Chapter 18 - Notes

18.1 - Aggregate Expenditure

Key Definition

• Aggregate expenditure (AE): the total amount of goods and services people want to buy across the whole economy
• AE = C + I + G + NX
  • C = Consumption
  • G = Government purchases
  • I = Planned investment (excludes unplanned inventory buildup)
  • NX = Net exports (exports − imports)
• Uses planned investment because you want to measure what people actually want to buy, not unsold stuff sitting in warehouses

The Core Idea: Output Adjusts to Meet Aggregate Expenditure

• If output > AE → unsold inventories pile up → businesses cut production
• If output < AE → businesses are selling faster than producing → they ramp up production
• Macroeconomic equilibrium: when total output (GDP) = aggregate expenditure
  • Y = AE (where Y = GDP)
• In the short run, demand drives output — if people don't want to buy, businesses won't produce

The Demand-Driven Short Run vs Supply-Driven Long Run

• Long run (decade+): focus on supply side — labour, capital, technology determine potential output (grows smoothly over time)
• Short run (year-to-year fluctuations): focus on demand side — aggregate expenditure determines actual output (moves in fits and starts)
• Actual GDP can differ from potential GDP:
  • Actual < potential (negative output gap): weak aggregate expenditure → production lines idle, workers unemployed — this CAN be an equilibrium because businesses won't produce what people won't buy
  • Actual > potential (positive output gap): economy overheating — extra shifts, deferred maintenance, overtime — not sustainable, eventually sparks inflation

Equilibrium GDP vs Potential GDP — DON'T CONFUSE THESE

• Equilibrium GDP: the level where output = aggregate expenditure — where the economy actually comes to rest
• Potential GDP: the economy's highest sustainable level of production — determined by available inputs
• They can be different! Equilibrium GDP can be below (or above) potential GDP
• The goal is for equilibrium GDP to equal potential GDP — the "Goldilocks" outcome

Output Gap Language

• Don't say the output gap got "bigger" or "smaller" — it's confusing because of negative numbers
• Instead say more negative (economy further below potential) or more positive (economy further above potential)
  • e.g., going from −2% to −3% = more negative output gap
  • e.g., going from −2% to −1% = more positive output gap

18.2 - The IS Curve: Output and the Rael Interest Rate

The Real Interest Rate is the Key Price

• The real interest rate (r) represents the opportunity cost of spending — you can spend now, or save, earn interest, and buy more later
• Higher r = higher opportunity cost of spending = people spend less
• Lower r = lower opportunity cost = people spend more
• The Bank of Canada uses the interest rate as its main tool to influence the economy

How the Real Interest Rate Affects Each Component of AE

1. Lower r → Higher Consumption

• Lower opportunity cost of spending now instead of saving
• Lower cost of borrowing for big-ticket items (cars, houses)
• Exception: people who live off interest income (retirees) may consume less — but this effect is small overall

2. Lower r → Higher Investment (the MOST sensitive component)

• Lower opportunity cost of investing in equipment/structures vs putting money in the bank
• A low enough rate can make billions of dollars of investment projects worth pursuing
• Investment is the most interest-rate-sensitive component of AE

3. Lower r → Higher Government Purchases (sometimes)

• Lower interest payments on government debt → more money left in the budget for spending on roads, bridges, etc.
• But governments might use the savings to pay down debt instead, so this effect isn't guaranteed

4. Lower r → Higher Net Exports (indirect mechanism)

• Lower Canadian interest rate → international investors send money elsewhere for better returns → less demand for C$ → Canadian dollar depreciates
• Cheaper C$ → Canadian exports cheaper for foreigners → exports rise
• Cheaper C$ → imports more expensive for Canadians → imports fall
• Exports up + imports down = net exports rise

The Chain: ↓r → ↑C + ↑I + ↑G + ↑NX → ↑AE → ↑GDP → more positive output gap

The IS Curve

• IS curve: shows the relationship between the real interest rate and the output gap
• Named because it describes Investment and Spending decisions / Interest Sensitivity of output
• Think of it as a macroeconomic demand curve
  • Vertical axis: real interest rate (the price/opportunity cost of spending)
  • Horizontal axis: output gap (total quantity of output relative to potential)
• The IS curve is downward-sloping: lower real interest rate → more spending → higher output → more positive output gap

How to Use the IS Curve

• Pick a real interest rate on the vertical axis → read across to the IS curve → read down to find the corresponding output gap
• e.g., at r = 4%, output gap might be −5%; at r = 1%, output gap might be +2.5%

Movement Along vs Shift

• Change in the real interest rate = movement ALONG the IS curve
• Change in other factors that affect AE at a given interest rate = SHIFT of the IS curve (covered later)

Historical Example: Early 1990s Recession

• Bank of Canada raised real interest rate to over 9% to fight inflation
• Result: investment fell sharply, consumption fell, C$ appreciated (hurting net exports) → AE fell → GDP fell below potential → unemployment rose from 8% to 11.7%
• But it worked: inflation fell to ~2% and stayed there for 30 years
• Demonstrates the IS curve in action — high r → negative output gap

