Econ 1020 SEMESTER 2 SUMMARY NOTES

8/18/2019 Econ 1020 SEMESTER 2 SUMMARY NOTES

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Topic 1 – Gross Domestic Product (GDP)

Macroeconomics vs Microeconomic

Microeconomics = the study of how individuals and firms make choices,how they interact in markets and how the government attempts toinfluence their choices

Macroeconomic = the study of the economy as a whole (includingtopics such as inflation, unemployment and economic growth)

Gross Domestic Product (GDP)

Gross Domestic Product (GDP) = the market value of all final goods

and services produced in a country during a period of timeo Elements:

Market value (not quantities as all goods have differentmeasurements of quantities)

Final goods and services (not intermediate goods andservices)

Produced domestically (not imports) Produced during the relevant period of time (not goods

produced before the period commenced – e.g. second-handgoods)

o Exclusions:

Domestic work Illegal activities Intermediate goods and services (i.e. goods and services

used in the production of a final good or service – cannotdouble count)

Note: the same good or service can be a final or anintermediate good depending on context (e.g. a tyresold to a car manufacturer is a intermediate goodwhile a tyre sold directly to a consumer is a finalgood)

Used, second-hand goods (second-hand goods have alreadybeen counted in the GDP of the time period in which theywere produced – cannot double count)

Financial assets (e.g. stocks, bonds, etc) Imports (foreign produced goods and services

GDP measures the size of the economy and total productiono This is important as knowing the size of the economy has

important policy and business implications (e.g. a business will beable to forecast sale figures and determine how much to invest)

o GDP also assists in other areas of macroeconomic analysis: Trade openness

Sustainability of a country’s debt Sustainability of a country’s current account deficit

Please note that LIFT does not warrant the correctness of the materials contained within the notes. Additionally, in some cases,these notes were created for previous semesters and years. Courses are subject to change over time, both in content and scope ofassessment. Thus the information contained within may or may not be assessed this semester, or the information may have beensuperseded. These notes reproduce some copyrighted material, the use of which has not always been specifically authorised bythe copyright owner. We are making these materials available for the purposes of research and study and as such believe that thisconstitutes fair dealing with any such copyrighted material pursuant to s 40 Copyright Act 1968 (Cth).


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GDP is denoted as Y

Measuring GDP

Production method (or value added method) = the sum of the

incremental value added at each stage of the production process Income method = the sum of the income generated from the sale of

domestically produced goods and serviceso The income method is almost identical to the production method

Expenditure method = the sum of expenditures on all domesticallyproduced goods and services

Each method will provide the same answer

Components of GDP

GDP = consumption + investment + government purchases + net exports

Y = C + I + G + NX

Consumption = any goods and services purchased by households o Consumption is divided into services (e.g. medical care, education),

durable goods (e.g. cars) and non-durable goods (e.g. food, clothes)o Excludes purchases of new houses

Investment = new fixed capital (e.g. machinery, factories, offices, etc),new inventory (goods that are produced but not sold) and newresidential houses

o Excludes depreciation of goods or purchases of financial securities(e.g. shares – this is merely a transfer of assets and no goods andservices are produced from buying and selling shares)

Government purchases = government spending on consumption andinvestment items

o Excludes transfer payment (e.g. Centrelink benefits) as no goodsand services are receive in return for these payments

Net exports = Exports – importso

Spending on imports is excluded as GDP is only concerned withspending on domestically produced goods and services

Example: A cotton farmer sells cotton to a fabric wholesaler for $5. Thewholesaler then processes it and sells it to a clothing retailer for $8. Theclothing retailer sews a shirt with the cotton, which they sell tocustomers for $10. What is the GDP (Y) of this shirt?

Production method: Y = value added at each stage of the productionprocess = $5 + ($8 – $5) + ($10 – $8) = $5 + $3 + $2 = $10

Income method: Y = sum of income generated at each stage of theproduction process = $5 + ($8 – $5) + ($10 – $8) = $5 + $3 + $2 = $10

Expenditure method: Y = money spent on the final product = market

value = $10


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o The increase in consumption caused by the purchase of importedgoods is cancelled out by the decrease of net exports

GDP per capita

GDP per capita =

GDP per capita is often seen as the average income per persono This is clearly inaccurate as everyone earns a different income

GDP per capita is used as an indicator of wellbeing or standard of living o If a country wants to increase their standard of living, their GDP

must increase faster than the populationo GDP per capita as an indicator of standard of living is inaccurate

because: There are many other factors that impact one’s

standard of living that is not considered whendetermining GDP e.g. crime rate, distribution of wealthacross the population, leisure, quality of health care andeducation, pollution

Gross National Happiness (GNH) has been suggestedas a new framework for measuring standard of living GNH considers sustainable development, culturalintegrity, ecosystem conservation and goodgovernance

Some events may increase GDP but reduce wellbeing caraccidents, money spent on medical service, fires, etc

Cross-country or cross-time comparison of GDP When comparing GDP cross-country, figures are based on Purchasing

Power Parity (PPP) valuation to account for price differences acrosscountries

o E.g. A haircut in the Philippines will cost less than in Australia,even when expressed in the same currency

When comparing GDP cross-time, inflation is adjusted for by using realGDP rather than nominal GDP figures

o Nominal GDP = the market value of final goods and servicesevaluated at current year prices

o Real GDP = the market value of final goods and services evaluatedat base year prices

The base year can be any year – prices are kept constant atthe prices in this year

Why? This fixes the problem caused by increases inprices of goods and services increasing GDP even ifproduction has not increased

A problem with this method is that over time, pricesof goods and services may change relative to eachother

GDP Deflator


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GDP deflator =

GDP deflator is a price index (no units) it is a measure of the averageprices of goods and services produced in the domestic economy

o The GDP deflator is not an important number in itself; rather, is

important in comparison of different years (e.g. if the GDP deflatoris 100 in 2010 and 103 in 2011, inflation has increased by 3%)

Inflation = % change in GDP deflator (% change in general price levelin the economy from one year to the next):

o % change in GDP deflator = %change in nominal GDP - % change inreal GDP

o Inflation = %change in nominal GDP – % change in real GDP

Example:

Production and Price Statistics of Futureland2010 2011

Product Quantity Price perunit ($)

Quantity Price perunit ($)

Wellington/Gumboots

95 50 110 60

Raincoat 500 35 550 40

ToiletPaper

500 35 550 15

Nominal

GDP

$42, 650 $51, 100

(a) Using 2010 as the base year, calculate the value of real GDP in2011:

Real GDP = 2011 quantity x 2010 quantity

Wellingtons: 110 x $50 = $5, 500Raincoats: 550 x $35 = $19, 250Toilet Paper: 1, 500 x $12 = $18, 000

Real GDP = $5, 500 + $19, 250 + $18, 000= $42, 750

The real GDP in 2011 is $42, 750.

(b) Calculate (i) the GDP deflator; and (ii) the price change between2010 and 2011, using 2010 as the base year.

(i)

GDP deflator =

=

= = 119.53


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Example: Between 2009 and 2010, Greece’s nominal GDP decreased by6% and it’s GDP deflator increased by 1.7%. What is the change in

Greece’s real GDP?

Inflation = %change in nominal GDP – % change in real GDP% change in real GDP = %change in nominal GDP – Inflation% change in real GDP = –6% – 1.7%

= –7.7%

Greece’s real GDP contracted by 7.7% in 2010.

Example con’t :

(ii)Price change between 2010 and 2011= inflation

Inflation = %change in GDP deflator= GDP deflator in 2011 – GDP deflator in 2010= 119.53 – 100= 19.53

The price change between 2010 and 2011 is 19.52.


