In-Class Review

Topics emphasized in-class for Test 2 (March 12). Complements Test 2 Review.

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Chapter 13 — Consumption and Saving

Consumption as a Function of Disposable Income

$C=f(Y_d)$

• Consumption depends on disposable income $Y_d$ (after-tax income)
• The consumption function is upward-sloping: more income → more consumption
• The slope of the consumption function equals the MPC

$\text{Slope}=\text{MPC}=\frac{\Delta C}{\Delta Y_d}$

Calculating the Slope (MPC)

If income rises by $1,000andconsumptionrisesby$700: $\text{MPC}=\frac{\$700}{\$1,000}=0.7$ The slope of the consumption function is 0.7.

MPC + MPS = 1

Every dollar of disposable income is either consumed or saved: $Y_d=C+S$

Therefore, the marginal propensity to consume and the marginal propensity to save always sum to 1: $\text{MPC}+\text{MPS}=1$

Using MPC + MPS = 1

If MPC = 0.7, then MPS = 1 − 0.7 = 0.3. Out of every extra dollar earned, 70 cents is consumed and 30 cents is saved.

Saving as a Function of Disposable Income

$S=f(Y_d)$ The saving function is also upward-sloping. Since $S=Y_d-C$, every point on the saving function is just disposable income minus the corresponding point on the consumption function.

• When $C>Y_d$ → dissaving (borrowing or drawing down savings)
• When $C<Y_d$ → positive saving

Movements Along vs. Shifts of the Consumption Function

Cause	Effect
Change in disposable income $Y_d$	Movement along the consumption function
Change in real interest rates, expectations, taxes, or wealth	Shift of the consumption function

Common Mistake

A raise at work → income changes → this is a movement along the curve, not a shift. Only non-income factors shift the curve.

Four Factors That Shift the Consumption Function

1. Real interest rates — higher rates → saving is more rewarding → consumption shifts down
2. Expectations — optimism → consumption shifts up; pessimism → shifts down
3. Taxes (disposable income) — tax cut → higher $Y_d$ → consumption shifts up
4. Wealth — higher wealth (rising house/stock prices) → consumption shifts up

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Chapter 14 — Investment

Investment as a Function of the Real Interest Rate

$I=f(r)$

• Investment depends on the real interest rate only (not nominal)
• Higher $r$ → lower present value of future revenues → less investment
• This produces a downward-sloping investment line: $r$ on the y-axis, $I$ on the x-axis
• A change in $r$ → movement along the line
• A change in technology, expectations, taxes, or lending → shift of the line

Exam Alert

Only real investment counts in macroeconomics — not financial purchases (buying stocks or bonds is not investment).

Three Parts of Investment

Type	Description
Business fixed investment	Machinery, equipment, and buildings purchased by firms
Residential investment	Construction of new housing
Inventory investment	Changes in unsold goods held by firms

What Determines Investment?

1. Real interest rate $r$ — movement along the line
2. Technological advances — shift right (more productive capital)
3. Expectations — optimism → right; pessimism → left
4. Corporate taxes — lower taxes → right; higher taxes → left
5. Lending standards and cash reserves — easier credit → right

Market for Loanable Funds

The cost of money is the real interest rate $r$.

Role	Actor
Supply (savers)	Households, government surpluses
Demand (investors)	Firms borrowing to buy new capital
Price	Real interest rate $r$

What shifts demand for loanable funds?

• Technology improvements → more profitable investment → demand shifts right
• Pessimism about future profits → demand shifts left

What shifts supply of loanable funds?

• Consumer savings behaviour (real interest rates, wealth, expectations)
• Government budget position (surplus adds to supply; deficit reduces it)

Exam Alert

In the loanable funds market, the government is a participant. A budget deficit means the government is a net borrower — it reduces the supply of loanable funds and raises the real interest rate (crowding out private investment).

