Macroeconomics Study Notes: Finance, Exchange Rates, Aggregate Demand & Supply, Fiscal and Monetary Policy

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Chapter 7: Finance, Saving, and Investment

Introduction to Finance and Capital

Finance studies how households and firms obtain, use, and manage financial resources, including risk management in financial decisions. Understanding the distinction between financial and physical capital is essential for analyzing investment and economic growth.

Financial capital: Funds available from saving, used to finance investment in physical capital.
Physical capital: Produced goods (machinery, tools, buildings) used to produce other goods and services.
Wealth: The total value of all assets owned at a given time.
Saving: The portion of income not spent on consumption or taxes; increases wealth.

Investment and Capital Stock

Gross investment: Total spending on new capital goods and replacement of worn-out capital.
Depreciation: Decline in the value of capital due to wear and tear.
Net investment: Change in capital stock; calculated as gross investment minus depreciation.
Capital stock increases only when net investment is positive.
Gross investment alone does not guarantee growth in capital stock unless it exceeds depreciation.

Financial Institutions and the Loanable Funds Market

Financial institutions: Firms (e.g., banks, mutual funds) that act as intermediaries by borrowing from savers and lending to borrowers.
Loanable funds market: The market where saving supplies funds and investment demands funds, determining the real interest rate.
Insolvency: When a financial institution's liabilities exceed its assets (negative net worth).
Illiquidity: Inability to meet short-term obligations, distinct from insolvency.

Interest Rates: Nominal vs. Real

Nominal interest rate: Percentage return on a loan measured in money terms, not adjusted for inflation.
Real interest rate: Nominal interest rate adjusted for inflation; represents the true cost of borrowing and real return to lenders.

Formula:

Real interest rate:

Example: If you borrow $100 at 5% interest, you pay $5 in interest. That 5% is the nominal interest rate. If inflation is 2%, the real interest rate is 3%.

Determinants of Saving and Investment

Investment is financed by household saving and borrowing from abroad; government spending is not a direct source of investment funds.
Private saving, government saving, and national saving are interconnected:
Firms invest if the expected rate of return exceeds the real interest rate.
Changes in the real interest rate cause movements along the demand/supply curves for loanable funds; changes in expectations, income, or policy shift these curves.
A government budget deficit increases demand for loanable funds, raises the real interest rate, and reduces private investment (crowding-out effect).
Ricardo-Barro effect: Suggests that a government deficit may increase private saving, partially offsetting crowding out.

Chapter 9: Exchange Rates and the Foreign Exchange Market

Exchange Rates and Currency Markets

Exchange rates determine the value of one currency in terms of another and are set in the foreign exchange market through supply and demand.

Exchange rate: Price at which one country's currency can be exchanged for another's.
Foreign exchange market: Where currencies are traded.
Currency appreciation: Value of a currency rises relative to another.
Currency depreciation: Value of a currency falls relative to another.

Determinants of Currency Demand and Supply

Demand for a currency: Driven by foreigners wanting to buy domestic goods, services, or assets.
Supply of a currency: Comes from domestic residents buying foreign goods, services, or assets.
Interest rate differentials: Higher domestic interest rates attract foreign investment, increasing demand for domestic currency.
Expectations: Anticipated appreciation increases current demand; anticipated depreciation increases supply.

Exchange Rate Systems and Central Bank Intervention

Crawling peg: Target exchange rate is adjusted gradually over time.
Flexible exchange rate: Currency value determined by market forces; central bank can influence indirectly.
Central bank intervention: Buying foreign currency increases domestic money supply and limits appreciation; selling domestic currency increases supply and lowers exchange rate.

Balance of Payments and Net Exports

Balance of payments: Record of all economic transactions between residents and the rest of the world.
Exports: Goods/services produced domestically and sold abroad.
Imports: Goods/services produced abroad and purchased domestically.
Net exports: , linking trade with saving, investment, and fiscal balance.

Market Equilibrium and Exchange Rate Movements

Exchange rate equilibrium: Where quantity of currency demanded equals quantity supplied.
If exchange rate is above equilibrium, currency depreciates until equilibrium is restored.
Movements along demand/supply curves are caused by changes in the exchange rate; shifts are caused by changes in expectations, interest rates, or income.

Chapter 10: Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)

Aggregate demand is the total quantity of goods and services that households, firms, governments, and foreigners plan to buy at each price level.

Aggregate demand curve: Shows relationship between price level and quantity of real GDP demanded.
Components: Consumption, investment, government spending, net exports.
Shifts in AD: Caused by changes in any component (e.g., fiscal/monetary policy, foreign income).

Aggregate Supply (AS)

Aggregate supply curve: Relationship between price level and quantity of real GDP firms are willing to produce.
Long-run aggregate supply (LRAS): Vertical at potential GDP; independent of price level.
Short-run aggregate supply (SRAS): Upward sloping due to sticky wages and input prices.
Potential GDP: Maximum output when all resources are fully employed.