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Topic 2 – Economic Growth and Business Cycles

Long-Run and Short-Run Mo vements

When analysing changes in GDP (or GDP per capita), it is useful todistinguished between short-run and long-run movements

o

Trend = long-run movementso Fluctuations = short-run movements (what happens around the

trend)

Potential GDP

A country’s long-run trend GDP value is called potential GDP

Potential GDP is NOT maximum GDPo Maximum GDP = the level of GDP attained GDP when firms

operate as long as they can and use as many workers as theycan hire

o

Potential GDP = the level of GDP attained when firms operate ontheir normal hours using a normal workforce (producing atcapacity)

Potential GDP will increase over time as labour productivity grows

Potential GDP can be bigger or smaller than actual GDP

Output gap (%) =

o If there is an economic boom, actual GDP is greater than potentialGDP (positive output gap)

o If there is an economic slump, actual GDP is less than potentialGDP (negative output gap)

Growth

Income growth rate =

o Where: = GDP of earlier year

= GDP of later year

Potential GDP vs Actual GDP


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To work out how long it would take for an investment to double, applythe rule of 70

o This is used to estimate the speed at which real GDP per capita isgrowing

A country with a higher growth rate will take less time forthat GDP per capita to double than a country with a slowergrowth rate

Number of years to double =

Financial System

All advanced economies have a well developed financial system

Financial system = the system of financial markets and financial

intermediaries through which firms acquire funds from householdso Financial markets = share and bonds market

Example: Real GDP per capita was $59, 629 in 2011 and $60, 839 in2012. What was the income growth rate?

Income growth rate =

=

=

= = 2.029%

Example: If you invest $1 on a saving account, that gives 4% interest peryear and you invest the interests back into the same account every year,how long would it take for the $1 investment to double to $2?

$1 x (1 + 0.04)n = $2(1 + 0.04)n = 2

N x ln(1 + 0.04) = ln(2)N x 0.04 = 0.7

N =

N =

(proof)N = 17.5 years

It would take 17.5 years for the investment to double.


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o Financial intermediaries = banks, credit unions, insurancecompanies

In financial markets, firms sell financial securities directly to saverso Financial security = a document that states the terms under which

funds pass from the buyer to the seller

Shares = financial securities that represent partialownership of the firm

Bonds = financial securities that represent promises torepay a fixed amount of funds (interest payments each year+ repayment of loan)

Financial intermediaries facilitate the flow of fund betweenborrowers and lenders/savers

o Banks specialise in assessing the risk of a loan, collecting fundsfrom various channels, allocating them to credit-worthy borrowersand setting a price (the interest rate) for the loans to reflect the

cost and risks involvedo The bank will pay the saver an interest in exchange for the use of

the savers funds and will charge the borrower a higher rate ofinterest to make a profit

Saving and Investment

The funds available to firms through the financial system comes fromsavings

When firms are using funds to purchase machinery, offices, etc, they areengaging in investment

In a closed economy, there are no exports (NX = 0) (all economies today

are open economies – engage with other economies in trading)o Y = C + I + G + NXo Y = C + I + Go I = Y – C – G

In a closed economy, the total value of saving in the economy mustequal the total value of investment

Savings:o SPrivate = Y + TR – T – C

The amount of income remaining after a household haspurchased goods and services, paid taxes and received

transfer payments)o SPublic = T – TR – G

The amount of tax revenue remaining after the governmenthas paid for government purchases and made transferpayments

o S = SPrivate + SPublico S = Y = TR – T – C + T – TR – Go S = Y – C – G (the same as I above)

Thus, S = I (as the real interest rate (r) will adjust until S = I)o The relationship between S, I and r an be described by the loanable

fund market model

In an open economy, domestic investment can be financed by foreigncapital (and domestic savings can be used to finance foreign investment)


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The Market for Loanable Funds

Market for loanable funds = the interaction of borrowers andlenders that determines the market interest rate and the quantity ofloanable funds exchanged

Demand for loanable funds is determined by the willingness of firmsto borrow funds to invest in new projects and of households to borrowto invest in new houses

o

Demand is downward sloping the lower the interest rate, thegreater quantity of investment projects firms can profitablyundertake

Supply of loanable funds is determined by the willingness ofhouseholds to save and the extent of government saving or dissaving

o Supply is upward sloping the higher the interest rate, thegreater the reward for saving and the larger the amount of fundshousehold will save

Equilibrium in the market for loanable funds will determine the quantityof loanable funds that will flow from lenders to borrowers as well as the

real interest rate Interest rate:

o Nominal interest rate = interest rate stated on the loano Real interest rate = nominal interest rate – inflation rateo The interest rate affects savings:

A rise in interest rates encourages households to save sothat they have more money in the future

A rise in interest rates will cause firms to borrow lessmoney as the interest to be paid back will be higher

A company should only borrow money to fund projects if theexpected return rate of the project is higher than the interest rate on

the borrowed money

Market for Loanable Funds:


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o If interest rates go up, companies will borrow less money as fewerprojects are profitable

Increase in demand for funds:

Increase in supply for funds:

Subprime Mortgage Crisis

The global financial crisis (GFC) of 2008 began with the subprimemortgage crisis in the USA in 2007

There are two different types of mortgages:o Prime mortgage = mortgages for borrowers with good credit

recordso Subprime mortgage = mortgages for borrowers with poorer

credit records (higher expected default rates)

The role of banks is to collect funds from individual savers and channelthem to individual borrowers

o Banks specialise in assessing the risk of a loan and in setting a

price (i.e. interest rate) to reflect the cost of the fund and the riskinvolved (i.e. higher risk higher interest rate)


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Because mortgage loans have a very long repayment duration (e.g. 20–30years), they are illiquid assets

o Banks developed mortgage-backed securities (MBS) to convertthis illiquid asset to liquid assets

MBS = a financial asset which the value is connected to

mortgage loans Investors of MBS, what they expect to get is a long-term

stable high investment return By selling a MBS to other investors for cash, banks not

only turn illiquid assets to liquid assets but alsotransfer the risk associated with mortgage loans to MBSholders

If a borrower defaults, the MBS holder bears the loss this gives the bank less incentive to scrutinisethe quality of loan applications but more incentive

to make loanso Borrowers with poor credit records are more

likely to get a loan with little or zero downpayments (liar loans)

This began the bloom of subprimemortgages

The low interest rate in the early 2000’s gave US households animpression that they would be able to make the interest payments

o When interest rates went back to a more normal level, manyhouseholds failed to meet the interest payment obligations

Failure to make payments home foreclosures large

number of houses went on the market housing prices fellas supply had increased

MBS values plummetedo Because many US ‘toxic’ MBS’s were sold to foreign financial

institutions, the impact was global Australian was not as negatively affected as the rest of the

world due to a timely resource boom, RBA lowered officialinterest rates, fiscal stimulus package and strongregulations

Mortgages:


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Business Cycle

Business cycle = alternative periods od expanding and contractingeconomic activity

During the expansion phase production, employment and income areincreasing above the trend in growth that the economy experiences over

time During the contraction phase production, employment and income are

falling below the trend in growth o A contraction phase may be followed by a recession

Recession = when total production and employmentare decreasing and economic growth is negative

o Contraction or recession ends with a business cycle trough theexpansion period will begin again

Phases of the Business Cycle:

Each business cycle is different however, they share commoncharacteristics:

o As the economy nears the end of an expansion Interest rates are usually rising Wages of workers are usually rising faster than prices

Profits of firms will be falling Household and firms will have substantially increased

debtso As the economy begins contraction

There will be a decline in spending by firms on capitalgoods or by households on new houses and durable goods

As spending declines sales decline firms cut back onproduction and lay off workers rising unemployment further declines in spending possible recession

o As the contraction or recession continues, economic

conditions gradually begin to improve


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Inflation rate: o During economic expansions, the inflation rate usually

increases (particularly near the end of the expansion) o During economic contractions, the inflation rate usually decreases

Exception: if expansion is due to rising productivity levels

and an expansion of potential GDP or if contractions iscaused by high prices for production inputs

