Final Review — Chapters 21–23

Covers the complete macroeconomic stabilization framework: the AD-AS model as the analytical backbone, monetary policy (Bank of Canada), and fiscal policy (government spending and taxes).

Key Concepts

• The AD-AS model determines equilibrium real GDP and the price level; shocks and policy work by shifting AD or AS
• AD shocks move output and prices in the same direction; AS shocks move them in opposite directions
• The Bank of Canada targets 2% inflation using the overnight rate; a Taylor-type rule guides decisions
• Fiscal policy uses $G$ and $T$ to shift AD; the multiplier amplifies initial spending changes
• Automatic stabilizers satisfy all three Ts (timely, targeted, temporary) — they are the most effective fiscal tool
• Monetary policy is faster and more reversible; fiscal policy is more powerful when monetary policy is at the ZLB
• Deficit = flow (annual); debt = stock (accumulated); Canada’s net debt (~33% of GDP) is lowest in the G7

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1. The AD-AS Framework (Ch. 21)

The Two Curves

Curve	Slope	Why
Aggregate Demand (AD)	Downward	↑ Price level → BoC raises real rates → ↓ spending (central bank channel)
Aggregate Supply (AS)	Upward (SR), Vertical (LR)	Excess demand → firms raise prices; fully flexible prices in LR

Exam Alert — The Central Bank Channel

AD slopes downward primarily because of the central bank channel: higher prices → higher inflation → BoC raises real interest rates → less spending. This is NOT the substitution effect (which is microeconomics).

Movement Along vs. Shift

Curve	Movement Along	Shift
AD	Change in price level	Change in $C$, $I$, $G$, or $NX$
AS	Change in price level	Change in production costs (inputs, productivity, exchange rate)

AD Shifters

Component	Shifts AD right when…
Consumption (C)	↑ Wealth, ↑ consumer confidence, ↓ taxes, ↑ gov’t transfers
Investment (I)	↑ GDP growth, ↑ business confidence, ↓ corporate taxes, ↓ uncertainty
Government (G)	Expansionary fiscal policy (spending bills, automatic stabilizers)
Net Exports (NX)	↑ Global GDP, ↓ Canadian dollar, ↓ foreign trade barriers

Common Mistake — Interest Rates and AD

• Rate change caused by inflation (BoC reacting to price level) → movement along AD (already built in)
• Rate change caused by recession (BoC cutting rates to boost output) → shift of AD to the right

AS Shifters (Production Cost Changes)

Factor	AS shifts left when…	AS shifts right when…
Input prices	↑ Labour or oil costs	↓ Labour or oil costs
Productivity	↓ Productivity	↑ Productivity
Exchange rate	C$ depreciates (imports cost more)	C$ appreciates

Stagflation

Output ↓ and prices ↑ simultaneously — the result of a leftward AS shift (e.g., oil price shock).

Diagnosing the Shock

Exam Alert — Diagnostic Rule

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

COVID-19: Output ↓ and prices ↓ → AD decreased Gulf War oil shock: Output ↓ and prices ↑ → AS decreased (stagflation)

3-Step Forecasting Framework

Exam Alert

1. Is it an AD or AS shift?
2. Is the shift right (increase) or left (decrease)?
3. What happens to real GDP and price level at the new equilibrium?

Time Horizons and the Shape of AS

Time Horizon	Duration	Prices	AS Curve
Very short run	A few weeks	Fixed	Horizontal
Short run	A few months	Sticky	Gently upward-sloping
Medium run	1–2 years	Less sticky	Steeply upward-sloping
Long run	Several years+	Fully flexible	Vertical (at potential output)

Exam Alert — Long Run

In the long run, the AS curve is vertical at potential output ($Y^{\ast }$). Changes in AD shift only the price level — not real output. This is the classical dichotomy.