18.3 - The MP Curve: What Determines the Interest Rate

Two Forces Determine the Real Interest Rate

Real interest rate = Risk-free rate (set by Bank of Canada) + Risk premium (determined by financial markets)

1. The Bank of Canada Sets the Risk-Free Rate

• 8 times a year, the Governing Council meets to decide the interest rate
• This process is called monetary policy
• The Bank sets the nominal interest rate, but since it accounts for inflation, it's effectively setting the real interest rate
  • e.g., nominal rate = 5%, inflation = 2% → real rate = 3%
• Specifically, the Bank targets the overnight rate — the interest rate on very short-term, nearly risk-free overnight loans
• Changes in this rate percolate through the whole economy — affecting savings rates, mortgage rates, credit card rates, business borrowing rates, etc.

2. Financial Markets Determine the Risk Premium

• Risk premium: the extra interest lenders charge to compensate for the risk of lending
• Riskier loans → higher risk premium → higher interest rate
  • e.g., credit cards charge more than car loans because car loans have collateral (the car)
  • Payday loans have outrageously high rates because borrowers are very risky
• The risk premium is a price — the price of bearing risk — determined by supply and demand in financial markets (mainly Bay Street / big banks)
• You can measure the risk premium using interest rate spreads: the difference between the interest rate on a loan and the risk-free rate (government bond rate) for the same duration
• Risk spreads are usually low and stable, but spike during financial crises (2007-2009, March 2020)
  

The MP Curve

• MP curve = "Monetary Policy" curve — illustrates the current real interest rate
• Drawn as a horizontal line at the current real interest rate
  • e.g., if risk-free rate = 2% and risk premium = 2%, then MP curve is a horizontal line at 4%
• Horizontal because the real interest rate is the same regardless of the output gap (the Bank sets it, not the market)
• The MP curve shifts when:
  • The Bank of Canada changes the risk-free rate (monetary policy change)
  • Financial market conditions change the risk premium
  • MP shifts up = higher real interest rate
  • MP shifts down = lower real interest rate

Historical Note: IS-MP vs IS-LM

• Older textbooks use the LM curve instead of the MP curve
• The LM curve analyzed Liquidity and Money supply — more complicated because the Bank used to set the money supply instead of directly setting the interest rate
• IS-MP is simpler and reflects how modern central banks actually operate (they announce an interest rate target)
• If you see "IS-LM analysis" elsewhere, it's the same basic ideas, just an older framework

18.4 - The IS-MP Framework

Here are your notes for 18.4:

The IS-MP Framework

Putting IS and MP Together

• IS curve: shows the output gap at each possible real interest rate (downward-sloping)
• MP curve: shows the current real interest rate (horizontal line)
• Their intersection = macroeconomic equilibrium → tells you the output gap
• e.g., if MP is at r = 4% and the IS curve says that corresponds to output gap = −5%, then the economy is producing 5% below potential

Booms and Busts Explained Through the IS-MP Framework

Boom (good times):

• Optimism → consumers spend more, businesses invest more → IS curve is far to the right
• Equilibrium: output gap ≈ 0, full employment, optimism is warranted

Bust (recession):

• Pessimism → consumers cut spending, businesses cut investment → IS curve shifts LEFT
• Equilibrium: negative output gap, unemployment, economy producing below potential
• The pessimism becomes self-fulfilling — people spend less because the economy is weak, and the economy is weak because people spend less

Key insight: recessions are individually rational but collectively terrible

• Each person makes their best decision (spend less when uncertain), but those decisions add up to a bad equilibrium
• Like a concert: if everyone stands, you have to stand too (seats = unemployed) — even though everyone sitting would be better for all
• There's no guarantee the economy will fix itself — a bad equilibrium can persist unless something changes

Analyzing Monetary Policy (Bank of Canada)

• When the Bank of Canada cuts the interest rate → MP curve shifts DOWN
  • → New equilibrium: higher GDP, more positive output gap
• When the Bank raises the interest rate → MP curve shifts UP
  • → New equilibrium: lower GDP, more negative output gap

2008-2009 example:

• Bank cut rates from 4.25% down to 1.0% → MP shifted down dramatically → helped stabilize the economy
• But at some point, rates can't go much lower (near zero) → monetary policy runs out of ammunition
• This is why fiscal policy was also needed

Analyzing Fiscal Policy (Government Spending and Taxes)

• When the government increases spending or cuts taxes → IS curve shifts RIGHT
  • → New equilibrium: higher GDP, more positive output gap, real interest rate unchanged
• When the government cuts spending or raises taxes → IS curve shifts LEFT
  • → Lower GDP, more negative output gap