Unemployment rate: o During economic expansions, the unemployment rate will

decreaseo During economic contractions and recessions, the unemployment

rate will decrease


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Topic 3 – Long-Run Growth

Growth

When economists refer to growth, it is mostly in reference to the long-run movement of real GDP per capita

o

Real GDP per capita is still considered the best measure ofeconomic growth despite its limitations in measuring wellbeing(higher income will allow individuals to afford better healthcare,education, more material possessions, etc)

There is an expectation in advanced countries that living standards willimprove

Economic growth causes an economy to produce increasing quantitiesand types of goods and services

In the long run, small difference in economic growth rates result in bigdifferences in living standards

Different countries have different economics growth rateso Poor countries have not experiences substantial economic growth

Labour Productivity

Labour productivity = the amount of output produced per labour o Labour = one worker per hour

For the standard of living to improve (consuming more goods andservices), there must be an increase in labour productivity

o Each person must be able to produce more output on average

Labour productivity will increase if there is:o

More physical capital o More human capita o Technological progress

The relationship between these three elements and labour productivityand output can be explained by the neoclassical growth model

o Neoclassical growth model = increases in the quantity ofcapital per hour worked and increases in technologydetermine how rapidly real GDP per hour worked andcountry’s standard of living will increase

Physical Capital: o

Physical capital includes manufacturing goods that are used toproduced other goods and services (e.g. computers, machines,factories, etc)

o Accumulating more physical capital will lead to growth but asphysical capital increases, the amount of output gained willdecrease (law of diminishing returns)

Human Capital: o Human capital is accumulated knowledge and skills that

workers acquire from education and training or from their lifeexperiences

o

An increase in human capital will shift the production functionupwards


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Technological Progress: o Technological progress (or change) refers to when firms can

produce more output using the same amount of inputs o Technological change can occur due to:

Better machinery and equipment

Better organization and management methodo Technological progress will shift the production function upwards

Per-Worker Production Function

Per-worker production function = the relationship between realGDP (or output) per hour worked and capital per hour worked ,holding the level of technology constant

Anything that affect the accumulation of physical capital, theaccumulation of human capital or technological progress will affectoutput per labour and will affect the production function

Examples:o A. An increase in subsidies on education this increase human

capital the production function will shift upwards (as K/L is thesame but Y/L has increased)

o B. An increase in population due to migration but the capital stockremains the same this increases labour the point at which theeconomy is at will move to the left along the production functionas both output per labour and capital per labour have decreaseddue to the increase in population

o C. A severe drought that affects the agricultural sector thisdecreases output per labour the production function will shift

downwards (as K/L is the same but Y/L has decreased)

Movements along and shift of the production function:


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New Growth Theory

New growth theory = a model of long-run economic growth thatemphasizes that technological change is influenced by economicincentives and opportunities within the market thus, is determined bythe working of the market system

Research and development is required for technological change tooccur (strong focus on human capital)

An increase in human capital will lead to increasing returns on a whole-economy scale as knowledge is:

o Non-rival = one firm’ use of the particular knowledge does notinhibit others from using it

o Non-excludable = once discovered knowledge become widelyavailable, anyone can use it

Without sufficient protection of intellectual property rights, individual orfirms will not be willing to invest in research and development

o

Firms would be worried that while they spend funds onresearch, other firms will use their research and reap benefits

To prevent this problem occurring by:o Protecting intellectual property rights through patents (for

manufactured products) and copyrights (for books, movies, musicand software)

o Subsidising research and development o Subsidising education (both at the school and firm level)

Economic Openness (Globalisation)

Economic openness is when a domestic economy is open to foreign

trade and investment Economic openness will affect growth

o E.g. When North Korea and South Korea, the two countries wereequally poor. However, South Korea opened up to internationaltrade and investment, while North Korea did not. The GDP percapita of South Korea is now 17 times that of North Korea

Types of economic openness: o Trade – domestic firms can import better equipment and

materials o Foreign Direct Investments (FDI) – firms build factories in a

foreign country or will buy ownership of a foreign company(brings in both funds and new technology)

Or foreign firms buy more than 10% shares in a domesticfirm (according to IMF)

o Foreign Portfolio Investment (FPI) – firms buy shares or bonds(less than 10%) in foreign companies (brings in only funds)

Trade and FDI’s increase competition in domestic firms to become more

efficient in order to survive

Advantages of economic openness: o Allows developing countries to break the cycle of low saving and

investment; thus, enabling higher growth and ultimately catch-up o

Technological developments are readily diffused beyond nationalborders


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Disadvantages of economic openness: o Rich nations exploit the developing world for low wages and poor

health and safety and environmental regulationso Undermines distinctive cultures o Market failures have a global impact (e.g. GFC)

Catch-Up

The economic growth model predicts that poor countries will growfaster than rich countries

o If this is correct, poor countries should be catching up with richcountries this is not the case

The hypothesis is that poor countries will experience a higher level of realGDP per capita growth than rich countries as developing countries arenot as greatly affected by diminishing marginal returns thandeveloped countries this will result in convergence in real GDP per

capita and standards of living throughout the world Reasons for slow economic growth in poor countries:

o Failure to enforce the rule of law (e.g. property rights, contracts) o Wars and revolutions o Poor public education and health o Slow technological developmentso Low rates of saving and investment

Poor countries can break out of a low-growth cycle through foreigninvestment (easier for the country to get funds and technology)


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Topic 4 – Aggregate Expenditure and Output in the ShortRun

Inventory and Investment

Inventories = goods that have been produced but not yet sold Inventoried will be accounted for in the investment section of GDP

Actual Investment (I) = Planned Investment (IP) + UnplannedInvestment (IU)

Planned investment includes: o Spending on equipment, machinery, factories and buildings o Planned changes in inventorieso New houses

Unplanned investment includes:o Unplanned changes in inventories

If less goods are sold than expected – Iu > 0

Firms will reduce production and employment willfall

Real GDP will fall in the next period If more goods are sold than expected – Iu < 0

Firms will increases production and employmentwill rise

Real GDP will rise in the next period

Actual investment spending > planned investment spending whenthere is an unplanned increase in inventories

Actual investment spending = planned investment spending when there is

no unplanned change in inventories Actual investment spending < planned investment spending when

there is an unplanned decrease in inventories

Example:

Toyota expects to sell 700 new cars to domestic consumers, 50 togovernments and 170 to overseas consumers every quarter. It also keep80 of its new cars in its showrooms.

1. How many new cars does Toyota produce per quarter? Whatis its planned investment?

Y = C + G + NX + IP + IU= 700 + 80 + 170 + 80 + 0= 1000

Toyota produced 1000 new car per quarter. Its plannedinvestment is 80 (planned change in inventory).


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Example con’t

2. If overseas market sales unexpectedly decline to 100, what isToyota’s unplanned investment and actual investment?

Unplanned investment would be 70 (unplanned change ininventory).Actual investment = IP + IU

= 80 + 70= 150

3. If domestic market sale unexpectedly rises to 800, what isToyota’s unplanned investment and actual investment?

Unplanned investment would be –100 (unplanned change ininventory).

Actual investment = IP + IU= 80 – 100= –20

Toyota would have to use old stock to fulfill demand.

