and down from month to month so we have a more clearer or stable view of underlying inflation in the country.

6.4 i) AE = C + I + G + X - M = Aggregate expenditure or aggregate demand for

domestically produced goods and services.

AE = $ 1,364,903 million in 2005

ii) GDP = AE + ∆V = $ 1,375,080 million in 2005

This is the formula used in the expenditure approach to measure GDP or national income.

iii) GDP > AE, because during the year 2005 the total production (output) of goods in Canada exceeded the demand for them. Producers had unsold goods which they added to their existing stock of inventories. As a result, there was a net accumulation of inventories equal to $10.2 billion. When this happens it is a bad sign about the direction of the economy because it implies that firms will have to reduce output in the near future in order to bring their inventories closer to line with demand and this results in employment cut-backs and a slowdown in the economy.

iv) During the year inventories rose by $ 10,177.0 million (+∆V). This happened because the demand for goods fell short of the production of goods (i.e. sales failed to match production).

v) ( X / GDP ) x 100 = 520,379 / 1,375,080 x 100 = 37.8 %

In 2005 Canada exported 37.8 % of its total production of goods and services. It shows that Canada's economy depends a lot on the rest of the world for jobs and its income.

vi) ( I / GDP) x 100 = 289,370 / 1,375,080 x 100 = 21.0 %

This rate is called the rate of gross fixed capital formation (GFCF) and shows what portion of our annual output of goods and services is devoted toward the future. The more we spend on new machinery and equipment and the construction of factory, commercial and engineering structures such as roads, bridges, pipelines, sewers etc. the better off we are going to be in the future. It is an important indicator of a country's underlying economic health and long-term economic prospects.

6.5 i) NDI = Wages and salaries + Corporation profits + government business enterprise

profits + interest and miscellaneous investment income + net farm incomes + unincorporated business income and rent + inventory valuation adjustment. NDI represents the dollar value of factor services (resources) such as labour, capital, land and entrepreneurial services supplied by households to firms annually.

NDI = (694,041 + 189,357 + 14,578 + 61,070 +1,321 + 83,636 + ( - 933) =

$ 1,043,070 million in 2005

ii) GDP = NDI + CCA + IT ; this is the factor income approach to the measurement of national income;

GDP = 1,043,070 + 156,181 + 175,829 = $ 1,375,080 million in 2005

iii) In 2005 Canada's income shares were as follows:

Employment Income: Wages & Salaries / NDI = 694,041 / 1,043,070 x 100 = 66.5%

Corporate Profits: Corporate Profits / NDI = 189,357 / 1,043,070 x 100 = 18.2% Investment Income: Investment income / NDI = 61,070 / 1,043,070 x 100 = 5.9%

iv) Capital consumption allowance (CCA) is a sum of money firms deduct from their revenues in order to determine their profit. It is a cost of doing business and represents the amount by which fixed capital goods such as buildings, machinery and equipment are used up or consumed annually in the process of producing goods and services for sale.

CCA is known as depreciation in economics. Generally accepted accounting principles (GAAP) require that the cost of a durable fixed asset such as a machine or a building be amortized over a period of time instead of being charged as an operating expense in the year of acquisition. The idea behind this is simple. If the asset has a useful life of say 10 years, its cost should be spread over 10 years as well to reflect the fact that it is gradually being used up in production.

6.6 i) GNP = GDP + investment income received from non-residents - investment

income paid to non-residents.

GNP = 1,375,080 + 47,213 - 71,753 = $ 1,350,540 million in 2005

ii) GNP and GDP defer in the way they define Canadian income. GDP defines as Canadian income all income generated inside Canada's geographical borders, even though part of that income ends up in the pockets of non-residents who supplied the resources that made it possible to generate that income. GNP, on the other hand, defines as income all income that ends up in the pockets of Canadian residents, irrespective of where in the world this income was generated. Thus to find GNP we add to GDP income that Canadians received from production activity outside their borders but subtract the income from Canadian production activity that was paid to investors who reside outside our borders. Since Canada is a net-debtor nation, which means that we owe foreigners more than they owe us, we pay them more than they pay us with the result that the income that accrues to Canadian residents is less than the income that is generated inside our borders.

iii) NNP = GNP - CCA = 1,350,540 - 175,829 = $ 1,174,711 million in 2005

iv) Net investment income paid to non-residents (- $24,540 million) / GDP x 100

(47,213 - 71,753) /1,375,080 x 100 = 1.8% of GDP

6.7 i) PI = NDI - Corporate income taxes - Retained Earnings + Transfer Payments +

Miscel. Adjustments. It represents the total income Canadian households received from all sources but before personal income taxes. PI = 1,043,070 - 49,492 - 95,790 + 133,766 + 693 = $ 1,032,247 million in 2005

ii) PDI = PI - Personal income taxes (incl. social security contributions). It is the sum of money -after taxes- that Canadians have available to spend or to save, as they see fit.

PDI = 1,032,247 - 240,761 = $ 791,486 million in 2005

iii) PDI / Population = 791,486,000,000 / 32,300,000 = $ 24,504 per person

iv) GDP / Population = 1,375,080,000,000 / 32,300,000 = $ 42,572 per person;

this is a broad measure of a country's standard of living.

v) Sp / PDI x 100 = 30,785 / 791,486 x 100 = 3.9%

In 2005 Canadian households saved 3.9% of their after-tax income and they spent (consumed) the rest.

vi) C / PDI x 100 = 760,701 / 791,486 x 100 = 96.1 %

Remember that PDI = C + Sp, and the consumption and saving rates add up to 100%

6.8 I) Real GDP = GDP / IPI x 100 = 1,446,307 / 112.8 x 100 = $ 1,282,187

millions of constant 2002 dollars in 2006 and 1,375,080 / 110.2 x 100 = $1,247,804 million in 2005 ii) Rate of growth (GR) = Real GDP t - Real GDP t-1 / Real GDP t-1 x 100 = 1,282,187 - 1,247,804 / 1,247,804 x 100 = 2.8 % in 2006 iii) Rate of overall inflation (IR) = IPI t - IPI t-1 / IPI t-1 x 100 = 112.8 - 110.2 / 110.2 x 100 = 2.4 % in 2006 iv) Rate of consumer inflation (IR) = CPI t - CPI t-1 / CPI t-1 x 100 = 109.1 - 107.0 / 107.0 x 100 = 2.0 % in 2006 v) Rate of population growth (POPGR) = POP t - POP t-1 / POP t-1 x 100 = 32,623,000 - 32,300,000 / 32,300,000 x 100 = 1.0 % in 2006

vi) Per capita GDP = GDP / Population = $ 1,446,307,000,000 / 32,623,000 = $ 44,334 per person

vii) Standard of living is how well-off, how prosperous, the average person in a country is. It measures the overall wellbeing of a society which includes goods and services, private and public goods and services, work and leisure. It is measured using GDP (or GNP) per capita. Although the per capita GDP is more representative of the goods and services consumed through markets on which we spend money, it is highly correlated with non-monetary indicators of well-being such as quality of health care and life expectancy.

viii) Personal disposable income per capita = PDI / Population = $842,302 / 32,623,000 = $ 25,819 per person in 2006. Measures how much money we have available for consumption and saving each year.

ix) Personal disposable income per household = PDI / Households =

$842,302 / 12,547,300 = $ 67,130 per household in 2006. Measures how much money the average household earns after taxes but including transfer payments from government each year in Canada.

x) A household is a self-contained unit of economic and social organization. Like a cell in biology, it is the smallest building block in the economy. Members of households make joint production, consumption, saving and investment decisions for their common good. The average number of persons per household is 2.6.

xi) Inflation-adjusted rate of growth in household disposable income is the annual percent increase in real PDI

Real PDI = PDI / CPI x 100 = $842,302 / 109.1 x 100 = $772,046 million in 2006 and $791,486 / 107.0 x 100 = $739,707 million in 2005 Rate of growth in real PDI = Real PDI t - Real PDI t-1 / Real PDI t-1 x 100 = $772,046 - $739,707 / $739,707 x 100 = 4.4 %

xii) The rate of advance in Canada�s living standard is the annual per cent increase in the real per capita GDP.

Real per capita GDP = Real GDP / Population = $ 1,282,187,000,000 / 32,623,000 = $ 39,303 in 2006 and $ 1,247,804,000,000 / 32,300,000 = $ 38,632 in 2005 Rate of advance (growth) in standard of living: Real per capita GDP t - Real per capita GDP t-1 / Real per capita GDP t x 100 = $39,303 - $38,632 / $38,632 x 100 = 1.7 %

6.9 I) Productivity ( Output per worker) = Real GDP / Persons Employed (N) = (1,446,307 / 112.8 x 100) / 16,484,000 = $ 77,784 in 2006 and (1,375,080 / 110.2 x 100) / 16,170,000 = $ 77,168 in 2005 ii) Rate of productivity growth (PRGR) = Real GDP / N t - Real GDP / N t-1 / Real GDP / N t-1 x 100 = $77,784 - $77,168 / $77,168 x 100 = 0.8 % iii) Rate of growth in the labour force (LGR): LGR = L t - L t-1 / L t-1 x 100 = 17,593,000 - 17,343,000 / 17,343,000 x 100 = 1.44 % growth in the country�s labour force in 2006 iv) Employment rate of growth (NGR): NGR = N t - N t-1 / N t-1 x 100 = 16,484,000 - 16,170,000 / 16,170,000 x 100 = 1.94 % growth in employment (people with jobs) in 2006

v) Potential Rate of Growth (PGR) = Labour force growth + productivity growth = 1.44 % + 0.80 % = 2.24 % in 2006

vi) The target for growth in the economy is 3.0%. In 2006 the economy�s capacity to produce grew by only 2.24%, which is substantially below the target. If this rate does not rebound, then the future rate of growth in the economy will slow down which will slow down the rate of advance in our living standards.

What is worse, however, is that our productivity growth ( 0.8%) is severely below what it should be (2.0%) which means that if we cannot find ways to work �smarter� we have to work �harder� by forcing more people out in the labour force (1.44%) !

In 2006 we were lucky, because employment (1.94%) grew faster than the labour force (1.44%), thus if you add the growth in employment with that of productivity (0.8%) 1.94% + 0.80% = 2.74% you find by how much the economy grew during the year (2.8%). Now that the pool of unemployed persons is drying out, the economy�s growth is bound to slow unless productivity rebounds.

Productivity growth has become Canada�s #1 problem and most significant challenge for the future.

