ECON 104: FINANCIAL ECONOMICS

Gross Domestic Product GDP

Market value of the final goods and services produced in a country during a given period.

Final good or service

Consumed by the ultimate user; because they are the end products of the production process, they are counted as part of the
GDP.

Intermediate goods or services

Used up in the production of final goods and services and therefore not counted in GDP

Value Added
For any firm the market value of its product or service minus the costs of inputs purchased from other firms

Consumption
Spending by households on goods and services, such as food, clothing and entertainment

Private-sector Investment
Spending by firms on final goods and services, primarily capital goods and housing.

Government Purchases
Purchased by federal, provincial, and municipal gov'ts of final goods; does not include gov't transfer payments or interest
paid on the public debt

Net Investment
Investment that adds to the total capital stock of the economy

Net Exports
Exports - Imports

Real GDP
A measure of GDP in which the quantities produced are valued at the prices in a base year rather than at current prices

Nominal GDP
A measure of GDP in which the quantities produced are valued at the current-year prices; measure the current dollar value
of production

GDP Deflator
A measure of goods and services included in GDP
Real GDP = Nominal GDP/GDP deflator X 100

Gross National Product GNP

The market value of goods and services produced by factors of production owned by residents of a country; equivalent in
magnitude to gross national income (GNI)

Labor Force
Total number of employed and unemployed in the economy

Unemployment Rate
The number of unemployed ppl divided by the labor force

Participation Rate
The percentage of working-age population in the labour force.
Participation rate = labor force/population X 100

Employment Rate
The percentage of the working age population that is employed
Employment Rate = employed/labour force X 100

Discouraged Workers
People who say they would like to have a job but have not made an effort to find one in the past four weeks.

Price Level
The overall level of prices at a point in time as measured by a price index such as CPI

Consumer Price Index (CPI)

For any period, measures the cost in that period of a standard basket of goods and services relative to the cost of the same
basket of goods and services in a fixed year, called the base year.
CPI = Cost of base-year basket in current yr/Cost of base-yr basket in base year X 100

Price Index
A measure of the average price of a given class of goods or services relative to the price of the same goods in a base year.

Rate of inflation
The annual percentage rate of change in the price level as measured, for example, by the CPI.

Deflation
A situation in which the prices of most goods and services are falling over time so that inflation is negative

Nominal Quantity
A quantity measured in terms of its current dollar value

Real Quantity
A quantity measured in terms of its constant dollar terms

Deflating (a nominal quantity)

The process of dividing a nominal quantity by a price index (such as CPI) to express the quantity in real terms

Indexing
The practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price
index; prevents the purchasing power of the nominal quantity being eroded by inflation.

Nominal Interest Rate

The type of interest rate you usually encounter in everyday life - the price per dollar borrowed per year

Real Interest Rate

The nominal interest rate minus inflation rate
r=i-inflation

Anticipated inflation
When the rate of inflation turns out to be roughly what most ppl had expected

Unanticipated inflation
When the rate of inflation turns out be substantially different from what most ppl had expected

Fisher Effect
The tendency for nominal interest rates to be high when inflation is high and low when inflation is low

Relative Price
The price of a specific good or service in comparison to the price of other goods and services

Zero inflation
When the price level stays roughly constant one year to the next
Stable inflation
When the inflation rate stays roughly constant one yr to the next

Accelerating inflation
When the inflation rate rises one year to another

Disinflation
When the inflation rate falls from one year to the next
(The BOC does this and it causes a recessionary gap)

Low inflation
Inflation between 1%-3% per year

Moderate inflation
Inflation between 3%-6% per year

High inflation
Inflation above 6% per year

Price signal distortion hypothesis

The claim that any substantial amount of change in the price level will make it difficult for market participants to interpret
the extent to which price changes involve relative price changes

Downward nominal wage rigidity hypothesis

The claim that low levels of inflation will reduce efficiency b/c real wage cuts will then typically require nominal wage cuts,
which will be resisted

Zero bound on nominal interest rates hypothesis

The claim that b/c interest rates cannot go below zero, a central bank may be unable to stimulate the economy with rate cuts
if the official interest rate is low to begin with

Planned aggregate expenditure PAE

Total planned spending on final goods and services

Menu Costs
The costs of changing prices

Disposable Income
Refers to income that includes the addition of transfers and deduction of taxes

Net Taxes
Refers to taxes - transfers

Consumption function
The relationship btwn consumption spending and its determinants, such as disposable income (after tax).

