Issue 1: Economic Growth. Syllabus Outline Economic Issues – Economic Growth Students learn to apply economic skills: calculate an equilibrium position.

Issue 1: Economic Growth

Syllabus Outline

Economic Issues – Economic Growth

Students learn to apply economic skills: calculate an equilibrium position for an economy using leakages and

injections determine the impact of the (simple) multiplier effect on national income explain the implications of the multiplier for fluctuations in the level of

economic activity in an economy

Students learn about economic issues in the Australian economy 3.1 Economic growth

3.1.1 aggregate demand and its components: Y = C+I+G+X–M3.1.2 injections and withdrawals (I+G+X; S+T+M)3.1.3 the simple multiplier: k = 1/(1–MPC)3.1.4 measurement of growth through changes in real GDP3.1.5 sources and effects of economic growth in Australia3.1.6 business cycle — trends

Review of the Circular Flow

The circular flow of income is useful for explaining economic theory, often called the Keynesian revolution, which is that:

the level of Aggregate determines the level of economic activity (i.e. production, income and ).

developed in the 1930’s, as a response to the Great Depression, it represented a radical departure from the accepted economic theory of the time, known as the Classical theory.

Keynes used a three sector model comprising households, firms & financial sector to illustrate the impact of & investment on the level of economic activity.

Savings (S) is regarded as a , or withdrawal, as it is income not spent - it aggregate demand.

Investment (I) is regarded as an injection because it increases the level of .

Financial institutions, such as banks, act as and provide a link between savers and investors.

Circular Flow - 3 Sector Model

Financial intermediaries, such as banks

Circular Flow - 3 Sector Model If planned savings is than planned investment

then the level of activity will fall. This is because the increase in demand coming from is less than the decrease in demand coming

from saving - with aggregate demand falling so does production, income and employment.

Income Consumption Saving Investment

Assume Y = 20 000, C = .75Y and I = 4 000

Final Time period

Circular Flow - 3 Sector Model If planned savings is than planned investment

then the level of economic activity will rise. This is because the increase in demand coming from

investment is greater than the decrease in coming from saving - with aggregate demand rising so does production, income and employment.

Income Consumption Saving Investment

Assume Y= 12 000, C= .75Y and I = 4 000

Final Time period

Circular Flow - Equilibrium

when the level of aggregate demand equals the level of production or aggregate supply the economy is said to be in .

this means that the business/firms sector is producing exactly what is being demanded and so there is no tendency for the level of economic activity to change.

In a three sector model, at equilibrium savings equals investment. 3 Sector Equilibrium:

AD = C + I

Circular Flow - 4 Sector Model

Keynes advocated the use of budgets/fiscal policy to influence the level of economic activity because it is unstable.

if the level of economic activity was low and there was unemployment of resources, then a budget (G>T) could raise AD and national income by a multiplied amount.

if there was excessive in the economy causing inflation, then the most appropriate budget would be a budget (G<T) to lower AD and national income by a multiplied amount.

Circular Flow - 4 Sector Model

in a four sector model, for equilibrium to occur (ie no tendency for economic activity to change) leakages must equal injections.

4 Sector Equilibrium:

AD = C + I + G

Circular Flow - 5 Sector Model

in a five sector model, for equilibrium to occur (ie no tendency for economic activity to change) leakages must equal injections.

4 Sector Equilibrium:

Aggregate Demand & Components 3.1.1

the level of Demand determines the level of economic (i.e. production, income and employment) – Keynesian economic theory In a 3 sector model the components of Aggregate Demand

are: AD = C + I In a 4 sector model the components of Aggregate Demand

are: AD = C + I + G In a 5 sector model the components of Aggregate Demand

are: AD = if demand (ie Gross National Expenditure/GNE

= C + I + G), is than the productive capacity of the economy (ie Gross Domestic Product/GDP) this will result in negative Net Exports - a current account deficit (CAD) will occur.

Injections increase Aggregate Demand and raise the level of economic activity. Injections are: Investment (I) spending ( ) and ( )

Withdrawals or leakages decrease Aggregate Demand and lower the level of economic activity. Leakages are: ( ) Taxation (T) and ( )

if injections > leakages the level of economic activity will if injections < leakages the level of economic activity will

Injections and Withdrawals 3.1.2

Focus Questions1. Define Keynesian economic theory.2. Explain what happens to the level of economic activity in a 3 sector

model when planned savings is greater than planned investment.3. Explain the Keynesian view of the role of government.4. Identify the components of aggregate demand in a 5 sector model.5. Calculate the value of exports for the following economic system to

be in equilibrium.

