ECO1000EconomicsSemester One, 2004

Lecture Twelve

A Few Notes on the Assignment Little things that must be improved:

Internet site referencing Clip art and decorations 1st person Dot points Presentation (try fully (left and right) justifying

text) Do not ask rhetorical questions

A Few Notes on the Assignment More Serious Things:

References/research Structure Answering the question/fulfilling the objectives Working together/ paraphrasing other works Effort

How to Improve Your Writing There is only one way and it takes time and

effort. To improve your writing you must read

more. By reading you learn how to structure

paragraphs and arguments. In addition, you improve your vocabulary which enables you to express yourself better.

Time Table For Next Week Next week, we have scheduled three 2-

hour revision tutorials plus three 2-hour revision student-led sessions.

You are requested to attend the session being undertaken by your regular tutor/student leader.

You may choose another session if you have a time table clash.

Structure of the Revision Sessions Including this lecture, you have the opportunity to

participate in 6 hours of revision. This should save you a lot of time.

Tutors will summarise the course and work through some relevant exercises/problems.

Student leaders will possess all the exam advice and will help you prepare for the examination. (If you want to hear my exam advice, you must go to one of the student-led sessions).

Revision

This is not necessarily an indication of what will be, or won’t be in the

exam. This is an overview of main concepts & diagrams.

General Suggestions

Review main definitions At the side of text pages or the glossary at the back

Know how to recognise definitions when phrased as a scenario

Characteristics of key economic situations eg market structures, money market

Identify main themes of the modules/chapters 10 principles of economics help to do this

Identify key diagrams & explanations that go with those diagrams

Revision Sources Review past few exams for structure

(2002 and 2003) Review study guide exercises Set yourself practice questions or re-do

those from the tutorials and student led sessions.

Exam Technique

Keep in mind the relative weightings Don’t bog down on multiple choice questions

Be prepared to move on and come back to questions you find difficult

Extended response 1. content most important 2. answer the specific question, especially in the

conclusion 3. keep writing. It increases your chances of making a

point that is worth marks

Study Technique Read your text over and over again. You do not

even have to sit down to deliberately study. Just read your text casually (at lunch, when you have a few spare minutes etc.)

You should by now have realised the importance of constructing an initial scenario (usually using a diagram) and then showing what happens when circumstances change.

Module OnePart One: Introductory Concepts

Introductory Concepts Explain each of the principles of

economics Describe and discuss the circular flow as

a model and definitions of components Identify and explain the difference

between positive and normative statements

Know about the nature and purposes of economic models

Module OnePart Two: Opportunity Cost

Opportunity Cost The cost of something is what you give up to get

it. We all face opportunity costs. However, we do not face them equally. This opens up the opportunity to specialise in the

production of a good in which we have a high cost and trade some of the surplus for a good in which our costs are higher.

Correct Calculation & Expression of Opportunity Cost

Food 10 8 6 4 2 0

Cloth 0 3 6 9 12 15Opp. Cost ofincreasingcloth prod.

2/3= 0.66kgs/wkof food

2/3= 0.66kgs/wkof food

2/3= 0.66kgs/wkof food

2/3= 0.66kgs/wkof food

2/3= 0.66kgs/wkof food

Comparative Advantage Whoever has the lower opportunity cost in

the production of a particular good is said to have a comparative advantage in the production of that good.

We would recommend specialisation in the good in which one has a comparative advantage.

What Combinations of Production Are Possible and Not Possible?

Information gigabytes/yr

Textilescu m/yr

Possible but inefficient

Possible and efficient

Impossible

Recognise the Increased Consumption Possibilities With Trade

Food(Kgs/wk)

Cloth (m/wk)

9

6

3 6 9 15

3

12

12

Utopia

Euphoria

*

Consumption Possibilities With Trade

What causes shifts in the PPF?

Information gigabytes/yr

Textilescu m/yr

What Policy/Social Decisions Cause Shifts Within the Frontier?

Information gigabytes/yr

Textilescu m/yr

750,000

1 m

500,000

5m 6.5 m16 m

*

*

Module TwoPart One: Supply and Demand

Determinants of Demand Tastes Price Price of related goods Expectations Income

Demand Curve

D

Quantity

Price Downward sloping (law of demand)

Change in price leads to a change in quantity demanded (movement along the curve)

What causes an Increase/Decrease in Demand?

Price

QuantityQ1

D1

Q2

D2

P

Q0

D0

Change in tastes, expectations or the price of related goods move the curve

Determinants of Supply Price Input prices Technology Expectations

Supply Curve

Price

Q

SUpward sloping (law of supply)

Change in price leads to a movement along the supply curve (change in quantity supplied)

What Causes an Increase/Decrease in Supply?

