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2013 Semester Two
ECON1102 Study
Notes DANIEL QUINN
ECON1102 Study Notes | Daniel Quinn
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Table of Contents Table of Contents .......................................................................................................... 1
Chapter 01: Output and Prices .................................................................................... 6
Indicators of Economic Performance ................................................................................. 6
Gross Domestic Product ...................................................................................................... 6
GDP as Total Output of Production ....................................................................................................... 6
GDP as Total Expenditure ........................................................................................................................ 7
GDP as Incomes of Capital and Labour .............................................................................................. 8
Circular Flow of Income ........................................................................................................................... 8
Nominal VS Real GDP............................................................................................................................... 8
Real GDP and Economic Wellbeing ................................................................................... 9
Factors of Economic Wellbeing not Measured by Real GDP .......................................................... 9
Factors of Economic Wellbeing as Measured by Real GDP .......................................................... 10
Consumer Price Index ............................................................................................................................ 10
Inflation ............................................................................................................................... 10
True Costs of Inflation ............................................................................................................................. 10
The Real Interest Rate ............................................................................................................................ 12
Deflation ................................................................................................................................................... 13
Does CPI Measure “True” Inflation ....................................................................................................... 13
Chapter 02: Savings and Wealth ............................................................................... 14
Savings and Wealth ........................................................................................................... 14
Stocks and Flows ..................................................................................................................................... 14
Capital Gains and Losses ...................................................................................................................... 14
Motives for Saving .............................................................................................................. 14
Saving and the Real Interest Rate ....................................................................................................... 14
Saving, Self-Control and Demonstration Effects ............................................................................... 15
National Saving and its Components ............................................................................... 15
Measurement of Nation Saving ........................................................................................................... 15
Private and Public Components of National Saving ....................................................................... 16
Public Saving and the Government Budget ..................................................................................... 16
Investment and Capital Formation ................................................................................... 16
Saving, Investment and Financial Markets ...................................................................... 17
Chapter 03: Unemployment and the Labour Market .............................................. 18
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Demand for Labour ............................................................................................................ 18
Shifts in Demand for Labour .................................................................................................................. 19
Supply of Labour ................................................................................................................ 20
Factors Affecting Labour Supply .......................................................................................................... 20
Trends in Real Wages and Employment ........................................................................... 20
Increase in Real Wages ......................................................................................................................... 20
Increasing Wage Inequality .................................................................................................................. 20
Unemployment ................................................................................................................... 22
Measuring Unemployment .................................................................................................................... 22
Costs of Unemployment ........................................................................................................................ 23
Types of Unemployment ........................................................................................................................ 23
Impediments to Full Employment ..................................................................................... 24
Minimum Wage Laws ............................................................................................................................. 24
Labour Unions .......................................................................................................................................... 24
Unemployed Benefits ............................................................................................................................. 24
Chapter 04: Short-term Economic Fluctuations ....................................................... 25
Contractions and Expansions ............................................................................................ 25
Output Gaps & Natural Rate of Unemployment (u*) ....................................................... 25
Okun’s Law ............................................................................................................................................... 26
Chapter 05: Spending and Output in the Short Run ................................................. 27
Keynesian Model Key Assumptions .................................................................................. 27
Aggregate Expenditure ..................................................................................................... 27
Consumption Function........................................................................................................................... 27
Two Sector Model ............................................................................................................... 29
Paradox of Thrift ...................................................................................................................................... 29
Four Sector Model .............................................................................................................. 30
The Multiplier ....................................................................................................................... 31
Tax Cuts ..................................................................................................................................................... 31
Marginal Propensity to Consume ........................................................................................................ 31
Marginal Propensity to Import .............................................................................................................. 31
Chapter 06: Fiscal Policy ............................................................................................ 32
Fiscal Policy ........................................................................................................................ 32
Government Expenditure ...................................................................................................................... 32
Taxes, Transfers and PAE ........................................................................................................................ 32
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Fiscal Multipliers ................................................................................................................. 33
Balanced Budget Multiplier (BBM) ....................................................................................................... 33
Considerations and Effects of Fiscal Policy as a Stabilisation Tool ................................................ 33
Fiscal Policy and Public Debt ............................................................................................ 34
Costs of Public Debt ............................................................................................................................... 35
Benefits of Public Debt ........................................................................................................................... 35
Fiscal Policy Challenges .................................................................................................... 35
Managing Demographic Change ...................................................................................................... 35
Distribution of Income ............................................................................................................................ 36
Chapter 07: Money ..................................................................................................... 37
Money and its Uses ............................................................................................................ 37
Measuring Money ................................................................................................................................... 37
Commercial Banks and Creation of Money ..................................................................................... 37
Money and Prices .............................................................................................................. 38