Aggregate E xpenditure Model

The AE model demonstrates that in any particular period, the level ofGDP is determined mainly by the level of aggregate expenditure

Assumption that prices (of goods and services and of capital and labour)are constant

o This assumption is reasonable in the short-run but not in the long-run

Planned Aggregate Expenditure = the total amount of spending inthe economy

o The sum of consumption, planned investment, governmentpurchases and net exports

AEP = C + IP + G + NX

Thus, Y = AEP + IU

Determining the Level of Aggregate Expenditure in the Economy

Consumption o Five important variables that determine the level of consumption

Current disposable income (Y d) = income remainingafter paying income tax and receiving transfer payment

As current disposable income increases (decreases),consumption increases (decreases)

Household wealth = value of a household’s assets inusthe value of it’s liabilities

As household wealth increases (decreases),

consumption increases (decreases), even if currentdisposable income is unchanged


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Expected future income = income expected to beearned by a household in the future

Current disposable income will explain consumptionwell providing that current income is not unusuallyhigh or low compared with expected future income

Price level = the average prices of goods and services inthe economy

An increase (decrease) in the price level woulddecrease (increase) a household’s wealth; thus,enabling them to purchase less (more) with thesame income

Real interest rate = the nominal interest rate correctedfor the impact of inflation

When the interest rate increases (decreases), thereward for saving increases (decreases); thus,

households are likely to save more (less) and spendless (more). The cost of money to spend on durablegoods also increases (decreases)

o Consumption has two components: Autonomous consumption consumption independent

of income Induced consumption consumption dependent on

income

o Consumption function: The consumption function explains the relationship

between consumption and disposable income A change in consumption depends on a change in

disposable income C = a + bY d

a = autonomous consumption

bYd = induced consumption o b = marginal propensity to consume (MPC)o Yd = disposable income

Marginal Propensity to Consume:

MPC =

=

o The resulting decimal is the percentage ofincome which a household will spend

Marginal Propensity to Save:

MPS =

=

o The resulting decimal is the percentage ofincome which a household will spend

MPC + MPS = 1

E.g. If MPC = 0.7 and MPS = 0.3, when Yd increases by$100, consumption will increase by $70 ($100 x

70%) and saving will increase by $30 ($100 x 30%)


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Investment o Four important variables that determine the level of investment

Expectation of future profitability

A firm is likely (unlikely) to invest in new factories,offices and equipment if they expect (do not expect)

that demand for their product to stay strong Interest rate

An increase (decrease) in the interest rate will resultin less (more) investment spending as it would bemore (less) expensive for firms to borrow money

Taxes

An increase (decrease) in company income taxwould decrease (increase) the after-tax profitabilityof investment spending

Cash flow = the difference between the cash revenues

received by the firm and the cash spending by the firm The more (less) profitable a firm, the greater (lesser)

its cash flow and the greater (lesser) its ability tofinance investment

Government Purchases o Main source of government revenue is taxation

The more (less) taxes the government receives, the more(less) funds the government has to spend on governmentpurchases

Net Exportso Three important variable that determine the level of net exports

The price level in Australia relative to the price level inother countries

When the inflation rate is lower (higher) in Australiathat in other countries, the prices of Australianproducts increase slower (faster) than the prices offoreign products. This increases (decreases) thedemand for Australian products exports willincrease (decrease) and imports will decrease

(increase) The economic growth rate in Australia relative to the

economic growth rate in other countries

If income rises faster (slower) in Australia than inother countries, Australian purchases of foreigngoods and services increases faster (slower) thatforeign purchases of Australian goods and services exports will decrease (increase) and imports willincrease (decrease)

The exchange rate between the Australian dollar andother currencies

An increase (decrease) in the value of the AUD willdecrease (increase) exports as Australian goods are


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more (less) expensive in foreign currencies andincrease (decrease) imports as foreign goods areless (more) expensive in AUD.

Components of AEP:

The Multiplier Effect

The multiplier effect is the process by which an increase in autonomousexpenditure leads to a larger increase in real GDP

o Why? If one area of spending increases, individuals affected by thatspending will receive more income. This extra income will bespent on other goods and service. Those people who receiveincome from those goods and services will receive more income.

This extra income will be spent on other goods and services (andso on)

Multiplier =

=

The larger MPC, the more sensitive an economy is to changes inautonomous expenditure

Example: A government increases its spending on schools by $10

million. If the MPC of the economy is 0.6, what is the multiplier? What isthe change in GDP due to this increase in spending?

Multiplier =

=

=

= 2.5

Δ GDP = Multiplier x Δ Government spending = 2.5 x $10 million = $25 million


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Equilibrium

Short-run equilibrium occurs when AEP = Y

In short-run equilibrium, Y is not necessarily equal to potential GDP

Short-run equilibrium:

If AEP > Y o The economy demands more than the economy produces

(total spending > total production) There will be an unplanned decrease in inventory (IU < 0)

Firms will increase production in the next period untilAEP = Y

Employment will rise to cater for the increase inproduction

o Knock-on effect: Increase in demand from consumers warehouse sells more goods warehouse orders more goodsfrom the producer producer increases production employment rises increased spending in other areas of theeconomy as individuals have more money

If AEP < Yo

The economy demands less than the economy produces (totalspending < total production) There will be an unplanned increase in inventory (IU > 0) Firms will decrease production in the next period until

AEP = Y Employment will fall to cater for the decrease in

productiono Knock-on effect: Decrease in demand from consumers

warehouse sells less goods warehouse orders less goods fromthe producer producer decreases production employmentfalls decreased spending in other areas of the economy as

individuals have less money may lead to a recession Increases and decreases in AEP cause the year to year fluctuations in GDP


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Topic 5 – Aggregate Demand and Aggregate Supply

Aggregate Demand and Supply M odel

The aggregate demand and supply model explains fluctuations in realGDP and in the price level

In the short run, the price level is determined by the intersection of theaggregate demand curve and the short-run aggregate supply curve

Aggregate Demand (AD) Curve

AD curve = the relationship between price level and quantity demandedof real output

A fall in the price level will increase the quantity of real output demanded

The aggregate demand curve is downward sloping. Why?o The Wealth Effect as the price level increases (decreases), real

wealth of households decreases (increases) (as they can buy less

(more) with their current wealth); thus, consumption decreases(increases)

o Interest Rate effect as the price level increases (decreases), thehouseholds and firms would have to borrow more (less) moneyfrom banks to conduct investment. This drives the nominalinterest rate up (down); thus, reducing (increasing) investment

o International Trade effect as the price level in Australiaincreases (decreases), the profitability of purchasing Australianproducts decreases (increases). Thus, exports will decrease(increase), imports will increases (decrease) and net exports will

decrease (increase)o

Note: it is assumed that government purchases are independent ofthe price level as government purchases are determined by policymakers

Movements along the AD curve occurs due to changes in the price level

Shifts of the AD curve occur due to:o Changes in government and central bank policies (e.g. if the

government purchases more goods regardless of the price level)o Changes in the expectation of households and firms (if

optimistic (pessimistic) about the future, there will be an increase(decrease) in consumption)

o

Changes in foreign variables (e.g. exchange rate, economicgrowth)

Aggregate Supply (AS) Curve

Aggregate supply is considered in terms of both in the short-run and inthe long run

Long-run aggregate supply (LRAS): o LRAS curve = the relationship between the price level and quantity

of real output supplied in the long-run Long-run = when no variable are fixed

o

LRAS curve is a vertical line in the long run, changes in theprice level do not affect the level of real GDP


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o LRAS curve is at potential GDP o Shifts of the LRAS curve occur due to:

Changes in capital stock (especially public infrastructure) Technological advance Changes in the number of workers

Short-run aggregate supply (SRAS): o SRAS curve = the relationship between the price level and quantity

of real output supplied in the short-run Short-run = when some variable are fixed

o SRAS is upward sloping. Why? As the price level rises, firms are willing to supply more

goods and services as the price of inputs rises slower thanthe rise in profits

o SRAS is different to LRAS due to sticky prices Prices are sticky (slow to respond to changes in AD) in the

short run because: Menu costs – there are generally cots involved in

changing the price of a good or service

Firms are uncertain about whether the increase indemand will be sustained or not

Wages (and other input costs) are locked into acontract (often for a period of years)

o Movements along the SRAS curve occurs due to changes in theprice level

o Shifts in the SRAS occur due to: The same factors that shift the LRAS curve

Expected changes in the future price level Adjustments by workers and firms to correct errors in

past expectations about the price level Unexpected changed in the price of an important

natural resource

Macroeconomic Equilibrium

Equilibrium occurs at the intersection of the AD curve and the SRAS curve

In the long run, the AD curve and the SRAS curve will intersect on theLRAS curve (the economy will be at potential GDP)