6.10 I) Population in 2005 + births - deaths + immigration - emigration = Population in 2006 = 32,523,898 + 343,517 - 234,914 + 256,559 - 36,311 = 32,852,749 in 2006

ii) Natural increase in population: births - deaths = 343,517 - 234,914 = 108,603 iii) Net migration: immigration - emigration = 256,559 - 36,311 = 220,248 iv) Birth rate out of 1000: Births / Population x 1000 = 10.56 per thousand v) Death rate out of 1000: Deaths / Population x 1000 = 7.22 per thousand vi) Population increase in % between 2005 and 2006: POPGR = POP t - POP t-1 / POP t-1 x 100 = 32,852,749 - 32,523,898 / 32,523,898 x 100 = 1.0 % 6.11 i) A turning point is when real GDP stops growing and starts falling, or stops

falling and begins growing ii) The peak is an upper turning point, the maximum point of the business cycle iii) The trough is the lower turning point or the minimum point of the business cycle iv) Expansion is when real GDP is rising from quarter to quarter or year to year v) Recovery is the early part of economic expansion following a trough and until the

previous peak has been surpassed vi) Boom is the latter part of an expansion, close or at the peak of the economic cycle vii) Recession is two consecutive (back-to-back) quarters of decline in real GDP.

When output has been falling for six months the economy is said to be in recession.

viii) Depression is a deep and prolonged drop in real GDP accompanied with falling

product and asset prices. Typically output can fall by more than 5% and keep falling or not rising for a period of 5-10 years

6.12 Actual Unemp. Employ. Potential GDP

Year GDP Rate (%) Rate (%) GDP Gap

1989 824.2 7.5 92.5 837.6 13.4 1990 825.1 8.1 91.9 844.0 18.9 1991 808.2 10.3 89.7 846.9 38.7 1992 815.5 11.2 88.8 863.3 47.8 1993 833.9 11.4 88.6 884.7 50.8 1994 874.0 10.4 89.6 916.9 42.9 1995 898.5 9.5 90.5 933.2 34.7 1996 913.6 9.6 90.4 950.0 36.4 1997 951.2 9.1 90.9 983.6 32.4 1998 991.3 8.3 91.7 1016.2 24.9 1999 1046.3 7.6 92.4 1064.4 18.1 2000 1100.8 6.8 93.2 1110.2 9.4 2001 1120.4 7.2 92.8 1134.9 14.5 2002 1152.9 7.7 92.3 1174.1 21.2 2003 1174.4 7.6 92.4 1194.7 20.3 2004 1210.9 7.2 92.8 1226.6 15.7 2005 1247.8 6.8 93.2 1258.5 10.7 2006 1282.2 6.3 93.7 1286.3 4.1

c) During the period 1990-1997 Canada underwent a mini-depression as the output gap

grew substantially larger and remained large for a considerably long period, much longer than is usually the case in a typical recession. This episode represents the worst economic performance since the Great Depression of the 1930s. It is not until 1998 that Canada�s economy started to perform better, coming close to closing the gap in 2000, but was interrupted by the dot.com stock meltdown of 2000-2001 and the 2001 recession in the USA. Fortunately the damage on Canada was not too big during the 2001-2003 period, Canada managing just narrowly to avoid a recession. The gap was finally closed in 2007.

Problem 6-12 Potential, Actual and GDP Gap, Canada: 1989-2006

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

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1400Billions of Real Dollars

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Actual GDPPotential GDPGDP Gap 6.13 i) Real GDP = GDP / IPI x 100 = 1,459.3 / 113.2 x 100 = $ 1,289.1 billion in Q4

2006

ii) GDP is the market value of all final goods and services produced by the market sector of the economy during the year. Nominal GDP is based on each year's current market prices whereas Real GDP is based on some base year's constant prices. Nominal GDP is not comparable over time because it incorporates the effect of inflation. Real GDP has the inflation effect removed and represents the level of output in the economy. Hence, Real GDP is a more meaningful measure of production.

iii) Per capita GDP in nominal terms: GDP / Population = 1,459,300,000,000 / 32,730,213 = $ 44,586 per person valued at 2006 prices

Per capita GDP in real terms: Real GDP / Population = 1,289,134,000,000 / 32,730,213 = $ 39,387 per person valued in constant 2002 dollars ( i.e. based on 2002 prices).

iv) UR = U / L x 100 = (L - N) / L x 100 = 1,076,000 / 17,716,000 x 100 = 6.1%

v) PR = L / CP x 100 = 17,716,000 / 26,363,000 x 100 = 67.2%

vi) Assuming that the economy's "full-employment" unemployment rate is at 6%, potential GDP is the output that would be produced if 94% or .94 of the labour force were employed. To get a rough estimate of the potential GDP we can use the simple rule of three:

Actual GDP = Potential GDP Actual NR "Full employment" NR

thus, 1,459.3 / .939 = Potential GDP / .94 Potential GDP = $ 1,460.9 billion in 2006

Output or GDP Gap = Potential GDP - Actual GDP = 1,460.9 - 1,459.3 = $ 1.6 billion, the economy is very close to full employment!

vii) - Canada's expected growth rate for 2006/2007: 3.0% $1,289.1 x 1.03 = $ 1,327.8 billion in Q4, 2007

- Canada's expected inflation rate for 2006/2007: 2.5% 113.2 x 1.025 = 116.0 in Q4, 2007

- Canada's expected nominal GDP in Q4, 2007: Expected Real GDP x Expected Implicit Price Index / 100 = 1,327.8 x 116.0 / 100 = $ 1,540.2 billion

viii) Output per worker: RGDP / N = 1,289,100,000,000 / 16,640,000 = $ 77,470 per employed person. Output per employee is a general measure of labour productivity. One of the three measures of a country�s long-term economic prospects.

6.15 a) The three most important indicators of short-term economic performance are:

� The seasonally-adjusted rate of unemployment � The annual rate of inflation (using the CPI or the IPI) � The annual rate of economic growth (using Real GDP or GNP)

b) The three most important indicators of long-term economic performance are:

� The rate of productivity growth � The rate of gross fixed capital formation (business & public

investment) � The rate of national saving in the economy

c) Total Production Real GDP National Income GDP or GNP Economic power GDP or GNP

Standard of living Per Capita GDP or GNP Cost of living CPI or IPI Loss of Purchasing power Rate of Inflation Size of Manpower Labour Force Job Creation Unemployment Rate

Productivity RGDP / Person Employed (N) Willingness to work Participation Rate

Tax burden Personal + Indirect Taxes / PI Willingness to save Personal Saving / PDI

Willingness to spend Personal Consumption C/PDI Consumer spending power Personal Disposable Income PDI Cost of borrowing Interest Rate

6.16 Macroeconomic Indicators 1993 2005 Ideal Unemployment Rate 11.1 % 6.9 % < 6.0 % Inflation Rate 1.9 % 2.2 % < 2.0 % Growth Rate 2.2 % 3.0 % > 3.0 % Productivity Growth Rate 1.5 % 1.1 % > 2.0 % National Saving Rate 13.7 % 23.8 % > 20.0 % Investment (GFCF) Rate 18.0 % 21.0 % > 20.0 % Living Standard (GDP/IPI/Pop) $29,053 $38,632 PDI per capita (PDI/CPI/Pop) $20,145 $22,901

As it can be seen from the above results, Canada�s three short-term indicators of economic performance have improved during this period, the unemployment rate is down, the growth rate is up and the inflation rate remains low. The three long-term indicators of economic performance show even stronger improvement, the savings and investment rates are up considerably to healthy levels while the productivity growth rate remains low. Obviously we still have some challenging work to do on the productivity side, but overall this is a big turn-around compared to 1993. 6.14 Formulae: Real GDP: GDP / IPI x 100 Growth Rate: RGDP t - RGDP t-1 / RGDP t-1 x 100 Inflation Rate: IPI t - IPI t-1 / IPI t-l x 100

Problem 6.14 Nominal Implicit Real Rate of Rate of

Year GDP Price Index GDP Inflation Growth

1971 98.4 24.3 404.9 --- --- 1972 109.9 25.7 427.6 5.8 5.6 1973 129.0 28.2 457.4 9.7 7.0 1974 154.0 32.4 475.3 14.9 3.9 1975 173.6 35.9 483.6 10.8 1.7 1976 200.0 39.3 508.9 9.5 5.2 1977 221.0 42.0 526.2 6.9 3.4 1978 244.9 44.8 546.7 6.7 3.9 1979 279.6 49.2 568.3 9.8 4.0 1980 314.4 55.2 569.6 12.2 0.2 1981 360.5 60.1 599.8 8.9 5.3 1982 379.9 65.1 583.6 8.3 -2.7 1983 411.4 68.7 598.8 5.5 2.6 1984 449.6 70.9 634.1 3.2 5.9 1985 485.7 73.2 663.5 3.2 4.6 1986 512.5 75.1 682.4 2.6 2.8 1987 558.9 78.8 709.3 4.9 3.9 1988 613.1 82.4 744.1 4.6 4.9 1989 657.0 86.1 763.1 4.5 2.6 1990 679.9 88.9 764.8 3.3 0.2 1991 685.4 91.5 749.1 2.9 -2.1 1992 700.5 92.7 755.7 1.3 0.9 1993 727.2 94.0 773.6 1.4 2.4 1994 770.9 95.1 810.6 1.2 4.8 1995 810.4 97.2 833.7 2.2 2.9 1996 836.9 98.8 847.1 1.6 1.6 1997 882.7 100.0 882.7 1.2 4.2 1998 915.0 99.6 918.7 -0.4 4.1 1999 982.4 101.3 969.8 1.7 5.6 2000 1076.6 105.5 1020.5 4.1 5.2 2001 1108.0 106.7 1038.4 1.1 1.8 2002 1152.9 107.8 1069.5 1.0 3.0 2003 1213.2 111.4 1089.0 3.3 1.8 2004 1290.8 114.7 1125.4 3.0 3.3 2005 1375.1 118.6 1159.4 3.4 3.0 2006 1446.3 121.4 1191.4 2.4 2.8

OUTPUT (REAL GDP) GROWTH IN CANADA: 1971 - 2006

72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06300

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1200Real GDP (Constant 1997 Dollars)

Real GDP

RATE OF INFLATION AS MEASURED BY THE

IMPLICIT PRICE INDEX: 1971 - 2006

72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

0

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Annual Percent (%) Rate of Change in I.P.I.

