TA: mourram@uwindsor.ca

Test 2 Review

Test Date: Thursday, March 12th — 45 multiple choice questions covering Chapters 13–16.

The four chapters form a logical chain: households save (Ch13) → firms borrow those savings to invest (Ch14) → the financial sector connects them (Ch15) → the same flows cross international borders (Ch16).

Key Concepts by Chapter

Chapter 13 — Consumption and Saving

• Consumption is the largest component of GDP (more than three-fifths)
• The MPC (marginal propensity to consume) is the slope of the consumption function; it falls between 0 and 1
• Consumption smoothing: spread spending evenly over time due to diminishing marginal benefit
• Permanent income hypothesis: consumption is driven by long-run average income, not current income
• Hand-to-mouth consumers: MPC = 1; spend all income as received; no smoothing
• A change in income → movement along the consumption function; changes in other factors → shift of the curve
• Four consumption shifters: real interest rates, expectations, taxes (disposable income), wealth

Chapter 14 — Investment

• Investment = business fixed investment + residential investment + inventory investment
• Investment is the most volatile component of GDP
• Rational Rule for Investors: invest if $\frac{\text{Revenue}}{r+d}>C$ (NPV form) or Revenue $>(r+d)\times C$ (user cost form) — these are equivalent
• Higher real interest rates → lower PV of future revenues → less investment (movement along the investment line)
• Four investment shifters (shift the line): technological advances, expectations, corporate taxes, lending standards
• Market for loanable funds: savers (suppliers) meet investors (demanders); real interest rate is the price

Chapter 15 — The Financial Sector

• Banks borrow from depositors and lend to investors, keeping only a fraction (reserve ratio) as reserves
• Money multiplier = 1 / reserve ratio; lower reserve ratio → larger multiplier → more money creation
• Bond prices and yields move inversely — this is the single most tested bond concept
• Stocks are valued by the present value of all future dividends: $P=D/r$
• Efficient Market Hypothesis (EMH): prices reflect all publicly available information → hard to beat the market
• Speculative bubble: prices rise above fundamental value; all bubbles eventually burst (Greater Fool Theory)
• Six financial lessons: compound interest, don’t pick stocks, diversify, past performance ≠ future, minimize fees, use index funds

Chapter 16 — International Finance and the Exchange Rate

• Demand for C$ comes from Canadian exports and financial inflows
• Supply of C$ comes from Canadian imports and financial outflows
• PPP (long run): exchange rates equalize prices across countries
• Interest rate parity: capital flows equalize returns across countries; higher Canadian rates → C$ appreciates
• Real exchange rate measures international competitiveness; real depreciation → exports ↑, imports ↓ → net exports ↑
• Three exchange rate regimes: floating, fixed, managed
• Balance of payments identity: Current Account + Financial Account = 0

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Formulas

Chapter 13 — Consumption and Saving

$\text{MPC}=\frac{\Delta \text{Consumption}}{\Delta \text{Income}}$

$\text{Savings}=\text{Income}-\text{Consumption}$

$\text{Net Wealth}=\text{Assets}-\text{Debts}$

Chapter 14 — Investment

Future Value (Compounding): $FV=PV\times (1+r{)}^n$

Present Value: $PV=\frac{FV}{(1+r{)}^n}$

Present Value of a Perpetuity (Rational Rule for Investors — NPV form): $PV=\frac{\text{Next year’s revenue}}{r+d}$

Exam Alert

Invest if $\frac{\text{Revenue}}{r+d}>C$ (NPV form)

User Cost of Capital: $\text{User cost of capital}=(r+d)\times C$

Exam Alert

Invest if Revenue $>(r+d)\times C$ (user cost form — mathematically identical to NPV form)

Chapter 15 — The Financial Sector

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

Bond Yield: $\text{Yield}\approx \frac{\text{Annual coupon payment}}{\text{Bond price}}$