Wealth effect
The tendency of changes in asset prices to affect households' wealth thus their spending on consumption goods and services

Asset price bubble

Occurs when the price of a financial or real asset or asset category rises much more rapidly than prices in general and by
much more than can be explained by fundamental factors

Marginal propensity to consume (mpc)

The amount by which consumption rises when disposable income rises by $1; 0 < mpc < 1

Average propensity to consume (APC)

Consumption/Disposable income
Autonomous expenditure
The portion of planned aggregate expenditure that is independent of output
Y= [100]+0.4Y

Induced expenditure
The portion of PAE that depends on output, Y
Y=100+[0.4Y]

Short Run Equilibrium Output

The level of output at which output Y equals PAE; the level of output that prevails during the period in which prices are
predetermined

Income-Expenditure muliplier
The effect of one-unit increase in autonomous expenditure on SR equilibrium output

Stabilization policies
Government policies that are used to affect PAE, with the objective of elimination output gaps

Expansionary policies
Gov't policy actions intended to increase planned spending and output

Contractionary policies
Gov't policy action intended to decrease planned spending and output

Discretionary fiscal policy

Changes in gov't spending and taxation deliberately made to stabilize PAE

Automatic stabilizers
Provisions in the law that imply automatic increases in gov't spending or decreases in taxes when real output declines

Government Debt Stability

The condition that gov't debt-to-GDP ratio does not change

Marginal propensity to import

The amount by which imports rise when income is raised by $1

Money
Any asset that can be used as a means of payment to purchase and to settle debts

Commodity Money
An asset with intrinsic value, such as a gold or silver coin, that is generally accepted as a means of payment for purchases
and to settle debts

Fiat Money
An asset with no intrinsic value, such as paper currency, that is generally accepted as a means of payment and to settle debts

Medium of exchange
An asset used in purchasing goods and services

Barter
Direct trade of goods and services for other goods or services

Unit of Account
A basic measure of economic value

Store of value
An asset that serves as a means of holding wealth
M1
Sum of currency outside banks and balances held in demand deposits

M2
All the assets in M1 plus additional assets that are usable in making payments but at a greater cost or inconvenience than
currency or chequing accounts

Bank Reserves
Cash or similar assets held by a commercial banks for the purpose of meeting depositor withdrawals and payments

100 percent reserve banking

A situation in which banks' reserves equal 100% of their deposits

Reserve-Deposit Ratio
Bank reserves/deposits

Fractional-reserve banking system

A banking system in which bank reserves are less than deposits so that the reserve-deposit ratio is less than 100%

Banking Panic
Occurs when there's a rush of withdrawals from the banking system made by depositors responding to news or rumors of
impending bankruptcy of multiple banks

Bank run
Occurs when the depositor of a particular bank respond to news or rumors of impending bankruptcy of that particular bank
by rushing to withdrawal their deposits from the bank

Currency
Refers to bank notes or coins

Seigniorage
Refers to the profit gained from the issue of paper money or coins

Deposit insurance
Is provided to financial institutions such as banks so that the deposits of their customers are insured in case the financial
institution goes bankrupt

Lender of last resort

An institution, typically a central bank, that will extend credit to financial institutions during a financial panic to keep the
payments system operating smoothly

Liquidity
Refers to the ease w/ which an asset can be converted to cash

Key Policy Rate

A general term for the interest rate that the central bank controls to achieve its monetary policy objective

Quantitative easing
The unconventional monetary policy of actively creating central bank reserves for the purchase of financial assets

Effective lower bound

The lowest feasible level for a central banks key policy rate

Credit easing
The unconventional monetary policy of the central bank purchasing private sector financial assets in order to reduce interest
rate spreads
Zero interest rate commitment
A promise made by central banks that will it will maintain its key policy rate at the effective lower bound for an extended
period

Open-market purchase
The purchase of gov't bonds from the public by the central bank for the purpose of increasing supply of bank reserves

Open-market sale
The sale by the central bank of gov't bonds for the purpose of reducing bank reserves

Open-market operations
Open-market purchases and sales

Reserve requirements
Set by some central banks, the minimum values of the ratio of bank reserves to bank deposits that commercial banks are
allowed to maintain; the bank of Canada does not have this

Government deposit shifting

The transfer of govt deposits by the central bank between the gov'ts accounts at the central bank and the gov'ts accounts at
commercial banks

Quantity equation
An amount of money times its velocity equals nominal GDP

MxV=PxY

Velocity of money
A measure of the speed at which money changes hands in transactions involving final goods and services; V= (P x Y)/M

Monetary Policy Objective

A central bank goal regarding a macroeconomic indicator that the bank influences

Inflation-control target
Refers either to the range of annual inflation rates w/in which the central bank aims to keep actual inflation or to the
midpoint of the target range

Total CPI
Synonym for the CPI; the adjective "total" emphasizes that is a broad measure of the price level

Core CPI
Measure of the price level that excludes the most volatile components of total CPI

Total CPI inflation

Rate of change of the total CPI

Core CPI inflation

Rate of change of the core CPI

Monetary Policy instrument

The view that the central bank changes its key policy rate (official interest rate) directly, and commercial banks respond by
changing market interest rates

Official interest rate

A general term for the interest rate which the central bank controls to achieve its monetary policy objective; a term for the
key policy rate

Prime business rate

The interest rate that commercial banks charge their least risky borrowers
Benchmark Rate
An interest rate upon which other interest rates are based

Overnight rate target

The interest rate that the BOC wants to prevail in the financial market where major Canadian institutions borrow and lend
funds to settle daily transactions w/ one another

