ECO 120- Macroeconomics
Weekend School #2
9th June 2007
Lecturer: Rod Duncan
Previous version of notes: PK Basu
Topics for discussion
• Module 4- The role of the government
– The tools the Australian government controls to
smooth short-run fluctuations in the economy
• Module 5- Macroeconomic applications
– The link between inflation and unemployment,
economic growth and Australian trade with the rest of
the world
• What will not be discussed
– Answers to Assignment #2 (use the CSU forum for
this)
Money
•
Money has three main functions in the
economy.
1. Money is a medium of exchange. We use
exchange money when we buy/sell to each other.
2. Money is a unit of account. Money is an agreed
measure for stating the value of other goods and
services.
3. Money is a store of value. Money can be kept
under the bed or inside a jar and used to exchange
for goods and services in the future.
Official measures of money
• M1 is the amount of notes and coins
(“currency”) in circulation plus current
deposits with banks.
• M3 is M1 plus all other bank deposits.
• Credit cards are not counted as money,
since using a credit card is accumulating
debt, whereas deposits at a bank can be
turned into money without accumulating
debt.
Money multiplier
•
What happens when you take $1 cash to a bank to
deposit it?
(1) You deposit the cash in the bank, and the bank creates an
account for you with $1 in it.
Money = $1
(2) The bank doesn’t keep the cash. Instead the bank has to keep
R, called the “reserve ratio” (0 < R < 1), of the $1 as reserves
and then loans out $(1 - R).
(3) The person who receives the loan of $(1-R) spends the cash,
and the merchant who receives the $(1-R) puts that in his bank.
This increases the merchant’s account by $(1-R).
Money = $1 + $(1-R)
Money multiplier
(4) The second bank keeps $R(1-R) as reserves and loans out
$(1-R)(1-R) = $(1-R)2 as new loans.
Money = $1 + $(1-R) + $(1-R) 2 + …
•
•
If this process continues, the value of money
created is 1/R = 1 + (1-R) + (1-R)2 + ...
So for every $1 floating in the economy in
currency, we have $1/R in currency plus
deposits in the economy. This ratio m = 1/R is
called the “simple money multiplier”. For every
$1 in currency that the government prints, the
money supply increases by m.
Equilibrium in the money market
• Equilibrium in the money market means supply
of money equals demand for money.
• Supply of money
– The supply of money depends on the level of
currency in the economy and the money multiplier.
The supply of money does not depend on the interest
rate.
• Demand for money
– People require money to make purchases, ie. How
much currency is in your pocket?
Demand for money
• The higher is income and prices, the greater the amount
of money required to make the purchases people will
wish to make.
• But a $1 in your pocket is a $1 not in the bank. In the
bank, that $1 would be accumulating interest, but in your
pocket, it accumulates no interest. So the interest rate is
the price of holding money as currency rather than as a
deposit in the bank. So we would expect that as the
interest rate rises, people will lower the level of currency
that they hold.
• The demand for money is downward-sloping in the
interest rate, i, and increases in income and prices.
Equilibrium in the money market
• The supply of money
does not depend on
the interest rate, so it
is vertical.
• The interest rate is
the price of holding
wealth as currency,
so money demand
falls as i rises.
Monetary policy
• The government can control the supply of
money and thus the interest rate. These actions
are called “monetary policy”.
• “Open market operations” are a means of the
government controlling the supply of money.
The government (in our case the Reserve Bank
of Australia or RBA) buys and sells government
securities, such as government bonds to control
the amount of money in the economy.
• If the RBA buys a bond with currency, the RBA
increases the money supply (by the change in
currency times the money multiplier).
Monetary policy
• If the RBA sells bonds
for currency, it
decreases the supply
of money.
• Monetary policy shifts
the money supply
curve and so changes
the equilibrium
interest rate.
Monetary policy
• “Monetary policy” is the government operation of
the money supply and interest rates.
• Typically we consider the problem of how the
government can manipulate monetary policy so
as to control economic variables such as output,
inflation, interest rates, etc.
• Issues: how monetary policy can “stabilize” the
economy? how will monetary policy affect
interest rates or exchange rates?
Who operates monetary policy?
• The Reserve Bank of Australia (RBA) is
responsible for monetary policy.
• The RBA was given 3 goals when it was created:
– Maintain low inflation
– Maintain low unemployment
– Maintain value of the A$
• The RBA was only given one policy tool- the
money supply to achieve 3 goals. In the mid
1990s, the RBA was simply told to have one
aim:
– Maintain low inflation- “inflation target” of 2-3%.
Definitions
• The RBA implements monetary policy through its
control of the cash rate.