Exam Alert

Bond price ↑ → Yield ↓ and Bond price ↓ → Yield ↑ (inverse relationship)

Fundamental Stock Value (Dividend Perpetuity): $\text{Stock Price}=\frac{D}{r}$

Price-to-Earnings (P/E) Ratio: $\text{P/E Ratio}=\frac{\text{Stock Price}}{\text{Earnings Per Share}}$

Relative Valuation: $\text{Estimated Price}=\text{Benchmark P/E}\times \text{Target Earnings Per Share}$

Chapter 16 — International Finance and the Exchange Rate

Real Exchange Rate: $\text{Real exchange rate}=\frac{\text{Domestic price (C\$)}}{\text{Foreign price in foreign currency}÷\text{Nominal exchange rate}}$

Current Account Balance: $\text{Current Account}=\text{Income received from abroad}-\text{Income paid abroad}$

Financial Account Balance: $\text{Financial Account}=\text{Financial inflows}-\text{Financial outflows}$

Balance of Payments Identity: $\text{Current Account}+\text{Financial Account}=0$

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Critical Tables and Relationships

Consumption Smoothers vs. Hand-to-Mouth (Ch13)

Effect of…	Consumption Smoothers	Hand-to-Mouth	Total Consumption
Temporary rise in income	Small ↑	Large ↑	Intermediate ↑
Permanent rise in income	Large ↑	Large ↑	Large ↑
Anticipated rise in income	No change	Large ↑	Intermediate ↑
News of future rise in income	Large ↑	No change	Intermediate ↑

Five Macro Insights on Consumption (Ch13)

Insight	Change	Effect on Consumption
1	Temporary income change	Small change in C
2	Permanent income change	Large change in C
3	Anticipated income change	No change in C
4	Learning about future change	Change now (not when money arrives)
5	Forecast future consumption	Difficult — driven by unexpected news

Four Investment Shifters (Ch14)

Shifter	Rightward Shift (More Investment)	Leftward Shift (Less Investment)
Technological advances	More productive capital / lower depreciation	Obsolescence
Expectations	Optimism about future profits	Pessimism
Corporate taxes	Tax breaks / cuts	Higher taxes
Lending standards & cash	Easier credit / more cash reserves	Tighter credit

Currency Supply and Demand (Ch16)

Flow	Effect on C$
Canadian exports ↑	Demand for C$ ↑
Financial inflows ↑	Demand for C$ ↑
Canadian imports ↑	Supply of C$ ↑
Financial outflows ↑	Supply of C$ ↑

Exchange Rate Regimes (Ch16)

Regime	Description	Canadian Example
Floating	Fluctuates freely with supply and demand	Since 1970
Fixed	Government sets and holds a fixed rate	1962–1970 at US$0.925
Managed	Government buys/sells currency to reduce volatility	1952–1960

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Common Exam Traps

Movement Along vs. Shift

• Change in income → movement along the consumption function
• Change in interest rates, expectations, taxes, or wealth → shift of the consumption function
• Change in real interest rate → movement along the investment line
• Change in technology, expectations, taxes, or lending → shift of the investment line

Investment vs. Saving/Stocks

In macroeconomics, investment means buying new physical capital — NOT buying stocks, bonds, or financial assets. Purchasing an existing stock is not “investment” in the macro sense.

Stock vs. Flow

Accumulated savings is a stock (wealth). New saving, income, and consumption are flows — they happen over a period of time.

User Cost — Don't Forget Opportunity Cost

The full cost of owning capital includes $(r\times C)$ — the return you forgo by tying up money. Out-of-pocket costs (insurance, gas) are only part of the story.

EMH Misinterpretation

The EMH does not say stock prices are always correct — only that they reflect all available information. Prices can still be wrong if all available information is wrong (e.g., during bubbles).

Balance of Payments Always Sums to Zero

A current account deficit is always exactly offset by a financial account surplus. If Canada buys more from abroad (imports), foreigners must be investing the difference back into Canada.

