Inflation and Supply Shocks

FROM WAGE CHANGES TO PRICE CHANGES
-If a change in money wages is positive (wages increase), short run aggregate supply will decrease (it shifts to the left due to increased costs). This causes prices to rise, and the overall effect is inflationary
-If an change in money wages is negative (wages decrease), short run aggregate supply will increase (it shifts to the right due to lowered costs). This causes prices to fall, and the overall effect is deflationary.

Wages up --> Costs up ---> SRAS shifts left --> Equilibrium price level rises


Okay... so so far, we've talked about two causes of inflation: gap effects and worker expectations. There is, however, a third cause of inflationary pressures: AN EXOGENOUS SUPPLY SHOCK (for an example, a change in the price of raw materials, such as oil, can increase the general price level, which is why vegetables can start to cost more when the price of oil goes up).

SOOO

ACTUAL INFLATION IS A COMBINATION OF:
1: GAP INFLATION
2: EXPECTATION INFLATION
3: SUPPLY SHCOK INFLATION (even though that's a bit of an afterthought)

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Next, we're going to talk about the difference between sustained/constant inflation and accelerating inflation.

CONSTANT/SUSTAINED INFLATION
-Here, we assume that there is no supply shock, and no output gaps
-As such, the ONLY cause for inflation when there is sustained inflation, is expectations
-This kind of inflation occurs when Y is equal to Y*

Let's summarize: constant inflation occurs when...
-There is no gap inflation
-There is no supply shock inflation
-Monetary growth is equal to the rate that wages increase at
-Actual inflation is equal to expected inflation

HOW IT WORKS:
1: Worker expectations trigger constant inflation (expectations cause workers to demand higher wages, which then causes SRAS to shift to the left)
2: The BoC validates the price increase by increase the money supply

SO.... let's say that we start off with expectation inflation at 2%. Workers anticipate future increases of 2% in the price level, so they demand higher wages, which causes SRAS to shift to the left as money wages rise. When the government validates this increase, they increase the money supply, which shifts SRAD to the right. Because of the way that this mechanism works, the price level will rise at the exact same rate as is predicted (because expectations are what catalyze the change). Actual inflation is equal to expected inflation, and output remains at Y*. THIS IS CONTINUOUS INFLATION AT A CONSTANT RATE.

NOTE* This isn't expansionary monetary policy- the BoC is not reducing the overnight target rate here- interest rates aren't affect by this. The BoC is merely accommodating for the growing demand for money by steadily increasing the nominal money supply. As such, the real money supply remains constant (so the ratio of money in the economy and the average price of products remains the same).

INFLATIONARY SUPPLY SHOCKS (negative supply shocks which temporarily inflate prices)
-Remember, in all cases of inflation, the price level rises to a new equilibrium level. In temporary inflationary situations, the price will simply remain at the new level, whereas in cases of persistent inflation, the equilibrium price level will continue to rise.

Inflationary supply shocks are caused by increased cost of productive inputs (for an example, an increase in the price of oil). This, in turn, causes costs to rise, which shifts SRAS to the left, and increases the price level while decreasing output.

BUT... as we know from previous chapters, this change is NOT permanent. Eventually, the higher unemployment which accompanies the supply-shock-recession puts downward pressures on wages, eventually causing them to fall. As a result of these wage-related cost savings to firms, the short run aggregate supply will shift back to its original level: costs will be the same as they once were, even though workers are being paid less. As SRAS shifts to the right, the price level and output level both shift back to what they were originally. SO, WE CAN CONCLUDE THAT INFLATIONARY SUPPLY SHOCKS ONLY CAUSE INFLATION IN THE SHORT RUN, AND THAT THERE IS NO SUSTAINED INFLATION HERE.

OKAY.. BUT WHAT HAPPENS WHEN WE HAVE AN ISOLATED SUPPLY SHOCK WHICH IS MONETARILY VALIDATED BY THE BoC?
Well, we start out at macroeconomic equilibrium, and then we shift SRAS to the left. This increases the price level and decreases the output level. After this, if the government tries to correct this recessionary gap by increasing the money supply (the money supply increases, which lowers interest rates, which increases investment and net exports, which drives aggregate expenditure up and shifts aggregate demand to the right), aggregate demand will shift to the right, which will bring output back to its equilibrium level, but at a higher general price level. As such, there will be more inflation than if the government does not intervene, but prices will still settle at the new equilibrium level, and inflation will not be persistant.

OKAY... BUT WHAT HAPPENS WHEN WE HAVE REPEATED SUPPLY SHOCKS WITHOUT MONETARY VALIDATION?
For an example, lets say we have cost push inflation, which occurs due to repeated increases in firms' costs. What happens then? Well, either the economy will stabilize at a higher price level and a smaller output level, OR persistent unemployment will erode the power of unions, causing monetary wages to fall, and bringing short run aggregate supply back to its original levels.

OKAY... BUT WHAT HAPPENS WHEN WE HAVE REPEATED SUPPLY SHOCKS WHICH ARE VALIDATED BY THE GOVERNMENT?
Well, then economies can enter into an inflationary spiral. For an example, if unions consistently negotiate to increase their monetary wages, and the government consistently validates this decrease in SRAS by printing more money, then an economy will experience consistent inflation (albeit, often the wage increases are very small, so inflation persists at a small but constant level). Basically, monetary validation reinforces price increases and offsets the natural tendency of Ye to return to Y* on its own, hence sustained inflation.

So.... is monetary validation of supply shocks desirable or undesirable? Yes and No!

No, because the BoC should allow for unemployment, which will eventually eliminate the output gap through the natural chain and anchor process.
Yes, because nations can avoid severe (albeit temporary) recessions by using monetary validation (although this comes at the cost of creating higher prices)

So its sort of a dilemma: governments must choose between long stretches of unemployment (no validating) or inflation (validating).



What is STAGFLATION? Stagflation is when supply shocks and monetary validating occur simultaneously, which leads to a NEGATIVE COMBINATION OF INFLATION AND UNEMPLOYMENT

Persistent Recessionary Gaps + Persistent Inflation: Continous SRAS shocks continue to push SRAS to the left, while continuous validation continues to push AD to the right. The overall effect on the output level is neutral, so the original recessionary gap is never closed. At the same time, both supply shocks and monetary validation continuously push up the price level, so the equilibrium price level will continuously rise while the economy remains in a recession. =(

The Gap Effect, and the Expectation Effect

THE WONDERFUL WORLD OF INFLATION:

People talk about inflation a LOT, so its probably a good idea know what it is. If you've survived macroeconomics without knowing what inflation is up until this point, congratulations, you live a seriously charmed life.

For the rest of us, lets reiterate:

Inflation is any rise in the general price level (P)

Inflation can be temporary/transitory (the price level increases to a new equilibrium price level, where it stays put for a while) or it can be sustained/persistant (the price level rises continuously over time)

In classical economics, aggregate demand shocks and aggregate supply shocks cause TEMPORARY inflation (one-time jumps in the price level) as a side effect of gap inflation. In this chapter, we are more concerned with exploring the causes of sustained inflation (which, as we will learn, is affected by people's expectations). We're also going to look at what causes accelerating inflation.

On a very basic level, prices can rise for two different reasons
1) There is a decrease in supply (this is called cost-push inflation)
2) There is an increase in demand (this is called demand-pull inflation)

HERE IS A LIST OF TERRIBLY IMPORTANT DEFINITIONS WHICH WE SHOULD ALL PROBABLY LEARN IF WE WANT TO DO WELL IN MACROECONOMICS:
Inflation - A rise in the consumer price index
Inflation Rate - The percentage change in the consumer price index
Zero Inflation - A situation where there is no percentage change in the consumer price index
Stable Inflation - A situation where the inflation rate remains relatively constant over time (ie: inflation is 2% for seven years in a row)
Accelerating Inflation - The inflation rate increases over time (ie: inflation is 2% in 1991, 4% in 1992, 8% in 1993, and 13% in 1994)
Disinflation - The inflation rate decrease over time (ie: inflation is 16% in 1991, 9% in 1992, 5% in 1993, and 3% in 1994)
Deflation - A negative rate of inflation: the consumer price index goes down (so goods end up costing less)

Low inflation: 1-3%
Medium inflation: 3-6%
High inflation: Over 6%
Hyperinflation: Over 20%

Why are we concerned with inflation? Because too much inflation inflicts a bunch of costs on society. Here are some of them:
-It decreases the purchasing power of people who are on fixed incomes (both contractually and in terms of pensionary incomes)
-It can arbitrarily redistribute income
-It undermines the efficiency of the price system by distorting relative prices (so its harder for consumers to tell if they are getting a good deal or if they are getting ripped off if the general price level is continuously in flux)

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One last important concept is NAIRU, which is the non-accelerating inflationary rate of unemployment. Basically, this is the rate of unemployment present in an economy when there are no inflationary or recessionary gaps (when Y is at Y*). This does not mean that there is no unemployment- only that there is no GAP unemployment (there can still be frictional and structural unemployment). NAIRU is also sometimes called "full employment," or U*.

We're going to look at why NAIRU is called NAIRU in this chapter

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INFLATION AND WAGE CHANGES:

Okay... why do people's wages change?