• Cash rate: The cash rate is the rate the RBA
charges bank for loans within the RBA reserves
system. The cash rate is the base interest rate
for the economy, and all other interest rates are
derived from it.
• Easy monetary policy: When the RBA lowers
the cash rate to stimulate AD.
• Tight monetary policy: When the RBA raises
the cash rate to cut off AD.
Interest rates
• As we saw in the Investment section, the
profitability of investment projects depends on
the nominal interest rate.
• The lower are interest rates, the more projects
will be profitable, so the higher will be
investment spending.
• Since the RBA controls the cash rate, and since
all interest rates depend on the cash rate, the
RBA controls I, and so can shift the AD curve.
How monetary policy works
Cause–Effect Chain of Monetary Policy:
RBA cash rate impacts interest rates
Interest rates affect investment
Investment is a component of AD
Equilibrium GDP is changed
SF1
SF2
10
10
8
8
6
6
D1
0
Investment
demand
0
Amount of investment, i
AS
Price level
AD1
Easy Monetary
Policy
AD2
Y
SF2
10
SF1
10
8
8
6
6
D1
0
Investment
demand
0
Amount of investment, i
Price level
AS
Tight Monetary
Policy
AD1
AD2
Real domestic output, GDP
Inflation targeting
• The RBA makes known their target or
desired level of inflation- 2-3% inflation.
• The RBA will tighten monetary policy, raise
i, if inflation appears to be too high.
• The RBA will loosen monetary policy,
lower i, if inflation appears to be too low.
• The RBA has to “look ahead” to the level
of future inflation.
Inflation targeting
• How can we put this into our AD-AS
model?
P
RBA
raises i
AS2008
AS2007
103
Target band
102
100
AD2008
AD2007
Y2007
Monetary policy and the open
economy
• Net Export Effect
– Changes in interest rate affect the value of the
exchange rate under floating exchange rate.
An increase in interest rate appreciates the
currency, resulting in lower net exports
– A decrease in interest rate leads to currency
depreciation and a rise in net exports
• So an easy monetary policy is enhanced
by the net export effect.
Sample exam question
QUESTION : B.3
Using the models from our subject, carefully explain the
consequences if the government reduces the supply of
paper money (or “cash”) by an amount, m.
a) What are the consequences on the total level of
money?
b) What are the consequences in the money market?
c) What are the consequences in the AD-AS model for the
economy as a whole?
Quantity theory of money
• There is a nice, simple model of money which explains
many features of money supply and demand. This
model is called the quantity theory of money.
• If we imagine that money is needed for all of the
purchases made each year, then demand for money is
the vale of purchases: PY.
• The supply of money for purchases is the amount of
cash in the economy.
• But each piece of money in the economy can be used
multiple times during a year in transactions. We call the
number of transactions the velocity of money “v”.
Quantity theory of money
• So the total supply of money for
transactions in a year is v times M: vM.
• So demand equals supply requires that:
PY = vM
• So if Y goes up, but nothing else does,
then average level of prices must fall.
• The QTM is good to use for thinking about
money and inflation.
Fiscal policy
• “Fiscal policy” is the government operation
of government spending (G) and taxes (T).
• Typically we consider the problem of how
the government can manipulate G and T
so as to control economic variables such
as output, inflation, interest rates, etc.
• Issues: how fiscal policy can “stabilize”
the economy? what about government
borrowing and public debt?
Definitions
• Budget deficit: the budget deficit is the
extent of overspending by the government
Budget deficit = G – T
• Expansionary fiscal policy: increasing
the budget deficit (G↑ or T↓) usually in a
recession.
• Contractionary fiscal policy: decreasing
the budget deficit (G↓ or T ↑) usually in an
economic boom.
Budget deficits and surpluses
• If the government spends more than it brings in
in taxes, what happens? (G > T)
• The money has to come from somewhere. For
developed countries, this means borrowing
(issuing government debt or “public debt”) from
domestic residents or foreigners.
• If the government is spending less than it brings
in in taxes, the government can reduce public
debt. The Australian government has followed
this policy in the last 10 years.
Types of fiscal policy
• We differentiate two types of fiscal policy:
– Discretionary fiscal policy: This is fiscal policy that
comes about from planned changes in G and T that
the government brings in in response to the economic
situation.
– Non-discretionary fiscal policy: This is fiscal policy
that comes about from the design of spending and
taxes. There is no government official actively
determining these changes.
Non-discretionary fiscal policy
• Certain parts of our spending and taxes
automatically increase demand in a recession
(when AD < potential GDP) and decrease
demand in a boom (when AD > potential GDP).
– Welfare spending and unemployment benefits are
part of G and increase in a recession and decrease in
a boom.