Overnight Rate
The market interest rate that financial institutions charge each other for overnight loans

Large Value Transfer System (LVTS)

An electric wire system overseen by the BOC that allows major financial institutions operating in Canada to send large
payments back and forth to each other

Settlement Balances
Accounts held at the BOC by financial institutions to settle their net payment obligations to one another

Operating Band
A term used by the BOC to describe the rage of possible overnight interest rates: from 0.25% points below the overnight
rate target to 0.25% points above the target

Deposit Rate
The interest rate that the BOC pays commercial banks for overnight deposits; it corresponds to the lower limit of the BOC's
operating bank for the over night rate
(0.25% points below the overnight target)

Bank Rate
The interest rate that the BOC charges commercial banks for overnight loans; it corresponds to the upper limit of the BOC's
operating band for the overnight rate; for decades, it was the Bank's official interest rate

Basis point
One hundredth of a percentage point; term often used in describing interest rates

Interest rate Spread

The difference, often measured in basis points, between a benchmark interest rate and a related market interest rate (such as
overnight rate and mortgage lending rate)

Aggregate Demand Curve (ADI)

Shows the relationship between short-run equilibrium output Y and the rate of inflation

Monetary Policy Rule

Describes how the action a central bank takes in response to changes in the state of the economy depends on the state of the
economy

Inflation Adjustment (IA) curve

A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions

Long-run aggregate supply (LRAS) curve

A relationship between potential output and the inflation rate; a vertical curve indicating that potential output is independent
of the inflation rate

Long-run Equilibrium
A situation in which actual output equals potential output and the inflation rate is state; graphically occurs when the ADI
curve, IA curve, and LRAS curve all intersect

Short-run equilibrium
A situation in which inflation equals the value determined by past expectations and pricing decisions, and output is
consistent w/ output of inflation rate; graphically occurs when ADI and IA intersect

Aggregate supply shock

Either an inflation shock or a shock to potential output

Inflation shock
A sudden change in the normal behavior of inflation rate, unrelated to the economy's output gap

Downward inflation shock

Sudden decrease in the inflation rate, unrelated to the economy's output gap

Upward inflation shock

Sudden increase in the inflation rate, unrelated to the economy's output gap

Nominal exchange rate

The rate at which two currencies can be traded for each other

Parity
Refers to the situation when one unit of one currency trades on the foreign exchange market for one unit of another
currency; "par"

Flexible exchange market

An exchange rate whose value is not officially fixed but varies according to the supply and demand fir the currency in a
foreign exchange market

Foreign Exchange Market

The market on which currencies of various nations are traded for another

Fixed exchange rate

An exchange rate whose value is set by official gov't policy

Market equilibrium value of the exchange rate (or equilibrium exchange rate)
The exchange rate that equates the quantities of the currency supplied and demanded in foreign exchange market

Bretton Woods system

An international monetary system under which many countries pegged their currencies to the USD; it operated from the end
of WWII until 1971

Devaluation
A reduction in the official value of a currency (in a fixed-exchange-rate system)

Revaluation
An increase in the official value of a currency (in a fixed-exchange-rate system)

Overvalued exchange rate

An exchange rate that has an official fixed value that is greater than the market equilibrium

Undervalued exchange rate

An exchange rate that has an official fixed value that is less than the market equilibrium

Capital controls
Taxes or rules such as constraints on foreign exchange transactions that impede money flows between economies; they are
sometimes used to prevent exchange rate fluctuations

International reserves
Foreign currency assets held by a gov't for the purpose of purchasing the domestic currency in the foreign exchange market
Balance-of-payments Deficit
The net decrease in a country's stock of international reserves over a year

Balance-of- payments Surplus

The net increase in a county's stock of international reserves over a year

Speculative attack
A massive selling of domestic currency assets by financial investors

Real exchange rate

The nominal exchange rate between the currencies of two countries adjusted for changes in the relative price levels in two
countries since a base year.

Law of one price (LOOP)

If transportation costs are relatively small, the price of an internationally traded commodity will be the same in all locations

Purchasing power parity (PPP)

The theory that nominal exchange rates are determined as necessary for the law of one price to hold

Power of compound growth

The fact that seemingly small differences in growth rates, maintained over long periods, will produce large difference in
magnitude

Compound interest
The payment of interest not only on the original deposit but on all previously accumulated interest
M=P(1+i)^n

Rule of 72
A rule of thumb stating that to find the number of years it takes a magnitude to double when it is growing at a constant rate,
divide 72 by the growth rate

Real GDP per person

Average labour productivity X share of population employed
Y/POP=Y/N X N/POP

Diminishing returns to capital

If the amount of labor and other inputs employed is held constant, then, the greater the amount of capital already in use, the
less an addition unit of capital will tend to add to production

Dutch disease
The tendency in an economy w/ a booming natural resource sector for the manufacturing sector to decline

Entrepreneurship
Behaviour that results in new products, services, technological processes, or organizational innovations that are productivity
enhancing