EC140 Final Exam Review
EC140 Final Exam Review
EC140 Final Exam Review
o Real after-tax Interest Rate = (1 Tax Rate) x Nominal Rate Inflation Rate
o Taxes depend on nominal interest rate true tax on interest
income depends on inflation rate
o Inflation: Raises nominal interest rates but not real interest
rates, Increases savers tax burdens, Lowers after-tax real
interest rate
Tax on capital income: Decreases supply of loanable funds
o Tax wedge driven between real interest rate and real after tax
interest rate
o Investment and saving decrease
Laffer Curve: Relationship between tax rate and amount of tax
revenue collected
o Higher tax rate doesnt always bring higher revenue
o Higher tax rate brings in more revenue per $ earned
o Higher tax rate decreases # of $ earned = 2 forces operate in
opposite directions
o At T*, revenue if maximized
o Tax rate < T*, rise in tax rate increases tax revenue
o Tax rate > T*, rise in tax rate decreases tax revenue
-Fiscal Stimulus: use of fiscal policy to increase production and
employment
Discretionary Fiscal Policy: Policy action initiated by act of
Parliament
Automatic Fiscal Policy: Fiscal policy action triggered by state of
economy with no gov. action occurs automatically given the
structure of gov. programs
-Increase in gov. outlays/decrease in gov. revenues = production and jobs
-Increase in expenditure on g/s directly increases aggregate expenditure
-Increase in transfer payments/decrease in tax revenues = increases
disposable income increase consumption expenditure
-Low taxes provide incentives to work and invest
-Automatic Fiscal Policy: Changes automatically in response to state of
economy
Tax Revenue: depends on tax rates and incomes tax rates people pay
are set by Parliament
o Incomes vary with real GDP = tax revenues depend on real GDP
when real GDP increases in expansion, tax revenues increases,
and vice versa
Transfer Payments: Gov. creates programs that pay benefits to
qualified people and businesses depending on economic state
o Expansion = unemployment falls = unemployment benefits
decrease
-High inflation and positive output gap, Bank raises overnight loans rate
target
Crawling Peg: Works like a fixed exchange rate except target value
changes (e.g. China operates crawling peg) avoid wild swings in
exchange rate that might happen if expectations become unstable and
avoid problem of running out of reserves
-Balance of Payments Accounts: International trading, borrowing, and
lending; 3 accounts = 0
Current Account: Records receipts from exports of g/s sold abroad,
payments for imports of g/s from abroad, net interest paid abroad, and
net transfers (e.g. foreign aid payments)
o CAB = X M + Net interest income + Net transfers
Capital and Financial Account: Records foreign investment in Canada
Canadian investment abroad
o Foreign investment: Includes both real (firms, factories), and
financial assets (gov. bonds)
Official Settlements Account: Change in gov.s holding of foreign
currency (official reserves)
o When official reserves increase, gov. is buying foreign currencies
= official settlements account will be negative (Canada pays to
obtain official reserves)
-Positive Net foreign investment = Borrowing from rest of world (e.g.
Americans buy Canadian gov. bonds)
-Net Borrower: country that borrows more from rest of world than its
lending has a positive net foreign investment (capital account surplus
Canada!)
-Negative net foreign investment = Lending to rest of world (e.g.
Canadians buy German gov. bonds) negative net foreign investment
(capital account deficit)
When unemployment rate > natural unemployment rate, real GDP <
potential GDP, output gap is negative
When unemployment rate < natural unemployment rate, real GDP >
potential GDP, output gap is positive
-Price level: average level of prices and value of money
Inflation: rising price level; Deflation: falling price level
Interested in price level b/c: Measure inflation/deflation rate,
Distinguish between money values and real values of economic
variables
-Why inflation and deflation are problems: unpredictable inflation or
deflation is a problem b/c it redistributes income and wealth, diverts
resources from production, lowers real GDP and employment
Unpredictable inflation/deflation rates changes income between
employers/workers
o Unexpected inflation = our wage buys us less, employers benefit
(higher profits)
Unpredictable inflation/deflation rates changes wealth between
borrowers/lenders
o Unexpected inflation = amount borrowed lends buys less =
borrower wins, lender loses
Unpredictable inflation/deflation rate = resources used to monitor it =
divert resources from production
o Hyperinflation: Inflation rate 50%+ that puts economy to a
stop and collapses society
Unpredictable inflation rates = higher profits = increase in investment
= temporary rise in GDP and employment leads to fall in GDP and
employment
-Consumer Price Index (CPI): Averages of prices paid by urban consumers
for a fixed basket of consumer g/s
Reference base period: CPI = 100
-Constructing the CPI: Selecting the CPI basket, Conducting monthly price
survey, Calculating CPI (Find cost of CPI basket at base period prices, find
cost at current period prices, calculate CPI for current period)
CPI = (Cost of basket at current period prices/Cost of basket at base
period prices) x 100
-Measuring inflation rate: [(CPI this year CPI last year) / CPI last year] x
100
-Biased CPI: CPI might overstate true inflation for 4 reasons
New Goods Bias: New goods that werent available in base year are
more expensive than goods they replace = upward bias on CPI
Quality Change Bias: Quality improvements yearly = we pay for
improved quality (not inflation)
Commodity Substitution Bias: CPI is fixed and doesnt take into
account consumers substitutions from goods whose prices increase