Week 1, Part 1: Introduction to Macroeconomics:
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Introduction to ECON1002: content and structure
Introduction to macroeconomics
Outline
Introduction to ECON1002: content and structure
Introduction to macroeconomics
What is macroeconomics? I
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Unit designed to introduce "macroeconomics" and provide tools to
analyze key "macroeconomic policy issues"
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Canvas site and UoS overview
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Structured essay
3/4
Outline
Introduction to ECON1002: content and structure
Introduction to macroeconomics
What is macroeconomics? I
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Concerned with broad themes: GDP, In‡ation, Unemployment
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What happens to the economy in the short-run: one-four years, i.e.
business cycles
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What happens to the economy in the long run
4/4
Week 1, Part 2: Measuring macroeconomic
performance: output
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Gross domestic product
Real GDP is not the same as economic wellbeing
Next week (Week 2)
Outline
Gross domestic product
Real GDP is not the same as economic wellbeing
Next week (Week 2)
Gross domestic product: measuring the nation’s output I
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De…nition: Gross domestic product (GDP) is the market value of the
…nal goods and services produced in a country during a given period.
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Market value
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Price times quantity.
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What about public goods and services?
As per this de…nition, what goods and services are not part of GDP
and why?
Example: Bread production
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To make a loaf of bread, a farmer grows wheat and sells it to the
miller for $0.50, the miller grinds the wheat into ‡our and sells to the
baker for $1.20 and the baker makes the ‡our into bread and sells it
for $2.00.
3 / 22
Australia’s historical GDP experience I
4 / 22
Real GDP increases because we are using more inputs.. I
Cross-country comparison. Source: OECD
5 / 22
Real GDP per capita I
What is the standard of living of an "average Australian"? Source:
World Bank
6 / 22
Output per hour worked or average labour productivity I
7 / 22
Female labour participation rate in Australia: Impact on
GDP? I
8 / 22
How to measure GDP? Three approaches I
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Three ways of measuring GDP
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Value-added method
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Expenditure method
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Income method
9 / 22
Example I
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Example: Steel-Car
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An economy with just two …rms: Steel company and Car company
10 / 22
Value-added method for GDP I
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Value-added is what the …rm adds to the value of the produced
inputs it buys from other …rms i.e. value of the …rm’s output less
value of purchases of intermediate goods (i.e. produced inputs)
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What do we sometimes need to use the "value-added" approach?
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"Bread" Example
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"Steel-Car" example
11 / 22
Value-added method for GDP II
12 / 22
The expenditure method for measuring GDP I
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All current production by …rms must be either:
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bought by households, other …rms, government and foreigners; or
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left unsold as inventories bought by the …rm which makes it.
13 / 22
The expenditure method for measuring GDP (contd) I
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Components of the expenditure method:
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C: Consumption expenditure. Spending by households on goods and
services, not including spending on new houses (around 55% of total
GDP on average)
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I: Investment. Spending by …rms on new buildings, machinery and
inventories, plus spending by households on new houses (23%)
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G: Government expenditure. Spending by federal, state and local
governments on goods and services (22%)
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NX: Net exports. Expenditure on exports (X) minus expenditure on
imports (M) (net 0%)
GDP = Y = C + I + G + NX
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Examples: Bread and Steel-Car?
14 / 22
The income method for measuring GDP I
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When a good or service is sold, the revenues from the sale are
distributed to the workers and the owners of the capital involved in
the production.
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GDP also equals labour income (wages) plus capital income
(pro…ts/rent/interest) from the production.
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Example: Steel-Car
15 / 22
Why the expenditure and income approaches give the same
answer? I
Circular ‡ow of Income
16 / 22
Since output is being evaluated at market prices, we need
to be careful about Nominal vs real GDP I
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Nominal GDP is current production at ‘current prices’.
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Problem: It can mislead when comparing GDP over time.
Real GDP is current production at ‘base year prices’.
17 / 22
Example: Prices and quantities in 2007 and 2013 I
18 / 22
Growth rate of Real vs Nominal GDP: Australia I
19 / 22
Growth rate of real GDP I
20 / 22
Outline
Gross domestic product
Real GDP is not the same as economic wellbeing
Next week (Week 2)
Real GDP is not the same as economic wellbeing I
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Leisure time is excluded.
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Non-market economic activities are excluded.
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Environmental quality and resource depletion are excluded.
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Quality of life is excluded.
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Poverty and economic inequality is excluded.
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Real GDP is nevertheless closely related to economic wellbeing.
21 / 22
Outline
Gross domestic product
Real GDP is not the same as economic wellbeing
Next week (Week 2)
Next week, Week 2 I
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What you should now be able to discuss:
GDP, di¤erent ways of measuring it; circular ‡ow of income, nominal
versus real GDP
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BOF (5th edition) Chapters 3 and 4
22 / 22
Week 2, Part 1: Measuring macroeconomic
performance: prices
BOF Chapter 3
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Consumer Price Index
In‡ation
Interest rates
Outline
Consumer Price Index
In‡ation
Interest rates
Measuring the price level: Consumer Price Index I
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A CPI is a measure of the weighted average of the percentage
change in the prices paid by households for a …xed basket of goods
and services
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CPI …gures are produced by the Australian Bureau of Statistics
(ABS) for each quarter (three months ending March, June,
September and December
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CPI results appear on the ABS website: https://www.abs.gov.au.
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Since 2018, annually re-weighting items in the basket
3 / 19
Pandemic and its impact on weights I
https://www.abs.gov.au/statistics/research/2020-annual-re-weightaustralian-consumer-price-index
4 / 19
Calculating CPI: an example I
5 / 19
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What are the weights of the 3 goods in the example?
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Suppose, movie once a week, 2 hamburgers a week and lights are
burning 12 hours per day.
Compute the following: "weighted average of the percentage change
in prices"
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The way CPI is calculated is basically an application of Laspeyres
index: weighted average of price changes through time
6 / 19
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Alternatively, compute the following:
CPI =
Cost of base-year basket in current year
Cost of base-year basket in base year
7 / 19
Using CPI for "de‡ating" I
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CPI can be used to convert nominal into real via a process called
"de‡ating"
8 / 19
Using CPI for Indexing I
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CPI can be used to convert real into nominal via a process called
"indexing"
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Example:
9 / 19
Outline
Consumer Price Index
In‡ation
Interest rates
INFLATION I
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In‡ation rate is the annual percentage rate of change in the average
price level, as measured by the CPI for example.
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In‡ation rate in December 2013
CPIDec2013 CPIDec2012
x100
CPIDec2012
10 / 19
Australia’s rate of in‡ation I
11 / 19
What about other countries? I
12 / 19
In‡ation is di¤erent from relative prices I
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In‡ation is di¤erent from relative price (price of one good relative to
other goods).
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If some prices rise while others remain constant, there is both a
change in relative prices and a positive rate of in‡ation.
If some prices rise while others fall, there is a change in relative
prices, but the rate of in‡ation may be zero, positive or negative,
depending on the relative frequency of price rises and falls.
13 / 19
However, does the CPI measure "true" in‡ation? I
The CPI overstates the actual level of in‡ation in the economy for two
signi…cant reasons:
1. Quality adjustment bias
2 Substitution bias
14 / 19
Why dont we like too much in‡ation? I
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Shoe leather costs
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Noise in the price system
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Distortions of the tax system
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Unexpected redistribution of wealth
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Interference with long-run planning
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Menu costs
15 / 19
Outline
Consumer Price Index
In‡ation
Interest rates
In‡ation and interest rates I
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In‡ation and interest rates are closely linked.
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Interest rates are among the most important variables in the
economy.
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Interest rates are managed by the central bank: in Australia, by the
Reserve Bank of Australia
16 / 19
In‡ation and interest rates I
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Real interest rate (r ): The percentage increase in the real
purchasing power of a …nancial asset.
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re‡ect the true cost of borrowing
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Nominal interest rate (i ): The percentage increase in the nominal,
or dollar, value of a …nancial asset.
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The Fisher equation
r =i
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π
What determines real interest rate? will see shortly!
17 / 19
De‡ation I
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De‡ation is a sustained fall in the average price level.
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Problem: It can lead to high real interest rates, and high real interest
rates discourage important expenditure types such as a …rm’s
investment in plant and equipment.
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Aside: Money, unlike other …nancial assets, pays no nominal interest
rate.
18 / 19
De‡ationary episodes I
19 / 19
Week 2, Part 2: Measuring macroeconomic
performance: saving and investment
BOF Chapter 4
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Saving
Saving by households
National Saving
Investment
Investment by …rms
Investment across sectors
Saving, investment, and the …nancial markets
Next week (Week 3)
Outline
Saving
Saving by households
National Saving
Investment
Investment by …rms
Investment across sectors
Saving, investment, and the …nancial markets
Next week (Week 3)
Outline
Saving
Saving by households
National Saving
Investment
Investment by …rms
Investment across sectors
Saving, investment, and the …nancial markets
Next week (Week 3)
Household saving I
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Saving (current income minus spending on current needs) is a ‡ow,
measured per unit of time
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Why do people save?
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Life-cycle saving
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Precautionary saving
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Bequest saving
What is the reward for saving? the real interest rate
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The higher the interest rate, the more attractive saving is, as the
higher the bene…t received from saving.
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The real interest rate is the rate at which the purchasing power of
the asset increases
3 / 17
Savings and wealth I
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Saving is closely related to wealth (assets-liabilities) or net worth,
which is a stock, measured at a point in time
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Capital gains: Increases in the value of existing assets
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Capital losses: Decreases in the values of existing assets
∆wealth = Saving + Capital gains – Capital losses
4 / 17
Household wealth in Australia I
5 / 17
Low saving rates (household saving as a fraction of
disposable income) I
6 / 17
Outline
Saving
Saving by households
National Saving
Investment
Investment by …rms
Investment across sectors
Saving, investment, and the …nancial markets
Next week (Week 3)
Components of National saving: three sectors of the
economy I
7 / 17
Measuring national saving I
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Recall our national income accounting identity:
GDP = Y = C + I + G + NX
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For simplicity, let NX = 0 (closed economy)
Y = C +I +G
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National saving is current income less spending on current needs.
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What part of this spending is just for current needs?
8 / 17
Private and public saving I
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If all of C and G is spending on current needs and NX = 0, national
saving becomes:
S =Y C G
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Private saving
Sprivate = Y
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T
C
Public saving
Spublic = T
G
9 / 17
Who is saving in Australia? Source: Bishop and Cassidy
(2012) RBA Bulletin I
10 / 17
Why national saving is important? I
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Saving …nances future investment
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If domestic savings low, must borrow from overseas . . . risky?
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National savings can provide a bu¤er against …nancial crisis
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But excessive savings also problematic...
11 / 17
Outline
Saving
Saving by households
National Saving
Investment
Investment by …rms
Investment across sectors
Saving, investment, and the …nancial markets
Next week (Week 3)
Outline
Saving
Saving by households
National Saving
Investment
Investment by …rms
Investment across sectors
Saving, investment, and the …nancial markets
Next week (Week 3)
Investment decision by …rms I
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What factors determine whether and how much …rms choose to
invest?
