hscnotes.weebly.comhscnotes.weebly.com/uploads/1/2/0/4/12042261/economics.docx · Web viewEquilibrium is the level where the income, output and employment plans of firms coincide

ECONOMIC GROWTHAggregate Demand and its Components

Y = C + I + G + (X-M)

What is aggregate demand?

It is the total amount which all sectors of the economy are willing and able to spend over a given time

period.

The 5 sector circular flow

Equilibrium

Within the circular flow of income, equilibrium is the expected goal.

S + T + M = G + I + X

Within the 3 sector model (there are only consumers, business and financial institutions). Therefore:

The reason is: All that can be spent (aggregate demand) in this economy is either consumption

expenditure or investment expenditure.1

AD = C + I

Within the 4 sector model (there are only consumers, business, financial institutions and the

government). This is closed economy because there is no overseas sector. Therefore:

The reason is: All that can be spent (aggregate demand) in this economy is consumption or investment

or taxation expenditure.

Within the 5 sector model (this is an open economy and involves the 4 sectors plus the overseas

sector). Therefore:

Equilibrium is the level where the income, output and employment plans of firms coincide with

spending patterns of all sectors of the economy.

Injections and Withdrawals

Category I or L Effect on the CFOIInvestment Injection Increases the amount of funds circulating through M3 and therefore the

amount spent on capital (financial, speculative, productive) Multiplied throughout the economy and stimulates consumption spending

Savings Leakage Unspent income is saved Money is not in circulation and therefore shrinks the size of the CFOI The higher the rate of savings, the less the economic growth of a nation

Taxation Leakage Unspent income is taxed Money is not in circulation and ) ∴ shrinks the CFOI and goes into the

government’s coffers If there is a surplus budget, this money may be locked up in the government’s

RBA accountsGovernment spending

Injection When the government runs a budget deficit, spending is greater than taxation (G>T)

∴ the increased money flows on in the form of increased wages, pensions, benefits and subsidies

Allows increased consumption expenditure by all citizen which is multiplied throughout the economy

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AD = C + I + G

AD = C + I + G + (X-M)

Imports Leakage With international trade, the goods actually enter Australia but the payment for them is a leakage as it goes overseas

When M > X, there is a deficit on the Balance of Merchandise Trade This imbalance causes an increased debt for Australia and is part of the reason

for an increased CAD and foreign debtExports Injection With international trade, the goods actually leave Australia but the payment

for them is an injection into our economy The funds enter our forex market When X > M, there is a surplus on the Balance of Merchandise Trade This imbalance has a positive effect on the economy and could actually assist in

decreasing the CAD and foreign debt

What is the Multiplier? Changes in equilibrium equal changes in income, output and employment.

Any change in one of the components of aggregate demand will affect Y, O or E.

What determines the size of the change and what is it? The Keynesian Multiplier effect determines the size of the change.

It is the number of times a change in expenditure is multiplied throughout the economy to cause a

change in income.

OR

How does it work? One person’s spending is another person’s income.

If the first person changes their spending patterns, it would have an ultimate effect on the other

person’s income.

The size of the effect depends on the size of the initial change.

On a macroeconomic scale, changes in spending can have massive effects on changes in aggregate

income, output and expenditure across the whole economy.

What are the characteristics of the multiplier (k)?3

Y = Multiplier X Expenditure

k = Y ÷ I

It has a lag effect.

It can work in both expansionary and contractionary directions.

All expenditure will have a multiplier effect.

Changes in injections and leakages all cause change in the multiplier.

Savings and the multiplier are inversely related. i.e. the more saving, the smaller the multiplier.

OR

Why does the multiplier formula look like this? If all expenditure causes a change in national income, output and employment, then at the most basic

level, consumption and savings will affect the size of the multiplier.

Costs and benefits of Economic Growth

Benefits CostsIncreased numbers and varieties of goods and services available.

Major cities can become the focus of growth and can become congested.