There are two factors which can explain why people's wages change
1) The gap effect
2) The expectation effect

THE GAP EFFECT
-Basically, this is demand-pull inflation caused by excess demand in the labour market.
-In an inflationary gap, we get GAP INFLATION. Y is larger than Y*, U is smaller than U*, and there is an excess demand for labour. As a result, firms are forced to raise wages in order to keep employees. The result of this rise in wages is that average costs rise (which, in turn, causes the short run aggregate supply to shift to the left, correcting the inflationary gap).
-In a recessionary gap, we get GAP DEFLATION. Y is smaller than Y*, U is greater than U*, and there is an excess supply of labour. As a result, firms can safely lower employee wages without the risk of losing employees (its better to have a low-paying job than no job at all). This, in turn, causes average costs to fall, which shifts short run aggregate supply to the right, correcting the inflationary gap.
-When there is no gap, there is NO INFLATION. Y equals Y*, U equal U*, demand and supply of labour are equal, wages remain constant, average costs remain constant, and the short run aggregate supply remains constant (as do prices).

The Phillips Curve shows the inverse relation between the unemployment rate and the rate of changes in nominal wages.

Basically, as unemployment gets higher, wage increases get smaller and smaller, and eventually, turn into wage decreases (salary cuts).

Classical economists ONLY considered the gap effect to be a source of inflation, and believed that gaps would only create a temporary period of inflation. They also believed that if there was no gap, that there would be no increase in wages...

They were entirely correct... there is also...

THE EXPECTATION EFFECT
-Here, expected inflation is taken into account when employees are negotiating wage demands with their employers
-Here, inflation is like a "self fulfilling prophecy". If employees believe that there will be inflation of a certain level over the next year, they will negotiate for higher wages to account for that inflation. This, in turn, increases firms' average costs, which shifts the SRAD curve to the left, effecting CAUSING an increase in prices in-step with what employees predicted. In other words, preemptively adjusting wages for expected inflation can MANUFACTURE real inflation!

Causes of expectation inflation:
-Expectation inflation can be caused by backward-looking, where people assume that past rates in inflation will continue into the future (people believe that history repeats itself)
-At the same time, if an economy has an extremely volatile inflation rate, it may take time for people to develop a psychological trend to respond to inflation- it takes a while to figure out how the pattern works and predict accurately for the future.
-Expectation inflation can also be forward-looking. Workers could look at governments' macroeconomic policies to predict what future changes may be in store (they can prognosticate).
-The main thing to remember is that in economics, we assume that people are RATIONAL BEINGS with their own best interests at heart. People try to use all available information to the best of their ability, and for the most part, they are correct. People can adjust rapidly to changes.

The TOTAL EFFECT: Changes in money wages are a combination of the gap effect and the expectation effect
-In this way, we can decompose an increase in the rate of wage changes into the gap effect (excess demand for labour) and the expectation effect (psychology)
-We can think of the expectation effect as the "cake" and the gap effect as the "icing", which causes increased wages changes on top of expected changes
-The total effect can be either positive or negative.

Monetary Policy in Canada

This is the last piece of the puzzle! This chapter is all about how the government of Canada uses policy instruments to change the money supply!

The central bank can set the money supply and let the market determine the interest rate

OR

The central bank can set the interest rate and the money supply will adjust to this interest rate

PROBLEMS WITH ADJUSTING THE MONEY SUPPLY DIRECTLY:
-The Bank of Canada (BoC) cannot directly control the money supply through the currency ratio and the reserve ratio (they can't control minds and make banks hold more or less assets and make people hold more or less money)
-Also, it's sometimes confusing as to which definition of the money supply should be used: H? M1? M2? Know know...

SO, the BoC sets the interest rate instead, and then accommodates for fluctuations and changes by using open market operations. (The US directly changes the money supply by printing more or less money, while Canada simply changes the bank rate)

There are 5 Different Policy Instruments The BoC Uses:
1: The Overnight Target Rate (Which is changes by changing the Bank Rate)
2: Buyback Operations (Specials and Reverses)
3: Shifting Government of Canada Accounts
4: Moral Suasion
5: The Announcement Effect

NOTE** It's important to know the difference between operational targets: usually, governments can only target one factor, so they have to choose between targeting

a) The Exchange Rate (from 1962-1970, Canada targeted the exchange rate and tried to keep its external value at 92.5)
b) The Interest Rate/Money Supply (from 1975-1982, the BoC would adjust interest rates to affect the money supply through the liquidity preference system. The problem was that interest rates became extremely volatile, and the government had no way of controlling the price level)
c) The Inflation Rate (the BoC uses interest rates and money supply as a policy instrument to affect the inflation rate, so the operational target is currently PRICES. The BoC tries to keep inflation at about 2%, because a little bit of inflation is healthy

Policy Variables: These are the ultimate targets for policy changes
Y - stable economic growth
U - low unemployment
P - Low Inflation !!! THIS IS THE PRESENT GOAL OF THE BoC

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THE 5 POLICY INSTRUMENTS

1: THE OVERNIGHT RATE

Note* the interest rates on borrowing increase as the term of the loan grows longer (as a compensation for leaving money inaccessible for a longer amount of time)

The Overnight Rate: This is the daily interest rate which chartered banks charge each other for borrowing money (or that investment dealers charge to banks for borrowing money) in cases where they have insufficient funds to clear cheques. These loans have a very short maturity (the term is extremely short) and the interest rates are MARKET DRIVEN

The BoC is the LENDER OF LAST RESORT

The Bank Rate is the rate which the BoC charges to lend to money to chartered banks. This is the upper limit of the overnight rate. Because the bank rate is so high, most chartered banks will not borrow from the bank of Canada unless all other sources refuse to loan them money

The Overnight Rate Operational Band: This is the difference between the highest overnight rate (the bank rate) and the lowest overnight rate (the rate the BoC pays to borrow for depoits)
-It is measured in basis points (each basis point is worth 0.01%, so an operational band of 50 basis points would mean a difference of 0.5% between the highest and lowest overnight rates)

Overnight Rate Target: the midpoint of the operational band for overnight rates, as set by the BoC
-THIS is the policy instrument used by the BoC to affect the interest rate
-There are fixed announcement dates: the BoC announces the overnight rate target 8 times per year

The USA uses a slightly different system...


OKAY: so basically, the bank rate is FIXED by the BoC
-Money's liquidity (the demand for money) is given
-The BoC accommodates the money supply to ensure equilibrium in the money market
-The money supply is thus endogenous, and becomes determined from the interest rates and the demand for money!

1: BoC increases the overnight rate (i goes up)
2: Banks increase their target reserves to buffer against this higher opportunity cost of borrowing from the BoC
3: The money supply decreases (because the reserve ratio is higher)
4: The market interest rate goes up!

This is a long-about way of showing how the market interest rate (which includes the prime rate, the 5-year mortgage rate, and commercial lines of credit) is related to the overnight interest rate!

NOTE* A change in the overnight rate target and other market interest rates usually happens very quickly BUT the demand for loans changes gradually (so the first step of the overall transmission mechanism is much faster than then subsequent steps)

As the demand for money changes, the BoC accommodates by using open market operations!

2: BUYBACK OPERATIONS (INCLUDING OPEN MARKET OPERATIONS)
-The BoC Uses Specials and Reverses to stabilize the overnight rate inside the operational band
-Buyback operations are used to fine-tune the overnight rate target within one basis point of the target

SPECIALS (Specials purchase and resale agreement):
-This is a transaction in which the BoC offers to purchase government of Canada securities from major financial players with an agreement to sell them back at a predetermined price the next business day
-This allows the BoC to put money into the system for one day
-This OFFSETS UPWARD PRESSURES on the overnight rate (by adding a bit to the money supply, the BoC decreases the interest rate a little bit)
-The BoC initiates SPRAs daily if overnight funds are generally trading above the target rate
-Differences between the purchase and the sale price determines the overnight rate

REVERSES (Sale and repurchase agreement)
-This is a transaction in which the BoC offers to SELL government securities to major financial parties with an agreement to buy them back at predetermined prices the next business day (this sale is called a reverse)
-Basically, this let's the BoC take cash out of the system for a day (by coaxing investors to temporarily store wealth in bonds instead of money)
-Reverses are used to offset downward pressures on the overnight rate
-The BoC initiates reverses daily if overnight funds are generally trading below the target rate

OPEN MARKET OPERATIONS (OMO): LONG RUN MONETARY ACCOMMODATION
-An OMO is the purchase/sale of government securities by the BoC in the open market for long run monetary accommodation
-Government securities are long run loans to the government
-Treasury bills are short term loans to the government
-These are auctioned off every Thursday, just like stocks, in a market

The BoC BUYS securities to increase excess reserves and attempt to increase the money supply
The BoC SELLS securities to decrease excess reserves and attempt to decrease the money supply

This analysis assumes that there are no cash drains, and that the reserve ratio remains constant in the long run (neither of which may be true)

3: SHIFTING GOVERNMENT OF CANADA DEPOSITS

Cash Management: The Bank of Canada shifts Government of Canada deposits to and from the Bank of Canada and the chartered banks. This is the major day-to-day instrument which the BoC uses to reinforce overnight rate targets within the operational band

Transferring money to a chartered bank increases their reserves, which allows the chartered bank to safely lend out more money, thus increasing the money supply
Transferring money from a chartered bank back to the BoC decreases chartered banks' reserves, which forces the chartered bank to lend out a smaller proportion of money, thus decreasing the money supply

4: MORAL SUASION

-The BoC enlists the cooperation of commercial banks
-This is possible because there is such a small number of banks in Canada
-Since there are not required reserves in Canada (required reserves are not legislated), this tool is more important
-For an example, the BoC may require an increase in settlement balances held at the BoC

5: THE ANNOUNCEMENT EFFECT

-There are fixed announcement dates where the BoC announces the bank rate (8 times per year)
-Like moral suasion, an increase in the bank rate sends a signal to the economy of the government's intentions, which can affect private investment (due to changed expectations)

CONCLUSION: The BoC fixes the overnight rate target, then uses buyback operations and shifting to reinforce it and open market operation to accommodate the demand for money in the long run

1: Policy instruments: The BoC sets the bank rate
2: The Money Market which defines reserves determines the money supply and the equilibrium interest rate
3: Transmission to real sector through the investment and net export effects

GAPBUSTING GUIDE

TO FIX A RECESSIONARY GAP (CREATE EASY MONEY)
-Decrease the target rate
-Increase the money supply
-Decrease interest rates
-Increase Investment and net exports
-Increase Aggregate Demand
-Y moves to the right, back to Y*

TO FIX AN INFLATIONARY GAP (TIGHTEN MONEY)
-Increase the target rate
-Decrease the money supply
-Increase interest
-Decrease investment and net exports
-Decrease aggregate demand
-Y moves left to Y*

The Transmission Mechanism

So... what happens when the money supply changes? How does this affect things? That's what we're going to figure out today!