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The investment decision is made based on the cost–bene…t principle.
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Invest: Marginal cost of investment < Marginal bene…t of investment
Key determinant of the level of investment: real interest rate
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either as borrowing cost or opportunity cost of internal funds
12 / 17
Outline
Saving
Saving by households
National Saving
Investment
Investment by …rms
Investment across sectors
Saving, investment, and the …nancial markets
Next week (Week 3)
Investment across sectors I
13 / 17
Outline
Saving
Saving by households
National Saving
Investment
Investment by …rms
Investment across sectors
Saving, investment, and the …nancial markets
Next week (Week 3)
The supply and demand for savings I
14 / 17
Changes in the demand for investment I
15 / 17
Changes in the supply of savings I
16 / 17
Outline
Saving
Saving by households
National Saving
Investment
Investment by …rms
Investment across sectors
Saving, investment, and the …nancial markets
Next week (Week 3)
Next week (week 3) I
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What you should now be able to discuss:
I
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I
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What is in‡ation? How is it measured?
In‡ation’s link to interest rates.
The link between S, I and the real interest rate.
NEXT WEEK: BOF Ch 2 (2.5), 5, 6
17 / 17
Week 3, Part 1: Measuring macroeconomic
performance: Unemployment
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Empoyment
Demand for labour
Supply of labour
Labour market
Trends in real wages and employment
Unemployment
Outline
Empoyment
Demand for labour
Supply of labour
Labour market
Trends in real wages and employment
Unemployment
Theory of Employment with perfectly competitive labour
markets I
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What does "perfect competition" mean?
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Supply and demand analysis is used to analyze the labour market.
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Demand for labour comes from employers who use labour to produce
goods and services.
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Supply of labour comes from people who work for pay.
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The price of labour is the wage rate per unit of time
3 / 20
Outline
Empoyment
Demand for labour
Supply of labour
Labour market
Trends in real wages and employment
Unemployment
Deriving the demand for labour: an example I
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How many workers should BCC hire if the wage rate was $60 000
per year? How about $50 000 per year?
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This then gives a relationship between the wage rate labour demand
(labour demand curve)
4 / 20
Demand curve for labour : intutively I
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Diminishing returns to labour
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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, see column (3).
The demand curve for labour is downward sloping.
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The higher the wage, the fewer workers employers will hire.
5 / 20
The demand curve for labour:graphically I
6 / 20
What causes SHIFTS in the demand for labour? I
Some instances
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Change in relative prices
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Change in labour productivity
7 / 20
Outline
Empoyment
Demand for labour
Supply of labour
Labour market
Trends in real wages and employment
Unemployment
Supply of labour I
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Reservation price of working: the minimum payment that you would
accept to work rather than your next best alternative.
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Example:
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Higher the wage, greater is the supply of labour
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Non-wage factors shift the labour supply curve
8 / 20
Labour supply: Graphically I
9 / 20
Outline
Empoyment
Demand for labour
Supply of labour
Labour market
Trends in real wages and employment
Unemployment
Equilibrium in the labour market I
10 / 20
Outline
Empoyment
Demand for labour
Supply of labour
Labour market
Trends in real wages and employment
Unemployment
Trend I. Real wage slow down I
11 / 20
Trend II. Rising wage inequality: First reason is Sectoral
shifts I
12 / 20
II. Rising inequality: Second reason is Globalization I
13 / 20
II. Rising inequality: Third reason is Technological change I
The "routinization of jobs" has resulted in job polarization (hollowing of
the middle). See Autor and co-authors for the analysis of US and Coelli
and Borland (2012) for Australia
14 / 20
What can policy makers do about wage inequality? I
Source: Guvenen, Kuruscu and Ozkan (2014)
15 / 20
Outline
Empoyment
Demand for labour
Supply of labour
Labour market
Trends in real wages and employment
Unemployment
Measuring unemployment I
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Employed (E): worked for at least 1 hour
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Unemployed (U): actively looked for work
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Labour Force (LF) = E + U
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Working age pop. = LF + Not in LF
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Unemployment rate = U/LF
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Participation rate = LF/working age pop.
16 / 20
Unemployment and participation rates I
17 / 20
Types of unemployment I
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Frictional
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Structural
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Job search
Short term
Match skills to vacancies
Long term
Cyclical
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Results from lower economic growth
18 / 20
Impediments to full employment I
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Minimum wage laws
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Labour unions
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Unemployment bene…ts
19 / 20
Cross-country comparison of unemployment rates I
20 / 20
Week 3, Part 2: Short-term Economic
Fluctuations
Chapter 6
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Contraction and expansion
Output gap and Natural rate of unemployment
Okun’s Law
What causes short-run ‡uctuations?
Next week (Week 4)..
Outline
Contraction and expansion
Output gap and Natural rate of unemployment
Okun’s Law
What causes short-run ‡uctuations?
Next week (Week 4)..
The Business Cycle I
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Cycle: Peaks and troughs
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level of GDP (Classical)
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Alternative way of determining business cycle is whether the growth
rate di¤ers signi…cantly from the historical average: growth cycle
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What is a Recession? Recession occurs when contraction is large.
Typically when there is 2 successive quarters of negative GDP
growth.
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Dating business cycle turning points
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National Bureau of Economic Research (US)
https://www.nber.org/cycles.html
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Melbourne Institute (Aust)
https://melbourneinstitute.unimelb.edu.au/publications/macroeconomicreports/phases-of-business-cycles-in-australia
3 / 12
GDP and Unemployment I
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Unemployment increasing during downturns
4 / 12
GDP and In‡ation I
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In‡ation slowing during downturns
5 / 12
Recession after 3 decades.. I
6 / 12
Outline
Contraction and expansion
Output gap and Natural rate of unemployment
Okun’s Law
What causes short-run ‡uctuations?
Next week (Week 4)..
Output gap I
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Output gap and potential output
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Output gap: actual output (Y ) – potential output or
full-employment output (Y )
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What if output falls and inputs are not being fully utilized? Assume
that Y is …xed.
Output gap in percent:
100
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Expansionary gap: Y
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Contractionary gap: Y
Y
Y
Y
Y >0
Y <0
7 / 12
Natural rate of unemployment I
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The natural rate of unemployment (unobservable) U is equal to
frictional plus structural unemployment. So in any economy,
unemployment rate is not zero.
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However, what we observe of the actual unemployment rate U
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An indicator of low utilization of resources
Relationship between U and U. In any .
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U U > 0: There is positive cyclical unemployment and a
contractionary output gap
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U
U < 0: Economy is experiencing an expansionary output gap
8 / 12
Outline
Contraction and expansion
Output gap and Natural rate of unemployment
Okun’s Law
What causes short-run ‡uctuations?
Next week (Week 4)..
Okun’s law I
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How much output is forgone with cyclical unemployment?
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Okun’s law is a quantitative relationship and is "rule of thumb"
In symbols:
Y Y
= β (U U )
100
Y
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β is estimated to be 1.8 in Australia and 2.0 in the U.S.
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Each extra percentage point of cyclical unemployment is associated
with a 1.8 percentage point increase in output gap
9 / 12
Example I
10 / 12
Outline
Contraction and expansion
Output gap and Natural rate of unemployment
Okun’s Law
What causes short-run ‡uctuations?
Next week (Week 4)..
What causes short-run ‡uctuations? I
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In the short-run, potential output remains constant, actual output
may mean we have a recessionary or expansionary gap.
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Firms adjust to short-run changes in demand by simply expanding
their output, keeping constant prices.
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This means that …rms change output in response to demand.
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Governments can help to eliminate output gaps by in‡uencing total
spending.
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Over the long run, changes in prices will bring the economy back to
potential output.
11 / 12
Outline
Contraction and expansion
Output gap and Natural rate of unemployment
Okun’s Law
What causes short-run ‡uctuations?
Next week (Week 4)..
Next week I
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What you should now be able to discuss:
I
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I
I
I
I
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Demand and supply of labour
Unemployment – defns and measurement
Barriers to full employment
The Business Cycle
Okun’s Law
Short vs Long run
NEXT WEEK, Week 4: BOF Ch 7
12 / 12
Week 4, Part 1: Short-run Macro: The Basic
Keynesian Model (Part 1)
BOF Chapter 7
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Introduction to Keynesian Model
Aggregate expenditure
Short-run equilibrium output
Equilibrium in a two-sector model
Paradox of Thrift
Outline
Introduction to Keynesian Model
Aggregate expenditure
Short-run equilibrium output
Equilibrium in a two-sector model
Paradox of Thrift
Introduction I
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John Maynard Keynes
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Main idea: use government policies to e¤ect the level of spending in
the economy. This will reduce or eliminate output gap.
Key assumption of the basic Keynesian model
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prices are …xed: …rms meet demand at preset prices
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why? menu costs
3 / 15
Outline
Introduction to Keynesian Model
Aggregate expenditure
Short-run equilibrium output
Equilibrium in a two-sector model
Paradox of Thrift
PAE and AE I
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Aggregate Expenditure: total spending on …nal goods and services
AE = C + I + G + NX
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Does planned expenditure/spending di¤er from actual spending?
YES
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Only for investment, planned di¤ers from actual investment. For
other components of spending, for simplicity we assume that planned
in the same as actual
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Planned aggregate spending (PAE)
PAE = C + I p + G + NX
(1)
4 / 15
An example to illustrate the di¤erence between planned
and actual I
5 / 15
Outline
Introduction to Keynesian Model
Aggregate expenditure
Short-run equilibrium output
Equilibrium in a two-sector model
Paradox of Thrift
Short-run equilibrium output I
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Short-run equilibrium output is the level of output at which output
equals planned aggregate expenditure
Y = PAE
I
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Another way to see this is when "withdrawals" equals "planned
injections"
S + T + M = Ip + G + X
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Injections (planned): all sources of exogenous expenditure in the
economy
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Withdrawals: part of income not used for consumption purposes
Disequilibrium if Y 6= PAE
6 / 15
Outline
Introduction to Keynesian Model
Aggregate expenditure
Short-run equilibrium output
Equilibrium in a two-sector model
Paradox of Thrift
Consumption function I
7 / 15
Savings function I
8 / 15
Investment function I
9 / 15
The 45-degree line I
10 / 15
The PAE schedule I
11 / 15
Graphical representation of the equilibrium in the short-run
in the Keynesian model I
12 / 15
Short-run equilibrium in a two sector economy using the
alternative view: Injections and Withdrawals I
13 / 15
Outline
Introduction to Keynesian Model
Aggregate expenditure
Short-run equilibrium output
Equilibrium in a two-sector model
Paradox of Thrift
Paradox of thrift I
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An implication of the Keynesian model is that:
I
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an attempt by the community to increase saving (in the short-run)
will fail
the economy will be worse o¤ as a result of the attempt
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Increasing the level of saving (or thriftiness) at each level of income
will shift the consumption function, and therefore PAE, down.
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Equilibrium GDP occurs at a lower GDP, and savings at same level
as before due to a lower Y.