Increased employment. The rich get richer.Increased real incomes of the population (sometimes this income growth is not even).

Growth favours non-cash industries and can lead to economic dualism.

Increased consumption, savings and investment. Results in destruction of social cohesion.Increased taxation, hence provision of public goods and services and infrastructure.

Structural unemployment occurs in the short run, however, this shouldn’t be long term.

Wealth generation leads to increased leisure time. Destruction of traditional economy.Increased ability for a nation to satisfy material wants.

Social costs or harmful externalities which can cause a poorer quality of life.

Increased demand for resources and therefore increased production levels decreased unemployment

Decreased present living standards in favour of the hope of increased future living standards (due to foregoing current consumption).

Development of a better education system contributing to an increase in the quality and quantity of labour resources. This is known as an improvement in Human Capital.

If resources are in heavy demand and short supply, the price of resources can be astronomical. This is inflationary because resource costs can be passed on to other sectors in the economy.

Improvements in the standards of housing. Balance of payment problems.Countries can plan for improvements in the standards of growth.

Resources can be exhausted from overuse or inappropriate use.

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Monopolies emerge. Increased foreign debt.Cost push and demand pull inflation.Growth patterns are uneven.

Objective: Sustained Economic Growth Economic growth is a sustained increase in the real rate of production over time.

It is measured by the growth of real GDP.

This economic indicator is calculated quarterly.

The economy rarely grows in a sustained way. It moves in cycles and has periods of faster and slower

growth.

Recession is a period of very slow and negative growth.

A recession is declared after two successive quarters of negative economic growth.

Trends in Economic Growth The Australian economic will see economic growth fluctuate with the economic cycle.

Even though real GDP rises and falls, its overall trend is rising.

The role of any government is to minimise economic fluctuations and maximise economic growth whilst

keeping factors such as inflation to a low level.

The government uses macroeconomic policies in a counter-cyclical way to minimise fluctuations.

Economic growth has been strong in Australia.

This sustained growth means Australia has not had a recession since 1990.

Australia’s performance in economic growth has been one of the highest in the OECD and is largely due

to the property boom, the resources boom and strong domestic consumption.

Other factors behind Australia’s economic growth include:

o Productivity changes reflection microeconomic reform in many industries.

o Low inflation and RBA control of monetary policy to control inflation breakouts.

o Relatively low interest rates.

o Business and consumer confidence.

o Increases in asset prices.

o Relative strength of the Chinese and US economies.

o Macroeconomic policies which have ensured growth is sustainable and not like to fuel inflation.

UNEMPLOYMENT5

Unemployment

What is unemployment? Where those who are willing and able to work are unable to find work due to structural, cyclical or other

factors within the economy.

What are the types of unemployment?

Structural

As the economy experiences structural change the workforce may not possess the skills required for the

positions available.

Cyclical

Due to economic downturns, there are fewer positions available than are wanted by labour units.

Seasonal

Results from changes in climate or occurs at specific time of the year.

Frictional

Exists in the time taken between being employed in two jobs. It is of a temporary nature.

Hidden

Are those who are no longer actively seeking work and are therefore not counted in the official statistics

Hardcore

Are those who are very difficult to place within the work force. This category may include alcoholics,

drug users or extremely disabled persons.

Calculating Unemployment

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The labour force That section of the population which is both willing and able to work.

The unemployment rate

The unemployed are willing and able to work, yet unable to find jobs. They are calculated as a

percentage of the labour force.

The Participation rate The participation rate includes the proportion of the working age population (15-65 yr olds) which is

either working or actively seeking work.

Trends in Unemployment The average unemployment rate hit a high of 10.7% in 1992-1993 following the 1990 recession.

This is the highest rate of unemployment since the Great Depression.

The unemployment rate has been steadily declining since 1996.

Due to strong economic growth between 1996 and 2008, the level of cyclical unemployment has fallen.

Increasing participation rates and many hidden unemployed returning to look for work.