Expansion o 1. The economy begins at point Ao 2. There is an increase in aggregate demand AD curve shifts to

the righto 3. The economy will move along the SRAS curve to point B this

point is beyond potential GDP; thus, indicating that resources arebeing over-utilised and there is upward pressure on wages

o 4. An increase in wages will increase the cost of production forfirms this will shift the SRAS curve to the left

o 5. The economy will move along the AD curve to point C theeconomy is back at potential GDP but the price level has risen


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Recession o 1. The economy begins at point Ao 2. There is a decrease in aggregate demand AD curve shifts to

the lefto 3. The economy will move along the SRAS curve to point B this

point is below potential GDP; thus, indicating that resources arebeing under-utilised and there is downward pressure on wages

(workers are willing to accept lower wages)o 4. A decrease in wages will decrease the cost of production for

firms this will shift the SRAS curve to the righto 5. The economy will move along the AD curve to point C the

economy is back at potential GDP but the price level has fallen

Expansion:

Expansion:


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Supply Shock o 1. The economy begins at point Ao 2. A sudden change in the availability of a natural resource (e.g. oil)

will decrease supply SRAS curve will shift to the lefto 3. The economy will move along the AD curve to point B this

point is below potential GDP; thus, indicating that resources arebeing under-utilised and there is downward pressure on wages(workers are willing to accept lower wages)

o 4. After an extended period of time (years), the resulting fall inwages will decrease the cost of production for firms this willshift the SRAS curve to the right (back to the original positi on)

o 5. The economy will move along the AD curve to point A theeconomy is back at potential GDP and at the same price level

Supply Shock:


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Topic 6 – Unemployment

Unemployment Rate

Each month, the ABD conducts a labour force survey to calculate theunemployment rate

To be classified by the ABS as unemployed, the person must have:o Worked for less than one hour in paid employment in the

week before the survey;o Actively looked for work in the previous four weeks; ando Is currently available to start work

Unemployment rate = percentage of the labour force that is unemployed

Labour force = no. employed + no. unemployed (according to ABS)

The unemployment rate does not give an accurate depiction of theunemployment situation in Australia due to the strict definition of‘unemployed’

o Discouraged workers (those available for work but havestopped searching for work as they believe there are no jobsfor them) are not included in the no. of unemployed

o Institutionalised people (i.e. people in jail) are not include o Those who are underemployed are considered as employed

(understates joblessness)

Features of unemployment:o UER of young people is much higher than that of older people

This is because the labour force in older age groups issmaller as many are retired

o In the past: The UER of women was higher than men The UER of men was more volatile than that of women The UER of different age groups was not that different

Labour Force Participation Rate

Labour force participation rate = percentage of the working agepopulation that is in the labour force

Working age population = anyone 15 years or older

Types of Unemployment

Cyclical Unemployment o Unemployment caused by the business cycle

Economic expansion job creation lowerunemployment

Economic contraction job destruction higherunemployment

o

Cyclical unemployment will equal 0 when the economy idproducing at its potential output level (Y=Y*)


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o After a contraction, the unemployment rate will not immediate risebecause discouraged workers re-enter the labour force (until theyfind work, they are unemployed) and business are reluctant to re-hire workers as they want to be confident that the expansion of thebusiness cycle is not just temporary before hiring more workers

(this lag may take 1–2 years) Frictional Unemployment

o Short term unemployment due to the fact that it takes time foremployees to find the right job and employers to find the rightemployees (mismatch of workers)

o Frictional unemployment includes seasonal unemployment – unemployment due to seasonal factors, such as weather and othercalendar-related events (e.g. ski instructors, employees at a beachresort, companies which sell Christmas products)

o Some frictional unemployment is good as it means that workers

and firms are taking their time to match the right workers with theright jobs

Structural Unemploymento Unemployment arising from the persistent mismatch between

the skills and characteristics of workers and the requirementsof jobs arising from the changing structure of the economy

o Structural unemployment is for a longer term than frictionalunemployment as it takes time for workers to learn new skills

o Factors that cause structural unemployment include technologicalchange, minimum wage, trade union power and efficiency wage

Full employment/natural rate of unemployment = when there is 0cyclical unemployment

o There will always be some frictional and structural unemploymento Natural rate of unemployment is also known as the non-

accelerating inflation rate of unemployment (NAIRU)

Long-term unemployment = a person is classified as long-termunemployed if they have been unemployed for one year or more

Costs of Unemployment

Unemployment has negative personal and social impacts

The size of the impact depends on the duration of the unemployment (thelonger people are unemployed, the more they lose their skills andworkplaces contract and thus it is harder for them to get a job)

Costs of unemployment to the economy as a whole: o Loss of GDP (people have less money to buy things)o Loss of human capital (skills deteriorate when people are

not using them)o Retraining costso Costs to government (due to unemployment benefits)o Opportunity cost of funds being directed towards unemployment

benefits

Costs of Unemployment to the unemployed: o Loss of income


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o Loss of skillo Loss of self-esteemo Social costs on society (e.g. problems)o Health problemso Crimeo

Political unrest

Unemployment Benefits

Unemployment benefits are an important automatic stabiliser of aneconomy

Unemployment benefits have the effect of:o Lessening financial pressure on the unemployed – allows more

time for job searching so they can find a job for which they are bestsuited to (allows for increased labour market efficiency)

o Reducing the opportunity cost of unemployment (i.e. reducing the

incentive to work) as the unemployed are still receiving an income(this leads to longer periods of unemployment)o Reducing income inequality

With unemployment benefits, the shift of real GDP after a demand shockwill be less severe

Without unemployment benefits: With unemployment benefits:


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Topic 7 – Inflation

General

Inflation = the sustained increase in the price level

Price level = a measure of the average price of goods and services inthe economy

o The price level is unitless

Inflation rate (%) = the percentage increase in the price level fromone year to the next

o Note: Since 1990, the inflation rate in Australia has usually beenbelow 4% (with the exception of one-off spikes)

There are a number of ways to measure the price level:o Consumer price index (CPI)o GDP deflatoro Producer price index (PPI)

o

Wholesaler price index (WPI)o Retail price index (RPI)

Types of inflation:o Inflation refers to an increase in price levels from year to yearo Deflation = negative inflation (decrease in the price level – e.g.

2%) Deflation expectation (occurs in countries with a long

trend of deflation – e.g. Japan) = consumers expect there tobe deflation, meaning that the price of goods and serviceswill decrease. Thus, consumers hold off their spending.

Aggregate demand continues to contract andunemployment increases.o Disinflation = a reduction in the inflation rate (i.e. the price

level is increasing but at a slower rate than the year before – e.g. achange in the inflation rate from 3% to 2%)

o Hyperinflation = very high inflation (no specific threshold as towhat constitutes ‘very high’ – usually where inflation > 100%)

Hyperinflation tends to occur in periods of war or politicalunrest when the government spends more than it has. Thegovernment will order more money to be supplied in theeconomy

Consumer Price Index (CPI)

The CPI is the most commonly used price index for measuring inflation

CPI= a measure of how much a typical family of four in a capital cityneeds to spend on a representative basket of goods and services in aparticular year relative to the base year

o Based upon the ABS’ market basket (i.e. what the ABS hasdetermined is what a typical household would purchase)

CPI is also referred to as the ‘cost -of-living’ index

The inflation rate is the % increase in CPI from year to year

The CPI overstates the true inflation rate due to:


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o Substitution bias – the CPI does not take into account consumersubstitution between products as the price of products change

o Increase in quality bias – the CPI does not take into account thepercentage of the increase in price that is due to an increase inquality of the good or service

o

New product bias – the ABS only updates its market basket every6 years; thus, new products will not be immediate included

o Outlet bias – the ABS does not take into account the prevalence ofdiscount stores and online shopping. Basing prices on full-pricestores will overstate the cost of the market basket.