14 / 15
Paradox of thrift, contd I
15 / 15
Week 4, Part 2: Short-run Macro: The Basic
Keynesian Model (Part 2)
BOF Chapter 7
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Short-run equilibrium in a four-sector model
Contraction in the short-run
Multiplier
Stabilization policy
Next week (Week 5)..
Outline
Short-run equilibrium in a four-sector model
Contraction in the short-run
Multiplier
Stabilization policy
Next week (Week 5)..
Components of the 4-sector model I
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A fully-‡edged four-sector model includes:
I
I
I
I
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The
The
The
The
household sector: consumption (C)
…rm sector: planned investment (IP )
government sector: government spending (G)
foreign sector: export (X)
The four-sector PAE is given by:
PAE = C + I p + G + NX
3 / 12
Expenditure components (mathematically) I
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Net taxes consist of an exogenous component unrelated to income,
T̄ , and a second component that is proportional to the level of
income, t:
T = T̄ + tY
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Consumption depends on after-tax income:
C
I
= C̄ + c (Y T )
= C̄ + cY c T̄ ctY
= C̄ c T̄ + c (1 t )Y
Import spending increases with income:
M = mY
4 / 12
Expenditure components (mathematically) II
I
Planned investment I p , government spending G and exports X are
all assumed to be exogenous.
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PAE, therefore with these assumptions about the expenditures, is
PAE = C̄
c T̄ + I p + G + X + (c (1
t)
m )Y
5 / 12
Numerical example: solving for equilibrium output I
Example: distinguish between exogenous expenditure, induced
expenditure and compute Y e
C̄ = 620, c = 0.86, m=0.01, t=0.06, I p =100, G=300, T=250, X =35
6 / 12
Graphical exposition of short-run equilibrium I
7 / 12
Outline
Short-run equilibrium in a four-sector model
Contraction in the short-run
Multiplier
Stabilization policy
Next week (Week 5)..
A decline in planned spending leads to a contraction and
output gap I
8 / 12
Keynesian cross and the recessions I
I
1990 recession in Australia: high interest rate and low consumer
con…dence
I
2020 pandemic induced recession: social distancing and lock-downs
I
Other recessions..
9 / 12
Outline
Short-run equilibrium in a four-sector model
Contraction in the short-run
Multiplier
Stabilization policy
Next week (Week 5)..
De…nition I
I
Income-expenditure multiplier
I
I
The e¤ect of a one-unit increase in exogenous expenditure on
short-run equilibrium output
for example, a multiplier of 5 means that a 10-unit decrease in
exogenous expenditure reduces short-run equilibrium output by 50
units.
I
c : marginal propensity of expenditure on goods and services in a
two sector economy
I
c (1 t ): marginal propensity of expenditure on goods and services
in a three sector economy (closed economy with government).
I
c (1 t ) m: marginal propensity of expenditure on domestically
produced goods and services in a four sector economy
10 / 12
Outline
Short-run equilibrium in a four-sector model
Contraction in the short-run
Multiplier
Stabilization policy
Next week (Week 5)..
Overview I
I
An important outcome of the Keynesian model is that contractions
and recessions are caused by inadequate demand.
I
Policies used to a¤ect planned aggregate expenditure, to eliminate
output gaps, are called stabilization policies.
I
I
Expansionary policies are government policy actions intended to
increase planned spending and output.
Contractionary policies are government policy actions designed to
reduce planned spending and output.
11 / 12
Outline
Short-run equilibrium in a four-sector model
Contraction in the short-run
Multiplier
Stabilization policy
Next week (Week 5)..
Next week I
I
What you should now be able to discuss:
I
I
Short-run analysis using the Keynesian model
NEXT WEEK (Week 5): BOF Ch 8 and 9
12 / 12
Week 5, Part 1: Fiscal Policy (Chapter 8)
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Stabilization role of Fiscal Policy
Fiscal policy in the Keynesian model
How can …scal policy be used to eliminate an output gap?
Other roles of …scal policy
Government de…cit and debt
Income inequality
Demographic change
Next (chapter 9)..
Outline
Stabilization role of Fiscal Policy
Fiscal policy in the Keynesian model
How can …scal policy be used to eliminate an output gap?
Other roles of …scal policy
Government de…cit and debt
Income inequality
Demographic change
Next (chapter 9)..
Outline
Stabilization role of Fiscal Policy
Fiscal policy in the Keynesian model
How can …scal policy be used to eliminate an output gap?
Other roles of …scal policy
Government de…cit and debt
Income inequality
Demographic change
Next (chapter 9)..
Keynesian model I
I
Two main components of …scal policy in the PAE
(= C + I p + G + NX ) are:
I
government purchases (G ) which have a direct impact on PAE
I
taxes (T̄ + tY ) and transfer payments (Q) that impact PAE
indirectly via consumption (= C̄ + c (Y T )).
I
T = (T̄
Q ) + tY
3 / 21
Outline
Stabilization role of Fiscal Policy
Fiscal policy in the Keynesian model
How can …scal policy be used to eliminate an output gap?
Other roles of …scal policy
Government de…cit and debt
Income inequality
Demographic change
Next (chapter 9)..
Contractionary gap in the example from last week I
c = .85 and t = 0.06
4 / 21
An increase in government purchases eliminates a
contractionary gap I
I
Since G is the exogenous component of spending, changing G by the
same amount as the drop in PAE will eliminate output gap
5 / 21
A cut in the tax rate "t" can eliminate a contractionary
gap I
I
Changing taxes will impact PAE indirectly. It will impact a
component of spending …rst, in this case C
I
c = .85 and t = 0.06. Assume also that NX = 0 and Q = 0
6 / 21
A cut in the tax rate "t" can eliminate a contractionary
gap II
I
PAE = C̄ + c (Y
T̄
tY ) + I p + G
7 / 21
Balanced budget multiplier I
I
Balanced budget: a balance between government spending and tax
revenue
I
Consider a case where there is an increase in spending and to pay for
that spending and keep the budget balanced, there is also a change
in net taxes. What will be the impact on output? Will it remain
unchanged?
I
No: Changes in G will directly impact PAE, but changes in taxes will
impact PAE depending on how much is spent (in this case, will
depend on the marginal propensity to consume, c).
I
The short-run e¤ect on equilibrium output because of a change in
government expenditure and net taxes is the "balance budget
multiplier."
8 / 21
The e¤ect of the baby bonus on PAE I
I
Consider a transfer payment Q of 5 million. What is the impact on
PAE if MPC is c=0.85?
I
But to keep its budget balanced, the government also reduces it
spending by 5 million.
9 / 21
Fiscal policy as a stabilisation tool: other considerations I
I
Fiscal policy and the supply side
I
Example: The Fiscal Stimulus package in Australia during the GFC
also included spending on roads, schools etc which would may also
a¤ect the potential output
I
Presence of automatic stabilizers: automatic changes in government
spending and revenue when output/income changes
I
Typically, it was believed that …scal policy is relatively in‡exible.
However, it is being used much more often
I
I
I
1930s, Japanese slump, GFC, and the recent pandemic
In most developed countries, monetary policy is constrained by the
zero lower bound.
Concerns about government spending and its impact on de…cits (see
next slide)
10 / 21
Budget de…cits I
11 / 21
Impact of COVID spending on public debt in 2020 I
https://www.imf.org/external/datamapper/G_XWDG_G01_GDP_PT@FM/ADVEC/FM_EMG/FM_LIDC
12 / 21
Outline
Stabilization role of Fiscal Policy
Fiscal policy in the Keynesian model
How can …scal policy be used to eliminate an output gap?
Other roles of …scal policy
Government de…cit and debt
Income inequality
Demographic change
Next (chapter 9)..
Other roles of Fiscal Policy I
Three key roles of …scal policy in Australia today are:
1. managing public debt
2. a¤ecting income distribution
3. responding to demographic change
13 / 21
Outline
Stabilization role of Fiscal Policy
Fiscal policy in the Keynesian model
How can …scal policy be used to eliminate an output gap?
Other roles of …scal policy
Government de…cit and debt
Income inequality
Demographic change
Next (chapter 9)..
How to …nance government spending? I
I
Government budget constraint refers to the concept that
government spending has to be …nanced either by raising taxes or by
government borrowing.
Gt + Qt
T
rBt 1 = Bt
Bt 1
I
There is then a relationship between budget de…cit and government
debt
I
A desirable level of public debt?
I
Low debt reduces crowding out
I
Intergenerational equity
I
Bene…ts of public spending – infrastructure.
14 / 21
Outline
Stabilization role of Fiscal Policy
Fiscal policy in the Keynesian model
How can …scal policy be used to eliminate an output gap?
Other roles of …scal policy
Government de…cit and debt
Income inequality
Demographic change
Next (chapter 9)..
Income inequality: how to measure it? I
I
Lorenz curve: graphical representation
I
Gini coe¢ cient: summary measure of inequality
I
the line of equality and the Lorenz curve
Gini= area between
total area under the line of equality
15 / 21
What is the gini coe¢ cient? I
I
In Australia the Gini coe¢ cient is 0.34 in 2014 (World Bank) and it
was 0.28 in 1981.
I
In most countries, except a few (Sweden), the gini coe¢ cient has
increased.
I
African countries, very high (close to 0.5).
16 / 21
How to compute the Lorenz curve: an example I
I
Assume that there are 100 households in total. The total income in
the economy is $2,660.
I
To draw the Lorenz curve we have to …rst calculate the cumulative
income earned
17 / 21
How to reduce inequality I
I
First, is lower income inequality desirable?
I
I
There is a …ne balance between equity-incentive.
Fiscal policy in‡uences the distribution of income by
I
I
Progressive income taxes
Transfer payments
18 / 21
An example to show how progressive taxation reduces
inequality I
I
Compute the average tax rate (100*(total tax paid/income)) for a
given annual income
19 / 21
Outline
Stabilization role of Fiscal Policy
Fiscal policy in the Keynesian model
How can …scal policy be used to eliminate an output gap?
Other roles of …scal policy
Government de…cit and debt
Income inequality
Demographic change
Next (chapter 9)..
Demographic change I
I
Australia’s population is expected to increase from 20.5 million in
2006 to 24.5 million in 2048.
I
Declining fertility rates and increased longevity means that people
65-and-over are likely to go from 13% of the population to 28% in
that time.
I
Impact of these demographics on both revenue and expenditure
(health care costs; old age pension and other insurance programs)
20 / 21
Outline
Stabilization role of Fiscal Policy
Fiscal policy in the Keynesian model
How can …scal policy be used to eliminate an output gap?
Other roles of …scal policy
Government de…cit and debt
Income inequality
Demographic change
Next (chapter 9)..
Next week I
I
What you should be able to discuss now
I
I
Fiscal policy (duing recessions and otherwise) and money,
commercial banks and how they create money
Next topic in Week 5 (Chapter 9)
21 / 21
Week 5, Part 2: Money, Prices and RBA
(Chapter 9)
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
How does the …nancial system allocate savings to productive uses?
What are the principal uses of money and how do we measure it?
What role do commercial banks play in money (M1) creation?
What is the relationship between money supply and the general level of
prices?
