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ECON1102 Study Notes Macroeconomics 1 Chapter 1 Measuring
Macroeconomic Performance: Output and Prices Key Issues
Indicators of macroeconomic performance Measuring output (GDP)
Measuring prices and inflation
Criteria for Evaluating Macroeconomic Performance 1. Rising
Living Standards economic growth
Tendency for the level of output (i.e. quantity and quality of
goods and services) to increase over time.
Material wellbeing. 2. Stable Business Cycle
Low volatility in fluctuation of expansionary and contractionary
gaps. 3. Relatively Stable Price Level (real currency value) low
(positive) rate of Inflation.
Inflation rise in prices. Deflation - fall in prices.
4. Sustainable Levels of Public and National Debt Public debt
borrowing by public sector from private sector (budget
deficits/surpluses). National debt borrowing by domestic
residents from foreign countries
(Influenced by an economys current account deficits/surpluses).
5. Balance between Current and Future Consumption
Expenditure vs. need to provide resources for future (saving) 6.
Full Employment
Provision of employment for all individuals seeking work
Measuring National or Aggregate Output
GDP: the market value of the final goods and services produced
in the domestic market in a given period. It measures aggregate
output or production. flow variable as it is a function of time.
Also a lag indicator.
Final goods or services: goods or services consumed by the
ultimate user because they are the end products of the production
processes they are counted as part of GDP. Intermediated goods or
services: goods or services used up in the production of final
goods or services and therefore not counted as part of GDP.
GDP Measurement Methods
Expenditure Method Expenditure on Final Goods and Services by
the ultimate user equals value of
production
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Amount consumers spend should equal market value (economic
agent) Computed by adding total amount spent by 4 groups
o Household consumptions (durables and non-durables) o Firms
(Business fixed investment (Capital) and NEW residential
investment, inventory.) o Government spending (Not government
transfers e.g. unemployment
benefits, social security, welfare payments, interest paid of
gvt. Debt) o Net purchases in foreign market
National accounting Identity: Aggregate Expenditure = Y = C + I
+ G + NX Production Method Aggregate Market Value of final goods
and services given indirectly by summing
the value added of all firms in the economy. GDP = Amount x
Market value Note: Intermediate goods and services: G+S used up in
production are not
counted in GDP e.g. flour in bread, services provided that only
give value to final product (or)
Value added: market Value of the production less the cost of
inputs from other firms, of each firm (= summation of value of
final goods), Allows value to be accurately distributed over
periods.
Represents portion of value to final G+S added by each firm o
Value added = Revenue Market Value
Income Method GDP is also given by aggregate income paid to
capital and labour in production of
Goods and services Revenue from sales is distributed to worker
and owner of capital GDP = Labour income (wages, salaries,
self-employed) + Capital Income (Physical
capital -made to owner of factories, machinery, office building,
Intangible Capitals trademarks, copyrights, patents, interest to
bondholder, income to owners, rent for land, royalties)
Despite a slight statistical discrepancy between these methods
in theory/conceptually all three should produce the same result.
GDP is usually given by the average of these three outcomes
Some items with no observed market prices are included in GDP:
national defence use costs of provisions, whilst some are excluded:
unpaid housework.
Nominal GDP: measures current dollar value of production by
valuation of
quantities at current market prices. Calculated by the
multiplying the quantity of each good produced in the economy by
current year prices and summing
Real GDP: values quantities of goods and services produced at
base year prices measure of the actual physical volume of
production. Calculated using Laspeyres index, Paasche Index or
Chain weighted Index.
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Real Growth Rate calculates the growth in the physical volume of
production between periods. Real Growth in GDP can be calculated
using Laspeyres index, Paasche Index or Chain weighted Index.
o Lespeyres Index involves calculating the value of GDP in
current year (here, 2006) and base year using a base year prices
(here, 2005), by multiplying the quantities of each good produced
in a each year by the corresponding price in 2005. Then commute the
growth rate of real GDP.
o Paasche Index involves calculating the value of GDP in current
year (2006) and pervious year (2005) using current year prices
(2006). The change in GDP, which is the Real GDP in 2006 less the
Real GDP is 2005, is divided by the Real GDP in 2005.
o The Chain Weighted Index averages the percentage growth of GDP
given by the Laspeyres Index and the Paasche Index to accurately
determine GDP.
Is GDP A Good Measure of Economic Wellbeing?
Economic welfare refers to the general economic wellbeing and
interests of the population.
GDP only accounts for the goods and services sold in the market
which to some extent is a general indication of economic wellbeing
positive correlation is expected
The following factors effect economic welfare by are not
accounted for in GDP: Leisure Time
o Having more time to enjoy worthwhile activities like family,
friends, sport, hobbies is a major benefit of wealthy
societies.
Non-market/home Production o No acknowledgment of unpaid house
work. o Particularly in poorer countries where citizens trade and
are self
sufficient their economic activity is undervalued. o Underground
economy legal and illegal transactions not recorded in
government data e.g. baby sitting, drug dealing. Quality of
Life
o Factors of life like traffic congestion, crime rate, open
space and public organisations which are not sold in markets but
still add to quality of life.
Inequality and Poverty o GDP does not convey the distribution of
wealth. o There could be extremes of rich and poor.
Environmental degradation and Pollution o Despite the difficulty
in valuing this intangible factor, decline in air
and water quality (pollution) negatively affect quality of
life.
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Note: Although, GDP doesnt capture all factors influencing
economic wellbeing, higher GDP per capita is positively related to
increased wellbeing. For example countries have better health care,
medicine, driven by technology
Measures of the Price Level
Consumer Price Index: For any period, measures the cost in that
period of a standard basket of goods and services relative to the
cost of the same based of goods and services in a fixed year
(called the base year). CPI is a tool used to measure the price
level and inflation in the economy CPI = Cost of basket in current
year / Cost of basket in base year
Rate of inflation: the annual percentage change in price level
measured by the CPI, mathematically represented by:
The change in relative prices is not inflation. They are changes
in response to demand and supply. Recall that inflation is a
sustained change the economys price level not simply a price rise.
It must be a general price change, not a specific one.
Cost of inflation: Shoe leather costs
o Money functions as a medium of exchange, thus inflation raises
cost of holding money. Inflation reduces the real purchasing power
of a given amount of money - longer it is hold, the larger
reduction.
o Insulate this loss by holding money in bank with interest
paid, but this is associated with inconvenience of frequent bank
visits. Businesses employ extra staff to make trips. Bank employ
extra staff for increased transaction.
Menu costs o Act of changing prices. Publicly lists prices need
to change. E.g. change
coins, menu, signs. Distortion of the tax system
o Taxes are not indexed to rate of inflation they are based on
nominal magnitudes. For example, inflation may raise peoples
nominal incomes (to compensate for rise in cost of living) moving
them into higher bracket even though their real incomes may not
have increased
Unexpected redistribution of wealth o Inflation causes
redistribution/transfers wealth between parties
Employers and employees Borrowers and lenders.
o If inflation is higher than expected, real wages of
predetermined wages will fall workers lose buying power. This is
offset buy gain in employers buying power, since real cost of
paying workers has declined. If inflation is lower than expected,
real wages will increase, meaning workers with
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have higher purchasing power, and employer will have to pay a
higher real cost.
o High Inflation means real dollar value of loan repayment is
less than expected.
o Associated with this process is fluctuation and volatility
which discourages people from working and saving, in an effort to
protect them against inflation.
Noise in the price system o Price system functions to allocate
resources efficiently establish
equilibrium. However, inflation distorts/ creates static or
noise in interpretation of price system obscuring information
creating inefficiency. Suppliers are unaware if increase in price
represents true increase in prices by increase in demand, or
general rise in price caused by inflation (quantity?) E.g. Asset
Price Bubble.
Interference with long-term planning o Of households and firms,
makes it difficult to discern how much funds
need to be saved for future events, projects Save too little-
comprise plan Save too much sacrificed pervious consumption
Note: evidence suggests inflation causes real consumption, real
investment and real GDP to fall, accompanied by increase in budget
deficit.
Deflation is costly and creates unexpected redistributions of
wealth. However,
the main cost of deflation is is to force the real rate of
inters higher than normal. This is because the nominal interest
rate cannot fall below zero. This acts to discourage certain types
of important expenditure in the economy, most notably firms
investment expenditure.
Nominal Interest rate: percentage change in the nominal value
(dollar value) of
a financial asset. Real interest Rate: percentage change in real
purchasing power of a financial
asset, adjusted for inflation. 1 + inom = (1 + ireal)(1+ ) Real
interest rate inom inflation rate Fisher effect: r = i
For borrowing and lending the real interest rate is most
relevant. Since, if nominal interest rates increase but inflation
rises by the same amount then the cost of borrowing has stayed
constant. When real (not the nominal) interest rate is low,
borrowers benefit from a lower real cost of borrowing. When real
interest rate is high, lenders benefit from receiving an increase
in purchasing power. So, lenders need to protect themselves from
the decline in the real interest rate; therefore they must raise
nominal interest rates in the face of inflation.
