Final (REVISED)

Final Review (Revised)

This version is narrowed to the material most likely on the final: Chapters 21–23 only. I’ve combined the instructor’s in-class review with your existing review notes and pulled in only the supporting ideas from earlier chapters that are directly needed to understand these three chapters.

Final Logistics

• Final exam: Saturday Apr 18 @ 3:30 PM
• Location: Toldo 100

Instructor Emphasis

The in-class review specifically highlighted:

• Ch. 22: expansionary vs. contractionary monetary policy, $i=r+\pi$, inflation target, 1–3% band, bank rate, target overnight rate, deposit rate, operating band, Bank of Canada functions, balance sheet ideas, fractional reserve banking, CDIC, deflation, QE
• Ch. 23: fiscal policy, what different levels of government spend on, $T$ vs. $G$, tax expenditures as hidden spending, discretionary fiscal policy, lags, marginal tax rates, automatic stabilizers

Key Concepts

• The AD-AS model determines equilibrium real GDP and the price level
• AD shocks move output and prices in the same direction; AS shocks move them in opposite directions
• The Bank of Canada targets 2% inflation within a 1–3% band using the overnight rate
• Expansionary monetary policy lowers rates to raise AD; contractionary monetary policy raises rates to reduce AD
• Expansionary fiscal policy means higher $G$ or lower $T$; contractionary fiscal policy means lower $G$ or higher $T$
• Automatic stabilizers are usually the best fiscal tool because they are timely, targeted, and temporary
• Deficit is a flow; debt is a stock

1. Chapter 21 — Aggregate Demand and Aggregate Supply

What the AD-AS model does

The AD-AS model is the macro version of supply and demand. It determines:

• Real GDP on the horizontal axis
• Price level on the vertical axis

Equilibrium is where AD and AS intersect.

Aggregate demand (AD)

Aggregate demand shows the relationship between the price level and the total quantity of output buyers plan to purchase.

$AE=C+I+G+NX$

AD slopes downward mainly because of the central bank channel: $\uparrow \text{Price level}\to \uparrow \text{inflation}\to \text{BoC raises real rates}\to \downarrow AE$

Exam Alert

The main reason AD slopes downward is the central bank channel, not the micro substitution effect.

Movement along vs. shift of AD

• Change in price level → movement along AD
• Change in $C$, $I$, $G$, or $NX$ → shift of AD

AD shifts right when:

• consumption rises
• investment rises
• government purchases rise
• net exports rise

AD shifts left when:

• consumption falls
• investment falls
• government purchases fall
• net exports fall

Common Mistake

Not every interest-rate change shifts AD.

• If the interest-rate change is the BoC responding to inflation from a different price level, that is part of movement along AD
• If the BoC deliberately changes rates to fight recession or overheating, that shifts AD

Aggregate supply (AS)

Aggregate supply shows the relationship between the price level and the quantity of output firms produce.

AS slopes upward in the short run.

Movement along vs. shift of AS

• Change in price level → movement along AS
• Change in production costs → shift of AS

Main AS shifters

1. Input prices
   • higher labour/oil costs → AS left
   • lower input costs → AS right
2. Productivity
   • lower productivity → AS left
   • higher productivity → AS right
3. Exchange rate
   • depreciation raises import/input costs → AS left
   • appreciation lowers imported-input costs → AS right

Stagflation

Falling output with rising prices. Usually caused by a leftward shift in AS.

Diagnosing shocks

Exam Alert

• Output and prices move in the same direction → AD shock
• Output and prices move in opposite directions → AS shock

Examples:

• Output ↓ and prices ↓ → AD decreased
• Output ↓ and prices ↑ → AS decreased

The 3-step forecasting framework

Exam Alert

For any macro scenario:

1. Is it an AD shift or an AS shift?
2. Is it an increase/right shift or a decrease/left shift?
3. What happens to real GDP and the price level?