Price

Quantity

S0

P

Q1 Q2Q0

S2

S1

Changes in input prices, expectations or technology shift the curve

Equilibrium

P

Q

Pe

Qe

D

S

What Happens to Equilibrium Price and Quantity When Supply and/or Demand Changes?

Price

Quantity

S0

P0

Q0

D0

P1

Q1

S1

D1

Module TwoPart Two: Elasticity

Revenue

Price

Quantity

S0

P0

Q0

D0

Q1

P1

D1

Elasticity A measurement of the responsiveness of

quantity demanded to a change in price, income, or the price of a substitute.

Calculated simply by:

%change in Qd

%change in price, income etc.

Remember: Actual elasticity can indicate

whether elastic or inelastic whether inferior or normal (if income elasticity) whether goods are substitutes or complements

(if cross price elasticity) Eg income elasticity = 2

Income elastic Normal good

Elasticity Depicted Geometrically

Inelastic Demand Curve

Elastic Demand Curve

Price

Quantity

Elasticity and Revenue

When demand is inelastic, an increase in price can increase revenue

Module TwoPart Three: Government Intervention

Government intervention Why would governments intervene in

markets? What are the forms of intervention? What happens to price and quantity? What happens to a market if government

intervention ceases? Assume it returns to equilibrium

Price floor (minimum price)Why will there be a surplus?

Price

Quantity

S0

P0

Q0

D0

P1

Q1

Price Ceiling (maximum price)Why will there be a ‘shortage’?

Price

Quantity

S0

P0

Q0

D0

P1

Q1

What Happens to Price and Quantity When Markets are Deregulated?

Price

Quantity

S0

P0

Q0

D0

P1

Q1

Who ‘Pays’ For a Tax on Goods and How Much Do They Pay?

Price

Quantity

S0

P0

Q0

D0

Pt

Qt

Consumer share of tax

P2

Producer share of tax

How Does the Imposition of a Tax Affect Consumer Price/Demand and Producer Revenue?

Price

Quantity

S0

P0

Q0

D0

Pt

Qt

P2

Initial producer revenue

Producer revenue with tax

Microeconomics: Summary Production Possibilities and Opportunity

Cost Supply and Demand Elasticity Government Regulation (price ceilings,

floors and taxes)

Macroeconomics

Module ThreeData for Macroeconomics

GDP What is GDP?

A measurement of the size of the economy or circular flow

Components of GDP (expenditure method): Consumption Investment Government Spending Net Exports

GDP = Y = C + I + G + NX

Inflation Inflation may be calculated using CPI or the

GDP deflator. Each calculation involves addition,

multiplication and percentage change.

Real and Nominal GDPYear Price of

ApplesQuantity of Apples

Price of Pears

Quantity of Pears

2000 $1 100 $2 50

2001 $2 150 $3 100

2002 $3 200 $4 150

Calculating Nominal GDPYear Apples Pears Nominal

GDP

2000 $1 X 100 $2 X 50 $200

2001 $2 X 150 $3 X 100 $600

2002 $3 X 200 $4 X 150 $1200

Calculating Real GDPYear Apples Pears Real GDP

2000 $1 X 100 $2 X 50 $200

2001 $1 X 150 $2 X 100 $350

2002 $1 X 200 $2 X 150 $500

Use price in base year

GDP Deflator (a measure of the price level or rise in nominal GDP caused by rising prices)

Year Deflator (Nominal/Real)

2000 $200/$200 X 100 = 100

2001 $600/$350 X 100 = 171

2002 $1200/$500 X 100 = 240

CPI (a measure of the cost of goods and services bought by the average consumer)

Find the basket of goods and services (ABS does this by survey)

Find the price of each good or service in each year

Calculate the cost of the basket in each year

Computing CPIYear Cost of

DVDsCost of Car Washes

Cost of Basket

2000 $1 X 500 $2 X 12 $524

2001 $2 X 500 $3 X 12 $1036

2002 $3 X 500 $4 X 12 $1548

Fix the basket (amounts remain the same as in base year)

Computing CPI (cont) Choose base year then compute CPI:

Year Calculate CPI

2000 $524/524 X 100 100

2001 $1036/524 X100 197

2002 $1548/524 X 100 295

Use CPI to Calculate Inflation RateYear Calculate Inflation Rate

2001 (197 – 100)/100 X 100

97%

2002 (295 – 197)/197 X 100

49%

Module FourThe Real Economy in the Long Run

Growth Productivity is a key determinant of growth. Getting more output from a given amount of factors of

production means that productivity has risen The factors of production enter into a production

function Y= A F(L, K, H, N)

Government policies (eg. education, population growth, savings and investment) can influence each factor to encourage growth

The Financial System Financial system matches savers with

borrowers. Private saving = Y – T – C Public Saving = T – G Total Saving = S In an economy, S = I

Loanable Funds Market

Interest rate

Quantity of Funds

D (from investors)

S (from savers)

Unemployment Cyclical and natural Cyclical unemployment is caused by:

Minimum Wages Unions Efficiency Wages Job Searching

Module FiveMoney and Prices

Money What is it? What are its functions? How is it created?