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Limitation to CPI
Quality Adjustment Bias o Failure to adjust for Improvement in
quality of goods and services, which
results in an increase in prices and consequently inflation. o
For example, if the CPI basket contains monthly rent and during
one
period the rent increase because of kitchen renovation, the CPI
will increase and incorrectly display a higher cost of living
despite an increase in price based on quality
o E.g. larger data storage computer has higher price New Goods
Bias (New goods not included)
o Extreme case of quality improvement o Where a new product is
introduced, that was not available in the base
year, creates distortions in comparisons (eg. computers were not
common 50 years ago).
Substitution Bias o CPI is a fixed basket of goods meaning it
does not account for the
substitution affect to relatively cheaper goods and services
that are close replacements for each other. Ignores consumers
ability to switch between products. E.g. Coffee and Tea
Therefore, since CPI fails to account for the above factors, CPI
overstates the rate of inflation and cost of living.
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Chapter 2 Saving and Wealth Key Issues
Definition and Measures of Saving Saving and Wealth Motives for
Saving Investment and Capital Accumulation Saving, Investment and
the Real Interest Rate
Flow: a measure that is defined per unit of time. Stock: a
measure that is defined at a point in time.
Savings is a flow variable measure that is defines per unit of
time. If saving is positive then assets are being accumulated. If
saving is negative then assets are being de-cumulated or
liabilities (debts) accumulated Note: household saving in Australia
is declining Saving = current income current spending Saving rate =
savings/income
Capital gains: increases in the value of existing assets.
Capital loses: decreases in
values of existing assets. Wealth = assets liabilities Change in
Wealth = Saving* + Capital gains Capital losses W = W(-1) + S + Net
Capital Gains A, L, W are stock variables measure defined at a
point in time *current income current spending; not accumulated
savings.
Motives For Saving (why do people save?)
Life-cycle saving - Saving to meet long term objectives. Saving
during working life for future consumption E.g. University fees,
retirement, home or car purchase.
Precautionary Saving - Resources put aside for protection/self
assurance against unexpected circumstances. E.g. loss of job,
recession, medical emergency.
Bequest Saving - Desire to leave family heirs or dependents an
inheritance or bequest. Often by people in higher income ladder.
E.g. children or charity.
Saving and the Real Interest Rate
Represent reward for saving increase in r increases opportunity
cost of not saving. However, small negative relationship since
increase interest rate means people need to save less to reach
target saving level in future years. Net effect: Other things equal
(ceteris paribus) saving to increase with real interest rate
Saving is also influenced by cultural factors and neighborhood
expectations
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o Lack of sufficient self-control or will power to undertake
optimal savings level. The consumptions benefits are in the future,
whilst the costs are immediate.
o Availability of consumer credit eg. Home equity loans. o
Demonstration effects conspicuous spending by others encourages
conspicuous spending by households. o Government provision of
welfare may reduce private saving for
retirement. National Saving
Measures aggregate saving in an economy by private and public
sectors (households, business, governments). Y = C + I + G + NX S =
Y C G
NX is assumed to be zero and note that saving is current income
current spending, therefore I (investment) and is for future needs.
Note: not all G and C are current good (durable Goods e.g. cars,
furniture, appliances, roads, bridges, schools, other
infrastructure). Hence, the equation above tends to overstates
current spending and understates national saving. S = Y C G S = Y C
G + T T S = (Y T C) + (T G) S = Private saving + public saving
o Where: T = T Q = net taxes = taxes paid by private sector to
government transfer payments from government to private sector
interest payments from government to private sector bond
holders.
o Transfer payments: (Q) payments the government makes to the
public for which it receives no current goods or services in
return
Government budget deficit: T < G [Receipts < Expenditures]
Government budget surplus: T > G Government balanced budget: T =
G National savings, not household savings, determines the capacity
of an economy
to invest in new capital goods and to achieve continued
improvement in living standards. Australias national saving has
showed slightly upward trends in recent years, despite a lower
household savings rate.
Investment and Capital Formation - National saving provides the
resources for investment. Investment is the purchase of new capital
goods. New capital goods increase productivity. Influences on the
level of Investment:
o Cost of capital: Nominal interest rate (i) The dollar
price/cost of the new plane (Pk) Physical depreciation rate on
capital ()
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Over time the price of the plane may rise or fall (capital gain
or capital loss) (change in Pk)
Cost of capital = price of capital (begin year) + interest cost
- price of (depreciated) capital (end year)
o Most important influences on investment decision are price of
capital good and real interest rate.
o Rise in the real interest rate will make investment less
attractive. o Rise in the price of capital goods will make
investment less attractive. o Cost vs. Benefit Investment decision:
Value of marginal product of
capital (benefit net of expenses and taxes) Cost of capital
Saving, Investment and Financial Markets
Economy with no access to international capital markets:
National Saving = Investment.
S = Y C T = I Saving is increasing function of real interest
rate supply of saving, therefore it is
upward sloping. Investment is a decreasing function of the real
interest rate demand for saving.
Downward sloping because rates link to WACC.
New Technology increased productivity increase marginal product
(investment more profitable) increase investment shift right
increase in r higher real interest rate makes saving attractive
move along the S curve.
Increase in Budget Deficit/ Increase in Budget Deficit decrease
in national savings decrease saving shift left increase r higher
real interest rate makes investment less attractive and causes a
move along the I curve.
An increase in the government budget deficit will reduce private
investment spending. A larger deficit reduces the supply of saving
(savings curve shifts inwards) and drives up the real interest
rate. The higher real interest rate makes investment less
attractive and causes a move along the I curve. The tendency of a
government budget deficit to reduce investment is called the
crowding out effect.
Note: change in real interest rate is a movement ALONG curve. In
a closed economy NS = I.
Chapter 3 Unemployment and the Labour Market
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Key Issues Demand for labour Supply and demand model of the
labour market Types of unemployment Impediments to full
employment
Demand for Labour
Diminishing returns to labour: if the amount of capital and
other inputs in use is held constant, then the greater the quantity
of labour already employed, the less each additional worker adds to
production.
Marginal Product of Labour (MPL): additional output associate
with additional labour unit.
Firm combines workers with a given amount of capital (machines
and buildings) to produce output.
Based on Low-hanging fruit principle and increasing opportunity
cost firm will assign worker to most productive jobs. Error! Not a
valid embedded object. [P is general price level]
Firm will compare benefit (Value MPL) of an additional worker
with cost of worker (Wage = W) [cost-benefit principle]. Note:
Model assumes that firm operates in a competitive market therefore
cannot set the wage it pays workers or price it receives for its
product.
Firms will continue to employ labour until (value of MPL = money
wage) Since MPL decreases as firm employs more workers, real wage
also has to fall (as
more workers are employed). This implies that a firms demand for
labour is a decreasing function of the real wage. Error! Not a
valid embedded object.
Shifts in Demand for Labour
Higher relative price for firms output (e.g. due to increased
demand). Workers production is more valuable, and therefore value
of marginal product increases (shifts right).
Higher marginal productivity of labour (e.g. large increase of
capital stock or new technology) as this leads to an increase in
the value of marginal product.
Supply of Labour At any given wage people decide if they are
willing to work by reservation price
(minimum payment that leaves you indifferent between working and
not working) cost-benefit principle application. Supply of labour
is the total number of people willing to work at each real wage,
Wi/P.
Shifts in Supply of labour
Size of working-age population (influenced by birth rate,
retirement ages, immigration rates).
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Participation rate/Social changes percentage of working age
population who seek employment e.g. women working more.
Real Unit Labour Costs = Real average labour cost / Average
labour productivity Increasing Wage inequality: Globalisation and
Technological change. Globalisation
Globalisation is the process of breaking down national barriers:
o Free trade agreements o Deregulation o Reduced tariffs/taxes
Open up economies to international market and encourages
specialization. Demand for workers in industries with comparatives
disadvantage experience
lower real wages and employment (shift demand left). This is due
to suffering from increased foreign competition, consumers purchase
overseas (cheaper or higher quality), which leads to a decrease in
the value of marginal product and therefore a decrease in demand
for workers.
Demand for workers in industries with comparatives advantage
experience higher real wages and employment (shift demand right).
This is because there is a greater demand for exports and therefore
there is an increase in the value of marginal product and an
increase in the demand for workers.
Note: countries employing higher skilled worker do better in
international trade heightening the inequality
Technological Change Technological change increases worker
productivity and is the basic source of
rising living standards. However, technological change affects
different workers in different ways. Note worker mobility
counteracts trends of wage inequality. A policy of providing
transition aid in training workers with obsolete skills is useful
response to problem.