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2. Monetary Policy (Ch. 22)

The Bank of Canada

• Created 1934; mandate: price stability and financial stability
• Operationally independent — politicians cannot dictate rate decisions
• Makes 8 rate decisions per year; must report to Parliament

The Inflation Target

• Target: 2% CPI inflation, within a 1–3% band (since 1995)
• Target is 2%, not 0%, for four deliberate reasons:

Reason	Explanation
1. Labour market grease	Wages are downwardly rigid; 2% inflation lets real wages fall without cutting nominal wages
2. Room to cut rates	A positive inflation rate keeps the nominal rate above zero, giving more room to stimulate
3. Deflation buffer	0% target leaves the economy one bad shock from deflation — dangerous for debt and spending
4. CPI overstates inflation	True inflation is likely near 0% when CPI reads 2% (substitution, quality, new-goods biases)

The Policy Rule (Taylor-Type)

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

Variable	Meaning
$r^{\ast }$	Neutral real interest rate (neither stimulative nor restrictive)
$\pi -2\%$	Inflation gap — how far inflation is from the 2% target
Output gap	$\frac{Y-Y^{\ast }}{Y^{\ast }}$ — how far actual GDP is from potential

Policy Rule Calculation

$r^{\ast }=2\%$, inflation $=4\%$, output gap $=+1\%$

$\text{Real overnight rate}=2\%+\frac{1}{2}(4\%-2\%)+1\%=4\%$ $\text{Nominal overnight rate}=4\%+4\%=8\%$ Policy is contractionary (rates well above neutral).

Exam Alert

In normal business cycles, the inflation gap and output gap push in the same direction:

• Recession: both gaps negative → cut rates
• Boom: both gaps positive → raise rates

Implementing Monetary Policy — Four Tools

The Corridor System:

Rate	Level	Role
Bank rate (ceiling)	Target + 0.25%	Max rate BoC charges for emergency loans
Deposit rate (floor)	Target − 0.25%	Rate BoC pays on overnight deposits

• Repos: BoC lends money to banks (buys bonds temporarily) → injects funds → overnight rate ↓
• Reverse repos: BoC borrows from banks (sells bonds temporarily) → withdraws funds → overnight rate ↑
• Open market operations: BoC buys bonds → injects money → rate ↓; sells bonds → withdraws money → rate ↑

Three Transmission Channels

Exam Alert

Raising the overnight rate reduces AD through all three simultaneously:

Channel	Mechanism
1. Other interest rates	Banks raise prime, mortgage, car loan rates → less borrowing and spending
2. Consumption timing	Higher rates reward saving → households delay purchases
3. Exchange rate	Higher rates attract foreign capital → C$ appreciates → exports fall, imports rise → NX ↓ → AD ↓

Unconventional Policy (When Rate = 0)

Forward Guidance: BoC publicly commits to keeping rates low for an extended period → lowers expected future rates → long-term rates fall today → stimulates investment

Quantitative Easing (QE): BoC purchases large quantities of long-term bonds → pushes long-term rates down → cheaper mortgages/corporate debt → more investment and consumption

• Downside: BoC takes losses if rates later rise; moral hazard for financial institutions

Lender of Last Resort: Emergency short-term loans to solvent banks facing a liquidity crisis (not for insolvent banks)

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3. Fiscal Policy (Ch. 23)

Government Spending and Revenue

Federal spending breakdown:

Category	Share
Social insurance (EI, OAS, CPP, health transfers)	46%
General government services	17%
Interest on debt	9%
Defence	7%

Federal revenue breakdown:

Source	Share
Individual income tax	51%
GST/HST	18%
Corporate income tax	16%

Income Tax and Marginal Rates

Exam Alert

Average tax rate ≠ marginal tax rate. The marginal rate applies only to the last dollar earned; the average rate is total tax ÷ total income — always lower than the top marginal rate.

