Principle #10 : In the short run, society faces a trade-off between inflation and unemployment. Economic policies Budgetary and fiscal policies Budgetary and fiscal policies Monetary policies Monetary policies

What is the role of government when aggregate expenditures (AD) are either too weak or too strong? Stabilizing the economy in order to reduce GDP growth as close as possible to its long-term trend. Stabilizing the economy in order to reduce GDP growth as close as possible to its long-term trend. Searching the full-employment equilibrium Searching the full-employment equilibrium Finding the optimal production level (not inflationary and full employment level of production) Finding the optimal production level (not inflationary and full employment level of production)

What are the two main macroeconomic type of policy? The budgetary and fiscal policy Expansionary or restrictive Under the responsibility of the parliament (federal or provincial) Tools: G and taxation and transfer payments Monetary policy Expansionary, restrictive, or accommodative Under the responsibility of the central bank (BoC) Tools: Money supply and the bank of Canada benchmark interest rate (taux directeur, director rate) The budgetary and fiscal policy Expansionary or restrictive Under the responsibility of the parliament (federal or provincial) Tools: G and taxation and transfer payments Monetary policy Expansionary, restrictive, or accommodative Under the responsibility of the central bank (BoC) Tools: Money supply and the bank of Canada benchmark interest rate (taux directeur, director rate)

How and in which circumstances do we apply macroeconomic policies? Economic Situation MacroeconomicPolicyTools Effects on AD (C, I, G, Xn) Inflationary gap Inflation > 3% Monetary and/or Budgetary Restrictive MM  and r  Or Taxes  Or G  Or Transferts  Slowdown of growth ( AD) Recessionary gap Inflation < 1% Cyclical unemployement Monetary and/or Budgetary Expansionnist MM  and r  Or Taxes  Or G  Or Transferts  Acceleration of growth ( AD) Full employement Inflation  2% Monetary: Accommodative Budgetary : auto. stabilisators r low and stable We let the stabilisators do their work Long term growth  PIB  3%

What are automatic stabilizers? Automatic stabilizers are a form of fiscal policy In a recession or slowdown, state spending increases to stabilize aggregate demand. Automatic stabilizers are a form of fiscal policy In a recession or slowdown, state spending increases to stabilize aggregate demand.

What is monetary policy? It is the set of measures taken by the Bank of Canada to influence the economy by varying the amount of currency in circulation. It is the set of measures taken by the Bank of Canada to influence the economy by varying the amount of currency in circulation

What are the tools of the Bank of Canada? The main tools of the Bank of Canada are the discount rate and the overnight rate (taux director). They can be used to achieve an expansionary, restrictive or accommodative monetary policy.

What is the target for the overnight rate? It is the midpoint of a range of 50 basis points (0,5%) It is the midpoint of a range of 50 basis points (0,5%) The top of the range is the official discount rate (taux d’escompte): the rate charged for loans to banks The low end is the rate paid to bank in excess (taux créditeur) This is what sends the signal for the fluctuations in interest rates to chartered banks. The top of the range is the official discount rate (taux d’escompte): the rate charged for loans to banks The low end is the rate paid to bank in excess (taux créditeur) This is what sends the signal for the fluctuations in interest rates to chartered banks.

50 points de base Discount Rate: BoC loans rate on its advances to members of the monetary system (eg private banks) Creditor rate Taux de rémunération des excédents Overnight rate (Taux directeur): median range) 1,25 1,0 0,75

The effects of lowering the overnight rate P. 312

The effects of increasing the overnight rate P. 314

2. 2.The monetary market Money represent all payment mediums that are accepted. It serves as a medium of exchange, a valuation unit and a reserve of wealth. Money represent all payment mediums that are accepted. It serves as a medium of exchange, a valuation unit and a reserve of wealth. The monetary market or money market: is the market where short term financial assets (up to one year) are exchanged. Money is the most liquid asset. With the floating exchange regime money can be bought and sold for other currencies. The monetary market or money market: is the market where short term financial assets (up to one year) are exchanged. Money is the most liquid asset. With the floating exchange regime money can be bought and sold for other currencies. In the short run, the interest rate make the monetary market clear, supply=demand. r represents the gains of financial assets in %. In the short run, the interest rate make the monetary market clear, supply=demand. r represents the gains of financial assets in %.

Money supply The money supply is equal to the total amount of cash that individuals and companies have outside banks and their deposits in checking accounts and personal current accounts (demand deposits of the public). The money supply is equal to the total amount of cash that individuals and companies have outside banks and their deposits in checking accounts and personal current accounts (demand deposits of the public). The Bank of Canada "control" the money supply indirectly. Influencing credit conditions through the discount rate (Bank Rate) and the target overnight rate, the central bank encourages commercial banks to increase or decrease the volume of loans. The Bank of Canada "control" the money supply indirectly. Influencing credit conditions through the discount rate (Bank Rate) and the target overnight rate, the central bank encourages commercial banks to increase or decrease the volume of loans. The money supply is an exogenous variable. The money supply is an exogenous variable.

Money supply MS Q r

Money demand The aggregate money demand (MD) is the sum of all individual demands for money. It depens on: The aggregate money demand (MD) is the sum of all individual demands for money. It depens on:  Interest rates: a higher interest rate increases the opportunity cost of holding money and reduces the amount demanded.  Price level: if prices increase, we must hold more money to buy more goods and services  Real GDP when aggregate spending increases, the quantity of money demanded in the economy increases.

MD curve MD Q r

Monetary market equilibrium If the interest rate (7%) is higher than the equilibrium level, the agents hold more money than desired: If the interest rate (7%) is higher than the equilibrium level, the agents hold more money than desired: They buy securities They buy securities The price of securities increases and their rates decreases The price of securities increases and their rates decreases We therefore have a lower interest rate We therefore have a lower interest rate It then evolves towards the equilibrium interest rate (5%) It then evolves towards the equilibrium interest rate (5%)

Monetary market Goods and services market Slope of the AD P Real GDP AD P1P1 r Q MS MD 1 r1r1 MD 2 r2r2 P2P2

Illustration of an expansionary monetary policy

Crowding out effect Definition. : additional shift of the AD from the effect of fiscal policy on interest rates  G   AD  MD  r  AD The crowding out effect reduces the effect of fiscal policy on the AD

Monetary market Goods and services Crowding out effect P PIB réel AD 1 r Q MS MD 1 r1r1 MD 2 r2r2 AD 3 AD 2