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Skill-biased technical change (replaces or assists): o Raises
marginal product of high-skill workers increase in productivity
increase in demand rise in real wages and employment. o Reduces
marginal product of low-skill workers (no longer required)
decrease in productivity decrease demand fall in real wages and
employment.
Unemployment
Labour Force: total number of people available for work. Labour
Force = Employed + Unemployed
o Employed: Person worked full-time or part-time during the past
week (or was on leave from a regular job)
o Unemployed: Person did not work during the preceding week and
made some effort to find work.
o Not in Labour Force: Person did not work in the past week and
was not actively seeking work (e.g. retirees, unpaid homemakers,
full-time student).
Unemployment Rate = (Unemployed/Labour Force)*100 Participation
Rate = (Labour Force/Working-age (15+) Population)*100 Working-age
(15+) Population = Labour force + Not in Labour force
Costs of Unemployment
Economic costs: output that is foregone since workforce is not
fully utilised. Psychological costs: long periods of unemployment
can lead to loss of self-
esteem, unhappiness and depression. Social costs: high
unemployment can lead to increased crime and associated
social problems e.g. crime, violence, alcoholism, drug abuse
Discouraged Workers: People who have given up looking for work (and
so a not
counted as unemployed) Types of Unemployment
Natural rate of employment: the part of the total unemployment
rate that is attributable to frictional and structural
unemployment; equivalently, the
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employment rate when cyclical is zero; i.e. the economy is not
in an expansionary or contracitonary gap.
Frictional unemployment: the short-term unemployment associated
with the process of workers searching for the right job.
Labor market is dynamic driven by changes in technology,
globalization and changing consumer tastes. This means new products
and companies (and thus jobs) are always being created.
Cyclical unemployment can improve efficiency of market bring
together those seeking and offering employment (e.g. left school or
change careers).
Cost are low (short-term physiological and direct economic
affects low) Can be economically beneficial/essential negative
costs (better fit of workers
into job positions higher productivity higher output in long
run). Structural unemployment: the long-term and chronic
unemployment that exists
when the skills or aspirations of workers are not matched to
jobs available in the economy.
Refers to availability and distribution of jobs and can be
caused by: lack of skills, language barriers or discrimination.
Also unions and minimum wage laws can cause structural
unemployment.
Cyclical unemployment: the extra unemployment that occurs during
periods of economic contractions and especially recessions.
Cyclical unemployment is costly in terms of foregone output and
underutilization of labour resources.
Factors that affect the rate of unemployment
Minimum wage: legal minimum hourly rate firms can pay employees
(Award wages).
o Despite minimum wages raising the unemployment rate it
benefits those workers who are lucky enough to receive a job in
this market (0 ND) as they will receive higher than normal wages.
Of course, those who are shut out of the market lose and are left
jobless.
o Taxpayers are worse off pay for unemployment insurance and
support and higher prices.
o Consumers are worse off, lower output o When minimum wage laws
are below equilibrium the market is not
affected, and will continue to operate in equilibrium.
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Labour union workers may negotiate on an individual basis with a
firm over wages and conditions. Alternatively may form labour
unions to bargain collectively. Unions tend to produce higher than
normal wage outcomes (above equilibrium clearing). Outcome
wmin=wunion.
Unemployment Benefits Government transfer payment paid to the
unemployed. This is a basic income to workers who are unemployed
and searching for work. Can have a disincentive effect on a workers
search effort prolong period before individual accepts
employment.
Other government regulations OH&S or Anti-discrimination.
Chapter 4 - Short-run Economic Fluctuations Key Issues
What is a recession? Business cycle fluctuations Output gaps and
cyclical unemployment
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Natural rate of unemployment Okuns law
Business Cycle
The business cycle refers to the fluctuations in economic
activity/GDP associated with periods of expansion (strong economic
performance) and contraction (weaker economic performance).
Contraction: period where GDP falls, moves from a peak to a
trough Expansion: period when GDP rises, moves from a trough to a
peak Peak is the beginning of a contraction, end of expansion high
point prior to a
downturn Trough is the end of a contraction, beginning of
expansion low point prior to a
recovery Note: Rule of Thumb for a recession is at least two
quarters of negative economic growth i.e. level of GDP has to fall
for at least two quarters. Potential Output (y*)
Amount of output (real GDP) an economy can produce when using
its resources (labour and capital) at normal rates.
Not the maximum output. Grows over time with growth in labour,
capital inputs and growth in technology.
Actual output (y) Actual level of GDP produced in the economy
Vary (expand or contract) due to:
o Changes in potential output ( y*) e.g. extreme weather
conditions decrease actual output contractionary gap recession
o Changes in utilization rate of labour and capital e.g.
immigration, new technologies increase actual output expansionary
gap / boom.
Output gap = y y* at a point in time. Occurs when utilization of
labor and capital is above or below normal rate. Thus,
y y*
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Expansionary gap: y* < y (Positive output gap) - opportunity
cost Contractionary gap: y* > y (Negative output gap) -
inflation
Natural Rate of Unemployment (u*): the part of the total
unemployment rate
that is attributable to frictional and structural unemployment;
equivalently, the unemployment rate that prevails when there is no
cyclical unemployment. Unemployment rate (u) tends to co-move with
the output gap in economy.
Contractionary gaps link to high unemployment rate Expansionary
gaps low unemployment rate Unemployment = (frictional + structural)
+ cyclical Cyclical unemployment = u u* Okuns law is systematic,
quantitative relationship between output gap and
cyclical unemployment. Implies, an extra percentage point of
cyclical unemployment is associated with an specific percentage
point increase in the output gap. For Australia, the percentage
point in approximately 1.5.
Okuns law implies negatively proportionality, meaning: o
Positive output gap (expansionary) causes a reduction in
cyclical
unemployment. o Negative output gap (contractionary) cause an
increase in cyclical
unemployment o When output gap = 0, there is no cyclical
unemployment.
Policymakers generally view both, a persistent contractionary or
expansionary as
problems. Contractionary gaps are associated with capital and
labour not being fully
utilised (cost in terms of forgone output). o Reduced total
economic value higher unemployment reduced
livings standards. o In order to reduce cyclical unemployment
levels, policy makers must
attempt to create an expansionary output gap. This can be
achieved by using resources at greater than normal rates. For
example, creating new infrastructure projects is new capital
investment, while using resources such as labour at higher rates
than normal.
o Implies that it is possible for an economy to suffer from
jobless recoveries, that is, output growth resumes however
employment does not grow. An increase in labour productivity can
mean that real net output grows leading to an expansionary gap
without net unemployment rates falling, as there is no strict
relationship between the two as a variable is involved. It is this
variable that changes in such situations.
Expansionary gaps are associated with firms operating above
normal capacity to meet demand. This can lead them price increase
(inflationary), leading to inefficient market.
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Chapter 5 Spending and Output in the Short-Run Key Issues
A model of output determination Keynesian Model Planned verses
actual expenditure A consumption function Equilibrium output in the
short-run
Keynesian Model
Key Assumption: Prices of goods are fixed/sticky in the
short-run. Firms do not change prices in response to a change in
demand for their products. Fix their price and meet demand at this
preset price by varying their level of production (labour and
output). The implication: changes in spending yield a change in
output above or below potential. Thus spending determines aggregate
output.
If prices where fully flexible, in theory prices would be
changing instantaneously with changes in demand menu costs. Also,
there will never be excess production because firms will cut prices
to sell it and never be persistent unemployment because workers
will cut their wages to keep and get jobs. Fluctuations in demand
will be accommodated by flexible prices and wages without changes
in output and employment.
In long-run, sustained changes in demand will eventually lead
firms to change their prices and cause production to return to
normal capacity.
Aggregate Expenditure
The actual expenditure in the economy is equivalent to
production/GDP since aggregate output is determined by spending.
Thus: AE = C + I + G + NX. (Note, I = real investment not
financial).
PAE is the total level of planned spending on goods and services
and may differ from the actual level of production. PAE = C + IP +
G + NX.
Since firms are meeting demand at preset prices they cannot
control how much they sell. Consequently, differences arise when
firms sell more or less than expected. When firms sell less output
than planned, it adds more than planned to its inventory stocks
(investment) and hence actual investment will exceed planned
(I>Ip). When firms sell more output than planned, it adds less
than planned to its inventory stocks (investment) and hence actual
investment will be below planned (I
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A Model of Consumption Expenditure Current disposable income is
an important influencer of household consumption
aggregate income less net taxes (Y T). Consumption Function:
Error! Not a valid embedded object.
o C-bar is exogenous (or autonomous) consumption. Factors (other
than disposable income) that could affect consumption, e.g. wealth,
real interest rates (external factors).
o Wealth Effect: changes in asset prices that affect spending. o
c(Y-T) Captures the effect of disposable income on consumption
(induced
consumption). c is the marginal propensity to consume
(parameter), or the change in consumption when disposable income
changes by a dollar. [0
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Disequilibrium o PAE > Y and INJP>WD; PAE < Y and
INJPPAE and WD>INJ) in the economy, and thus, firms find an
increase in their inventory (unsold stock), such that their actual
investment, which includes inventories, is greater than their
planned investment. This situation is also known as excess supply.