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Three-Step Exchange Rate Framework (Ch16)

Exam Alert

For any exchange rate scenario:

1. Which curve shifts? — Exports/financial inflows → Demand. Imports/financial outflows → Supply.
2. Which direction? — Increase → rightward. Decrease → leftward.
3. What happens to equilibrium? — Read off the new exchange rate (appreciation or depreciation).

Practice: Interest Rate Rise

The Bank of Canada raises interest rates above U.S. rates.

Step 1: Higher Canadian rates attract foreign investors → financial inflows increase → Demand for C$shifts\ast \ast .\ast \ast Step2:\ast \ast Inflowsincrease\to rightward(increase)shift.\ast \ast Step3:\ast \ast Higherdemand\to \ast \ast C$ appreciates.

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Definitions Summary

MPC (Marginal Propensity to Consume) Fraction of each extra dollar of income spent on consumption; slope of the consumption function.

Permanent Income Best estimate of long-term average income; what drives consumption for consumption smoothers.

Hand-to-Mouth Consumer Spends all income as received; MPC = 1; does not smooth consumption.

Disposable Income After-tax income: income minus taxes.

Precautionary Saving Saving to prepare for a financial emergency (target: 3–6 months of living expenses).

User Cost of Capital The annual cost of using one unit of capital: $(r+d)\times C$; includes opportunity cost and depreciation.

Market for Loanable Funds The market connecting savers (suppliers) and investors (demanders); the real interest rate is the price.

Money Multiplier $1/\text{Reserve Ratio}$; total deposits created from an initial deposit as banks loan out fractions.

Bond Yield Effective interest rate on a bond: approximately coupon / price. Moves inversely with bond price.

Duration Risk Risk that rising interest rates reduce the value of existing fixed-rate bonds; greater for longer-term bonds.

Efficient Market Hypothesis (EMH) Stock prices reflect all publicly available information; beating the market consistently is very difficult.

Speculative Bubble Asset prices rise above fundamental value, fueled by expectations of further price increases.

Nominal Exchange Rate Price of one currency in terms of another (e.g., ¥90 per C$); determined by the forex market.

Real Exchange Rate Domestic price relative to foreign prices; measures international competitiveness. Low = competitive.

Purchasing Power Parity (PPP) Long-run theory: exchange rates adjust so identical goods cost the same in all countries.

Interest Rate Parity Capital flows equalize returns across countries; higher domestic rates attract inflows and appreciate the currency.

Balance of Payments Record of all transactions between a country and the world; Current Account + Financial Account = 0.

Current Account Tracks income flows across borders (exports, imports, investment income, transfers).

Financial Account Tracks financial flows across borders (FDI, portfolio investment, loans/deposits).

In-Class Review (Things on the Exam)

Ch13: C function C=f(Yd) shifts vs movements along the C function slope = mpc calculate the slope mpc + mps = 1 yd = c + s S=f(Yd) factors tha shifts the C function

ch14: I = f(r) real I only what are the parts of I skip 14.3 what determines I what causes these shifts, etc. money market: S and D what causes the shift of D and S cost of money = r governments budget: T = G budget surplus budget deficit balanced budget eg. G=$1000 t=20% gov’t budget is balanced at Y = ? G = T, T = t*Y

ch15: balance sheet: A and L banks functions bank runs BoC functions - conduct M.P. (lender of last resort) CDIC (FDIC) shadow banks, reserve ratio bond market - shares, dividends, diversify skip 15.3/15.4 what is money functions of money fractional reserve banking

ch16: ER X, IM, NX ER: appreciation vs. depreciation of our currency change in X, IM, NX, change in Y S and D for our currency shifts of S and D curves price of our $ - ER fixed vs floating ER

other: GDP gap: Y = Y*, U = U* Y > Y*, U < U* Y < Y*, U > U*