Next week (Week 6)
Outline
How does the …nancial system allocate savings to productive uses?
What are the principal uses of money and how do we measure it?
What role do commercial banks play in money (M1) creation?
What is the relationship between money supply and the general level of
prices?
Next week (Week 6)
Banks and their role I
I
Banks play an important role via …nancial intermediation
I
Stand between savers and investors
I
Pool saving of small savers; only need to evaluate each large loan
request once.
I
Asymmetric information
I
Help identify productive borrowers
I
Provide access to credit that may otherwise be unavailable (e.g. to a
small business)
3 / 17
What is a bond? I
I
A legal promise to repay a debt: principal + interest payments.
I
I
Issued by governments
Issued by …rms
I
The coupon rate: rate at time bond issued (not to be confused with
the prevailing interest rate).
I
Coupon payment (if annual) = principal x coupon rate
4 / 17
The price of a Bond: an example I
I
Tanya purchases a two-year bond with a principal amount of $1000
and the price of the bond is $1000. It has a coupon rate of 5% per
annum. Calculate the total earnings from this bond
I
Tanya wants to sell her bond at the end of year 1 after receiving her
…rst coupon payment. How much can she expect to get if the
prevailing interest rate is now 6%? How about 4%?
I
At current interest rates of 6% the buyer will recieve $1050 after 1
year. To calculate then the bond price
I
I
If current interest rates are 4%, the principal to be paid is:
I
I
$1050 = Bond price x 1.06; that is a bond price of $990.57.
$1050 = Bond price x 1.04; that is a bond price of $1010.
A general principle is that bond prices and interest rates are inversely
related.
5 / 17
What is a Stock? I
I
Stock refers to a claim to partial ownership of a …rm.
I
Stockholders receive returns on their …nancial investment in two
forms.
I
I
A dividend (a regular payment received by stockholders for each
share that they own).
Shareholders also receive returns in the form of capital gains when
the price of their stock increases in the stock market.
6 / 17
Stock Pricing I
I
If you expect a $1 dividend and the market price of the stock will be
$80 in one year, you should pay
I
I
I
If you expect a $5 dividend and a $80 stock price in one year, you
should pay
I
I
I
Stock price x 1.06 = $85
Stock price = $85/1.06 = $80.19
A higher expected dividend, higher is the stock price today
I
I
Stock price x 1.06 = $81
Stock price = $81/1.06 = $76.42
Note in the above example the interest rate is the rate on a safe
asset.
What if the stock was risky?
I
Stock price x 1.16 = $81
7 / 17
Outline
How does the …nancial system allocate savings to productive uses?
What are the principal uses of money and how do we measure it?
What role do commercial banks play in money (M1) creation?
What is the relationship between money supply and the general level of
prices?
Next week (Week 6)
Money and its uses I
I
Money has 3 uses:
I
I
I
Medium of exchange: an asset used in purchasing goods and services
Unit of account: measuring value
Store of value:
8 / 17
How do we measure money? I
I
How is money measured?
I
I
I
Currency: notes & coins issued minus holdings of notes and coins by
all banks and the Reserve Bank
M1: currency + current bank deposits (money held in cheque and
savings accounts)
M3: M1 + deposits of private non-banks
9 / 17
Outline
How does the …nancial system allocate savings to productive uses?
What are the principal uses of money and how do we measure it?
What role do commercial banks play in money (M1) creation?
What is the relationship between money supply and the general level of
prices?
Next week (Week 6)
Money supply and role of commercial banks I
I
Money supply consists of currency and also bank deposits.
I
I
Therefore the amount of money partly depends on the behaviour of
commercial banks and their depositors.
Key concept: Bank Reserves. Why do banks hold a fraction of their
deposits as reserves?
I
to meet the demand of withdrawals
10 / 17
Quick look at the balance sheet of the bank I
I
Assets (currency) + loans = liabilities (deposits)
I
Bank reserves not part of money supply
I
Desired "Reserve-deposit" ratio = reserves/deposits
I
I
deposits=reserves/RD ratio
Reserves/deposit ratio falls
I
I
I
Deposits increase
Money supply increases
Money multiplier: 1/(RD ratio)
11 / 17
Quick look at the balance sheet of the bank: an example I
12 / 17
Outline
How does the …nancial system allocate savings to productive uses?
What are the principal uses of money and how do we measure it?
What role do commercial banks play in money (M1) creation?
What is the relationship between money supply and the general level of
prices?
Next week (Week 6)
In the long-run I
I
There is a close link between the amount of money circulating in the
economy and the general level of prices.
I
A rapidly growing supply of money leads to quickly rising prices, i.e.
in‡ation.
13 / 17
Quantity theory of money I
I
The quantity equation is an identity that states that the nominal
value of expenditure (PY ) in the economy must be equivalent to the
stock of money (M ) multiplied by its velocity of circulation (V ).
MV
I
So what is velocity? Velocity is a measure of the amount of
expenditure that can be …nanced from a given amount of money
over a particular time period.
V =
I
PY
I
PY
M
The higher this ratio, the higher the speed at which money circulates.
14 / 17
Quantity theory of money: in the long run I
I
Assumptions:
I
I
I
If V depends on payment technologies and is approximately constant
over the period of interest; and
Real output, Y , is approximately constant during the period of
interest, then:
M V̄ = P Ȳ
Example: If M were to increase by 10%, there would be a
corresponding increase in P of 10%
15 / 17
Money growth, in‡ation, real GDP growth, 1960-1990 in
110 countries I
16 / 17
Outline
How does the …nancial system allocate savings to productive uses?
What are the principal uses of money and how do we measure it?
What role do commercial banks play in money (M1) creation?
What is the relationship between money supply and the general level of
prices?
Next week (Week 6)
Next week I
I
What you should be able to discuss now
I
I
Role of Banks; relationship between money and prices
NEXT WEEK: BOF Ch 9.6 and 10
17 / 17
Week 6, Part 1: The RBA and the Economy
Ch 9.6 and Ch 10.1
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Current stance of the Monetary Policy
Monetary policy in normal times
Transmission of monetary policy
An overview
How is the cash rate set?
Impact of cash rate on other interest rates
RBA and the real interest rate
Outline
Current stance of the Monetary Policy
Monetary policy in normal times
Transmission of monetary policy
An overview
How is the cash rate set?
Impact of cash rate on other interest rates
RBA and the real interest rate
Current stance of the Monetary Policy I
I
Speech by the Governor Philip Lowe:
https://www.rba.gov.au/media-releases/2021/mr-21-04.html
3 / 13
Current stance of the Monetary Policy II
I
"The Board will not increase the cash rate until actual in‡ation is
sustainably within the 2 to 3 per cent target range. For this to
occur, wages growth will have to be materially higher than it is
currently. This will require signi…cant gains in employment and a
return to a tight labour market. The Board does not expect these
conditions to be met until 2024 at the earliest"
4 / 13
Outline
Current stance of the Monetary Policy
Monetary policy in normal times
Transmission of monetary policy
An overview
How is the cash rate set?
Impact of cash rate on other interest rates
RBA and the real interest rate
RBA in normal times I
I
https://www.rba.gov.au/
I
The RBA is Australia’s central bank, and has two main
responsibilities
I
I
I
maintaining stability of the currency, which is regarded as
maintaining low in‡ation via monetary policy
oversight and regulation of …nancial markets
Monetary policy is now conducted by the RBA directly targeting
interest rates (conventional monetary policy)
I
unconventional monetary policy: forward guidance, quantitative
easing
5 / 13
Outline
Current stance of the Monetary Policy
Monetary policy in normal times
Transmission of monetary policy
An overview
How is the cash rate set?
Impact of cash rate on other interest rates
RBA and the real interest rate
Outline
Current stance of the Monetary Policy
Monetary policy in normal times
Transmission of monetary policy
An overview
How is the cash rate set?
Impact of cash rate on other interest rates
RBA and the real interest rate
Overiew of the transmission of monetary policy I
6 / 13
Cash rate in Australia and Policy rates in other countries I
7 / 13
Outline
Current stance of the Monetary Policy
Monetary policy in normal times
Transmission of monetary policy
An overview
How is the cash rate set?
Impact of cash rate on other interest rates
RBA and the real interest rate
How is the cash rate set? I
I
Commercial banks hold reserves in exchange settlement accounts
(ESA) with the RBA.
I
Banks don’t want to have to keep more reserves than needed in
these ESAs as they pay zero or very low interest rate
I
Use the overnight cash market (overnight cash rate) to meet their
transactionary need if they run low
I
I
commercial banks borrow and lend money for very short periods of
time in order to manage their balances in the ESAs.
How is this related to MP?
I
I
I
Suppose the cash rate is higher than the target cash rate.
RBA wants to lower the cash rate. How does it do that?
Conducts open-market purchase: Suppose RBA purchases bonds
(or …nancial assets) from Bank A, it credits Bank A’s exchange
settlement account. Bank A has excess reserves. The excess reserves
in the system will in turn lowers the cash rate
8 / 13
How is the cash rate set? II
I
Suppose the cash rate is lower than the target? The RBA sells
bonds to Bank B, debits Bank B’s ESA. This reduces the reserves
and is called open-market sale.
I
These operations by the RBA are called Open Market Operations
9 / 13
Outline
Current stance of the Monetary Policy
Monetary policy in normal times
Transmission of monetary policy
An overview
How is the cash rate set?
Impact of cash rate on other interest rates
RBA and the real interest rate
Consider 90-day bills market I
Recall: (i) Bonds don’t have to be held till maturity and (ii) Bond prices
and interest rates are inversely related
10 / 13
RBA increases the cash rate: impact on the 90-day bill
market I
I
If the cash rate has increased; other interest rates also increase!
11 / 13
Cash rate and other interest rates I
12 / 13
Outline
Current stance of the Monetary Policy
Monetary policy in normal times
Transmission of monetary policy
An overview
How is the cash rate set?
Impact of cash rate on other interest rates
RBA and the real interest rate
Can the RBA control real interest rates? I
I
The Reserve Bank controls the nominal interest rate through
open-market operations.
I
However, many important decisions such as saving and investing are
based on the real interest rate.
r =i
π
I
The real interest rate, r , is the nominal rate, i, minus the in‡ation
rate, π
I
Some economists believe that the central bank can in‡uence the
nominal interest rate in the very short-run when prices are …xed
I
In the long-run however the real interest rate is determined by the
saving-investment decisions as discussed earlier
13 / 13
Week 6, Part 2: The RBA, output gap and
in‡ation
(Chapter 10)
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
How does the RBA eliminate output gap?
How does the RBA …ght in‡ation?
Policy reaction function
In 2 weeks
Outline
How does the RBA eliminate output gap?
How does the RBA …ght in‡ation?