As there are costs involved with carrying unsold stock, less income
is consumed so that withdrawals exceed injections. Firms attempt to
remove this excess inventory, however, in the short term, prices do
not change, such that the firm cannot dump their inventory and
instead revise their production levels downward in order to avoid
these costs. Subsequently, GDP will fall until it reaches
equilibrium level. The reverse is also true firms cannot raise
prices to satisfy excess demand, and therefore the only option is
to increase production, resulting in GDP rising to its equilibrium
level. [REVIESE GRAPHS]
The Paradox of Thrift
Consider a savings function given by and investment function IP
where equilibrium is initially at Y0e, that is where savings equals
investment
Suppose there is an exogenous increase in an agents desire to
save (). That is, at every level of income there is an increase in
savings by a constant amount. Resulting in a parallel shift in
savings function to S1.
Since the actions of saving reduce economic activity, the
aggregate amount of savings actually remains unchanged, but the
level of GDP will fall. Hence, an attempt to increase savings
results in the economy being worse off.
This decline in exogenous consumption can be explained using the
Y=PAE diagram. Essentially, the decrease in PAE means there is less
actual expenditure (Y) and lower levels of income to ensure that
savings again match planned investments.
Four Sector Model
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PAE = C + IP + G + NX Consumption Function:Error! Not a valid
embedded object. Tax Function: Error! Not a valid embedded object.
Import Function: Error! Not a valid embedded object. Error! Not a
valid embedded object.
The Multiplier
Multiplier is the effect of a one-unit increase in exogenous
expenditure on short run equilibrium output. The multiplier
suggests that an additional dollar of exogenous PAE results in more
than a dollars worth of GDP.
For example, if the multiplier is 5 and increase of 10 units in
exogenous expenditure results in a 50 units increase in output.
In general, a change in exogenous expenditure produces a larger
change in short-run output since actions to spend by one party,
results in successive rounds of changes in income and spending for
others which results in a larger change in short-run output.
For example, if consumers increase spending this increases sales
directly, but also inadvertently increases the income of workers
and firm owners. This enables workers and owners to increase their
own spending, which results in a recursive process.
As the marginal propensity to consume is typically less than 1,
the income/expenditure benefit of each round decreases as less of
diminishing proportion transfers between parties.
2-sector Model Multiplier = 1 / 1 c [M>1 since 0
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o Contractionary Policies decrease PAE and output. Recall, an
increase in real output raises planned aggregate expenditure,
since
higher output (and, equivalently, higher income) encourages
households to consume more (and firms too).
Chapter 6 - Fiscal Policy Key Issues
Fiscal policy and output gaps Effects of different fiscal
instruments Limitations of fiscal policy Fiscal policy and
demographics Public debt and government budget constraint
Fiscal Policy Introduction
Components of Fiscal policy: o Government expenditure (G):
current goods & services, investment and
infrastructure. o Taxes (T - direct, indirect) income taxes,
consumption taxes. o Transfer payments (Q) benefits, pensions. Note
that transfer payments
are not part of G because the government does not receive any
goods or services in return.
Government decisions about these variables can affect the level
of output in the economy.
G spending has a direct effect on PAE. T and Q have an indirect
effect. Government Spending and Output Gaps
o Government purchases component of PAE exogenous G shift PAE
(parallel).
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Taxes, Transfers and PAE o Indirect effect on PAE affect
disposable income (Y-T) o Tax cuts and increases in transfer
payments (decrease T) increase
disposable income PAE increases. o Tax increases and decreases
in transfer payments (increase T) decrease
disposable income PAE decreases. o Thus, slope of PAE curve and
depends on t.
Larger t - flatter PAE (decrease PAE) Smaller t steeper PAE
(increase PAE)
Governments can change the exogenous part of T, T-bar or the tax
rate t. Taxes on labour Income rate rates and structure of
government payments can
influence labour supply decisions Taxes on capital Company tax
rates can influence firms investment decisions
and affect the level of private capital Fiscal Multipliers in
the 4-Sector Model
Total change in GDP is given by the change in variable
multiplied by multiplier value. Error! Not a valid embedded
object.
A proportion of tax cuts may be saved and not fully spent,
therefore the tax multiplier is lower.
Balanced Budget Multiplier: the short-run effect of equilibrium
GDP of an equal change in government expenditure and net taxes. The
initial government budget surplus/deficit is T G. Hence, the
initial deficit is kept constant when there is equal change in T
and G components. The balanced budget multiplier determines the
change in output that results from an equivalent change in T and G.
Note budget surplus/deficit is a flow variable.
Hence, output will change by less than one for every unit change
in G as c and m are < 1. Hence, output will change by less than
one for every unit change in G. Graphically since an increase in G
will shift the PAE upwards by increase in G (PAE1), simultaneously
an increase in T will shift the PAE curve downwards (PAE2) by less
than increase in G since (c-m) < 1. The net effect of these
operations will be an overall increase in PAE at every level of
output and consequently a net increase in equilibrium output from Y
to Y2.
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The Role of Fiscal Policy in Stabilising the Economy Problems
with fiscal policy
Supply side o The model doesnt take into account that fiscal
policy influences both
PAE and the economys productive capacity, through affecting the
supply factors of the economy. E.g. investments in roads, airports,
schools, lead to growth in potential output
o Whilst taxes and transfer payments affect saving and
investment. E.g. tax cuts could motivate people to work harder as
they are able to keep a larger proportion of their earnings, hence
increasing potential output. (Taxes on labour and capital affects
labour and investment supply decision).
o The multiplier effect is also not instantaneous. Problem of
Deficits
o Expansionary fiscal policy in attempt to close contractionary
gaps may lead to large sustained budget deficit, which reduce
national savings
o When government spending is above tax revenue, reduction in
national saving will in turn, reduce investments in new capital
good an important source of long-term economic growth.
Inflexibility of Fiscal policy (lags) o Model assumes
discretionary changes in fiscal policy are made in a timely
manner/instantaneously in response to output gaps. o However, in
reality changes in government spending and taxes involve
lengthy legislative processes o The model does not also consider
non-output focused government
objectives such as including national defense and income support
to the poor.
Due to these factors, and time lag issues, ideally,
macroeconomic policy should be used as a forward looking tool, e.g.
fiscal policy changes made today should be designed to influence
future (forecast) levels of output
Discretionary fiscal policy refers to deliberate changes in the
level of government spending, transfer payments or taxation.
Includes spending items such as health and defense, or fiscal
stimulus such The Education Revolution, or NBN.
Automatic stabilizers are provisions in law that imply automatic
increase in government spending and decrease in taxes when real
output declines. Refers to the tendency for a system of taxes and
transfers which are related to the level of income to automatically
reduce the size of GDP fluctuations. e.g. when the economy is
booming, GDP rising, there will be high tax receipts due to the
progressive tax system and lower transfer payments reduces PAE. Or
when
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24
the economy is in recession, GDP declines, income taxes decline
and transfer payments increase increases PAE
o Called automatic because responses to contractions/expansions
occur without legislative process
Discretionary fiscal policy is equated with structural changes
in the budget where there are direct decisions amount the amount of
government spending, tax collections and transfer payments. Called
structural deficit because this deficit exists even when the
economy is at potential it is a fundamental expenditure >
receipts scenario.
Whereas Automatic stabilizers drive cyclical fiscal changes and
is dependent on the economic conditions.
Budget Constraint, Public Debt and Fiscal Policy
The budget constraint refers to concept that government spending
in any period has to be financed by taxes or government
borrowing.
The budget constraints relates government outlays (purchases (G)
and transfer payments (Q)) to their sources of financing:
o Taxes (T) o Borrowing (through issuing security like bonds).
Denote Bt as borrowings
at period t. o Printing Money inflationary.
The outstand stock of government borrowing is called public
debt. Public debt is the sum of past deficits minus any surpluses.
Public debt = past deficits surpluses.
Since interest must be paid on loans government spending also
includes interest payments of rBt-1 Hence,
Gt + Qt + rBt-1 = Tt + Bt Bt-1 Gt + Qt + rBt-1 - Tt = Bt Bt-1
When the government runs a deficit budget, the LHS is positive
(G+Q+rB>T), and
the level of public debt grows (implies Bt > Bt-1).