Rate of Inflation

RATE OF GROWTH (IN REAL GDP) IN CANADA:

1971 - 2006

72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

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Annual Percent (%) Rate of Growth in Real GDP

Rate of Growth

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GROWTH IN CANADA'S LIVING STANDARD,

1971 - 2006

72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 0615

17.5

20

22.5

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27.5

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32.5

35

37.5

40Per Capita Real GDP in 1997 Dollars (000s of $)

Per Capita Real GDP

CANADA�S COST OF LIVING AS MEASURED BY THE IMPLICIT PRICE INDEX (CPI): 1962 � 2004

72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 060

20

40

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140Implicit Chained Price Index (IPI), 1997 = 100

Implicit Price Index 6.17 a) 1962 100.0 1972 139.2 1982 349.5 1992 534.7 2002 635.3

1963 101.7 1973 150.1 1983 369.4 1993 544.3 2003 653.1 1964 104.6 1974 166.3 1984 385.7 1994 545.4 2004 664.8 1965 107.2 1975 184.3 1985 400.7 1995 556.9 2005 679.4 1966 110.9 1976 198.1 1986 417.5 1996 565.8 2006 693.0 1967 115.1 1977 213.9 1987 435.9 1997 574.8 1968 119.7 1978 233.2 1988 453.4 1998 580.0 1969 125.1 1979 254.4 1989 476.0 1999 589.9 1970 129.2 1980 280.4 1990 498.9 2000 605.8 1971 133.0 1981 315.2 1991 526.8 2001 621.6

b) Since 1962, the cost of living in Canada has risen almost 7 times or 693.

d) $100 / 605.8 X 100 = $14.43. $100 in 1962 will buy you today less than $14.5

worth of products. The buying power of money has shrank to one seventh of its value in 1962.

e) 1962 50.5 1972 70.3 1982 176.4 1992 269.9 1963 51.3 1973 75.8 1983 186.5 1993 274.7 1964 52.8 1974 83.9 1984 194.7 1994 275.3 1965 54.1 1975 93.0 1985 202.3 1995 281.1

1966 56.0 1976 100.0 1986 210.8 1996 285.6 1967 58.1 1977 108.0 1987 220.0 1997 290.2 1968 60.4 1978 117.7 1988 228.8 1998 292.8 1969 63.2 1979 128.4 1989 240.3 1999 297.8 1970 65.2 1980 141.5 1990 251.8 2000 305.8 1971 67.1 1981 159.1 1991 265.9 2001 313.8

2002 320.7 2003 329.7 2004 335.6 2005 343.0 2006 349.9

CANADA�S COST OF LIVING AS MEASURED BY THE CONSUMER PRICE INDEX (CPI): 1962 � 2006

1962 = 100.0

62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 060

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7.1 You are provided with the following fictitious national income and consumption data: Y=GDP C S MPC MPS APC APS 240 260 -20 0.75 0.25 1.08 -0.08 260 275 -15 0.75 0.25 1.06 -0.06 280 290 -10 0.75 0.25 1.04 -0.04 300 305 - 5 0.75 0.25 1.02 -0.02 320 320 0 0.75 0.25 1.00 0.00 340 335 5 0.75 0.25 0.99 0.01 360 350 10 0.75 0.25 0.97 0.03 380 365 15 0.75 0.25 0.96 0.04 400 380 20 0.75 0.25 0.95 0.05 420 395 25 0.75 0.25 0.94 0.06 440 410 30 0.75 0.25 0.93 0.07 __________________________________________________________________ a) Calculate S, MPC, MPS, APC and APS S = Y - C Eg.: -20 = 240 - 260 MPC = )C = 275 - 260 = 15 = 0.75 )Y 260 - 240 20 MPS = )S = -15 - (-20) = +5 = 0.25 )Y 260 - 240 20 also MPS = 1.00 - MPC = 1.00 - 0.75 = 0.25 APC = C = 260 = 1.08 Y 240 APS = S = -20 = -0.08 Y 240 also APS = 1.00 - APC = 1.00 - 1.08 = -0.08 b) Explain the difference between MPC and APC. MPC is the relative change in consumption expenditure ()C) to a given change in income ()Y) and expresses how fast we spend the money we earn. It is called the marginal propensity

to consume and it measures the rate of spending in relation to the rate of earning. In the above example, it says that the average consumer tends to spend seventy five cents out of every dollar they earn. By measuring how fast we spend the money we earn, MPC serves as a measure of our willingness to spend (consume) and captures consumer psychology. It is the most important behavioural variable in macroeconomic theory. When consumer sentiment shifts from a mood of optimism to a mood of pessimism, the amount we spend out of every dollar we earn diminishes and the MPC declines. APC is the cumulative average of total consumption expenditure to total income (C/Y) and it is called the average propensity to consume. It includes autonomous consumption (") which is how much we have to spend to survive, even when we do not earn any income. Since it is the average of two totals, it does not capture changes in consumer psychology and therefore it lacks the behavioural significance that the MPC has. Observe that APC tends to fall as our income rises from a value greater than one (APC > 1) to a value of less than one (APC < 1). In other words, at low levels of income, we cannot help but consume more than we earn because our survival needs come first. But as our income rises to a higher level, we consume more, and even though we consume more we spend less than we earn and we can afford to save as well. At the break/even level of income, we spend as much as we earn, so at that point we neither go to debt any more, nor do we save either, i.e. (APC = 1) c) On graph paper, plot (C) against (Y) (i.e., C on Y-axis; Y on X-axis). Then draw the 45

degree line (hint: plot Y against Y). See attached diagram d) What is the break/even level of income? What is the meaning of this concept? The break/even level of income (Yb/e) = $320 billion. It is where Y = C or S = 0 e) What is the slope of the consumption function? What is it equal to? The slope of the consumption function is )C / )Y = 0.75 and is equal to the MPC f) On separate graph paper, plot (S) against (Y) (i.e., S on Y-axis (vertical) and Y on X-axis

(horizontal). See attached diagram g) What is the break/even level of income? Should it be the same as (d) above? The break/even level of income is (Yb/e) = $320 billion. It is where S = 0 or Y = C h) What is the slope of the Saving Function? What is it equal to? The slope of the saving function is )S / )Y = 0.25 and is equal to the MPS or 1 - MPC

Income and Consumption Expenditure and the Break/Even Point

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Saving (S)

7.2 You are given the following national income and expenditure data for the Canadian

economy, in billions of dollars ($).

Change in GDP=Y=AS C I G X M AE=AD Inventory 280 160 70 80 90 70 330 -50 300 175 70 80 90 75 340 -40

320 190 70 80 90 80 350 -30 340 205 70 80 90 85 360 -20 360 220 70 80 90 90 370 -10 380 235 70 80 90 95 380 0 400 250 70 80 90 100 390 +10 420 265 70 80 90 105 400 +20 440 280 70 80 90 110 410 +30 460 295 70 80 90 115 420 +40

____________________________________________________________________ a) Calculate AE for each level of income (Y) and determine the equilibrium level of income (Ye)

and changes in inventories. See above table. Ye = $380 billion, where AS = AE or where )V = 0 b) On graph paper, plot the AE and AS curves; point out the equilibrium point (AE and AS on

vertical axis, Y on horizontal axis; AE, AS and Y are in billions of dollars). See attached diagram c) Calculate the MPC, MPS, MPM and MPCD. MPC = )C = 175 - 160 = 15 = 0.75 )Y 300 - 280 20

MPS = 1 - MPC = 1 - 0.75 = 0.25 MPM = )M = 75 - 70 = 5 = 0.25 )Y 300 - 280 20 MPCD = MPC - MPM = 0.75 - 0.25 = 0.50 What it means is that consumers tend to spend 75% of the income they earn while they spend 25% of the income they earn on imported goods and services. In other words, only 50% of the income they earn gets spent on domestically produced goods and services.

280 300 320 340 360 380 400 420 440 460280

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AS AE

d) Calculate the Multiplier (k) of the economy. k = 1 = 1 = 1 = 2x 1 - MPCD 1 - 0.50 0.50 What this means is that every dollar injected into the economy in the form of an expenditure triggers two dollars of additional economic activity in the form of additional output and income. e) Assuming that the full-employment (Yf) level of income occurs at Yf=$420 billion, how large

is the output (GDP) gap? How large is the expenditure gap? What type of expenditure gap do we have? Recessionary or Inflationary? Illustrate on graph b) above.

The output gap or GDP gap = Yf - Ye = $420 - $380 = $40 billion This means that the economy is producing $40 billion below its maximum production capacity or potential output or �full-employment� level of GDP. When the economy is producing below its potential it is characterized with high unemployment and is what happens when the economy undergoes a recession. It is called a recessionary or deflationary gap. The economy is not producing up to capacity because there is not enough aggregate demand (AE) to propel the economy to a higher level of production. Hence we have a recessionary gap. The size of the recessionary gap = GDP gap = $40 = $20 billion k 2 What this means is that if aggregate demand (AE) where to rise by $20 billion, the multiplier effect would trigger a $40 billion rise in output and income, i.e. )AE x k = )Y or $20 x 2 = $40 billion See the next diagram for a graphical illustration: If the AE curve where to shift upwards by $20 billion to AE�, the equilibrium level of income Ye will increase to the full-employment level of income Yf, and equilibrium at full employment will be achieved, i.e. Ye = Yf

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a) Wha Auto It mbillion a b) Wha MPCshows thato spend c) Writ

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are given the following equation for the consumption function:

C = 100 + 0.8Y

t is the level of autonomous consumption expenditure? What does this mean?

nomous consumption, " = 100

eans that even if income (Y) where to fall to xero, households will still spend $100 year, the minimum they need to spend on consumption to survive.

t is the marginal propensity to spend (MPC)? What does MPC mean? Discuss.

= 0.8, It means that out of every dollar of income households will spend 80 cents. It t consumers spend $80 out of every $100 they earn and this indicates their willingness

out of income.

e the equation for the Saving Function. What is the marginal propensity to save S)? What does MPS mean? How are MPC and MPS related?

Y - C Y - ( 100 + 0.8 Y)

S = Y - 100 - 0.8 Y S = -100 + ( Y - 0.8 Y ) S = -100 + 0.2 Y The MPS = 0.2 (the slope of the function). It means that out of every $100 earned, households will tend to save $20, or 20% of their earned income. Remember that: MPC + MPS = 1.00 or MPS = 1 - MPC = 1 - 0.8 = 0.2 d) Create a Table which shows the different levels of consumption (C) which correspond to

the different levels of income (Y) from 0 to 1000 in 100 increments. Then, on graph paper plot C against Y (Y should be on horizontal axis).