– Income and company taxes are part of T and depend
on GDP, they increase during a boom and decrease
during a recession.
• These act as “automatic stabilizers” on the
economy, reducing the variability of the
economy.
Cyclically-adjusted budget deficits
• The automatic stabilizers raise the budget deficit
in a recession and lower the budget deficit in a
boom.
• This fact means that we can not just look at the
budget deficit to determine whether the
government is “overspending”, we also have to
take into account where we are in the business
cycle.
• Adjusting the budget deficit for the point we are
in the business cycle is called “cyclically
adjusting”. We would expect even a “sensible”
government to be in a deficit in a recession.
Stabilizing a boom
P
LR AS
AS
AD
Yn
Y0
Y
Stabilizing a recession
P
LR AS
AS
AD
Y0
Yn
Y
Discretionary fiscal policy
• Discretionary fiscal policy is the
manipulation of G and T by government
officials typically to reduce the severity of
shocks to the economy.
• It sounds like a good idea, but how does it
work in reality?
• There are many problems and limitations
to the use of fiscal policy to reduce
recessions and booms.
Problems with discretion
• Scenario: Imagine a train driver that has
only one control- an accelerator/brake that
he or she can push or pull on to control the
train. This is exactly the same situation as
the government faces with fiscal policy.
• Now what limitations can the train driver
face?
Train driver problem
GDP
Time
June
August
Problems with discretion
• Limitations:
– Correctness of data: Is the train driver seeing the
tracks correctly? Or Does the government get the
right data about where the economy is?
– Timing of data: Is the train driver seeing the tracks
with enough time to react? Or Does the government
get the statistics quickly enough to do anything?
– Decision lags: Can the train driver make a decision
about the correct action before the train reaches the
problem spot? Or does the government have time to
design the correct fiscal policy?
Problems with discretion
– Administration lags: If the driver pulls on the
control, how long will it take for the brakes to start to
work? Or New spending and taxes have to be
passed through parliament, which takes time, even
after a decision is made.
– Operational lags: If the brakes start to work, how
long before the train slows down? Or New
government spending and taxes take time to affect
the economy.
• So even the best-designed fiscal policies can go
wrong if they are in response to the wrong data
or if they take too long to affect the economy.
Political considerations
• There are further concerns we might have about
the operation of fiscal policy.
– Politicians have to remain popular. No one likes
taxes, and everyone likes new spending on
themselves. Will a politician make an unpopular
decision that may result in them losing the election if it
is the best decision for the economy.
– Electoral cycles: Governments have to be reelected every 3-4 years. So a politician would love to
engineer a boom right before his or her election.
Crowding out
• Another problem with fiscal policy is that an
increase in G may increase output but at the
expense of other components of aggregate
expenditure.
Y = C + I + G + NX
• Since the economy returns to potential GDP
over the long-run, an increase in G must come
at the expense of either C, I or NX or all 3.
• If an increase in G reduces investment spending
over the long-run, this could lead to lower future
growth in the economy.
Crowding out
• How can this happen?
– An increase in G shifts the AD curve to the right.
– This results in higher Y and higher P.
– The increased government borrowing in the market
for savings raises the interest rate.
– Higher interest rates lead to lower investment
spending so I drops, shifting AD left.
– Higher interest rates leads to an appreciation of the
A$ (as foreign investors put their money in Australia),
so NX drops, shifting AD left.
Crowding out- I and NX
AS
ASLS
AD1
P3
P2
P1
AD2
Q1
Q2 Qp
AD3
Government debt
• One problem that economic commentators
always point to is the level of government debt“Our debt is too high.”
• How do we evaluate the level of government
debt? How do we know is it is “too high”.
• Government debt is like any other form of debt.
You evaluate the debt relative to the
income/wealth of the person incurring the debt.
• A $500,000 debt might be high to you and me,
but it might mean nothing to Kerry Packer.
Government debt
• So we need to evaluate government debt
relative to “government income”. But what
is the appropriate form of “government
income”, as the government doesn’t earn
or produce anything.
• Generally we use the income of the
country as the comparison, since the
government is free to tax or claim any part
of GDP.
Government debt
• So our criterion for “too much” is debt (B, since
typically government debt is issued in
government bonds) over GDP (Y):
B/Y
• Banks would make much the same calculation
when considering whether to issue someone a
home loan.
• In general debt is growing at the rate of interest
each year, r, while GDP is growing at the growth
rate of the economy, g.
Debt Comparison
Country
Australia
United States
European Union
Japan
OECD
Net Debt/GDP (%)
1985 1995 2000
15.0 23.5 9.7
41.9 58.9 43.0
34.1 53.8 48.0
69.7 24.8 58.6
41.4 48.8 44.1
2003
2.9
47.1
49.4
80.2
48.7
Primary Surplus/GDP (%)
2000 2003
2.4 1.7
4.1 -2.7
4.1 0.6
-6.1 -6.3
.
