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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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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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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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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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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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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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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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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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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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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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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