Conversely, public debt falls with a government surplus.
Since fiscal policy involves decisions about G, Q, T the
government budget constraint demonstrates how these choices
influence the level of public debt.
Costs of Public Debt
Crowding Out: High levels of government borrowing may raise real
interest rates crowd-out private investment and capital formation
(S & I model). Thus one reason a government may drop debt is to
encourage investment expenditure by the private sector.
Intergenerational Equity: the concept that the current
generation should not impose an unfair burden on future
generations. Borrowing because deficit budgets cant be sustained
forever surpluses required in order to reduce debt. Thus, we should
not enjoy benefits of budget deficits now and pass on costs of
those deficits to future generations. Recent budget surplus and
sales of
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25
assets such as Telstra have allowed the government to help pay
off debts accumulated as a result of past budget deficits the GFC
has forced the government budget back into deficit.
Benefits of Public Debt
One use of public debt is to finance the provision of public
infrastructure. Where infrastructure has the characteristics of a
public good it will be under-supplied by the private sector.
Some estimates suggest that the returns to investment in
infrastructure are relatively high.
Thus it is possible that public debt may have a net benefit for
the economy, even when allowing for crowding out and
intergenerational equity effects.
Fiscal Policy Challenges Demographic Change
Demographic changes are alterations to structure of population.
Australias population is expected to increase from 20.5m in 2006 to
24.5m in
2048. Declining fertility rates and increases longevity means
that people 65 and over
are likely to go from 13% of population to 22% in that time.
This has implications for government expenditure, as health, aged
care and
pension spending will increase over that time. Government budget
deficits are predicted from 2025 onwards based on
government revenue being about 22% of GDP. Coincidently, senior
citizen typically pay minimal tax, therefore the Australian
government must borrow more in order to finance expenditure as
per the budget constraint. Recall, that the budget constraint
refers to concept that government spending in any period has be
financed by taxes or government borrowing. Additional measures to
address this issue include raising the retirement age, increasing
taxes, or encouraging younger people to being working earlier
rather than study for longer there is a cost-benefit trade-off
here.
Tax smoothing: a theory that states that the government should
run a budget surplus now if it anticipates higher government
spending in the future.
Distribution of Income
Key function of fiscal policy - influence distribution of income
changing disposable income available to households, through net
taxes.
Net taxes = tax paid by a household less transfer payments
received. Progressive Taxes: a system of taxation that levies
higher tax rates on additional
dollars earned as income increases less unequal distribution of
income. Government transfer payments are also targeted toward
low-income earners as
they are means tested. Gini Coefficient: summary measure of
income inequality.
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Error! Not a valid embedded object. Lorenz curve: graphical
representation of income inequality. A Gini coefficient of 0
implies perfect income equality and larger coefficients
imply higher income inequality.
Note: Fiscal policy is not often used these days to stablise the
economy. This is because of supply side issues (undesirable
long-run consequences), excessive national debt, and is relatively
inflexible as discretionary changes to the budget take time to
approve.
Fiscal policy is not often used as a stablisation tool. However,
fiscal policy does have important roles in the economy. Three of
these roles are:
1. To influence the distribution of disposable income across
households. 2. The management of the likely pressures on government
expenditure implied by
the ageing of the population. 3. The management of the
governments public debt.
Chapter 7 - Money, Prices and the Reserve Bank Key Issues
Money and its uses Private banks and money creation Money and
prices Reserve Bank of Australia Cash rate and exchange settlement
funds
Money: an asset that can be used in making purchases. Functions
of money:
o Medium of exchange (asset used in purchases) money removes the
problem associated with barter (direct trade) by eliminating the
double coincidence of wants problem. Thus money significantly
reduces search costs.
o Unit of account (basic measure of economic value) standardized
value comparisons.
o Store of Value (means of holding or transferring wealth. Many
assets hold this property but do not posses the first 2 functions
e.g. stock, loans and bonds).
Currency = notes and coin on issue (less what is held by banks
and RBA). M1 = Currency + Current deposits with banks (cheque and
savings accounts). M3 = M1 + all other bank deposits of non-bank
private sector Broad Money = M3 + borrowings from private sector by
non-bank depository
corporations less what these non-banks hold with banks.
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The sources of money in a modern economy are governments
(currency) and the
banking system (deposits). Banks as Creators of Money
Households and firms deposit all currency in banking system Bank
reserves: reserves of cash kept by banks to meet their customers
deposit
withdrawal demands. A 100 % reserve banking system means all
deposits are kept in form of cash reserves.
Assets Liabilities
Reserves = $100m Deposits = $100m
Reserve-deposit ratio: the ratio of reserves to total deposits
held by a bank. Fractional-reserve banking system: a banking system
in which the reserve
deposit ratio is less than 100%. Some reserves are left for
regular withdrawals; the rest (excess over R/D) can be loaned to
households and firms that demand additional currency. Banks are now
intermediaries. E.g. R/D=10%; reserves = 10M, loans = 90M and
deposits = 100M.
Assets Liabilities
Reserves = $10m Deposits = $100m Loans = $90m
Assume that private citizen prefer bank deposits to cash for
making transactions,
therefore loans will ultimately be redeposited into the banking
system again after each round.
Assets Liabilities
Reserves = $100m Deposits = $190 Loans = $90m
Here, after re-deposits, R/D = 0.53 (too high, so more lending
rounds occur to
get R/D = 0.10). Thus, banks make additional loans and they
re-deposited.
Assets Liabilities
Reserves = $19m Deposits = $100 + $ 81m + $90m
Loans = $90m + $81m
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+ $81m
Here, after reserves = $100m and deposits = $271m, thus R/D =
0.37 (too high, so more lending rounds occur to get R/D = 0.10).
Thus, Banks Make Additional Loans and they Re-Deposited.
Continue process expanding loans and deposits until R/D =
required ratio Thus, the banking system creates money through the
process of holding deposits
and lending out excess, which affects the money Supply. An
increase in deposits driving ratio downwards.
To solve for total deposits (D) recall that, Money supply =
currency held by public + bank deposits. When the public withdraws
cash from the banks, the overall money supply declines. Deposit
multiplier: Error! Not a valid embedded object.
Money and Prices
The long run supply of money and the general price level are
closely linked. Velocity: a measure of the amount of expenditure
that can be financed from a
given amount of money over a particular time period (What is the
average value of transitions that a dollar can be used for in a
given period of time? How fast does currency circulate?). This is
only approximate recall second hand sales are not included in GDP
yet these have some effect on velocity. V = P x Y/M = nominal
GDP/money stock
Quantity theory derives the relationship between price level and
the amount of money circulating the economy. The quantity theory is
based on the quantity equation (M x V = P x Y), which states that
the money stock times velocity equals nominal GDP which is true by
definition (M (money stock), V (velocity of money circulation), P x
Y (nominal GDP)).
Key assumptions: velocity is constant and output is constant,
i.e. current payment methods and production technologies are
fixed.
Therefore, quantity theory equation is: Error! Not a valid
embedded object. This can be algebraically manipulated to: Error!
Not a valid embedded object. This implies that price level is
proportional to the money stock.
Therefore, a specific percentage increase in money stock yields
the same percentage increase in price level and thus, growth rate
of money supply equals rate of inflation. Although, this
relationship is only approximate and does not always hold.
Implications: quantity theory links the growth rate of money to
price levels (the inflation rate). Intuitively this make sense,
since an increase in the supply of
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29
money with a relatively fixed supply of goods and services will
bid up in prices, hence resulting in a higher price, that is
inflation.
The central banks is responsible for the operation of monetary
policy and stability and efficiency of the financial markets. In
Australia, the RBA Act (1959 Cmwlth), stated that the RBAs
operations should contribute to the stability of the Australian
currency, maintenance of full employment and economic prosperity
and welfare of the people of Australia.
RBA has a 2-3% target inflation band.
The Reserve Banks action of buying and selling bonds is known as
Open Market Operations (OMO). OMO provides a means by which the RBA
can influence the overall level of cash (via exchange settlement
funds) and provides a means by which the RBA can ensure the
overnight cash rate is equal to its target rate
Each commercial bank has an exchange settlement account with the
RBA, which is used to manage flow of funds with other commercial
banks generated by commercial activities of their customers. ESA
must always be in credit and can never be overdrawn.
The financial system that helps manage and maintain exchange
settlement accounts by facilitating borrowing and lending of funds
for periods of less than 24 hours is called the overnight cash
market. The interest rate on these loans is called the overnight
cash rate.
Note: government spending and private sector tax payments also
have an effect on overall level of exchange settlement funds.