Velocity ..................................................................................................................................................... 38
Quantity Theory ....................................................................................................................................... 38
Reserve Bank of Australia .................................................................................................. 38
Influencing Interest Rates: Open-market Operations ...................................................................... 39
Chapter 08: The Reserve Bank & the Economy........................................................ 40
Money ................................................................................................................................. 40
Demand for Money ................................................................................................................................ 40
Control of Money supply ....................................................................................................................... 41
Bonds ................................................................................................................................... 42
Implications of RBA’s Target Cash Rate on Bill Market .................................................................... 42
Effect of RBA on the Economy ........................................................................................... 43
Note on the Real Interest Rate ............................................................................................................. 43
PAE and the Real Interest Rate ............................................................................................................ 43
Policy Reaction Function ................................................................................................... 44
Chapter 09: Aggregate Demand & Aggregate Supply .......................................... 45
Aggregate Demand Curve ............................................................................................... 45
Shifts of the AD Curve ............................................................................................................................ 46
Inflation and Supply Decisions .......................................................................................... 47
Inflation Inertia ......................................................................................................................................... 47
Inflation and the Output Gap .............................................................................................................. 47
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Aggregate Supply: Short-Run and Long-Run ................................................................... 48
Self-Correcting Economy ...................................................................................................................... 48
Applications of the AD-AS Model: Sources of Inflation ................................................... 49
Excessive Aggregate Spending ........................................................................................................... 49
Inflation Shocks ........................................................................................................................................ 49
Shocks to Potential Output ................................................................................................................... 50
Controlling Inflation ............................................................................................................ 50
Recessionary Gap .................................................................................................................................. 50
Chapter 14: Exchange Rates ..................................................................................... 51
Nominal Exchange Rate .................................................................................................... 51
Real Exchange Rates ......................................................................................................... 51
Determining Exchange Rates ............................................................................................ 51
Purchasing Power Parity (PPP) .............................................................................................................. 51
Supply and Demand Analysis ............................................................................................................... 52
Monetary Policy and the Exchange Rate ........................................................................ 53
Fixed Exchange Rates ....................................................................................................... 53
International Reserves ............................................................................................................................ 54
Speculative Attacks ............................................................................................................................... 54
Fixed VS Flexible Exchange Rates .................................................................................... 55
Advantages of Flexible Regime ........................................................................................................... 55
Advantages of Fixed Regime ............................................................................................................... 55
Chapter 15: NX and International Capital Flows ..................................................... 56
Balance of Payments ......................................................................................................... 56
Current Account ..................................................................................................................................... 56
Capital Account ..................................................................................................................................... 56
Capital Flows and the Relationship between the Capital and Current Accounts ........ 57
Determinants of Capital Flows ........................................................................................... 57
Small Open Economies .......................................................................................................................... 58
Saving, Investment and Capital Flows ............................................................................. 58
Saving, Investment and Net Exports ................................................................................. 59
Chapter 10: Economic Growth .................................................................................. 60
Why Nations Become Rich: Average Labour Productivity .............................................. 60
Determinants of Labour Productivity .................................................................................................. 60
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Costs of Economic Growth ................................................................................................ 61
Promoting Economic Growth ............................................................................................ 61
Are there Limits to Growth? ............................................................................................... 62
Chapter 11: The Production Function ........................................................................ 63
Aggregate Production Functions ...................................................................................... 63
Capital ...................................................................................................................................................... 63
Labour ....................................................................................................................................................... 64
The Cobb-Douglas Production Function .......................................................................... 65
Diminishing Marginal Productivity ........................................................................................................ 65
Income Distribution ................................................................................................................................. 65
Constant Returns to Scale ..................................................................................................................... 66
Growth Accounting ............................................................................................................ 66
Economic Growth and Factors of Production .................................................................................. 66
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Chapter 01: Output and
Prices Indicators of Economic Performance
1. Rising living standards
Tendency for quantity and quality of foods and services to increase over time
Output divided by population = output per capita
2. Avoiding extremes of macroeconomic performance
All economies experience the short run business cycle – tendency for economies to pass
through periods of economic expansion (low unemployment, rapid economic growth)
followed by contraction (sluggish or falling output growth, rising unemployment)
Recessions: two consecutive quarters of falling economic output
Governments try to steer economies somewhere between the two extremes
3. Maintaining real value of currency
Inflation: tendency for general level of prices in an economy to rise over time
Goal is to keep inflation at a low positive rate
4. Ensuring sustainable levels of public and foreign debt
An unsustainable debt is one that cannot be paid off with governments current and
projected income have to cut back expenditure causes stress less expenditure
on other uses such as health/education/infrastructure
Even if there is surplus, there is still opportunity cost of repaying debt instead of
spending it on legitimate uses
5. Balancing current expenditure against the need to provide resources for the future
6. Providing employment for all individuals seeking work
Gross Domestic Product
GDP as Total Output of Production
The market value of the final goods and services produced in a country in a given period
(usually 3 months)
High levels of GDP usually high standards of living in all areas such as live expectancy and
access to opportunities
The following sections dissect the definition of GDP to explain each individual section
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Market Value
quantity1 x price1 + quantity2 x price2 … etc
For public goods, prices do not exist add cost of provision
Final Goods and Services
Goods or services consumed by the ultimate user (end products of production process)
Intermediate goods or services: G/S used up in production of final G/S not counted in GDP
SPECIAL Case: If a product goes through multiple stages of production, and over the span of
more than one year years, how much of the value contributes to which years GDP?