Remember the marginal efficiency of investment function?

There are two reasons why interest rates and desire for investment are negatively related
-lower interest rates mean that there is a lower opportunity cost for investing (it costs less to borrow money)
-when interest rates are lower, investing in capital becomes more attractive than keeping money in bonds (so if buying a new mixmaster will have a 4% yield, my friend the baker is much more likely to buy one when an equivalently-priced bond would only give him a 2% yield)
-Investment is determined by the REAL interest rate: for simplicity's sake, just assume that there is no inflation in this model for now

SO: There is an investment transmission mechanism

Let's do this in steps

1: The government changes the money supply (we'll learn how in the next little while)
2: The change in the money supply, thanks to the way the money market works, causes interest rates to fall (this is liquidity preference theory)
3: Lower interest rates cause investment to increase (this is marginal efficiency of investment theory)
4: Increased investment causes the family of aggregate expenditure curves for this economy to shift up
5: A shift up in aggregate expenditure causes aggregate demand to shift to the right, indicating an increasing in GDP, a decrease in unemployment, and an increase in the price level

BE SURE THAT YOU CAN REPRESENT EACH OF THESE STEPS GRAPHICALLY! If you have any questions about that, just send me an email and I will spell it out for you! =D

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THERE IS ALSO AN EXCHANGE RATE TRANSMISSION EFFECT:

In open economies, consumers are not restricted to buying domestic bonds- they can also buy bonds sold by foreign governments. Thus, when the interest rate falls for one country in comparison with other countries, this makes that particular country's bonds less attractive for investors (if China's interest rate is 25% and Canada's is 4%, why the hell would you put your money in Canadian bonds [assuming the Chinese bonds were relative risk-free]). As a result, when domestic interest rates fall, investors tend to pull money OUT of the domestic economy and into foreign economies. This DEVALUES domestic currencies.

We know that when domestic currencies are devalued, this makes it more attractive for foreign economies to import domestic goods, and less attractive for local consumers to import foreign goods (for price-related reasons). Thus, net exports increases. This leads to an increase in aggregate expenditure, and subsequently, an rightward shift in the aggregate demand curve!

SO! There are 2 different pathways through which changes in the money supply can affect aggregate demand in an economy (and by association, Y, U, and P)

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THE LONG RUN NEUTRALITY OF MONEY

Classical economists divided the economy into real and monetary sectors: they believed that changes in the money supply only affected the price level, but would not impact GDP in the long run
MV = PY where V and Y are constant (money has a constant velocity, and GDP tends to return to its potential leve in the long run)

Modern economist now understand that in the short run, changes in the money supply CAN impact GDP through the monetary transmission mechanism. At the same time, they state that in the long run, the "anchor and chain" mechanism will bring GDP back to its potential level (through wage adjustment)

Pretend this graph indicated that the increase in AD was due to an increase in the money supply. In the long run, inflationary pressures cause wages to increase, which effectively raises costs for firms. This shifts aggregate supply to the left until the real GDP is back at Y*, but at a higher price level

Hysteresis: some economists debate that Y* can be affected by short run trends in Y, not just factors and productivity (for an example, a long-lasting recessionary gap may cause worker skills to depreciate, thus bringing productivity down, and consequently lowering potential GDP as well)

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SOME OTHER COOL THINGS
-Changes in the money supply cause larger changes in the interest rate when the money-demand curve is STEEP
-Changes in the interest rate cause larger changes in investment when the MEI curve is very FLAT

MONETARISTS: believe that the LPF is steep and the MEI is flat- they think that monetary changes can cause LARGE changes in GDP and price levels
KEYNESIANS: believe that the LPF is very flat and that the MEI is very steep- they think that monetary changes are much less effective than fiscal changes in affecting GDP and the price level

That's all for now. Only one more bit to cover for the midterm! =D

The Demand & Supply for Money

The Liquidity Preference Function: This shows people's preference to hold money (cash balances) rather than bonds (interest bearing assets)

-People have a choice between holding their wealth in one of two ways: bonds or money
-Money pays no returns, and bonds do pay a return
-The opportunity cost of holding money is the interest rate one earns on a bond
-People only want to hold money when it provides benefits which at least equal the cost of forgoing bond interest

3 REASONS WHY PEOPLE HOLD MONEY

1: TRANSACTION DEMANDS FOR MONEY
-People hold money so that they can make transactions

2: PRECAUTIONARY DEMAND FOR MONEY:
-People hold money in case they experience an emergency where money would is required
-There is uncertainty sometimes about the timing of receipts and payments, so it can be strategic to have a buffer of cash savings to "tide yourself over"

3: SPECULATIVE DEMAND FOR MONEY:
-People hold money because they believe it will be more strategic to buy bonds in the near future than in the immediate present (if the interest rate is really low, for interest, waiting for the interest raise to rise before buying bonds will be more financially strategic)

The transaction and precautionary demands for money account for the distance between the money demand curve and the Y-axis. When the demand for money shifts to the left or right, this is usually due to a change in transaction demands (for an example, if GDP increases or prices increase, consumers will have higher transaction demands)

The speculative demand for money explains why the liquidity preference curve is downward sloping: the opportunity cost of holding money increases as interest rates increase, so the higher the interest rates, the lower the demand for money (this is dependent on nominal interest rates, rather than real interest rates, as this is a PSYCHOLOGICAL, rather than an accounting effect)

Income, Prices, and The Nominal Interest Rate Affect Demand for Money!

The higher income is, the more transactions there are within an economy, so the higher demand for money will be
+ Positive Relation

The higher the nominal interest rate, the lower the demand for money will be, for reasons related to opportunity cost
- Negative Relation

The higher the price level is, the higher demand for money will be (this is called inflationary demand for money), because a greater monetary value of transaction will be required to facilitate the same amount of real spending: households need more money to carry out their transactions.
+ Positive Relation

Note* when interest rates are very very very high, the only demand for money is transaction demands (so this is the space between the liquidity preference function's asymptote and the Y axis)

THE SUPPLY OF MONEY

-The money multiplier is relatively constant
-The currency ration and and reserve ratio only change during times of uncertainty (usually, they both increase when the future is murky)
-The money supply is independent from the interest rate (although it affects the interest rate)
-In our model, we say that the money supply is a constant, and that it is perfectly inelastic: it is represented by a straight line on our graph
-The real money supply is M/P: this describes money's purchasing power in terms of goods and services


PUTTING SUPPLY AND DEMAND TOGETHER: MONETARY EQUILIBRIUM
(This is also called liquidity preference theory of interest, or the portfolio balance theory)
-This is a short run analysis of how interest rates are affected by the money supply- it is very different than the long run analysis we talked about earlier

Okay: So..
-The supply of money is perfectly inelastic (a vertical line)
-The demand for money varies inversely with the interest rate (it is a downward sloping curve)

Equilibrium occurs when demand and supply for money intersect: M = L

Notice that because the demand for money is downward sloping, the money supply affects equilibrium interest rates: a higher money supply renders lower interest rates, while a lower money supply renders higher interest rates

Monetary equilibrium is a stable equilibrium: if there is higher demand for money than money supplied, then a large number of people will begin to sell-off their bonds to generate some extra money. Because of an excess influx of bonds being sold on the market, the price of bonds will fall, while their relative yields will increase. This, in turn, causes the interest rate to rise, and it will rise until the money market is in equilibrium. A similar mechanism returns interest rates to an equilibrium level when there is an excess supply of money.

That's all for now!

Bonds!

TODAY: WE ARE GOING TO LEARNING ABOUT THE MONEY MARKET: This basically let's us understand how the money supply determines the interest rate

BONDS: What are bonds...

Well... Wealth is accumulated purchasing power, and wealth can be held in assets, or "things which you own" -This includes both money and "interest bearing assets"

Any household's financial portfolio includes a combination of money and interest bearing assets- choosing a different investment plan is just a matter of deciding how much of your wealth you wish to hold as money, and how much of it you wish to hold as an asset

Money has no risk of lost value (other than inflation), but also does not give you any returns as an investment

Interest bearing assets include bonds (IOUs from companies or the government), stocks (shares of control of a company) and other things (like real estate). They contain an element of risk, in that they can decrease in value over time and cause you to lose money, but on the other hand, they can generate returns (so you can profit off of investing of interest bearing assets if they increase in value)

TO SIMPLIFY OUR MODEL (for now) WE'RE GOING TO ASSUME THAT THERE ARE ONLY TWO KINDS OF ASSETS: MONEY & BONDS!