2.6 -1.5
Sample exam question 1
QUESTION : C.2
A balanced budget fiscal policy would require the government to spend
more when the economy is in a boom (and taxes are high) and
require the government to spend less when the economy is in a
recession (and taxes are low).
(a) Explain the business cycle using the AD-AS model, assuming that it
is changes to the AD curve that makes the cycle happen. Assume
here that government spending is held constant over the business
cycle.
(b) Explain the effect of a balanced budget fiscal policy on the business
cycle using the AD-AS model.
(c) Is the balanced budget fiscal policy helping or hindering the
economy?
Sample exam question 2
QUESTION : C.3
The monetarists believe that the aggregate supply
(AS) curve is very steep, while the Keynesians
believe the AS curve is flat.
(a) Explain how fiscal policy would work in each
case in the aggregate demand-aggregate supply
(AD-AS) model.
(b) What would you expect that the two camps
have to say about the effectiveness of fiscal or
monetary policy?
Unemployment
• A person becomes unemployed:
– Job loser
– Job leaver
– New entrant or re-entrant into the labour force
• He or she is no longer unemployed:
– Hired or recalled
– Withdraws from the labour force
Population
Working age
population
Labour Force
Employed or
Unemployed
Labour Force
Participation
Rate
Unemployment
Rate
Labour force participation rate
Proportion of country’s population that takes
part in its economic activities directly (either
actually taking part or willing to)
Labour Force
/
Working Age Population
X
LFPR In Australia, in September 2003 :
( 10.237 million / 15.955 million ) x 100 = 64.2 %
100
Unemployment rate
Proportion of country’s labour force that is
unemployed.
( Number Unemployed
/ Labour Force )
UR in Australia, in September 2003 :
(0.591 million / 10.237 million) x 100 = 5.8%
X
100
Types of unemployment
• Three main types of unemployment:
– Cyclical unemployment
– Frictional unemployment
– Structural unemployment
Cyclical unemployment
• Associated with the ups and downs of
the business cycle
• Takes place due to insufficient aggregate
demand or total spending- reflects shifts in
AD curve.
• High during recessions and low during
booms.
• Fiscal and monetary policies can reduce
cyclical unemployment - policies are
relevant.
Frictional unemployment
• Associated with the period of time in
which people are searching for jobs, being
interviewed and waiting to commence
duties.
• It is inevitable and always exist
• Fiscal and monetary policies can not reduce
frictional unemployment – macroeconomic
policies are irrelevant.
• Policies that make it easier to find new jobs
will affect frictional unemployment.
Structural unemployment
• Associated with wider structural or technological
changes in the economy that may make some
jobs redundant.
• It is inevitable and always exist
• Lasts longer than frictional unemployment
• Fiscal and monetary policies can not reduce structural
unemployment – macroeconomic policies are
irrelevant.
• Policies that encourage workers to retrain skills or to
move to a new area with more jobs will decrease
structural unemployment.
“Full” employment
• Full employment means when all productive
resources in the economy are in full use implies no cyclical unemployment - still frictional
and structural unemployment exist - they can be
low - but can never be zero.
• The full-employment rate of unemployment is
called the “natural rate of unemployment”.
• Domestic output consistent with the natural rate
of unemployment is “potential output” or “full
employment level of GDP”.
Classical employment theory
• Economy always operates under full
employment - it is automatic and self
sustaining - if there is any unemployment
that is only temporary.
• Price-wage flexibility
– the assumption that all prices, including wages and
interest rates, are flexible and will, rapidly adjust to
remove disequilibria
• Classical theory and laissez faire
– the price system ensured that price-wage flexibility
and fluctuations in the interest rate was capable of
maintaining full employment
Price Level
Classical theory
P1
P2
AD1
AD2
Q1
Real Domestic Output
Keynesian employment theory
• Full employment is not automatic - unemployment exists
for longer periods - the Great Depression of the 1930s sticky wages and prices.
• Horizontal aggregate supply curve during recession ‘recessionary’ or ‘Keynesian’ range.
– Change in AD impacts on unemployment - not on price level.
• Once the full employment level is reached - vertical AS
curve - change in AD affects price level only.
• Unstable aggregate demand - especially investment, so
that demand management and stabilisation policies by
the government are essential.