Measuring Inflation (using CPI)

Method:o Step 1: Calculate the cost of the basket of goods and services

($)

Costs = (price of good 1 x quantity of good 1) + (price ofgood 2 x quantity of good 2) + … + (price of good n xquantity of good n)

Costs = P1Q1 + P2Q2 + …+ PnQn o Step 2: Calculate the CPI

o Step 3: Calculate the inflation rate (%)

Note:o Any year can be used as the base year changing the base year

will change the CPI values but will not change the inflation ratebetween two years

o CPI of the base year = 100

Example: Use the information in the following the table to calculate theannual rate of inflation for 2009 as measure by the CPI (where 2006 is thebase year)

Product Quantity Price(2006)

Price(2008)

Price(2009)

Haircuts 1 $20 $22 $25Hamburgers 9 $4 $4.20 $4.50

DVDs 2 $15 $15 $14

Costs (2006) = (1x$20) + (9x$4) + (2x$15) = $86Costs (2008) = (1x$22) + (9x$4.20) + (2x$15) = $89.80Costs (2009) = (1x$25) + (9x$4.50) + (2x$14) = $93.50

CPI (2008) =

=

=


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Nominal vs. Real variables Nominal variable are not adjusted for inflation

Real variable are adjusted for inflation

The purchasing power of the dollar falls over time as the price level rises(i.e. you could buy more stuff for $1 in 1960 than you can in 2013)

Comparing dollar value over time:

o Real value =

o =

o Nominal value (year 2) = Nominal value (year 1) x

Nominal vs. Real Interest Rates

Exact equation:

Approximated equation: o Where:

r = real interest rate i = nominal interest rate π = inflation rate

o Note: in the exact equation: r , i and π are expressed in decimalform not as a % (e.g. 0.03 not 3%). In the approximated equation,they can be expressed as a %

The real interest rate represents the true cost to borrowers and thetrust (before tax) return to lender

o Banks and other financial institutions forecast the inflation rate inorder to obtain the best return. If the actual inflation rate differsfrom the expected inflation rate, the trust cost and return will bedifferent from the expected cost and return

If actual inflation < expected inflation

Lenders gain and borrowers lose If actual inflation > expected inflation

Borrowers gain and lenders lose

CPI (2009) =

=

=

= 4.12%

The inflation rate in 2009 was 4.12%.


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o Governments with large public debts will have an incentive toraise inflation above the expected level in order to reduce theirreal cost of borrowing

Causes of Inflation

Inflation is cause by too much money chasing too little goods andservices

There are two types of inflation:o Demand–pull inflation caused by an increase in the aggregate

demand for goods and services (positive demand shock) andproduction levels are unable to meet this demand immediately

Excess demand pulls the price level up leads to higheremployment and higher output

Can be caused by expansionary monetary policy,expansionary fiscal policy, increase in consumer

confidence, increase in export demand from overseas, etco Cost –push inflation caused by a decrease in the aggregate

supply of goods and services (negative supply shock) andproduction levels are unable to meet this demand immediately

Excess demand pulls the price level up leads to loweremployment and lower output

Can be caused by natural disasters, increase in importprices, increase in wages that exceed productivity growth,increase in electricity prices, etc

Price wage spiral = demand-pull inflation will raise the price level;thus, triggering cost-push inflation

o Process = demand-pull inflation cause an increase in the price level real wages decrease workers bargain for higher wages tocompensate for inflation nominal wages will increase

Demand-pull inflation: Cost –push inflation:


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negative supply shock (SRAS curve moves to the left) as the cost ofproduction has increased cost-push inflation causes anotherincrease in the price level real wages decrease etc

Costs of Inflation on the Economy

National income generally increases with inflation; thus, it is a fallacy tobelieve that as the price rises, consumers can no longer afford to buy as

many goods and services Inflation affects the distribution of income some people will find

that their income rises faster than the rate of inflation; however, peopleon fixed incomes are likely to be hurt by inflation

Paper money will decrease in value (costs of holding paper money)

Menu costs = costs to firms of changing prices

Increases in nominal income will push people into higher tax brackets

Price wage spiral:


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Topic 8 – Money & Banking

Money

Money = assets that people are generally willing to accept inexchange for goods and services or for the payment of debts

Functions of money:o Medium of exchange – a single good is recognised as the thing

used to buy other goods and serviceso Unit of account – goods and services are measured in terms of

one unit type (e.g. $)o Store of value – money is stored easily and does not lose value

(excluding the effect of inflation)o Standard of deferred payment – money can be used for

borrowing and lending

Measures of money:

o

Currency = notes and coins held by the non-bank privatesector (i.e. individuals and firms)

o M1 = currency + the value of all demand deposits with banksin Australia

Demand deposits = deposits in financial institutions thatare transferrable by cheque, debit cards at EFTPOSterminals and through electronic transfer betweenaccounts

o M3 = M1 + all other deposits (e.g. term deposits) with banks in Australia

o Broad money = M3 + deposits into non-bank deposit-takinginstitutions (e.g. credit unions, building societies, etc), excludingholdings of currency and deposits of non-banking depositorycorporations (e.g. finance companies, money market corporationsand cash management trusts)

Note: liquidity (accessibility) of money decreases as youmove from currency to broad money

Bank Balance Sheet

A bank balance sheet lists the assets, liabilities and shareholder’sequity of a bank

o

Assets include: Reserves = deposits that a bank keeps as cash in the bank’s

vaults or on deposit with the RBA

Banks must hold reserves to meet theirobligations when savers withdraw money

o If a bank does not have enough cash to meetsits obligations, it will be forced to sell its non-liquid assets (e.g. shares and bonds) quicklyor borrow from the RBA or other banks at acost

Loans = promises from households and business to repaymoney borrowed

Securities = shares and bonds


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o Liabilities include: Deposits = money that households deposit with banks

This is a liability as the bank is liable to pay saversback when savers wish to receive their money)

o Shareholder’s equity = the value of the bank

Shareholder’s equity = Total assets – total liabilities A bank will be solvent when assets > liabilities

(equity will be positive)

A bank will be insolvent when assets < liabilities(equity will be negative)

o When a bank becomes insolvent, it has threeoptions:

Declare bankruptcy Bail-out – external investors inject

new capital into the bank

Bail-in – bank creditors convert loansinto shares

Total assets must equal total liabilities & shareholder’s equity

A bank balance sheet allows one to understand where a bank receives itsfunding and how it uses those funds

Example bank balance sheet:

Assets Liabilities + Shareholder’s equity

Reserves 10 Deposits 100

Securities 50 Shareholder’s equity 50

Loans 90

Total Assets 150 Total Liabilities 150

T-Account = a simplified version of a bank balance sheet whichreflects changes in values of assets or liabilities (ignores values thatdo not change)

Example T-account:

Assets Liabilities + Shareholder’s equity

Reserves +20 Deposits +20

Creation of Money

Banks create money by issuing credit (loans) through the multipliereffect

o E.g. If a bank receives $500 in deposits and the reserve ratio is10%, it will keep $50 as reserves and lend $450. This $450 will bedeposited within another bank; thus, increasing its reserves. Themoney supply has been increased from $500 to $950 (and so on)

Reserve ratio = the ratio of deposits that a bank keeps as reserves

o Reserve ratio =

o

A bank’s reserve ratio is often 10%


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Simple deposits multiplier =

o The smaller the reserve ratio, the greater the growth in the moneysupply

Central Bank and the Money Supply The RBA will engage in monetary policy to affect the money supply

The RBA is involved in the financial system to alter daily liquidity inthe system to keep interest rates unchanged

o Process: Everyday there is a large volume of withdrawals andinjections of money into the financial system this leas to banksexperiencing either a shortage or surplus of funds at the end of theday

If there’s a shortage banks have to purchase funds on theshort-term (overnight) money market this increasedemand for overnight funds (cash) this pushes up the

price of overnight funds (i.e. the overnight money marketinterest rate, known as the cash rate)

If there’s a surplus banks will sell funds on the overnightmoney market this increase supply of overnight funds this pushes the cash rate downwards