The workforce is more feminised with women’s participation levels increasing in recent years.

There is a pool of structurally unemployed workers who have lost their jobs due to:

o Microeconomic reform in industry

o Structural change policies at a microeconomic and macroeconomic level

o Decreased protection in many Australian industries

o Changes to technology within industry

o Increased productivity of labour

Costs of unemployment7

Labour force = Employed + Unemployed

Unemployment rate = Unemployed X 100 Labour force 1

Participation rate = Labour force X 100 Working Age Population 1

There are two main costs of unemployment: economic and social

Economic costs This is evident when the economy does not produce enough jobs and potential goods and services are

lost.

Unemployment is most prevalent among disadvantaged and minority groups.

Income equality is worsened by unemployment. This can be shown by the Lorenz Curve and calculated

by the Gini coefficient.

Budget deficits are worsened as there are increased transfer payments paid to the unemployed. This

may have spill over effects onto the foreign debt.

The government receives less tax revenue when unemployment is high; this lead to major revenue

shortfalls.

Social costs Long term influences may involve psychological effects on the individual such as depression.

Financial losses for the individual.

The unemployed have lower real incomes, which has an effect on their standard of living.

The gap between the rich and poor widens causing social problems.

The unemployment benefits spent on the unemployed could have been allocated to other

macroeconomic projects.

The government must reallocate its funds towards job training schemes, retraining programs, job

placement and other community employment projects.

INFLATION

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Inflation Defined: A sustained increase in the general price level.

Inflation is measured by the consumer price index.

The CPI measures the changes in the price levels of a basket of goods and services over an annual

period.

The RBA uses the CPI as guide for determining interest rates.

The underlying rate of inflation determines the underlying relationship between demand and supply in

the economy.

The RBA targets an inflation rate between 2-3%.

Australia has not had a period of stagflation (high inflation and high unemployment) since the 1970s.

The Consumer Price Index The CPI is the economic indicator of inflation.

It is calculated quarterly by the ABS.

Annual movements in the CPI are the sum of the previous four quarters.

It is expressed as a percentage change to the base year.

Calculating inflation

In order for goods and services to be included in the inflation calculation they must be representative of

what consumers buy.

The basket of goods and services varies from time to time. It is representative of items that consumers

buy regularly.

Items are weighted in the basket. Some items are more important than others.

In order to compare inflation rates, they must be compared to a base year.

Headline vs. Underlying rate of inflation... which is the better measure?

The headline rate

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Annual inflation rate = Change in CPI X 100 Previous year CPI 1

The ordinary CPI inflation rate.

Everything in the CPI is counted.

The rate is important for those who wish to know the “Cost of Living”.

The underlying rate Designed by the Treasury.

Measures the “true rate”.

The underlying rate is the better measure.

All the highly volatile, seasonal or government decision effects have been removed, this means that

what is left is a better guide to sustained shifts in prices.

The current government macroeconomic objectives are based on the underlying rate of inflation.

The government and RBA are committed to keeping the underlying inflation rate to between 2-3% on

average in an economic cycle.

Causes of Inflation There are 3 types of inflation: demand pull, cost push and imported.

Demand pull In a market where demand exceeds supply, prices rise if output cannot expand further. Consumers

force prices up with their demand.

Cost push When the costs of production rise they may be passed on to consumers or absorbed by the business.

Wages are one of the biggest causes of inflation. When wage rises outstrip productivity increases, this

is highly inflationary.

Business will attempt to pass on increasing costs to consumers.

Imported inflation This is caused by international transactions.

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Falls in the $A can cause depreciation-inflation spirals. Inflation may also be caused due to tariffs on

imported goods.

Other causes If consumers feel that prices will rise in the near future, they may make purchases now. Hence, if D > S,

this will cause inflation. This is caused by inflationary expectations.

Government policies may also be inflationary. This may be due to increases in taxes, deregulation or

privatisation of an industry.

Excessive increases in the money supply may be inflationary. If more money is chasing the same

amount of goods and services, this fuels inflation.