So.... Here's a chart

Money: Cash in circulation, as well as deposits held in checking accounts: it has no risk, and generates no returns
Bonds: All other forms of interest bearing assets: it has risk, but can also generate returns
Debt: An interest-earning financial asset: this is a synonym for a bond: when you are a creditor, loaning money to a company, you are effectively buying a debt. There is some risk involved (because there is a chance that the company will go bankrupt and be unable to pay back the loan), but there is also a guaranteed rate of return, as determined by the bond agreement.
Equity: Claims on real capital: This describes stocks, which are a "gift" to companies. Companies may pay dividends to stockholders, but there is no guarantee of this.

BOND TERMINOLOGY: This is dense, awful stuff, so get ready

A BOND: A financial contract to pay fixed amounts at future specified dates, and to repay the principal (a loan agreement or a debt are both synonyms for bonds)
A DEBTOR: A borrower, or someone who sells bonds
A CREDITOR: A lender, or someone who buys bonds
THE INTIAL PRICE OF THE BOND: The original loan value or face value of the bond (ie: the principal)
A COUPON: The dollar value of the fixed returns on the bond
THE COUPON YIELD: Coupon / Initial Price (so, if the bond was valued at $100, and the coupon was $10 for a one-year loan, the coupon yield would be 10%, because 10/100 = 0.10

Initial Price * Coupon Yield = Coupon
100 * 10% = $10 Coupon!

PRICE OF THE BOND (Pb): Originally, this is the face value, or principal of the bond, BUT once the bond is sold, it is the present value of the bond in the market (so the price of the bond can change depending on market conditions)
PRESENT VALUE (PV): A discounted value of all future expected income streams using the MARKET RATE OF INTEREST (the discount rate). The price of the bond which a buyer is willing to pay to receive a future income stream provided by a bond
BOND YIELD: How much money you will make off of the bond- this is determined by a combination of the coupon, plus capital gain (as bonds are a form of asset, and can gain value depending on market conditions)
MARKET YIELD (i): The 'average' interest rate in all money-bearing assets currently in a market: the time-sensative value of money (in other words, the minimum rate on interest which you would impose on debtors to loan them money)
TERM (t): The time it takes to completely pay off a bond (principal and coupons)
JUNK BOND: A riskier, high-yield bond (BBB)

Basic ideas:
-The Present Value is equal to the Price of the Bond, which is equal to the face value of the bond at the time of issuance if the market rate of interest is equal to the coupon yield (which it usually is), because the present value, if you use the market rate, will be the face value
-The Present Value is equal to the Price of the Bond, which is equal to Face Value of the bond at maturity, because the bond has no return at that point: just principal
-As a lender, returns higher than those for the market rate are desirable

Note*

There are 3 yields (or rates of return, or interest rates)
-The coupon yield (which is guaranteed, according to the bond agreement)
-The bond yield (which can change depending on market conditions)
The market yield (which is the interest rate of money-bearing assets currently in a market): generally, coupon yields for bonds are set at the market rate for the time when they are issued

demand for money is a function of the NOMINAL rate of interest

Three cases where bonds are sold
Case 1: The bond is price "at par"
Case 2: The bond is sold at a discount (it is worth less in the market than it's face value, so it is sold for less than its face value
Case 3: The bond is sold at a premium (it is worth more in the market than it's face value, so it is sold for more than its face value)

Interest rates affect the present market value of bonds.

The price of bonds varies inversely with interest rates!
R = return one year hence
i = annual market rate of interest (sometimes called the discount rate)
PV = Present value

PV = R/(1 + i)

PV = R/(1 + i)-exponent t (where t is the number of years in the future)

So if the return on a bond one year hence is $110, and the interest rate is 3%, then
PV = 110/(1.03)
PV = $106.80

If the return on a bond is $120 in two years and the interest rate is 10%, then
PV = 120/(1.10)^2
PV = $99.17

The price of a bond is the present value of that future income stream
-The buyer will not pay more than PV for the bond, and the seller will not sell it for less than PV
-The higher the interest rate, the lower the present value of the bond, and vice versa, in order to keep the coupon yield equal to the market interest rate. Basically, we just always fiddle with the present value to make the bond yield equal to the market interest rate (or simply "the" interest rate)

Pb * Bond Yield = Coupon

On most bonds, only the coupon yield is constant.

So, with a given face value, or original bond price of $100, and an original market interest rate of 10%, the issuer of the bond (the borrower) will offer a coupon of $10, or a coupon rate of 10% to compete in the market. This means that the coupon will be $10

Coupon yield = Coupon/Face Value
10/100 = 0.10 = 10%
Bond Yield = The market rate of interest, so there is no capital gain initially...

BUT

let's say that the market interest rate jumps to 20%

The present value of the bond falls to around $60
The price of the bond falls to around $60
-The bond yield (including the present value of future payments + capital gain as the bond approaches maturity) rises to market interest rates of 20%

That's all for today!

MONEY MONEY MONEY

Money Money Money!


THE NATURE OF MONEY

-Classical economists arbitrarily divided economies into the real sector, and the monetary sector.
-The REAL SECTOR describes the allocation of resources to produce different goods
-Resource allocation (use of factors) is dependent on relative prices
-Relative prices affect output (so if wood is cheaper than brick, an economy will produce more wood houses than brick houses

-The MONETARY SECTOR encompasses changes in the money supply (how much money is circulating in an economy)
-Most economists believe that a change in the money supply would just change the absolute price level in the long run
-If relative prices do not change (ie: the price of both wood and brick rises proportionately), then this will not change the allocation resources
-This shows the NEUTRALITY OF MONEY (A change in the money supply can change the macroeconomic price level, but it will not change relative prices, or GDP)
-The amount of money circulating in an economy affects ABSOLUTE prices, but not relative prices (so while the price of wood will go up, so will the price of bricks, and consequently, the price of houses)

-In modern economic theories, money supply has no long run effect on GDP (it only affects the price level)
-In the short run, however, money supply can affect both price level and GDP

This is the exchange identity: MV = PY : The velocity of money (the size of the money supply multiplied by the amount of times money is used in an economy) is equal to the general price level multiplied by real output. In other words, what you give up (the amount of many people spend to get things) is equal to what you get (the value of the real goods produced by an economy)

THE DEFINITION OF MONEY: 3 ESSENTIAL CHARACTERISTICS

1: Money is a medium of exchange
-Barter requires the "double coincidence of wants" (you have to want what I have, and I have to want what you have)
-Because such situations rarely occur, money is an excellent "in-between" medium-of-exchange for facilitating trade

There are stipulations, however!
1: Money only works as a medium of exchange if people expect that others will accept their money as a legitimate form of payment
2: Money should have a generally high value relative to its weight (or else it will be awkward to exchange: can you imagine if sand or dirt were money, for instance!)
3: It must be divisible (you can divide a dollar in half. You cannot divide a live cow in half)
4: It must not be counterfeit-able (which explains the elaborate construction of dollar-bills)

2: Money is a method of storing wealth
-Earning and spending are not synchronized (ie: you may work on a Monday, but not wish to buy anything until a Saturday)
-Money has stable value which does not diminish over time
-It is a method of deferred payment (this is sometimes cited as the 4th role of money)

3: Money is a unit of account, or financial measurement
-We use money as a unit of measurement: we measure different transactions using dollars, thus it is a sort of accounting unit which facilitates accounting.

NOTE* Demand deposits (aka: deposits into an easily-accessible checking account) count as money, as they satisfy all of these conditions!

THE ORIGINS OF MONEY

1: Commodity Money
-Money was originally precious metals, such as gold
-These were generally recognized as valuable and accepted as payment in most places- they did not wear away or lose value over time, and they had a stable value

Problems:
-Originally, these metals were carried in bulk, so they would have to be weighed, and then stamped by a ruler, guaranteeing the weight of "face value"
-Clipping and shaving
-debasement led to inflation and Quantity Theory of Money

Gresham's Law:
-Bad money forces good money out of the system
-People will hang on to money with high intrinsic value (because it is a very good method for storing wealth)

2: Token Money
-To overcome the problems associated with commodity money, would was deposited at a goldsmith's vault for safekeeping. The goldsmith would give owners a receipt, and this receipt of ownership of the gold was exchanged, rather than the gold itself. Eventually, banks replaced goldsmiths, performing a similar function
-Bank notes were paper money, which were FULLY BACKED by gold (ie: convertible on demand)
-A country whose money is fully backed by gold is on the gold standard

3: Fractionally Backed Money
-Banks discovered that while some customers withdraw gold, and some customers deposit gold, most of their customers are simply trading indirectly using bank notes
-Thus, banks could issue more notes convertible to gold than they actually have gold in their vaults as reserves, and then charge interest on this lent money to generate profits.
-The fraction of money held in reserve affects the money supply: the higher the amount held in reserve, the lower the money supply (because money held in banks cannot be in circulation)

4: Fiat Money: Legal Tender
-Here, the state promises that a certain form of paper or coin currency is legally money, so it becomes money
-Over time, central banks took control of the note issuance: while it was originally backed by gold, it is now only fractionally backed
-Ultimately most of the money we deal with on a day to day basis is not backed by gold at all (for instance, if we went to the neighborhood bank, deposited a cheque, and asked for gold, the teller would probably think we were very strange)
-Most countries abandoned the gold standard by 1940 (WW2)

Legal Tender: The law requires that this be accepted to repay debts- refusal discharges debt.
-Fiat money is backed by the productive capacity of an economy
-Fiat money is valuable because it can purchase goods and pay debts (today's money is fiat money)

5: Bank Deposits (Modern Money)
-Money held by the public in the form of deposits withdrawn on demand from banks (no notice is required)
-(Checks and debit cards, however, are not considered money)
-Bank deposits function on a fractional reserve system: banks create money by granting more loans than deposits to cover them (so if a run on the banks were to occur, the banks would not actually have enough money on hand to pay everyone back.