Policy reaction function
In 2 weeks
PAE and the real interest rate I
I
A fall in interest rate increases household consumption expenditure
through:
I
I
I
discouraging households to save more as the reward for saving
decreases
encouraging household spending that would be …nanced by credit
A fall in interest rates increases planned investment expenditure
through:
I
I
lowering the cost of borrowing, increasing the pro…tability of business
investment in capital equipment
lowering the cost of mortgages for residential housing
3 / 10
Example I
In an economy described by:
C = 640 400r + 0.8(Y
I p = 250 600r
G = 300
X = 20
T = T̄ = 250
T)
4 / 10
RBA …ghs a recession by running an "expansionary policy"
I
I
Recessionary gap=200; multiplier=...; How much should be the
increase in exogenous spending component of PAE? Let the interest
rate be initially 5%
5 / 10
Does lower interest rate always increase spending by
households? I
I
Not really....
I
I
Households may raise saving for precautionary reasons.
They might try to repay their debt instead
6 / 10
Outline
How does the RBA eliminate output gap?
How does the RBA …ght in‡ation?
Policy reaction function
In 2 weeks
RBA …ghts in‡ation via a contractionary policy I
I
Suppose the potential is 4600 instead
I
If demand continues to be high, there might be an upward pressure
on prices
7 / 10
Outline
How does the RBA eliminate output gap?
How does the RBA …ght in‡ation?
Policy reaction function
In 2 weeks
Policy reaction function I
I
Policy reaction function is a simple mathematical representation of
how the Reserve Bank adjusts interest rates in light of the state of
the economy.
I
Taylor rule (1993): ) found that a rule that linked the output gap
and the in‡ation rate (in decimal) to the real interest rate (in
decimal) for the US Federal Reserve Bank under Alan Greenspan
worked well
rt = 0.01 + 0.5(
I
Yt
Y
Y
) + 0.5(π t
πT )
And
it = rt + π t
I
Example: in‡ation is 5% and output gap is zero. What should be
the real and nominal interest rates? For simplicity that the target
πT = 0
8 / 10
Policy reaction function (prf) I
9 / 10
Outline
How does the RBA eliminate output gap?
How does the RBA …ght in‡ation?
Policy reaction function
In 2 weeks
Next week I
I
What you should now be able to discuss:
I
I
RBA: how it eliminates output gap and …ghts in‡ation
In 2 weeks: BOF Ch 11 and 12
10 / 10
Week 8, Part 1: Aggregate Demand-Aggregate
Supply Model
Chapter 11
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
What is the aggregate demand curve?
What is the aggregate supply curve?
Demand shocks and in‡ation shocks
Why is the cash rate at 0.10 percent? I
3 / 24
Why is the cash rate at 0.10 percent? I
Recall
rt = 0.01 + 0.5( Y tY Y ) + 0.5(π t
π T ) and it = rt + π t
4 / 24
Outline
What is the aggregate demand curve?
What is the aggregate supply curve?
Demand shocks and in‡ation shocks
What is the aggregate demand curve? I
I
Endogenous negative e¤ect of high in‡ation on planned
spending/output
I
Higher in‡ation leads RBA to raise interest rates according to policy
reaction function, resulting in lower consumption/investment
I
Higher in‡ation also reduces real value of nominal assets (e.g.,
money holdings), possibly lowering consumption
I
Higher in‡ation can reduce real value of …xed income payments for
retirees, possibly lowering consumption
I
Higher in‡ation can increase uncertainty, possibly lowering
consumption
I
Higher in‡ation can increase price of exports, possibly lowering
exports
I
Vice versa for lower in‡ation
5 / 24
This is the aggregate demand curve I
6 / 24
What causes the aggregate demand curve to shift? I
I
A change in planned spending other than that which is caused by
in‡ation
I
Exogenous changes (other than changes in output and interest rate)
in consumption, investment, government spending, and exports
I
I
e.g. technological improvements, foreigners wanting to buy domestic
goods
Exogenous changes in the policy reaction function
7 / 24
Exogenous increase in spending other than due to a
change in in‡ation I
8 / 24
Exogenous change in the Reserve bank’s in‡ation policy
reaction function I
9 / 24
...but why does in‡ation change in the …rst place? I
I
First, in‡ation changes very slowly, hence persistent (“inertial")
I
I
I
due to public’s expectations
long-term wage and price contracts
But it is also a¤ected by the output gap and “cost-push" shocks
10 / 24
Self-ful…lling in‡ation expectations I
11 / 24
The Phillips curve I
I
Mathematically:
π t = π et + γ(
I
Yt
Y
Y
) + et
(1)
“Accelerationist” assumption for expectations: π et = π t 1 =)
∆π t = γ(
Yt
Y
Y
) + et
(2)
where γ > 0 is the slope of the Phillips Curve
I
Cost-push shock, et , captures exogenous forces such as large
changes in oil prices
I
Thus, in‡ation changes when the economy is above/below potential
and/or there is a cost-push shock
12 / 24
Outline
What is the aggregate demand curve?
What is the aggregate supply curve?
Demand shocks and in‡ation shocks
What is the aggregate supply curve? I
I
Endogenous e¤ect of output on in‡ation
I
Based on the Phillips curve:
I
I
I
I
an expansionary gap leads to rising in‡ation
a contractionary gap leads falling in‡ation
at potential output leads to medium and stable in‡ation
There are actually two aggregate supply curves!
I
I
I
In the very short run, no e¤ect of output on in‡ation
) SRAS curve is horizontal at the current level of in‡ation
Expansionary/contractionary gaps cause in‡ation to rise/fall
) SRAS curve shifts up/down
In the long run, output is at potential regardless of in‡ation
) LRAS is vertical
13 / 24
These are the two aggregate supply curves! I
14 / 24
What causes the short-run aggregate supply curve to shift?
I
I
Exogenous changes in spending (eg. …scal spending)
I
Exogenous in‡ation shocks (e.g., oil price spikes, exogenous changes
in expectations)
I
Endogenous changes in in‡ation expectations (∆π et = ∆π t 1 )
I
SRAS curve doesn’t like to stay still unless ∆π t = 0!
I
This only happens when Y = Y (i.e., the economy is on the LRAS
curve)
15 / 24
Exogenous changes in aggregate supply (e.g., Oil price
spike) I
16 / 24
Increase in in‡ation expectations I
17 / 24
Decrease in in‡ation expectations I
18 / 24
Bringing it all together I
I
In “General Equilibrium”, aggregate demand equals aggregate supply
I
When economy is in long-run equilibrium, Y = Y and π = π e
) ∆π t = 0, rt = r̄ (e.g., 0.01 in reaction function in eqn. 10.2)
I
Shocks push the economy away from potential in the short run to
short-run equilibrium with contractionary/expansionary gap
I
Shock captured by an initial shift in either AD or SRAS curve
I
Economy returns back to potential in the long run because:
I
I
Output gap causes in‡ation to adjust via the Phillips Curve
(price/wage setting) )SRAS curve shifts
As in‡ation changes, the RBA adjusts interest rate, causing output
to change ) movement along the AD curve
19 / 24
Outline
What is the aggregate demand curve?
What is the aggregate supply curve?
Demand shocks and in‡ation shocks
A positive demand shock (e.g., a housing boom) I
20 / 24
An in‡ation shock (e.g., a dramatic rise or fall in oil prices)
I
21 / 24
Adjustment back to the long-run equilibrium I
I
Regardless of source of shock, self-correcting adjustment is same:
I
1. Output gap causes in‡ation to adjust via the Phillips Curve
(price/wage setting) ) =)AS curve shifts
I
2. As in‡ation changes, the RBA adjusts interest rate, causing
output to change ) =)movement along AD curve
22 / 24
Adjustment back to long-run equilibrium from
expansionary gap I
23 / 24
Adjustment back to long-run equilibrium from
contractionary gap I
24 / 24
Week 8, Part 2: Aggregate Demand-Aggregate
Supply Model and Macroeconomic Policy
Chapter 12
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Stabilisation Policy and In‡ation Targeting
Shocks to Potential Output and the “Great In‡ation”
Fiscal Policy and the Supply side
AD/AS and COVID-19
Next Week, Week 9
Outline
Stabilisation Policy and In‡ation Targeting
Shocks to Potential Output and the “Great In‡ation”
Fiscal Policy and the Supply side
AD/AS and COVID-19
Next Week, Week 9
Stabilisation policy and in‡ation targeting I
I
RBA has an in‡ation target of 2-3%, but also seeks to stabilise the
output gap (“dual mandate”)
I
In conducting monetary policy, it evaluates shocks that it thinks are
hitting the economy
I
Given lags in e¤ect of policy, response depends on whether shock is
seen to be short-lived or persistent
I
Typically, the RBA will “look through” short-lived shocks (e.g.,
Queensland ‡oods)
I
For persistent demand shocks, RBA believes self-correction of
economy too slow and could lead in‡ation away from target
) policy response shifts AD curve
For persistent in‡ation shocks, RBA lets the economy self correct
) policy response moves along the AD curve
I
I
Fortunately, in‡ation targeting appears to speed up self correction by
anchoring in‡ation expectations: π et = π̄ instead of π et = π t 1
3 / 20
“Leaning against the wind" for a persistent negative
demand shock I
4 / 20
...compared to self correction I
5 / 20
Accommodative (“Dovish") response to an adverse
in‡ation shock I
6 / 20
...compared to response to an adverse in‡ation shock
under in‡ation targeting (and anchored expectations) I
7 / 20
Outline
Stabilisation Policy and In‡ation Targeting
Shocks to Potential Output and the “Great In‡ation”
Fiscal Policy and the Supply side
AD/AS and COVID-19
Next Week, Week 9
Shocks to potential output I
I
A reduction in resources available represents an adverse aggregate
supply shock
I
However, it shifts both the SRAS curve up and LRAS to the left
I
Thus, it leads to higher in‡ation, but no further adjustment, all else
equal
8 / 20
A negative shock to potential (e.g., productivity growth
slowdown) I
9 / 20
The ”Great In‡ation" and lessons learned I
I
Many economists believe the “Great In‡ation" in the 1970s was due
to policy mistakes
I
Mistakes were in terms of overly optimistic beliefs about potential
output and a lack of focus on in‡ation
I
This led to wage/price spirals and “stag‡ation"
I
In‡ation targeting provides a nominal anchor that keeps in‡ation
expectations low and stable
I
Credibility requires “hawkish" response to adverse aggregate supply
shocks
10 / 20
The “Great In‡ation” I
11 / 20
The “Great In‡ation’I
12 / 20
The “Great In‡ation’I
13 / 20
In‡ation targeting in Australia I
14 / 20
Outline
Stabilisation Policy and In‡ation Targeting
Shocks to Potential Output and the “Great In‡ation”
Fiscal Policy and the Supply side
AD/AS and COVID-19
Next Week, Week 9
Fiscal policy and the supply side I
I
As discussed in the Keynesian model, …scal policy a¤ects aggregate
demand by in‡uencing planned spending
I
However, it likely also has supply-side e¤ects that can alter potential
output
I
Empirically questionable how large these e¤ects are (depends on the
elasticity of labour supply)
I
Research suggests relative e¤ects are “state dependent", with much
larger AD e¤ects in contractionary gap than at potential
15 / 20
A cut in marginal tax rates I
16 / 20
Outline
Stabilisation Policy and In‡ation Targeting
Shocks to Potential Output and the “Great In‡ation”
Fiscal Policy and the Supply side
AD/AS and COVID-19
Next Week, Week 9
16 / 20
AD/AS and COVID-19 I
I
COVID-19 represents both an adverse aggregate supply shock and a
larger aggregate demand shock
I
Zero lower bound (ZLB) on interest rates means monetary cannot
easily stimulate AD and the economy won’t easily “self-correct"
I
Fiscal policy: multipliers and social insurance
17 / 20
What the RBA would like to do... I
18 / 20
Summary I
I
AD/AS model provides a useful framework for thinking about
transmission of di¤erent shocks to output and in‡ation
I
In‡ation targeting has been successful in anchoring in‡ation
expectations, but requires “hawkish" response to in‡ation shocks
I
Fiscal policy can have demand and supply-side e¤ects, but estimates
suggest demand dominates, especially in contractionary gaps
I
COVID-19 can be understood through lens of AD/AS model, but
ZLB means economy won’t “self-correct"
19 / 20
Outline
Stabilisation Policy and In‡ation Targeting
Shocks to Potential Output and the “Great In‡ation”
Fiscal Policy and the Supply side
AD/AS and COVID-19
Next Week, Week 9
Next Week, Week 9 I
I
Next week: BOF Ch 14-15 (Economic growth and aggregate
production)
20 / 20
Week 9, Part 1: Economic Growth and
Aggregate Production
BOF Chapter 13
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Economic growth in perspective
Labour productivity and growth
Costs of growth and growth policies
What drives economic growth? I
3 / 16
Di¤erent hypotheses I
I
Population
I
C(K)apital
I
Resource extraction
I
Geography
I
Policy and institutions
I
Technology and ideas
4 / 16
A virtual in…nity of ideas I
I
Objects (e.g., silicon dioxide) vs. ideas (e.g., using sand for
computer chips instead of beaches)
I
Ideas are non-rivalrous (E = mc 2 )
I
People create ideas, although obviously not all are good!