Income (Y) Consumption ( C ) Saving 0 100 -100 100 180 - 80 200 260 - 60 300 340 - 40 400 420 - 20 500 500 0 600 580 20 700 660 40 800 740 60 900 820 80 1000 900 100

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e) Create another Table which shows the different levels of consumption (C) which

correspond to different rates of spending (MPC) from 0 to 1.00 in 0.10 increments. For your purposes assume that the level of income remains constant at Y = 500. Then, on a separate graph plot C against MPC.

Income (Y) MPC Consumption ( C )

500 0.00 0 500 0.10 50 500 0.20 100 500 0.30 150 500 0.40 200 500 0.50 250 500 0.60 300 500 0.70 350 500 0.80 400 500 0.90 450 500 1.00 500 _____________________________________________________

350

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7.4 a) MPC = 0.6, from C = 60 + 0.6 Y MPM = 0.2, from M = 30 + 0.2 Y MPCD = MPC - MPM = 0.6 - 0.2 = 0.4 k = 1 / 1 - MPCD = 1 / 1 - (MPC - MPM) = 1 / 1 - 0.4 = 1 / 0.6 = 1.67 b) To find Ye solve for AS = AE. Since AS = Y, then solve for Y = AE Y = AE = C + I + G + X - M = 60 + 0.6 Y + 80 + 90 + 100 - ( 30 + 0.2 Y ) = 60 + 0.6 Y + 80 + 90 + 100 - 30 - 0.2 Y = 300 + 0.4 Y Y - 0.4 Y = 300 0.6 Y = 300 Y = 300/0.6 = 500 Therefore, Ye = $500 Billion c) Y = AE = C + I + G + X - M = 60 + 0.6 Y + 90 + 90 + 100 - ( 30 + 0.2 Y ) = 60 + 0.6 Y + 90 + 90 + 100 - 30 - 0.2 Y = 310 + 0.4 Y Y - 0.4 Y = 310 0.6 Y = 310 Y = 310/0.6 = 516.7 Therefore, Ye = $516.7 Billion. The Multiplier is not affected since neither MPC nor MPM changed. d) Y = AE = C + I + G + X - M = 60 + 0.6 Y + 90 + 100 + 100 - ( 30 + 0.2 Y ) = 60 + 0.6 Y + 90 + 100 + 100 - 30 - 0.2 Y = 320 + 0.4 Y Y - 0.4 Y = 320 0.6 Y = 320 Y = 320/0.6 = 533.3 Therefore, Ye = $533.3 Billion. The Multiplier is not affected since neither MPC nor MPM changed.

e) Y = AE = C + I + G + X - M = 60 + 0.7 Y + 80 + 90 + 100 - ( 30 + 0.2 Y ) = 60 + 0.7 Y + 80 + 90 + 100 - 30 - 0.2 Y = 300 + 0.5 Y Y - 0.5 Y = 300 0.5 Y = 300 Y = 300/0.5 = 600 Therefore, Ye = $600 Billion In this case the multiplier (k) does change since the MPC has increased to 0.7 from 0.6 k = 1 / 1 - MPCD = 1 / 1 - (0.7 - 0.2) = 1 / 1 - 0.5 = 1 / 0.5 = 2.0 7.6 You are given the following equations: C = 20 + 0.87 Yd Consumption Function Yd = Y - ( T + Sb ) Relationship between PDI and GDP (or Y) T = 10 + 0.20 Y Tax Function Sb = 0.20 Y Business Saving Function I = 115 Investment Function G = 140 Government Expenditure Function X = 145 Export Function M = 10 + 0.25 Y Import Function

a) Since C and Sp is expressed as a function of Yd (i.e. PDI) we need to convert these functions out of gross income (Y). Thus,

Yd = Y - ( 10 + 0.20 Y + 0.20 Y ) = Y - 10 - 0.40 Y = Yd = - 10 + 0.60 Y Sp = Yd - C = Yd - 20 - 0.87 Yd = - 20 + 0.13 Yd (Note that MPC out of Yd = 0.87 while MPSp out of Yd = 0.13) Now, substitute Y for Yd: Sp = - 20 + 0.13 ( - 10 + 0.60 Y ) = - 20 - 1.3 + 0.078 Y = Sp = - 21.3 + 0.078 Y

b) MPM = )M / ) Y = 0.25 which is the coefficient or slope of the import function MPT = )T / ) Y = 0.20 which is the coefficient or slope of the tax function MPS = MPSp + MPSb = 0.20 + 0.078 = 0.278

c) The income multiplier (k) is:

k = 1 / MPW = 1 / (MPS + MPT + MPM) = 1 / 0.278 + 0.20 + 0.25 = k = 1 / 0.728 = 1.37 x

d) To calculate Ye we also need to convert the C-function as a function of Y:

C = 20 + 0.87 Yd = 20 + 0.87 ( - 10 + 0.60 Y ) = 20 - 8.7 + 0.522 Y C = 11.3 + 0.522 Y

To find the equilibrium level of income (Ye) we need to solve for AS = AE Since AS is also equal to Y, we solve for: Y = AE Y = C + I + G + X - M Y = 11.3 + 0.522 Y + 115 + 140 + 145 - 10 - 0.25 Y Y = 401.3 + 0.272 Y Y - 0.272 Y = 401.3 0.728 Y = 401.3 Y = 401.3 / 0.728 = 551.2 Thus, Ye = $551.2 billion e) J = I + G + X = 115 + 140 + 145 = $ 400 billion L = S + T + M = -21.3 + 0.078 Y + 0.20 Y + 10 + 0.20 Y + 10 + 0.20 Y = - 1.3 + 0.728 Y = - 1.3 + 0.728 (551.2) = $ 400 billion f) C = 11.3 + 0.522 (551.2) = $299.0 billion Sp = - 21.3 + 0.078 (551.2) = $21.7 billion Sb = 0.20 (551.2) = $110.2 billion St = - 21.3 + 0.278 (551.2) = $131.9 billion T = 10 + 0.20 (551.2) = $120.2 billion I / Y = 115 / 551.2 X 100 = 20.8% X / Y = 145 / 551.2 X 100 = 26.3% S + T = 131.9 + 120.2 = $252.1 billion I + G = 115 + 140 = $255.0 billion

g)

7.8 a) Yd = Y � (T + Sb) = Y � (0.25Y + 0.15Y) = Y � 0.40Y = 0.6Y C = 20 + 0.95 Yd = 20 + 0.95 (0.6Y) = 20 + 0.57Y Sp = Yd � C = Yd � (20 +0.95Yd) = -20 + (1-0.95Yd) = -20 + 0.05Yd Since Yd = 0.6Y, Sp = -20 + 0.05 (0.6Y) = -20 + 0.03Y

b) MPS = MPSp + MPSb = 0.03 + 0.15 = 0.18 MPT = 0.25 MPM = 0.32 k = ________1 __________ = _______1________ = __1__ = 1.33

MPS + MPT + MPM 0.18 + 0.25 + 0.32 0.75 c) AS = AE Y = AE Y = C + I + G + X � M Y = 20 + 0.57Y +240 + 300 + 390 � (20 + 0.32Y) Y = 20 + 0.57Y +240 + 300 + 390 � 20 - 0.32Y Y = 930 + 0.25 Y Y - 0.25 Y = 930 0.75 Y = 930 Y = 930 / 0.75 = $1,240.0 Ye = $1,240.0 Billion

c) S - I = -20 + 0.18Y �240 = 203.2 � 240 = -36.8 billion T-G = 0.25Y � 270 = 310 � 300 = +10 billion X-M = 390 � 20 � 0.32Y = 390 � 416.8 = -26.8 billion In this economy, the domestic private sector investment expenditures exceed domestic saving by $36.8 billion,which means that the currently generated sources of funds are not sufficient to meet the financing needs of the business sector. It means that the business sector has to find sources of funds outside the domestic private sector of the economy. Luckily, the public sector has a surplus of funds that can be lent to the private sector. The public or government sector of the economy, on the other hand, is generating more funds than it needs to finance its expenditures. It has a surplus of funds of $10 billion that it can lend to the domestic private sector of the economy. Still, the total supply of funds generated by the private and public sectors of the economy (S + T) is not enough to meet the demands from the private and public sectors (I + G), which means that the country is short of funds by $26.8 billion. The country will have to borrow these funds from the rest of the world. The foreign sector of the economy is experiencing a deficit of $26.8 billion. This means that the country as a whole is spending $26.8 billion more than it earns, resulting in an international trade deficit of $26.8 billion. Conversely, when one spends more than they earn, they need to borrow the difference, which means that the country will have to import capital from the rest of the world.

e) AE,AS AS = Y = GDP AE= C+I+G+X-M

$930 Ye = $1,240 Y = GDP J, L L = S+T+M $930 J = I+G+X Y = GDP

Ye

S, I (S � I ) Y = GDP

-$36.8 T, G (T � G)

+$10 Y = GDP X, M Y = GDP

-$26.8 NX = ( X � M )

7.9 a) Yd = Y - 0.35Y - 0.15Y + 100 Yd = 100 + 0.50Y

b) C = 30 + 0.90 (100 + 0.50Y) C = 120 + 0.45Y

c) Sp = -30 + 0.10 (100 + 0.50Y)

Sp = -20 + 0.05Y

d) G = BG - TP = 230 - 100 = $130 bil.

e) MPSp = 0.05 (from the personal saving function Sp) MPSb = 0.15 (from the business saving function) MPM = 0.30 (from the import function) MPT = 0.35 (from the tax function) ----------- MPW = 0.85

k = 1 / MPW = 1.176

f) AS = AE

Y = C + I + G + X - M Y = 120 + 0.45Y + 120 + 130 + 160 - 20 - 0.30Y Y = 510 + 0.15Y

0.85Y = 510 Ye= $ 600 billion

g) C = 120 + 0.45(600) = $390 bil.