THE CANADIAN BANKING SYSTEM:

Canada (and many other countries) has a central bank which controls the money supply (the bank of Canada, which a run by a "governor" of the bank of Canada)
-Although the Bank is owned and operated by the government, it operates separately from the cabinet on a day to day basis: it is ultimately held responsible the cabinet, however.

In Canada, our current governor of the Bank of Canada is Mike Carney (Monetary Policy) and our current minister of finance is Jim Flaherty (Fiscal Policy)

THE FUNCTIONS OF THE BANK OF CANDA

1: It is the Bankers' Bank
-It is a lender of last resort to Chartered Banks (they can lend money from the BoC if they have to)
-Chartered Banks have their checking accounts at the Bank of Canada (reserves)
-As of 2002, about $1.2 billion was actually held in asset form at the bank of Canada

2: It is the government's bank
-The government has a chequing account at the BoC
-The government replenishes this account from larger accounts at Chartered Banks
-The BoC's monetary tool is "switching" the location of government accounts (between the BoC and Chartered Banks)

3: It regulates the money supply
-It prints money (this is only done as a reaction in Canada)

4: It regulates financial markets
-It prevents panic and bank failures
-Financial intermediaries (chartered and commercial banks) borrow short term and loan long term from the BoC, so increases in the bank rate squeezes them, and makes the "overnight market" less attractive: basically the higher the BoC sets the bank rate, the higher Chartered Banks will set their prime rate in order to continue to profit, and the more money they will hold in reserve to avoid getting "dinged" with interest for borrowing from the government should a customer seek to withdraw money
-The BoC is concerned about the exchange rate

So, the money supply involves the government, central banks, and chartered banks

The Canadian System

Canada- few banks with many branches (the banking sector is much more like an oligopoly)
USA- many banks with fewer branches (the banking sector is much more like monopolistic competition)
The systems are a bit different, but they essentially function the same way

COMMERCIAL BANKS: Includes chartered banks (formed prior to 1980), smaller banks trusts and credit unions, and foreign banks
A commercial bank is a profit-maximizing private corporation

Chartered Banks
-They hold deposits (trust companies also do this)
-They transfer deposits by cheque (the post office also does this)
-They make loans (credit unions also do this)
-They invest in government securities (insurance companies also do this)
-The government used to require the chartered banks to old money on reserve, but this is no longer required after reforms to the Bank Act (1980)

Interbank Cooperation
-Several Banks can make pooled loans to large companies (which they all benefit from due to the interest paid)
-Charted Banks must now compete against credit card companies
-Debit Cards
-Cheque clearing distinguishes chartered banks (they will turn cheques into money!)
-A clearing house settles interbanks debts: the net difference is accomplished by change in deposits at the bank of Canada

Chartered Banks are Profit-Maximizing Private Corporations:
-Their main asset is securities and loans
-Their main liability is deposits
-They make profits by borrowing money for less than they lend it for
-Competition is strong among different banks, which leads to competitive rates, which is good for consumers

The Big 5:
Royal
Toronto Dominion
Scotia
CIBC
BMO

Note* Our prof usually refers to chartered and commercial banks interchangeably

RESERVES
-Their purpose is to meet demands on deposits for chartered banks
-A RUN ON THE BANKS is when more depositors wish to withdraw more deposits than there are reserves

WAYS TO AVOID A RUN ON THE BANKS:

1: Reserves- the BoC can induce an INCREASE in reserves and avert a run on the banks by
-Loaning money directly to chartered banks
or
-Open Market Operations: buying securities from Chartered Banks

2: The Canadian Deposit Insurance Coporation
-A Federal Crown Corporation
-Insures deposits in any one account up to $100,000
-A problem is that this insurance is an incentive for banks to pursue riskier investment options "if this investment makes us money, the depositor wins- if it loses us money, then the taxpayer loses"

TYPES OF RESERVES:
1: A Reserve Ratio is the chartered bank's fraction of deposit liability held in Cash of BoC deposits

Actual reserves = reserves the Chartered Bank actually holds
Target reserves = reserves a Chartered Bank wishes to hold
Excess reserves = reserves a Charted Bank holds above target
Secondary reserves = liquid assets convertible to cash (ie: T-bills, and government bonds)

The old bank act required banks to hold reserves for stability and confidence in the system, and to regulate the money supply

Competition from intermediaries and international banks who were not required to hold reserves lead to the elimination of required reserves. Now, the BoC uses the "overnight target rate" (how much interest it charges target rates on overnight loans) to regulate reserves and control the money supply

Presently, actual reserves are about 0.5% of total Chartered Banks liabilities (so we are using a fractional reserve system)

THE FRACTIONAL RESERVE SYSTEM

The reserve ratio is much much less than 1, at about 0.5% of total liabilities. Chartered banks only hold a small portion of deposits on reserve, and the BoC will bail them out if reserves are too low to meet demands on deposits.

The Cost for chartered Banks of borrowing from the BoC (the Bank rate, or the "overnight rate") determines how much reserves banks will hold. An increase in the cost of borrowing will induce the Chartered Banks to hold more reserves

BANK RATE INCREASES ---> BANKS HOLD MORE IN RESERVES
BANK RATE DECREASES ---> BANKS HOLD LESS IN RESERVES

Target reserve ratios are now determined independently by Chartered Banks, but there is incentive for them to still hold some reserves on hand, in order to avoid losing money: the Bank rate determines the opportunity cost of the risk of loaning out more than is on reserve for Chartered Banks.

The Creation of Money!

Assume:
-There is a fixed reserve ratio
-There are no leakages or cash drains (this implies that a change in the money supply will manifest as a change in deposits)

2 Conditions are required for Banks to Make Money

1: The Public must be willing to use bank deposits as money

currency ratio = (public cash holdings/public bank deposits) or C/D

2: banks must be willing to use the fractional reserve system

reserve ratio = (reserve assets/deposit liabilities) or R/D

If the currency ratio is equal to 1, then there is no banking system
If the reserve ratio is equal to 1, there is no creation of money (there is just safety deposit boxes)

The Creation of Deposit Money

Assume:
-cr = 0 (all of the cash is deposited in banks)
-rr = 0.20 (banks loan out 80% of their deposits)

The creation of money is possible due to the fractional reserve system

Changes in the money supply are equal to deposits or withdrawals / The reserve ratio

The currency ratio acts as a cash drain, or leakage. The uncertainty of the banking system increases the currency ratio and decreases the multiple expansion of the money supply (the more cash people hold onto instead of converting into a bank deposit, the smaller the change in the money supply due to banks loaning out money)- we saw this sort of thing happen in 2008 with the US financial meltdown- people lost faith in the banks and wanted their money back, so the money supply in the United States suddenly decreased.

On the other hand, deposits are very convenient (thanks to debit cards), which decreases the currency ratio

High Powered Money (H) is "cash": a combination of cash held on reserve by banks, and cash in circulation within the public.
H = rr * D + cr * D

THE MONEY MULTIPLIER

Money Supply = M

M = D + C (bank deposits + money in circulation)

But, C = cr * D

so

M = (1 + cr)D

H = R + C

R = rr * D and C = cr * D

Therefore, H = (rr + cr)D

The money multiplier = Changes in M/Changes in H
= (1 + cr)/(rr + cr)

If the currency ratio = 0, then the money multiplier = 1/rr

If banks want to hold more money (the reserve ratio increases) or if the public wants to hold more cash (the currency ratio increases), then the money multiplier gets smaller: basically, the more loanable money which is held in banks, the higher the multiplier effect for money!

AN EXAMPLE OF THE MONEY MULTIPLIER

Assume:
-A constant reserve ration of 0.20
-cr = 0

Person 1 deposits $100 in the bank.
The bank loans out $80 to person 2
Person 2 deposits $80 in another bank
The bank loans out $64 to person 3
Etc...

With each transaction, the money supply increases by a decreasing amount (it works similarly to the expenditure multiplier effect)
So, let's do the math: 100 * the money multiplier = 100 *(1/0.20) = 500!

Monetary Base (H) = C + R - this is the amount of cash in an economy
Money Supply (M) = C + D - This is the amount of money in an economy (because not all money is cash!)

Variable reserve ratios make the the money multiplier equation complicated, but it still works

Cash Drains: Money creation is not automatic- it depends on public and bank behaviors
Public: Uncertainty causes the cr to increase, which makes it harder to create new money
Bank: Uncertainty causes the rr to increase, which makes it harder to create new money

TYPES OF DEPOSITS

Demand Deposit
-Can be withdrawn on demand (no notice required)
-Money can be transfered via cheque

Savings Deposit
-Notice of withdrawal required
-Non-transferable by cheque

Term Deposit
-Chequable savings accounts are now available, so the old distinction isn't as useful
-Today, "term deposit" distinguishes "notice accounts" from other accounts
-A deposit must be left in the account for a term: if withdrawn early, there is a reduced interest rate on that money (so the depositor gets less bang for their buck)

Definitions of the money supply
H = High Powered Money, or cash in public and cash in reserves
M1B = Cash in public + Demand Deposits (this emphasizes the exchange medium function of money)
M2 = M1B + savings deposits at chartered banks (emphasize money's wealth storage function)
M2+ = M2 + Deposits at other intermediaries, including credit unions, trust companies, insurance companies, and MMFs
M2++ = M2+ and all other mutual finds + Canada Savings Bonds

The BoC uses M2's to control inflation.