Price Level
Keynesian theory
P1
AS
AD1
AD2
Q2 Q1
Real Domestic Output
Sample exam question
QUESTION : B.2
The government wants to spend money reducing
unemployment. What effect on official
unemployment statistics would the following
policies have:
a) Increasing the unemployment benefit,
b) Lengthening the period during which people can
get the unemployment benefit,
c) Funding more job-training programs, and
d) Increasing the funding for university enrolments.
Measuring inflation
• We measure the general price level
through a price index such as the
Consumer Price Index (CPI)
• Inflation is a continuous rise in the general
price level. We measure inflation:
Inflation
rate
=
Current year index - Previous year
index
x
Previous year index
100
Inflation in Australia, 1970-2004
18
16
14
12
10
8
6
4
2
0
-2
1970
1975
1980
1985
1990
1995
2000
Two types of inflation
• We can differentiate two different sources
of inflation in an economy:
• Demand-Pull Inflation
• Occurs when an increase in AD pulls up the price
level.
• Cost-Push Inflation
• Occurs when an increase in the cost of production
at each price level shifts the AS curve leftward
resulting in increased prices.
Demand-pull inflation
• Short-run: There is an increase in demand, such as an
increase in consumer spending, so AD shifts rightward.
AS does not change in the short run, and we have a
movement along the AS curve. Price level and GDP
increases..
• Long run: Workers will realise their real wages have
fallen and will demand and receive increased nominal
wages. As costs rise, supply decreases and the AS to
shift to the left. Price level increases, and GDP declines.
• May be caused by expansionary fiscal and monetary
policies - can be countered by contractionary policies by
the government.
Price Level
Demand-pull inflation- SR and LR
ASLR
AS1
P3
c
P2
b
P1
a
A decrease in
aggregate
supply....
Increases the price
level and output
returns to original
level
AD2
AD1
o
Q1 Q2
Real GDP
Cost-push inflation
• Short-run: Increased prices and decreased real
output (and more unemployment). Causes can
be:
• Wage push : increase in wage rate - power of
trade unions
• Supply shocks - increase in prices of major
raw materials - oil etc.
• Profit push : increase in profit requirement of
large monopoly businesses.
• The AS curve shifts to the left/up as prices and
costs rise, and firms cut back on output.
Cost-push inflation
• Long-run: There are two scenarios.
– Government intervention ( shift in AD): If government
intervenes to increase AD, prices and output will rise,
moving us back to the natural rate of output.
• No Government intervention (no shift in AD): If
government does not intervene to increase AD, a
severe recession will result. However nominal wages
will eventually decline and will restore AS to its
original position, moving us back to the natural rate of
output.
Cost-push inflation- SR and LR
ASLR
AS2
Price Level
AS1
P3
b
c
P2
P1
An attempt to
increase AD
will only further
increase the
price level
a
AD1
o
Real GDP
Q1 Q2
Phillips curve
• Suggests an inverse relationship (or a trade-off) between
inflation and the unemployment rate
• Named after A W Phillips who originally discovered the
relationship between unemployment and nominal wages,
using British data in 1950s.
• In general, inflation is associated with economic
expansion, and unemployment with economic recession.
• During expansion : the greater the rate of growth of AD inflation is high, and unemployment is low.
• During recession : the slower the rate of growth of AD inflation is low, and unemployment is high.
Phillips curve
Annual rate of inflation
(percent)
7
6
5
4
3
2
1
0
1
2
3
4
5
6
7
Unemployment rate (percent)
Policy implications of Phillips curve
• Trade-off suggests : a rise in inflation
should lead to a decline in unemployment,
and vice versa.
• In general, both can not be brought down
to the minimum level.
• The society must make a choice between
low inflation and low unemployment.
Inflation (%)
Phillips curve in Australia
18
16
14
12
10
8
6
4
2
0
-2 0
1977
1983
1993
1970
2
4
6
Unemployment (%)
8
2003
10
12
Stagflation
• Simultaneous experience of high and increasing
unemployment and inflation - cost-push inflation.
• Caused by :
• Aggregate supply shocks such as severe
increases in fuel costs, and devaluations;
• Productivity declines; or
• Inflationary expectations and wages expectations about the likely future path and
rate of increase of the general price level.
Sample exam question
QUESTION : C.4
(a) Carefully explain what the Phillips curve shows.
(b) Why did the experiences of the Australian
economy in the 1970s seem to contradict the
Phillips curve?
(c) How could the rise in oil prices in the early
1970s explain what we were observing with the
Phillips curve?
Long-run growth
• We are ultimately interested in the level of
resources each individual in society has access
to. The level of resources will then somewhat
determine what opportunities each person has.
• So we are ultimately interested in GDP per
person of an economy. Growth is the increase
of GDP per capita over time.