Commercial banks Reserve Bank

Money Supply & Demand

Quantity of money

Value ofMoney

Price Level

A

Moneydemand

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

M1

MS1

The Effects of Monetary Injection

Suppose the RBA injects money into the economy by lowering the cash rate: The supply of money curve shifts to the right. The equilibrium value of money decreases. The equilibrium price level increases.

The Effects of Monetary Injection

Quantity of money

Value ofMoney

Price Level

A

B

Moneydemand

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

M1

MS1

M1

MS2

2....decreases the value of money ... 3. and

increasesthe pricelevel.

1. An increase in the money supply...

The Quantity Theory of Money

How the price level is determined and why it might change over time may be explained by the quantity theory of money. This theory has two main arguments: The quantity of money available in the economy

determines the value of money. The primary cause of inflation is the growth in the

quantity of money.

Inflation Causes of inflation

Quantity theory

Problems with having high inflation Menu costs Shoeleather costs etc.

Module SixThe Open Economy

An Open Economy… Exchanges goods and assets with the rest

of the world. Flow of goods (NX) Flow of money (NFI) Equilibrium: NX = NFI and S = I + NFI All this can be depicted using a single

three-part diagram.

(a) The Market for Loanable Funds (b) Net Foreign Investment

(c) The Market for Foreign-Currency Exchange

Net foreigninvestment,NFI

RealInterest

Rate

Net ForeignInvestment

r 1

RealInterest

Rate

Quantity ofLoanable Funds

r1

Supply

Demand

Quantity ofDollars

RealExchange

Rate

E1

Supply

Demand

Module SevenAggregate Demand and Aggregate

Supply

The AD/AS Model

AS

AD

Output

Price Level

Why the Curves Slope the Way They Do

AD: Pigou’s wealth effect Keynes’ interest rate effect Mundell-Fleming exchange rate effect

AS: Neoclassical misperceptions Keynesian sticky wages New Keynesian sticky prices

What Shifts the Curves? AD:

C, I, G, NX

AS: Input prices Productivity Expectations of a higher or lower price level.

Long Run EquilibriumLRAS

SRAS

AD

Output

Price level

Natural rate

Module EightPolicy

Monetary Policy

AD1AD0

MS1MS0

MDMoney Market

Interest rate

Price Level

Increase MS, Increase AD (and vice versa)

Fiscal Policy

Increase government spending, increase AD and vice versa

AD0

AD1

Fiscal Policy and the Multiplier Effect

AD0

AD1AD2

Multiplier Formula Simple: Multiplier = 1/(1 – MPC) Where MPC is the marginal propensity to

consume. When MPC = 0.5, Multiplier = 2.

Fiscal Policy and Crowding Out

AD0AD1

AD2

Increase in government spending eventually increases interest rates through increased money demand which then decreases investment and consumption

Unemployment/Inflation Trade-Off

There is a trade-off that policy makers face. Increase output (decrease unemployment) and you increase prices. Decrease prices and you decrease output (increase unemployment). Try it on the ADAS model.

The trade-off is depicted geometrically by the Phillips curve.

Phillips Curve

Unemployment rate

Inflation Rate

Policy Debates The pros and cons of active stabilisation The pros and cons of using discretionary

monetary policy How much should inflation be? The pros and cons of balance budgets

What You Should Know About Now

PPF’s Supply and Demand + Elasticity +

Government Policies GDP and Growth Open Economy Macroeconomics ADAS Monetary and Fiscal Policy

What ECO1000 Should Have Taught You

How to think logically in a step-by-step fashion

The importance of defining your terms and constructing your arguments carefully

The value of objective analysis And, of course, the content that constitutes

elementary economics.

Tips for Success in the Future Never make the same mistake twice. Enrol in an economics major. Study hard.

Golden Rules for Success in Business

Rule Number One:Never Lose Money

Rule Number Two:Never Forget Rule Number One

THE END Exam is very soon. Attend the revision sessions next week. The course leader and tutors are available

for consultation over the next few weeks (including during the first exam week)

Seek help if you need it.