The Multiplier

• One person's spending = another person's income → initial spending ripples through the economy
• The multiplier measures how much total GDP changes for each extra dollar of initial spending (including all ripple effects)
• ΔGDP = ΔSpending × Multiplier
  • e.g., $40 billion in government spending × multiplier of 2 = $80 billion increase in GDP
• Higher marginal propensity to consume → bigger ripple effects → larger multiplier
• The multiplier determines how far the IS curve shifts: IS shifts by ΔSpending × Multiplier

How the Multiplier Works (the ripple chain):

• Government hires construction workers to build roads (direct effect)
• Workers spend their income on cars → Ford workers earn more (first ripple)
• Ford workers buy lunch at Subway → Subway hires more staff (second ripple)
• Subway staff buy clothes → clothing store earns more (third ripple)
• And so on... each round gets smaller but they all add up

Summary: What Shifts What

18.5 - Macroeconomic Shocks

The Big Rule: Spending shocks shift IS, Financial shocks shift MP

Spending Shocks → Shift the IS Curve

1. Consumption — increases if people feel more prosperous

• ↑ Wealth (stock market boom, rising house prices)
• ↑ Consumer confidence (optimism about future income)
• ↑ Government assistance (e.g., more EI payments)
• ↓ Taxes (more disposable income)
• ↓ Inequality (redistributing to low-income people who spend more of their income)

2. Investment — increases if it's profitable to expand

• ↑ GDP growth (expanding economy → need more production capacity)
• ↑ Business confidence (optimism about long-term profitability)
• ↑ Investment tax credits (lower after-tax cost of new equipment)
• ↓ Corporate taxes (higher after-tax profits)
• ↑ Easier lending standards / more cash reserves
• ↓ Uncertainty (managers restart shelved projects when outlook clears)

3. Government Purchases — increases with expansionary fiscal policy

• Spending bills (highways, military, infrastructure)
• Automatic stabilizers — programs that automatically increase spending when economy is weak
• Transfer payments (EI, Old Age Security) do NOT directly shift IS — they transfer money, don't buy goods/services
  • But they can indirectly boost consumption if recipients spend the money

4. Net Exports — increase due to global factors

• ↑ Global GDP growth (foreigners have more money → buy more Canadian goods)
• ↓ Canadian dollar (our exports cheaper, imports more expensive)
• ↓ Trade barriers in foreign markets (easier to sell abroad)
• ↑ Trade barriers protecting Canadian market (fewer imports)
• Trade agreements and trade wars affect both imports AND exports → net effect on NX is unclear

Remember: reverse any of these arrows and the IS curve shifts LEFT instead of right

Financial Shocks → Shift the MP Curve

1. Changes in Monetary Policy (Bank of Canada)

• ↑ Risk-free rate → MP shifts UP
• ↓ Risk-free rate → MP shifts DOWN
• Signaling expected future rate increases can also shift MP UP (because long-term rates partly reflect expectations of future short-term rates)
• Important: if inflation rises 1% and the Bank raises the nominal rate by 1%, the real rate is unchanged → MP doesn't shift

2. Changes in the Risk Premium (Financial Markets)

• ↑ Default risk (higher chance borrowers won't repay) → MP shifts UP
• ↑ Liquidity risk (banks can't easily sell loans to get cash) → MP shifts UP
• ↑ Interest rate risk (uncertainty about future rates/inflation for long-term loans) → MP shifts UP
• ↑ Risk aversion (lenders become more reluctant to take on risk) → MP shifts UP
• Reverse any of these → MP shifts DOWN

Three-Step Recipe for Any Scenario

1. Is this a spending shock (IS) or financial shock (MP)?
2. Which direction does the curve shift?
3. What happens to GDP/output gap and the real interest rate in the new equilibrium?

Key Pattern to Remember:

• IS shifts → GDP changes but real interest rate stays the same
• MP shifts → GDP changes AND real interest rate changes

Practice Scenarios from the Textbook:

• Government cuts military spending → IS left → lower GDP, unchanged r
• Consumer confidence booms → IS right → higher GDP, unchanged r
• Risk premium rises due to uncertainty → MP up → lower GDP, higher r
• China puts tariff on Canadian exports → IS left → lower GDP, unchanged r
• Bank of Canada cuts rate → MP down → higher GDP, lower r
• Government incentives for EV factories → IS right → higher GDP, unchanged r
• European growth picks up → IS right → higher GDP, unchanged r
• Political uncertainty freezes investment → IS left → lower GDP, unchanged r
• Bank of Canada reduces risk premium → MP down → higher GDP, lower r
• Stock market crash → IS left (wealth down → consumption down) → lower GDP, unchanged r
• Bank of Canada raises rates → MP up → lower GDP, higher r
• Canadian dollar appreciates → IS left (exports more expensive) → lower GDP, unchanged r

Questions

1. All else equal, an increase in the real interest rate in Canada will cause a ________________ and an ___________ in net exports.
   Appreciation, decrease