2022 Federal brackets: $15\%$ (≤$50,197)\to$20.5%$($50,197–$100,392)\to$26%$($100,392–$155,625)\to$29%$($155,625–$221,708)\to$33%$(>$221,708)

Fiscal Policy Mechanics

Expansionary: ↑$G$ or ↓$T$ → AD shifts right → GDP ↑, prices ↑ (appropriate in recession) Contractionary: ↓$G$ or ↑$T$ → AD shifts left → GDP ↓, prices ↓ (appropriate in boom)

Exam Alert — Direct vs. Transfer

Direct spending (G) has a larger immediate effect than transfer payments:

• Direct spending goes straight into GDP ($1spent=$1 in GDP)
• Transfers only affect GDP to the extent recipients spend (not save) the money — MPC fraction leaks into saving

The Spending Multiplier

Initial spending ripples through the economy: income → spending → income → spending…

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

Multiplier

MPC = 0.8, government spends $100M $\text{Multiplier}=\frac{1}{0.2}=5\Rightarrow \Delta \text{GDP}=\$100\text{M}\times 5=\$500\text{M}$

Common Mistake — Tax Multiplier

A tax cut has a smaller multiplier than direct spending because only MPC of the first dollar is spent: $\text{Tax multiplier}=\frac{\text{MPC}}{1-\text{MPC}}$

Three Time Lags (Why Fiscal Policy Is Slow)

Lag	Description
Recognition lag	GDP data released with delay; recession may not be confirmed quickly
Legislative lag	Spending bills must pass Parliament
Implementation lag	Infrastructure projects take time to begin (“shovel-ready” problem)

The Three Ts of Good Fiscal Policy

Exam Alert

Good discretionary fiscal policy must be:

• Timely — fast enough to matter before the recession ends
• Targeted — directed at high-MPC households (those who will spend, not save)
• Temporary — withdrawn once the economy recovers

Crowding Out

Crowding Out

Government borrowing ↑ → demand for loanable funds ↑ → real interest rate ↑ → private investment ↓

Common Mistake

Crowding out partially offsets fiscal policy — it does NOT fully negate it. Net fiscal effect is still positive, just smaller than the raw multiplier implies.

Automatic Stabilizers

Automatic Stabilizer

A program that automatically expands spending (or cuts taxes) in recessions and contracts in booms — without new legislation.

Stabilizer	How it works
Employment Insurance (EI)	Payouts rise automatically as unemployment increases
Progressive income tax	Tax revenues automatically fall in recessions (lower income → lower bracket)
Social assistance	Enrollment rises as more qualify during downturns

Exam Alert

Automatic stabilizers satisfy all three Ts simultaneously. This is why economists prefer them over discretionary policy.

Deficits, Debt, and the Stock-Flow Distinction

Exam Alert — Stock vs. Flow

• Deficit/surplus = flow (measured over a year): $G>T$ → deficit; $T>G$ → surplus
• Debt = stock (accumulated over all time): sum of all past deficits minus surpluses

Canada’s net federal debt ≈ 33% of GDP (2020) — lowest in the G7.

International comparison (net debt / GDP, 2020): Japan 169% → Italy 142% → France 104% → USA 103% → UK 94% → Germany 50% → Canada 33%

When Deficits Are Appropriate

1. Recession — countercyclical stimulus
2. Crisis — war, pandemic, natural disaster
3. Productive investment — infrastructure with long-term returns (future beneficiaries share the cost)

Why a Balanced Budget Requirement Would Be Counterproductive

• Forces pro-cyclical policy: recession → revenues fall → must cut spending → worsens recession
• Eliminates automatic stabilizers — the most effective fiscal tool

Reasons NOT to Worry About Debt

1. Most Canadian debt is owed by Canadians to Canadians — internal transfer, not a net burden
2. Future generations share the debt but also the benefits of what it financed
3. Government can roll over debt; doesn’t need to fully repay
4. Government has options households don’t: raise taxes, issue currency

Reasons TO Worry About Debt

1. Crowding out → slower private investment and growth
2. Interest payments consume future revenue — less room for programs or tax cuts
3. Risk of confidence crisis → higher borrowing costs → self-fulfilling spiral
4. Sovereign default — catastrophic for the financial system at high debt levels

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4. Monetary vs. Fiscal Policy Comparison

Feature	Monetary Policy	Fiscal Policy
Tool	Overnight rate	$G$ and $T$
Authority	Bank of Canada	Parliament / Finance Minister
Speed	Fast (8 decisions/year)	Slow (3 lags)
Effectiveness at ZLB	Weak — rate can’t go below ~0%	Strong — still shifts AD directly
Crowding out	No	Yes (government borrowing raises rates)
Reversibility	Easy (just change the rate)	Hard (politically difficult to cut spending)
Best tool for recessions	When rates are above ZLB	When rates are at ZLB

Remember

Monetary and fiscal policy work together most effectively. During COVID-19, the BoC cut rates to the ZLB while the federal government ran massive deficits — both simultaneously expanded AD.