Near Money and Money Substitutes

There is debate over the definition of the money supply: if a medium of exchange is important, than M1B should define the money supply. If a storage of wealth is important, than deposits that pay higher returns but are not chequable (ie: the M2 series) should count as part of the money supply

Near Money is not a good medium of exchange, but it IS a good store of wealth (like Savings Bongs, Mutual Funds, and Money held in trust accounts)
Money Substitutes are good methods of exchange, but not good methods of storing wealth (like credit cards and debit cards)

Whew. That's all!

GROWTH ACCOUNTING

It is generally believed that labour accounts for about 2/3 of all income generated, and that capital accounts for approximately 1/3 of national income

as such, percentage-growth in potential national income is = to the percentage change in the level of technology + 2/3 * the percentage change in labour + 1/3 * the percentage change in capital

MEASURING TECHNOLOGICAL CHANGE

-It is impossible to directly measure technological change. Solow tried, and got a Nobel Prize.

-The Solow growth model included only 3 independent varaibles: labour, capital, and "other"

-This "other" is the "Solow Residual" or "Total Factor Productivity" or "A" (in our model). It captures all growth in GDP which is not accounted for by changed in N (L and H) and K.

-BIG PROBLEM HERE: Solow's model included both the quantity and quality of labour and capital, and a great deal of technological change is EMBODIED with labour or capital (so technology factors into labour or capital, and cannot always be separated them from). For instance, if one of my shitty sweat-shop sewing machines breaks down and I decide to replace it with an uber-fast, ultra-modern sewing machine, the capital stock will remain the same for my sweatshop, but the technology level has increased.

-As such, the Solow residual underestimates true technical change (as it can only include disembodied technological changes)

--------------------------

The Cobb-Douglas Aggregate Production Function is an example of an aggregate production function with 2 characteristics
-The law of diminishing marginal utility
-Constant returns to scale

For this APF, Y = A * N(2/3) * K(1/3)

Here, equal growth rates in labour and capital cause total GDP to grow at the same rate (as it would in a steady state)

y = A * k(1/3)

This is the per-capita APF, where y is per-capita GDP, and k is the capital-labour ratio
Equal growth rates in both labour and capital (ie: a constant k) cause y (per capita GDP) to remain constant

SO: BIG QUESTION: HOW DO WE ALLOW FOR GROWTH?

1: Increase savings (let per capita savings become larger)- in order for growth to occur, the economy requires sufficient savings to increase the capital stock faster than the population growth.

If you are in the Robert Gateman club of not-breeding, choosing NOT to personally contribute to population growth can also help economies grow here...

2: Increase technology: This requires infrastructural developments (health, education, law, physiological needs such as food and water taken care of), and many such developments are difficult for developing nations to set up.

WHY IS TECHNOLOGICAL CHANGE IMPORTANT?

Technological improvements lead to increased productivity, which increases the potential per-capita GDP

Embodied Technical Change = technical change intrinsic to the particular human or unit of physical capital in use: it is a change in the quality of the input (so a higher education, or a computer upgrade would both be examples of embodied technical changes)

Disembodied Technical Change = technical change that is NOT intrinsic to human or physical capital in use. This is a change other than to the quality of the capital (so if my sweat-shop fore-woman comes up with a fantastic new sewing procedure which halves the time it takes her to sew a sneakers, and then she teaches all of her sweat-shop buddies how to sew like this, that new technique would be an example of a disembodied technical change)

Usually, disembodied changes eventually become embodied, so the distinction becomes less important over the long run.

CONVERGENCE HYPOTHESIS: This an interesting theory, and there are 2 different facets of it

1: Absolute Convergence: the tendency for GDP AND Growth Rates in GDP to be equal across nations: each nation will have the same steady state values for y* and k*
-This assumes that different countries have the same marginal propensity to save, the same rate of population growth, and the same rate of technological improvement
-This theory states that if two countries have the same growth model, then even if one starts farther to the left, they will both end up with the same standard of living

2: Conditional Convergence: the tendency for Growth Rates in GDP to be equal across nations: each nation will have the same steady state values.
-This theory assumes different marginal propensities to save for different nations, different population growth rates, and different technological growth rates
-This theory acknowledges that different countries will have different per-capita GDP, but states that they will have THE SAME GROWTH RATES!

-------------------------------------------------

NEW GROWTH MODELS

The Neoclassical Growth Model made growth dependent on exogenous variables such as population growth, the savings rate, and the rate of technological change.

Some new growth theories alter the 2 assumptions of the Neoclassical Model:
-Instead of technology as exogenous, they state that technological changes can be explained within the economic model
-Instead of having diminishing marginal returns, some new growth models suggest that the marginal product of capital is constant, or that there is even increasing marginal product of capital over time!

-----------------------------------

ENDOGENOUS TECHNOLOGICAL CHANGE:
Endogenous growth is self-sustaining growth
In this theory, we assume constant marginal product of capital
For an example, if the price of an input rises, firms will develop a new technology rather than just switching to an existing alternative input (so market structures and competition can facilitate technological change)
-Some people believe that competition foster technological change: others believe, especially in the case of health technologies, that only monopolies can risk the large expenditure required to create new drugs

LEARNING BY DOING: In the 1940s, Shumpeter said that innovation was a one-way street- that research caused new developments, which led to new machines and new products. Today, things work different: it is more of a 2-way street. There is a feedback mechanism (ie: the Japanese method of building cars, where the mechanics and workers collaborate with the designer in order to streamline research and production in such a way that is productively efficient).

SHOCKS and INNOVATION:
-Different countries respond to economic shocks in different ways. Some will find different countries to produce goods in where costs are cheaper: others will change production methods and increase technology to make it more cost effective!

---------------------------------------

INCREASING MARGINAL RETURNS TO INVESTMENT: Here, each new addition to the capital stock is more productive than the last.

There are 2 sources of increasing marginal returns to investment:

Market-Development Fixed Costs (Paul Romer)
-The original investment into new knowledge or technology has a large fixed cost
-Adopting or adapting this new technology once it has already been established is cheaper
-Also, consumers, wait to use new technologies
-In this way, the costs decrease as more and more people adopt new technologies, so the returns to scale increase with increasing investment

Knowledge
-It is a public good, so it is not subject to the law of diminishing marginal returns
-New ideas are non-excludable and non-rivalrous (as much as copyright laws try to prevent people from accessing them)
-New ideas are pure public goods
-New ideas may not suffer diminishing marginal returns
-SOOOO, because ideas play such a big role in economics, and ideas are practically unlimited, economics doesn't have to the be DISMAL SCIENCE! Yay!

------------------------------------

LIMITS TO GROWTH

-1970s, the club of Rome published a book called "Limits to Growth"
-This book predicted that increased growth would eventually destroy the earth's resources...

Here is their usual anti-growth argument: growth will look like more of what we witness today: production of mostly useless, impractical consumer goods with a short lifespan, which end up in the landfills in a couple of years.

This could be countered with the argument that growth can still occur, but under that condition that instead of producer large quantities of shitty goods, we focus on producing higher-quality, cleaner, longer-lasting, more efficient products.
-Growth permits societies to protect the environment and help the poor (if you haven't noticed, environmental protection legislation is more a by-product of mature industrial economies, and less-so of developing nations)
-The thought is that market participants will react to supply shortages, and innovate around them (ie: by the time oil runs out, productive processes will have innovated away from it)

RESOURCE EXHAUSTION
-Limits to growth are based on fixed technology and resources
-BUT, technology leads to more efficient resource use
-AND technology leads to the discovery of new resources
-Problem: THERE ARE TOO MANY PEOPLE: More people on the earth means that we will require more resource expenditure

POLLUTION:
-Economic growth creates pollution. Nuff said

Although many economists believe that growth creates opportunities for humankind to combat resource depletion and pollution through increased technologies, a lot of these beliefs are based on blind faith.

Like... we are basically relying on our ability to innovate away from these problems...

but what if we simply can't do that? Then what..............?

The Neoclassical Growth Model and Steady States

THE NEOCLASSICAL GROWTH THEORY: This focuses on capital accumulation, and how it is affected by savings

One important function in the neoclassical growth theory is the AGGREGATE PRODUCTION FUNCTION. This function shows the relationship between total real output and total inputs (sort of like a "macro" version of the production function for individual firms we saw in microeconomics)

REMEMBER from the last leccture? There are three main determinants of economic growth: labour, capital, and technology. Well, with the aggregate production function, we say that output is technology times a function of labour and capital

Y = A x F(N,K) where A = total factor productivity (disembodied technology), N = Labour and Human Capital, and K = capital (both quantity and quality)

Now what happens if we divide through by N?

Well, we get

y = A x F(k) where y is the amount of GDP produced per worker, and k is the amount of physical capital available for each worker

Also, potential output is also representable here

Y* = A x F(Nfe, Kfc) where Nfe is full employment, and Kfc is full capacity. In other words, potential output is technology times a function of labour at its full employment level, and physical capital at its full- capacity level

Some important things to remember:
We assume in the long run that income is at its potential level (that there is no output gap)
L is labour quantity, H is labour quality, and N includes both the quality and quantity of labour.
K includes both the quality and quantity of physical capital
We omit land as a factor input for the sake of simplicity in this model
Technology includes entrepreneurship and savviness

PROPERTIES OF THE NEOCLASSICAL AGGREGATE PRODUCTION CURVE

1: In the short run, there are diminishing returns to scale: as more of a variable factor is added to a given amount of fixed factor, the additional output generated by the added factor (the "return") will get increasingly smaller and smaller: they will diminish... ceteris paribus (they will diminish if all other things are held constant) after a certain point (they will not begin to diminish immediately)
But, this is only true of the short run when one factor is increased, and all other factors are held constant!