5 / 16
Outline
Economic growth in perspective
Labour productivity and growth
Costs of growth and growth policies
What causes the aggregate demand curve to shift? I
I
Long-run growth is ultimately more important for standards of living
than business cycles
I
Considerable heterogeneity in real per capita GDP across countries
I
Long-run growth represents a rightward shift in potential GDP in the
AS/AD model
6 / 16
Long-run growth vs. business cycles I
7 / 16
Distribution of GDP per capita in 2018 across countries I
8 / 16
Long-run growth in the AS/AD Model I
9 / 16
Outline
Economic growth in perspective
Labour productivity and growth
Costs of growth and growth policies
The Crucial role of Labour productivity in countries
becoming rich I
I
What determines a country’s growth rate?
I
Let Y denote real GDP, N denote population, and L denote the size
of the labour force
I
Then, real per capita GDP can be decomposed into labour
productivity and the participation rate (share of population that is
working):
Y
L
Y
=
N
L
N
I
Both have increased over the past 50 years, but labour productivity
much more so
10 / 16
Real per capita GDP and labour productivity in Australia I
11 / 16
Real per capita GDP and labour-force participation rate in
Australia I
12 / 16
Labour productivity and labour-force participation rate in
Australia I
13 / 16
Determinants of labour productivity I
I
Human capital
I
Physical capital
I
Land and other natural resources
I
Technology
I
Entrepreneurship and management
I
Political and legal environment
14 / 16
Outline
Economic growth in perspective
Labour productivity and growth
Costs of growth and growth policies
Costs of growth and growth policies I
I
A high saving rate means foregone consumption (“Golden rule”
capital stock)
I
R&D is costly and is incentivized by patents that restrict use of ideas
I
Environmental degradation
15 / 16
Policies to support growth I
I
Public education
I
Public investment in infrastructure
I
Subsidies for basic research
I
Property rights
16 / 16
Week 9, Part 2: Production function approach to
understaning growth
BOF Chapter 14
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Capital, labour, and aggregate production
The aggregate production function
Growth accounting
Next week (Week 10)
Outline
Capital, labour, and aggregate production
The aggregate production function
Growth accounting
Next week (Week 10)
Capital I
I
The physical capital stock (K) is accumulated from net investment
I
Capital takes time to accumulate and to produce output with, but
must be paid for up front
I
Thus, …rms often borrow to purchase capital and the opportunity
cost of investment is the real interest rate, r
I
Willingness to pay a real interest rate depends on the “marginal
product of capital", MPK
I
How much does an extra unit of capital increase output?
I
Key principle: there is a diminishing marginal productivity of capital
K "=) MPK #
3 / 20
How many shovels do you need to dig a ditch? I
4 / 20
Labour I
I
Labour (L) supply is often measured in hours, not number of people
I
It can be changed at the intensive and extensive margin
I
Labour demand is downward sloping because of the diminishing
marginal product of labour, MPL :
L "=) MPL #
I
In a competitive labour market, labour will be paid a real wage equal
to it marginal product
W
MPL =
P
5 / 20
Aggregate production I
I
The two key factors of production for aggregate output are capital
and labour
I
Everything else (e.g., land, technology, institutions, human capital,
ideas) can be lumped together as “total factor productivity"
I
We can think about a production function by looking at the output
that would be produced for di¤erent inputs of capital and labour
I
We will consider tabular, graphical, and mathematical
representations of a production function
6 / 20
Production Table I
7 / 20
Surface plot I
8 / 20
Plot holding L …xed (at L = 3 in this case) I
9 / 20
Mathematically I
Yt = At F (Kt , Lt )
I
Yt is output at time t, At is “total factor productivity" at time t, Kt
is capital at time t, and Lt is labour hours at time t
I
F () is a function that captures the relationship between capital and
labour leading to higher output, but also diminishing marginal
products of capital and labour (i.e., F 0 () > 0; F 00 () < 0)
I
An example of a widely-used explicit function is the Cobb-Douglas
production function:
Yt = At Ktα , L1t α
10 / 20
Outline
Capital, labour, and aggregate production
The aggregate production function
Growth accounting
Next week (Week 10)
The Cobb-Douglas aggregate production function I
I
Robert Solow and others proposed using the Cobb-Douglas
production function to describe the economy as a whole
Yt = At Ktα L1t
α
I
Story of Douglas and Cobb!
I
Why does it work so well?
I
It represents theoretical concepts that might be reasonable. Lets
look at them
11 / 20
Properties of the Cobb-Douglas aggregate production
function I
I
Replicability (constant returns to scale): 2Yt = At (2Kt )α , (2Lt )1
I
Marginal product of capital:
∂Yt
= αAt Ktα 1 L1t
∂Kt
I
I
α
α
Yt
MPK = α K
: diminishing marginal productivity of capital
t
K "=) MPK #
Marginal product of labour:
∂Yt
= (1
∂Lt
I
α)At Ktα Lt
α
MPL = (1 α) YLtt : diminishing marginal productivity of labour
L "=) MPL #
12 / 20
Properties of the Cobb-Douglas aggregate production
function II
I
Marginal products and distribution of income in the economy
W
L = (1
α )Y
capital and labour shares of income should be constant
I
Real wages should increase with labour productivity and
13 / 20
Real wages and labour productivity I
14 / 20
Capital share I
15 / 20
Outline
Capital, labour, and aggregate production
The aggregate production function
Growth accounting
Next week (Week 10)
Capital share I
I
Again due to Robert Solow, winner of the 1987 Nobel Prize in
Economics
I
Output growth separated into components due to capital growth,
labour supply growth, and total factor productivity (TFP) growth
∆Yt
∆Kt
=α
+ (1
Yt 1
Kt 1
I
∆A t
A t 1 is
∆Lt
∆At
+
Lt 1
At 1
growth of TFP (a.k.a. "Solow residual") and is measured as
∆Yt
∆At
=
At 1
Yt 1
I
α)
α
∆Kt
Kt 1
(1
α)
∆Lt
Lt 1
TFP growth is generally more important for overall economic growth
than capital accumulation
16 / 20
Shares of average 3.2 percent real GDP growth in
Australia between 1980-2013 I
17 / 20
The role of TFP over time and across countries
(”productivity growth slowdown" in the 1970s) I
18 / 20
Krugman’s (1994) “inspiration vs. perspiration"
questioning of the Asian growth miracle I
19 / 20
Outline
Capital, labour, and aggregate production
The aggregate production function
Growth accounting
Next week (Week 10)
Next week I
I
What you should be able to discuss:
I
I
I
I
I
Given diminishing marginal productivity of capital, economic growth
per capita is largely driven by TFP growth
TFP re‡ects policy and institutions, technology and ideas
Growth policies should target labour productivity (e.g., public
education to increase human capital)
The aggregate production function provides a useful construct to
think about economic growth
Next week: BOF Ch 15
20 / 20
Week 10, Part 1: The Solow-Swan Model of
Economic Growth
BOF Chapter 15
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Saving, investment, and capital accumulation
Solow-Swan model
Outline
Saving, investment, and capital accumulation
Solow-Swan model
Saving, investment, and capital accumulation I
I
Capital accumulation results from investment
I
Investment is ultimately …nanced by saving
I
Total saving (private and public) equals investment for the world as
a whole
I
Mathematically, Y = C + I + G (closed-economy or world as a
whole)
S private + (T
)S
G)
= I
total
= I
3 / 14
Review from Ch. 4: real interest rate balances investment
demand based on MPK and saving I
4 / 14
Outline
Saving, investment, and capital accumulation
Solow-Swan model
Solow-Swan model and the aggregate production function I
I
The key building block of the model is the aggregate production
function from Ch. 14:
Y = AF (K , L)
I
To solve model, we need production function in per capita terms
(assuming, for simplicity, the whole population is employed L = N):
Y
= AF
L
K L
,
L L
)
Y
= Af
L
K
L
I
Follows from constant returns to scale (replicability): multiplying
factors by (1/L) leads to (1/L)Y
I
Per capita output Y /L depends positively on per capita capital
K /L, but with diminishing marginal product
I
Graphically equivalent to when we plot a slice of the production
function for Y and K given …xed L
5 / 14
Per capita production function and diminishing marginal
productivity of capital MPK I
6 / 14
What determines per capita output? I
Y
= Af
L
K
L
I
Total factor productivity A and per capita capital K /L determine
per capita output Y /L
I
Given A, we can solve for unique K /L at which per capita output
Y /L is neither increasing nor decreasing, but is in “steady state”
I
We will do this mathematically …rst and then graphically
7 / 14
Solving the Solow-Swan model mathematically (I) I
I
Consider the two components of per capita investment
I
I rep
I net
=
+
L
L
L
I
I rep is replacement investment needed to keep the per capita capital
(K /L) unchanged given depreciation and population growth
I
I net is net investment that leads to per capita capital accumulation
if positive or a decrease in per capita capital if negative:
∆
I
K
L
=
I net
,∆
L
∆( ) denotes “change” – i.e., ∆( KLtt )
K
L
=
Kt
Lt
I rep
L
I
L
Kt
Lt
1
1
8 / 14
Solving the Solow-Swan model mathematically (II) I
I
For simplicity, assume constant saving rate θ (e.g., 0.3), depreciation
rate d (e.g., 0.05), and population growth rate n (e.g., 0.02)
I
A constant saving rate θ could re‡ect perfect inelasticity of saving
supply w.r.t. the real interest rate and implies per capita investment:
Y
I
=θ
L
L
I
Constant depreciation rate d and population growth rate n imply per
capita replacement investment:
I rep
K
= (d + n )
L
L
I
Thus, the change in per capita capital K /L is mathematically
determined by:
K
Y
K
∆
=θ
(d + n )
L
L
L
9 / 14
Solving the Solow-Swan model mathematically (III) I
I
Per capita capital K /L will remain unchanged when per capita
investment is equal to per capita replacement investment:
K
L
∆
I
Y
K
= (d + n )
L
L
“Steady-state” per capita capital (K /L) depends on particular
production function. E.g., Cobb-Douglas:
Y = AK α L1
I
=0)θ
α
)
Y
=A
L
K
L
α
L 1
L
α
=A
K
L
α
Substitute into steady-state equation and solve for (K /L)
θA
K
L
α
K
= (d + n ) )
L
K
L
=
θA
d +n
1
1 α
10 / 14
Mathematical predictions of the Solow-Swan model I
I
E.g., Cobb-Douglas production function implies steady-state per
capita income:
α
1 α
θA
Y
=A
L
d +n
I
Depends positively on TFP, saving rate θ, and capital share α, but
negatively on depreciation rate and population growth rate
11 / 14
Solving the Solow-Swan model graphicallyl I
I
Easier to solve graphically given more general production functions
I
Production function only needs to exhibit diminishing marginal
productivity of capital to imply unique steady state given K > 0
12 / 14
Production and saving functions I
13 / 14