Time horizons and the AS curve

Time horizon	AS shape	Meaning
Very short run	Horizontal	prices fixed
Short run	Gently upward-sloping	sticky prices
Medium run	Steeper	more prices adjusted
Long run	Vertical	full price flexibility

Exam Alert

In the long run, AS is vertical at potential output $Y^{\ast }$. Changes in AD affect the price level, not real GDP.

2. Chapter 22 — Monetary Policy

The Bank of Canada

The Bank of Canada (BoC) is Canada’s central bank.

Main functions:

1. conduct monetary policy
2. issue currency
3. act as lender of last resort
4. support financial stability

Important background:

• created in 1934
• operationally independent
• accountable to Parliament
• makes 8 rate decisions per year

Inflation target

The BoC targets:

• 2% inflation
• within a 1–3% control range

Exam Alert

Know both:

• target = 2%
• acceptable band = 1–3%

Why target 2% instead of 0%?

1. Greases the labour market — nominal wages are downwardly rigid
2. Leaves room to cut interest rates in recessions
3. Provides a buffer against deflation
4. CPI overstates true inflation, so measured 2% may be closer to true 0%

Deflation

Deflation is dangerous because it:

• raises the real burden of debt
• encourages people to delay spending
• can worsen recessions and financial stress

Monetary policy rule

The instructor explicitly wrote: $i=r+\pi$

That means:

• nominal interest rate = real interest rate + inflation

The course also uses a Taylor-type rule: $\underset{\text{Real overnight rate}}{\underbrace{\text{Overnight rate}-\pi }}=r^{\ast }+\frac{1}{2}(\pi -2\%)+\text{Output gap}$

Then: $\text{Nominal overnight rate}=\text{Real overnight rate}+\pi$

Where:

• $r^{\ast }$ = neutral real interest rate
• $\pi -2\%$ = inflation gap
• output gap = how far GDP is from potential

Exam Alert

In a normal recession:

• inflation is below target
• output gap is negative
• the BoC should cut rates

In a boom:

• inflation is above target
• output gap is positive
• the BoC should raise rates

Expansionary vs. contractionary monetary policy

Expansionary monetary policy

• lower the overnight rate
• borrowing becomes cheaper
• consumption and investment rise
• the dollar tends to depreciate
• AD shifts right

Contractionary monetary policy

• raise the overnight rate
• borrowing becomes more expensive
• consumption and investment fall
• the dollar tends to appreciate
• AD shifts left

Overnight rate and operating band

The BoC’s main instrument is the target overnight rate.

The operating band / corridor system:

Rate	Level	Role
Bank rate	Target + 0.25%	ceiling
Target overnight rate	middle	main policy rate
Deposit rate	Target - 0.25%	floor

Exam Alert

The instructor specifically flagged:

• bank rate
• target overnight rate
• deposit rate
• operating band

BoC tools

1. Bank rate / deposit rate corridor
2. Repos — inject funds, push overnight rate down
3. Reverse repos — withdraw funds, push overnight rate up
4. Open market operations — buy bonds to lower rates; sell bonds to raise rates

Three transmission channels of monetary policy

A change in the overnight rate affects AD through three channels:

1. Other interest rates
   • mortgages, car loans, business loans, etc.
2. Consumption timing
   • high rates encourage saving and delay spending
3. Exchange rate
   • higher Canadian rates attract foreign capital, causing appreciation and lower net exports

Exam Alert

Raising the overnight rate reduces AD through all three channels at once.

Fractional reserve banking, CDIC, and lender of last resort

These were mentioned in the in-class final review because they connect to monetary policy and financial stability.

Fractional reserve banking

Banks keep only a fraction of deposits as reserves and lend out the rest.

$\text{Money Multiplier}=\frac{1}{\text{Reserve Ratio}}$

CDIC

CDIC protects eligible deposits and helps prevent bank runs.

Lender of last resort

The BoC can make emergency loans to banks facing liquidity problems.

Common Mistake

The BoC should lend to solvent but illiquid banks, not insolvent ones.