Open market purchase: the purchase of government bonds from the
public by the Reserve Bank for the purpose of increases the
balances in the banks exchange settlement accounts. [Cr ESA]
Open market sale: the sale by the Reserve Bank of government
bonds to the public for the purpose of reducing the balances in
banks exchange settlement accounts. [Dr ESA]
Bank with exchange settlement account surplus or deficits can
borrow and lend money between each other in the overnight cash
market, at the overnight cash rate. The return on ESA funds are
quite low so there is incentive to not accumulate too many funds,
however they must also never be overdrawn.
If there is excess cash in the system so that there is pressure
for the cash rate to fall below targets, RBA will sell bonds and
this will reduce the supply of cash.
If there is a shortage of cash in the system so that there is
pressure for the cash rate to rise above the target, RBA will buy
bonds and this will increase the supply of cash.
These conditions hold because the level of funds held in the
exchange settlement accounts affect the supply and demand of
borrowing the overnight cash market, and therefore the cash
rate.
Since the money supply is given by currency held by public +
bank reserves / desired reserve-deposit ratio, the level of bank
reserves directly influences the
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30
money supply that is an increase in bank reserves, increases by
a greater amount the money supply and a decrease in bank reserves,
decreases by a greater amount the money supply.
In its OMO the RBA rarely buys and sells government securities
outright. Rather it uses repurchase agreements (repos). Here
purchases and sales of securities are only for a certain period
(say a week), after which the original transaction is reversed.
Channel Cash Rate
RBA pays interest in funds held in ESA accounts at rate which is
0.25% below its cash rate target. Lower bound.
Banks can, at any time, borrow cash from the RBA at a rate that
is 0.25% above target cash rate Upper bound.
Demand for Cash and the Target cash rate At any interest above
4.75 banks have zero demand for a stock of cash, since they can
always get what they require from the RBA for 4.75%. At any
interest rate below 4.25 banks will demand an infinite amount of
cash, since they can always earn 4.25% from their exchange
settlement accounts. Between 4.75 and 4.25 we just assume banks
demand for cash is negatively related to the cash rate.
Note cash rates are annual effective rates.
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Chapter 8: The Reserve Bank and the Economy Key Issues
Demand for money Bond prices and yields Money Market Cash Rate
and Bond Rates PAE and the Real Interest Rate Policy Reaction
Function
Demand for Money is the amount of wealth an individual chooses
to hole in
form of money. Risk vs. Expected Return: Risky assets need to
pay a higher expected return to induce individuals to hold
them.
Benefits and Costs of Holding Money:
Main benefit from holding money is its usefulness in making
transactions medium of exchange function. Transactions demand for
money can be affected by financial innovation e.g. credit cards,
ATM reduced need to hold money
Cost - many forms of money pay zero interest (currency) or very
low rates of interest (transactions accounts) opportunity cost of
holding money - return earned by holding wealth in the form of
other assets e.g. Bonds pay a fixed amount of interest each period,
Equities pay dividends, capital gain
Assume: o Money pays a zero nominal interest rate. o Nominal
expected return on other assets is positive. o Nominal interest
rate is represented as i.
Demand for money by households and firms is affected by: o
Nominal interest rate, (i) - negatively related to i. Increasing
nominal
interest rate, increase the opportunity cost of holding money
and reduce the amount demanded.
o Real output (or GDP), (y) - positively related to y. Larger
GDP means higher incomes and greater transactions volumes are
likely to lead to increased demand more money.
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32
o Price level, (P) - positively related to P. Inflation means
the dollar value of general G+S increase, require more money for
transactions
Money Demand Curve
Nominal Demand [Link shape to opportunity costs of money] Error!
Not a valid embedded object.
Real Demand Error! Not a valid embedded object.
Shifts in the Demand for Money
Real income (y) Price level (P) (only if we measure nominal
money on horizontal axis) Technological Change and Financial
Innovation (E.g. Development and spread of
ATMs decrease demand shift left) Stock market volatility can
increase demand for safer assets. Political instability can lead
people to worry about inflation and hoard currency.
Supply of Money
The supply curve for money is vertical - position is determined
by the actions of the RBA (OMO), independent of i. No change in
money supply.
Or, the supply curve for money is horizontal - RBA supplies
money on demand (at a given i).
Recall, RBA is able to control the money supply (currency and
deposits) by OMO with the public.
Asset Prices and Yields
Yield or return on a financial asset is inversely related to the
assets price. Bond: type of financial asset, issued by someone
seeking to borrow money. Principal amount: amount of money lent by
purchaser of bond. Coupon rate: the interest rate attached to a
bond (= Coupon Payment/Principal). Coupon payment: the dollar
amount of interest payments on a bond.
Consider, RBA reduces Ms which to raise interest rates:
(Vertical Ms is exogenous?)
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33
OMO: RBA sells bonds to the public in exchange for M (reduces M)
[!] D is downward sloping because a low interest rate would not
promote lending
between banks, so banks are more inclined to leave money in
their ESA, thus reducing the demand for base money. Supply is
controlled by RBA OMO, and inelastic wrt. cash rate. Higher target
cash rate shifts demand to the right (expands demand).
At the initial (old equilibrium) interest rate there will be an
excess demand for money and an excess supply of bonds as bond will
be over-valued at this lower interest rate.
The excess supply of bonds will put downward pressure on bond
prices, which raises the interest rate. This process will continue
until the demand for money has been reduced to equal the lower
supply.
Consider, endogenous money supply: Interest Rate Target
Given the demand for money function, the RBA will supply
whatever quantity of money that is required to achieve its target
value for the interest rate. Thus at any time, the RBA can either
control the money supply or set a target value for the interest
rate.
Monetary Policy and the Money Market
Recall, RBA targets the very short-term interest rate (overnight
interbank rate) and undertakes its OMO mainly with banks. What are
the implications of the cash rate on longer-term interest
rates?
Consider maker for Market for 90-Day Bills.
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34
Supply curve indicates the willingness of firms to supply/issue
bills (ie. to borrow for 90-days). Recall that when bill price is
high, the interest rate on bills is low so firms want to supply
more bills (ie. borrow more). Cost is lower.
Demand curve indicates the willingness to lend to firms (ie.
demand for 90-day bills). Recall that when bill price is high, the
interest rate on bills is low, so no one is willing to lend much
(ie. demand for bills is relatively low) Return is poorer.
Effect of an Increase in the Cash Rate on the 90-Day Bill Market
RBA raises its target level for the cash rate. Assume banks (and
some other financial institutions) are able to participate in both
the overnight cash market and in the commercial bill market.
o [DEMAND] Lenders leave the bill market in favour of higher
returns in the overnight cash market Demand for commercial bills
(willingness to lend to firms) will fall: Demand curve shift left.
HIGH PRICE = LOW INTEREST RATE = LOW RETURN = LOW D!
o [SUPPLY] Borrowers in cash market will now seek funds in the
90-day bill market, due to the higher cash rate supply of
commercial bills (demand for 90-day loans) will rise: Supply curve
shift outwards. HIGH PRICE = LOW INTEREST RATE = LOW COST = LOW
S!
[KEY IDEA: if the RBA increases the funds in the overnight cash
market, then investors who previously dealt in the 90-day bill
market now seek higher returns in the overnight cash market, and
borrowers who obtained funds from the overnight cash market
restructure their financing plans and move to longer-maturity loans
with a comparatively lower interest rate. Think as if the two
markets were mutually exclusive. RBAs targeting has an indirect
effect on longer-term interest rates].
The price of bills falls and the interest rate rises.
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35
Thus, changes in cash rate eventually lead to changes in
longer-term interest rates.
Market Rates = Cash Rate + Premium (for risk or liquidity
factors) Recall, Error! Not a valid embedded object.. Thus, if
inflation is sticky in the
short-run, RBA can control nominal and real interest rates (in
SR). Note: r can be negative if nominal inflation is below
inflation.
Real interests move in a direction of real cash rates however
this is no exact relationship.
The RBA controls the nominal interest rate thought its targeting
of the overnight cash interest rate. Because inflation is slow to
adjust, in the short-run the reserve bank can control the real
interest rate as well. In the long run, however, the real interest
rate is determined by the balance of savings and investment.
PAE and the Real Interest Rate
Higher real interest rates will lead households to defer current
consumption (positive effect on saving and borrowing costs are
higher). Thus, Error! Not a valid embedded object.
Higher real interest rates will raise the cost of capital and
reduce investment by firms. Thus, Error! Not a valid embedded
object.
(Assume G, T and X (N-X-bar, not NX-bar) are exogenous)
Therefore, Error! Not a valid embedded object.
The implication of this is that PAE will rise and fall with the
real interest rate (as set by the RBA when inflation is sticky)
since exogenous expenditure now depends on the real interest rate.
The RBA now has a mechanism by which monetary policy can affect PAE
and equilibrium output.