Convergence to steady state I
14 / 14
Week 10, Part 2: The Solow-Swan Model of
Economic Growth: Model predictions and
empirical evidence
BOF Chapter 15
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Model predictions and empirical evidence
The importance of TFP for long-run growth
Next week (Week 11)
Outline
Model predictions and empirical evidence
The importance of TFP for long-run growth
Next week (Week 11)
Two key model predictions I
I
Capital accumulation cannot generate sustained long-run growth on
its own due to diminishing marginal productivity of capital
I
There will be convergence of per capita incomes as returns to capital
accumulation will be higher in poor countries than rich countries
3 / 14
Di¤erent returns to capital accumulation I
4 / 14
Di¤erent returns to capital accumulation I
5 / 14
Empirical Evidence I
I
There is mixed empirical evidence for convergence across countries
I
There seem to exist “growth clubs” that converge to distinct steady
states based on di¤erent institutions and policies (e.g., “open”
economies with fewer trade restrictions)
I
There has been convergence in income per person across the world
due to China and India
6 / 14
Convergence? I
7 / 14
Convergence in high income countries since 1970? I
8 / 14
Convergence in high income countries since 1970? I
9 / 14
Convergence in the world’s open ecoomies I
10 / 14
Convergence for people not countries? I
11 / 14
Outline
Model predictions and empirical evidence
The importance of TFP for long-run growth
Next week (Week 11)
The importance of TFP for long-run growth I
I
Again, per capita output depends on TFP and per capita capital
K /L:
K
Y
= Af
L
L
I
Given that capital accumulation does not lead to sustained long-run
growth on its own, TFP growth must play the lead role
I
As TFP increases, it generates further capital accumulation towards
a new higher steady state
I
Economic and political institutions are important for TFP
I
However, technological change is the most plausible source of
ongoing increases in TFP
12 / 14
Technology and steady state in the Solow-Swan model I
13 / 14
Outline
Model predictions and empirical evidence
The importance of TFP for long-run growth
Next week (Week 11)
Next week, Week 11 I
I
What you should be able to discuss:
I
I
I
I
I
I
I
Solow-Swan model makes predictions about the role of saving and
investment on economic growth
A higher saving rate will increase steady-state per capita income, but
will not generate sustained growth due to diminishing MPK
However, di¤erent returns to capital accumulation for labour
productivity predict convergence of income per person
There is some empirical support for convergence, especially
conditioning on institutions and policy
Sustained long-run growth due to technological change and capital
accumulation that results from it
Solow-Swan model can be used to understand long-run trends
economic activity across countries
Next time: BOF Ch 17
14 / 14
Week 11, Part 1: Exchange Rates
BOF Chapter 17
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
The nominal exchange rate
The real exchange rate
Theory of purchasing power parity
Outline
The nominal exchange rate
The real exchange rate
Theory of purchasing power parity
The nominal exchange rate I
I
The nominal exchange rate is the price of a currency–e.g., Japanese
Yen (JPY)–in terms of other currencies
I
There are bilateral nominal exchange rates between the Australian
dollar (AUD) and most other currencies in the world
I
The Australian dollar is the …fth most traded currency in the world
3 / 16
Most traded currencies I
4 / 16
The nominal exchange rate I
I
Any bilateral exchange rate can be expressed in two ways.
E.g.,AUD/JPY or JPY/AUD
I
Focus on price of the Australian dollar in terms of the foreign
currency (e.g., AUD/JPY, called the "Yen-Dollar exchange rate")
I
This price increases when AUD appreciates and decreases when AUD
depreciates
5 / 16
Price of AUD in terms of JPY (1 AUD=83 JPY) I
6 / 16
Price of JPY in terms of AUD (1 JPY=0.012 AUD) )(1
AUD=83 JPY) I
7 / 16
More exchange rates I
I
Given two bilateral exchange rates (e.g., JPY/AUD and MXN/JPY),
a third (e.g., MXN/AUD) can be determined
I
Also useful to look at a trade-weighted exchange rate index (TWI)
based on basket of bilateral exchange rates
I
This price increases when AUD appreciates and decreases when AUD
depreciates
8 / 16
Price of JPY in terms of AUD (1 JPY=0.012 AUD) I
9 / 16
Price of MXN in terms of JPY (1 MXN=5.55 JPY)
)(MXN/JPY)(JPY/AUD)=5.550.012 )(1 MXN=0.067
AUD) I
10 / 16
Price of MXN in terms of AUD (1 MXN=0.067 AUD) I
11 / 16
Australian TWI (2010-2020, 1970=100) I
12 / 16
Outline
The nominal exchange rate
The real exchange rate
Theory of purchasing power parity
The real exchange rate I
I
A real exchange rate is a measure of the price of the average
domestic good in terms of the average foreign good
q=
I
I
I
I
P
eP
= f
P f /e
P
q is the real exchange rate
e is the nominal exchange rate (price of AUD in terms of foreign
currency–e.g., AUD/JPY)
P is the domestic CPI and P f is the foreign CPI
Real exchange rate accounts for di¤erent rates of in‡ation across
countries in measuring the purchasing power of the Australian dollar
13 / 16
Purchasing Power of the Australian Dollar I
I
Thus, q captures purchasing power of the Australian dollar in terms
of how much $1 of Australian goods will trade for Japanese goods
I
If q is higher, then Australian goods are worth (cost) relatively more
than Japanese goods
I
Typically a high real exchange rate will raise imports and lower
exports (q "=)net exports# )
14 / 16
Outline
The nominal exchange rate
The real exchange rate
Theory of purchasing power parity
Purchasing Power Parity I
I
PPP theory depends on the "law of one price" which is that is the
transport costs are relatively small then the price of an
internationally traded commodity must be the same
I
"law of one price" will mean that the real exchange rate should be 1
I
E.g., price of computer in Australia = price of computer in Japan
when measured in the same currency
I
PPP does not hold due to transportation costs, nontraded goods,
and other border e¤ects ("How wide is the border?")
I
However, PPP helps explain why countries cannot perpetually
depreciate currency ("beggar thy neighbour") to boost net exports
I
Ongoing depreciation requires in‡ationary monetary policy, meaning
real exchange rates will not fall as much as nominal exchange
15 / 16
PPP in practice I
16 / 16
Week 11, Part 2: Exchange Rates
BOF Chapter 17
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
A supply and demand model of the exchange rate
Monetary policy, …xed exchange rates, and currency crises
Next week
Outline
A supply and demand model of the exchange rate
Monetary policy, …xed exchange rates, and currency crises
Next week
A supply and demand model of the exchange rate I
I
Australian households and …rms supply AUD on the foreign
exchange (FX) market (usually via banks)
I
Supply of AUD on FX market due to desire to purchase foreign
goods or assets
I
Foreign households and …rms demand AUD from the FX market
I
Demand for AUD on FX market due to desire to purchase Australian
goods or assets
I
"Fundamental value" of exchange rate is market-clearing price e at
which quantity supplied equals quantity demanded
3 / 17
FX market I
4 / 17
Supply and demand shifters in the FX market I
I
Supply:
1. Preferences for foreign goods and services (see graph)
2. Increase in real GDP (implies more demand for imports)
3. Increase in relative returns on foreign assets
I
Demand:
1. Foreign preferences for Australian goods and services
2. Increase in global economic activity (implies more demand for
exports)
3. Increase in relative returns on Australian assets (e.g., rise in domestic
interest rates)
I
Volatility of exchange rates due to impact of expectations for future
activity
5 / 17
Shift in supply I
6 / 17
Outline
A supply and demand model of the exchange rate
Monetary policy, …xed exchange rates, and currency crises
Next week
Monetary policy and the exchange rate I
I
A change in the monetary policy interest rate directly a¤ects both
supply and demand in the FX market
I
An increase in the policy rate decreases supply and increases demand
(see graph)
I
This leads to an appreciation of the exchange rate
I
For open economies, the exchange rate and its e¤ect on net exports
provide an important transmission channel of monetary policy
I
Contractionary policy (r ") causes consumption and investment to
fall, but q " also causes net exports to fall
7 / 17
E¤ect of increase in policy rate in the FX market I
8 / 17
Fixed exchange rates I
I
Historically, many countries have …xed the price of their currency in
terms of other assets (e.g., gold standard), including foreign currency
I
A …xed exchange rate stabilises the real exchange rate, although it
limits independent monetary policy due to "impossible trinity"
I
But unlike in‡ation targeting regimes that "…x" the price of goods
and services and have yet to be abandoned, …xed exchange rate
regimes tend to fail (Obstfeld-Rogo¤ "The Mirage of Fixed
Exchange Rates")
9 / 17
"Impossible Trinity" I
10 / 17
Why do …xed exchange rate regimes tend to fail? I
I
If a …xed exchange rate is di¤erent than the fundamental value, it
implies massive changes in foreign reserves held by the central bank
I
Undervaluation leads to reserve accumulation, while overvaluation
leads to reserve depletion (see graph)
I
FX markets like to test overvalued …xed exchange rates by
conducting "speculative attacks"
I
These cost speculators little if unsuccessful, but lead to big payo¤ if
central bank devalues to avoid running out of foreign reserves
I
This is how George Soros got rich(er) betting against the UK staying
in the EMS (…xed-exchange rate system leading up to the Euro)
I
Speculative attacks can become self-ful…lling prophecies (see graph)
11 / 17
An overvalued exchange rate I
12 / 17
A speculative attack I
13 / 17
The challenge of defending a currency I
I
Without in…nite reserves, central banks eventually have to raise
interest rates to defend a …xed exchange rate (see graph)
I
This can lead to severe economic contraction and political unrest
I
Argentina and Turkey went through such currency crises in recent
times
I
In already weak economies, policy interest rates were raised by more
than 10 percentage points to defend currencies
I
But exchange rates still depreciated, with many loans contracted in
foreign currencies (real debt ")
I
IMF provided $30b (USD) loan facility to the Argentine government
"without conditions"
14 / 17
Defending the currency I
15 / 17
Fixed, ‡ oating, or currency union? I
I
Open-economy Keynesian "Mundell-Fleming" model suggests
countries facing AD shocks bene…t from ‡oating exchange rates
I
Allows independent monetary policy that is more powerful due to
exchange rate transmission channel
I
But Robert Mundell, winner of the 1999 Nobel Prize, also did
research on optimal currency areas
I
Common business cycles and labour mobility important
I
Europe?