2: In the long run, there are constant returns to scale: When all factors increase the same amount, output will also increase by that amount (so if I double the amount of workers and also the amount of sewing machines, my sweat shop should double its output of shitty sneakers!)

3: Technology is nuetral: A affects the productivity of K and N equally, so although technology is present, it will not disproportionately impact any one factor.

Image Plz! y = f(k)

4: Steady state equilibrium: Here, the per-capita capital (k) and the per capita output (y) remain constant over time, so /\y = /\k = 0

If the population is growing at n, then income and capital must also grow at the same rate in order to remain in a steady state equilibrium. In other words, in order to be in a stead state equilibrium, the percentage change in output must equal the percentage change in capital, which must = the percentage change in the workforce.

y* and k* are the steady state values (they don't change over time)

Investment required to provide capital for new workers and to replace machines that have worn out (depreciation) is just equal to the national savings in a steady state equilibrium, so New Capital + Replacement Capital = Investment = Savings

If savings is greater than investment, than capital per worker will increase, and thus output per worker will also increase

If savings is just equal to investment, then the capital per worker will be k* and thus output per worker will be y*

When savings is equal to required investment, the economy is in a steady state equilibrium, each worker will have access to k*, and will produce y*

MORE ON THE STEADY STATE

To maintain k at a constant rate, investment depends on both population growth and the depreciation rate. Some of investment will have to go to the new workers

WE ASSUME that the population growth rate is constant: thus, to keep capital per worker constant, you must grow capital by nk (the population growth rate times the amount of capital per worker)
WE ASSUME that the rate of depreciation is constant: thus to keep capital per worker constant, you must grow capital by dk as well (the depreciation rate times the amount of capital per worker)

The level of investment required to fund all of this capital growth to maintain a constant capital-worker ratio can be represented by
I = (n + d)k

THE SAVINGS FUNCTION
Here, we assume that we have a frugal economy (there is no government or international trade)
We also assume that the marginal propensity to save is constant
So:
S/N = sy = sf(k)
in other words, per capita savings are a function of per-capita output, which in turn, is a function of the labour-capital ratio

PUTTING IT ALL TOGETHER:
The net change in the capital-labour ratio is equal to the excess of actual savings over required investment
/\k = to per-capita savings - the capital-labour ratio multiplied by (the population growth rate + the rate of depreciation)

In a steady state, /\k = o, so per-capita savings must be equal to per-capita required investment
sy* = (n + d)k*

Image plz

If we graph the production function, the savings function, and the required investment function with money on the Y axis and the capital labour ratio on the X axis, the savings function and the required investment function will eventually intersect: this point is the steady state equilibrium, E
at E, actual investment is just equal to required investment
the capital-labour ratio k* and standard of living y* are constant
At capital labour ratios lower than k*, savings will be greater than required investment, so the capital labour ratio and the standard of living will both increase.

Economic Growth: Savings and Investments

The Very Long Run: Economic Growth Models

We can measure long run economic as the annual percentage change in per-capita real potential GDP.
Ecoonomic growth causes Y* to move to the right.

The standard of living is measured by the per capita real actual GDP: The average income generated by each individual within an economy

Although a small difference in growth rates may not seem to make a huge difference, compounded over time, smaller changes in growth rates can have a huge impact on economic growth!
-1% growth rate increases GDP by 10% in 10 years
-7% growth rate increases GDP by 100% in 10 years

Even a small change in the growth rate can cause major long term changes in terms of living standards- much more than gap-busting can, anyways...

Malthus thought that output would not be able to grow at a fast enough rate to keep up with population growth

In this unit, we're going to be studying the depressing, Neoclassical growth model, and then we'll be looking at some more optimistic modern growth models.

(As a general note, most asian countries have a much larger growth rate than the rest of the world, currently. This is because they are developing rather rapidly!)

THE PROS AND CONS OF GROWTH

What are some benefits of economic growth?
-Growth may increase the standard of living, as long as the economy is growing more quickly than the population. This means that people are able to buy more crap!
-Economic growth may help governments to alleviate poverty- the more national wealth a country has access to, the greater their ability to redistribute that wealth to those who are worse off.

What are the costs of economic growth?

1: Opportunity Cost: In order to allow for economic growth, individuals need to divert resources away from present consumption and into investment (ie: savings). For an example, a government has the option of spending 100 million dollars on new parks and public spaces now, OR it can spend that money on educating it's citizens, which won't generate any immediate benefit, but will create better workers and a stronger tax base 20 years into the future

2: Personal hardships to those who can't adapt to change (ie: the poor old blacksmith who goes out of business and doesn't want to retrain for a new job more befitting of the information age)

3: NEGATIVE EXTERNALITIES
-Pollution
-Resource Depletion
-Global Warming
-Financial Meltdown
-Congestion
-Stress
-Disease
-Reduced Happiness (if you want to see this sort of thing in action, check out Carl Honore's "In Praise of Slowness"

SOURCES OF ECONOMIC GROWTH
Well, as we learned in the last chapter, in the long run, output is a function of the supply of factors (usually capital and labour, and this includes embodied increases in quality, not just quantity), and productivity (which can also by thought of as technological change)

In this chapter, we flip this idea around and reconfigure it, to state that we have four determinants of growth

1: Supply of labour: the quantity of labour
2: Human capital: the quality of labour (this is acquired through on-the-job training and education)
3: Physical capital: both the quantity and quality of plant, equipment, inventories, and residential construction
4: Technological change: This is sort of a catch-all category for all sorts of different changes, including changes in the productive process, innovation and invention (creative new ideas), new products, new organizations and many other things!

THE NEOCLASSICAL GROWTH MODEL
-Economic growth occurs in the long run, and related to increasing Y*, not output gaps

Long run growth is determined, largely, by investment and savings. In a nutshell, savings allows for more investment, and greater investment in productive capital increases potential output in the long run

In the short run, we assume that the interest rate is constant, so we use the equilibrium condition savings must = investments and use this to determine output
In the long run, we assume that potential GDP is constant, We also see that both savings and investment are a function of the interest rate, so we use the equilibrium condition S = I to determine what the equilibrium interest rate will be.

In this model of savings, we focus on public savings, which is a combination of private savings (Y* - C - T) and public savings (G - T)

NS = (Y* - C - T) + (T - G)
NS = Y* - C - G

When the interest rate increases, we know that consumption will decrease (because the opportunity cost of borrowing money has risen). When consumption decreases while income remains the same, national savings increases. As a result, high interest rates encourage more people to save money, and as a result, this creates a larger "pot" of loanable funds which accumulates in banks. Basically national savings as a function of interest rates is positively sloped.

What about investment????? Well, we use the marginal efficiency of investment curve to measure the degree of investment as a function of interest rates: this curve basically shows the demand for investment at each interest rate
This curve is negatively sloped. As interest rates rise, the opportunity cost of borrowing money to fund new investments also increases, which leads to decreased desired investment.

SO... what happens when we graph both desired national savings and desired investment together? We get two criss-crossing curves! The point where the two curves intersect is where NS = I: this is the equilibrium point- it does not change over time. If there is an excess supply of funds, this will mean that banks do not need to charge as much interest to prospective borrowers, so the interest rates will naturally fall, which drives up investment until it is equal to savings. Likewise, if there is excess demand for loanable funds, banks will know that that loaning out money when there are not many hard assets to cover their asses should the loan go unpaid is RISKY BUSINESS, so they will charge higher interest rates to compensate for this risk. Higher interest rates, likewise, discourages excess investment and encourages national savings until the economy is in equilibrium once again!

An increase in either public savings OR in the marginal efficiency of investment causes the level of equilibrium savings and investment to increase. This increased investment leads to long term increases in potential national income (because investment allows for the accumulation of new capital production factors). As such, although savings can be bad for an economy in the short run (because increased savings puts recessionary pressure on an economy), they are good in the long run, because they create opportunities for new growth! Woooooooooooo!

Macroeconomic Timespans

Macroeconomic Time Spans: Changes can have different effects over the long run than they do in the short run! This is just going to be a brief comparison exercise between the long run and the short run.

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IN THE SHORT RUN:
-Changes in national income are a function of factor utilization rate: for an example, the rate of employment. When more people are employed, more factors are being utilized, so national income increases
-National income is demand-induced: aggregate demand determines what the national income is going to be. The higher demand is, the higher the factor utilization rate will have to be in order to sate demand.
-Actual GDP, or Y determines national income: this means that there can be recessionary or inflationary output gaps
-Fiscal and monetary policy can affect both aggregate demand and actual national income
-Policies focus on shifting aggregate demand
-Gapbusting is the political objective
-Policies affect utilization rates
-Policies are focused on stabilizing real GDP at it's potential

IN THE LONG RUN
-Changes in national income are a function of both the supply of factors (ie: the size of the labour force), and factor productivity (ie: how productive and useful, on average, each worker is). The larger the workforce, and the more productive that workforce is, the higher national income will be
-National income is supply-induced: even if demand increases, wages will simply adjust and price will change, but producers will still produce the same amount in the long run UNLESS their production capabilities change. The supply and productivity of factors affects supply, and therefore, can change production in the long run.
-Potential GDP (Y* or Yfe) is a better determinant of what the national income will be. While understanding that output gaps do occur thanks to the business cycle, it is long run aggregate supply which basically determines what GDP will be
-Fiscal and monetary policy have a neutral effect (or even a negative effect: if expansionary policies increase consumption at the expense of savings, then there will be a smaller "pot" for investors to borrow from, so investment will be lower in the long run, causing a lower long run GDP)
-Policies are aimed at affecting potential GDP
-Technological change is key
-Policies attempt to affect factor supply and productivity
-Growth is the political goal

Cool?