[CHECK EXAMPLE 8.4 & 8.5]
Policy Reaction Function: mathematical representation of how
central banks adjust interest rates in light of the state of the
economy.
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36
The model assumes that RBA will set level of real interest rate
as a function of the state of the economy. Policy reaction
functions characterise the central banks behaviour.
Taylor Rule: [Output gap affects level of interest rates] Error!
Not a valid embedded object.
Simplified policy reaction function: [Primarily depends on
inflation. R-bar is interest when inflation zero. G is how many
percentage points the interest rate rises with inflation]. Error!
Not a valid embedded object.
Simplified policy reaction function with inflation target:
[Target could be 2.5, or the mid-point of their target range].
Error! Not a valid embedded object.
o Positive slope RBA raises the real rate as inflation rises
(Inflation is associated with an expansionary gap.
In practice, the reserve banks information about the level of
potential output and the size and speed of the effects of its
actions is imprecise. Thus monetary policymaking is as much an art
as a science.
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37
Chapter 9: Aggregate Demand and Aggregate Supply Key Issues
Aggregate Demand (AD) Curve Slope and Shifts in the AD Curve
Inflation: Inertia and the Output Gap Aggregate Supply (AS) Curve
AD-AS Model Applications
Aggregate Demand (AD) Curve: Shows the relationship between
short-run
equilibrium output, (y), and the rate of inflation (); the name
of the curve that reflects the fact that short-run equilibrium
output is determined by, and equals, total planned spending in the
economy; increases in inflation reduce planned spending and
short-run equilibrium output, so he aggregate demand curve AD, is
downward sloping.
There is a NEGATIVE relationship between output and inflation
(logic behind negative slope): Error! Not a valid embedded
object.
This relation occurs due to the actions of the reserve bank to
match planned spending with capacity, otherwise there will be
changes to the general price level. When inflation is high, the
reserve bank responds by raising the real interest rate. The
increase in the real interest rate reduces consumption and
investment spending, hence reduces equilibrium output.
Other reasons for the slope include net wealth (inflation
distorts asset prices and affects peoples spending patterns)
especially true for money and the purchasing power of money.
Inflation also affects wealth/income distribution, inflation tends
to affects those on lower incomes more, who spend a greater
proportion of their income. Inflation also crates greater
uncertainty amongst households and firms, reducing their spending.
Also, the price of domestic good and services changes on the
international market, leading to a decline in exports.
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Shifts in AD Curve: Changes in spending caused by factors other
than interest rates (exogenous
spending). Exogenous change in the RBAs policy reaction
function, r-bar component
change in r at every level of AD.
Note: a change in inflation corresponds to movement along AD
curve, provide interest rate are consistent with policy reaction
function. CHANGES TO THE REAL INTERST OR INFLATION RATE DO NOT
SHIFT THE AD CURVE - CHANGES TO THE POLICY REACTION FUNCTION
DO!
Why does inflation move slow? Inflation expectations and
long-term wage price contracts (think of the employer bargaining
future wages). The cycle: low inflation expectations, slow increase
in wage and projection costs, and low inflation.
Inflation and Aggregate Supply (AS)
AD curve contains two endogenous variables the output gap and
Inflation shocks.
Inflation Inertia refers to the notion that inflation is sticky
or inertial. This is because the rate of inflation tends to change
relatively slowly each year in the absence of adverse stocks.
Reflects the influence of:
o Inflation expectations become a self-fulfilling prophecy. If a
firm expects inflation to rise, they will charge more to shield
themselves from the higher that is expect.
o Long-term nominal wage and price contracts. For example, a
union negotiating in a high-inflation environment is much more
likely to demand a rapid increase in nominal wages over the life of
the contract that it would in a price stable economy.
Output Gap Inflation Expansionary (y>y*) -Sales exceed normal
production rate.
Rising
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-Increase prices to cut excess demand. Contractionary (y
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Note: this implies the economy is self-correcting, however, this
speed of return to LR equilibrium may be unacceptably slow. The
greater the initial gap the longer correction period. This is in
contrast to Keynesian economics, which assumes sticky prices.
This self-correction process means SRAS moves to bring the
economy into long-run equilibrium.
Shocks to AD Curve (by fiscal or monetary policy)
Increase in PAE results in expansionary shifts in AD curve
(right shift). When the economy is already at potential, any
increases in exogenous PAE will put upward pressure on inflation
and shift up SRAS (e.g. military spending which increases G).
Note: In the long run, y = y* (the increase in output is only
temporary) but higher
inflation occurs. BUT by increasing (contractionary monetary
policy) and shifting its policy reaction function upwards, the RBA
can decrease PAE and move AD curve to left. This will offset the
positive spending shock.
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Shocks to Aggregate Supply - Inflation shocks (SRAS) and
potential output shocks (LRAS).
Inflation shocks shift in the SRAS curve. Inflation shocks are
unrelated to the nations output gap. E.g. examples rising
energy/oil costs. Creates stagflation (recession + higher
inflation)
o Sudden change in the rate of inflation that is unrelated to
output gap I.e. LRAS is unchanged. Examples: Large increases in
economy-wide wages, or large falls in manufactured goods prices
(China) e.g. large change in oil prices.
Potential output Shock: shifts the LRAS curve.
o Fall in Potential Output e.g. smaller capital stock due to
sharp rise in oil as less energy efficient equipment is
retired.
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o Note: because this is a fall in potential output, decline in
output is permanent and inflation rate is higher. This is costly in
terms of forgone output.
Anti-inflationary monetary policy
Shift AD left by increasing r-bar (upward shift in PRF). This
reduces the level of inflation. In the short run, output falls. In
the long run, output returns to potential but at a lower inflation
rate. In the short run there is lower output and higher
unemployment and little to no reduction in inflation as it is
sticky, benefits are long term.
Disinflation: a substantial reduction in the rate of inflation.
Once a country has attained a low inflation rate it may introduce
institutional arrangement to help ensure that the lower rate is
sustained. Also peoples expectations may be anchored to lower
inflation. Disinflation is costly because it has recessionary
short-term effects.
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Chapter 14 Exchange Rates and the Open Economy Key Issues
Nominal and real exchange rates Purchasing Power Parity (PPP)
Supply and Demand Model of the Exchange Rate Fixed Exchange
Rates
Nominal Exchange Rate: the rate at which two currencies can be
traded for each
other. Units of foreign currency per (one) unit of domestic
currency; $F/$D. The asset is in the denominator.
Nominal exchange rates are the price of one currency in terms of
another one. e = number of units of foreign currency that one unit
of the domestic currency
will buy = $F/$D. o Hence an appreciation (deprecation) of e is
an appreciation
(depreciation) of $D. This means D has changed values relative
to other countries purchasing power.
The trade-weighted exchange rate is an average of one countrys
exchange rtes with all of its trading partners, where relatively
important trading partners are accorded a relatively larger
rate.
Fixed vs. floating exchanger rate systems. Real Exchange Rate:
the price of the average domestic good or service relative
to the price of the average foreign good or service, when prices
are expressed in terms of a common currency. Error! Not a valid
embedded object.
Real exchange rates measures the price of average domestic goods
relative to the price of average foreign goods (when prices are
expressed in common currency).
A rise in the real exchange rate implies that domestic goods are
becoming more expensive relative to foreign goods. Other things
equal, this tends to reduce exports and encourage imports; with the
overall effect of reducing the level of net exports.
A fall in the real exchange rate implies that domestic goods are
becoming cheaper relative to foreign goods. Other things equal,
this tends to increase exports and discourage imports. This leads
to a rise in net exports.
Determination of the exchanger rate (PPP and S/D for
currencies)
Law of one price: if transport costs are relatively small, the
price of an internationally traded commodity must be the same in
all locations. Otherwise arbitrage opportunities exist.
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Purchasing Power Parity (PPP): the theory that nominal exchange
rates are determined as necessary if the law of one price holds;
Pf/P=e. Implications:
o Exchange rates are determined by relative price levels. o
Exchange rate adjusts so that price levels in two countries are
equal
(when measured in a common currency). o Countries that
experience relatively high inflation will tend to have
depreciating currencies. Error! Not a valid embedded object.
Limitations of PPP
o Stronger support for PPP in the long run (i.e. over decades),
than short-run.
o Non-traded goods - goods difficult to trade internationally
e.g. haircut. o Trade barriers such as tariffs and quotas - raise
costs of transporting
goods internationally. o Some goods are not identical and cannot
be compared. E.g. Japanese cars
are unique to American cars. Supply and Demand Model for
currencies (Explains short run behaviour better
than PPP). o Note: model determined with respect to domestic
country o Supply of AUD - Australian (domestic) households and
firms who want to
purchase foreign goods, services or financial assets. Such
purchases require foreign currency so households and firms supply
Australian dollars in exchange for foreign currency (Yen). SLOPE:
An increase in the number of JPY offered per AUD, makes Japanese
goods and services more attractive for Australians. SLOPE: An
increase in the number of JPY offered per AUD, makes Japanese
goods/services more attractive.
o Demand for AUD - Foreign/Japanese households and firms who
want to purchase Australian goods, services or financial assets.