16 / 17
Outline
A supply and demand model of the exchange rate
Monetary policy, …xed exchange rates, and currency crises
Next week
Fixed, ‡ oating, or currency union? I
I
Summary
I
I
I
I
I
I
I
The nominal exchange rate is determined by supply and demand in
the FX market
The real exchange rate measures to the purchasing power of a
currency
Purchasing power parity does not hold in the short run
Monetary policy in an open economy is helped by a ‡oating
exchange rate
A …xed exchange rate can stablise the real exchange rate and
in‡ation
But …xed exchange rate regimes leave countries particularly prone to
speculative attacks and typically fail at some point
Next week: Trade balances and capital ‡ows: BOF Ch 18
17 / 17
Week 12, Part 1: Trade balances and capital
‡ows
BOF Chapter 18
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
The balance of payments
Capital ‡ows
Outline
The balance of payments
Capital ‡ows
The balance of payments I
I
Why are there so many transactions in the foreign exchange market
that involve Australian dollars?
I
To answer this, we need to think about the current account and the
capital account
I
Together, these two accounts make up the balance of payments
between residents of Australia and the rest of the world
3 / 19
The current account I
I
The current account records all transactions in a year that involve an
exchange of goods and services or income and transfer payments
between Australia and the rest of the world
I
It is "current" because it relates to output and income in the current
year
I
Payment ‡ows into Australia (corresponding to purchases of AUD in
FX market) are a credit (+) on the current account
I
Payment ‡ows out of Australia (corresponding to sale of AUD in FX
market) are a debit (-) on the current account
I
Exports and imports are recorded at "free on board" values "at the
docks" of the originating country
I
Shipping costs are counted as a service
4 / 19
Examples of current account transactions I
5 / 19
Elements of the current account I
6 / 19
The current account balance for Australia I
I
For most countries, the trade balance is the main component of the
current account
I
That is, a current account de…cit goes hand-in-hand with a trade
de…cit
I
However, for Australia, income payments are a large component of
the current account
I
Even when Australia runs a trade surplus, it typically still has a
current account de…cit due to net ‡ows of income payments (e.g.,
interest, dividends) out of Australia
I
Income payments ‡owing out of Australia are to foreign investors
who hold Australian assets (e.g., Australian government bonds,
equities for Australian companies)
7 / 19
The current account balance and components as a
percentage of GDP I
8 / 19
The capital account I
I
Why are there net ‡ows of income payments out of Australia?
I
The answer lies with the capital account
I
The capital account records all transactions in a year that involve a
transfer of assets between Australia and the rest of the world
I
Assets are claims on future income
I
Capital ‡ows into Australia are a credit (+) on the capital account
I
Capital ‡ows out of Australia are a debit (-) on the capital account
9 / 19
Elements of the capital account I
10 / 19
The capital account balance for Australia I
I
Australia has had net capital in ‡ows (i.e., a capital account surplus)
for many years
I
That is, the rest of the world has purchased a lot of Australian assets
I
Income payments on those assets help explain the current account
de…cit
I
Is this a problem?
I
Depends what Australia did with the proceeds from the sale of
assets (i.e., bonds, equities)
11 / 19
The balance of payments and the exchange rate I
I
The overall balance of payments (BP) depends on the current
account (CAB) and the capital account (KAB):
CAB + KAB = BP
I
If there is an excess supply of domestic currency, BP < 0 and
foreign reserves will be depleted
I
If there is an excess demand for domestic currency, BP > 0 and
foreign reserves will be accumulated
I
Under a ‡oating exchange rate, BP = 0 =) CAB =
I
The capital account balance is just a mirror image of the current
account balance for Australia
KAB
12 / 19
Outline
The balance of payments
Capital ‡ows
Capital ‡ows I
I
Because CAB = KAB for Australia, net capital in‡ows (KAB > 0)
can cause there to be a current account de…cit (CAB < 0)
I
Of course, CAB = KAB also means that a current account de…cit
can cause there to be net capital in‡ows
I
Which is it?
I
Historical movements in interest rates and the exchange rate suggest
it is capital ‡ows causing the current account balance
13 / 19
The relationship between the domestic real interest rate
and capital in‡ows I
14 / 19
The risk of open capital markets I
I
Capital ‡ows can suddenly stop in a crisis
I
Financial crises (e.g., the Asian Crisis and GFC) involve "‡ights to
safety"
I
In general, an increase in the perceived relative risk of domestic
assets can lead to a reduction in capital in‡ows
15 / 19
The relationship between risk and capital in‡ows I
16 / 19
A sudden stop I
I
The risk of a "sudden stop" of capital ‡ows is the inherent problem
with running current account de…cits
I
If KAB #, then CAB "
I
The required sudden increase in the current account can only come
about from:
1. a massive change in net exports (X " and/or M #)
2. default on income payments for assets
I
Or a country can try to attract back capital ‡ows with very high
interest rates
I
But such measures often result in political turmoil and renegotiation
of debt
17 / 19
Asian crisis I
18 / 19
Asian crisis I
19 / 19
Week 12, Part 2: Trade balances and capital
‡ows
BOF Chapter 18
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
The "twin de…cits" phenomenon
Next week
Outline
The "twin de…cits" phenomenon
Next week
The "twin de…cits" phenomenon I
I
A government budget de…cit (T
I
To maintain the same level of investment, a country with a
government budget de…cit needs more capital in‡ows
I
This implies a current account de…cit: i.e., KAB > 0 =) CAB < 0
I
Typically, a higher current account de…cit will occur due to a large
trade de…cit (NX < 0)
I
This is "twin de…cits" phenomenon (government budget de…cit =)
trade de…cit)
I
Better explains trade de…cits than unfair trade practices (a trade war
will not "…x" the U.S. trade de…cit)
I
Consistent with exchange rate appreciations given budget/trade
de…cits
G < 0) reduces national saving
3/6
Australia’s experience I
I
Investment has been higher than national saving for many years
I
This explains the ongoing current account de…cit
I
Capital in‡ows also explain why the AUD is one of the most traded
currencies in the world
I
Is this good or bad?
I
It depends whether the investment led to higher growth to help pay
back foreign investors
I
The mining boom was an example of this seeming to work, although
Australia probably should have saved more at height of boom
4/6
National saving, investment, and the trade balance I
5/6
Outline
The "twin de…cits" phenomenon
Next week
Summary I
I
The balance of payments reveals how trade ‡ows and capital ‡ows
are related
I
Relying on capital in‡ows to …nance investment in physical capital is
risky, but can lead to higher growth
I
The Australian dollar is heavily traded because of capital in‡ows,
mostly in the form of foreign purchases of (dollar-denominated) debt
I
Next Week: Summary and review of key models: BOF Ch 19
6/6
Week 13: Summary and Review
Aarti Singh
University of Sydney
ECON1002 Introductory Macroeconomics
Outline
Review of key models
School of thoughts
Study tips
Future study and career options
Outline
Review of key models
School of thoughts
Study tips
Future study and career options
You may ask yourself, what’s the point of all of these
diagrams? I
I
A key challenge with macro is that everything is simultaneously
determined:
1. Income causes consumption, consumption causes income
2. The output gap causes in‡ation and in‡ation causes the output gap
3. Net investment causes the level of physical capital, physical capital
causes net investment
I
This simultaneity can lead to confusion in trying to reason what
happens when something in the economic environment changes
I
A model is smarter than we are in thinking about simultaneity and
solving for “general equilibrium" in the economy
I
As with Supply/Demand diagram for a given market, the Keynesian
cross, AD/AS, and Solow-Swan diagrams provide convenient ways to
remember how to use the underlying models
3 / 21
Macro Model 1: The Keynesian cross I
4 / 21
A negative wealth shock I
5 / 21
A boost in government spending I
6 / 21
A cut in the tax rate I
7 / 21
Macro Model 2: The AD/AS Model I
8 / 21
Adjustment back to long-run equilibrium from
contractionary gap I
9 / 21
“Leaning against the wind" for a persistent negative
demand shock I
10 / 21
The Global Financial Crisis I
11 / 21
A spike in oil prices I
12 / 21
Macro Model 3: The Solow-Swan model I
13 / 21
An increase in technology I
14 / 21
Macro Model 4: Supply and demand model of the FX
market I
15 / 21
Increase in the policy interest rate I
16 / 21
Fixed exchange rate I
17 / 21
Outline
Review of key models
School of thoughts
Study tips
Future study and career options
Schools of macroeconomic thought I
I
Emphasis on di¤erent models and beliefs about magnitudes of
implied e¤ects vary by “school of thought"
1. Traditional Keynesians emphasize aggregate demand (Keynesian
cross) and stabilization policy
2. Monetarists and New Classicals emphasize AD/AS and expectations
3. New Keynesians also emphasize AD/AS, but consider frictions such
as imperfect competition and sticky prices
4. Growth Theorists and the Real Business Cycle School emphasize
Solow-Swan and technology shocks, although “new growth theory"
also thinks about imperfect competition and innovation
18 / 21
Outline
Review of key models
School of thoughts
Study tips
Future study and career options
Study tips I
I
Go through your notes from lectures
I
In lectures I emphasize what we think is most important and that is
most likely to be on the exam
I
When you are unsure about your knowledge of a concept or model,
use the textbook as a reference (the answer is there!)
I
Review tutorials and practice …nal
I
But questions will not be the exact same, just same format
19 / 21
Outline
Review of key models
School of thoughts
Study tips
Future study and career options
Future study and career options I
I
More advanced courses in macro will cover richer models of business
cycles, long-run growth, and …nancial markets, interactions between
…scal and monetary policy
I
These models and their predictions are used by policy institutions
(e.g., the RBA or Treasury), in …nance, and large businesses
I
There are many careers that make use of economics degrees
(“economist" means many things –e.g., USyd Economics’alumni)
I
A model is just a model, but it allows you to see patterns (e.g.,
…nancial crises) and respond to them (understanding risks)
I
Economic literacy will immunize you from confused or misleading
politicians or conspiracy theories
20 / 21
Thank you and Good Luck!!
21 / 21