I = $120 G = $130 X = $160 M = 20 + 0.30(600) = $200 T = 0.35(600) = $210 bil

BG = 130 + 100 = $230 bil

h) Budgetary balance: T - BG = 210 - 230 = $-20 bil i) International trade balance: X - M = 160 - 200 = $-40 bil

j) Savings/Investment balance: S - I = 100 - 120 = $-20 bil

where S = Sp + Sb =0.15Y - 20 + 0.05Y = -20 + 0.20Y

k) (S - I) + (T - BG) + (M - X) = 0

or (S - I) + (T - BG) = (X - M) Thus, ( -20 ) + ( -20 ) = ( -40 )

AE, AS AS = Y = GDP AE� = C+I�+G+X-M AE = C+I+G+X-M Ye Ye� Y J, L L = S+T+M J� = I�+G+X J = I+G+X 0 Ye Ye� Y 7.5 a) The effect of an improvement in business confidence (ψ) on the economy. It results in up-ward parallel shifts in the injections (J) and aggregate expenditure (AE) functions which induces a rise in demand, production, employment and the equilibrium national income (Ye)

AE, AS AS = Y = GDP AE� = C+I+G�+X-M AE = C+I+G+X-M Ye Ye� Y J, L L = S+T+M J� = I+G�+X J = I+G+X 0 Ye Ye� Y 7.5 b) The effect of an increase in government spending (G) on the economy. It results in up-ward parallel shifts in the injections (J) and aggregate expenditure (AE) functions which induces a rise in demand, production, employment and the equilibrium national income (Ye)

AE, AS AS = Y=GDP AE = C+I+G+X-M AE� = C�+I+G+X-M Ye� Ye Y J, L L� = S+T�+M L = S+T+M J = I+G+X 0 Ye� Ye Y 7.5 c) The effect of an increase in income tax rates (MPT) on the economy. It results in up-ward rotational shift in the leakages (L) function and a down-ward rotational shift in the aggregate expenditure (AE) function which induces a drop in demand, production, employment and the equilibrium national income (Ye)

AE, AS AS = Y=GDP AE� = C+I+G+X-M� AE = C+I+G+X-M Ye Ye� Y J, L L = S+T+M L� = S+T+M� J = I+G+X 0 Ye Ye� Y 7.5 d) The effect of a decrease in the propensity to import (MPM) on the economy. It results in down-ward rotational shift in the leakages (L) function and a up-ward rotational shift in the aggregate expenditure (AE) function which induces a rise in domestic demand, production, employment and the equilibrium national income (Ye)

AE, AS AS = Y=GDP AE = C+I+G+X-M AE� = C�+I�+G+X-M Ye� Ye Y L� = S�+T+M J, L L = S+T+M J = I+G+X J� = I�+G+X 0 Ye� Ye Y 7.5 e) The effect of an increase in interest rates (r) on the economy. It results in up-ward rotational shift in the leakages (L) function as consumers increase their saving rate (MPS) and decrease their consumption rate (MPC) and a down-ward rotational shift in the aggregate expenditure (AE) function as businesses reduce capital investment spending (I) which together induce a drop in domestic demand, production, employment and the equilibrium national income (Ye)

8.1 a) Since we have an output gap (GDP gap) of $40 billion, it implies that the economy is not producing at full-capacity (Yf), therefore, it is experiencing a recessionary gap (deflationary gap) of $20 billion.

Therefore, the government should pursue an expansionary fiscal policy, i.e. increase the level of government spending ()G) and decrease the level of taxes through a cut in income tax rates ()MPT) or both.

b) Since the expenditure gap i.e. the amount of deficient spending power in the economy, is equal to $20 billion, the government should raise spending by $20 billion, i.e.

)G = $20 Thus, + )G x k = +)Y Or, $20 x 2 = $40 billion c) The government should lower income taxes by a lump sum of $40 billion -)T ÷ + )Yd + x (MPCD) ÷ )CD ÷ + )AE x k ÷ + )Y -$40 + $40 0.50 + $20 + $20 x 2 + $40 billion

d) Initially, the government will have to borrow $20 billion (assuming it chooses the option of raising government spending), thus the initial budget deficit will be $20 billion

Once the rise in government expenditures raises the country�s total income by $40 billion, the government stands to benefit as well by seeing its tax revenue rise by the change in income times the marginal income tax rate (MPT) which is assumed to be 0.20 or 20%. The government will see its tax revenue (T) rise by $8 billion Thus, + )Y x MPT = + )T + $40 x 0.20 = + $8 billion Thus the final impact on its budget deficit will not be $20 billion but $12 billion + )G = $20 Less + )T = $ 8 )G - )T = $12 billion e) Initially, the government�s debt-to-GDP ratio stands at $150 / $380 = 39.5 % After the expansionary policy action, the government�s debt-to-GDP ratio will fall to 38.6% because even though the public debt rises by $12 billion to $162 billion, the country�s national income or GDP rises as well by $40 billion. Increase in government debt: $150 + $12 = $162, thus $162 / $420 = 38.6 %

8.2 a) To find Ye solve for AS = AE. Since AS = Y, then solve for Y = AE Y = AE = C + I + G + X - M = 70 + 0.6 Y + 75 + 80 + 70 - ( 10 + 0.2 Y ) = 70 + 0.6 Y + 75 + 80 + 70 - 10 - 0.2 Y = 285 + 0.4 Y Y - 0.4 Y = 285 0.6 Y = 285 Y = 285/0.6 = 475 Therefore, Ye = $475 Billion b) If Yf = $500 Billion, then GDP Gap or Output Gap is: Yf - Ye = $500 - $475 = $25 Billion The Expenditure Gap is: GDP Gap / Multiplier The Multiplier (k) is: 1 / 1 - MPCD = 1 / 1 - (0.6 - 0.2) = 1 / 1 - 0.4 = 1 / 0.6 = 1.667 Therefore, the GDP Gap is $25 / 1.67 = $15 Billion Since Ye < Yf, we have a Recessionary (Deflationary) Gap

c) The type of fiscal policy recommended here is Expansionary fiscal policy, i.e. an increase in government spending (+)G) or a decrease in tax collections (-)T) or a combination of both.

d) )G x k = )Y )G x 1.667 = $25 Therefore, )G = $15 Billion 8.3 a) marketable bonds are issued in large denominations for terms ranging from 1 year to 30

years, and pay a fixed rate of interest over the duration of the bond until they mature.

Treasury bills are issues in smaller denominations for terms ranging from 3 months (91 days) to 365 days. They do not carry a coupon rate of interest but rather are sold at a discount over their face value, but when they mature they pay the full face value.

Canada savings bonds are not really bonds, rather they are government securities that issued to the retail investing public. They can be redeemed (cashed in) at any time, and the holder receives the accrued interest until the day they cash them in. They are similar to a bank term deposit certificate.

b) The relationship between interest rates and bond prices is inversely proportional, meaning that whenever interest rates rise, the price of bonds falls and whenever interest rates fall, the price of bonds rises. This happens because they carry a fixed rate of interest over the life of the bond.

8.4 a) An Expansionary fiscal policy is a deliberate government budgetary action designed to give a boost to the economy, namely an increase in government spending (+)G) or a decrease in tax collections (+)T) or a combination of both.

b) A Contractionary fiscal policy is deliberate government budgetary action designed to slow down the growth in aggregate demand in the economy and by extension reduce the rate of inflation by taking pressure off limited production capacity, namely through a decrease in government spending (-)G) or an increase in tax collections (+)T) or a combination of both.

c) Automatic or Built-in Stabilizers are various government programs or institutional

features that have the result of automatically raising government spending and automatically lowering tax collections when the economy slows down; and automatically lowering government spending and raising tax collections when the economy picks up.

The best example of an automatic stabilizer is the Employment Insurance System. When the economy slows down, falls into recession and workers lose their jobs, they stop paying premiums into the employment insurance fund, i.e. like a tax cut (-)T) but they draw out of the plan employment insurance payments, like an increase in government spending (+)G). Other examples include a) social assistance (welfare payments to the poor when employment insurance payments run out); b) the progressive nature of the income tax system, i.e. as personal income rises, we are pushed to a higher tax bracket and as personal income falls we are pushed to a lower tax bracket, thus the marginal propensity to pay tax (MPT) falls when the economy slows down and rises when the economy picks u; and c) agricultural support programs whereby during years of low agricultural output farmers� income is subsidized by the government to ease the negative impact on their financial condition.

d) An annually-balanced budget is a budget that the government is supposed to balance, i.e. T = G in each calendar or fiscal year, i.e. over a twelve month period.

A cyclically-balanced budget is a budget that the government is supposed to balance over the span of the business cycle, i.e. over a seven (7) year period. The advantage of the cyclically-balanced budget is that the government�s hands are not tied, instead the government has the leeway to run budget deficits during recession years with the budget returning automatically to balance or surplus during expansion years. This way, the government has the room to exercise its fiscal policy obligations toward the economy.

8.5 a) The public debt is the total debt accumulated by the government sector. It is the total

amount borrowed over the years and outstanding at a given point of time. An other way of defining it is as the sum of all deficits minus surpluses over the years. In Canada, the public debt is the debt of the federal government, but since provincial governments also have the power to borrow, public debt should also include the total debt accumulated by all provincial governments. When we add the debts of the two levels of government we have total government debt. An even broader measure of debt should also include the debts of municipal governments.

b) A budget surplus is when government revenues for the year exceed government expenditures leaving a surplus of funds. A budget deficit is when government expenditures for the year exceed government revenues, leaving a deficit that needs to be financed by borrowing money. A balanced budget is when the level of government revenues for the year is equal to

the level of government expenditures.

c) The budget deficit is the difference between what the government spends during a year and what it collects in revenues (is a flow variable). The public debt on the other hand is the total debt accumulated over time and outstanding at a point in time (is a stock variable).

d) The budget deficit is the excess of what the government spends minus what it collects during a single year (T - G). The trade deficit, is the excess of what a country imports from the rest of the world minus what it exports to the rest of the world during a given year (X - M). A more complete measure of the trade balance is known as the current account balance.

e) Public debt is the debt of the government or public sector. Private debt is the debt of the private sector of the economy, meaning the combined debt of households and businesses.

f) Public debt is the total debt of the government sector of the economy (federal, provincial and local or municipal levels of government). External debt is the debt of the country owed to non-residents, i.e. to counterparties in the rest of the world. The external debt includes both debts of the public as well as private sectors of the economy.

8.7 a) The three options a government has to finance a budget deficit are:

i) borrow from the general public, i.e. borrow from its own citizens, directly from individuals as with Canada Savings Bonds or indirectly through institutions such as banks, life insurance companies, pensions funds and investment funds.

ii) borrow from foreigners (non-residents), i.e. borrow savings from other countries.

iii) borrow from the central bank. Since central banks are part of the government, borrowing from a central bank implies the creation of money, i.e. like �printing money�

b) The federal government issues securities which are IOUs. There are three types of securities issued by the federal government:

i) bonds (securities with terms ranging from 1 year to 5, 10, 20 and 30 years). Bonds are redeemable only at maturity, i.e. the end of the term; are transferable, i.e. can be sold in the secondary market and pay a fixed interest rate for the term of the bond called the coupon rate.

ii) treasury-bills (securities with terms less than 1 year, like 1 month, 3 months , 6 months , 9 months and up to 364 days). Like bonds, t-bills are redeemable only at maturity, but are transferable before maturity. Unlike bonds they do not carry a coupon rate, rather they are discount instruments, meaning they are purchased at a discount to their face value, the difference being the gain. In Canada, they are issued every two weeks on a Wednesday.

iii) Canada Savings Bonds. CSBs are not really bonds but investment certificates, since they are redeemable, i.e. cashable at any time prior to maturity without risk of losing the interest earned to that day.

c) The potentially most inflationary means of financing a budget deficit is borrowing from the central bank since it involves the creation of money. The least inflationary method is borrowing from the general public, i.e. internal borrowing from your own citizens.