Such purchases require $A so Japanese households and firms supply
Yen in exchange for $A. SLOPE: The more JPY that must be offered
for per AUD, the less attractive Australian goods and services are
for the Japanese.
Shifts in the Supply Curve
Increase in Supply Curve as the AUD Depreciates e falls (Shift
right).
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o Increased preference for Japanese goods o Increase in
Australian GDP (income effect). Allows for greater
consumption, part of which will be from imports. o (Expected)
increase in the real return on Japanese assets, greater return
(given risk held constant). This attracts savers in Japan who
leave the Australian markets.
Shifts in the Demand Curve (Exogenous shift in the desire of
Japanese to purchase Australian GS/Assets)
Increase in Demand Curve as the AUD Appreciates e rises (Shift
right). o Increased preference for Australian goods. o Increase in
Japanese GDP (income effect). o (Expected) increase in the real
return on Australian assets.
Monetary Policy and the Exchange Rate
In open economies like Australia, the exchange rate provides an
additional channel by which monetary policy can influence the level
of aggregate demand and GDP.
If the RBA tightens monetary policy (by raising the real
interest rates), this will increase demand for the dollar and
produce an appreciation of the exchange rate. But, the supply curve
may also shift (inwards) as Australians buy less foreign
assets.
The higher e or appreciation of the AUD should reduce net export
and increase imports, which decreases overall economic activity as
measured by AD. Thus the strong dollar reduces net exports and
higher interest rate reduce consumption and investment.
[!] Note: monetary policy is more effective in open economy with
flexible exchange rate.
A Real Appreciation and NX
Recall, real exchange rate = eP/Pf. Then if domestic and foreign
prices are sticky in the short-run, the nominal
appreciation will lead to an appreciation of the real exchange
rate. Thus, the higher value of the dollar will tend to reduce the
level of next exports,
reducing aggregate demand and the level of output. Fixed
Exchange Rates
An exchange rate whose value is set officially by government
policy. Country fixes the value of its currency against some other
currency (or a basket of currencies). The value of a fixed exchange
rate may deviate from its fundamental value due to supply and
demand in the FX market.
Devaluation: decrease in official value of currency.
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Revaluation: increase in official value of currency. Under fixed
exchange rate a currencys value can differ from its fundamental
value (intersection of supply and demand curves actual exchange
rate) Overvalued exchange rate: an exchange rate that has an
officially fixed value
greater than its fundamental value.
Central bank buy back the extra supply of domestic currency and
become a demander of the currency. Overvalued currencies can also
be maintained by restricting international trade/transactions
(imports/quotas/tarrifs).
Undervalued exchange rate: an exchange rate that has an
officially fixed value less than its fundamental value.
International Reserves: foreign currency assets held by a
government for the purpose of purchasing the domestic currency in
the foreign exchange market. There is obviously a limit to
reserves, and a fixed exchange rate can collapse in this case.
o Balance of payments deficit: net decline in a countrys stock
of international reserves over one year.
o Balance of payments surplus: the net increase in a countrys
stock of international reserves over a year.
Note: devaluation means everything in domestic currency is now
worth less Fixed Exchange Rates are Subject to Speculative
Attacks
Speculative Attack: massive selling of domestic currency assets
by financial investors (domestic and foreign). Driven by fear of
(expected) devaluation (currency is overvalued, and reserves could
be low). Increases supply of domestic currency and leads to a fall
in the fixed currencys fundamental value. Central bank needs to buy
a greater value of domestic currency, which increases the further
increases reserves deficit. Devaluation may eventually be required.
Thus, fear of devaluation causes devaluation self-fulfilling
prophecy.
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Monetary Policy to Defend an Overvalued Exchange Rate
Currency is overvalued so central bank tights monetary policy.
Higher domestic interest rates should also shift the supply curve
left and reduce quantity demanded!
If currency is undervalued, central banks should adopt
expansionary monetary policy, which reduces the real interest rate
and decreases demand. The Demand curve shifts left and the supply
curve shifts right.
Conflict for Policymakers - Stabilize the currency, vs.
Stabilise the domestic
economy. Actions to stablise the currency and stop speculative
attacks may have a contracitonary effect on the domestic
economy.
Pegged/fixed exchange rates provide potential benefits to
countries who are poor monetary policy managers who have high
inflation.
Note: Overvalued currencies have the fixed line ABOVE
equilibrium Undervalued currencies have the fixed line BELOW
equilibrium. In undervalued, excess demand is met by central banks
who obtain foreign currency in exchange for
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domestic currency (loose domestic currency reserves). In
overvalued cases, foreign currency is depleted to purchase domestic
currency and inflate the price this is very risk and creates risk
of speculative attacks.
Advantages/Disadvantages of a Flexible Regime
[FOCUS] Countries can use monetary policy for domestic
stabilization strengthens impact of aggregate demand (independent
monetary policies)
[AUTOMATIC] Automatic adjustment to equilibrium in the foreign
exchange market
Volatility negative impact on trade Advantages/Disadvantages of
Fixed Regime
(Potentially) stable exchange rate, may promote trade (less
volatility and financial risk). However, speculative attacks
threaten the long-term predictability of a fixed exchanged rate
Countries cannot use monetary policy for domestic stabilization
[MAJOR DISADVANTAGE!]
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Chapter 15 The Balance of Payments: Net Exports and
International Capital Flows Key Issues
Balance of payments Relationship between the capital and the
current accounts Determinants of international capital flows
Saving, investment and capital inflows
Balance of Payments: Record of transactions between residents of
a country and
non-residents. o Current Account: Transactions leading to a
change of ownership of
commodities or a direct flow of income [G/S + interest
payment/income payment on foreign investment].
o Capital Account: Transactions involving the purchase or sale
of assets [Bonds and equity].
Current Account:
Balance on merchandise trade (exports imports of goods) + Net
services (difference between total service credit and debit) =
Balance on good and services + Net income (includes labour and
property income; interest, dividend and
royalty payments. CR is an inflow, DR is an outflow) + Current
transfers (migrant funds, foreign aid) = Balance on Current
Account
Current account deficit, when DR>CR. Current account surplus
when CR>DR.
Account Debit Credit Merchandise trade
Domestic purchase of Japanese car
Sale of wheat to Russia
Services Domestic buyer pays freight cost on imports
Overseas buyer pays freight costs on exports
Income Domestic company pays foreign employee
Foreign company pays domestic employee
Transfer Domestic relative sends cash gift to overseas
resident
Over relative send cash gift to domestic resident.
Capital Account:
o Transactions between domestic and foreign residents that
involve the acquisition of an asset or a liability
o New liabilities are recorded as credits (as they bring in
foreign exchange) like exports of goods and services
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o Acquisition of assets are recorded as debits (as they require
foreign exchange to be given up by domestic residents) like imports
of goods and services
o Balance on capital account is difference between total credit
items (sales of domestic assets/acquisitions of a liability by a
domestic resident) and total debit items (purchase of foreign
assets/discharge of a liability by a domestic resident) in the
capital account of the balance of payments.
The capital account is divided between two sectors. o The
official sector records the transactions of the government sector
and
the Reserve Bank. o The non-official sector records the
transactions of private sector firms,
financial institutions and households. Balance on Financial
Account:
The important part of the capital account is the balance on the
financial account, which records:
o Direct and portfolio investment balances of net foreign
investment in Australia and Australian investment abroad.
o Plus changes in the RBAs holdings of foreign exchange and
gold. A smaller part of the capital account is the balance on the
capital account, which
records: o The cancellation of debts of poor countries and funds
taken in and out by
migrants. o Plus, the net acquisition/disposal of non-produced,
non-financial assets,
e.g. records sales of embassy land or patents and copyrights.
Capital Account:
Net capital transfers + Net acquisition/disposal of
non-produced, non-financial assets = Balance on capital account +
Balance on financial account (foreign investment) = Balance on
Capital and Financial Account
International capital flows: flows of financial capital between
countries as a
result of the sale or purchase of one countrys assets by other
countries. Capital inflows: when financial capital flows into a
country as the result of a sale of a domestic asset. This is
equivalent to a domestic resident acquiring a liability to an
overseas agent. Capital outflows: when financial capital flows out
of a country as the result f a purchase of a foreign asset. This is
equivalent to a foreign resident acquiring a liability to a
domestic agent.
International Capital Flows Purchases and sales of real and
financial assets across international borders are called
international capital flows. From the perspective