• Y / N = output per person
Long-run growth
• But not every person in an economy is “economically
productive”, so if we want to link “worker productivity”
and GDP per capita , we need:
• Y / N = (Y/Nw) (Nw/N)
• Y/Nw = output per worker depends on labour productivity,
which depends on skills in workforce, capital, tech
• Nw/N = labour force participation rate which depends on
cultural attitudes and aging of the population
Labour force participation
• Growth in GDP per capita can come from
increasing Nw/N.
– As people move from subsistence farming on
rural areas to paid employment in urban
areas, labour force participation rises.
– As women move out of unpaid domestic work
to paid domestic work, labour force
participation rises.
• But obviously there is a limit to this sort of
growth.
Labour force participation
Australian Labour Force Part'n
0.6
0.5
0.4
0.3
0.2
0.1
19
50
19
53
19
56
19
59
19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98
0
Labour force participation
• And as the Australian population ages, we
will eventually see this LFP start to
decline, as the population of retirees
increases.
• This will be a major challenge for Australia
in the relatively near future.
Output per worker
• Output per worker, Y/Nw, is the main source of
growth in Australia.
• So growth in Australia depends on increasing
the productivity of our workers. What
determines how productive a worker is?
– The skills of the worker.
– The physical capital the worker uses.
– The level of technology the worker and capital have
access to.
Output per worker
Australian Real GDP per Worker
60000
50000
40000
30000
20000
10000
19
50
19
53
19
56
19
59
19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98
0
Output per worker
• Output per worker was $22,000 in 1950
and $52,000 in 2000 in constant dollars.
(Once we remove the effects of inflation.)
• So how are Australian workers today over
twice as productive as workers in 1950?
– New technologies (mechanization, robotics,
computers, etc)
– More capital (powered floor polishers instead
of mops)
Output per capita
• So once we combine labour force changes
and worker productivity changes, we wind
up with change in output per capita over
time.
• Real GDP per capita was $9,200 in 1950
and $25,500 in 2000.
• Australians in 2000 have almost twice as
much resources per person than
Australians did in 1950.
Long-run growth in Australia
Australian Real GDP per Capita
30000
25000
20000
15000
10000
5000
19
50
19
53
19
56
19
59
19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98
0
Long-run growth in Australia
• While there was a temporary blip in GDP
in early 1950s, 1980s and 1990s, the
overall picture is one of steadily increasing
GDP per person over time.
• What can be done to ensure growth in
Australia?
– Increasing productivity per worker.
• Increasing skill levels, increasing capital
and increasing technology.
But remember…
• Remember what it is that GDP measures:
the market value of all goods and services
sold in the economy.
– Ignores non-market goods, such as domestic
work and pollution.
– Does not include black market goods.
– Having longer holidays might make for a
happier workforce, but would lower GDP.
Growth and economic development
What about other countries?
• Relative to the rest of the developed world,
Australia is a fast-growing economy.
• Australia is behind the United States, but
ahead of countries such as the UK and
NZ.
• Relative to our neighbours (East Asia),
Australia is a very prosperous country.
Relative to developed countries
Relative Real GDP per Capita
35000
30000
25000
20000
15000
Australia
USA
UK
NZ
10000
5000
19
50
19
53
19
56
19
59
19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98
0
Relative to our neighbours
Relative Real GDP per Capita
30000
25000
20000
Australia
15000
10000
5000
19
50
19
53
19
56
19
59
19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98
0
Japan
Hong Kong
Indonesia
Convergence
• “Convergence” is the idea that we would
expect countries that are initially poorer
should grow faster than countries that are
richer.
• Why?
– Technology- Poor countries can piggy-back
for free off the technology developed by rich
countries.
– Capital flow- We expect investors to rush to
invest in countries with cheap wages.
Convergence
• Over time, we expect poor countries to
grow faster than rich countries, so GDP
per capita across different countries
should “converge” over time.
• Is this idea true?
• We saw that certain countries like Japan
and South Korea started off poorer than
Australia but caught up.
Catching up?
East Asian Miracle?
35000
30000
25000
20000
15000
Australia
Japan
USA
S Korea
China
10000
5000
19
50
19
53
19
56
19
59
19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98
0
Malaysia
But look!
African development?
35000
30000
25000
20000
15000
Australia
USA
Kenya
Nigeria
Uganda
10000
5000
19
50
19
53
19
56
19
59
19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98
0
Malawi
Consequences of growth
Life
Adult
Enrollm
ent
Expectancy
Literacy
in Edu
per capita
HDI
Rank
Norway
78.5
100
97
29,918
0.942
1
Australia
78.9
100
116
25,693
0.939
5
USA
77
100
95
34,142
0.939
6
Japan
81
100
82
26,755
0.933
9
Indonesia
66.2
86.9
65
3,043
0.684
110
Kenya
50.8
82.4
51
1,022
0.513
134
Uganda
44
67.1
45
1,208
0.444
150
Malawi
40
60.1
73
615
0.4
163
GDP
Closed and open economies
• A closed economy is one that does not
interact with other economies in the world.