Note: the cash rate is the interest rate upon which allother interest rates are based upon

o If the RBA did not intervene, the daily changes in liquidity wouldcause interest rates to fluctuate wildly

Open market operations = the RBA purchasing or selling financial

instruments such as Cth government securities (CGS) and privatebonds and securities, either by outright purchase or sale or by theuse of a repurchase agreement

o Repurchase agreement = RBA offers to buy or sell CGS’s and other

financial instruments from/to banks provided the bank isprepared to repurchase (or resell) them at a future date (usually ina few days at an agreed price

o The RBA can control the money supply by: Purchasing bank securities will increase bank’s

reserves and lead to an increase in the money supply Selling securities will decrease bank’s reserves and

lead to a decrease in the money supply Reserve requirements = some central banks will change reserve ratios to

control the money supplyo Increasing the reserve ratio will decrease the money supply (as

less money can be loaned)o Decreasing the reserve ratio will increase the money supply (as

more money can be loaned)

Quantitative easing = expanding the money supply to boost growth wheninterests are near 0%


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Quantity Theory of Money

A theory that explains the price level and inflation in the long run

Money Supply x Velocity of Money = Price Level x GDPo MV = PYo This is so as the amount of money spent (MV) must equal the

amount sold (PY)o Velocity of money = the average number of times each dollar is

used to purchase goods and services

ΔM + ΔV = ΔP + ΔY o Rearranged to be: Inflation (ΔP) = ΔM + ΔV – ΔY

V is assumed to be constant in the long run; thus:

Inflation = ΔM– ΔY o If the growth in the money supply is

greater than the growth in GDP, there willbe inflation (and vice versa)


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Topic 9 – Monetary Policy

Monetary Policy

The main goals of the RBA is to:o Maintain the financial integrity and stability of the Australian

financial systemo Implement monetary policy

Monetary policy = actions taken the by the RBA to manage interestrates in order to achieve macroeconomic objectives

Goals of monetary policy:o Full employment of the labour forceo Stability of the Australian currencyo Economic prosperity and welfare for the people of Australia

Monetary policy is mainly achieved through setting the cash rate

Since 1993, the RBA has focussed monetary policy mainly on achieving

price stabilityo Inflation targeting = a monetary policy strategy where the central

bank commits to a specific level or range of inflation In Australia, the RBA’s inflation target is between 2% and

3% per annum on average over the business cycle

A business cycle will typically last a few years. It ispossible for the RBA to tolerate the inflation ratebeing below 2% or above 3% in a given year

The RBA is concerned with core inflation, which is the CPIinflation after removing temporary price fluctuations

of individual items Why? Such temporary price fluctuations will

disappear quickly. Any monetary policy put in placeto respond to these changes will have a lag of 6-12months; thus, would be unnecessary when actuallytaking effect

Interbank Money Market

Exchange settlement account (ESA) = the bank account that commercialbanks, other financial institutions and the Commonwealth government

holds with the RBAo ESA’s are used when transferring money between banks and

the RBA (not when dealing with customers)o Funds in the account are called exchange settlement funds (ESF)

ESF’s are part of a bank’s reserves ESF’s earn interest at a rate 025% less than the target cash

rate; thus, there is an incentive to minimise ESF’s

If bank’s have insufficient funds in their ESA’s to settle necessary

transactions, they must borrow from other banks’ ESA’s in the InterbankMoney Market (IMM) (also known as the Overnight or Wholesale Money

Market


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o The interest charged on funds borrowed in the IMM is known asthe cash rate (determined by the supply and demand for cash inthe IMM)

The demand for money will shift to the right if real GDPincreases (as the number of sales has increased, meaning

that consumers need to hold more money) or if the pricelevel increase (as the amount of money needed for a giventransaction has increases)

The RBA controls the supply of cash through open marketoperations

Open Market Operations (OMO’s)

OMO’s involves the RBA purchasing or selling financial instrumentsuch as Commonwealth Government Securities and private bonds either through outright sale or by the use of a repurchase agreement

The RBA can determine the supply of cash in the IMM through OMO’so RBA selling securities this reduces liquidity in the IMM as the

banks purchases these securities with ESF’s; thus, decreasing the

supply of cash. There will be excess demand for cash in theIMM, causing the cash rate to rise.

o RBA buying securities this injects liquidity in the IMM as themoney received by banks from these sales goes into their ESA’s;thus, increasing the supply of cash. There will be excess supplyfor cash in the IMM, causing the cash rate to fall.

Retail Money Market

The RBA only has the power to set the cash rate; however, the cash ratestrongly influences other interest rates in the economy, such asmortgage rates and business loan rates.

o Thus, the cash rate can have an impact on real GDP

If the cash rate decreases, banks would prefer to lend excessivereserves to borrowers outside of the IMM . This means that the supply

RBA selling securities: RBA buying securities:


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of funds in other money markets would increase, causing interest rates tofall.

Effect on Aggregate Demand

Changes in interest rates will affect consumption, investment and net

exports and thus, aggregate demand Consumption:

o Substitution Effect – if the interest rate increases, households areencouraged to save more and delay current consumption. This willlower current consumption

o Income Effect – higher interest rates will have different effects onnet savers and net borrowers. Higher interest rates means higherlifetime income for net savers but lower lifetime income for netborrowers. This will prompt net savers to consumer more nowand net borrowers to consume less.

Overall, consumption will decrease

Investment: o Higher interest rates mean higher costs of borrowing, which will

lower investmento Higher interest rates could lower share pries, reducing the amount

of capital firms can raise by issuing shares

Net Exports: o Higher interest rates in Australia makes investing in Australian

financial assets more attractive that those in other countries. Thisdrives the $AUD up. Exports decreases and imports decrease, netexports decrease.

Overall:o If the interest rates increases – consumption, investment and

net exports decreases. Thus, aggregate demand decreases. o If the interest rate decreases – consumption, investment and net

exports increases. Thus, aggregate demand increases.

Expansionary vs Contractionary Policy

Expansionary monetary policy = the use of monetary policy to lowerinterest rates in order to increase real GDP. This is used when there isa negative output gap (economic slump, negative demand shock)

o

Process: 1. The RBA undertakes OMO’s and buys bonds and

securities this injects liquidity into the IMM andincreases the supply of cash in the IMM

2. The excess supply of cash decreases the cash rate 3. This decreases interest rates 4. This increases aggregate demand 5. Real GDP and the price level will increase


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Contractionary monetary policy = the use of monetary policy to raiseinterest rates in order to refuse inflation. This is used when there is apositive output gap (economic boom, high inflation)

o Process: 1. The RBA undertakes OMO’s and sells bonds and

securities this withdraws liquidity into the IMM anddecreases the supply of cash in the IMM

2. The reduction in supply of cash increases the cash rate 3. This increases interest rates

4. This decreases aggregate demand 5. Real GDP and the price level will decrease

Effectiveness of Monetary Policy

Monetary policy can only affect aggregate demand and is largely

ineffective at dealing with stagflation caused by a negative supplyshock

Expansionary monetary policy:

Contractionary monetary policy:


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o Expansionary monetary policy would raise the inflation ratefurther

o Contractionary monetary policy would raise the unemploymentrate further

Monetary policy is subject to time lags by the time that the

monetary policy has its full impact on the economy, the economiccircumstances may have changed and the policy may no longer beappropriate

Monetary policy affects some sectors and groups of people morethan others (e.g. the effect on net exports affects those in the agriculture,manufacturing and services sector more as they face much internationalcompetition)

For monetary policy to be effective:o Changes in the cash rate must be passed on to interest rates and

other financial assetso

Firms, consumers and investors must respond to changes in realinterest rates (consumption and investment must change)o Net exports must also respond to changed in the interest rate

For expansionary monetary policy to be effective, banks must be willingto expand credit/lending