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5. Formulas

Aggregate Expenditure

$AE=C+I+G+NX$

Multiplier (from Spending)

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

Change in GDP from Spending

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

Tax Multiplier

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

Note

Tax multiplier < spending multiplier because only MPC of a tax cut flows into spending in the first round.

Monetary Policy Rule (Taylor-Type)

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

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

Where:

• $r^{\ast }$ = neutral real interest rate
• $\pi$ = current inflation rate
• Output gap $=\frac{Y-Y^{\ast }}{Y^{\ast }}$ (positive = overheating; negative = recession)

Output Gap

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

Average Tax Rate

$\text{Average tax rate}=\frac{\text{Total tax paid}}{\text{Total income}}$

Exam Alert

Average tax rate < marginal tax rate under a progressive tax system. Only the last dollar earned is taxed at the marginal rate.

Budget Balance

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

• Positive → surplus (reduces debt)
• Negative → deficit (adds to debt)

Corridor System

$\text{Bank rate}=\text{Overnight target}+0.25\%$ $\text{Deposit rate}=\text{Overnight target}-0.25\%$

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6. Definitions

Aggregate Demand (AD) The relationship between the price level and total quantity of output buyers plan to purchase; downward-sloping due to the central bank channel.

Aggregate Supply (AS) The relationship between the price level and total quantity of output suppliers produce; upward-sloping in the short run, vertical in the long run.

Stagflation Declining real GDP combined with rising prices; caused by a leftward shift in AS (e.g., oil shock).

Potential Output ($Y^{\ast }$) The long-run equilibrium level of real GDP at which the vertical long-run AS curve sits.

Classical Dichotomy The long-run principle that the price level and real output are independent — changes in AD affect only prices, not real GDP.

Sticky Prices Prices that adjust sluggishly; explain why AS is upward-sloping in the short run (not all sellers immediately respond to demand changes).

Monetary Policy The Bank of Canada’s use of the overnight rate to influence inflation and output.

Overnight Rate The interest rate at which major financial institutions lend to each other overnight; the BoC’s primary instrument.

Neutral Real Interest Rate ($r^{\ast }$) The real rate consistent with full employment and 2% inflation; neither stimulative nor restrictive.

Output Gap $(Y-Y^{\ast })/Y^{\ast }$; positive means overheating (inflationary pressure), negative means recession.

Zero Lower Bound (ZLB) The ~0% floor on nominal interest rates; beyond this, conventional monetary policy cannot further stimulate.

Forward Guidance BoC’s public commitment to keep rates low for a stated period; lowers long-term rates even when the overnight rate is already at zero.

Quantitative Easing (QE) Large-scale purchases of long-term bonds to inject money and lower long-term rates when the overnight rate is at the ZLB.

Fiscal Policy Government use of spending ($G$) and taxes ($T$) to influence aggregate demand and stabilize the economy.

Multiplier $1/(1-\text{MPC})$; the factor by which GDP changes per dollar of direct spending, capturing ripple effects through the economy.

Crowding Out Government borrowing raises real interest rates → reduces private investment → partially offsets fiscal stimulus.

Automatic Stabilizer A program (EI, progressive tax) that automatically boosts spending in recessions and contracts in booms without new legislation; satisfies all three Ts.

Budget Deficit $G>T$ in a given year; a flow measure that adds to the stock of debt.

Net Government Debt Gross debt minus government financial assets; Canada’s is ~33% of GDP — lowest in G7.

Moral Hazard Institutions taking on excess risk because they expect to be bailed out (relevant to QE and lender-of-last-resort).

Sovereign Default Government failure to repay debt; triggers a financial crisis.