– There are no exports, no imports, and no
capital flows.
• An open economy is one that interacts
freely with other economies around the
world.
An open economy
• An open economy interacts with other
countries in two ways.
– It buys and sells goods and services in world
product markets.
– It buys and sells capital assets in world
financial markets.
• The Australian economy is a mediumsized open economy—it imports and
exports relatively large quantities of goods
and services.
Exports and imports
• Exports are domestically produced goods
and services that are sold abroad.
• Imports are foreign produced goods and
services that are sold domestically.
• Net exports (NX) or the trade balance is
the value of a nation’s exports minus the
value of its imports.
– NX = X - M
Net exports
• A trade surplus is a situation where net
exports (NX) are positive.
Exports > Imports
• A trade deficit is a situation where net
exports (NX) are negative.
Imports > Exports
Millions A$
0
-6
-4000
-9
-6000
-12000
-12
% of GDP
-8000
-15
In A$
-18
-10000
-21
-24
% of GDP
19
49
19
51
19
53
19
55
19
57
19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
Net Exports (1949-1996)
4000
6
2000
3
0
-2000
-3
Net exports and domestic GDP
• Aggregate Expenditure = C + I + G + X - M
• Level of X depends on foreign countries’
income, not domestic income
• Level of M is dependent on domestic
income or GDP.
What affects net exports?
• The tastes of consumers for domestic and
foreign goods.
• The prices of goods at home and abroad.
• The exchange rates at which people can use
domestic currency to buy foreign currencies.
• The costs of transporting goods from country to
country.
• The policies of the government toward
international trade.
Exchange rate
The exchange rate is the rate at which a person can
trade the currency of one country for the currency of
another.
The nominal exchange rate is expressed in two ways.
•In units of foreign currency per one Australian
dollar
•In units of Australian dollars per one unit of the
foreign currency
Exchange rate
At an exchange rate between the US dollar and the
Australian dollar is 0.70 US cents to one Australian
dollar.
•One Australian dollar trades for 0.70 of US$. [This
is the form we will use.]
•One US$ trades for 1.43 (1/0.7) of an Australian
dollar.
Determination of exchange rates
• The market price of something is determined in
the market.
• Under the Floating Rate system, price of a
currency (its exchange rate) in the international
market for currency is determined by its demand
and supply.
• A$ is a floating currency - floated in December
1983.
19
49
19
51
19
53
19
55
19
57
19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
US$
1.6
450
1.4
400
Yen/A$
1.2
1
US$/A$
0.4
0.2
0
250
0.8
200
0.6
150
100
50
0
Japanese Yen
Value of A$ (1949-1996)
350
300
Determination of exchange rates
• Demand for A$ (people who want to buy
A$):
– By overseas buyers of Australian goods
and services (including their tourist visits to
Australia)
– By overseas investors who want to buy
Australian physical and financial assets.
• Supply of A$ (people who want to sell A$):
– By Australian importers (including overseas
trips by Australians)
– By Australian investors who want to buy
physical and financial assets overseas.
Appreciation/Depreciation
If a dollar buys more foreign currency, there is an
appreciation of the dollar -- say, one A$ buys one
US$ instead of 70 US cents at present.
If it buys less there is a depreciation of the dollar -say, one A$ buys 50 US cents instead of 70 US cents at
present.
Demand for A$
• As exchange rate (US$ per A$) increases (say,
from US$ 0.70 to US$ 1), exports become more
expensive. Overseas buyers will buy less of
Australian goods and services. Demand for A$
falls.
(Just opposite when the value of A$ decreases)
So, Demand curve for A$ (or any other currency)
is downward sloping - as exchange rate
increases, demand for the currency falls, and
vice versa.
Supply of A$
•As exchange rate increases (say, from US$ 0.70 to
US$ 1), imports become cheaper. Australians will buy
more of foreign (imported) goods and services.
Supply of A$ increases.
(Just opposite when the value of A$ decreases)
So, Supply curve of A$ (or any other currency) is
upward sloping - as exchange rate increases, supply
of the currency increases,
and vice versa.
Determination of exchange rates
Exchange
rate (cost of 1
A$ in terms
of US$)
Supply of A$
Demand for A$
Amount of A$
Sample exam question
QUESTION : C.1
World oil prices rise and are likely to stay high for the
future. Assuming all else held constant:
(a) Explain the effects of a rise in the price of oil on
Australia using the aggregate demand-aggregate supply
(AD-AS) framework.