Economic effects of inflation

Economic growth and uncertainty Rapidly rising inflation increases consumer and business uncertainty about the future.

Consumer spending and business investment might fall.

This means aggregate demand falls, therefore slowing economic growth.

Wages Rapidly rising inflation decreases real wages (the purchasing power of income).

Therefore, inflation causes higher demands for money wages and puts pressure on the industrial

relations system.

Sometimes if wages are rising fast enough, they will outstrip inflation as people try to hedge against

future inflation rises.

Income distribution When there is inflation, the gap between rich and poor widens.

The rich can hedge against inflation through investing or saving and therefore increase their income and

wealth.

The poor have no ability to hedge against inflation.

Unemployment If inflation is high enough, economic growth will slow and cause cyclical unemployment.

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This means that the economy is experiencing both rising unemployment and inflation called stagflation.

This is usually caused by cost push inflation, not demand-pull because strong aggregate demand usually

causes decreasing unemployment.

International competitiveness During times of inflation our exports become more expensive and this affects the sales of Australia’s

goods and services on global markets.

Inflation can then affect our CAD.

Australia should only be seriously concerned if our inflation rates are higher than OECD averages or the

rates of our major trading partners.

Exchange rates If inflation increases, then demand for our exports decreases. This can cause a depreciation of the $A.

There could be less foreign direct investment and a further depreciation of the dollar.

DISTRIBUTION OF INCOME AND WEALTHBasic Terminology

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Personal Income: the amount of funds, in dollar terms, available to households from selling the factors

of production over a period of time.

Wealth: the total monetary value of physical and financial assets held by an individual.

Income inequality: the degree to which income is unevenly distributed among households in the

economy. It is measured by the Lorenz curve and Gini coefficient.

Relative poverty: the difference between the incomes of one householder compared to another.

Absolute poverty: the estimated personal income a householder needs to survive.

Mean income: the average level of income in Australia.

Deciles or Quintiles: 10% or 20% groupings of the population that are calculated when incomes are

ranked in increasing order.

Household income terms Disposable income: gross income – tax. Income remaining after the payment of taxation. Income one

can use for consumption.

Money income: aka nominal income. Income expressed in monetary terms.

Real income: What one’s money income is really worth. What goods and services can buy. What the

purchasing power of one’s money is. Real income depends on prices.

Measurement of income inequality Income inequality relates to the degree to which income is unevenly distributed amongst an economy’s

population.

A Lorenz Curve is a graphical representation of income distribution.

If income were evenly distributed across the population, the nation’s income would fall on the line of

perfect equality.

The further the Lorenz Curve is away from the line of perfect equality, the worse the income inequality

within a nation.

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The Gini coefficient measures the distribution of income across a nation.

The Gini coefficient is measured by the distance between the Lorenz Curve and the line of perfect

equality.

If the Gini coefficient equals:

o 0 this illustrates perfect equality of income distribution

o 1 this illustrates perfect inequality of income distribution (single household earns all the income)

o Between 0 and 1 that illustrates various degrees of income inequality

There is significant income inequality in Australia, yet, there is greater disparity in other developed

nations such as the USA.

Sources of Income Wages from the sale of labour.

Rent from land and property.

Earnings from capital (investment interest and shares).

Profits from entrepreneurial skills.

Social welfare.

Other income (eg. intellectual property)

Individuals sell the factors of production (land, labour, capital, enterprise) to earn an income.

Sources of Wealth What assets of value do we own to give wealth?

Dwelling capital

Business capital

Consumer durables

Government bonds and securities

Money base (cash)

Investments abroad

Equity investments

Most private sector wealth is in the form of property and/or business capital.

Income is used to create wealth.

Trends in income and wealth Over ½ the population earns less than the average income per week. This indicates that few people

have high incomes and a large number of people have very low incomes.