6. Calculate from the following what is going to happen to the level of economic activity.

7. Calculate the year in which there is a current account deficit.

Investment (45) Savings (40) Taxation (35) Govt. Spending (40) Imports (25)

Tax (30) Exports (40) Govt. Spend (40) Imports (50) Invest. (25) Savings (15)

Year GDP $m. C I G

1 600 400 50 100

2 700 500 100 150

Circular Flow - 4 Sector Model If planned leakages are than planned injections then

the level of economic activity will rise. This is because the in demand coming from the

injections is greater than the decrease in demand coming from the leakages - with aggregate demand rising so does production, income and employment.

Assume Y = 12 000, C = .75Y, I = 4 000, Taxation = 0 and Govt. Spending = 1000

Final Time period

Income

(Y)

Consumption

(C)

Savings

(S)

Taxation

(T)

Investment

(I)

Government

(G)

The Simple Multiplier 3.1.3

Fundamental to theory is not only the view that aggregate demand determines level of economic activity but also that play a key role in influencing economic activity.

Economic activity is inherently and will fluctuate over time (ie economic cycle) & government is needed to control economic activity.

During the Great Depression Keynes maintained, however, that government was not expected to take up all unemployed labour directly through its own spending programmes as any increase in spending would have a larger or effect on income levels.

In other words, a small increase in spending, including government spending, would generate through the (k) an even larger increase in income and employment levels.

The Simple Multiplier 3.1.3

The multiplier can be determined mathematically and any activity that spending will reduce the multiplier effect – so savings (S), taxation (T) and imports (M) all reduce the multiplier effect.

In a sector model, which is households, firms and financial sectors, the simple multiplier is the reciprocal of the marginal propensity to save (MPS).

Multiplier (k) = __1_ or __1___

1 – MPC

The Simple Multiplier 3.1.3

Consider the previous 3 & 4 sector tables: In the 3 sector model, the equilibrium level of income is 16 000,

while in the 4 sector model it is 20 000. When moving from 3 to 4 sectors the only change has been an

increase in government spending (G) of 1 000 and this has produced an income change 4 000 (16 000 to 20 000) – therefore the multiplier is 4.

This can be verified by the multiplier formula for a 3 sector model:

Multiplier (k) = 1 or 1

MPS 1 – MPC = 1/.25 or 1/1 -.75 = 4

Y C S I

The Keynesian Y Diagram

Assume: C = 50 +.75Y

0 100 200 300 400 National Income

100

200

300

400

Expenditure

50

125

-50

-100

0

100

50

Y C S I

0 40

100

300

500

700

Focus Question

Assume: C = 60 +.8Y and I = 40

a. Complete the table:

0 100 200 400 500 600 800 National Income

200

400

600

800

Expenditure

100

-60

-200

0

200

40b. Calculate:

MPC MPS k EqY

500

c. Graph & label: Consumption Savings Investment Y (C + S) AD (C + I)

Y C S I

The Keynesian Y Diagram

Assume: C = 50 +.75Y

and I = 50

0 100 200 300 400 National Income

100

200

300

400

Expenditure Y = C + S

50

50

50

50

0 50 -50

100 125 -25

200 200 0

50

50

300 275 25

400 350 50

500 425 75

50

125

C

I

C + I

-50

-100

0

100

50

S

I

Note: if Y = C + S and if C = 50 +.75Y

then Y = 50 +.75Y + S and S = -50 +.25Y

Autonomous Consumption Induced Consumption = MPC

Y C S I

0 60 -60 40

100 140 -40 40

300 300 0 40

500 460 40 40

700 620 80 40

Focus Question

Assume: C = 60 +.8Y and I = 40

a. Complete the table:

0 100 200 300 400 500 600 800 National Income

200

400

600

800

Expenditure

100

-60

-200

0

200

40

b. Calculate: MPC MPS k EqY

500

c. Graph & Label: Consumption Savings Investment Y (C + S) AD (C + I)

C

C + I

Y

S

I

Y C S I

The Multiplier Effect

100 200 300 400 500 National Y

100

200

300

400

Expenditure

Y = C + S

75

75

75

75

0 50 -50

100 125 -25

200 200 0

75

75

300 275 25

400 350 50

500 425 75

C + I

-50

-100

0

75

S

I

500If investment rose by 25 to 75

the new equilibrium level of income will be where:

I1

C + I1

125

50

Calculating Equilibrium

100 200 300 400 500 National Y

100

200

300

400

Expenditure

Y = C + S

C + I

-50

-100

0

75

S

I

500

I1

C + I1

125

50

Method 1: Savings = Investment

Method 2: Multiplier Method

Focus Questions

1. Explain what happens when leakages exceed injections in a 4 sector model.

2. Define the ‘multiplier’.3. Provide the multiplier formula for a 3 sector model.4. Distinguish between autonomous and induced spending.5. If C = 100 + .8Y and I = 100, Calculate:

a) marginal propensity to consume (MPC)b) marginal propensity to save (MPS)c) the multiplier (k)d) equilibrium level of income

6. Calculate from the following table:a) MPCb) MPSc) Multiplierd) Equilibrium level of income

Y C S I

200 200 0 100

400 360 20 100

600 520 80 100

800 680 120 100

1000 840 160 100

Measurement of Growth –real GDP 3.1.4

growth is measured by the growth in real Gross Domestic (GDP) over time. This is the total value of goods and services produced in an economy adjusted for any inflation.

or money Gross Domestic Product (GDP) is inappropriate as it will artificially increase if there are price increases/ .

Converting nominal GDP into GDP to accommodate for inflation changes and provide a more accurate measurement of production is achieved by the formula:

real GDP = nominal GDP x 100

Measurement of Growth – real GDP 3.1.4 Real GDP is often seen as an inadequate indicator of living

standards for a number of reasons: hours worked per week or the length of working life is not

taken into account. quality of life indicators, including the value of leisure are

ignored. The exclusion of economic development issues can be overcome by other measures, such as the Human Development Index (HDI).

income distribution inequalities are not reflected in the measurement.

negative externalities, such as pollution and increased traffic congestion, generated by production are not taken into account.

changing population makes real GDP an unreliable measurement. To overcome this problem real GDP per capita, where population divides it, may be used.

Sources & Effects of Economic Growth 3.1.5

The sources of economic growth can come from any of the components of , being: consumption, investment, government spending and net exports.

Private expenditure is the largest component of demand by far and provides approximately 60 per cent of all spending in the Australian economy.

It has also provided the largest change in growth throughout

the last decade to 2004.

Sources & Effects of Economic Growth 3.1.5

Economic growth provides a number of for the economy: increases in real per capita/standard of living for

those employed resources. growth may occur, particularly if the

existing employed resources cannot meet the increased demand for goods and services despite their productivity increases.

higher as increased demand for goods and services will eliminate any excess productive capacity. Investment is a particularly important component of aggregate demand as it adds to the nation’s stock of real capital and so provides scope for further economic growth.

government budget benefits, through both a reduction in its expenditure on benefits and increased taxation revenue – ‘ dividend’

Sources & Effects of Economic Growth 3.1.5

A number of costs may be associated with economic growth : structural may result from any structural

change accompanying economic growth . inequality in income becomes greater if the

benefits of economic growth are not shared equally . deterioration in quality, through pollution of

the natural environment or depletion of non-renewable resources as a result of excessive growth .

other economic may suffer, such as external stability and low inflation.

Trends in the Business Cycle 3.1.6

Level of Economic Activity

Time

Trend Line

Business Cycle A – No Govt. Intervention

capitalist market economies experience fluctuations in the level of economic activity over time - the cycle

for many years, ‘ -faire’ government meant no govt. attempt to control economic activity and swings in the business cycle resulted in numerous and recessions.

Trends in the Business Cycle 3.1.6

Level of Economic Activity

Time

Trend Line

Business Cycle A – No Govt. Intervention

Business Cycle B – with Govt. Intervention

acceptance of Keynesian theory, meant now had a role in controlling economic activity to minimise swings in the business cycle, particularly to reduce unemployment and control inflation.

use of demand weapons, such as fiscal & monetary policies as counter-cyclical policies reduced swings in the business cycle.

Trends in the Business Cycle 3.1.6

The business cycle is fluctuations in the level of economic activity over time and: since 1992, the Australian economy entered a

phase of uninterrupted economic , albeit with different growth rates, for the rest of the decade and

economic growth has prevailed into this decade.

Focus Questions

1. Distinguish between nominal GDP and real GDP.

2. Explain why real GDP is regarded as an inadequate measure of economic growth.

3. Identify the sources of economic growth.

4. Discuss the costs and benefits of economic growth for individuals, businesses and governments.

5. Outline the role of government counter-cyclical polices in moderating swings in the business cycle.

6. Describe the trends in the Australian business cycle.

Y C S I

The Keynesian Y Diagram

Assume: C = 50 +.75Y

and I = 50

100 200 300 400 National Income

100

200

300

400

Expenditure Y = C + S

50

50

50

50

0 50 -50

100 125 -25

200 200 0

50

50

300 275 25

400 350 50

500 425 75

C

C + I

-50

-100

0

100

50

S

I