Effects Influencing Aggregate Demand

Wealth effect: Higher price level reduces real wealth, decreasing consumption.
Interest rate effect: Higher price level increases interest rates, reducing borrowing and spending.
International trade effect: Higher price level reduces exports, increases imports, lowering net exports.

Shifts in Aggregate Supply and Demand

Increase in labor or capital, or technological advancement, shifts both SRAS and LRAS rightward.
Increase in production costs (e.g., oil prices) shifts SRAS leftward.
Fiscal policy (e.g., tax cuts, transfer payments) increases AD.
Increase in foreign income raises exports and AD.
Increase in expected inflation shifts AD rightward.

Gaps and Policy Responses

Recessionary gap: Real GDP < potential GDP; expansionary policies used to increase AD.
Inflationary gap: Real GDP > potential GDP; contractionary policies used to reduce AD.
In an inflationary gap, rising wages increase costs, shifting SRAS leftward until long-run equilibrium is restored.

Chapter 13: Fiscal Policy

Overview of Fiscal Policy

Fiscal policy involves government decisions on spending and taxation to influence economic activity, stabilize the economy, and manage aggregate demand.

Federal budget: Annual statement of planned revenues and expenditures.
Budget deficit: Government spending exceeds tax revenues.
Budget surplus: Tax revenues exceed government spending.
Balanced budget: Revenues equal expenditures.
Government debt: Total accumulation of past deficits minus surpluses.
Transfer payments: Payments to individuals without receiving goods/services in return (e.g., unemployment benefits).

Taxation, Incentives, and the Tax Wedge

Tax wedge: Gap between before-tax and after-tax wage; affects work incentives.
Higher income taxes reduce labor supply and potential GDP.
Countries with higher tax wedges (e.g., France) have lower work incentives than those with smaller wedges (e.g., Canada).
When taxes increase, before-tax wages rise but after-tax wages fall.

Fiscal Policy Tools and Multipliers

Expansionary fiscal policy: Increases spending or decreases taxes to stimulate the economy.
Contractionary fiscal policy: Decreases spending or increases taxes to slow the economy.
Government expenditure multiplier: Measures the change in aggregate demand from a change in government spending.

Formula:

Required increase in government spending:

Example: If the multiplier is 2.5 and policymakers want AD to increase by $5 billion.

Automatic Stabilizers and Policy Lags

Automatic stabilizers: Fiscal policies that operate without direct government action (e.g., income taxes, unemployment benefits).
During recessions, tax revenues fall and transfer payments rise automatically.
Policy lags: Recognition lag (identifying problems), law-making lag (passing policies), and impact lag (time for effects to materialize).

Balanced Budget Calculations

To find GDP that balances the budget: Set government outlays equal to tax revenue and solve for GDP.

Example: If outlays = $100 billion , then ; billion.

After-Tax Real Interest Rate Calculation

First, subtract taxes from the nominal interest rate, then subtract inflation.

Formula:

After-tax nominal rate:
After-tax real rate:

Example: Nominal rate = 11%, tax rate = 25%, inflation = 4%: After-tax nominal = After-tax real =

Chapter 14: Monetary Policy

Overview of Monetary Policy

Monetary policy is conducted by the central bank (Bank of Canada) to control the money supply and interest rates, aiming to achieve economic goals such as stable inflation and full employment.

Inflation target: Typically 2% (within a 1-3% range) to maintain price stability.
Overnight interest rate: Main policy tool; rate at which banks lend to each other short-term.
Open market operations: Buying/selling government securities to influence money supply and interest rates.
Money supply: Total amount of money circulating in the economy.

Transmission Mechanism and Policy Actions

Monetary policy transmission mechanism: Process by which changes in interest rates affect spending, output, and inflation.
Expansionary monetary policy: Lowers interest rates, increases money supply, stimulates spending and economic growth.
Contractionary monetary policy: Raises interest rates, decreases money supply, slows economic activity and reduces inflation.

Central Bank Tools and Effects

Bank rate: Interest rate charged by the central bank to commercial banks; influences other rates.
Buying government securities increases bank reserves, lowers interest rates, and increases money supply.
Selling government securities decreases reserves, raises interest rates, and decreases money supply.
If overnight rate rises above target, central bank buys securities to lower it; if below, sells securities to raise it.

Monetary Policy and Exchange Rates

Lowering the overnight rate reduces Canadian interest rates relative to foreign rates, decreasing demand for Canadian dollars and lowering the exchange rate.
A lower exchange rate makes exports cheaper and imports more expensive, increasing net exports.
Raising the overnight rate has the opposite effect, reducing spending and shifting aggregate demand leftward.

Policy Use in Economic Gaps

Monetary policy is used to close recessionary gaps by lowering interest rates and increasing money supply.
Buying government securities increases reserves and supports economic growth.
As output approaches potential GDP, unemployment decreases.

Summary Table: Key Macroeconomic Concepts

Concept	Definition	Key Formula
Net Investment	Change in capital stock
Real Interest Rate	Nominal rate adjusted for inflation
Net Exports	Exports minus imports
Government Expenditure Multiplier	Change in AD per $1 of government spending
After-tax Real Interest Rate	Interest rate after taxes and inflation