Inflation Targeting

Arguments in favour inflation targeting:o The RBA can have an impact on inflation but not on real GDP (in

the long run, real GDP returns to its potential level and potentialGDP is not affected by monetary policy)

o

An inflation target makes it easier for households and firms toform accurate expectation of future inflation; thus, improving theirplanning

o Helps institutionalise good Australian monetary policyo Promotes accountability

Arguments against inflation targeting:o Reduces the flexibility of monetary policy to address other goalso Assumption that the RBA can accurately forecast future inflation

rates is not always correcto Holding the RBA accountable only for an inflation goal may make it

less likely that the RBA will achieve other important goals

Independence of the RBA

The RBA is independent of the government ; however, as the RBA iscreated under legislation, the RBA would not conduct monetary policythat strongly opposed the government

Reasons for independence:o Avoid inflationo Avoid the government using the central bank for political purposes

Reasons against independence:o No accountability as members are not elected

The Governor of the RBA is second only to the Treasurer of Australiain their ability to affect the Australian economy


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Topic 10 – Fiscal Policy

Fiscal Policy

Fiscal policy = changes in federal taxes, transfer payment andgovernment purchase that are intended to achieve macroeconomicpolicy objectives, such as full employment, price stability andsustainable economic growth

o Fiscal policy typically refers to actions of the federal government(not those of the state and local government)

o Not all decisions about taxing and spending by the federalgovernment are fiscal policy decisions only those intended toachieve macroeconomic policy goals (e.g. a decision to cut taxes ofthose with private health insurance is a health policy action, not afiscal policy action)

Fiscal policy can offset the effects of the business cycle on the economy

o

Change in government purchases, transfer payments and taxes willaffect aggregate demand, which will affect real GDP, employmentand the price level

Automatic stabilisers = government transfer payments and taxesthat automatically increase or decrease along with the businesscycle (e.g. no government action required)

o In an expansion taxes increase and transfer payments decreaseo In a recession taxes decrease and transfer payments increaseo Automatic stabilisers does not amount to fiscal policy as it

does not involve government action

Discretionary fiscal policy = when the government is taking actionsto change transfers or taxes to achieve its economic objectives

o Expansionary fiscal policy: Used in an economic slump An increase in government purchases or transfer payments

or a decrease in taxes increases ADo Contractionary fiscal policy

Used in an economic boom (when the inflation rate is high) A decrease in government purchases or transfer payments

or a increase in taxes decreases AD

Multiplier Effect A change in government purchases or taxes will lead to a series of

induced changes in consumption and investment

o Change in AD = government purchase amount x multiplier

o The taxation multiplier has a negative effect because an increase in

taxes will decrease real GDP


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o The taxation multiplier is smaller that the government purchasesmultiplier in absolute values because a change in taxes will lead toa change in disposable income. Some of this change will be savedand some will be spent (according to MPC and MPS values).Whereas, the initial impact on aggregate demand of government

purchases is total. The multiplier figures are based on the assumption that the price level is

constant.o However, the price level is not constant. Therefore, real GDP will

not increase by the full multiplier, as an increase in aggregatedemand will cause a rise in the price level.

Crowding Out

Crowding out = a decline in private expenditure as a result of anincrease in government purchases which has diverted financial and

real resources away from the private sector Financial crowding out = if the government finances it spending by

borrowing, it will increase the demand for funds and thus, push theinterest rates up. Higher interest rates will reduce private consumptionand investment and may cause the AUD to appreciate, causing net exportto decline.

Resource crowding out = the government competes with the privatesector for labour, land, intermediate goods and other real resources,putting upward pressure on wages and prices. Higher wages and pricesreduce private consumption, investment and net exports.

There will be partial crowding out in the short run and possibly complete

crowding out in the long run (no increase in Y)

Crowding out effect:


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o In an expansion, it is likely there will be a budget surplus. Tobalance the budget, the government must decrease taxes andincrease government purchases and transfer payment throughdiscretionary expansionary fiscal policy. This would lead to afurther increase in real GDP and inflation.

Long-Run Effect of Fiscal Policy

Fiscal policy can either be to meet short run or long run goals o Short run effect – stabilising the economy o Long run effect – expanding the productive capacity of the

economy and increasing the rate of economic growth

The long-run effect of tax policy: o Tax wedge = the difference between the pre-tax and post-tax

return to an economic activityo Economists believe that the smaller the tax wedge for any

economic activity, then more of that economic activity will occur

Supply Side Policies

Supply side policies = fiscal policies that have long run effects byexpanding the productive capacity of the economy and increasingthe rate of economic growth.

o These policies primarily affect LRAS

Examples: o Lowering personal income tax may increase the incentive to work;

thus, the labour supplyo Lowering company income tax and capital gain tax might

encourage investment Reagonomics = the supply-side economic policies promoted by the US

President Ronald Reagan during the 1980’s. o His main policies included reducing income tax, capital gain tax,

government spending, government regulation and inflation

Supply side policies seem good in theory; however, in practice, no one issure if there is an actual effect on the LRAS curve as the effect is in thelong-run and a lot of stuff happens in the long-run


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Topic 11 – Macroeconomics in an Open Economy

Balance o f Payments

Balance of payments = the record of a country’s international trade,

borrowing, lending, capital and investment flows with othercountries

Balance of Payments = Current Account Balance + Capital AccountBalance + Financial Account Balance + net errors and omissions = 0

Current Account Balance (CAB):o Records current, or short term, flows of funds into and out of a

countryo Current account includes:

Net exports (NX) (also called the balance of trade in goodsand services):

The value of the goods and services in a country

exports minus the value of the goods and services acountry imports

If NX is positive, there is a trade surplus but if NX isnegative, there is a trade deficit

Net primary income (NPI):

Income received by Australian residents frominvestments in other countries (e.g. profits,dividends and interest repayments on loans) andincome sent home by Australians working overseasminus income paid overseas on investments in

Australia by residents of other countries and incomesent home by expatriates working in Australia Net secondary income (NSI):

Transfers received by Australian residents fromother countries minus transfers made to residents ofother countries (including overseas aid, remittancesand pensions)

o Remittances = cash gifts sent by emigrants totheir families back in their original countries

Capital Account Balance (KAB):o Records minor transactions such as migrants’ asset transfers,

debt forgiveness and sales and purchases of non-produced,non-financial assets (land titles, copyright, patents, trademarksand franchises)

Financial Account Balance (FAB):o Financial account balance is equal to foreign purchases of

physical and financial assets in Australia (capital inflow)minus Australian purchases of physical and financial assets inforeign countries (capital outflows)

o Financial account includes: Foreign direct investment (FDI) – e.g. firms buy or build

physical assets (e.g. factories) abroad


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currencies and the domestic currencydepreciates.

A high debt to GDP may lead to a lowercredit rating, causing a higher riskpremium on future borrowing.

Foreign Exchange Market

Nominal exchange rate = the value of one country’s currency interms of another country’s currency

o The real exchange rate corrects the nominal exchange rate forchanges in prices of goods and services between countries (evenwhen the prices are put in the same currency)

Money is exchange on the foreign exchange (FX) market

Nominal exchange rate =

The market exchange rate is determined by demand and supply of two

currencies Demand for $AUD comes from:

o Foreign firms and consumers that want to buy goods and servicesproduced in Australia

o Foreign firms and consumers that want to invest in Australiao Currency traders who believe that the value of the $AUD will be

greater in the future

Supply of $AUD comes from:o Australian firms and consumers who want to buy foreign products o Australian firms and consumers who want to invest overseas

o

Currency traders who believe that the value of the $AUD will beless in the future

Foreign exchange matter:


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Policy in an Open Economy

Monetary policy has a greater impact on aggregate demand in anopen economy (with a flexible exchange rate regime) than in a closedeconomy

o Expansionary monetary policy will lead to lower interest rates,

which will lead to an exchange rate depreciation, which increasenet exports. In a closed economy there is no net exports that wouldbe affected.

Fiscal policy has a smaller impact on aggregate demand in an openeconomy than

Econ 1020 SEMESTER 2 SUMMARY NOTES

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