8.8 a) (100.0 - 98.175) / 98.175 x (365 / 91) x 100 = 7.46% b) (100.0 - 99.116) / 99.116 x (365 / 182) x 100 = 1.79% c) (100.0 - X ) / X x (365 / 91) x 100 = 5.27% (100.0 - X) / X x 365 / 91 = 0.0527 36500 - 365 X / 91 X = 0.0527 4.7957 X = 36500 - 365 X 369.7957 X = 36500 The Bid Price (X) = 98.703 d) (100.0 - X ) / X x (365 / 224 ) x 100 = 5.61% The Bid Price (X) = 96.672

8.9

B C D E F G Net Federal Public GDP IPI Total Interest Governmt

Year Debt current $ 2002=100 Population

Cost Revenues

1962 14825 44665 15.8 18583 832 6506 1967 17707 69698 18.8 20378 1182 9974 1972 22079 109913 23.8 22218 2110 17119 1977 41517 220973 38.9 23726 4708 35283 1982 107622 379859 60.4 25117 15114 67289 1987 281832 558949 73.1 26449 28718 86746 1992 445729 700480 85.9 28367 43861 126086 1997 608996 882733 92.8 29907 47281 149889 2002 565312 1152905 100.0 31373 39651 183930

2007 523905 1530540 116.6 32970 33945 235966

B/C*100 F/G*100 F/C*100 F/B*100 B/D*100 B/D*100/E

a) ( i ) ( ii ) ( iii ) ( iv ) ( v ) ( v i )

Interest Interest Real Cost to Interest

to Cost to Real Debt

Debt-to-GDP

Revenue GDP Public Debt

Debt per

Year Ratio Ratio Ratio Ratio 2002 $ Capita

1962 33.2% 12.8% 1.9% 5.6% 93829 5049 1967 25.4% 11.9% 1.7% 6.7% 94186 4622 1972 20.1% 12.3% 1.9% 9.6% 92769 4175 1977 18.8% 13.3% 2.1% 11.3% 106727 4498 1982 28.3% 22.5% 4.0% 14.0% 178182 7094 1987 50.4% 33.1% 5.1% 10.2% 385543 14577 1992 63.6% 34.8% 6.3% 9.8% 518893 18292 1997 69.0% 31.5% 5.4% 7.8% 656246 21943 2002 49.0% 21.6% 3.4% 7.0% 565312 18019

2007 34.2% 14.4% 2.2% 6.5% 449318 13649

b) Discussion:

i) The debt-to-GDP ratio decreased between 1952 and 1977, increased between 1977 and 1997 and has been falling ever since. From a high of 69% of GDP in 1997, it has come down to 34.2% in 2007.

ii) When you divide the annual interest cost of servicing the public debt by total federal government revenue, you will find that while in the 1950s and 1960s interest charges absorbed close to 10% of federal revenue, by the 1980s and 1990s, interest payments account for a third of federal government revenue. This indicates that the federal government had less money to allocate toward all other functions of government. A financial squeeze. Since then the situation has improved dramatically with interest payments accounting for less than 15 cents out of every dollar of federal revenue.

iii) Has the same significance as ii) above, but instead relates interest charges to GDP. Interest charges accounted for over 6% of GDP in 1992 compared to less than 2% in the 1950s and 1960s. In 2007, had fallen down to only 2.2% of GDP.

iv) The interest charges to public debt shows the effective average rate of interest being paid by the federal government to service its debt. The average rate of interest paid on federal debt has more than doubled during this period from less than 6.0% in the 1950s to over 12.0% in the 1980s. In 2007 it was down to 6.5%, around where it was in 1967.

v) By dividing the gross public debt by the implicit price deflator, we get a picture of the real (inflation adjusted) level of public debt. Debt per capita increased slowly between 1952 and 1972, but has doubled since then. This dramatic rise in the debt level is not sustainable in the future. Sooner or later any government is forced to stop borrowing, starts raising taxes and cut spending. This is what happened during the 1990s. Since 1997 the federal government has achieved budget surpluses, which have brought down the debt/GDP ratio to 34.2 % in 2007.

vi) On a per capita basis, the federal government debt rose dramatically between 1972 and 1997 but has been falling as fast since then.

Conclusion: The growth in the federal government's debt has not been fictional, nor is it only due to inflation. The public debt has risen in real terms, has risen relative to the population and relative to our production. Obviously by the 1990s, Canada reached its limits in terms of the ability of the federal government to carry any more debt. Since 1997, the situation has improved dramatically and continues to improve.

8.10 Since potential GDP, Yf = $575 billion and the actual or Ye = $551.2 billion,

a) GDP gap = Yf - Ye = $23.8 billion, since Ye < Yf, it is a recessionary (deflationary) gap

The size of the expenditure gap = GDP Gap / k = $23.8 / 1.37 = $17.37 billion

b) It is recommended that the government pursue expansionary fiscal and/or expansionary monetary policies, i.e. +)G, - )T, + )Sm, - )r

c) If the government chooses to eliminate the gap by raising expenditures, it should

increase them by the amount of the expenditure gap, i.e. by $17.37 billion, i.e. +)G x k = +)Y Following this fiscal policy action the government budget deficit will rise from

$ -19.8 bil. to $ -32.4 billion. T - G = 10 + 0.20 (575.0) - (140 + 17.37) = 125.0 - 157.37 = $-32.4 billion. The budget deficit will increase by $12.6 billion

d) If the government chooses to eliminate the gap by cutting taxes, it should cut

income tax rates by: - )I ==> + )Yd ===> MPC ===> + )CD ===> + )AE ===> k ===> + ) Y To find )T, solve for Yf = AE: Yf = C + I + G + X - M 575 = 11.3 + J(575) + 115 + 140 + 145 - 10 - 0.25 (575) - 575 J= 11.3 + 115 + 140 + 145 - 10 - 0.25 (575) - 575 - 575 J= - 317.45 J= 0.552, where 0.552 is the new coefficient of the consumption function C = 20 + 0.87 Yd Yd = -10 + 0.60 Y = Y - 10 - .20 Y - 0.20y C = 11.3 + 0.522 Y where 0.522 = 0.87 (0.60) Then, if 0.522 = 0.87 J, then J = 0.634 Yd = - 10 + 0.634 Y = Y - 10 - 0.166 Y - 0.20 Y T = -10 + 0.166 Y, thus the new MPT will be = 0.166 Therefore, the tax rate must be lowered from 20% to 16.6 % Following this fiscal policy action the budget deficit will rise to $ -34.5 billion, i.e. T - G = 10 + 0.166 (575) - 140 = $-34.5 billion

The budget deficit will rise by $14.7 billion, assuming no other variables such as MPC, MPM and MPSb have changed.

e) Clearly raising government spending option results in a lower deficit than the tax-

cutting option. 8.11 a) Since potential or full-employment GDP occurs at Yf = 1,200 and the equilibrium

level, as calculated in problem 7.8, occurs at Ye = 1,240, we are facing a negative output gap which means that the economy is operating beyond its full-employment

point, i.e. GDP gap = Yf - Ye = 1,200 - 1,240 = -40 billion

In this case we are facing an inflationary expenditure gap, the magnitude of which depends on the income multiplier (k). To find out the size of the inflationary gap solve for: Expenditure gap ()AE) x k = GDP Gap, or GDP gap / k = Expenditure gap = -40 / 1.33 = -30 billion

b) To close the gap and bring the economy back to a non-inflationary equilibrium

where Ye = Yf, the government needs to follow contractionary fiscal and/or monetary policies, i.e. -)G, + )T, - )Sm, + )r

c) If the government chooses to eliminate the gap by cutting expenditures, it should

reduce them by the amount of the expenditure gap, i.e. by $30 billion, i.e. -)G x k = +)Y or -30 x 1.33 = -40 billion Following this fiscal policy action the government budget surplus will rise from

$ +10 bil. to $ +30 billion. T - G = 0.25 Y � G = 0.25 (1200.0) - 270 = 300 - 270 = $+30 billion. The budget surplus will increase by $20 billion

d) If the government chooses to eliminate the gap by raising taxes, it should raise

income tax rates which will produce the following results:

+ )I ==> - )Yd ===> MPC ===> - )CD ===> - )AE ===> k ===> - ) Y

To find out by how much the government needs to raise income tax rates ∆MPT,

solve for Yf = AE, where τ is the tax rate and now becomes our unknown variable. Since we know that Yf should equal Ye = 1,200, we substitute 1,200 for Ye in the equation and solve for τ. Remember that T = τY and Yd = Y � (T + Sb). Thus, Yd = Y - (τ Y + Sb) = Y - τ Y � 0.15Y = (1-0.15) Y � τ Y = 0.85Y � τ Y Y = AE

1200 = C + I + G + X � M 1200 = 20 + 0.95 (0.85Y � τ Y) + 240 + 300 + 390 � 20 � 0.32Y 1200 = 20 + 0.95 [(0.85)(1200) � τ (1200)] +240 +300 + 90 � 0 �

0.32(1200) 1200 = 20 + 969 � 1140 τ + 910 �384 1200 = 1515 - 1140 τ

1140 τ = 315 τ = 315 / 1140 = 0.2763

Thus, the government will have to raise income tax rates from 25% to 27.63%, a rise of 2.763 percentage points. Following this fiscal policy action the government budget surplus will rise from $ +10 bil. to $ +30 billion.

T - G = 0.2763 Y � G = 0.2763 (1200.0) - 300 = 331.56 -300 = $+31.56 billion. The budget surplus will increase by $21.56 billion

f) The impact on the government�s finances of either policy action is more or less

the same from the government�s budget balance point of view. Whether the government should choose one or the other option will hinge on other factors and policy objectives it might want to attain. For example, conservatives would prefer to cut spending while liberals would prefer to raise taxes.