o For example, if grain has $0.50 market value bought by general flour to be ground
into flour valued at $1.20 bought by bakery to bake into bread and sold to
consumers, valued at $2.00
Company Revenues Cost of Purchased Inputs
Value Added YEAR
ABC Grain $0.50 $0 $0.50 2011
General Flour $1.20 $0.50 $0.70 2011
Hot n Fresh $2.00 $1.20 $0.80 2012
Total $2.00
o Calculate the value added by each firm and add the ones in their own years
o GDP added to 2011 $1.20
o GDP added to 2012 $0.80
GDP as Total Expenditure
Add total amount spent:
o Households (consumption) + firms (investment) + government purchases + net exports
o Y = C + G + I + NX (National Income Accounting Identity)
Consumption: spending by households on G&S such as food, clothing and entertainment
o Durables: long-lived consumer goods (cars, furniture)
o Non-durables: shorter-lived goods and services (food, clothing, haircuts)
Investment: spending by firms on final G&S primarily capital goods and housing
o Business fixed investment: then purchase by firms of new capital goods such as
machinery, factories that increase productive capacity
o Residential investment: the construction of new homes and apartment buildings
o Inventory investment: Goods produced by a firm but has not been sold during the
current period treated as purchased by the firm
Government purchases: purchases by federal, state and local governments on final G&S such as
fighter planes and teaching in schools
o ONLY include payments in which G&S are received in return no transfer payments
(social security benefits unemployment benefits, pension)
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Chapter 15: NX and
International Capital Flows Balance of Payments
Balance of payments: record of transactions between residents of a country and non-residents
Current account: transactions leading to a change of ownership of commodities or a direct flow
of income (most significantly, exports and imports)
Capital account: transactions involving purchase or sale of assets
Current Account
Balance on merchandise trade: exports (credit) less imports (debit)
Net services: difference between total credit and debit items on net services account (services
include freight costs, shipping insurance costs etc.)
Net income: difference between total credit and debit items on net income account (various
direct income payments such as interest, dividend, royalty payments, labour, property)
Current transfers: difference between total credit and debit one off transactions not recorded
elsewhere in the current account
o Funds brought into a country by newly arrived immigrants = credit item
o Foreign aid Australia sends to developing countries = debit item
Current Account = Sum of all of its components above
Current account deficit = negative value for current account (surplus is positive)
Capital Account
Convention:
o Inflow of foreign exchange = credits
o Outflow of foreign exchange = debits
New liability (borrowing from foreign lenders) inflow of foreign exchange credit item
Acquiring new assets (lending to foreign borrowers) outflow of fx debit item
This convention keeps capital account consistent with current account
o Exports inflow of fx credit
The capital account is divided into:
o Official sector: transactions of government sector and Reserve Bank
o Non-official sector: transactions of private sector firms, financial institutions and
households
TB
NFI
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Balance on financial account (significant part of capital account)
o Direct and portfolio investment balances of net foreign investment in Australia and
Australian investment abroad
o Plus changes in RBA’s holdings of foreign exchange and gold
Balance on capital account (smaller part of capital account)
o Cancellation of debts of poor countries
o Net acquisition/disposal of non-produced, non-financial assets e.g. sales of embassy
land, patents and copyrights
Capital Flows and the Relationship between the
Capital and Current Accounts
Borrowing equivalent of selling a real/financial asset
Lending equivalent of buying a real/financial asset
International capital flows: purchases and sales of real and financial assets across borders
Capital inflows: purchases of domestic assets by foreigners
Capital outflows: purchases of foreign assets by domestic households and firms
In closed economies, national savings equal investment
International capital flows allow countries whose productive investment opportunities are
greater than domestic saving to fill in the gap by borrowing from abroad
CAB + KAB = 0 (KAB = capital account balance)
Suppose an Australian purchases a $40 000 Japanese car and writes a cheque for $40 000
The Japanese company has 3 options with the money
o Purchase Australian goods/services
Hence, Australia’s $40 000 export = $40 000 import ΔCAB = 0 and no capital
inflows or outflows so KAB = 0 CAB + KAB = 0
o Acquire Australian assets CAB = -40 000 while KAB = 40 000 CAB + KAB = 0
Including storing it in Australian bank
o Could swap with $40 000 with a third party for another currency such as its own yen,
but third party then only have the two preceding options
Determinants of Capital Flows
Main determinants of any asset return and risk
Other things equal, a higher domestic real interest will increase capital inflows
o Foreigners buy more domestic assets, domestic residents buy less foreign assets