(b) Explain the effect of higher world oil prices on the
Australian external accounts and the exchange rate.
(c) How would your answers to (a) and (b) change if the
world’s second-largest oilfield was discovered southwest
of Perth? Explain carefully.
Balance of payments
Reflected in international balance of payments
accounts.
Records all transactions between the entities in
Australia and those in foreign nations
Two basic accounts:
•Current Account
•Capital Account
Balance of payments
•Current account of a country’s international
transaction refers to the record of receipts from the sale
of goods and services to foreigners (exports), the
payments for goods and services bought from
foreigners (imports), and also property income (such as
interest and profits) and current transfers (such as gifts)
received from and paid to foreigner.
•Capital account is a summary of country’s asset
transactions with the rest of the world.
Balance of payments
Current Account Balance (+,-)
=
Capital Account Balance (+,-)
Demand for A$ equals Supply of A$.
If we have a current account deficit (we are importing
more than we are exporting), then we must also have
a capital account deficit (investors overseas are
accumulating Australian assets).
CAD (Current Account Deficit)
and exchange rate
CAD impacts on :
•Inflow of foreign investment - higher the CAD,
higher the surplus in capital account - higher
investment in Australia by the foreigners - higher
the demand for A$.
•Outflow of foreign currency - income (interest &
profit) on foreign investment goes out of the
country- higher the CAD, higher the demand for
foreign currency - higher the supply of A$.
Exact impact depends on relative strengths of the
two opposing forces.
Current Account Deficits (19491996)
4000
5
2000
0
19
49
19
51
19
53
19
55
19
57
19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
-2000
0
-4000
-6000
-5
-10000
% of GDP
Millions A$
-8000
-12000
-14000
-16000
% of GDP
-10
-18000
-20000
-22000
-15
-24000
-26000
-28000
-30000
In A$
-20
Is the Current Account Deficit a
Problem?
• Represents a debt we will have to repay in
the future.
• Just as for a household, the extent of the
problem depends on our ability to service
the debt- but notice that CAD as a
percentage of GDP (ability to service debt)
is still low.
Sample exam question
QUESTION : B.5
a) What is Australian foreign debt? How do
we calculate it?
b) Why does it matter to economists that
most of Australian foreign debt is held by
firms and households (the private sector)
rather than the government (the public
sector)?
Terms of Trade
The ratio of average price of goods
and services exported by a country
to the average price of its imports.
If prices of imported goods are rising at a
faster rate than the prices of exported
goods, then the terms of trade for that
economy is considered as deteriorating.
The economy is loosing in the process
of foreign trade.
19
49
19
52
19
55
19
58
19
61
19
64
19
67
19
70
19
73
19
76
19
79
19
82
19
85
19
88
19
91
19
94
Million A$
Terms of Trade (1949-1995)
200
175
150
125
100
75
50
25
0
Purchasing Power Parity (PPP)
The purchasing-power parity theory is the simplest and
most widely accepted theory explaining the variation of
currency exchange rates.
According to the purchasing-power parity theory, a
unit of any given currency should be able to buy the
same quantity of goods in all countries.
Intuition for PPP
In an open economy, I have the choice of buying
an orange in Australia or an orange from
Indonesia and importing the orange back to
Australia.
If transport costs are low, the price of traded
goods should be the SAME, once we translate
into a common currency.
This is called the law of one price.
Purchasing-Power Parity
• Law of one price
– When converted to a common currency value
through the exchange rate, the price of identical
goods should be the same across countries:
Pd = E x Po/s,
• Where Pd is the domestic price, Po/s is the
foreign price and E is the exchange rate.
Tips for preparing for the exam
•
•
•
Practice. Do the problems in the back of the
book chapters. Do the problems on the book’s
website. Do the problems in the study guide.
Read the question. Read carefully.
Answer the question. Don’t answer the
question you think was asked. Answer the
question that actually was asked. Most exam
errors happen here. Remember to read the
question.
Tips for preparing for the exam
•
•
•
Be sure to answer all of the question.
Don’t put down too much. Don’t provide a
whole background of a model unless the
question asks for it. If the question asks you to
analyse a scenario, go straight into the
scenario.
Don’t put down too little. In an essay
question, provide your reasoning and analysis.
Draw a relevant graph and talk about the
graph. Don’t just say “Yes.”
Final exam tip
• Don’t panic! Relax and breath. You do
not need to write for 3 hours to do well in
an economics exam. Often a well-ordered
sentence is worth more than 2 pages of
semi-coherent babbling. Stop and think
about your answer.