Problem # 9-1

Interest Rate (r)(%) Money Demand (Dm) Money Supply (Sm)

18 30 60 16 40 60 14 50 60 12 60 60 10 70 60 8 80 60 6 90 60

The money multiplier (Mk) is:

9brmbt

H

1 9scttm

H

1 9bre 9bAm

MMPL

k =−

=−

=1

11

1 0 85

.-1,b) Assuming that the Bank of Canada purchases $2 billion of treasury bills from chartered anks it buys the securities from them and pays them with cash, thereby increasing their liquid eserves. Then the banks take this cash and they loan it out to clients. Because the money ultiplier is x5, the total supply of money in the economy will increase by $2 bil X 5 = $ 10

illion. With the money supply higher by 10 billion, short-term interest rates will fall from 12% o 10%. This is what is known as an expansionary monetary policy.

ence, the money Supply will increase by $2 billion H 5 = $10 billion and interest rates fall to

0%.

-1,c) Assuming that the Bank of Canada sells $2 billion of treasury bills to chartered banks, it ells the securities to them and gets paid in cash from them, thereby reducing the cash reserves of hartered banks by $2 billion. Because the money multiplier is x5, the total supply of money in he economy is reduced by $2 bil x 5 = $10. With the money supply lower by $10 billion, short-erm interest rates will rise from 12% to 14%. This is what is known as a contractionary

onetary policy.

ence, the money Supply will decrease by $2 billion H 5 = $10 billion and interest rates rise to

4%.

-1,d) Assuming that as a consequence of the GDP increase the demand for money rises by $10 illion then, with the money supply remaining constant at $60 billion, the equilibrium interest ate is pushed up from 12% to 14%. With more demand but the same supply of money in the conomy, money because more scarce, and the price of money increases.

-1,e) To mitigate the rise in interest rates, the Bank of Canada can expand the supply of money y $10 billion by buying $2 billion in treasury bills from the chartered banks as in 5.1 b above. s a result interest rates remain constant at 12%. This is what is known as an accommodating onetary policy..

9.2 a) The main measures of money supply are: M1: demand (chequing or non-interest paying deposits) with chartered banks M2: demand, saving and term deposits (all deposits) with chartered banks

M2+ all deposits with banks and non-bank deposit taking financial institutions (NBFIs)

b) M1 consists of demand deposits only, whereas M2 consists of all deposits c) M2 consists of all deposits with chartered banks only whereas M2+ consists of all

deposits with banks and non-bank financial intermediaries (NBFIs) like trust companies, caisse populaires.

d) M2 and M2+ 9.3 a) The net interest spread is the difference between the average interest charged on

loans and the average interest paid on deposits b) The short-term interest rate is the interest rate charged or paid on deposits and

loans with short-term maturities, strictly speaking involving terms of 1 year or less, but broadly speaking of terms ranging up to 5 years. Short-term interest rates are known as money market rates.

c) The long-term interest rate is the interest rate charged or paid on long-term

loans such as government and corporate bonds. These loans are better known as securities and the interest rate is called the yield. It involves debt securities with terms ranging from 5 years all the way out to 30 years. Bonds with a 10-year term are the most representative of long-term bonds.

d) The difference between long-term rates and short-term rates reflects the premium

a lender charges the borrower for assuming the risk of fixing the rate for a long period of time, during which it is hard to predict what will happen to interest rates in financial markets. It is known as the long vs short interest rate differential and reflects the steepness of the yield curve. Since the lender takes on this risk it is normal that he be compensated for the extra risk by charging a higher rate. This is why normally, long-term interest rates are higher than short-term interest rates.

e) The real rate of interest is the interest rate charged or received on a deposit or a

security less the current (or more strictly speaking the expected) rate of inflation. Since inflation reduces the value of money, the lender loses when he lends money an amount equal to the rate of inflation. With 3% inflation on a one year term deposit, your money is worth 3% less at the end of the year. Therefore, to compensate the lender for the loss in the value of their money the borrower is asked to add the expected 3% inflation rate to the price of the loan, thereby increasing the nominal rate paid on the loan. Thus if the lender wants to earn a real 3% return on the money is lending, he will charge a total of 6%, if he

expects inflation to average 3% over the coming year. 9.4 The transmission mechanism describes how changes in the demand for money or the

supply of money have on interest rates and through interest rates on the rest of the economy, namely aggregate demand, income, production, employment and prices. An increase in the supply of money generally has a favourable effect on the economy while a decrease in the supply has a restrictive effect.

The flow chart of the transmission mechanism:

Dm

Smr

C

IAE k GDP, N, Y

Graphical illustration of the effect of a decrease in the money supply (Sm) on the economy:

2

1

Sm' Smr

r1

r0

Qm1 Qm0 Qm

Dmr0

r1

r

2

r0

r1

r

2

I C

3 3I C

CII1 I0 C1 C0

%%% AE0

AE1

AS

Y,GNP

AE,AS

Y1 Y0Yf 9.6 Expansionary monetary policy is a central bank policy designed to stimulate an

expansion and create jobs in the economy by increasing the money supply (+)Sm) and decreasing the level of short-term interest rates (-)r), i.e. increasing the availability and reducing the cost of credit. It is used whenever the growth in aggregate demand is slowing and unemployment is rising and the economy is at risk of falling into a recession or in a recession.

Contractionary monetary policy is a central bank policy designed to slow down an expansion and reduce inflationary pressures in the economy by reducing the money supply (-)Sm) and increasing the level of short-term interest rates (+)r), i.e. reducing the

availability and increasing the cost of credit. It is used whenever the growth in aggregate demand is higher than desirable or when the inflation rate is starting to rise above the desired level.

9.9 a) The appropriate macroeconomic policies to fight high unemployment in the

economy are i) expansionary fiscal policy, such as an increase in the level of government spending (+)G) and decreasing the level of taxes (-)T) and ii) expansionary monetary policy, such as an increase in the money supply (+)Sm) and a decrease in short-term interest rates

(-)r). b) The appropriate macroeconomic policies to fight rising inflation in the economy are i) contractionary fiscal policy, such as a decrease in the level of government spending (-)G) and increasing the level of taxes (+)T) and ii) contractionary monetary policy, such as a decrease in the money supply (-)Sm) and an increase in short-term interest rates (+)r).

9.8 a) The two most important instruments of monetary policy in Canada are the overnight

interest rate also known as the policy rate and open market operations b) Open market operations are purchases and sales of Government of Canada

treasury bills in the open market. Purchasing treasury bills from chartered banks it increases their liquidity and expands their ability to lend. Selling treasury bills to chartered banks reduces their liquidity and curtails their ability to make loans and hence expand the money supply.

c) The overnight financing rate is the rate at which major participants in the money market (mostly banks) borrow and lend one-day funds to each other. The central bank sets the target rate at which it wants to see banks charge each other on these day to day loans. It is the principal instrument through which the central bank determines short-term interest rates in the economy.

d) The key policy rate of the Bank of Canada is the overnight financing rate.

e) The bank rate is the minimum rate at which the Bank of Canada lends money to the members of the Canadian Payments Association (e.g. banks). It is set at the upper limit of the operating band which is 50 basis points with its midpoint the target for the overnight financing rate. In effect it is 25 basis points higher than the target for the overnight rate.

f) The prime rate is the rate at which chartered banks lend to their most credit worthy customers and serves as the benchmark upon all other chartered bank lending rates are set.

9.11 a) The desired reserve or liquidity ratio is: Liquid Assets / Total Assets = $20 / $100 x 100 = 20%

b) The net interest margin (NIM) or interest spread is interest income minus interest expense.

Income from securities $20 x 0.08 = $1.60 Income from loans $75 x 0.11 = $8.25 Total interest income $9.85 billion Interest Expense (Interest paid on deposits) $90 x 0.07 = $6.30 Net interest income $3.55 billion Thus, the NIM = $3.55 / $100 x 100 = 3.55 %

c) The bank�s net income is net interest plus other income minus loan loss provisions minus non-interest expenses:

Income from securities $20 x 0.08 = $1.60 Income from loans $75 x 0.11 = $8.25 Total interest income $9.85 less Interest on deposits $90 x 0.07 = $6.30 equals Net interest income $3.55 plus Other income $1.00 less Provisions for credit losses $1.50 equals Total income $3.05 less Non-interest expenses $1.75 equals Net income (profit) $1.30 ==== d) Return-on-Equity (ROE): $1.30 / $10 x 100 = 13.0 % e) Return-on-Assets (ROA): $1.30 / $100 x 100 = 1.3 % 9.12 a) 100.0 - 98.365 365 -------------------- X --------- X 100 = 6.67 % 98.365 91

b) 100.0 - 92.184 365 ---------------------- X --------- X 100 = 8.50 % 92.184 364 9.7

r Sm S�m r S�m Sm Dm Dm a) Policy induced drop in rates b) Policy induced rise in rates 9.13 a) When short-term interest rates rise, the carrying cost of holding bonds increases

and this reduces the attractiveness of holding bonds. Hence the demand for bonds decreases which causes the price of bonds to fall.

b) If there is a massive increase in the amount of bonds available for sale the supply

curve for bonds will shift to the right. Given the demand for bonds, the equilibrium price of bonds will fall. A fall in the price means that prospective buyers are demanding a higher return on the bonds. Since bonds pay a fixed coupon rate during their term, paying less for bonds implies a rise in their yield, which is to say in long-term interest rates.

9.14 a) Nominal Rate (e.g. Prime Rate) - Inflation Rate = Real Prime Rate

b) Real interest rates have been falling from the mid-1960s until the mid-1970s reaching negative levels in the 1970s. Starting from 1981, real interest rates rose to very high levels and more or less stayed at those levels through most of the 1980s. It can be inferred that monetary policy became a lot more restrictive or contractionary during the 1980s than it was during the 1970s. With contractionary policies in effect one would expect inflation to come down.

c) The objective of monetary policy in Canada between 1981-1992 has been

contractionary. Yes it has achieved its intended objective because we can see that the rate of inflation in Canada has come down considerably during the 1990s and has stayed low. As a direct result of lowering inflation and inflation expectations, eventually interest rates have fallen to the lowest levels during this period and the economy has been expanding strongly.