QE and unconventional policy

When the overnight rate is near 0%, conventional policy becomes limited.

Forward guidance

The BoC promises rates will stay low for a while, lowering expected future rates.

Quantitative easing (QE)

The BoC buys long-term bonds to lower long-term interest rates and stimulate spending.

Exam Alert

QE is used when the policy rate is near zero and the BoC still wants to stimulate the economy.

3. Chapter 23 — Government Spending, Taxes, and Fiscal Policy

What fiscal policy is

Fiscal policy means using:

• government spending $G$
• taxes $T$

to affect aggregate demand and stabilize the economy.

Expansionary vs. contractionary fiscal policy

Expansionary fiscal policy

• increase $G$
• decrease $T$
• AD shifts right
• used in recessions

Contractionary fiscal policy

• decrease $G$
• increase $T$
• AD shifts left
• used in booms / inflationary periods

Levels of government and what they spend on

The instructor highlighted this directly.

• Federal government: defence/military, transfers, national programs, social insurance
• Provincial governments: especially health and education
• Municipal governments: local services like police, garbage, local infrastructure

Government revenue and taxes

Federal revenue comes mainly from:

• individual income tax
• sales taxes (GST/HST)
• corporate taxes

Local governments rely heavily on property tax.

Marginal tax rate vs. average tax rate

Exam Alert

• Marginal tax rate = tax rate on the last dollar earned
• Average tax rate = total tax paid / total income

Average tax rate is lower than the top marginal tax rate under a progressive tax system.

Tax expenditures = hidden spending

A tax expenditure is a deduction, exemption, or credit that lowers taxes owed.

Examples:

• RRSP deductions
• charitable credits
• child-care deductions

Why this matters:

• It works like government spending through the tax system
• It often looks politically cheaper because it does not appear as direct spending

Direct spending vs. transfers

Direct government purchases

• immediately count in GDP
• stronger direct effect on AD

Transfers

• only affect GDP when households spend them
• effect depends on MPC

Exam Alert

Direct spending usually has a larger immediate effect than transfer payments.

The multiplier

Initial spending creates further rounds of spending.

$\text{Multiplier}=\frac{1}{1-\text{MPC}}$

$\Delta GDP=\Delta G\times \frac{1}{1-\text{MPC}}$

Tax cuts have a smaller multiplier: $\text{Tax multiplier}=\frac{\text{MPC}}{1-\text{MPC}}$

Common Mistake

The tax multiplier is smaller because people save part of a tax cut in the first round.

Discretionary fiscal policy and lags

The instructor pointed directly to lags and discretionary fiscal policy.

Three main lags:

1. Recognition lag — time to realize there is a recession
2. Legislative/decision lag — time to pass policy
3. Implementation/execution lag — time to actually spend the money

The three Ts of good fiscal policy

Exam Alert

Good discretionary fiscal policy should be:

• Timely
• Targeted
• Temporary

Automatic stabilizers

Automatic stabilizers work without new legislation.

Examples:

• Employment Insurance (EI)
• progressive income tax
• social assistance

Why economists like them:

• timely
• targeted
• temporary

Exam Alert

Automatic stabilizers satisfy all three Ts better than most discretionary policy.

Crowding out

When government borrows more:

• demand for loanable funds rises
• real interest rate rises
• private investment falls

Crowding Out

Government borrowing raises interest rates and reduces some private investment.

Common Mistake

Crowding out partially offsets stimulus. It does not mean fiscal policy becomes useless.

Deficit vs. debt

The instructor explicitly flagged $T$ vs. $G$.

• If $G>T$ → deficit
• If $T>G$ → surplus

Exam Alert

• Deficit / surplus = flow over a year
• Debt = stock accumulated over time

Canada’s net debt is low relative to other G7 countries in the course notes.