Income tends to be highest for people in the prime of their working lives. i.e. between 25-54

Younger people earn less per week that other people due to:14

o fewer skills than older people

o income levels are low at the start of working life

o younger people general work part time jobs

Average income levels fall for people past age 55 as they approach retirement and begin to rely on

pensions.

Average income for females is approximately 65% of males due to:

o attitudes to female employees

o women have less opportunity to gain skills and education

o women are more likely to work part time

o women have trouble breaking through the glass ceiling in order to achieve management positions

Statistics indicate that people born overseas earn slightly higher incomes that people born in Australia.

Those people from Non English speaking backgrounds earn less than people born in Australia.

The ethnic group which has substantially lower average incomes is Aboriginal and Torres Strait Islanders

Couples with no dependent children have the highest weekly median income.

Single people have the lowest median income per week. This reflects the number of elderly people

living alone and on pension incomes.

There is also income inequality between Australians based on whether they are urban or rural dwellers.

Urban or city dwellers tend to be earns of above average incomes. Yet, rural dwellers experience slow

growth in their incomes and find that their income levels fluctuate with the prosperity of the town they

live in.

Reasons for income inequality There are many reasons for income inequality including differences in:

Age

Education

Gender

Occupation

Cultural or ethnic background

Family structure

The main explanation is MARKET POWER. That is, having the ability to sell the factors of production in a

market economy. Government economic policies can also cause widening gaps between rich and poor.

Social costs of income inequalityAssociated with worsening relative poverty are social costs such as:

Increased crime.

Suicide.

Disease.

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Reduced life expectancy.

Substance dependence.

Emergence of social classes and divisions.

Potential conflicts between those of different income streams.

Possibility of political and social upheaval.

Economic costs of income inequality Reduces consumption and real investment.

Encourages conspicuous consumption.

Reduced potential economic growth.

Relative poverty may worsen.

Increased welfare burden on the government with opportunity costs.

Poverty becomes not just a problem for the poor.

EXTERNAL STABILITYExternal Stability

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Measurement of External StabilityCAD as a % of GDP Foreign debt as a % of GDP Net foreign liabilities as a % of GDP

Australia finances a lot of its borrowing for the CAD from overseas

Net foreign debt has grown significantly since the 1980s

Australia’s foreign liabilities average close to 60% of GDP

The CAD is classes as sustainable if it averages less than 3% of GDP

Australia’s foreign debt is one of the largest (per capita) in the world

Australia’s foreign liabilities are largely generated by the private sector

Australia’s CAD averages 5% of GDP Australia has difficulty in servicing the foreign performance

Foreigners invest and loan Australia more than we invest and borrow from overseas

Australia is vulnerable to external shocks because of its CAD problem

A large foreign debt will affect future economic performance

The fluctuating exchange rate causes increasing or decreasing burdens of foreign liabilities

Australia’s CAD is largely generated by the private sector

A large foreign debt will affect Australia’s international credit rating

As a % of GDP, net foreign liabilities have grown. Australia is very reliant on capital inflow

The government component of the foreign debt has been eliminated in recent years due to budget surpluses

Trends in external stability The CAD has progressively grown as a problem since the 1980s.

The size of the foreign debt, per capita, is one of the worst in the world.

The servicing of the foreign debt has become a chronic problem for Australia in recent years.17

External StabilityCurrent Account DeficitNet foreign debtThe Australian Dollar1. Structural increases in the CAD.

2. Impacts on macroeconomic policy.

3. Contributes to foreign debt.

4. Restrains economic growth.

5. Is it sustainable?

1. Foreign debt > $500 bn and over 50% of GDP.

2. Is it sustainable?

3. The debt trap has begun.

4. There is a huge debt servicing burden.

5. Movements in the $A have an impact on the size of the foreign debt.

6. Australia’s foreign debt is one of the world’s largest on a per capita basis.

1. There are wild fluctuations in the value of the $A.

2. The movements in the $A affect the size of the foreign debt and CAD.

3. The movements also affect the amount of foreign investment.

4. Movements in the $A also affect export and import prices.

Australia’s CAD has fluctuated with:

o depreciation in the $A

o use of debt financing rather than equity financing by businesses

During the 1990s the foreign debt was approximately 40% of GDP. This figure has significantly risen over

the last decade.