66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 0 1 2 3 4 5 6 7

0

5

10

15

20

-5

Percent (%) Rate

Prime Rate Real Rate of Interest

REAL RATE OF INTEREST IN CANADA: 1966-2007 Prime Interest Rate minus Inflation Rate (IPI)

Year Prime Rate Infl. Rate Real Rate of Interest

1966 6 4.9 1.11967 6 4.4 1.61968 6.9 4.3 2.61969 7.9 5.1 2.81970 8.2 4.4 3.81971 6.5 4.7 1.81972 6 5.8 0.21973 7.6 9.7 -2.11974 10.7 15.3 -4.61975 9.4 10.6 -1.21976 10 9.6 0.41977 8.5 6.6 1.91978 9.7 6.7 31979 12.9 10.1 2.81980 14.3 10.1 4.21981 19.3 10.7 8.61982 15.8 8.4 7.41983 11.2 5.5 5.71984 12.1 3.3 8.81985 10.6 3 7.61986 10.5 3.1 7.41987 9.5 4.6 4.91988 10.8 4.5 6.31989 13.3 4.5 8.81990 14.1 3.3 10.81991 9.9 2.9 71992 7.5 1.3 6.21993 5.9 1.5 4.41994 6.9 1.1 5.81995 8.6 2.3 6.31996 6 1.6 4.41997 5 1.3 3.71998 6.6 -0.5 7.11999 6.4 1.7 4.72000 7.3 4.2 3.12001 5.8 1.1 4.72002 4.2 1.1 3.12003 4.7 3.3 1.42004 4 3.2 0.82005 4.4 3.4 12006 5.8 2.5 3.32007 6.2 3.1 3.1

10.1 You are provided with the following information regarding Canada's international transactions for 2005: (billions of $)

a)

BALANCE OF PAYMENTS, 2005 Billions of Canadian Dollars

Current Account Credit (+) Debit (-) Balance Merchandise exports 451.8 Merchandise imports 388.3 Balance on merchandise trade + 63.5 Exports of services 67.0 Import of services 79.1 Balance on services - 12.1 Investment receipts 48.2 Investment payments 70.7 Balance on investment income - 22.5 Transfer receipts 8.2 Transfer payments 9.0 Balance on transfers - 0.8 Balance on invisibles - 35.4 Balance on Current Account + 28.1 Capital & Financial Account Canadian direct investment abroad -40.6 Foreign direct investment in Canada 35.0 Portfolio investment abroad -53.3 Portfolio investment in Canada 26.6 Balance on Capital Account - 32.3 Change in official international reserves - 1.7 Statistical discrepancy 5.9 Overall balance of payments 0 Gross Domestic Product (GDP) 1,375.1 b) What is the balance on merchandise trade? + $ 63.5 balance on services? - $ 12.1 balance on investment income? - $ 22.5 balance on invisibles? - $ 35.4 balance on current account? + $ 28.1 value of our exports (X)? $ 518.8 value of our imports (M)? $ 467.4 value of our net exports (NX)? $ 51.4 balance on capital account? - $ 32.3 overall balance of payments (BOP)? Zero What is the change in foreign exchange reserves? An increase of $1.7 billion

c) What is the share of exports (X) and imports (M) as a percent of GDP in Canada in 2005?

X / GDP * 100 = 518.8 / 1375.1 = 37.7 % M / GDP * 100 = 467.4 / 1375.1 = 34.0 % d) What is the current account balance as a percent of GDP in 2005? NX / GDP * 100 = 28.1 / 1375.1 = 2.0 % of GDP 10.2 Using the classification and terminology of the BOP, identify each one of the following

transactions and indicate on which side of the ledger (credit or debit) they belong to. E.g. export of goods, current a/c credit; import of services, current a/c debit; FDI investment, capital a/c credit; FDI divestment, capital account negative credit; portfolio investment abroad, capital a/c credit, etc.

a) Domtar sells 50,000 tons of newsprint to the New York Times. GOODS EXPORT (+) b) Alcan Aluminum sells its Greek subsidiary to a local Greek company. CANADIAN FOREIGN DIRECT DIVESTMENT (-) c) The Bank of Montreal lends $100 million to the Mexican state-owned company

Pemex. PORTFOLIO INVESTMENT ABROAD (-) d) The Province of Quebec issues $200 million bonds on the Eurobond market. PORTFOLIO INVESTMENT IN CANADA (+) e) The Hudson's Bay Co. buys 5,000 pairs of ladies' shoes from an Italian firm. GOODS IMPORT (-) f) A resident of Canada sells 2,000 shares of IBM on the New York Stock

Exchange. PORTFOLIO DIVESTMENT ABROAD (-) g) A resident of Canada buys a hotel in Morocco. CANADIAN FOREIGN DIRECT INVESTMENT ABROAD (-)

h) Norsk Hydro, a Norwegian firm builds a $400 million magnesium smelting plant in Quebec. FOREIGN DIRECT INVESTMENT IN CANADA (+)

i) Noverco, the Montreal-based gas utility buys a local gas utility based in Burlington, Vt., U.S.A.

CANADIAN FOREIGN DIRECT INVESTMENT ABROAD (-) j) A Pakistani worker living in Canada sends a $500 remittance to relatives in

Lahore. TRANSFER PAYMENT (-) k) SNC-Lavalin, a Montreal-based engineering consulting firm is awarded a contract

to design a hydro-electric dam in China. SERVICE EXPORT (+) l) General Motors of Canada declares a $0.75 per share quarterly dividend to its

U.S. parent. INVESTMENT INCOME PAYMENT (-) m) Hydro-Quebec makes annual payment of interest on its 20-year bonds to U.S.

investors. INVESTMENT INCOME PAYMENT (-) n) McDonald's Canada makes a quarterly payment for royalties to its U.S. parent. SERVICE IMPORT (-) o) Japanese pension funds purchase new issues of Government of Canada bonds. PORTFOLIO INVESTMENT IN CANADA (+)

10.3 Using Demand-Supply graphs illustrate what will happen to the foreign exchange value of the Canadian dollar in each one of the following circumstances (draw a separate graph for each case):

All other factors being constant: a) Canadian merchandise exports rise Demand shifts to the right, exchange rate rises b) Canadian exports of services fall Demand shifts to the left, exchange rate falls c) Foreign direct investment into Canada rises Demand shifts to the right, exchange rate rises d) Portfolio investment into Canada falls Demand shifts to the left, exchange rate falls e) Canadian merchandise imports falls Supply shifts to the left, exchange rate rises f) Canadian imports of services rise Supply shifts to the right, exchange rate falls g) Canadian foreign direct investment abroad falls Supply shifts to the left, exchange rate rises h) Short-term capital flows into Canada rises Demand shifts to the right, exchange rate rises i) Canadian merchandise exports rise while short-term capital flows out of Canada

fall Demand shifts to the right and supply shifts to the left and exchange rate rises j) Canadian exports of services rise while Canadian imports of services rise Demand shifts to the right and supply shifts to the right, exchange rate remains

unaffected k) Investment income of Canadians rises while short-term capital inflows fall

Demand shifts to the right and demand shifts to the left, exchange rate remains unaffected

10.4 You are given the following exchange rates for two dates: August 19, 2005 and August 18, 2006:

2005/08/19 2006/08/18 1 Canadian Dollar buys U.S. Dollar 0.8238 0.8902 Euro 0.6778 0.6949 British Pound 0.4592 0.4734 Japanese Yen 91.1600 103.0600 Swiss Franc 1.0500 1.0973 Mexican Peso 8.8731 9.6246 Chinese Renminbi 6.6756 7.0972 Russian Ruble 23.5294 23.8095 Indian Rupee 35.8423 41.3223 Australian Dollar 1.0971 1.1736

a) Calculate the one year percent change in the value of the Canadian currency (appreciation or depreciation).

b) ANSWER: 0.8902 - 0.8238 / 0.8238 X 100 = 8.1% APPRECIATION

b) Calculate the exchange value of each of the above currencies in terms of the Canadian dollar (how many Canadian dollars do each of these currencies buy?).

2005/08/19 2006/08/18 1 US Dollar buys Canadian Dollar 1.2139 1.1233 1 Euro buys Canadian Dollar 1.4754 1.4390 1 British Pound buys 2.1778 2.1124 1 Japanese Yen buys 0.0110 0.0097 1 Swiss Franc buys 0.9524 0.9113 1 Mexican Peso buys 0.1127 0.1039 1 Chinese Renminbi buys 0.1498 0.1409 1 Russian Ruble buys 0.0425 0.0420 1 Indian Rupee buys 0.0279 0.0242 1 Australian Dollar buys 0.9115 0.8521 c) Suppose the price of a Big Mac trio is $5.49 Canadian. Calculate the price in

each of the above currencies. 2005/08/19 2006/08/18 Price of Big Mac trio in: U.S. Dollar 4.52 4.89 Euro 3.72 3.81 British Pound 2.52 2.60 Japanese Yen 500.5 565.8 Swiss Franc 5.76 6.02 Mexican Peso 48.71 52.84 Chinese Renminbi 36.65 38.96 Russian Ruble 129.18 130.71 Indian Rupee 196.77 226.86 Australian Dollar 6.02 6.44

d) Now find the value of the U.S. dollar against all of these currencies and calculate the percent appreciation or depreciation in its value between 2005 and 2006

2005/08/19 2006/08/18 % Change 1 US Dollar buys U.S. Dollar 1.0000 1.0000 ---- Euro 0.8228 0.7806 - 5.13% British Pound 0.5574 0.5318 - 4.59% Japanese Yen 110.66 115.77 + 4.62% Swiss Franc 1.2746 1.2327 - 3.29% Mexican Peso 10.7710 10.8117 + 0.38% Chinese Renminbi 8.1034 7.9726 - 1.61% Russian Ruble 28.5620 26.7462 - 6.35% Indian Rupee 43.5085 46.4191 + 6.68% Australian Dollar 1.3318 1.3183 - 1.01% e) Suppose the price of 1 ounce of gold is $623.85 U.S. Calculate the price of an

ounce of gold in each of the above currencies. 2006/08/18 1 oz of gold is in: Canadian Dollar 700.77 Euro 486.98 British Pound 331.76 Japanese Yen 72223.1 Swiss Franc 769.02 Mexican Peso 6744.9 Chinese Renminbi 4973.7 Russian Ruble 16685.6 Indian Rupee 28958.5 Australian Dollar 822.42 10.5 Suppose the Bank of Canada was to maintain the value of the Canadian dollar at $0.85

U.S. Indicate what type of foreign exchange intervention you would recommend the central bank take in each of the following cases, and illustrate each one using demand and supply diagrams.

a) Market forces are pushing the exchange value above 0.85 U.S.

ANSWER: SELL CANADIAN DOLLARS AND BUY US DOLLARS b) Market forces are pushing the exchange value below 0.85 U.S.

ANSWER: SELL US DOLLARS AND BUY CANADIAN DOLLARS