Government Budget

Condition	Description
Balanced budget	$T=G$
Budget surplus	$T>G$ (government saves — adds to loanable funds supply)
Budget deficit	$T<G$ (government borrows — reduces loanable funds supply)

Where:

• $G$ = government spending
• $T$ = tax revenue
• $t$ = tax rate
• $Y$ = national income

$T=t\times Y$

Government Budget Calculation

Given: G = \1{,}000$,$t = 20%$

Find the income level $Y$ at which the budget is balanced:

Set $T=G$: $t\times Y=G$ $0.20\times Y=\$1,000$ $Y=\$5,000$

The budget is balanced when national income is $5,000.

• If Y > \5{,}000$\to$T > G$ → surplus
• If Y < \5{,}000$\to$T < G$ → deficit

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Chapter 15 — The Financial Sector

What Is Money?

Money is anything widely accepted as payment for goods and services or repayment of debts.

Three functions of money:

1. Medium of exchange — eliminates the need for a double coincidence of wants (barter)
2. Store of value — holds purchasing power over time
3. Unit of account — a common measure to compare the value of different goods

Remember

A good must perform all three functions to be considered money. Gold, for example, satisfies all three.

Bank Balance Sheet

Banks must balance their assets (what they own or are owed) against their liabilities (what they owe others).

Assets	Liabilities
Loans (to borrowers)	Deposits (from savers)
Reserves (vault cash + BoC account)	Shareholder equity
Government securities

Exam Alert

Assets = Liabilities + Equity. Banks earn profit on the spread between lending rates and deposit rates.

Bank Functions

1. Accept deposits from savers (bank borrows from you)
2. Make loans to borrowers (bank lends your money out)
3. Create money through fractional reserve lending
4. Provide liquidity — convert illiquid loans into liquid deposits

Fractional Reserve Banking

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

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

Fractional Reserve Lending

Reserve ratio = 10%. A $1,000 deposit:

• Bank A keeps $100,lends$900
• Bank B keeps $90,lends$810
• … continues until total deposits = $10,000

$\text{Money Multiplier}=\frac{1}{0.10}=10$

Bank Runs

A bank run occurs when many depositors try to withdraw their funds simultaneously, fearing the bank will fail.

• Banks only hold a fraction of deposits as reserves — they cannot repay everyone at once
• Bank runs become self-fulfilling: the fear of insolvency causes the insolvency
• Historical example: during the Great Depression, thousands of U.S. banks failed due to bank runs

How bank runs are prevented:

Mechanism	Description
CDIC	Canada Deposit Insurance Corporation — insures deposits up to $100,000 per category per institution (equivalent to FDIC in the U.S.)
BoC as lender of last resort	Bank of Canada provides emergency loans to solvent banks facing short-term liquidity crises

Bank of Canada (BoC) Functions

The Bank of Canada is Canada’s central bank. Key functions:

1. Conduct monetary policy — sets the overnight lending rate to manage inflation and economic growth
2. Issue currency — sole issuer of Canadian bank notes
3. Lender of last resort — provides emergency liquidity to banks facing runs or crises
4. Regulate and supervise the financial system
5. Manage foreign exchange reserves

Lender of Last Resort

The BoC’s role as the ultimate source of short-term credit for banks facing a liquidity crisis. By guaranteeing that solvent banks can always borrow, the BoC prevents panic-driven bank runs from causing unnecessary bank failures.

Shadow Banks

Shadow banks are non-bank financial institutions that perform bank-like functions but are not regulated like banks and do not have access to BoC support.

Examples: hedge funds, money market mutual funds, insurance companies, payday lenders.

• They take on similar risks as banks (borrowing short, lending long)
• They are outside the safety net: no deposit insurance, no lender of last resort
• Played a key role in the 2008 financial crisis — their collapse spread to the entire financial system

Common Mistake

Shadow banks are not illegal or necessarily harmful — they provide important financial services. The concern is that their systemic risks are less visible and less regulated.

Bond Market, Stocks, Dividends, and Diversification

Bonds: fixed-income debt instruments; price and yield move inversely $\text{Yield}\approx \frac{\text{Annual coupon}}{\text{Bond price}}$

Stocks (shares): partial ownership in a company; pay dividends from profits $\text{Stock Price}=\frac{D}{r}$

Diversification: spreading investments across many assets to reduce risk

• Eliminates idiosyncratic risk (firm-specific)
• Cannot eliminate systematic risk (market-wide)
• Easiest way to diversify: buy a low-cost index fund

Exam Alert

Six financial lessons: compound interest, don’t pick stocks, diversify, past performance ≠ future, minimize fees, use index funds.