When deficits make sense

1. Recession — to support AD
2. Crisis — war, pandemic, disaster
3. Productive investment — infrastructure with long-run benefits

4. Monetary Policy vs. Fiscal Policy

Feature	Monetary Policy	Fiscal Policy
Main tool	Overnight rate	$G$ and $T$
Institution	Bank of Canada	Government / Parliament
Speed	Faster	Slower
Main problem	Less effective at zero lower bound	Suffers from lags
Crowding out?	No direct crowding out	Yes
Reversibility	Easier	Harder politically

Exam Alert

In a normal recession, monetary policy is usually faster. At the zero lower bound, fiscal policy becomes especially important.

5. High-Yield Study Frameworks

A. If the question gives a macro event

Ask:

1. Is it changing spending or production costs?
2. Therefore is it AD or AS?
3. Does output rise or fall?
4. Does the price level rise or fall?

B. If the question is about BoC policy

Ask:

1. Is inflation above or below 2%?
2. Is output above or below potential?
3. Should the BoC cut or raise the overnight rate?
4. Is that expansionary or contractionary?

C. If the question is about fiscal policy

Ask:

1. Is the government changing $G$ or $T$?
2. Is the policy expansionary or contractionary?
3. Is it discretionary or automatic?
4. Will there be lags or crowding out?

6. Formula Sheet

Chapter 21

$AE=C+I+G+NX$

$\text{Output Gap}=\frac{Y-Y^{\ast }}{Y^{\ast }}$

Chapter 22

$i=r+\pi$

$\underset{\text{Real overnight rate}}{\underbrace{\text{Overnight rate}-\pi }}=r^{\ast }+\frac{1}{2}(\pi -2\%)+\text{Output gap}$

$\text{Bank rate}=\text{Target overnight rate}+0.25\%$

$\text{Deposit rate}=\text{Target overnight rate}-0.25\%$

Chapter 23

$\text{Multiplier}=\frac{1}{1-\text{MPC}}$

$\text{Tax multiplier}=\frac{\text{MPC}}{1-\text{MPC}}$

$\text{Budget balance}=T-G$

7. Definitions

Aggregate Demand (AD) The relationship between the price level and the total quantity of output buyers plan to purchase.

Aggregate Supply (AS) The relationship between the price level and the total quantity of output firms produce.

Stagflation Falling output with rising prices, caused by a leftward AS shift.

Potential Output ($Y^{\ast }$) The level of GDP the economy can sustainably produce in the long run.

Monetary Policy Bank of Canada actions that use interest rates and related tools to influence inflation and output.

Overnight Rate The rate at which major financial institutions lend to one another overnight.

Bank Rate The ceiling of the operating band; 0.25% above the target overnight rate.

Deposit Rate The floor of the operating band; 0.25% below the target overnight rate.

Expansionary Monetary Policy Lowering interest rates to stimulate AD.

Contractionary Monetary Policy Raising interest rates to reduce AD.

Quantitative Easing (QE) Large-scale BoC purchases of long-term bonds to lower long-term interest rates when short-term rates are near zero.

Fiscal Policy Government use of spending and taxes to influence aggregate demand.

Expansionary Fiscal Policy Higher $G$ or lower $T$ to increase AD.

Contractionary Fiscal Policy Lower $G$ or higher $T$ to reduce AD.

Automatic Stabilizer A government program that automatically offsets recessions and booms without new legislation.

Tax Expenditure A deduction, exemption, or credit that acts like hidden spending through the tax system.

Crowding Out Reduced private investment caused by higher interest rates when the government borrows more.

Budget Deficit When $G>T$ in a year.

Budget Surplus When $T>G$ in a year.

Debt The accumulated stock of past deficits minus surpluses.

Final Takeaway

If the final is only on Chapters 21–23, your top priorities should be:

1. AD vs. AS shifts
2. How to diagnose shocks from changes in output and prices
3. How the BoC uses the overnight rate and operating band
4. Expansionary vs. contractionary monetary and fiscal policy
5. Automatic stabilizers, lags, multiplier, crowding out, deficit vs. debt