Cool! =D

Honestly, just read the chapter for this one: it's short, and it makes more sense than the class notes...

Supply and Demand-Side Economics

Long-run aggregate supply, however, can shift if the potential national income shifts. When potential national income increases, this brings the equilibrium price level down, and the equilibrium level of GDP up in the long run. Neoclassical economists believe that policies which intend to bring real economic growth and betterment should focus on shifting potential national income to the right (increasing it): they believe that policies which only focus on increasing aggregate demand merely cause price-inflation in the long run.

So, for a classical economist, instead of using short term fiscal policy "gap-busting" to correct short term deviations from potential national income (boosting or reducing government expenditures to correct recessionary and inflationary gaps), policies should focus on brining potential national income forward, and closing the gap through increased potential economic growth! We call this SUPPLY-SIDE ECONOMICS

SO... let's say that an economy is in an inflationary state... there are a few things which policy-makers can do to fix this

1: They can do nothing. The chain and anchor system of long term economic adjustment will make wages higher, which shifts AS to the left and brings the economy back to Y*, but with a higher price level
2: The government could engage in some "gap-busting" policies (ie: they could raise taxes and decrease expenditures to kick aggregate demand back to the left, which would bring equilibrium GDP back to its potential levels)
3: The government could focus on increasing long run aggregate supply. This is also called Reaganomics: some policies in with vein include cutting personal income taxes (which increases incentives to work), cutting corporate income taxes (which increases production and investment). This shifts LRAS to the right to close the gap, and arguably, there is no negative effect on overall tax revenues, despite these cuts (because the increased long run equilibrium national income creates a larger tax base, so the government is still able to generate the same amount of revenue, despite taxing at lower rates).

CRITICISMS of SUPPLY SIDE ECONOMICS

Although these sorts of policies may increase LRAS, critics note that decreases in personal income tax also increase disposable income, which drives consumption upward. Also, decreases in corporate income tax are likely to cause corporations to increase their levels of investment. Thus, while LRAS will shift to the right, aggregate demand will also shift to the right, and the inflationary gap will persist, even if the economy's productive potential grows. This means that economies where supply side economic policies are instated will experience EVEN LARGER price inflation.

FISCAL POLICY

There are two different models we use for the economy: the short run model and the long run model. These two models are very different.

Fiscal policies which are based on the long run model is focused on increasing economic growth by increasing either labour, capital, or technology. These are factors which cause the potential national income to shift, and thus, they create long-run changes in economic potential.

The short run model, on the other hand, deals with temporary fluctuations in the economy which causes GDP to fall above or below potential: this is the economy model which is centered around the business cycle. Most policies in this vein are based around gap-busting, or eliminating recessionary and inflationary gaps.

It is not particularly difficult to determine the direction of the shift which must be kickstarted by fiscal policies: rather, it is the mixture and the magnitude which is hard to determine (for an example, if lowering taxes is likely to eliminate a recessionary gap, the question which the government must ask is how much of a tax cut should be given, how long should these cuts persist for, and which taxes should be affected by the cut).

STABILIZATION POLICY
-This is meant to damped the fluctuations caused by the business cycle
-This reduces the amplitude of the fluctuations (so recessionary and inflationary gaps are less extreme)
-This is GAPBUSTING!

While the automatic economic adjustment which occurs thanks to natural wages shifts WILL bring economies back to potential GDP, one problem is that the natural adjustment process can take a very long time, and while the economy is adjusting to reduce a recessionary gap, unemployment will be high, and the economy will remain unproductive for a long while. Government stabilization policies can fix recessionary gaps a lot more quickly by increasing government expenditures and decreasing taxation. This boosts aggregate demand, and shifts equilibrium GDP back to Y* a lot more quickly than the natural AS shift to the right would have.

Contractionary fiscal policy works in a very similar way: if there is an inflationary gap, the government increases taxation and decreases government expenditure to shift aggregate demand to the right, thus bringing equilibrium GDP back to Y* much faster than the natural AS shift to the left would have.

THE PARADOX OF THRIFT!

In a recession, the natural tendency is for individuals to increase savings: while such prudent actions may benefit individuals, on a larger aggregate level, frugality decreases consumption, and therefore, it also reduces aggregate expenditures, aggregate demand, and GDP as a whole. As a result, this psychological tendency towards thriftiness in a recession can exacerbate recessionary gaps. A historical example of this occurred in the great depression when governments actually RASIED taxes as a response to the hard economic times.

Note* this negative economic result of savings only really applies to the short run: in the short run, increased savings means decreased consumption, and therefore decreased aggregate demand. In the long run, however (as we will learn in the next chapter), an increase in savings facilitates an increase in investment, which leads to a higher aggregate demand.

AUTOMATIC FISCAL STABILIZATION: This refers to built-in tax and expenditure rates which automatically stabilize the business cycle without the government having to specifically set up any policies
-Basically, tax 'n spend systems decrease the simple multiplier, so injections and withdrawals from the economy create smaller shifts in GDP.
-Automatic stabilization can be represented by the slope of the budget function (as GDP increases, there are more withdrawals from the economy)
-Discretionary stabilization (ie: expansionary and contractionary policies) can be represented by a shift in the budget function (so governments are taxing and spending at different rates for the same national income rate)
-Taxes aren't the only automatic stabilizer: other ones include employment insurance and welfare payments (which are forms of withdrawals or expenditures)

ONE FINAL IMPORTANT THOUGHT: WHY ARE ECONOMISTS SO LEERY ABOUT FISCAL STABILIZATION POLICY???
Why not just increase expenditures and lower taxes to fight unemployment???

Wellll....

There can be policy lags- so by the time a budgetary policy gets through the political process and takes effect, it may already be obsolete, or even counter-productive (remember, stabilization policy is extremely time-sensitive)

Also, economists recognize that many households are not "fooled" by short term changes in tax structures. Many households base their spending on what they believe their long term incomes are going to be (as Milton Friedman predicted), so short term changes in taxation which temporarily boosts income may not cause changes in spending habits.

Finally, most economists believe that fiscal policy creates too broad and general a change in the economic environment to fine tune an economy for optimal performance. While stabilization policy may be useful when large, sweeping economic changes are required, many economists believe that it is unnecessary overkill for small economic imbalances which will correct themselves.

THE LONG TERM EFFECTS OF FISCAL POLICY

While increased government purchases lead to increased AE, AD, and GDP in the short run, in the long run, they may "crowd out" private-sector consumption and investment
Similarly, while decreased taxes may increase AE, AD, and GDP in the short run, the long run effect is less clear. On the one hand, some economists believe that decreased taxes may increase investment and incentive to work in the long run, thus drumming up GDP. On the other hand, some economists believe that decreased taxes may crowd out public spending on public goods (case and point, check out Alberta's decaying public infrastructure)

Supply Shocks and Other Important Things!

SUPPLY SHOCKS: These also correct themselves in the long-run, but unlike demand shocks, these do not cause any net changes in the price level.

NEGATIVE SUPPLY SHOCK
-Let's say that the cost of oil rises: this shifts AS to the left, which decreases overall economic output and increases the price level.
-There is now a recessionary gap in the economy, and this will cause unemployment to rise
-As unemployment rises, firms can get away with paying their workers less, so wages fall
-Because wages are a cost, production costs fall, and this shifts aggregate supply to the right, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE

POSITIVE SUPPLY SHOCK
-Let's say that a new technology emerges which lowers the price of electricity: this shifts AS to the right, which increases overall economic output and decreases the price level
-There is now an inflationary gap in the economy, and this will cause unemployment to fall below its natural level
-As unemployment falls wages rise (overtime and worker retention)
-Because wages are a cost, production costs rise, and this shifts aggregate supply to the left, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE

BUT, just because the economy is the same, this doesn't mean that wealth doesn't shift. In the event of a negative supply shock wealth tends to shift from the workers to the capital owners (so workers are paid less, and company owners make more money)

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SHOCKS AND THE BUSINESS CYCLE

Positive supply and demand shocks cause GDP to rise above it's potential level for a period of time, and then to fall back to potential (because inflationary gaps cause decreased unemployment, higher wages, and increased factor prices)

THESE SHOCKS ARE RANDOM...

SO:

The economy's adjustment system accounts for these random shocks, and basicaly incorporates them into business cycles (short term fluctuations of the economy)

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LONG RUN AGGREGATE SUPPLY: This is the relationship between price and GDP after changes in input prices have been taken into account. LRAS is the result of automatic adjustments which bring GDP back to its potential level. LRAS is also called classical aggregate supply, because classical economists assumed that the economy has an automatic tendency to return to Y*

LRAS, graphically, is a vertical line at Y*, because the amount of goods produced at the normal utilization rate is Y*

The only thing which this can be used to demonstrate is price changes: as long as factor prices rise by the same proportion as output prices, then Y*remains constant

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SHIFTING Y*