There has been a rise in Australia’s investment overseas with asset acquisition tripling.

There has been a rise in foreign liabilities to Australia.

Yet, there has been a rise in Australia’s loans to other nations.

Australia has a relatively narrow export base and a reliance on imports.

Australia’s lack of domestic savings is contributing to its external problems.

The $A is volatile and a significant contributor to the level of external liabilities.

Tightening of domestic macroeconomic policies of restrain consumption and therefore import spending,

has implications for Australian economic growth.

Microeconomic reform has occurred to increase industrial efficiency and international competitiveness.

ENVIRONMENTAL MANAGEMENTEcological Sustainable Development The field of environmental economics is about the pursuit of sustainable economic growth.

Sustainability involves:

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o valuing biological diversity

o non-depletion of resources

o decreasing environmental pollution

o increasing quality of life

o raising awareness of the effects of environmental decisions

Ecological sustainable development (ESD) involves encouraging economic growth without

compromising the preservation of the environment.

Resource exploitation contributes to economic growth in the present day, yet compromises the future

economic growth and standards of living of future populations.

Hence, by managing resource use in the present, a government using ESD principles is allowing future

generations access to resources. This is the principle of intergenerational equity.

Governments also need to be aware that when environmental decisions are made, they often cannot be

reversed. This decision irreversibility is a key issue in ESD.

It is also important for governments to come to terms with placing value on environmental resources.

Market Failure There are many benefits to economic growth such as:

o increasing demand for goods and services

o increased standards of living

o decreased unemployment

o increasing government revenue

Yet, the price mechanism does not take into account the social costs associated with economic growth.

These environmental social costs are not borne by individuals or business, therefore they are not

accounted for by the price mechanism.

The price mechanism only reflects private property not the “common heritage of humankind”.

The price mechanism model does not take into the future demand for goods and services or the

exploitation of resources.

The concept of depreciation of natural capital is also not reflected in the price mechanism.

Market failure reflects the weaknesses of the price mechanism in representing these environmental

considerations.

Private and public goods Public goods are:

o Non-excludable: which means that consumers cannot be excluded from using these goods even if

they are not prepared to pay for them. Eg. clean environment, defence forces. Such a concept

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ensures that there will be free riders using these goods. Therefore, there is little incentive for the

private sector to engage in producing them.

o Non-rival: which means that use of this good by one consumer doesn’t diminish the quantity

available for other consumers.

Environmental Issues

Preservation Without preservation of the environment there will be nothing left for future generations.

The principle of intergenerational equity is about ensuring fair access to resources for future

generations.

The environment is essential for both personal health and economic growth.

Governments need to use strategies which:

o Protect the integrity of endangered areas

o Control pollution

o Encourage the use of plantation timbers

o Quarantine against dangerous pests

o Raise community awareness

o Balance short term economic costs against long term or future economic gains using ESD strategies

o Ensure that the “polluter pays”

Controlling PollutionPollution issues:

Pollution is transnational

Acid rain, CFCs

Kyoto Protocol

Environmental refugees

Treaties

Greenhouse gas emissions

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Global warming

Polar ice caps

El Nino

Skin cancer

Air, noise, water

Externalities Social and environmental costs which are not calculated as part of the costs of production are known as

externalities.

Externalities may be either:

o positive: eg. less traffic congestion

o negative: eg. pollution, increased noise

Most environmental externalities are negative in nature.

Depletion of Natural Resources Depletion of natural resources affects future generations. It is not a sustainable practice.

It is very difficult to assess what is an optimal rate of use of resources.

Alternative energy sources (not fossil fuels) are the key to sustainability, such as:

o wind

o solar power

o bio fuel

o recycling

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