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Chapter 16 — International Finance and the Exchange Rate

The Exchange Rate (ER)

The nominal exchange rate is the price of one currency in terms of another, determined by supply and demand in the foreign exchange market.

Reading an Exchange Rate

If the exchange rate is ¥90 per C$, then one Canadian dollar buys 90 Japanese yen.

Exports, Imports, and Net Exports

Term	Definition
Exports (X)	Goods and services sold to foreigners; generates demand for C$
Imports (IM)	Goods and services bought from foreigners; generates supply of C$
Net Exports (NX)	$NX=X-IM$; positive = trade surplus, negative = trade deficit

Exam Alert

Flow	Effect on C$
Exports ↑	Demand for C$\uparrow \to C$ appreciates
Imports ↑	Supply of C$\uparrow \to C$ depreciates
Financial inflows ↑	Demand for C$\uparrow \to C$ appreciates
Financial outflows ↑	Supply of C$\uparrow \to C$ depreciates

Appreciation vs. Depreciation

Term	Meaning	Effect on Trade
Appreciation	C$buys\ast \ast more\ast \ast foreigncurrency(C$ stronger)	Exports ↓ (Canadian goods cost more abroad); Imports ↑ (foreign goods cheaper) → NX ↓
Depreciation	C$buys\ast \ast less\ast \ast foreigncurrency(C$ weaker)	Exports ↑ (Canadian goods cheaper abroad); Imports ↓ (foreign goods cost more) → NX ↑

Common Mistake

A stronger dollar sounds good, but appreciation hurts exporters — Canadian goods become more expensive for foreign buyers. Depreciation boosts exports and NX.

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Definitions

Consumption Function A curve plotting consumption against disposable income; upward-sloping with slope equal to the MPC.

MPC (Marginal Propensity to Consume) The fraction of each additional dollar of disposable income spent on consumption; the slope of the consumption function.

MPS (Marginal Propensity to Save) The fraction of each additional dollar of disposable income saved: $\text{MPS}=1-\text{MPC}$.

Disposable Income ($Y_d$) After-tax income: $Y_d=\text{Income}-\text{Taxes}$. The income variable in the consumption function.

Exports (X) Goods and services produced domestically and sold to foreigners; creates demand for the domestic currency.

Imports (IM) Goods and services produced abroad and purchased domestically; creates supply of the domestic currency.

Net Exports (NX) Exports minus imports: $NX=X-IM$. A positive value is a trade surplus; negative is a trade deficit.

Appreciation An increase in the value of a currency — it buys more foreign currency.

Depreciation A decrease in the value of a currency — it buys less foreign currency.

Money Anything widely accepted as payment; performs three functions: medium of exchange, store of value, unit of account.

Fractional Reserve Banking System where banks keep only a fraction of deposits as reserves and lend out the rest, creating new money in the process.

Reserve Ratio The fraction of deposits a bank keeps on hand rather than lending out.

Money Multiplier $1/\text{Reserve Ratio}$; total deposits created from an initial deposit as lending cascades through the banking system.

Bank Run A situation where many depositors simultaneously try to withdraw funds, potentially causing a solvent bank to fail due to insufficient reserves.

CDIC (Canada Deposit Insurance Corporation) Federal Crown corporation that insures eligible deposits up to $100,000 per category per member institution; prevents bank runs by guaranteeing deposits.

Lender of Last Resort The Bank of Canada’s role in providing emergency short-term credit to banks facing a liquidity crisis, preventing bank runs from spiralling into failures.

Shadow Bank A non-bank financial institution performing bank-like functions (borrowing short, lending long) without bank-style regulation or access to central bank support.

Balanced Budget When government spending equals tax revenue: $G=T$.

Budget Surplus When $T>G$; the government is a net saver, adding to the supply of loanable funds.

Budget Deficit When $G>T$; the government is a net borrower, reducing the supply of loanable funds and putting upward pressure on real interest rates.